Management accounting notes @ mba bk

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Management accounting notes @ mba bk

  1. 1. MANAGEMENT ACCOUNTING
  2. 2. LESSON – 1 INTRODUCTIONThe term “Management Accounting” is of recent origin. It was first coined by the BritishTeam of Accountants that visited the U.S.A. under the sponsorship of Anglo-AmericanProductivity Council in 195 with a view of highlighting utility of Accounting as an“effective management tool”. It is used to describe the modern concept of accounts as atool of management in contrast to the conventional periodical accounts prepared mainlyfor information of proprietors. The object is to expand the financial and statisticalinformation so as to throw light on all phases of the activities of the organisation.All techniques which aim at appropriate control, such as financial control, budgetedcontrol, efficiency in operations through standard costing, cost-volume-profit theory etc,are combined and brought within the purview of Management Accounting.Management Accounting evolves a scheme of accounting which lays emphasis on theplanning of future (logical forecasting), simultaneously finding the deviations betweenthe actual and standards. Another significant feature of Management Accounting isreporting to top-management. Finally, accounting information should be presented insuch a way as to assist the management in the formulation of policy and in the day-to-day conduct of business. For example, the published accounts of business concerns donot furnish management 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 from them fortheir guidance and action.DEFINITION OF MANAGEMENT ACCOUNTINGManagement Accounting may be defined as “the presentation of accounting informationin such a way as to assist the management in the creation of the policy and day-to-dayoperation of an undertaking” – Management Accounting of the Anglo-American toproductivity.The Institute of Chartered Accountants of England has defined it –
  3. 3. “Any form of accounting which enables a business to be conducted more efficiently canbe regarded as Management Accounting”.Robert N. Anthony has defined Management Accounting as follows-“Management Accounting is concerned with accounting information that is useful tomanagement.”According to American Accounting Association, “Management Accounting includes themethods and concepts necessary for effective planning for, choosing among alternativebusiness actions and for control through the evaluation and interpretation ofperformance”. This definition is fairly illustrative.According to Kohler, Forward Accounting includes “Standard costs, budgeted costs andrevenues, estimates of cash requirements, break even charts and projected financialstatements and the various studies required for their estimation, also the internalcontrols regulating and safeguarding future operating.”Blending together into a coherent whole financial accounting, cost accounting and allaspects of financial management”. He has used this term to include “the accountingmethods, systems and techniques which, coupled with special knowledge and ability,assist manageme4nt in its task of maximizing profits or minimizing losses.” – JamesBatty.Thus all accounting which directly or indirectly providing effective tools to managers inenterprises and government organizations lead to increase in productivity is“Management Accounting.”OBJECTIVES OF MANAGEMENT ACCOUNTING:The basic objective of Management Accounting is to assist the management in carryingout its duties efficiently.The objectives of Management Accounting are:
  4. 4. 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 three principlesdevices, 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. 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 encompasses withinits fold a searching analysis and branches of business operations. However, thefollowing facets of Management Accounting indicate the scope of the subject.
  5. 5. 1. Financial Accounting.2. Cost Accounting3. Budgeting & Forecasting4. Cost Control Procedure5. Statistical Methods6. Legal Provisions7. Organisation & Methods1. 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 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.
  6. 6. 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 activities connectedwith collecting, processing, interpreting and presenting information to management. TheManagement Accounting satisfies the various needs of management for arriving atappropriate business decisions. They may be described as follows: 1. Modification of Data:Accounting data required for decision – making purposes is supplied by managementaccounting through resort to a process of classification and combination which enablesto retrain similarities of details without eliminating the dissimilarities (e.g.) combination ofpurchases for different months and their breakup according to class of product, type ofsuppliers, days of purchase, territories etc. 2. Analysis & Interpretation of Data:The data becomes more meaningful with the analysis and interpretation. For example,when Profit and Loss account and Balance Sheet data are analyzed by means ofcomparative statements, ratios and percentages, cash-flow-statements, it will open upnew directions for its use by management. 3. Facilitating Management ControlManagement Accounting enables all accounting efforts to be directed towards control ofdestiny of an enterprise. The essential features in any system of control are thestandards for performance and measure of deviation therefrom. This is made possiblethrough budgetary control and standards costing which are an integral part ofManagement Accounting.
