Accounting and Finance for Managers

Accounting and Finance for Managers

School of Distance EducationBharathiar University, Coimbatore - 641 046

MBA First YearPaper No. 3

Author: M P Pandikumar

Copyright © 2007, Bharathiar UniversityAll Rights Reserved

Produced and Printedby

EXCEL BOOKS PRIVATE LIMITEDA-45, Naraina, Phase-I,

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SCHOOL OF DISTANCE EDUCATIONBharathiar UniversityCoimbatore-641046

CONTENTS

Page No.

Lesson 1 Financial Accounting 7

Lesson 2 Trial Balance 33

Lesson 3 Final Accounts 47

Lesson 4 Depreciation Accounting 67

UNIT-II

Lesson 5 Financial Statement Analysis 87

Lesson 6 Ratio Analysis 95

Lesson 7 Funds Flow Statement Analysis 120

Lesson 8 Cash Flow Statement Analysis 136

UNIT-III

Lesson 9 Cost Accounting & Preparation of Cost Statement 149

Lesson 10 Budgetary Control 167

Lesson 11 Marginal Costing 178

UNIT-IV

Lesson 12 Financial Management 207

Lesson 13 Time Value of Money 214

Lesson 14 Sources of Long Term Finance 222

Lesson 15 Capital Market Developments in India 230

Lesson 16 Indian Financial System 235

Lesson 17 SEBI in Capital Market Issues 240

Lesson 18 Capital Budgeting 246

Lesson 19 Risk and Return 269

UNIT-V

Lesson 20 Cost of Capital 281

Lesson 21 Leverage Analysis 291

Lesson 22 Capital Structure Theories 298

Lesson 23 Working Capital Management 304

UNIT-I

ACCOUNTING AND FINANCE FOR MANAGERS

Number of Credit Hours: 3

Subject Description: This course presents the principles of accounting, preparation of financialstatements, analysis of financial statements, costing techniques, financial management and its functions.

Goals: To enable the students to learn the basic principles of accounting and preparation and analysisof financial statements and also the various functions of financial management.

Objectives: On successful completion of the course the students should have:

1. understood the principles and objectives of accounting.

2. learnt the preparation of financial statements and the various techniques of analyzing the financialstatements.

3. learnt the costing methods and its application in decision making.

4. learnt the basic objectives of financial management , functions and its application in financial decisionmaking .

UNIT I

Financial Accounting - Definition - Accounting Principles - Concepts and conventions - Trial Balance– Final Accounts (Problems) - Depreciation Methods-Straight line method, Written down valuemethod.

UNIT II

Financial Statement Analysis - Objectives - Techniques of Financial Statement Analysis: AccountingRatios: construction of balance sheet using ratios (problems)-Dupont analysis. Fund Flow Statement- Statement of Changes in Working Capital - Preparation of Fund Flow Statement - Cash FlowStatement Analysis- Distinction between Fund Flow and Cash Flow Statement. Problems

UNIT III

Cost Accounting - Meaning - Distinction between Financial Accounting and Cost Accounting - CostTerminology: Cost, Cost Centre, Cost Unit - Elements of Cost - Cost Sheet - Problems.

Budget, Budgeting, and Budgeting Control - Types of Budgets - Preparation of Flexible and fixedBudgets, master budget and Cash Budget - Problems -Zero Base Budgeting.

Marginal Costing - Definition - distinction between marginal costing and absorption costing - Breakeven point Analysis - Contribution, p/v Ratio, margin of safety - Decision making under marginalcosting system-key factor analysis, make or buy decisions, export decision, sales mix decision-Problems

UNIT IV

Objectives and functions of Financial Management - Role of Financial Management in the organisation- Risk-Return relationship- Time value of money concepts - Indian Financial system - Legal, Regulatoryand tax framework. Sources of Long term finance - Features of Capital market development in India- Role of SEBI in Capital Issues.

Capital Budgeting - methods of appraisal - Conflict in criteria for evaluation - Capital Rationing -Problems - Risk analysis in Capital Budgeting.

UNIT V

Cost of Capital - Computation for each source of finance and weighted average cost of capital -EBIT-EPS Analysis - Operating Leverage - Financial Leverage - problems.

Capital Structure Theories - Dividend Policies - Types of Divided Policy.

Working Capital Management - Definition and Objectives - Working Capital Policies - Factors affectingWorking Capital requirements - Forecasting Working Capital requirements (problems) - CashManagement - Receivables Management and - Inventory Management - Working Capital Financing -Sources of Working Capital and Implications of various Committee Reports.

UNIT-I

LESSON

1FINANCIAL ACCOUNTING

CONTENTS1.0 Aims and Objectives1.1 Introduction1.2 Process of Accounting

1.2.1 What is Cash System?1.2.2 What is Accrual System?1.2.3 Value at Which it is to be Recorded ?

1.3 Utility of the Financial Statements1.3.1 To Management1.3.2 To Shareholders, Security Analysts and Investors1.3.3 To Lenders1.3.4 To Suppliers1.3.5 To Customers1.3.6 To Govt. and Regulatory Authorities1.3.7 To Promote Research and Development

1.4 Accounting Principles1.5 Accounting Concepts

1.5.1 Money Measurement Concept1.5.2 Business Entity Concept1.5.3 Going Concern Concept1.5.4 Matching Concept1.5.5 Accounting Period Concept1.5.6 Duality or Double Entry Accounting Concept1.5.7 Cost Concept

1.6 Accounting Conventions1.6.1 Convention of Consistency1.6.2 Convention of Conservatism1.6.3 Convention of Disclosure1.6.4 Persons of Nature1.6.5 Persons of Artificial Relationship1.6.6 Persons of Representations1.6.7 Receiver of the Benefits1.6.8 Giver of the Benefits

1.7 Real Accounts1.8 Nominal Accounts1.9 Transactions in between the Real A/c

1.9.1 What is Movement-In?1.9.2 What is Movement-Out?

1.10Journal entries in between the accounts of two different categories1.10.1 What is meant by Ledger?1.10.2 Ledgering

1.11 Case Let1.12 Let us Sum up1.13 Lesson-end Activity1.14 Keywords1.15 Questions for Discussion1.16 Suggested Readings

8

Accounting and Financefor Managers 1.0 AIMS AND OBJECTIVES

In this less we shall discuss about financial accounting. After going through this lessonyou will be able to:

(i) analyse process of accounting and accounting concepts.

(ii) discuss accounting conventions.

1.1 INTRODUCTION

Accounting is a business language which elucidates the various kinds of transactionsduring the given period of time. Accounting is defined as either recording or recountingthe information of the business enterprise, transpired during the specific period in thesummarized form.

What is meant by accounting?

Accounting is broadly classified into three different functions viz

Recording

Classifying and Transactions of Financial Nature

Summarizing

Is accounting an equivalent function to book keeping ?

No, accounting is broader in scope than the book keeping., the earlier cannot beequated to the later. Accounting is a combination of various functions viz

American Institute of Certified Public Accountants Association defines the term accountingas follows "Accounting is the process of recording, classifying, summarizing in asignificant manner of transactions which are in financial character and finally resultsare interpreted."

Qualities of Accounting:

l In accounting, transactions which are non- financial in character can not be recorded.

l Transactions are recorded either individually or collectively according to their groups.

l Users should be able to make use of information.

Accounting

Recording of Transactions

Classification

Summarisation

Interpretation

9

Financial Accounting1.2 PROCESS OF ACCOUNTING

Financial Accounting is described as origin for the creation of information and thecontinuous utility of information

After the creation of information, the developed information should be appropriatelyrecorded. Are there any scales/guide available for the recording of information? Yes,What are they?

They are as follows

l What to record: Financial Transaction is only to be recorded

l When to record: Time relevance of the transaction at the moment of recording

l How to record: Methodology of recording - It contains two different systems ofaccounting viz cash system and accrual system

1.2.1 What is cash system?

The revenues are recognized only at the moment of realization but the expenses arerecognized at the moment of payment. For e.g. sale of goods will be considered under

Step 1 Identification of Transaction

Step 2 Preparation of Business Transactions

Step 3 Recording of Transactions in Journal

Step 4 Posting In Ledgers

Step 5 Preparation of Unadjusted Trial Balance

Step 6 Pass of Adjustment Entries

Step 7 Preparation of Adjusted Trial Balance

Recording

Gro

uping S

umm

arizing

Trading and P& L A/c Balance Sheet

Preparation

10

Accounting and Financefor Managers

this method that only at the moment of receipt of cash out of sale of goods. The chargeswhich were paid only will be taken into consideration but the outstanding, not yet paidwill not be considered. For e.g. Rent paid only will be considered but not the outstandingof rent charges.

