MANAGEMENT ACCOUNTINGMANAGEMENT ACCOUNTING      BABASAB PATIL (BEC DOMS)
MANAGEMENT ACCOUNTING                                LESSON – 1                             INTRODUCTIONThe term “Manageme...
MANAGEMENT ACCOUNTINGpolicy and day-to-day operation of an undertaking” – Management Accountingof the Anglo-American to pr...
MANAGEMENT ACCOUNTINGThus all accounting which directly or indirectly providing effective tools tomanagers in enterprises ...
MANAGEMENT ACCOUNTING  2. Target Setting Principle – fixation of an optimum target which is     variously known as standar...
MANAGEMENT ACCOUNTING      operation. It plays an important role in assisting the management in the      creation of polic...
MANAGEMENT ACCOUNTINGmanagement for arriving at appropriate business decisions. They may bedescribed as follows:   1. Modi...
MANAGEMENT ACCOUNTINGManagement Accounting draws upon sources, other than accounting, for suchinformation as is not capabl...
MANAGEMENT ACCOUNTINGLIMITATIONS OF MANAGEMENT ACCOUNTINGComparatively, Management Accounting is a new discipline and is s...
MANAGEMENT ACCOUNTING                                LESSON – 2    FINANCIAL ACCOUNTING AND MANAGEMENT ACCOUNTINGThe terms...
MANAGEMENT ACCOUNTING   in a variety of uses, like flexibility, comparability etc. This difference is so   important that ...
MANAGEMENT ACCOUNTING                                  LESSON – 3             FUNCTIONS OF FINANCIAL CONTROLLERThe gradual...
MANAGEMENT ACCOUNTING       budgets and cost standards, together with the necessary procedure to       effectuate the plan...
MANAGEMENT ACCOUNTINGAs a matter of general principle, all accounting functions, even though remotelyconnected with financ...
MANAGEMENT ACCOUNTING                                 LESSON – 4FINANCIAL STATEMENTS:According to the American Institute o...
MANAGEMENT ACCOUNTING   10.      Economists and investment analysis, etc.                  IMPORTANCE OF FINANCIAL STATEME...
MANAGEMENT ACCOUNTINGImportance of National Economy: The rise & growth of the corporate sector, toa great extent, influenc...
MANAGEMENT ACCOUNTING                                   LESSON – 5   ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTSFi...
MANAGEMENT ACCOUNTINGanalysis gives the management considerable insight into levels and areas ofstrength and weakness. Sin...
MANAGEMENT ACCOUNTINGany increase or decrease in those items. Thus, while in a single Balance Sheetthe emphasis is on pers...
MANAGEMENT ACCOUNTING                   BALANCE SHEET AS ON 31ST DECEMBER                                                 ...
MANAGEMENT ACCOUNTINGSOLUTION:                            Swadeshi Polytex Limited                        COMPARATIVE INCO...
MANAGEMENT ACCOUNTING                            Swadeshi Polytex Limited                       COMPARATIVE BALANCE SHEET ...
MANAGEMENT ACCOUNTINGLiabilities &Capital:Current LiabilitiesBills Payable           50             75           +25      ...
MANAGEMENT ACCOUNTING               FOR THE YEARS ENDED 31ST DECEMBER 1987 AND 1988                                       ...
MANAGEMENT ACCOUNTING3. Trend Percentage: Trend Percentages are immensely helpful in making a   comparative study of the F...
MANAGEMENT ACCOUNTING                                 LESSON – 6                             RATIO ANALYSISMeaning and Nat...
MANAGEMENT ACCOUNTINGsystematic manner. Besides, in order to reach valid conclusions, ratios have tobe compared with some ...
MANAGEMENT ACCOUNTING                                   LESSON – 7PROFITABILITY RATIOS:Profitability is an indication of t...
MANAGEMENT ACCOUNTINGThe term “Operating profit” means “Profit before Interest & Tax.” The term“Interested” means “Interes...
MANAGEMENT ACCOUNTING                       Interest                                               +                  ----...
MANAGEMENT ACCOUNTING     10.        Earnings       Per        Share       (EPS)           =------------------------------...
MANAGEMENT ACCOUNTING                                 LESSON – 8   1. Fixed assets turnover ratio : This ratio indicates t...
MANAGEMENT ACCOUNTINGIn case details regarding and closing receivable and credit sales are notavailable the ratio may be c...
MANAGEMENT ACCOUNTING                   Average monthly or daily credit salesIn fact, the two ratios are interrelated Debt...
MANAGEMENT ACCOUNTING                              Total Purchases                    ----------------------------------  ...
MANAGEMENT ACCOUNTINGCost of goods sold during the year------------------------------------------------------Average inven...
MANAGEMENT ACCOUNTING                   Inventory at the beginning of the accounting period +Inventory at                 ...
MANAGEMENT ACCOUNTING(iii) Price trends: In case of possibility of a rise in prices, a large inventory maybe kept by busin...
MANAGEMENT ACCOUNTING                                 LESSON – 9FINANCIAL RATIOSFinancial Ratios indicate about the financ...
MANAGEMENT ACCOUNTINGhas already been given in the performs analysis balance sheet in the precedingchapter.Book debts outs...
MANAGEMENT ACCOUNTING                                Liquid assets                        ---------------------------     ...
MANAGEMENT ACCOUNTINGThe capacity of the firm to meet the last requirement can be ascertained bycomputing the various cove...
MANAGEMENT ACCOUNTING(b) DEBT-EQUITY RATIO: The debt-equity ratio is determined to ascertain thesoundness of the long-term...
MANAGEMENT ACCOUNTING   1. Simplifies financial statements: Ratio Analysis simplified the      comprehension of financial ...
MANAGEMENT ACCOUNTINGFinancial statements show only historical cost but not market value.The comparision of one firm with ...
MANAGEMENT ACCOUNTINGIllustration 1: Following is the Profit and Loss Account and Balance Sheet of JaiHind Ltd., Redraft t...
MANAGEMENT ACCOUNTING                              BALANCE SHEETLiabilities                    Rs.     Assets             ...
MANAGEMENT ACCOUNTINGDirect Wages                                              2,00,000Manufacturing expenses             ...
MANAGEMENT ACCOUNTINGStock of finished goods                                          1,00,000Current assets              ...
MANAGEMENT ACCOUNTING                        Current liabilities         1,50,000                        External equities...
MANAGEMENT ACCOUNTING                    --------------------------------------------------                = -------------...
MANAGEMENT ACCOUNTING                                   Gross profit            Gross Profit Ratio = ---------------------...
MANAGEMENT ACCOUNTING          Stock               Velocity                                        =     -----------------...
MANAGEMENT ACCOUNTINGCreditor’s Velocity is 2 months, it means that Account Payable are 1/6th of thePurchases for the year...
MANAGEMENT ACCOUNTING                                LESSON – 10                        FUNDS FLOW ANALYSISThe technique o...