  7. 7. 4. Formulation of Business Budgets:One of the primary functions of management is planning. It is done by ManagementAccounting through the process of budgeting. It involves the setting up of objectives,and the selection of the most appropriate strategies by comparing them with referenceto some discriminating criteria. Probability, Probability, forecasting, and trends are someof the techniques used for this purpose. 5. Use of Qualitative Information:Management Accounting draws upon sources, other than accounting, for suchinformation as is not capable of being readily convertible into monetary terms. Statisticalcompilations, engineering records and minutes of meeting are a few such sources ofinformation. 6. Satisfaction of Informational Needs of Levels of Management:It serves management as a whole according to its requirements it serves top middle andlower level managerial needs to subserve their respective needs. For instance it has asystem of processing accounting data in a way that yields concise information coveringthe entire field of business activities at relatively long intervals for the top management,technical data for specialized personnel regularly and detailed figures relating to aparticular sphere of activity at short intervals for those at lower rungs of organizationalladder.The gist of Management Accounting can be expressed thus, it is a part of over allmanagerial activity – not something grafted on to it from outside – guiding and servicingmanagement as a body, to derive the best return form its resources, both the itself andfor the super system within which it functions.From the above discussions, one may come to the following conclusions about thefundamental approach in Management Accounting.Firstly, the Management Accounting functions is a managerial activity and it puts itsfinger in very pie without itself making them it guides and aids setting of objectives,planning coordinating, controlling etc. But it does not itself perform these functions.Secondly it serves management as a whole – top middle and lower level – according toits requirements. But in doing so it never fails in keeping in focus the macro-approach tothe business as a whole.
  8. 8. Thirdly, it brings in the concept of cost-Benefits analysis. The basic approach is to splitall costs and benefits into two groups – measurable and non measurable. It is easy todeal with measurable costs which are expressed in terms of money. But there areseveral ventures such as office canteens where the cost-benefits may not be monetarilymeasurable.LIMITATIONS OF MANAGEMENT ACCOUNTINGComparatively, Management Accounting is a new discipline and is still very much in astate of evolution. There fore it comes across the same impediments as a relatively newdiscipline has to face-sharpening of analytical tools and improvement of techniquescreating 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.
  9. 9. LESSON – 2 FINANCIAL ACCOUNTING AND MANAGEMENT ACCOUNTINGThe terms financial accounting, and management accounting, are not prices descriptionof the activities they comprise. All accounting is financial in the sense that all accountingsystems are in monetary terms and management, of course, is responsible for thecontent of financial accounting reports. Despite this close interrelation, there are somefundamental differences between the two 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 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
  10. 10. 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.
  11. 11. LESSON – 3 FUNCTIONS OF FINANCIAL CONTROLLERThe gradual growth of management accounting has brought with it a recognition of thedesirability of segregating the accounting function from other activities of a secretarialand financial nature in order to make possible a more accurate accounting control overmultifarious, complex and sprawling business operations. As a natural corollary,controller has come into being by way of a skilled business analyst who, due to histraining and experience, is the best qualified to keep the financial records of thebusiness and to interpret these for the guidance of the management.It is not surprising, therefore, that controllership function has developed pari passu withthe development of management accounting so much so that there is a tendency torecord the two as synonymous. In a way, this is true because of controller in the UnitedStates does all that management accounting is expected to accomplish, in fact,controller is the pivot round which system of management accounting revolves.Generally speaking, controllership function embraces within its broad sweep and widecurves, all accounting functions including advice to management on course of action tobe taken in a given set of circumstances with the object of completely eliminating therole of intuition in business affairs.Concept:There is no precise concept of controllership as it is still in an evolutionary state. Even ifthe concept was possible of being described, it cannot be said that, wherever acontroller is in existence, he exercises all the functions that a theoretical controller isexpected to do because the real meaning of the term is dependent upon the agreementbetween him and the undertaking the seeks to serve. However, the controllers’ Instituteof America has drafted a seven-point concept of modern controllership. The hallmarksof 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 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
  12. 12. 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 of theUnited States, have spelt out the functions of the controller in still greater detail but theseven-point concept of modern controllership is board enough to leave no phase ofpolicy or organization beyond the controller’s jurisdiction. Through the concept has beenlaid down mainly from the functional point of view, it lifts the notion of controllership frompedestrian paper-shuffling to a top-management attitude that aids decision – making, itbroadens controller’s outlook 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 of his holdingthe office but depends, in no small measure, upon hi personality, mental equipment,industrial background and his capacity to convince others of his ability as well asintegrity. Moreover, it would depend upon the terms of his appointment and, therefore, itis bound to vary with every individual undertaking. The terms of appointment may befixed by the Board of Directors or may be included in the Articles of Association of theCompany.As a matter of general principle, all accounting functions, even though remotelyconnected with finance, are included in the responsibilities of the controller. As the chiefaccounting authority, the controller normally has his place in the top-level managementalong with the Treasurer who looks after bank accounts and the safe custody of liquidassets. Usually, the elevation of Controller to the post of Vice-President Finance intaken for granted and is considered only a routine matter.Modern Controller does not do any controlling, as is commonly understood, in terms of
  13. 13. line authority over other departments, his decision regarding the best accountingprocedures to be followed by line people are transmitted to the Chief Executive whocommunicates them by a manual of instructions coming down through line chain ofcommand to all people affected by the procedures.Limitation:It is also necessary that the limitation of Controller’s role imposed by the very nature ofhis work, must be borne in mind. Though the Controller helps in bringing together allphases of management, he does not pretend to solve the problems of production ofmarketing, he knows their nature and so can discuss in detail with all levels ofmanagement the financial implications of solutions they suggest.