1.2.2 What is accrual system?

The revenues are recognized only at the time of occurrence and expenses are recognizedonly at the moment of incurring.

Whether the cash is received or not out of the sales, that will be registered/counted astotal value of the sales.

The next most important step is to record the transactions. For recording, the value ofthe transaction is inevitable, to record values, the classification of values must be

1.2.3 Value at which it is to be recorded ?

There are four different values in the business practices, among the four, which oneshould be followed or recorded in the system of accounting?

Original Value: It is the value of the asset only at the moment of purchase or acquisition

Book Value: It is the value of the asset maintained in the books of the account. The bookvalue of the asset could be computed as follows

Book Value = Gross(Original) value of the asset - Accumulated depreciation

Realizable Value: Value at which the assets are realized

Present Value: Market value of the asset

Classifying: It is one of the important processes of the accounting in which grouping oftransactions are carried out on the basis of certain segments or divisions. It can bedescribed as a method of Rational segregation of the transactions. The segregationgenerally into two categories viz cash and non-cash transactions.

The preparation of the ledger A/cs and Subsidiary books are prepared on the basis ofrational segregation of accounting transactions. For example the preparation of cashbook is involved in the unification of cash transactions.

Summarizing: The ledger books are appropriately balanced and listed one after another.The list of the name of the various ledger book A/cs and their accounting balances isknown as Trial Balance. The trial balance is summary of all unadjusted name of theaccounts and their balances.

Preparation: After preparing, the summary of various unadjusted A/cs are required toadjust to the tune of adjustment entries which were not taken into consideration at thetime of preparing the trial balance. Immediately after the incorporation of adjustments,the final statement is readily available for interpretations.

Purposes of preparing financial statements:

l Financial accounting provides necessary information for decisions to be taken initiallyand it facilitates the enterprise to pave way for the implementation of actions

l It exhibits the financial track path and the position of the organization

l Being business in the dynamic environment, it is required to face the ever changingenvironment. In order to meet the needs of the ever changing environment, thepolicies are to be formulated for the smooth conduct of the business

l It equips the management to discharge the obligations at every moment

l Obligations to customers, investors, employees, to renovate/restructure and so on.

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Financial Accounting1.3 UTILITY OF THE FINANCIAL STATEMENTS

The financial statements are found to be more useful to many people immediately afterpresentation only in order to study the financial status of the enterprise in the angle oftheir own objectives.

1.3.1 To Management

The financial statements are most inevitable for the management to take rational decisionsto maintain the sustainability in the business environment among the other competitors.

1.3.2 To Shareholders, Security Analysts and Investors

The information extracted from the financial statements are processed by the abovementioned people to identify not only the financial status but also to determine the qualitiesof getting appropriate rate of return out of the prospective investment.

1.3.3 To Lenders

The lenders do study about the business enterprise through the available information ofits financial statements normally before lending. The aim of the study is to analyse thestatus of the firm for the worthiness of lending with reference to the payment of interestperiodicals and the repayment of the principal.

1.3.4 To Suppliers

The suppliers are in need of information about the business fleeces before sale of goodson credit. The Suppliers are very cautious in supplying the goods to the business housesbased on the various capacities of themselves. The most important capacity required aswell as expected from the buyer firms is that prompt repayment of dues of the creditpurchase from the suppliers. This quality of prompt payment could be known throughculling out the information from the balance sheet.

It mainly plays pivotal role in answering the status inquiries about the buyer

1.3.5 To Customers

The legal relationship of the transferability of ownership of the products is obviouslyunderstood through financial information available in the statements. The agreement ofwarranty and guarantee is tested through the financial status of the enterprise.

1.3.6 To Govt., and Regulatory Authorities

The taxes to be paid to the central and state govts on the revenues only throughpresentation of information.

1.3.7 To Promote Research and Development

For research and development, the amount of investment required is voluminous, whichhas to be mobilized from either internally or externally to the requirement of the futureprospects of the enterprise.

The following questions should be answered one after the another in meeting raisingneeds of the research and development

l How much to be raised?

l When the required amount to be raised?

l How to raise the required resources?

Check Your Progress

12


The above questions could be answered through immense financial planning exercise byway of extracting and utilizing the financial information from the Accounting statementsof the enterprise.

Check Your Progress

(1) Financial Accounting is

(a) Recording

(b) Classifying

(c) Summarising

(d) Recording, Classifying, Summarizing, Interpretation of financial information

(2) Book value of the asset is

(a) Gross value of the asset - Depreciation

(b) Gross value of the asset

(c) Gross value of the asset - Accumulated depreciation

(d) None of the above

1.4 ACCOUNTING PRINCIPLES

The transactions of the business enterprise are recorded in the business language, whichrouted through accounting. The entire accounting system is governed by the practice ofaccountancy. The accountancy is being practiced through the universal principles whichare wholly led by the concepts and conventions.

The entire principles of accounting are on the constructive accounting concepts andconventions

1.5 ACCOUNTING CONCEPTS

The following are the most important concepts of accounting:

l Money Measurement concept

l Business Entity concept

l Going Concern concept

l Matching concept

l Accounting Period concept

l Duality or Double Entry concept

l Cost concept

Accounting Principles

Accounting Concepts Accounting Conventions

13

Financial Accounting1.5.1 Money Measurement Concept

This is the concept tunes the system of accounting as fruitful in recording the transactionsand events of the enterprise only in terms of money. The money is used as well asexpressed as a denominator of the business events and transactions. The transactionswhich are not in the expression of monetary terms cannot be registered in the book ofaccounts as transactions.

For e.g. 5 machines, 1 ton of raw materials, 6 fork lift trucks, 10 lorries and so on. Theearly mentioned items are not expressed in terms of money instead they are illustratedonly in numbers. The worth of the items are getting differed from one to another. Torecord the above enlisted items in the book of accounts, all the assets should be convertedin to money. For e.g. 5 lathe machines worth Rs 1,00,000; 1 ton of raw materials worthamounted Rs. 15,00,000 and so on.

The transactions which are not in financial in character cannot be entered in the book ofaccounts.

1.5.2 Business Entity Concept

This concept treats the owner as totally a different entity from the business. To put in tonutshell "Owner is different and Business is different". The capital which is broughtinside the firm by the owner, at the commencement of the firm is known as capital. Theamount of the capital, which was initially invested should be returned to the ownerconsidered as due to the owner; who was nothing but the contributory of the capital.

For e.g. Mr Z has brought a capital of Rs.1 lakh for the commencement of retailingbusiness of refrigerators. The brought capital of Rs. 1 lakh has utilized for the purchaseof refrigerators from the Godrej Ltd. He finally bought 10 different sized refrigerators.Out of 10 refrigerators, one was taken away by the owner Mr. Z

In the angle of the firm

The amount of the capital Rs.1 lakh has to be returned to the owner Mr. Z, whichconsidered to be as due. Among the 10 newly bought refrigerators for trading, one wastaken away by the owner for his personal usage. The one refrigerator drawn by theowner for his personal usage led the firm to sell only 9 refrigerators. It means that Rs.90,000 out of Rs. 1 Lakh is the volume of real capital and the Rs.10,000 worth of therefrigerator considered to be as drawings; which illustrates the capital owed by the firmis only Rs. 90,000 not Rs. 1 lakh.

In the angle of the owner

The refrigerator drawn worth of Rs.10,000 nothing but Rs.10,000 worth of real capitalof the firm was taken for personal use as drawings reduced the total volume of thecapital of the firm from Rs.1 lakh to Rs. 90,000, which expected the firm to return thecapital due amounted Rs. 90,000.