Management accounting book
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Management accounting book

  1. 1. MANAGEMENT ACCOUNTINGMANAGEMENT ACCOUNTING BABASAB PATIL (BEC DOMS)
  2. 2. MANAGEMENT ACCOUNTING LESSON – 1 INTRODUCTIONThe term “Management Accounting” is of recent origin. It was first coined bythe British Team of Accountants that visited the U.S.A. under the sponsorship ofAnglo-American Productivity Council in 195 with a view of highlighting utility ofAccounting as an “effective management tool”. It is used to describe themodern concept of accounts as a tool of management in contrast to theconventional periodical accounts prepared mainly for information of proprietors.The object is to expand the financial and statistical information so as to throwlight on all phases of the activities of the organisation.All techniques which aim at appropriate control, such as financial control,budgeted control, efficiency in operations through standard costing,cost-volume-profit theory etc, are combined and brought within the purview ofManagement Accounting.Management Accounting evolves a scheme of accounting which lays emphasison the planning of future (logical forecasting), simultaneously finding thedeviations between the actual and standards. Another significant feature ofManagement Accounting is reporting to top-management. Finally, accountinginformation should be presented in such a way as to assist the management inthe formulation of policy and in the day-to-day conduct of business. Forexample, the published accounts of business concerns do not furnishmanagement with information in a form that suggest the line on whichmanagement policies and actions should proceed. It requires further analysisclassification and interpretation before the management can draw lessons fromthem for their guidance and action.DEFINITION OF MANAGEMENT ACCOUNTINGManagement Accounting may be defined as “the presentation of accountinginformation in such a way as to assist the management in the creation of the BABASAB PATIL (BEC DOMS)
  3. 3. MANAGEMENT ACCOUNTINGpolicy and day-to-day operation of an undertaking” – Management Accountingof the Anglo-American to productivity.The Institute of Chartered Accountants of England has defined it –“Any form of accounting which enables a business to be conducted moreefficiently can be regarded as Management Accounting”.Robert N. Anthony has defined Management Accounting as follows-“Management Accounting is concerned with accounting information that isuseful to management.”According to American Accounting Association, “Management Accountingincludes the methods and concepts necessary for effective planning for,choosing among alternative business actions and for control through theevaluation and interpretation of performance”. This definition is fairlyillustrative.According to Kohler, Forward Accounting includes “Standard costs, budgetedcosts and revenues, estimates of cash requirements, break even charts andprojected financial statements and the various studies required for theirestimation, also the internal controls regulating and safeguarding futureoperating.”Blending together into a coherent whole financial accounting, cost accountingand all aspects of financial management”. He has used this term to include “theaccounting methods, systems and techniques which, coupled with specialknowledge and ability, assist manageme4nt in its task of maximizing profits orminimizing losses.” – James Batty. BABASAB PATIL (BEC DOMS)
  4. 4. MANAGEMENT ACCOUNTINGThus all accounting which directly or indirectly providing effective tools tomanagers in enterprises and government organizations lead to increase inproductivity is “Management Accounting.”OBJECTIVES OF MANAGEMENT ACCOUNTING:The basic objective of Management Accounting is to assist the management incarrying out its duties efficiently.The objectives of Management Accounting are: 1. The compilation of plans and budgets covering all aspects of the business e.g., production, selling, distribution research and finance. 2. The systematic allocation of responsibilities for implementation of plans and budgets. 3. The organization for providing opportunities and facilities for performing responsibilities. 4. The analysis of all transactions, financial and physical, to enable effective comparisons to be made between the forecasts made and actual performance. 5. The presentations to management, at frequent intervals, of up-to-date information in the form of operating statements. 6. The statistical interpretation of such statements in a manner which will be of utmost assistance to management in planning future policy and operation.To achieve the above objectives, Management Accounting employs threeprinciples devices, viz.,- 1. Forward Looking Principle – basis on the past and all other available data, forecasting the future and recommending wherever appropriate, the course of action for the future. BABASAB PATIL (BEC DOMS)
  5. 5. MANAGEMENT ACCOUNTING 2. Target Setting Principle – fixation of an optimum target which is variously known as standard, budget etc., and through continuous review ensuring that the target is achieved or exceeded. 3. The Principle of Exception – instead of concentrating on voluminous masses of data, Management Accounting concentrates on deviations from targets (which are usually known as variances) and continuous and prompt analysis of the causes of these deviations on which to base management action.SCOPE OF MANAGEMENT ACCOUNTING:The scope of Management Accounting is wide and broad based. It encompasseswithin its fold a searching analysis and branches of business operations.However, the following facets of Management Accounting indicate the scope ofthe subject. 1. Financial Accounting. 2. Cost Accounting 3. Budgeting & Forecasting 4. Cost Control Procedure 5. Statistical Methods 6. Legal Provisions 7. Organisation & Methods 1. Financial Accounting: This includes recording of external transactions covering receipts and payments of cash, recording of inventory and sales and recognition of liabilities and setting up of receivables. It also preparation of regular financial statements. Without a properly designed accounting system, management cannot obtain full control and co-ordination. 2. Cost Accounting : It acts as a supplement to financial accounting. It is concerned with the application of cost to job, product, process and BABASAB PATIL (BEC DOMS)
  6. 6. MANAGEMENT ACCOUNTING operation. It plays an important role in assisting the management in the creation of policy and the operation of undertaking. 3. Budgeting & Forecasting: These are concerned with the preparation of fixed and flexible budgets, cash forecast, profit and loss forecasts etc., in co-operation with operating and other departments. Management is helped by them. 4. Cost Control Procedure: It is concerned with the establishment and operation of internal report in order to convert the budget in to operating service. Management is helped by them by measuring actual results budgetary standards of performance. 5. Statistical Methods : These are concerned with generating statistical and analytical information in the form of graphs charts etc. of all department of the organization. Management need not waste time in understanding the facts and more time and energy can be utilized in sound plans and conclusions. 6. Legal Provisions: Many management decisions depend upon the provisions of various laws and statutory requirements. For example, the decision to make a fresh issue of shares depends upon the permission of controller of capital issues. Similarly, the form of published accounts, the external audit the authority to float loans, the computation and verification of income, filing tax returns, making tax payments for excise, sales, payroll income etc., all depend on various rules and regulations passes from time to time. 7. Organization & Methods: They deal with organization, reducing the cost and improving the efficiency of accounting as also of office operations, including the preparation and issuance of accounting and other manuals, where these will prove useful.It is clear that Management Accounting has a vital relation with all those areasexplained above.FUNCTIONS OF MANAGEMENT ACCOUNTING:The functions of management accounting may be said to include all activitiesconnected with collecting, processing, interpreting and presenting informationto management. The Management Accounting satisfies the various needs of BABASAB PATIL (BEC DOMS)
  7. 7. MANAGEMENT ACCOUNTINGmanagement for arriving at appropriate business decisions. They may bedescribed as follows: 1. Modification of Data:Accounting data required for decision – making purposes is supplied bymanagement accounting through resort to a process of classification andcombination which enables to retrain similarities of details without eliminatingthe dissimilarities (e.g.) combination of purchases for different months andtheir breakup according to class of product, type of suppliers, days of purchase,territories etc. 2. Analysis & Interpretation of Data:The data becomes more meaningful with the analysis and interpretation. Forexample, when Profit and Loss account and Balance Sheet data are analyzed bymeans of comparative statements, ratios and percentages,cash-flow-statements, it will open up new directions for its use bymanagement. 3. Facilitating Management ControlManagement Accounting enables all accounting efforts to be directed towardscontrol of destiny of an enterprise. The essential features in any system ofcontrol are the standards for performance and measure of deviation therefrom.This is made possible through budgetary control and standards costing whichare an integral part of Management Accounting. 4. Formulation of Business Budgets:One of the primary functions of management is planning. It is done byManagement Accounting through the process of budgeting. It involves thesetting up of objectives, and the selection of the most appropriate strategies bycomparing them with reference to some discriminating criteria. Probability,Probability, forecasting, and trends are some of the techniques used for thispurpose. 5. Use of Qualitative Information: BABASAB PATIL (BEC DOMS)
  8. 8. MANAGEMENT ACCOUNTINGManagement Accounting draws upon sources, other than accounting, for suchinformation as is not capable of being readily convertible into monetary terms.Statistical compilations, engineering records and minutes of meeting are a fewsuch sources of information. 6. Satisfaction of Informational Needs of Levels of Management:It serves management as a whole according to its requirements it serves topmiddle and lower level managerial needs to subserve their respective needs. Forinstance it has a system of processing accounting data in a way that yieldsconcise information covering the entire field of business activities at relativelylong intervals for the top management, technical data for specialized personnelregularly and detailed figures relating to a particular sphere of activity at shortintervals for those at lower rungs of organizational ladder.The gist of Management Accounting can be expressed thus, it is a part of overall managerial activity – not something grafted on to it from outside – guidingand servicing management as a body, to derive the best return form itsresources, both the itself and for the super system within which it functions.From the above discussions, one may come to the following conclusions aboutthe fundamental approach in Management Accounting.Firstly, the Management Accounting functions is a managerial activity and itputs its finger in very pie without itself making them it guides and aids settingof objectives, planning coordinating, controlling etc. But it does not itselfperform these functions.Secondly it serves management as a whole – top middle and lower level –according to its requirements. But in doing so it never fails in keeping in focusthe macro-approach to the business as a whole.Thirdly, it brings in the concept of cost-Benefits analysis. The basic approach isto split all costs and benefits into two groups – measurable and non measurable.It is easy to deal with measurable costs which are expressed in terms of money.But there are several ventures such as office canteens where the cost-benefitsmay not be monetarily measurable. BABASAB PATIL (BEC DOMS)