  14. 14. LESSON – 4FINANCIAL STATEMENTS:According to the American Institute of Certified Public Accountants, “Financialstatements reflect a combination of recorded facts accounting conventions and personaljudgements and the judgements and conventions applied affect them materially.” Thisstatement makes clear that the accounting information as depicted by the financialstatements are influenced by three factors viz. recorded facts, accounting conventionsand 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 analysis with a viewto assessing the economic and financial position of any business or industrial concern interms of profitability, liquidity or solvency. Such persons and 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 10. Economists and investment analysis, etc.
  15. 15. IMPORTANCE OF FINANCIAL STATEMENTSIMPORTANCE TO MANAGEMENT:Financial statements help the management to understand the position, progress andprospects of business results. By providing the management with the causes ofbusiness results, they enable them to formulate appropriate policies and courses ofactions for the future. The management communicate only through these financialstatements their performance to various parties and justify their activities and therebytheir existence.IMPORTANCE TO THE SHAREHOLDERSThese statements enable the shareholders to know about the efficiency andeffectiveness of the management and also the earning capacity and the financialstrength of the company.IMPORTANCE TO LENDERS/CREDITORS:The financial statements serve as a useful guide for the present suppliers and probablelenders of a company. It is through a critical examination of the financial statements thatthese groups can come to know about the liquidity profitability and long-term solvencyposition of a company. This would help them to decide about their future course ofaction.IMPORTANCE TO LABOUR:Workers are entitled to bonus depending upon the size of profit as disclosed by auditedprofit and loss account. Thus, P & L a/c becomes greatly important to the workers inwage negotiations also the size of profits and profitability achieved are greatly relevant.IMPORTANCE TO PUBLIC:Business is a social entity. Various groups of the society, though not directly connectedwith business, are interested in knowing the position, progress and prospects of abusiness enterprise. They are financial analysts, lawyers, trade associations, tradeunions, financial press research scholars, and teachers, etc.Importance of National Economy: The rise & growth of the corporate sector, to agreat extent, influences the economic progress of a country. Unscrupulous & fraudulentcorporate managements shatters the confidence of the general public in joint stockcompanies which is essential for economic progress & retard economic growth of thecountry. Financial Statements come to rescue of general public by providing informationby which they can examine & asses the real worth of the company & avoid being
  16. 16. 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.
  17. 17. 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 a treatmentof the information contained in the income statement and the Balance Sheet so as toafford full diagnosis of the profitability and financial soundless 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 analysis canbe of two types.(i) External Analysis: This analysis is done by those who are outsiders for thebusiness. The term outsiders includes investors, credit agencies, government and othercreditors who have no access to the internal records of the company.(ii) Internal Analysis: This analysis is done by persons who have access to the booksof account and other information related to the business.On the basis of modus operandi. According to this, financial analysis can also be twotypes.(i) Horizontal analysis: In case of this type of analysis, financial statements for anumber of years are reviewed and analyzed. The current year’s figures are comparedwith the standard or base year. The analysis statement usually contains figures for twoor more years and the changes are shown recording each item from the base yearusually in the from of percentage. Such an analysis gives the management considerableinsight into levels and areas of strength and weakness. Since this type of analysis isbased on the data from year to year rather than on the date, it is also termed as
  18. 18. Dynamic Analysis.(ii) Vertical analysis: In case of this type of analysis a study is made of the quantitativerelationship of the various terms in the financial statements on a particular date. Forexample, the ratios of different items of costs for a particular period may be calculatedwith the sales for that period such an analysis is useful in comparing the performance ofseveral companies in the same group, or divisions or departments in the samecompany.TECHNIQUES OF FINANCIAL ANALYSISA financial analyst can adopt one or more of the following techniques/tools of financialanalysis. 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 or NetLoss on account of operations. A comparative Income Statement will show the absolutefigures for two or more periods, the absolute change from one period to another and ifdesired the change in terms of percentages. Since, the figures for two or more periodare shown side by side, the reader can quickly ascertain whether sales have increasedor decreased, whether cost of sales has increased or decreased etc. Thus, only areading of data included in Comparative Income Statements will be helpful in derivingmeaningful conclusions.Comparative Balance Sheet: Comparative Balance Sheet as on two or more differentdates can be used for comparing assets and liabilities and finding out any increase ordecrease in those items. Thus, while in a single Balance Sheet the emphasis is onpersent position, it is on change in the comparative Balance Sheet. Such a Balancesheet is very useful in studying the trends in an enterprise.