Type of Capital

Real Capital 10 Refrigerators

@Rs.1 lakh

Monetary Capital Rs.1lakh provided

by Mr. Z

Recording of transactions are only in terms of money in the

process

14


1.5.3 Going Concern Concept

The concept deals with the quality of long lasting status of the business enterpriseirrespective of the owners' status, whether he is alive or not. This concept is known asconcept of long-term assets. The fixed assets are bought in the intention to earn profitsduring the season of the business. The assets which are idle during the slack season ofthe business retained for future usage, in spite of that those assets are frequently sold outby the firm immediately after the utility leads to mean that those assets are not fixedassets but tradable assets. The fixed assets are retained by the firm even after the usageis only due to the principle of long lastingness of the business enterprise. If the businessdisposes the assets immediately after the current usage by not considering the futureutility of the assets in the firm which will not distinguish in between the long-term assetsand short-term assets known as tradable in categories.

1.5.4 Matching Concept

This concept only makes the entire accounting system as meaningful to determine thevolume of earnings or losses of the firm at every level of transaction; which is anoutcome of matching in between the revenues and expenses.

The worth of the transaction is identified through matching of revenues which aremainly generated from the sales volume and the expenses of the firm at every level.

For example, the cost of goods sold and selling price of the pen of ABC Ltd are Rs. 5and Rs. 10 respectively. The firm produced 100 ball pens during the first shift and out of100 pens manufactured 20 pens are considered to be damage which cannot be suppliedto the customers, rejected by the quality circle department. There was an order from thefirm XYZ Ltd., which amounted 80 pens to be supplied immediately.

The worth of the transaction of the firm at every level of the transaction is being studiedonly through the matching of revenues with the expenses.

At first instance, the firm produced 100 pens which incurred the total cost of Rs 500required to match with the expected revenues of Rs 1,000; illustrated the level of profithow much would it accrue if the entire level of production is sold out ?

If the entire production capacity is sold out in the market the profit level would be Rs 500.

Out of the 100 pens manufactured 20 were identified not ideal for supply as damages, theremaining 80 pens were supplied to the individual retailer The retailer has been dispatched80 pens amounted Rs 400 which equated to Rs 800 of the expected sales At the momentof dispatching, the firm expected to earn a profit of Rs 400 at the level of 80 pens supplied.After the dispatch, the retailer found that 50 pens are in accordance with the order placementbut the remaining are to the tune of the retailers' specifications. Finally, the retailer hasagreed to make the payment of the bill only in accordance with the order placed whichamounted Rs 500 out of the expenses of the manufacturer Rs 250.

This concept facilitates to identify the worth of the transaction at every moment.

1.5.5 Accounting Period Concept

Though the life period of the business is longer in span, which is classified into theoperating periods which are smaller in duration. The accounting period may be eithercalendar year of Jan-Dec or fiscal year of April-Mar. The operating periods are not

Concept of fusion in between the expenses and revenues

Owner and business organizations are two separate entities

Accounting concept for long lastingness of the business enterprise

15

Financial Accountingequivalent among the trading firms, which means that the operating period of one firmmay be shorter than the other one. The ultimate aim of the concept is to nullify thedeviations of the operating periods of various traders in the trading practice.

According to the Companies Act, 1956, the accounting period should not exceed morethan 15 months.

1.5.6 Duality or Double entry accounting concept

It is the only concept which portrays the two sides of a single transaction. The law ofentire business revolves around only on mutual agreement sharing policy among theplayers. How mutual agreement is taking place ?

The entire principle of business is mainly conducted on mutual agreement among theparties from one occasion to another. The payment of wages are only made by the firmout of the services of labourers. What kind of mutual agreement in sharing the benefitsis taking place? The services of the labourers are availed by the firm through the paymentof wages. Like-wise, the labourers are regularly getting wages for their services in thefirm.

Payment of Wages = Labourers' service

In the angle of accounting aspects of a firm, the labourer services are availed throughthe payment of wages nothing but the mutual sharing of benefits. Availing of services ortaking the services of the labourers only through the cash payment whatever you makeat the end i.e., giving wages.

This is being denominated into two different facets of accounting viz Debit and Credit.Every debit transaction is appropriately equated with the transaction of credit.

The entire above sample of transactions are being carried out by the firm through theraising of financial resources. The resources raised were finally deployed in terms ofassets. It means that the total funds raised by the firm is equated to the total investments.

From the below table illustration, it is clearly evidenced that the entire raised financialresources are applied in the form of asset applications. It means that the total liabilitiesare equivalent to the total assets of the firm.

Concept of uniform accounting horizon among the firms to evade deviations

Total Financial Resources Total Assets

Liabilities Assets Share capital Plant and Machinery Preference Share Capital Land and Buildings Debentures/Long Term Borrowings Fixtures and Tools Retained Earnings Delivery vehicles Commercial Paper Furniture – Industry and office Public Deposits Office administrative devices Bank Loan Marketable securities Overdraft Short-term investments Pre received Income Closing stock Outstanding Expenses Pre paid expenses Sundry Creditors Outstanding Income Bills Payable Sundry debtors Provision for Taxation Bill Receivable Cash at Bank Cash in Hand

16


1.5.7 Cost Concept

It is the concept closely relevant with the going concern concept. Under this concept,the transactions are recorded only in terms of cost rather than in market value. Fixedassets are only entered in terms of the purchase price which is a original cost of theasset at the moment of purchase. The depreciation is deducted from the original valuewhich is the initial purchase price of the asset will highlight the book value of the asset atthe end of the accounting period. The marketing value of the asset should not be takeninto consideration, Why? The main reason is that the market value of the asset is subjectto fluctuations due to demand and supply forces. The entry of market value of the assetwill require the frequent update of information to the tune of changes in the market. Willit be possible to record the changes taken place in the market then and there? This is notonly not possible for regular updating of information but also leads to lot of consequences.Though the firm is ready to register the market value; which market value has to betaken into consideration? The market value can be bifurcated into two categories vizRealizable value and Replacement value.

Realizable value is the value of the asset at the moment of sale or realization. Replacementvalue is the another value which considered at the moment of replacing the old assetwith the new one. These two cannot be the same at single point of time and the wearand tear of the asset will play pivotal role in fixing the realization value which has thedemarcation over the later.

1.6 ACCOUNTING CONVENTIONS

Accounting conventions are bearing the practical considerations in recording thetransactions of the business enterprise in systematic manner.

l Convention of consistency

l Convention of conservatism

l Convention of disclosure

1.6.1 Convention of consistency

The nature of recording the transactions should not be changed at any cause or moment.It should be maintained throughout the life period of the firm. If a firm follows thestraight line method of charging the depreciation since its inception should be followedwithout any change . The firm should not alter the method of charging the depreciationfrom one method to another. The change cannot be entertained. If any change has to beincorporated, the valid reason for change should be emphasized.

1.6.2 Convention of conservatism

The conservatism wont give any emphasis on the anticipation of the firm, instead it givesparamount importance to all possible uneventualities of the firm without considering thefuture profits.

The most important of the rule of guidance at the moment of valuing the stock is asfollows:

Stock Valuations:

"Stock of the goods should be valued either market price or cost whichever is lower"

To anticipate the future losses due to default in the payments of the customers;

Provision is created for bad and doubtful debts of the firm in order to meet the lossesexpected. out of the defaulters.

Concept of mutual agreement and sharing of benefits

17

Financial Accounting1.6.3 Convention of disclosure

According to this convention, the entire status of the firm should be highlighted / presentedin detail without hiding anything; which has to furnish the required information to variousparties involved in the process of the firm.

Next stage is to classify the accounts into various categories.

Classification of Accounts: The entire process of accounting brought under three majorsegments ; which are broadly grouped into two categories.

Check Your Progress

(1) Accounting principles are

(a) Accounting concepts only (b) Accountingconventions

(c) Accounting concepts & conventions only (d) None of the above

(2) Money measurement concept is

(a) Financial transactions only (b) Non financial transactions only

(c) Both (a) & (b) (d) None of the above

(3) Distinction of the assets is on the basis of

(a) Going concern concept (b) Time period concept

(c) Business entity concept (d) Duality concept

(4) The worth of transactions are identified only through

(a) Cost concept (b) Matching concept

(c) Business entity concept (d) Double entry accounting concept

(5) Total Liabilities = Total Assets is dealt

(a) Business entity concept (b) Cost concept

(c) Going concern concept (d) Duality concept

The entire accounts of the enterprise is broadly classified into two categories viz PersonalAccounts and Impersonal Accounts. The Impersonal accounts is further classified intotwo categories viz Real accounts and Nominal accounts.