  9. 9. MANAGEMENT ACCOUNTINGLIMITATIONS OF MANAGEMENT ACCOUNTINGComparatively, Management Accounting is a new discipline and is still verymuch in a state of evolution. There fore it comes across the same impedimentsas a relatively new discipline has to face-sharpening of analytical tools andimprovement of techniques creating uncertainty about their applications. 1. There is always a temptation to make an easy course of arriving at decision to intuition rather than taking the difficulty of scientific decision-making. 2. It derives its information from financial accounting, cost accounting and other records. Therefore, strength and weakness of Management Accounting depends upon the strength and weakness of basic records. 3. It is one thing to record, interpret and evaluate an objectives historical event converted into money figures, while it is something quite different to perform the same function in respect of post possibilities, future opportunities and unquantifiable situation. Execution of the conclusions drawn by the management accountant will not occur automatically. Therefore, a continuous effort to achieve the goal must be made at all levels of management. 4. Management Accounting will not replace the management and administration. It is only a toll of management. Of course, it will save the management from being immersed in accounting routine and process the data and put before the management the facts deviating from the standard in order to enable the management to take decisions by the rule of exception. BABASAB PATIL (BEC DOMS)
  10. 10. MANAGEMENT ACCOUNTING LESSON – 2 FINANCIAL ACCOUNTING AND MANAGEMENT ACCOUNTINGThe terms financial accounting, and management accounting, are not pricesdescription of the activities they comprise. All accounting is financial in thesense that all accounting systems are in monetary terms and management, ofcourse, is responsible for the content of financial accounting reports. Despitethis close interrelation, there are some fundamental differences between thetwo and they are: 1. Subject Matter : Managements need to focus attention on internal details is the origin of the basic differences between financial accounting and management accounting. In financial accounting, the enterprise as a whole is dealt with while, in management accounting, attention is directed towards various parts of the enterprise which is regarded mainly as a combination of these segments. Thus financial statements, like balance-sheets and income statements, report on the overall status and performance of the enterprise but most management accounting reports are concerned with departments products, type of inventories, sales or other sub-division of business entity. 2. Nature – Financial accounting is concerned almost exclusively with historical records whereas management accounting is concerned with the future plans and policies. Management’s interest in the past is only to the extent that it will be of assistance in influencing company’s future. The historical nature of financial accounting can be easily understood in the context of the purposes for which it was designed but management accounting does not end with the analysis of what has happened in the past and extends to the provision of information for use in improving results in future. 3. Dispatch – In Management Accounting, there is more emphasis on furnishing information quickly then is the case with financial accounting. This is so because up-to-date information is absolutely essential as a basis for management action and management accounting would lose much of its utility if information required the time lag between the end of accounting period and the preparation of accounting records for the same, it has not been, and cannot be, totally eliminated. 4. Characteristics – Financial accounting places great stress on those qualities in information which can command universal confidence, like objectivity, validity absoluteness, etc. whereas management accounting emphasizes those characteristics which enhance the value of information BABASAB PATIL (BEC DOMS)
  11. 11. MANAGEMENT ACCOUNTING in a variety of uses, like flexibility, comparability etc. This difference is so important that a serious doubt has been raised as to whether both the types of characteristics can be preserved within the same framework.5. Type of Data Used Financial accounting makes use of data which is historical quantitative, monetary and objective, on the other hand management accounting used data which is descriptive, statistical subjective and relates to future. Therefore management accounting is not restricted, as financial accounting is, to the presentation of data that can be certified by independent auditors.6. Precision – There is less emphasis in precision in management accounting because approximations are often as useful as figures worked out accurately.7. Outside Dictates – As financial accounting ahs been assigned the role of a reference safeguarding the interests of different parties connected with the operation of a modern business undertaking, outside agencies have laid down standards for ensuring the integrity of information processed and presented in financial accounting statements. Consequently, financial accounting statements are standardized and are meant for external use. So, far as management accounting is concerned, there is no need for clamping down such standards for the preparation and presentation of accounting statements as management is both the initiator and user of data. Naturally, therefore, management accounting can be smoothly adapted to the changing needs of management.8. Element of compulsion – These days, for every business, financial accounting has become more or less compulsory indirectly if not directly, due to a number of factors but a business is free to install, or not to install, a system of management accounting. BABASAB PATIL (BEC DOMS)
  12. 12. MANAGEMENT ACCOUNTING LESSON – 3 FUNCTIONS OF FINANCIAL CONTROLLERThe gradual growth of management accounting has brought with it arecognition of the desirability of segregating the accounting function fromother activities of a secretarial and financial nature in order to make possible amore accurate accounting control over multifarious, complex and sprawlingbusiness operations. As a natural corollary, controller has come into being byway of a skilled business analyst who, due to his training and experience, is thebest qualified to keep the financial records of the business and to interpretthese for the guidance of the management.It is not surprising, therefore, that controllership function has developed paripassu with the development of management accounting so much so that thereis a tendency to record the two as synonymous. In a way, this is true becauseof controller in the United States does all that management accounting isexpected to accomplish, in fact, controller is the pivot round which system ofmanagement accounting revolves.Generally speaking, controllership function embraces within its broad sweepand wide curves, all accounting functions including advice to management oncourse of action to be taken in a given set of circumstances with the object ofcompletely eliminating the role of intuition in business affairs.Concept:There is no precise concept of controllership as it is still in an evolutionary state.Even if the concept was possible of being described, it cannot be said that,wherever a controller is in existence, he exercises all the functions that atheoretical controller is expected to do because the real meaning of the term isdependent upon the agreement between him and the undertaking the seeks toserve. However, the controllers’ Institute of America has drafted a seven-pointconcept of modern controllership. The hallmarks of the concept are: i. To establish, coordinate and administer, as an integral part of management, an adequate plan for the control of operations. Such a plan would provide, to the extent required in the business, for profit planning, programs for capital investing and financing, sales forecast, expense BABASAB PATIL (BEC DOMS)
  13. 13. MANAGEMENT ACCOUNTING budgets and cost standards, together with the necessary procedure to effectuate the plan. ii. To compare performance with operating plans and standards and to report and interpret the results of operations to all levels of management and to the owners of business. This function includes the formulation and administration of accounting policy and the compilation of statistical records and special reports as required.iii. To consult with all segments of management responsible for policy or action concerning any phase of the operations of business as it relates to the attainment of objectives and the effectiveness of policies, organization structure and procedures.iv. To administer tax policies and procedures. v. To supervise and coordinate the preparation of reports to governmental agencies.vi. To assure fiscal protection to the assets of the business through adequate internal control and proper insurance coverage.vii. To continuously appraise economic and social forces and government influences and interpret their effect on business.The controllers’ Institute, as well as the National Industrial conference Board ofthe United States, have spelt out the functions of the controller in still greaterdetail but the seven-point concept of modern controllership is board enough toleave no phase of policy or organization beyond the controller’s jurisdiction.Through the concept has been laid down mainly from the functional point ofview, it lifts the notion of controllership from pedestrian paper-shuffling to atop-management attitude that aids decision – making, it broadens controller’soutlook and provides him with specific goals.Status of Controller:There is no fixed place for the controller in the hierarchy of management. It issometimes said that the status of controller is not ensured simply by virtue ofhis holding the office but depends, in no small measure, upon hi personality,mental equipment, industrial background and his capacity to convince others ofhis ability as well as integrity. Moreover, it would depend upon the terms of hisappointment and, therefore, it is bound to vary with every individualundertaking. The terms of appointment may be fixed by the Board of Directorsor may be included in the Articles of Association of the Company. BABASAB PATIL (BEC DOMS)