  19. 19. The preparation of comparative financial statements can be well understood with thehelp of the following illustration.ILLUSTRATION : From the following Profit and Loss Accounts and the Balance Sheetof Swadeshi polytex Ltd. For the year ended 31st December, 1987 and 1988, you arerequired to prepare a comparative Income Statement and Comparative 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
  20. 20. 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 Creditors 150 200 Debtors 200 300Tax 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
  21. 21. SOLUTION: 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 Operating 50 60 10 +20ExpensesOperating Profit 150 190 +40 +26.67
  22. 22. 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 Assets 500 740 240 +50Fixed 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%Liabilities &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 Liabilities : 100 150 +50 +50%6%DebenturesTotal Liabilities 400 575 +175 +43.75%
  23. 23. 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-size BalanceSheet of Swadeshi Polytex Ltd., for the years ended 31st December, 1987 & 1988SOLUTION: Swadeshi Polytex Limited COMMON – SIZE INCOME STATEMENT 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 Expenses 6.25 6Operating Profit 18.75 19Interpretation: The above statement shows that though in absolute terms, the cost ofgoods sold has gone up, the percentage of its cost to sales remains constant at 75%,
  24. 24. this is the reason why the Gross Profit continues at 25% of sales. Similarly, in absoluteterms the amount of administration expenses remains the same but as a percentage tosales it has come down by 5%. Selling expenses have increased by 25%. This all leadsto net increase in net profit by 25% (i.e., from 18.75% to 19%)
  25. 25. 3. 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 managementsince by substitution percentages for large amounts, the brevity and readabilityare achieved. However, trend percentages are not calculated for all of the itemsin the financial statements. They are usually calculated only for major items sincethe purpose is to highlight important changes.Besides, Fund flow Analysis, Cash Flow Analysis and Ratio Analysis are theother tools of Financial Analysis which have been discussed in detail as separatechapters.
  26. 26. LESSON – 6 RATIO ANALYSISMeaning and Nature of ratio analysisThe term “ratio” simply means one number expressed in terms of another. It describesin mathematical terms the quantitative relationship that exists between two numbers,the terms “accounting ratio”. J. Batty points out, is used to describe significantrelationships between figures shown on a Balance Sheet, in a Profit and Loss Account,in a Budgetary control System or in any other Part of the accounting organisation. RatioAnalysis, simply defined, refers to the analysis and interpretation of financial statementsthrough ratios. Nowadays it is used by all business and industrial concerns in theirfinancial analysis. Ratio are considered to be the best guides for the efficient executionof basic managerial functions like planning, forecasting, control etc.Ratios are designed to show how one number is related to another. It is worked out bydividing one number by another. Ratios are customarily presented either in the form of acoefficient or a percentage or as a proportion. For example, the current Assets andcurrent Liabilities of a business on a particular date are Rs. 2.5 Lakhs and Rs. 1.25lakhs respectively. The resulting ratio of current Assets and current Liabilities could beexpressed as (i.e. Rs. 2,00,000/1,25,000) or as 200 per cent. Alternatively in the form ofa proportion the same ratio may be expressed as 2:1, i.e. the current assets are twotimes the current liabilities.Ratios are invaluable aids to management and others who are interested in the analysisand interpretation of financial statements. Absolute figures may be misleading unlesscompared, one with another. Ratios provide the means of showing the relationshipwhich exists between figures. Though there is no special magic in ratio analysis, manyprefer to base conclusions on ratios as they find them highly useful for makingjudgments more easily. However, the numerical relationships of the kind expressed byratio analysis are not an end in themselves, but are a means for understanding thefinancial position of a business. Generally, simple ratios or ratios compiled from a singleyear financial statements of a business concern may not serve the real purpose. Hence,ratios are 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 systematicmanner. Besides, in order to reach valid conclusions, ratios have to be compared withsome standards that are established with a view to represent the financial position ofthe business under review. However, it should be borne in mind that after computing theratios one cannot categorically say whether a particular ratio is god or bad as the
  27. 27. conclusions may vary from business to business. A single ideal ratio cannot be appliedfor all types of business. Speedy compiling of ratios and their presentations in theappropriate manner are essential. A complete record of ratios employed in advisableand explanation of each, and actual ratios year by year should be included. This recordmay be treated 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 to whichthe determinants of a ratio belong. On this basis of ratios could be classified 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 and unsuitablebecause analysis of Balance sheet and Balance sheet and income statement can notbe done in insalaion. The have to be studied together in order to determine theprofitability and solvency of the business. In order that ratios serve as a toll for financialanalysis, they are now classified as:(1) Profitability Ratios, (2) Coverage Ratios, (3) Turn-over Ratios, (4) Financial ratios,(a) Liquidity Ratios (b) Stability Ratios.