What is personal accounts?

It is an account which deals with a due balance either to or from these individuals ona particular period. It is an account normally reveals the outstanding balance of the firmto individuals e.g. suppliers or outstanding balance from individuals e.g. customers. This

Accounts

Personal Accounts

Impersonal Accounts

Real Accounts Nominal Accounts

Persons Out of Nature

Persons Out of

Representations

Persons Out of

Law Relationship

18


is the only account which emphasizes the future relationship in between the businessfirm and the individuals.

The personal accounts can be classified into three categories.

1.6.4 Persons of Nature

Persons who are nothing but outcome of nature i.e., almighty.

1.6.5 Persons of Artificial relationship

Persons who are made out of artificial relationship through legal structure is known asorganizations, corporate, partnership firm and so on. The companies and partnershipfirm are governed by the Companies Act 1956 and the partnership act. The relationshipamong the owners of the company or partners of the firm are totally structured throughrespective laws.

E.g.: LIC, SBI, Companies are most important illustrations governed by the artificialrelationship among the members through LIC act, SBI act and the Companies act 1956and so on respectively.

1.6.6 Persons of representations

This classification represents amount outstanding or prepaid in connection with theindividual transactions.

(i) Outstanding of electricity charges: Electricity charges outstanding is withreference to the electricity board TNEB, Rent prepaid refers that rent of the officeis made as an advance payment for the forthcoming month to the owner of thebuilding.

The personal account is the account of future relationship; to maintain the relationshipof future in two different angles viz Receiver of the benefits from the firm andgiver of the benefits to the firm.

1.6.7 Receiver of the benefits

For E.g.: The credit sale of the goods worth of Rs 1,500 to Mr X. In this transaction Mr.X is the receiver of the benefits through the credit sale of the firm. Till the collection ofthe sale benefits, the firm should maintain the relationship of business with the Mr. X inthe books of accounts.

1.6.8 Giver of the benefits

For E.g: The credit purchase of the goods worth of Rs 3,000 from Mr. Y. The giver ofthe goods nothing but the supplier of the goods Mr. Y should be recorded in the books ofthe firm till the payment of dues of the credit purchase. The future relationship is maintainedin the books of the accounts till the payment process is over.

1.7 REAL ACCOUNTS

It is a major classification which highlights the real worth of the assets. This is theaccount especially deals with the movement of assets. It is an account not only revealsthe value and movement of the assets taking place in between the firm and also otherparties due to any transactions.

Debit the Receiver Credit the Giver

19

Financial Accounting

Date Particulars Ledger Folio

Debit Rs

Credit Rs

To Debit the Name of the account

Number of the day in the month, Name of the month and Year in full

To credit the Name of the account

Page number in the respective ledger

The movement of the assets can be classified into two categories viz the assets whichare coming into the firm and the assets which are going out of the firm.

Whenever any movement of the assets taking place with reference to any transactionseither coming into the firm or going out of the firm should be recorded in accordancewith the set golden rules of this account.

1.8 NOMINAL ACCOUNTS

This is an account deals with the amount of expenses incurred or incomes earned. Itincludes all expenses and losses as well as incomes and gains of the enterprise. Thisnominal account records the expenses and incomes which are not carried forwarded tonear future.

The process of the accounting in normal practice as follows:

The practice starts with the journalizing of entries. After journalisation, the entries passedin the journal will be passed into the ledger A/c. The immediate next stage is to preparethe trial balance.

What is meant by the journal entry ?

It is an entry systematically recorded to the tune of golden rules of accounting in thejournal book is known as journal entries.

How the journal entries are entered?

The journal entries are recorded in the sequential order. The order of recording isconventionally done on the basis of date. The journal entry usually contains two differentparts, which are nothing but two different accounts affecting the transactions.

Journalising the entries are different from one transaction to another The difference isonly due to nature and characteristics of the transactions. To journalise as easy as possible,the systematic approach to be adopted to post the transactions without any ambiguity.

Journalising can be generally categorized into following various categories.

l Taking place within the same natured accounts

l Taking part in between accounts of two different in categories

First, we will discuss the journalizing of entries of the same natured accounts. This canbe classified into various segments

l Transactions only in between the personal accounts

l Transactions only in between the real accounts

Under the category of transactions which affect only the personal accounts are as follows:

l Between the persons of the nature

Debit What comes in Credit What goes out

Debit all the expenses and losses Credit all incomes and gains

20


l Between the persons of the artificial relationship

l Between the persons of Representations

What are the points to observed at the moment of journalizing ?

l The nature of the accounts to be identified

l The accounts to be correlated to the golden rules

l Once the accounts are finalized, the next stage is to pass the entry through properdebiting and crediting of the accounts respectively.

The meaning of the transaction should be made explicit for easier understanding throughbrief and catchy narration to follow as well as evade the ambiguity in near future.

Mr Sundar is a debtor who has paid Rs 1,500, in the bank A/c

l Transaction is identified which is in between two different persons under thepersonal A/c, they are nothing but persons of nature.

l The benefits are shared in between two persons viz. Mr. Sundar and Banker whoare nothing but giver and receiver of the benefits respectively.

l It means that Sundar is the giver of Rs 1,500 to Banker who is the receiver of thesame Rs. 1,500.

Final step is to pass the journal entry

Bank A/c Dr Rs. 1,500

To Sundar A/c Cr Rs. 1,500

(Being cash is paid by sundar to Bank A/c)

1.9 TRANSACTIONS IN BETWEEN THE REAL A/C

Real A/c is an account to highlight the movement of the assets. If any simultaneousmovement is taking place in between two different assets of the enterprise can beexplained with the following example:

Purchase of a Plant and Machinery of Rs.15,000.

The purchase of a plant and machinery is only through cash payment to the vendor.

What are the two different type of assets involved in the movement during the purchase?

There are two different type of assets viz. Cash and Plant & Machinery

To put in nutshell, among the two assets, Cash is one of the current assets and the Plant& Machinery is one of the fixed assets. In general, these two are brought under thecategory of assets or applications of the firm.

Debit the Receiver Bank Debit the Melvin A/c

Credit the Giver Sundar Credit the Sundar A/c

Mr. Sundar Bank

Personal A/cs Persons of Nature

Giver Receiver

21

Financial AccountingIf the assets are involved in the transaction, Real account should only be referred.

How the movement of assets is taking place at the moment of purchase ?

The movement of the assets classified into two segments viz. movement in and movementout.

1.9.1 What is movement - in?

The movement - in is the movement of the assets to the business enterprise. With referenceto above cited example which asset is coming into the business enterprise? Plant &Machinery is the asset which comes into the business enterprise only at the moment ofpurchase.

1.9.2 What is movement - out?

The movement-out is the movement of the assets from the business enterprise. Fromthe above illustrated example, which asset is going out of the firm during the purchase?Cash resources are going out of the firm in order to make the payment of the purchaseto the supplier of the assets.

Cash Resources

Plant & Machinery

Next stage is to highlight the movement of the assets during the purchase

What is coming in ?- Plant & Machinery

What is going out ?- Cash Resources

Plant & Machinery A/c Dr Rs.15,000

To Cash resources A/c Cr Rs.15,000

(Being Plant & Machinery is purchased)

What is the basic point to be registered ?

During the purchase, the plant & machinery worth of Rs.15,000 is coming into the firm,in turn Rs.15,000 worth of cash resources are going out of the firm. During the cashpurchase, the assets are moving from one entity to another viz. from business enterpriseto supplier and vice versa.

1.10 JOURNAL ENTRIES IN BETWEEN THE ACCOUNTSOF TWO DIFFERENT CATEGORIES

l Transactions are in between the Real A/c and Personal A/c:

This type of the transaction is mainly governed by one important principle that futurerelationship. It major focus on the maintenance of future relationship among the partiesinvolved, till the realization of the transaction is over.