  14. 14. MANAGEMENT ACCOUNTINGAs a matter of general principle, all accounting functions, even though remotelyconnected with finance, are included in the responsibilities of the controller. Asthe chief accounting authority, the controller normally has his place in thetop-level management along with the Treasurer who looks after bank accountsand the safe custody of liquid assets. Usually, the elevation of Controller to thepost of Vice-President Finance in taken for granted and is considered only aroutine matter.Modern Controller does not do any controlling, as is commonly understood, interms of line authority over other departments, his decision regarding the bestaccounting procedures to be followed by line people are transmitted to theChief Executive who communicates them by a manual of instructions comingdown through line chain of command to all people affected by the procedures.Limitation:It is also necessary that the limitation of Controller’s role imposed by the verynature of his work, must be borne in mind. Though the Controller helps inbringing together all phases of management, he does not pretend to solve theproblems of production of marketing, he knows their nature and so can discussin detail with all levels of management the financial implications of solutionsthey suggest. BABASAB PATIL (BEC DOMS)
  15. 15. MANAGEMENT ACCOUNTING LESSON – 4FINANCIAL STATEMENTS:According to the American Institute of Certified Public Accountants, “Financialstatements reflect a combination of recorded facts accounting conventions andpersonal judgements and the judgements and conventions applied affect themmaterially.” This statement makes clear that the accounting information asdepicted by the financial statements are influenced by three factors viz.recorded facts, accounting conventions and personal judgements.OBJECTIVES OF FINANCIAL STATEMENTS: 1. To provide reliable information about economic resources and obligations of a business and other needed information about changes in such resources or obligations. 2. To provide reliable information about changes in net resource [resources less obligations] arising out of business activities and financial information that assits in estimating the earning potentials of business. 3. To disclose to the extent possible, other information related to the financial statements that is relevant to the needs of the users of these statements.USES AND USERS OF FINANCIAL STATEMENTS:Different classes of people are interested in the financial statement analysiswith a view to assessing the economic and financial position of any business orindustrial concern in terms of profitability, liquidity or solvency. Such personsand bodies include: 1. Shareholders 2. Debenture-holders 3. Creditors 4. Financial institutions and commercial banks 5. Prospective investors 6. Employees and trade unions 7. Tax authorities 8. Govt. departments 9. The company law board BABASAB PATIL (BEC DOMS)
  16. 16. MANAGEMENT ACCOUNTING 10. Economists and investment analysis, etc. IMPORTANCE OF FINANCIAL STATEMENTSIMPORTANCE TO MANAGEMENT:Financial statements help the management to understand the position,progress and prospects of business results. By providing the management withthe causes of business results, they enable them to formulate appropriatepolicies and courses of actions for the future. The management communicateonly through these financial statements their performance to various partiesand justify their activities and thereby their existence.IMPORTANCE TO THE SHAREHOLDERSThese statements enable the shareholders to know about the efficiency andeffectiveness of the management and also the earning capacity and thefinancial strength of the company.IMPORTANCE TO LENDERS/CREDITORS:The financial statements serve as a useful guide for the present suppliers andprobable lenders of a company. It is through a critical examination of thefinancial statements that these groups can come to know about the liquidityprofitability and long-term solvency position of a company. This would helpthem to decide about their future course of action.IMPORTANCE TO LABOUR:Workers are entitled to bonus depending upon the size of profit as disclosed byaudited profit and loss account. Thus, P & L a/c becomes greatly important tothe workers in wage negotiations also the size of profits and profitabilityachieved are greatly relevant.IMPORTANCE TO PUBLIC:Business is a social entity. Various groups of the society, though not directlyconnected with business, are interested in knowing the position, progress andprospects of a business enterprise. They are financial analysts, lawyers, tradeassociations, trade unions, financial press research scholars, and teachers, etc. BABASAB PATIL (BEC DOMS)
  17. 17. MANAGEMENT ACCOUNTINGImportance of National Economy: The rise & growth of the corporate sector, toa great extent, influences the economic progress of a country. Unscrupulous &fraudulent corporate managements shatters the confidence of the generalpublic in joint stock companies which is essential for economic progress &retard economic growth of the country. Financial Statements come to rescue ofgeneral public by providing information by which they can examine & asses thereal worth of the company & avoid being cheated by unscrupulous persons.Limitations of Financial Statements: 1. It shows only historical cost. 2. It does not take into account the price level changes. 3. It considers only monetary aspects but does not consider some vital non-monetary factors. 4. It is based on convention and judgement. Hence there is no accuracy. 5. Comparison of Financial Statements depends upon the uniformity of Accounting policies. 6. It is subject to window dressing. BABASAB PATIL (BEC DOMS)
  18. 18. MANAGEMENT ACCOUNTING LESSON – 5 ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTSFinancial Statement are indicators of the two significant factors:(i) Profitability, and (ii) Financial soundnessAnalysis and interpretation of financial statements, therefore, refer to such atreatment of the information contained in the income statement and theBalance Sheet so as to afford full diagnosis of the profitability and financialsoundless of the business.TYPES OF FINANCIAL ANALYSISFinancial Analysis can be classified into different categories depending upon(i) The materials used and (ii) The modus operandi of analysisON THE BASIS OF MATERIAL USED: According to this basis financial analysiscan be of two types.(i) External Analysis: This analysis is done by those who are outsiders for thebusiness. The term outsiders includes investors, credit agencies, governmentand other creditors who have no access to the internal records of the company.(ii) Internal Analysis: This analysis is done by persons who have access to thebooks of account and other information related to the business.On the basis of modus operandi. According to this, financial analysis can alsobe two types.(i) Horizontal analysis: In case of this type of analysis, financial statements fora number of years are reviewed and analyzed. The current year’s figures arecompared with the standard or base year. The analysis statement usuallycontains figures for two or more years and the changes are shown recordingeach item from the base year usually in the from of percentage. Such an BABASAB PATIL (BEC DOMS)
  19. 19. MANAGEMENT ACCOUNTINGanalysis gives the management considerable insight into levels and areas ofstrength and weakness. Since this type of analysis is based on the data fromyear to year rather than on the date, it is also termed as Dynamic Analysis.(ii) Vertical analysis: In case of this type of analysis a study is made of thequantitative relationship of the various terms in the financial statements on aparticular date. For example, the ratios of different items of costs for aparticular period may be calculated with the sales for that period such ananalysis is useful in comparing the performance of several companies in thesame group, or divisions or departments in the same company.TECHNIQUES OF FINANCIAL ANALYSISA financial analyst can adopt one or more of the following techniques/tools offinancial analysis. 1. Comparative Financial Statements: Comparative financial statements are those statements which have been designed in a way so as to provide time perspective to the consideration of various elements of financial position embodied in such statements. In these statements figures for two or more periods are placed side by side to facilitate comparison. Both the income statement and Balance Sheet can be prepared in the form of Comparative Financial Statements.Comparative Income Statement: The Income statement discloses net profit orNet Loss on account of operations. A comparative Income Statement will showthe absolute figures for two or more periods, the absolute change from oneperiod to another and if desired the change in terms of percentages. Since, thefigures for two or more period are shown side by side, the reader can quicklyascertain whether sales have increased or decreased, whether cost of sales hasincreased or decreased etc. Thus, only a reading of data included inComparative Income Statements will be helpful in deriving meaningfulconclusions.Comparative Balance Sheet: Comparative Balance Sheet as on two or moredifferent dates can be used for comparing assets and liabilities and finding out BABASAB PATIL (BEC DOMS)
  20. 20. MANAGEMENT ACCOUNTINGany increase or decrease in those items. Thus, while in a single Balance Sheetthe emphasis is on persent position, it is on change in the comparative BalanceSheet. Such a Balance sheet is very useful in studying the trends in anenterprise.The preparation of comparative financial statements can be well understoodwith the help of the following illustration.ILLUSTRATION : From the following Profit and Loss Accounts and the BalanceSheet of Swadeshi polytex Ltd. For the year ended 31st December, 1987 and1988, you are required to prepare a comparative Income Statement andComparative Balance Sheet. PROFIT AND LOSS ACCOUNT (In Lakhs of Rs.)Particular 1987 1988 *Assets 1987 1988 Rs. Rs. Rs. Rs.To Cost of Goods sold 600 750 By Net 800 1,000 SalesTo operating ExpensesAdministrative Expenses 20 20Selling Expenses 30 40To Net Profit 150 190 800 1,000 800 1,000 BABASAB PATIL (BEC DOMS)
  21. 21. MANAGEMENT ACCOUNTING BALANCE SHEET AS ON 31ST DECEMBER (In Lakhs of Rs.)Liabilities 1987 1988 Assets 1987 1988 Rs. Rs. Rs. Rs.Bills Payable 50 75 Cash 100 140Sundry 150 200 Debtors 200 300CreditorsTax Payable 6% 100 150 Stock 200 300Debentures 6% 100 150 Land 100 100Preference 300 300 Building 300 270CapitalEquity Capital 400 400 Plant 300 270Reserves 200 245 Furniture 100 140 1300 1520 1300 1520 BABASAB PATIL (BEC DOMS)
  22. 22. MANAGEMENT ACCOUNTINGSOLUTION: Swadeshi Polytex Limited COMPARATIVE INCOME STATEMENT FOR THE YEARS ENDED 31ST DECEMBER AND 1988 (In Lakhs of Rs.) Absolute Percentage increase or increase or decrease in decrease in 1988 1988 1987 1988Net Sales 800 1000 +200 +25Cost of Goods 600 750 +150 +25SoldGross Profit 200 350 +50 +25Operating 20 20 - -ExpensesAdministrationExpensesSelling 30 40 +10 +33.33ExpensesTotal 50 60 10 +20OperatingExpensesOperating 150 190 +40 +26.67Profit BABASAB PATIL (BEC DOMS)