  28. 28. LESSON – 7PROFITABILITY RATIOS:Profitability is an indication of the efficiency with which the operations of the businessare carried on. Poor operational performance may indicate poor sales and hence poorprofits. A lower profitability may arise due to the lack of control over the expenses.Bankers, financial institutions and other creditors look at the profitability ratios indicatorwhether or not the firm earns substantially more than it pays interest for the use ofborrowed funds and whether the ultimate repayment of their debt appears reasonablycertain. Owners are interested to know the profitability as it indicates the return whichthey can on their investments. 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) itindicates the percentage of return on the total capital employed in the business. It iscalculated on the basis of the following formula. Operation Profit x 100 ------------------------------- Capital employedThe term capital employed has been given different meanings by different accountants.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 the meaninggiven in the third point above.The term “Operating profit” means “Profit before Interest & Tax.” The term “Interested”means “Interested on long term borrowing”. Interest on short – term borrowings will bededucted for computing operating profit. Non-term borrowing will be deducted forcomputing operating profit. Non-trading incomes such as interested on Government
  29. 29. securities or non-trading losses or expenses such as loss on account of fire, etc., willalso 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 different fromthe “Net Operating Profit” Which is used for computing the “Return on Total CapitalEmployed” in the business. This because the shareholders are interested in TotalIncome 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 Interest + ----------------------------------------- 1 – (Tax rate)The principle payment instalment is adjusted for tax effects since such payment is notdeductible from net profit for tax purposes.
  30. 30. 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 – operating income Operating Cost 9. Operating Ratio = --------------------------------- x 100 Net Sales Amount available to Equity Shareholders 10. Earnings Per Share (EPS) = ------------------------------------------------------------ Number of Equity Shares Market Price per Share 11. Price – Earnings (P/E) Ratio = ------------------------------------------- Earning Per Share
  31. 31. 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 ofthem are being explained below:(i) Debtors” turnover ratio (Debtors, Velocity): Debtors constitute an importantconstituent of current assets and therefore the quality of debtors to a great extentdetermines a firm’s liquidity. Two ratios are used by financial analysis to judge theliquidity of a firm. They are (i) Debtor’s turnover ratio, and (ii) Debt collection periodratio.The Debtor’s turnover ratio is calculated as under: Credit sales --------------------------------------------- Average accounts receivableThe term Accounts Receivable include “Trade Debtors” and Bill Receivable”.In case details regarding and closing receivable and credit sales are not available the
  32. 32. ratio may be calculated as follows: Total Sales --------------------------------------------- Accounts ReceivableSignificance: Sales to Accounts Receivable Ratio indicates the efficiency of the staffentrusted with collection of book debts. The higher the ratio, the better it is, Since itWould indicate that debts are being collected more promptly. For measuring theefficiency, it is necessary to set up a standard figure, a ratio lower then the standard willindicate inefficiency.The ratio helps in Cash Budgeting, since the flow of cash form customers can beworked out on the basis of sales.(ii) Debt collection Period ratio: The ratio indicates the extent to which the debts havebeen collected in time. It gives the average debt collection period. The ratio is veryhelpful to the lenders because it explains to them whether their borrowers are collectingmoney within a reasonable time. An increase in the period will result in greater blockageof funds in debtors. The ratio may be calculated 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) ------------------------------------------------------------------- Average monthly or daily credit salesIn fact, the two ratios are interrelated Debtor’s turnover ratio can be obtained by dividingthe months (or days)In a YEAR by the average collection period (e.g., 12/2-6). Similarly Where the numberof months (or days) in a year are divided by the debtors turnover, average debt
  33. 33. 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. A shortcollection period implied prompt payment by debtors. It reduces the chances of baddebts.A longer collection period implies too liberal and inefficient credit collectionperformance. However, in order to measure a firm’s credit and collection efficiency itsaverage collection period should be compared with the average of the industry. It shouldbe neither too liberal nor too restrictive. A restrictive policy will result in lower saleswhich will reduce profits.It is difficult to provide a standard collection period of debtors. It depends upon thenature of the industry, seasonable character of the business and credit policies of thefirm. In general, the amount of receivables should not exceed a 3-4 months’ creditsales.(iii) Creditors’ turnover ratio (Creditors’ velocity): It is similar to debtors ‘TurnoverRatio. It indicates the speed with which the payment for credit purchases are made tothe 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 accounts payable havenot been given, the ratio may be calculated as follows: 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 be computedby any one of the following methods:
  34. 34. 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 period enjoyedratio indicate about the promptness or otherwise in making payment of creditpurchases. A higher “creditors turnover ratio” or a “lower credit period enjoyed ratio”.Signifies that the creditors are being paid promptly, thus enhancing the creditworthiness of company. However, a very favourable ratio to this effects also shows thatthe business is not taking full advantage of credit facilities which can be allowed by thecreditors.Stock Turnover Ratio: This ratio indicate whether investments in inventory is efficientlyused or not. It therefore, explains whether investment in inventories is within properlimits or not. The ratio is calculated as follows:Cost 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 and dividing bytwelve.Inventory ratio can be calculated regarding each constituent of inventory. It may thus becalculated regarding raw materials, Work in progress & finished goods. Cost of goods sold1* --------------------------------------------------
  35. 35. 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 computing thestock Turnover Ratio. However, in the absence of complete information, the inventoryTurnover 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 of inventoryat the beginning and at the end of the accounting period. 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 the liquidity of theinventory. A high inventory turnover ratio indicates brisk sales. The ratio is, therefore, ameasure to discover the possible trouble in the form of overstocking or overvaluation.The stock position is known as the graveyard of the balance sheet. If the sales are quicksuch as a position would not arise unless the stocks consists of unsalable items. A lowinventory turnover ratio results in blocking of funds in inventory becoming obsolete ordeteriorating in quality.It is difficult to establish a standard ratio of inventory because it will differ from industry.However, the following general guidelines can be given.