Goods sold to Gopal Rs.15,000.

Meaning: The goods were sold on credit to Gopal amounted Rs.15,000.

Supplier Business Enterprise

Movement - In Plant & Machinery Debit What Comes in Movement - Out Cash Resources Credit What goes out

22


First, what are the various A/cs involved in the transaction ?

There are two different A/cs viz Real A/c and Personal A/c

How Real A/c and Personal A/c are considered for journalizing the entries?

During the sales, irrespective of nature, Goods are moving out of the firm, which finallywill reach the individual Gopal. The goods, which are sold out to Gopal led to movementof goods out of the firm. Any movement of asset should be referred only to the tune ofReal A/c. The goods which are going out of the firm could be recorded as transactionunder the Real A/c i.e."Credit what goes out". While recording the transaction, it shouldnot be entered as Goods A/c, Why ? Instead of recording as Goods A/c, which are goingout of the firm should be mentioned only with reason of going out. The reason for goodsgoing out of the firm is only due to sales; has to registered in the books of accounts at thetime of entering the journal entries.

The second account which gets affected is the personal A/c of representations. Thegoods sold out on credit led to register the receiver of goods who has not paid at themoment of sale. Gopal is the individual received the goods on credit during the salesexpected to make the payment as per the terms of credit period. Till the maturity of thecredit period agreed, the firm should wait and collect the amount from the individual whois nothing but the receiver of goods.

Next step is to record the journal entry

Gopal A/c Dr Rs.15,000

To Sales A/c Cr Rs.15,000

(Being goods sold on credit to Gopal)

l Transaction in between the Real A/c and Nominal A/c

l Office Rent paid Rs.10,000

What are the two different accounts involved in the above illustrated transaction?

First one is the Rent A/c and another is Cash A/c only due to cash payment at themoment of making the payment of rent.

What is the nature of Rent A/c?

The Rent which is paid to the owner is an expense out of the benefits derived out of theasset during the previous month. In accordance with the Nominal A/c all the expensesare to be recorded, i.e. "Debit all the expenses and losses."

The second is in relevance with the cash payment which finally led to the movement ofcash resources from the firm to the owner of the Asset. This mobility of the assets leadsto movement - out which in connection with the Real A/c is the account for the assets.

Check Your Progress

(1) Rent paid

(a) Debit - Rent ; Credit - The giver (b) Debit - Cash; Credit - Rent

(c) Debit - Rent; Credit - Cash (d) None of the above

(2) Purchase of assets in between the two different accounts

Rent paid Expense - Office Rent paid Nominal A/c - Debit All expenses and losses Movement - out Cash – moving out of the firm Real A/c - Credit what goes out

Movement-out-Real A/c

Goods are moving out of the firm

Credit what goes out Sales A/c

Receiver of benefits- Personal A/c Receiver of the goods on credit with future relationship

Debit the receiver Gopal A/c

Contd...

23

Financial Accounting(a) Real A/c and Personal A/c (b) Real A/c and Nominal A/c

(c) Personal A/c and Personal A/c (d) Real A/c and Real A/c

(3) Identify nature of the transactions: Sundar has purchased goods on creditfrom M/s Melvin & Co Rs.15,000. The portion of the goods were found todamaged which worth of Rs 5,000. Sundar immediately returned the damagedgoods to Melvin & Co.

(a) Identify the various types of accounts involved in the above illustratedtransactions.

(b) Pass the journal entries with regards to the nature of accounts involved.

Illustration 1

Pass the following various journal entries.

(i) Jan 1, 2006 Mr. Sundar has started business with a capital of Rs 50,000

(ii) Jan 2,2006 Goods purchased Rs 10,000

(iii) Jan 5, 2006 Goods sold Rs 5,000

(iv) Jan 10, 2006 Goods purchased from Mittal & Co Rs 10,000

(v) Jan 11, 2006 Goods sold to Ganesh & Co Rs 10,000

(vi) Jan 12,2006 Goods returned to Mittal & Co Rs 1,500

(vii) Jan 20,2006 Goods returned from Ganesh Rs 2,000

(viii) Jan 31,2006 Office Rent paid Rs 500

(ix) Feb 2,2006 Interim Cash Dividend paid Rs 3000

(x) Feb 8, 2006 Cash withdrawn from bank Rs 2,000

(i) Jan 1, 2006 Mr. Sundar has started business with a capital of Rs 50,000

Rs Rs

(ii) Jan 2, 2006 Goods purchased Rs 10,000

Rs Rs


Rs Rs

(iv) Jan 10, 2006 Goods purchased from Mittal & Co Rs 10,000

Rs Rs

Cash A/c Dr 50,000 Jan 1, 2006 To Sundar’s capital A/c Cr 50,000

Being capital brought by sundar as cash

Purchase A/c Dr 10,000 Jan 2, 2006 To Cash A/c Cr 10,000

Being cash purchase is made

CashA/c Dr 5,000 Jan 5, 2006 To Sale A/c Cr 5,000

Being cash sale is made

Purchase A/c Dr 10,000 Jan 10, 2006 To Mittal A/c Cr 10,000

Being credit purchase from Mittal

24


(v) Jan 11, 2006 Goods sold to Ganesh & Co Rs. 10,000

Rs Rs

(vi) Jan, 12, 2006 Goods returned to Mittal & Co Rs. 1,500

Rs Rs

(vii) Jan 20, 2006 Goods returned from Ganesh Rs. 2,000

Rs Rs

(viii) Jan 31, 2006 Office Rent paid Rs. 500

Rs Rs

(ix) Feb 2, 2006 Interim Cash Dividend received Rs. 3000

Rs Rs

(x) Feb 8, 2006 Cash withdrawn from bank Rs. 2,000

Rs Rs

Classification of transactions is being done only on the basis of preparing the ledgeraccounts. The accounts are classified on the basis of nature and characteristics.

How the account transactions are classified ?

The accounts are classified through the preparation of ledger.

1.10.1 What is meant by Ledger?

Ledger is nothing but preliminary book of accounting transactions at which, each accountis separately maintained through the allotment of various pages for exclusive recording.The exclusive allotment of pages for every account to finalize their balances. Finally,ledger can be understood that is a document of grouping the transactions under oneheading .

It is a fundamental book of accounts which mainly highlights the status of the accounts.

Example: Plant & Machinery’s ledger A/c should reveal the transactions of the sale &purchase of the plant and machinery.

How the transactions are recorded in the ledger ?

The journal entries which are recorded nothing but posting of the entries in the ledgerbook of accounts. Posting / entering the journal entries are routinely carried outimmediately after the transactions.

Prior to discuss the posting of journal entries into the ledger accounts, every body shouldknow the contents of the ledger. The ledger is segmented into two different categories.

Mittal &Co A/c Dr 1,500 Jan 12, 2006 To Purchase Return A/c Cr 1,500

(Being the goods returned to supplier Mittal &Co)

Sales ReturnA/c Dr 2,000 Jan 20, 2006 To Ganesh&co Cr 2,000

Being sales return made by Ganesh & Co

Office Rent A/c Dr 500 Jan 31, 2006 To Cash A/c Cr 500

Being office rent paid

Cash A/c Dr 3,000 Feb 2, 2006 To Interim Dividend Cr 3,000

Being cash interim dividend received

Cash A/c Dr 2,000 Feb 8, 2006 To Bank Cr 2,000

Being cash withdrawn from the bank

Ganesh A/c Dr 10,000 Jan 11, 2006

To SaleA/c Cr 10,000

Being credit sale made to Ganesh

25

Financial AccountingProforma of the Ledger Account

Dr Name of the Account Cr

Journal entries are divided into two categories viz

1. Debit item of the transaction

2. Credit item of the transaction

Once the journal entries are identified for classification, the entries should be recorded inaccordance with the date order of the transactions in the respective pages.

While recording a transaction, normally a journal entry has got an impact on two or eventhree different accounts.

1.10.2 LedgeringIt is a process of recording the transactions under one group from the early process ofjournalizing. Without journalizing, ledgering is not meaningful. The process of ledgeringinvolves with various steps. The process commences from only at the completion ofjournalizing and ends at the end of balancing of journal accounts.