  23. 23. MANAGEMENT ACCOUNTING Swadeshi Polytex Limited COMPARATIVE BALANCE SHEET AS ON 31ST DECEMBER, 1987, 1988 Figures in lakhs of rupeesAssets 1987 1988 Absolute Percentage increase or increase (+) decrease or decrease during 1988 (-) during 1988Current Assets:Cash 100 140 40 +40Debtors 200 300 100 +50Stock 200 300 100 +50Total Current 500 740 240 +50AssetsFixed Assets:Land 100 100 - -Building 300 270 -30 -10%Plant 300 270 -30 -10%Furniture 100 140 +40 +40%Total Fixed Assets 800 780 -20 -2.5%Total Assets 1300 1520 220 +17% BABASAB PATIL (BEC DOMS)
  24. 24. MANAGEMENT ACCOUNTINGLiabilities &Capital:Current LiabilitiesBills Payable 50 75 +25 +50%Sundry Creditors 150 200 +50 +33.33%Tax Payable 100 150 +50 +50%Total Current 300 425 +125 +41.66%LiabilitiesLong-term 100 150 +50 +50%Liabilities : 6%DebenturesTotal Liabilities 400 575 +175 +43.75%Capital & Reserves6% Pre. Capital 300 300 - -Equity Capital 400 400 - -Reserves 200 245 45 22.5Total Shareholders’ 900 945 45 5%FundsTotal Liabilities and 1300 1520 220 17%Capital 2. Common – size Financial Statements: Common – size Financial Statements are those in which figures reported are converted into percentages to some common base. In the Income Statement that sale figure is assumed to be 100 and all figures are expressed as a percentage of this total.Illustration: Prepare a Common – size Income Statement & Common-sizeBalance Sheet of Swadeshi Polytex Ltd., for the years ended 31st December,1987 & 1988SOLUTION: Swadeshi Polytex Limited COMMON – SIZE INCOME STATEMENT BABASAB PATIL (BEC DOMS)
  25. 25. MANAGEMENT ACCOUNTING FOR THE YEARS ENDED 31ST DECEMBER 1987 AND 1988 (Figures in Percentage) 1987 1988Net Sales 100 100Cost of Goods Sold 75 75Gross Profit 25 25Opening Expenses:Administration Expenses 2.50 2Selling Expenses 3.75 4Total Operating 6.25 6ExpensesOperating Profit 18.75 19Interpretation: The above statement shows that though in absolute terms, thecost of goods sold has gone up, the percentage of its cost to sales remainsconstant at 75%, this is the reason why the Gross Profit continues at 25% ofsales. Similarly, in absolute terms the amount of administration expensesremains the same but as a percentage to sales it has come down by 5%. Sellingexpenses have increased by 25%. This all leads to net increase in net profit by25% (i.e., from 18.75% to 19%) BABASAB PATIL (BEC DOMS)
  26. 26. MANAGEMENT ACCOUNTING3. Trend Percentage: Trend Percentages are immensely helpful in making a comparative study of the Financial statements for several years. The method of calculating trend percentages involves the calculation of percentage relationship that each item bears to the same item in the base year. Any year may be taken as base year. It is usually the earliest year. Any intervening year may also be taken as the base year. Each item of base year is taken as 100 and on that basis the percentages for each of the years are calculated. These percentages can also be taken as Index Numbers showing relative changes in the financial data resulting with the passage of time. The method of trend percentages is useful analytical device for the management since by substitution percentages for large amounts, the brevity and readability are achieved. However, trend percentages are not calculated for all of the items in the financial statements. They are usually calculated only for major items since the purpose is to highlight important changes. Besides, Fund flow Analysis, Cash Flow Analysis and Ratio Analysis are the other tools of Financial Analysis which have been discussed in detail as separate chapters. BABASAB PATIL (BEC DOMS)
  27. 27. MANAGEMENT ACCOUNTING LESSON – 6 RATIO ANALYSISMeaning and Nature of ratio analysisThe term “ratio” simply means one number expressed in terms of another. Itdescribes in mathematical terms the quantitative relationship that existsbetween two numbers, the terms “accounting ratio”. J. Batty points out, is usedto describe significant relationships between figures shown on a Balance Sheet,in a Profit and Loss Account, in a Budgetary control System or in any other Partof the accounting organisation. Ratio Analysis, simply defined, refers to theanalysis and interpretation of financial statements through ratios. Nowadays itis used by all business and industrial concerns in their financial analysis. Ratioare considered to be the best guides for the efficient execution of basicmanagerial functions like planning, forecasting, control etc.Ratios are designed to show how one number is related to another. It is workedout by dividing one number by another. Ratios are customarily presented eitherin the form of a coefficient or a percentage or as a proportion. For example, thecurrent Assets and current Liabilities of a business on a particular date are Rs.2.5 Lakhs and Rs. 1.25 lakhs respectively. The resulting ratio of current Assetsand current Liabilities could be expressed as (i.e. Rs. 2,00,000/1,25,000) or as200 per cent. Alternatively in the form of a proportion the same ratio may beexpressed as 2:1, i.e. the current assets are two times the current liabilities.Ratios are invaluable aids to management and others who are interested in theanalysis and interpretation of financial statements. Absolute figures may bemisleading unless compared, one with another. Ratios provide the means ofshowing the relationship which exists between figures. Though there is nospecial magic in ratio analysis, many prefer to base conclusions on ratios asthey find them highly useful for making judgments more easily. However, thenumerical relationships of the kind expressed by ratio analysis are not an endin themselves, but are a means for understanding the financial position of abusiness. Generally, simple ratios or ratios compiled from a single year financialstatements of a business concern may not serve the real purpose. Hence, ratiosare to be worked out from the financial statements of a number of years.Ratios, by themselves, are meaningless. They derive their status partly from theingenuity and experience of the analyst who uses the available data in a BABASAB PATIL (BEC DOMS)
  28. 28. MANAGEMENT ACCOUNTINGsystematic manner. Besides, in order to reach valid conclusions, ratios have tobe compared with some standards that are established with a view to representthe financial position of the business under review. However, it should be bornein mind that after computing the ratios one cannot categorically say whether aparticular ratio is god or bad as the conclusions may vary from business tobusiness. A single ideal ratio cannot be applied for all types of business. Speedycompiling of ratios and their presentations in the appropriate manner areessential. A complete record of ratios employed in advisable and explanationof each, and actual ratios year by year should be included. This record may betreated as a part of an Accounts Manual or a special Ratio Register may bemaintained.CLASSIFICATION OF RATIOS:Ratios can be classified into different categories depending upon the basis ofclassification.The traditional classification has been on the basis of the financial statement towhich the determinants of a ratio belong. On this basis of ratios could beclassified as: 1. Profit and loss Accounts Ratios, i.e. ratios calculated on the basis of the items of the Profit and Loss account only e.g. Gross Profit ratio, stock turnover ratio, etc. 2. Balance sheet ratios, i.e., ratio calculated on the basis of figures of Balance sheet only, e.g., current ratio, debt-equity etc. 3. Composite ratios or inter-statements ratios, i.e., ratio on figures of profit and loss account as well as the balance sheet, e.g. fixed assets turnover ratio, overall profitability ratio etc.However, the above basis of classification has been found to be guide andunsuitable because analysis of Balance sheet and Balance sheet and incomestatement can not be done in insalaion. The have to be studied together inorder to determine the profitability and solvency of the business. In order thatratios serve as a toll for financial analysis, they are now classified as:(1) Profitability Ratios, (2) Coverage Ratios, (3) Turn-over Ratios, (4) Financialratios, (a) Liquidity Ratios (b) Stability Ratios. BABASAB PATIL (BEC DOMS)
  29. 29. MANAGEMENT ACCOUNTING LESSON – 7PROFITABILITY RATIOS:Profitability is an indication of the efficiency with which the operations of thebusiness are carried on. Poor operational performance may indicate poor salesand hence poor profits. A lower profitability may arise due to the lack of controlover the expenses. Bankers, financial institutions and other creditors look at theprofitability ratios indicator whether or not the firm earns substantially morethan it pays interest for the use of borrowed funds and whether the ultimaterepayment of their debt appears reasonably certain. Owners are interested toknow the profitability as it indicates the return which they can on theirinvestments. The following are the important profitability ratios: 1. OVERALL PROFITABILITY RATIOS:It is also called “Return on investment” (ROI) or Return On Capital Employed(ROCE) it indicates the percentage of return on the total capital employed in thebusiness. It is calculated on the basis of the following formula. Operation Profit x 100 ------------------------------- Capital employedThe term capital employed has been given different meanings by differentaccountants. Some of the popular meanings are as follows: i) Sum-total of all assets whether fixed or current ii) Sum-total of fixed assets iii) Sum-total of long-term funds employed in the business, i.e.,Share capital + Reserves & Surplus + Long Term loans + Non business assets +Fictitious assets.In Management accounting, the term capital employed is generally used in themeaning given in the third point above. BABASAB PATIL (BEC DOMS)
  30. 30. MANAGEMENT ACCOUNTINGThe term “Operating profit” means “Profit before Interest & Tax.” The term“Interested” means “Interested on long term borrowing”. Interest on short –term borrowings will be deducted for computing operating profit. Non-termborrowing will be deducted for computing operating profit. Non-tradingincomes such as interested on Government securities or non-trading losses orexpenses such as loss on account of fire, etc., will also be excluded. 2. Return on Shareholders “Funds”: In case it is desired to work out the profitability of the company from the shareholders point of view, it should be computed as follows: Net Profit after interest & tax ---------------------------------------- x 100 Shareholders’ FundsThe term Net Profit here means “Net Incomes after Interest & Tax” It is differentfrom the “Net Operating Profit” Which is used for computing the “Return onTotal Capital Employed” in the business. This because the shareholders areinterested in Total Income after Tax including Net Non-operating Income (i.e.,Non-operating Income – Non-operating Expenses) 3. Fixed dividend Cover: This ratio is important for preference shareholders entitled to get dividend at a fixed rate in priority to other shareholders. The ratio is calculated as follows: Net Profit after Interest & tax Fixed dividend cover =------------------------------------------------- Preference dividend 4. Debt service coverage ratio: The interest coverage ratio, as explained above, does not tell us anything about the ability of a company to make payment of principle amounts also on time. For this purpose debt service coverage ratio is calculated as follows: Net Profit before interest & tax Debt service coverage ratio = --------------------------------------------------- Principal Payment Instalment BABASAB PATIL (BEC DOMS)