  36. 36. (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 regarding thefollowing 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 of inventoryat the beginning of the accounting period & inventory at close of the accounting period).This may give a very high turnover ratio.(ii) Supply conditions: In case of conditions of security inventory may have to be keptin high quality for meeting the future requirements.(iii) Price trends: In case of possibility of a rise in prices, a large inventory may be keptby business. Reverse will be the case if there is a possibility of fall in prices.(iv) Trend of volume of business: In case there is a trend of sales being sufficientlyhigher than sales in the past, a higher amount of inventory may be kept.
  37. 37. LESSON – 9FINANCIAL RATIOSFinancial Ratios indicate about the financial position of the company. Accompany isdeemed to be financially sound if it is in a position to carry on its business smoothly andmeetits obligions, both short – term as well as longterm, without strain. It is a soundprinciple of finance that the short-term requirements of funds should be met out of shortterm funds and long-term requirements should be met out of long-term funds. Forexample if the payment for raw materials purchases are made through the issuedebentures it will create a permanent interest burden on the enterprise. Similarly, if fixedassets are purchased out of funds provide by bank overdraft, the firm will come to griefbecause such assets cannot be sold away when payment will be demanded by thebank.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-termsolvency ratios”. As enterprise must have adequate working-capital to run its day-to-dayoperations. Inadequacy of working capital may bring the entire business operation to agrinding halt because of inability of enterprise to pay for wages, materials & otherregular expenses.CURRENT RATIOS: This ratio is an indicator of the firm’s commitment to meet itsshort-term liabilities. It is expressed as follows: Current assets ----------------------------- Current LiabilitiesCurrent assets mean assets that will either be used up or converted into cash within ayear’s of time or normal operating cycle of the business, whichever is longer. Currentliabilities means liabilities payable within a year or operating cycle, whichever is longer,out of existing current assets or by creation of current liabilities. A list of items include incurrent assets & current liabilities has already been given in the performs analysisbalance sheet in the preceding chapter.Book debts outstanding for more than six months & loose tools should not be included
  38. 38. 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 of solvency dueto the fact that if the current assets are reduced to half, i.e., 1 instead of 2, then also thecreditors will be able to get their payments in full. However a business having seasonaltrading activity may show a lower current ratio at a creation period of the year. A veryhigh current ratio is also not desirable since it means less efficient use of funds. This isbecause a high current ratio means excessive dependence on long-term sources ofraising funds. Long-term liabilities are costlier than current liabilities & therefore, this willresult 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 mean that thecompany will be in position to meet adequately its short-term liabilities. In fact, thecurrent ratio should be seen in relation to the component of current assets & liquidity. Ifa large portion of the current assets comprise obsolete stocks or debtors outstanding fora long term, time, the company may fail even if the current ratio is higher then 2.The current ratio can also be manipulated very easily. This may be done either by eitherpostponing certain pressing payments or postponing purchase of inventories or makingpayment of certain current liabilities.Significance: The current ratio is an index of the concern’s Financial stability since itshows the extent of working capital which is the amount by which the current assetsexceed the current liabilities. As stated earlier, a higher current ratio would indicateinadequate employment of funds while a poor current ratio is a danger signal to themanagement. It shows that business is trading beyond its resources.(II) QUICK RATIO: This ratio is also termed as “acid test ratio” or “liquidity ratio”. Thisratio is ascertained by comparing the liquid assets (i.e., assets which are immediatelyconvertible into cash without much loss) to current liabilities prepaid expenses and stockare not taken as liquid assets. The ratio may be expressed as: Liquid assets --------------------------- Current liabilitiesSome accountants prefer the term “Liquid Liabilities” for “Current Liabilities” or thepurpose of ascertaining this ratio. Liquid liabilities means liabilities which are payablewithin a short period. The bank over-draft (if it becomes a permenant mode of financing)& cash credit faculties will be excluded from current liabilities in such a case.