D r Cash A/c Cr Dr Krishna Capital A/c Cr

Dr Cash A/c Cr Dr Krishna Capital A/c Cr

Date Particular Date Particulars To By

Debit item of the journal transaction “Cash A/c” to be recorded in the credit side of the remaining A/c i.e

Enter the journal entry in the Ledger A/c Cash A/c Dr Rs. 50,000

To Krishna’s capital A/c Rs. 50,000

Credit item of the journal transaction “Krishna capital A/c” to be recorded in the debit side of the A/c i.e. Cash A/c

Process of Ledgering

Identify the transaction

Open the ledger accounts involved in the journal entries

Identify the two accounts involved

Krishna started the business with a capital of Rs 50,000

Two accounts - Cash A/c & Krishna Capital A/c

Open Ledger accounts Cash A/c & Krishna Capital A/c

To Krishna capital Rs. 50,000 By Cash Rs. 50,000

Krishna capital A/c debited into cash A/c Cash A/c credited into Krishna capital A/c

26


Next step is to Balance the individual Ledger A/c:

How to balance the ledger A/c?

The individual ledger A/c may have more than two transactions during the specified period.

l The first step is to find out the totals of debit and credit side of the ledger account.

l The second step is to compare the totals of the two different sides

l The third step is to find out the total of which side is greater over the other

l The fourth step is to identify the difference among the two different side balancesi.e., debit and credit side totals.

l The fifth step is most important step which balances the difference on the total ofthe side which bears lesser total over the greater.

l If the balance of the debit side of the ledger is more than the credit side of theledger is called as Debit balance ledger and vice versa in the case of Credit balanceledger

l The closing balance of one ledger account will become automatically a openingbalance of the same ledger account for next accounting period.

Post the journal entries into respective ledger accounts. And list out their accountingbalances.

(i) Jan 1, 2006 Mr. Sundar has started business with a capital of Rs. 50,000

Rs Rs

(ii) Jan 2, 2006 Goods purchased Rs 10,000

Rs Rs


Rs Rs

(iv) Jan, 10, 2006 Goods purchased from Mittal & Co Rs 10,000

Rs Rs

(v) Jan, 11, 2006 Goods sold to Ganesh & Co Rs.10,000

Rs Rs

(vi) Jan, 12, 2006 Goods returned to Mittal & Co Rs. 1,500

Rs Rs

Cash A/c Dr 50,000 Jan 1, 2006 To Sundar’s capital A/c Cr 50,000

Being capital brought by Sundar as cash

Purchase A/c Dr 10,000 Jan 2, 2006 To Cash A/c Cr 10,000

Being cash purchase is made

CashA/c Dr 5,000 Jan 5, 2006 To Sale A/c Cr 5,000

Being cash sale is made

Purchase A/c Dr 10,000 Jan 10, 2006 To Mittal A/c Cr 10,000

Being credit purchase from Mittal

Ganesh A/c Dr 10,000 Jan 11, 2006 To SaleA/c Cr 10,000

Being credit sale made to Ganesh

Mittal & Co A/c Dr 1,500 Jan 12, 2006 To Purchase Return A/c Cr 1,500

Being the goods returned to supplier Mittal & Co

27

Financial Accounting(vii) Jan 20, 2006 Goods returned from Ganesh Rs. 2,000

Rs Rs

(viii) Jan 31, 2006 Office Rent paid Rs. 500

Rs Rs

(ix) Feb 2, 2006 Interim Cash Dividend received Rs. 3000

Rs Rs

(x) Feb 8, 2006 Cash withdrawn from bank Rs. 2,000

Rs Rs

List out the various accounts which are involved in the enterprise during the year?

I. Cash Account

II. Sundar Capital Account

III. Purchase Account

IV. Sales Account

V. Mittal & Co Account

VI. Ganesh & Co Account

VII. Sales Return Account

VIII. Purchase Return Account

IX. Office Rent Account

X. Interim Dividend Account

XI. Bank Account

Dr Cash Account Cr

To balance b/d 49,500

Note: Debit side total is greater than the credit side total of the cash account. Afterdetermining the difference, the cash account shows Debit Balance.

Cash A/c Dr 2,000 Feb 8, 2006 To Bank Cr 2,000

Being cash withdrawn from the bank

Office Rent A/c Dr 500 Jan 31, 2006 To Cash A/c 500

Being office rent paid

Cash A/c Dr 3,000 Feb 2, 2006 To Interim Dividend Cr 3,000

Being cash interim dividend received

Sales ReturnA/c Dr 2,000 Jan 20, 2006 To Ganesh& co Cr 2,000

Being sales return made by Ganesh & Co

Date Particular Rs Date Particulars Rs Jan 1 Jan 5 Feb 2 Feb 8

To Sundar Capital 50,000 To Sale 5,000 To Interim Dividend 3,000 To Bank 2,000

J an 2 Jan 31

By Purchase 10,000 By Office Rent 500 By Balance c/d 49,500

60,000 60,000

28


Dr Sundar Capital Account Cr

` By Balance B/d 50,000

Note: Sundar capital account is having the greater credit balance over the debit balanceaccount which led to credit balance account.

Dr Purchase Account Cr

To Balance B/d 20,000

Note: Purchase account is bearing the debit balance account

Dr Sale Account Cr

By Balance B/d 15,000

Note: Sale account is bearing the credit balance account

Dr Sales Return Account Cr

To Balance B/d 2000

Note: Sales return account is having the debit balance account

Dr Purchase Return Account Cr


Note: Purchase return account is bearing credit balance account

Dr Mittal & Co Account Cr


Note: Mittal & Co account is having the greater total in the credit side than the debitside led to credit balance at the closing

Date Particulars Rs Date Particulars Rs To Balance c/d 15,000 Jan 5

Jan 11 By Cash 5,000 By Ganesh 10,000

15,000 15,000

Date Particulars Rs Date Particulars Rs Jan 20 To Ganesh 2000 By Balance c/d 2000

2000 2000

Date Particular Rs Date Particulars Rs To Balance c/d 1,500 Jan 12 By Mittal &Co 1500

1,500

Date Particulars Rs Date Particulars Rs Jan 12 To Purchase Return 1,500

To Balance c/d 8,500 Jan 10 By Purchase 10,000

10,000 10,000

Date Particular Rs Date Particulars Rs To Balance c/d 50,000 Jan 1 By Cash 50,000

50,000 50,000

Date Particular Rs Date Particulars Rs Jan 2 Jan 10

To Cash 10,000 To Mittal & Co 10,000

By Balance c/d 20,000

20,000 20,000

29

Financial AccountingDr Ganesh & Co Account Cr


Note: Ganesh & Co account is bearing a greater debit side total than the credit side totalwhich led to have debit balance account

Dr Office Rent Account Cr

To Balance B/d 500

Note: Office rent account is bearing debit balance

Dr Interim Dividend Account Cr

By Balance B/d3,000

Note: Interim dividend account is having the credit balance

Dr Bank Account Cr


Note: Bank account is having the credit balance

1.11 CASE LET

Singania Chartered Accountants Firm established in the year 1956, having very goodnumber of corporate clients. It continuously maintains the quality in audit administrationwith the clients since its early inception. The firm is eagerly looking for promising studentswho are having greater aspirations to become auditors. The firm is having an objectiveto recruit freshers to conduct preliminary auditing process with their corporate clients.

For which the firm would like to select the right person who is having conceptual knowledgeas well as application on the subjects. It has given the following Balance sheet to theparticipants to study the conceptual applications. The participants are required to enlistthe various concepts and conventions of accounting.

Date Particulars Rs Date Particulars Rs Jan 31 To Cash 500 By Balance c/d 500

500 500

Date Particulars Rs Date Particulars Rs Jan 11 To Sale 10,000 Jan 20

By Sale Return 2,000 By Balance c/d 8,000

10,000 10,000

Date Particular Rs Date Particulars Rs To Balance c/d 3,000 Feb 2 By Cash 3,000

3,000 3,000

Date Particular Rs Date Particulars Rs To Balance c/d 2,000 Feb 2 By Cash 2,000

2,000 2,000

30


Balance sheet as on dated 31st Mar, 2006

List out the various accounting concepts dealt in the above balance sheet.