  31. 31. MANAGEMENT ACCOUNTING Interest + ----------------------------------------- 1 – (Tax rate)The principle payment instalment is adjusted for tax effects since such paymentis not deductible from net profit for tax purposes. Net Profit Before Interest & Tax 5. Interest Coverage Ratio =------------------------------------------------------- Interest Charges Gross Profit 6. Gross Profit Ratio =------------------------------------------------- x 100 Net Sales Net Profit 7. Net Profit Ratio =------------------------------------------------ x 100 Net Sales Operating Profit Operating Profit Ratio =-------------------------------------------- x 100 Net SalesOperating Profit = Net Profit + Non-Operating expenses – Non – operatingincome Operating Cost 9. Operating Ratio = --------------------------------- x 100 Net Sales Amount available to Equity Shareholders BABASAB PATIL (BEC DOMS)
  32. 32. MANAGEMENT ACCOUNTING 10. Earnings Per Share (EPS) =------------------------------------------------------------ Number of Equity Shares Market Price per Share 11. Price – Earnings (P/E) Ratio =------------------------------------------- Earning Per Share BABASAB PATIL (BEC DOMS)
  33. 33. MANAGEMENT ACCOUNTING LESSON – 8 1. Fixed assets turnover ratio : This ratio indicates the extent to which the investments in fixed assets contribute towards sales. If compares with a previous period, it indicates whether the investment in fixed assets has been judicious or not. The ratio is calculated as follows: Net Sales --------------------------------- Fixed Assets (NET) 2. Working Capital Turnover Ratio: This is also known as Working Capital Leverage Ratio. This ratio indicates whether or net working capital has been utilized in making sales. In case a company can achieve higher volume of sales with relatively small amount of working capital, it is an indication of the operating efficiency of the company. The ratio is calculated as follows. Net Sales ---------------------------------- Working CapitalWorking capital turnover ratio may take different forms for different purposes.Some of them are being explained below:(i) Debtors” turnover ratio (Debtors, Velocity): Debtors constitute animportant constituent of current assets and therefore the quality of debtors to agreat extent determines a firm’s liquidity. Two ratios are used by financialanalysis to judge the liquidity of a firm. They are (i) Debtor’s turnover ratio, and(ii) Debt collection period ratio.The Debtor’s turnover ratio is calculated as under: Credit sales --------------------------------------------- Average accounts receivableThe term Accounts Receivable include “Trade Debtors” and Bill Receivable”. BABASAB PATIL (BEC DOMS)
  34. 34. MANAGEMENT ACCOUNTINGIn case details regarding and closing receivable and credit sales are notavailable the ratio may be calculated as follows: Total Sales --------------------------------------------- Accounts ReceivableSignificance: Sales to Accounts Receivable Ratio indicates the efficiency of thestaff entrusted with collection of book debts. The higher the ratio, the better itis, Since it Would indicate that debts are being collected more promptly. Formeasuring the efficiency, it is necessary to set up a standard figure, a ratiolower then the standard will indicate inefficiency.The ratio helps in Cash Budgeting, since the flow of cash form customers canbe worked out on the basis of sales.(ii) Debt collection Period ratio: The ratio indicates the extent to which thedebts have been collected in time. It gives the average debt collection period.The ratio is very helpful to the lenders because it explains to them whethertheir borrowers are collecting money within a reasonable time. An increase inthe period will result in greater blockage of funds in debtors. The ratio may becalculated by any of the following methods. Months (or days) in a year (a) ---------------------------------------------------- Debtors’ turnover Average Accounts Receivable x Months (or days) in a year (b)-------------------------------------------------------------------------------------- Credit sales for the year Accounts receivable (c)------------------------------------------------------------------- BABASAB PATIL (BEC DOMS)
  35. 35. MANAGEMENT ACCOUNTING Average monthly or daily credit salesIn fact, the two ratios are interrelated Debtor’s turnover ratio can be obtainedby dividing the months (or days)In a YEAR by the average collection period (e.g., 12/2-6). Similarly Where thenumber of months (or days) in a year are divided by the debtors turnover,average debt collection period is obtained (i.e., 12/6 – 2 months)Significance: Debtors’ collection period measures the quality of debtors since itmeasures the rapidity or slowness with which money is collected from them. Ashort collection period implied prompt payment by debtors. It reduces thechances of bad debts.A longer collection period implies too liberal and inefficient credit collectionperformance. However, in order to measure a firm’s credit and collectionefficiency its average collection period should be compared with the average ofthe industry. It should be neither too liberal nor too restrictive. A restrictivepolicy will result in lower sales which will reduce profits.It is difficult to provide a standard collection period of debtors. It depends uponthe nature of the industry, seasonable character of the business and creditpolicies of the firm. In general, the amount of receivables should not exceed a3-4 months’ credit sales.(iii) Creditors’ turnover ratio (Creditors’ velocity): It is similar to debtors‘Turnover Ratio. It indicates the speed with which the payment for creditpurchases are made to the creditors. The ratio can be computed as follows: Credit Purchases ------------------------------------------- Average accounts payableThe term Accounts payable include “Trade Creditors” and “Bills payable”In case the details regarding credit purchases, opening closing accountspayable have not been given, the ratio may be calculated as follows: BABASAB PATIL (BEC DOMS)
  36. 36. MANAGEMENT ACCOUNTING Total Purchases ---------------------------------- Account Payable(iv) Debt payment period enjoyed ratio (Average age of payable):The ratio give the average credit period enjoyed from the creditors. It can becomputed by any one of the following methods: Month’s or days in a year(a) --------------------------------------------------- Creditors’ turnover Average accounts payable x Months (or days) in a year(b)---------------------------------------------------------------------------------------- Credit purchases in the year Average accounts payable(c) ------------------------------------------------------------------------- Average monthly (or daily) credit purchasesSignificance: Both the creditors turnover ratio and the debt payment periodenjoyed ratio indicate about the promptness or otherwise in making payment ofcredit purchases. A higher “creditors turnover ratio” or a “lower credit periodenjoyed ratio”. Signifies that the creditors are being paid promptly, thusenhancing the credit worthiness of company. However, a very favourable ratioto this effects also shows that the business is not taking full advantage of creditfacilities which can be allowed by the creditors.Stock Turnover Ratio: This ratio indicate whether investments in inventory isefficiently used or not. It therefore, explains whether investment in inventoriesis within proper limits or not. The ratio is calculated as follows: BABASAB PATIL (BEC DOMS)
  37. 37. MANAGEMENT ACCOUNTINGCost of goods sold during the year------------------------------------------------------Average inventoryAverage inventory is calculated by taking stock levels of raw materials work – in– process, finished goods at the end of each months, adding them up anddividing by twelve.Inventory ratio can be calculated regarding each constituent of inventory. It maythus be calculated regarding raw materials, Work in progress & finished goods. Cost of goods sold1*-------------------------------------------------- Average stock of finished goods Materials consumed2** ---------------------------------------------- Average stock of raw materials Cost of completed work3*** ------------------------------------------ Average work in progressThe method discussed above is as a matter of fact the best basis for computingthe stock Turnover Ratio. However, in the absence of complete information, theinventory Turnover Ratio may also be computed on the following basis. Net sales ------------------------------------------------- Average inventory at selling PricesThe average inventory may also be calculated on the basis of the average ofinventory at the beginning and at the end of the accounting period. BABASAB PATIL (BEC DOMS)
  38. 38. MANAGEMENT ACCOUNTING Inventory at the beginning of the accounting period +Inventory at the end of the accounting periodAverage Inventory =-------------------------------------------------------------------------------------- 2Significance: As already stated, the inventory turnover ratio signifies theliquidity of the inventory. A high inventory turnover ratio indicates brisk sales.The ratio is, therefore, a measure to discover the possible trouble in the form ofoverstocking or overvaluation. The stock position is known as the graveyard ofthe balance sheet. If the sales are quick such as a position would not ariseunless the stocks consists of unsalable items. A low inventory turnover ratioresults in blocking of funds in inventory becoming obsolete or deteriorating inquality.It is difficult to establish a standard ratio of inventory because it will differ fromindustry. However, the following general guidelines can be given.(i) The raw materials should not exceed 2-4 months’ consumption of the year.(ii) The finished goods should not exceed 2-3 months’ sales(iii) Work in progress should not exceed 15-30 days’ cost of sales.PRECAUTIONS: While using the Inventory Ratio, care must be taken regardingthe following factors:(i) Seasonable conditions: If the balance sheet is prepared at the time of slackseason, the average inventory will be much less (if calculated on the basis ofinventory at the beginning of the accounting period & inventory at close of theaccounting period). This may give a very high turnover ratio.(ii) Supply conditions: In case of conditions of security inventory may have tobe kept in high quality for meeting the future requirements. BABASAB PATIL (BEC DOMS)
  39. 39. MANAGEMENT ACCOUNTING(iii) Price trends: In case of possibility of a rise in prices, a large inventory maybe kept by business. Reverse will be the case if there is a possibility of fall inprices.(iv) Trend of volume of business: In case there is a trend of sales beingsufficiently higher than sales in the past, a higher amount of inventory may bekept. BABASAB PATIL (BEC DOMS)