  39. 39. 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 inventory hold-ups. Forexample if two units have the same current ratio but different liquidity ratio, it indicatesover-stocking by the concern having low liquidity ratio as compared to the concernwhich has a higher liquidity ratio.Thus, debtors are excluded from liquid assets for the purpose of comparing super –quick ratio. Current liabilities & liquid liabilities have the same meaning as explainedabove. The ratio is the more measure of firms’ liquidity position. However, it is notwidely used in practice.STABILITY RATIO: These ratios help in ascertaining long term solvency of a firm whichdepends basically on three factors:(i) Whether the firm has adequate resources to meet its long term funds requirements.(ii) Whether the firm has used an appropriate debt-equity mix to raise long-term funds.(iii) Whether the firm earns enough to pay interest & instalment of long-term loans intime.The capacity of the firm to meet the last requirement can be ascertained by computingthe various coverage ratios, already explained in the preceding pages. For the other tworequirements, the following ratios can be calculated.(1) FIXED ASSETS RATIO: This ratio explains whether the firm has raised adequatelong-term funds to meet its fixed assets requirements. It is expressed as follows: Fixed assets --------------------------- Long – Term fundsThe ratio should not be more than 1. If it is less than 1, it shows that a part of the
  40. 40. working capital has been financed through long-term funds. This is desiarable to someextent because a part of working capital termed as “Core Working Capital” is more orless is a fixed nature. The ideal ratio is 67.(ii) CAPITAL STRUCTURE RATIOS: These ratios explains how the capital structure offirm is made up or the debt-equity mix adopted by the firm. The following ratios fall inthe category.(a) Capital Gearing Ratio: Capital gearing (or leverage) refers to the proportionbetween fixed interest or dividend bearing funds & non-fixed interest or dividend bearingfunds in the total capacity employed in the business. The fixed interest or dividendbearing funds include the funds provided by the debenture holders & preferenceshareholders. Non-fixed interest or dividend bearing funds are the funds provided by theequity shareholders. The amount, therefore, includes the Equity Share Capital & otherReserves. A proper proportion between the two funds is necessary in order to keep thecost of capital at the minimum. The capital gearing ratio can be ascertained as follows: Funds bearing fixed interest or fixed dividend -------------------------------------------------------------------- Equity Shareholder’s Funds(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 known as“External – Internal” equity ratio. Total long-term debt Debt – Equity Ratio = ------------------------------------------ Shareholder’s fundsSignificance: The ratio indicates the preparation of owners’ stake in the business.Excessive liabilities tend to cause insolvency. The ratio indicates the extent to which thefirm depends upon outsiders for its existence. The ratio provides a margin of safety tothe creditors. It tells the owners the extent to which they can gain the benefits ormaintain control with a limited investment.(c) Proprietary ratio : It is a variant of debt-equity ratio. It establishes relationshipbetween the proprietor’s funds & the total tangible assets. It may be expressed as:
  41. 41. Shareholder’s funds = -------------------------------- Total tangible assetsSignificance: This ratio focuses the attention on the general financial strength of thebusiness enterprise. The ratio is of particular importance to the creditors who can findout the proportion of shareholders funds in the total assets employed in the business. Ahigh proprietary ratio will indicate a relatively little danger to the creditor’s etc., in theevent of forced reorganization or winding up of the company. A low proprietary ratioindicates greater risk to the creditors since in the event of losses a part of their moneymay be lost besides loss to the properties of the business. The higher the rate, thebetter it is. A ratio below 50 percent may be alarming for the creditors since they mayhave to lose 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: 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
  42. 42. 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 not revealedby the financial statements. If the management of the company changes, it may haveadverse effect on the future profitability of the company but this cannot be judged byhaving a glance at the financial statements of the company.Financial statements show only historical cost but not market value.The comparision of one firm with another on the basis of ratio analysis without takinginto account the fact of companies having different accounting policies will bemisleading 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
  43. 43. 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 financial statementson their basis can be very well understood with the help of the illustrations given in thefollowing pages: COMPUTATION OF RATIOSIllustration 1: Following is the Profit and Loss Account and Balance Sheet of Jai HindLtd., Redraft the for the purpose of analysis and calculate the following ratios: i. Gross Profit Ratios ii. Overall Profitability Ratio iii. Current Ratio iv. Debt-Equity Ratio v. Stock Turnover Ratios vi. 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 50,000
  44. 44. Selling & Distribution 50,000expensesLoss on sale of plant 55,000Interest on Debentures 10,000Net Profit 3,85,000 13,00,000 13,00,000 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 STATEMENT
  45. 45. Sales Rs. 10,00,000Less: Cost of salesRaw material consumed (op. Stock + Purchases – 2,00,000Closing Stock)Direct 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 goods 1,00,000 5,00,000soldGross 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.