Explain the treatment of accounting concepts

Check Your Progress

(1) Financial Accounting is:

(a) Accounting of business transactions

(b) Accounting of Financial transactions only

(c) Accounting of Non-financial transactions

(d) Accounting of both financial and non-financial transactions

(2) Accounting concept is:

(a) Theory of accounting (b) Procedures of accounting

(c) Rules of accounting (d) Practice of accounting

(3) Journal is:

(a) Preliminary step of accounting

(b) Intermediate step of accounting

(c) Both (a) & (b)

(d) Final step of accounting

(4) Ledger account is prepared

(a) On the basis of single entry system of accounting

(b) On the basis of double entry accounting system

(c) Both (a) & (b)


1.12 LET US SUM UP

" Accounting is the process of recording, classifying, summarizing in a significant mannerof transactions which are in financial character and finally results are interpreted."

Liabilities Assets Capital(A.Pandit) 1,00,000 Building 80,0000 (+) Commission 4,925 Depreciation 2.5% 2,000 1,04,925 78,000 (+)Net profit 11,869 Furniture 23,000

1,16,794 Depreciation 10% 2,050 (-)Drawings 16,000 20,950

1,00,794 Closing stock 1,14,500 Capital( B.Pandit) 1,00,000 Sundry Debtors 25,000 (+)Commission 1,187 Cash in hand 400

1,01,187 (+) Net profit 11,869

1,13,056 (-)Drawings 16,000 97,056 Bank overdraft 29,000 Sundry creditors 12,000

2,38,850 2,38,850

31

Financial AccountingThe revenues are recognized only at the moment of realization but the expenses arerecognized at the moment of payment. The charges which were paid only will be takeninto consideration but the outstanding, not yet paid will not be considered. The revenuesare recognized only at the time of occurrence and expenses are recognized only at themoment of incurring. The financial statements are found to be more useful to many peopleimmediately after presentation only in order to study the financial status of the enterprise inthe angle of their own objectives. The entire accounting system is governed by the practiceof accountancy. The accountancy is being practiced through the universal principles whichare wholly led by the concepts and conventions. Money measurement concept tunes thesystem of accounting as fruitful in recording the transactions and events of the enterpriseonly in terms of money. Business entity concept treats the owner as totally a differententity from the business. Going concern concept deals with the quality of long lasting statusof the business enterprise irrespective of the owners' status, whether he is alive or not.Matching concept only makes the entire accounting system as meaningful to determine thevolume of earnings or losses of the firm at every level of transaction. Duality or Doubleentry accounting concept is the only concept which portrays the two sides of a singletransaction. The law of entire business revolves around only on mutual agreement sharingpolicy among the players. Personal accounts is an account which deals with a due balanceeither to or from these individuals on a particular period. Real Accounts is the accountespecially deals with the movement of assets. Nominal Accounts is an account deals withthe amount of expenses incurred or incomes earned. It includes all expenses and losses aswell as incomes and gains of the enterprise.

1.13 LESSON-END ACTIVITY

Assume you are a new-appointed Senior Manager of a firm. How what would yousuggest to the accounting department for better accounting circulation?

1.14 KEYWORDS

Record

Accounting

Revenues

Personal Account

Normal Account

Real Account

Classifying

Summarizing

Business Entity Concept

Money Measurement Concept

Going Concern Concept

Matching Concept

Duality Concept

Ledger

1.15 QUESTIONS FOR DISCUSSION

1. Define Accounting.

2. Illustrate the Accounting process.

32


3. Classify the various kinds of values in the accounting process.

4. Highlight the journalizing process of accounting.

5. Explain the process of ledgering of transactions of the business firm.

6. Write brief note on the various classification of accounts.

7. Explain the golden rules of accounting.

1.16 SUGGESTED READINGS

M.P. Pandikumar “Accounting & Finance for Managers”, Excel Books, New Delhi.

R.L. Gupta and Radhaswamy “Advanced Accountancy”.

V.K. Goyal, “Financial Accounting”, Excel Books, New Delhi.

Khan and Jain “Management Accounting”.

S.N. Maheswari “Management Accounting”.

S. Bhat “Financial Management”, Excel Books, New Delhi.

Prasanna Chandra, “Financial Management – Theory and Practice”, Tata McGrawHill, New Delhi (1994).

I.M. Pandey, “Financial Management”, Vikas Publishing, New Delhi.

Nitin Balwani “Accounting & Finance for Managers”, Excel Books, New Delhi.

LESSON

2TRIAL BALANCE

CONTENTS

2.0 Aims and Objectives

2.1 Introduction

2.2 Grouping of Various Accounting Transactions

2.3 Preparation of the Trial Balance

2.4 Why the Subsidiary Accounts have to be prepared?

2.4.1 Purchase Book

2.4.2 Purchase Returns Book

2.4.3 Sales Book

2.5 Steps involved in the Sales Book

2.5.1 Sales Return Book

2.6 Steps Involved in the Sales Return Book

2.6.1 Trade Bills Book

2.6.2 Bills Receivable Book

2.7 What is meant by the Cash Transaction?

2.7.1 Double Columnar Cash Book

2.7.2 Three Columnar Cash Book

2.7.3 Multi Columnar Cash Book

2.7.4 Petty Cash Book

2.8 Let us Sum up

2.9 Lesson-end Activity

2.10Keywords

2.11Questions for Discussion

2.12Suggested Readings

2.0 AIMS AND OBJECTIVES

In this lesson we shall discuss about trial balance. After going through this lesson you willbe able to:

(i) discuss grouping of various accounting transactions

(ii) analyse preparation of the trial balance.

2.1 INTRODUCTION

The next most important stage is to prepare the statement (summary) of accountingbalances and their names for the specified accounting period to the tune of principle ofgrouping transactions, known as Trial Balance.

34


Trial Balance is a list of accounting balances and their names; of the enterprise duringthe specified period which includes debit and credit balances of the various balancedledger accounts out of the journal entries.

2.2 GROUPING OF VARIOUS ACCOUNTINGTRANSACTIONS

There are eleven different ledger accounts involved out of the journal entries whichalready transacted are finally balanced. The balanced ledger accounts should be preparedas a summary list of their balances and names. The total of both balances are equivalentto each other. The major reason for the equivalent balances on both sides is only due toposting of entries to the tune of "Double Entry Accounting Concept (Or) Duality Concept".This is the concept which equates the total amount of resources raised with the totalamount of applications of the enterprise.

Purposes of preparing the Trial Balance:

l To prepare a statement of disclosure of final accounting balances of various ledgeraccounts on a particular date

l To prepare a statement of cross checking device of accounting while in theprocess of posting of entries which mainly on the basis of Double entry accountingprinciple. It facilitates the accountant to have systematic posting of entries

l It facilitates the enterprise for the preparation of Trading & Profit and Loss Accountsfor the year ended…………….. and the Balance sheet as on dated ………………..

l It provides the birds' eye view of accounting balances of various ledger accountsduring the specified period.

2.3 PREPARATION OF THE TRIAL BALANCE

The preparation of the trial balance is classified on the basis of three different accountsviz

l Real Account (R)

l Nominal Account (N)

l Personal Account (P)

The classification of the transactions not only on the basis of accounts but also on thebasis of payments and receipts. These payments and receipts classification furthersegmented into following categories

Payments category - Debit Balance

Debit Balance is the source of following golden rules of the three different accounts

Personal Account - Debit the Receive

Nominal Account-Debit all the expenses and losses

Real Account - Debit what comes in & Debit all assets

l Trading Expense Category (TE)

l Profit and Loss Category (PL)

l Assets- Balance Sheet (BA)

Receipts category-Credit Balance

Credit Balance is the major source of other half of the golden rules of accounting

Personal Account-Credit the Giver

Nominal Account- Credit all income and gains

Real Account- Credit what goes out & Credit all liabilities

l Trading Income Category (TI)

l Profit and Loss Category (PL)

l Liabilities - Balance Sheet (BL)

35

Trial BalanceThe detailed Proforma of the trial balance is given in the Annexure -I for betterunderstanding

The following trial balance of the Sundar firm is prepared from the previous list ofjournal entries and ledger accounting balances.