  40. 40. MANAGEMENT ACCOUNTING LESSON – 9FINANCIAL RATIOSFinancial Ratios indicate about the financial position of the company.Accompany is deemed to be financially sound if it is in a position to carry on itsbusiness smoothly and meetits obligions, both short – term as well as longterm,without strain. It is a sound principle of finance that the short-termrequirements of funds should be met out of short term funds and long-termrequirements should be met out of long-term funds. For example if thepayment for raw materials purchases are made through the issue debentures itwill create a permanent interest burden on the enterprise. Similarly, if fixedassets are purchased out of funds provide by bank overdraft, the firm will cometo grief because such assets cannot be sold away when payment will bedemanded by the bank.Financial ratios can be divided into two broad categories: (1) Liquidity Ratios & (2) Stability Ratios(1) LIQUIDITY RATIOS: These ratios are termed as “working capital” or“short-term solvency ratios”. As enterprise must have adequate working-capitalto run its day-to-day operations. Inadequacy of working capital may bring theentire business operation to a grinding halt because of inability of enterprise topay for wages, materials & other regular expenses.CURRENT RATIOS: This ratio is an indicator of the firm’s commitment to meetits short-term liabilities. It is expressed as follows: Current assets ----------------------------- Current LiabilitiesCurrent assets mean assets that will either be used up or converted into cashwithin a year’s of time or normal operating cycle of the business, whichever islonger. Current liabilities means liabilities payable within a year or operatingcycle, whichever is longer, out of existing current assets or by creation ofcurrent liabilities. A list of items include in current assets & current liabilities BABASAB PATIL (BEC DOMS)
  41. 41. MANAGEMENT ACCOUNTINGhas already been given in the performs analysis balance sheet in the precedingchapter.Book debts outstanding for more than six months & loose tools should not beincluded in current assets. Prepaid expenses should be taken as current assets.An ideal current ratio is 2. The ratio of 2 is considered as a safe margin ofsolvency due to the fact that if the current assets are reduced to half, i.e., 1instead of 2, then also the creditors will be able to get their payments in full.However a business having seasonal trading activity may show a lower currentratio at a creation period of the year. A very high current ratio is also notdesirable since it means less efficient use of funds. This is because a highcurrent ratio means excessive dependence on long-term sources of raisingfunds. Long-term liabilities are costlier than current liabilities & therefore, thiswill result in considerably lowering down the profitability of the concern.It is to be noted that the mere fact current ratio is quite high does not meanthat the company will be in position to meet adequately its short-term liabilities.In fact, the current ratio should be seen in relation to the component of currentassets & liquidity. If a large portion of the current assets comprise obsoletestocks or debtors outstanding for a long term, time, the company may fail evenif the current ratio is higher then 2.The current ratio can also be manipulated very easily. This may be done eitherby either postponing certain pressing payments or postponing purchase ofinventories or making payment of certain current liabilities.Significance: The current ratio is an index of the concern’s Financial stabilitysince it shows the extent of working capital which is the amount by which thecurrent assets exceed the current liabilities. As stated earlier, a higher currentratio would indicate inadequate employment of funds while a poor current ratiois a danger signal to the management. It shows that business is trading beyondits resources.(II) QUICK RATIO: This ratio is also termed as “acid test ratio” or “liquidity ratio”.This ratio is ascertained by comparing the liquid assets (i.e., assets which areimmediately convertible into cash without much loss) to current liabilitiesprepaid expenses and stock are not taken as liquid assets. The ratio may beexpressed as: BABASAB PATIL (BEC DOMS)
  42. 42. MANAGEMENT ACCOUNTING Liquid assets --------------------------- Current liabilitiesSome accountants prefer the term “Liquid Liabilities” for “Current Liabilities” orthe purpose of ascertaining this ratio. Liquid liabilities means liabilities whichare payable within a short period. The bank over-draft (if it becomes apermenant mode of financing) & cash credit faculties will be excluded fromcurrent liabilities in such a case.The ideal ratio is 1.This ratio is also an indicator of short-term solvency of the company.A comparison of the current ratio to quick ratio shall indicate the inventoryhold-ups. For example if two units have the same current ratio but differentliquidity ratio, it indicates over-stocking by the concern having low liquidityratio as compared to the concern which has a higher liquidity ratio.Thus, debtors are excluded from liquid assets for the purpose of comparingsuper – quick ratio. Current liabilities & liquid liabilities have the same meaningas explained above. The ratio is the more measure of firms’ liquidity position.However, it is not widely used in practice.STABILITY RATIO: These ratios help in ascertaining long term solvency of a firmwhich depends basically on three factors:(i) Whether the firm has adequate resources to meet its long term fundsrequirements.(ii) Whether the firm has used an appropriate debt-equity mix to raiselong-term funds.(iii) Whether the firm earns enough to pay interest & instalment of long-termloans in time. BABASAB PATIL (BEC DOMS)
  43. 43. MANAGEMENT ACCOUNTINGThe capacity of the firm to meet the last requirement can be ascertained bycomputing the various coverage ratios, already explained in the precedingpages. For the other two requirements, the following ratios can be calculated.(1) FIXED ASSETS RATIO: This ratio explains whether the firm has raisedadequate long-term funds to meet its fixed assets requirements. It is expressedas follows: Fixed assets --------------------------- Long – Term fundsThe ratio should not be more than 1. If it is less than 1, it shows that a part ofthe working capital has been financed through long-term funds. This isdesiarable to some extent because a part of working capital termed as “CoreWorking Capital” is more or less is a fixed nature. The ideal ratio is 67.(ii) CAPITAL STRUCTURE RATIOS: These ratios explains how the capitalstructure of firm is made up or the debt-equity mix adopted by the firm. Thefollowing ratios fall in the category.(a) Capital Gearing Ratio: Capital gearing (or leverage) refers to the proportionbetween fixed interest or dividend bearing funds & non-fixed interest ordividend bearing funds in the total capacity employed in the business. Thefixed interest or dividend bearing funds include the funds provided by thedebenture holders & preference shareholders. Non-fixed interest or dividendbearing funds are the funds provided by the equity shareholders. The amount,therefore, includes the Equity Share Capital & other Reserves. A properproportion between the two funds is necessary in order to keep the cost ofcapital at the minimum. The capital gearing ratio can be ascertained as follows: Funds bearing fixed interest or fixed dividend------------------------------------------------------------------- - Equity Shareholder’s Funds BABASAB PATIL (BEC DOMS)
  44. 44. MANAGEMENT ACCOUNTING(b) DEBT-EQUITY RATIO: The debt-equity ratio is determined to ascertain thesoundness of the long-term financial position of the company. It is also knownas “External – Internal” equity ratio. Total long-term debt Debt – Equity Ratio = ------------------------------------------ Shareholder’s fundsSignificance: The ratio indicates the preparation of owners’ stake in thebusiness. Excessive liabilities tend to cause insolvency. The ratio indicates theextent to which the firm depends upon outsiders for its existence. The ratioprovides a margin of safety to the creditors. It tells the owners the extent towhich they can gain the benefits or maintain control with a limited investment.(c) Proprietary ratio : It is a variant of debt-equity ratio. It establishesrelationship between the proprietor’s funds & the total tangible assets. It maybe expressed as: Shareholder’s funds = -------------------------------- Total tangible assetsSignificance: This ratio focuses the attention on the general financial strengthof the business enterprise. The ratio is of particular importance to the creditorswho can find out the proportion of shareholders funds in the total assetsemployed in the business. A high proprietary ratio will indicate a relatively littledanger to the creditor’s etc., in the event of forced reorganization or windingup of the company. A low proprietary ratio indicates greater risk to thecreditors since in the event of losses a part of their money may be lost besidesloss to the properties of the business. The higher the rate, the better it is. Aratio below 50 percent may be alarming for the creditors since they may have tolose heavily in the event of company’s liquidation on account of heavy losses. ADVANTAGES OF RATIO ANALYSISFollowing are some of the advantages of ratio analysis: BABASAB PATIL (BEC DOMS)
  45. 45. MANAGEMENT ACCOUNTING 1. Simplifies financial statements: Ratio Analysis simplified the comprehension of financial statements. Ratios tell the whole story of changes the financial condition of the business. 2. Facilitates inter-firm comparison: Ratio Analysis provides date for inter-firm comparison. Ratios highlight the factors associated with successful & unsuccessful firms. They also reveal strong firms & weak firms, over-valued & under valued firms. 3. Makes intra-firm comparision possible: Ratio Analysis also makes possible comparision of the performance of the different divisions of the firm. The ratios are helpful in deciding about their efficiency or otherwise in the past & likely performance in the future. 4. Helps in planning: Ratio Analysis helps in planning & forecasting. Over a period of time a firm or industry develops certain norms that may indicate future success or failure. If relationship changes in firms data over different time periods, the ratios may provide clues on trends and future problems. Thus “Ratio can assist management in its basic functions of forecasting planning coordination, control and communication”.LIMITATIONS OF ACCOUNTING RATIOS 1. Comparative study required: Ratios are useful in judging the efficiency of the business only when they are compared with the past results of the business or with the results of a similar business. However, such a comparision only provides a glimpse of the past performance and forecasts for future may not be correct since several other factors like market conditions, management policies, etc. may affect the future operations. 2. Limitations of financial statements: Ratios are based only on the information which has been recorded in the financial statements which suffer from a number of limitations.For example non-financial charges though important for the business are notrevealed by the financial statements. If the management of the companychanges, it may have adverse effect on the future profitability of the companybut this cannot be judged by having a glance at the financial statements of thecompany. BABASAB PATIL (BEC DOMS)