  46. 46. Bank balance 50,000Sundry debtors 1,00,000Liquid assets 1,50,000Stock of raw materials 1,50,000Stock 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
  47. 47. (iii) Current Ratio = ------------------------------- = -------------------------- = 2.67 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 -------------------------------------------------- = ---------------- = 5 Average inventory of finished goods 1,00,000(c) As regard average inventory of raw materials:
  48. 48. 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 National TradersLtd. 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/- closingstock of the year is Rs. 10,000 above the opening stock. Bills receivable amount 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: Gross profit Gross Profit Ratio = ------------------------- x 100 SalesGross profit = Rs. 4,00,000/-
  49. 49. 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 Receivable equal to 3months’ 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 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
  50. 50. 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. 12,10,000Creditor’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 --------------------
  51. 51. LESSON – 10 FUNDS FLOW ANALYSISThe technique of Funds Flow Analysis is widely used by the financial analyst, creditgranting institutions and financial managers in performance of their jobs. It has becomea useful tool in their analytical kit. This is because the financial statements, i.e., “IncomeStatement” and the “Balance Sheet” have a limited role to perform. Income statementmeasures flow restricted to transactions that pertain to rendering of goods or services tocustomers. The Balance Sheet is merely a static statement. It is a statement of assetsand liabilities which does not focus major financial transactions which have been behindthe balance sheet changes. One has to draw inferences after comparing the balancesheets of 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 the balancesheet will simply show a higher capital figure and higher fixed assets figure. In case,one compares the current year’s balance sheet with the previous year, then only onecan draw an inference that fixed assets were acquired by raising share capital of Rs.2,00,000. Similarly, certain important transaction which might occur during the course ofthe accounting year might not find any place in the balance sheet. For example, if a loanof Rs. 2,00,000 was raised and paid in the accounting year the Balance sheet will notdepict this transaction. However, a financial analyst must know the purpose for whichthe loan 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 to workingcapital. Of these the last definition of the term is by far the most common definition of“fund”.There are also two concepts of working capital – gross and net concept. Gross workingcapital refers to the firm’s investment in current asset while the term net working capitalmeans excess of current assets over current liabilities. It is in the latter sense in whichthe term ‘funds’ is generally used.Current Assets: The term ‘Current Assets’ includes assets which are acquired with theintention of converting them into cash during the normal business operations of thecompany.The broad categories of current assets, therefore, are 1. Cash including fixed deposits with banks. 2. Accounts receivable, i.e., trade debtors and bills receivable, 3. Inventory i.e., stocks of raw materials, work-in-progress, finished goods, stores
  52. 52. and spare parts. 4. Advances recoverable, i.e., the advances given to supplier of goods and services or deposit with government or other public authorities, e.g., customer, port authorities, advance income tax, etc. 5. Pre-paid expenses, i.e. cost of unexpired services e.g., insurance premium paid in advance, etc.Current Liabilities: The term ‘Current Liabilities’ is used principally to designate suchobligations whose liquidation is reasonably expected to require the use of assetsclassified as current assets in the same balance sheet or the creation of other currentliabilities or those expected to be satisfied within a relatively short period of time usuallyone year. However, this concept of current liabilities has now undergone a change. Themore modern version designates current liabilities as all obligations that will requirewithin the coming year or the operation cycle, whichever is longer. The use of existingcurrent assets or the creation of other current liabilities . in other words, the more factthat an amount is due within a year does not make it current liability unless it is payableout of existing current assets or by creation of current liabilities. For exampledebentures due for redemption within a year of the balance sheet date will not be takenas a current liability if they are to be paid out of the proceeds of a fresh issue of shares /debentures or out of the proceeds realized on account of sale of debentures redemptionfund investments.The term current liabilities also includes amounts set apart or provided for any knownliability of which the amount cannot be determined with substantial accuracy e.g.,provision for taxation, pension etc., These liabilities are technically called provisionsrather than liabilities.The broad categories of current liabilities are: 1. Accounts payable e.g., bill payable and trade creditors. 2. Outstanding expenses, i.e., expenses for which services have been received by the business but for which the payment has not made. 3. Bank-over drafts. 4. Short-term loans, i.e., loans from banks, etc., which are payable within one year from the date of balance sheet. 5. Advance payments received by the business for the services to be rendered or goods to be supplied in future. 6. Current maturities of long-term loans, i.e., long-term debts due within a year of the balance sheet date or installments due within a year in respect of these loans, provided payable out of existing current assets or by creation of current
  53. 53. liabilities, as discussed earlier. However, installments of long-term loans due after a year should be taken as non-current liabilities.Meaning of “Flow of Funds” The term “Flow” means change and therefore, the term“Flow of Funds” means “Change in Funds” or “Change in working capital”. In otherwords, any increase or decrease in working capital means “Flow of Funds”.USES OF FUNDS FLOW A STATEMENTFunds flow statement helps the financial analyst in having a more detailed analysis andunderstanding of changes in the distribution of resources between two balance sheetdates. In case such study is required regarding the future working capital position of thecompany, a projected funds flow statement can be prepared. The uses of funds flowstatement can be put as follows. 1. It explains the financial consequences of business operations. Funds flow statement provides a ready answer to so many conflicting situations, such as: • Why the liquid position of the business is becoming more and more unbalanced inspite of business making more and more profits. • How was it possible to distribute dividends in excess of current earnings or in the presence of a new loss for the period? • How the business could have good liquid position in spite of business making losses or acquisition of fixed assets? • Where have the profits gone?Definite answers to these questions will help the financial analyst in advising hisemployer / client regarding directing of funds to those channels which will be mostprofitable for the business. 2. It answers intricate queries. The financial analyst can find out answers to a number of intricate questions. • What is the overall credit-worthiness of the enterprise? • What are the sources of prepayment of the loans taken? • How much funds are generated through normal business operations?

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