  46. 46. MANAGEMENT ACCOUNTINGFinancial statements show only historical cost but not market value.The comparision of one firm with another on the basis of ratio analysis withouttaking into account the fact of companies having different accounting policieswill be misleading and meaningless. 3. Ratios alone are not adequate : Ratios are only indicators they cannot be taken as final regarding good or bad financial position of the business Other things have also to be seen. 4. Window dressing: The term window dressing means manipulations of accounts in a way so as to conceal vital facts and present the financial statements in a way to show a better position than what it actually is. On account of such a situation presence of a particular ratio may not be a definite indicator of good or bad management. 5. Problem of price level changes: Financial analysis based on accounting ratios will give misleading results if the effects of changes in price level are not taken into account. 6. No fixed standards: No fixed standards can be laid down for ideal ratios. For example, current ratio is generally considered to be ideal if current assets are twice the current liabilities. However, in case of these concerns which have adequate arrangements with their bankers for providing funds when they require, it may be perfectly ideal if current assets are equal to slightly more than current liabilities. 7. Ratios area composite of many figures: Ratios are a composite of many different figures. Some cover a time period, others are at an instant of time while still others are only averages. A balance sheet figures shows the balance of the account at one moment of one day. It certainly may not be representative of typical balance during the year. It may, therefore, be conducted that ratio analysis, if done mechanically, is not only misleading but also dangerous.The computation of different accounting ratios & the analysis of the financialstatements on their basis can be very well understood with the help of theillustrations given in the following pages: COMPUTATION OF RATIOS BABASAB PATIL (BEC DOMS)
  47. 47. MANAGEMENT ACCOUNTINGIllustration 1: Following is the Profit and Loss Account and Balance Sheet of JaiHind Ltd., Redraft the for the purpose of analysis and calculate the followingratios: i. Gross Profit Ratios ii. Overall Profitability Ratioiii. Current Ratioiv. Debt-Equity Ratio v. Stock Turnover Ratiosvi. Liquidity Ratios PROFIT AND LOSS ACCOUNT Db. Cr.ParticularsOpening stock of finished 1,00,000 Sales 10,00,000goodsOpening stock of raw 50,000 Closing stock of raw 1,50,000materials materialsPurchase of raw materials 3,00,000 Closing stock of finished 1,00,000 goodsDirect wages 2,00,000 Profit on sale of shares 50,000Manufacturing expenses 1,00,000Administration expenses 50,000Selling & Distribution 50,000expensesLoss on sale of plant 55,000Interest on Debentures 10,000Net Profit 3,85,000 13,00,000 13,00,000 BABASAB PATIL (BEC DOMS)
  48. 48. MANAGEMENT ACCOUNTING BALANCE SHEETLiabilities Rs. Assets Rs.Share Capital: Fixed Assets 2,50,000Equity Share Capital 1,00,000 Stock of raw materials 1,50,000Preference share capital 1,00,000Reserves 1,00,000 Stock of finished 1,00,000Debentures 2,00,000 Sundry debtors 1,00,000Sundry Creditors 1,00,000 Bank Balance 50,000Bills Payable 50,000 6,50,000 6,50,000SOLUTION: INCOME STATEMENTSales Rs. 10,00,000Less: Cost of salesRaw material consumed (op. Stock + Purchases 2,00,000– Closing Stock) BABASAB PATIL (BEC DOMS)
  49. 49. MANAGEMENT ACCOUNTINGDirect Wages 2,00,000Manufacturing expenses 1,00,000Cost of production 5,00,000Add: Opening stock of finished goods 1,00,000 6,00,000Less: Closing stock of finished goods. Cost of 1,00,000 5,00,000goods soldGross Profit 5,00,000Less: Operating Expenses:Administration expenses 50,000Selling and distribution expenses 50,000 1,00,000Net operating profit 4,00,000Add: Non-trading income: 50,000Profit on sale of shares 4,50,000Less: Non-trading expenses or losses:Loss on sale of plant 55,000Income before interest & tax 3,95,000Less: Interest on debentures 10,000Net Profit before tax 3,85,000 BALANCE SHEET (OR POSITION STATEMENT) Rs.Bank balance 50,000Sundry debtors 1,00,000Liquid assets 1,50,000Stock of raw materials 1,50,000 BABASAB PATIL (BEC DOMS)
  50. 50. MANAGEMENT ACCOUNTINGStock of finished goods 1,00,000Current assets 4,00,000Sundry creditors 1,00,000Bills Payable 50,000Current liabilities 1,50,000Working Capital (Rs. 4,00,000 – Rs. 1,50,000) 2,50,000Add Fixed assets 2,50,000Capital employed 5,00,000Less Debentures 2,00,000Shareholders’ net worth 3,00,000Less Preference share capital 1,00,000Equity shareholders’ net worth 2,00,000Equity shareholders’ net worth is represented by: 1,00,000Equity Share capital 1,00,000Reserves 2,00,000Ratios: Gross Profit x 100 50,000 x 100 (i) Gross Profit Ratio ---------------------------- -------------------------- = 50% Sales 10,00,000 Operating Profit x 100 4,00,000 x 100 (ii) Overall Profitability Ratio = ------------------------------- = --------------------- = 80% Capital employed 5,00,000 Current assets 4,00,000 (iii) Current Ratio = ------------------------------- = -------------------------- = 2.67 BABASAB PATIL (BEC DOMS)
  51. 51. MANAGEMENT ACCOUNTING Current liabilities 1,50,000 External equities 3,50,000 (iv)Debt Equity Ratio: = -------------------------- = --------------------- = 1.17 Internal equities 3,00,000 (or) Total long- term debt 2,00,000 ------------------------------ =----------------- = 0.40 Total long-term funds 5,00,000 (or) Total long-term debt 2,0,00,000 ----------------------------- =-------------------- = 0.67 Shareholders’ funds 3,00,000 (v) Stock turnover ratio: Cost of goods sold 5,00,000 (a) As regards average total inventory = ---------------------------- = ----------------- = 2.5 Average inventory* 2,00,000 (*) of raw materials as well as finished goods) (b) As regards average inventory of finished goods: Cost of goods sold 5,00,000 BABASAB PATIL (BEC DOMS)
  52. 52. MANAGEMENT ACCOUNTING -------------------------------------------------- = ---------------- = 5 Average inventory of finished goods 1,00,000 (c) As regard average inventory of raw materials: Materials consumed 2,00,000 -------------------------------------------------- = ---------------- = 2 Average inventory of materials 1,00,000 Liquid assets 1,50,000(iv) Liquid Ratio: ------------------------- = ----------------- =1 Current liabilities 1,50,000ILLUSTRATION 2 : Following are the ratios to the trading activities of NationalTraders Ltd. Debtor’s Velocity 3 Months Stock Velocity 8 Months Creditor’s Velocity 2 Months Gross Profit Ratio 25 percentGross profit for the year ended 31st December, 1988 amount to Rs. 4,00,000/-closing stock of the year is Rs. 10,000 above the opening stock. Bills receivableamount to Rs. 25,000 and Bills payable to Rs. 10,000.Find out: (a) Sales, (b) Sundry Debtors; (c) Closing Stock & (d) Sundry CreditorsSOLUTION : (a) Sales: BABASAB PATIL (BEC DOMS)
  53. 53. MANAGEMENT ACCOUNTING Gross profit Gross Profit Ratio = ------------------------- x 100 SalesGross profit = Rs. 4,00,000/- 4,00,000Sales = ----------------------------- x 100 = Rs. 16,00,000 25 (b) Sundry Debtors : Debtor’s Debtor’s Velocity = --------------------- x 12 Sales“Debtor’s Velocity of 3 months” Presumably means that Accounts Receivableequal to 3 months’ Sales or ¼ of the year’s sales. Rs. 1,60,000Account Receivable = --------------------- x 1 4,00,000 4Less Bills Receivable 25,000 -------------------------Sundry Debtors 3,75,000 ------------------------- (c) Closing Stock: Cost of goods sold BABASAB PATIL (BEC DOMS)
  54. 54. MANAGEMENT ACCOUNTING Stock Velocity = ------------------------------------------ Average stock Cost of goods sold = Sales – Gross profit = 16,00,000 – 4,00,000 = Rs. 12,00,000 12,00,000 Average Stock = ------------------------- x 8 = Rs. 8,00,000 12 Total of Opening and Closing stock = 8,00,000 x 2 = 16,00,000 Closing Stock is higher than Opening Stock by Rs. 10,000 16,00,000 - 10,000 Therefore, Opening Stock = --------------------------------- 2 = 7,95,000Hence, Closing Stock = 7,95,000 + 10,000 or Rs. 8,05,000 (d) Sundry Creditor’s: Total Creditor’s Creditor’s Velocity i.e., = ------------------------------ x 12 PurchasesPurchases = Cost of goods sold + Closing Stock – opening Stock = 12,00,000 + 8,05,000 – 7,95,000 = Rs. 12,10,000 BABASAB PATIL (BEC DOMS)
  55. 55. MANAGEMENT ACCOUNTINGCreditor’s Velocity is 2 months, it means that Account Payable are 1/6th of thePurchases for the yearHence Account Payable = Rs. 2,01, 667Less : Bills Payable = 10,000 --------------------Sundry Creditor’s Rs. 1,91,667 -------------------- BABASAB PATIL (BEC DOMS)
  56. 56. MANAGEMENT ACCOUNTING LESSON – 10 FUNDS FLOW ANALYSISThe technique of Funds Flow Analysis is widely used by the financial analyst,credit granting institutions and financial managers in performance of their jobs.It has become a useful tool in their analytical kit. This is because the financialstatements, i.e., “Income Statement” and the “Balance Sheet” have a limited roleto perform. Income statement measures flow restricted to transactions thatpertain to rendering of goods or services to customers. The Balance Sheet ismerely a static statement. It is a statement of assets and liabilities which doesnot focus major financial transactions which have been behind the balancesheet changes. One has to draw inferences after comparing the balance sheetsof two periods. For example, if the fixed assets worth Rs. 2,00,000 arepurchased during the current year by raising share capital of Rs. 2,00,000 thebalance sheet will simply show a higher capital figure and higher fixed assetsfigure. In case, one compares the current year’s balance sheet with the previousyear, then only one can draw an inference that fixed assets were acquired byraising share capital of Rs. 2,00,000. Similarly, certain important transactionwhich might occur during the course of the accounting year might not find anyplace in the balance sheet. For example, if a loan of Rs. 2,00,000 was raisedand paid in the accounting year the Balance sheet will not depict thistransaction. However, a financial analyst must know the purpose for which theloan was utilized and the source from which it was raised. This will help him inmaking a better estimate about the company’s financial position and policies.The term “fund” generally refers to cash, to cash and cash equivalents, or toworking capital. Of these the last definition of the term is by far the mostcommon definition of “fund”.There are also two concepts of working capital – gross and net concept. Grossworking capital refers to the firm’s investment in current asset while the termnet working capital means excess of current assets over current liabilities. It isin the latter sense in which the term ‘funds’ is generally used.Current Assets: The term ‘Current Assets’ includes assets which are acquiredwith the intention of converting them into cash during the normal businessoperations of the company.The broad categories of current assets, therefore, are BABASAB PATIL (BEC DOMS)

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