Table 2.1: Trial Balance

From the Table 2.1, it is obviously understood that the total amount of debit balances areequated to the total of credit balances of the enterprise.

The above statement of accounting balances are the resultant out of the ledger accountswhich is easier in preparation only at the moment, the firm has limited number oftransactions.

Check Your Progress

(1) Trial balance is

(a) The statement of accounting balances

(b) The statement of various account names

(c) The statement of accounting balances and their names


(2) Trial balance contains

(a) Debit balance only

(b) Credit balances only

(c) Debit and credit balances only


(3) Trial balance is the statement prepared on the basis of

(a) Business entity concept

(b) Matching concept

(c) Double entry accounting concept

(d) Realization concept

Prepare trial balance from the following text of information extracted from the book ofaccounts of Ms. Selvi.

Ms Selvi has brought a monetary capital of Rs. 1,00,000 for the conduct of business on1st April, 2007. The brought capital was converted into real capital for the business in theform of tradable goods and commodities. She purchased household articles for tradewhich amounted Rs. 60,000. She has bought a service vehicle for Rs 1,500. She keepsRs. 20,000 in the form of deposit at bank for contingencies. The remaining balance iskept in the form of cash in hand for meeting the day today expenses.

Sl. No. Particulars Debit Balances Rs

Credit Balances Rs

1. Cash A/c 49,500 2. Sundar Capital A/c 50,000 3. Purchase A/c 20,000 4. SalesA/c 15,000 5. Sales ReturnA/c 2,000 6. Purchase ReturnA/c 1,500 7. Mittal &CoA/c 8,500 8. Ganesh &CoA/c 8,000 9. Office Rent A/c 500 10. Interim Dividend A/c 3,000 11. BankA/c 2,000

Total 80,000 80,000

36

Accounting and Financefor Managers 2.4 WHY THE SUBSIDIARY ACCOUNTS HAVE TO BE

PREPARED?

If the transactions of the enterprise are voluminous, to ease the process of posting thetransactions, the transactions should be classified into two categories. The transactionsare segmented one on the basis of regular and another on the basis of non-regularoccurrence.

The regular / frequent occurrence of transactions are recorded only in the separatebooks which are known as subsidiary book of accounts or subsidiary journals instead torecord in the regular journal. The infrequent transactions are recorded / posted in theoriginal journal or Journal proper which do not have any specific subsidiary journal orsubsidiary books.

The subsidiary journals or books are developed by the firms only based on the occurrenceof the transactions. Normally the frequent occurrence of the transactions of the firm aremajor formation of the subsidiary books of the accounting system.

The following are the subsidiary books on the major frequent occurrence of transactions

Subsidiary books are classified on the basis of transactions viz Cash transactions andNon-cash transactions

First , let us discuss the Non-cash transactions

What is meant by the Non-cash transaction?

The Non-cash transaction is a transaction out of credit terms and conditions of theenterprise.

The Non cash transactions shall include the following transactions of the enterprise,which do not involve any cash ; are as follows

l Credit Sales Book

l Credit Purchases Book

l Credit Sales Return Book

l Credit Purchases Return Book

l Bills Payable Book - Out come of Credit transaction

l Bill Receivable Book - Out come of Credit transaction

2.4.1 Purchase Book

The purchase book is called in other words as purchase journal . It is a book meant forcredit purchases only for resale

Subsidiary Books

Cash Transaction

Non-Cash Transaction

Sales Book

Bill Payable Book

Bills Receivable

Book

Purchase Return Book

Sales Return Book

Purchase Book

Cash Book

37

Trial Balance Proforma of the Purchases Book

The purchase book usually contains various components viz.

Name of the supplier - From whom the raw material were procured on credit

Ledger folio - It is the number of the page where the journal entry istransacted.

Inward Invoice No - The book contains the invoice number of the creditpurchase of the goods from the supplier

Amount (Rs) -The book contains the value of credit purchasetransactions from the supplier.

Steps involved in posting the entries:

l Posting the entries pertaining to the individual accounts into the Purchase journal

l The total of the purchase journal is determined on monthly and finally should beposted into debit side of the purchase account- To satisfy the rule of Real Account;which not only contains the cash purchase but also the credit purchase of the firmduring the year.

2.4.2 Purchase Returns Book

This is a book of goods returned to the supplier which are out of credit purchases.

The return of goods out of the credit purchase is due to non confirmation with thespecification mentioned in the order.

Proforma of the Purchase Returns Book

The purchase returns book consists of various components viz

Name of the supplier - To whom the goods/ raw material purchased , were returned

Ledger folio - It is the number of the page where the journal entry is posted

Debit Note No -It is the page number on the original copy of the documentsent to the firm to whom the goods are sent

Amount (Rs) -The book should illustrate the value of goods/raw materialsreturned out of credit purchase

Steps involved:

l Posting the entries of the purchase returns to the individual suppliers' account intothe purchase return journal

l The monthly total of the purchase journal is credited into the purchase return account

2.4.3 Sales Book

It is a book maintained by the enterprise only during the moment of selling the goods oncredit. It is pronounced in other words as sales journal.

Proforma of the Sales Book

The sales normally contains the following components

Name of the customer - The sales book usually records the name of the buyerwho has been sold the goods or raw materials on credit

Date Name of the Customer Ledger Folio Out ward Invoice No. Amount Rs

Date Name of the Customer Ledger Folio Credit Noted No. Amount Rs

Date Name of the Supplier Ledger Folio Inward Invoice No. Amount Rs

38


Ledger Folio - The page number where the journal entry is posted / transacted

Out Ward Invoice No- This book registers the invoice number of the goods /raw materials sold out to the buyers on credit.

Amount (Rs)- It is fundamental document to earmark the value of thegoods/raw materials sold out on credit to the variousbuyers. It facilitates the firm to identify the amount ofsales transacted on credit as well as to collect theamount of dues from the buyers.

2.5 STEPS INVOLVED IN THE SALES BOOK

l Sale of the goods/raw materials to the individual buyers are entered on daily basis

l The monthly total of sales book is credited into the sales account of the firm whichincludes both the sale transactions of cash as well as credit

2.5.1 Sales Return Book

It is a book which registers the goods sold on credit and received from the buyers. Thesales return from the buyers is due to non confirming to the specifications mentioned atthe moment of placement of the order. It is known as sales return journal.

Proforma of the Sales Return Book

The following are the various components dealt in the design of the book

Name of the customer - It includes the most important information about the buyerwho returned the goods /raw materials, non-confirming to specifications of the placed.

Ledger folio - It contains the page number of the journal entry posted.

Credit Note No - It is a number on the original copy of the document sent tothe firm from whom the goods are received i.e., buyer

2.6 STEPS INVOLVED IN THE SALES RETURN BOOK

l Sales return of the enterprise from the individual buyers are recorded immediatelyafter the transactions

l The monthly total of the sales return is posted into the debit side of the sales returnaccount in accordance with the rule of Real account

2.6.1 Trade Bills Book

The trade bills book can be classified into two categories viz Bills receivable book andBills payable book.

2.6.2 Bills Receivable Book

It is a book maintained especially for promissory notes & Bill of exchanges acceptedby the customers out of their dues , as an out come of credit sale of the enterprise.The bills receivable and promissory notes are nothing but the resultant of the creditsale transactions of the enterprise not only to safe guard the interest of enterprise butalso to collect the dues from the customers as per the terms of the trade agreedearlier.

Date Name of the Supplier Ledger Folio Debit Note No. Amount Rs

39

Trial BalanceProforma of the Bills Receivable Book

The various components of the Bills payable book are as follows

From whom Received- The either bill or promissory received from whom? .The nameof the party should entered at the moment of receiving the negotiable instruments of thetrade.

Acceptor - The person / institution who/which accepts the terms of thebill to make the payment

Date of the bill -At when the bill is drafted/ drawn for obtaining the acceptanceof the buyer ;who bought the goods on credit

Term -Modalities involved in the process of payment of the duesmentioned in the bill

Date of Maturity - Date at when the bill to be presented for collection from thecustomer.

Where payable -The place of amount payable by the customers or buyers whobought the goods on credit.

Amount (Rs) -It reveals the amount How much to be collected from thecustomer through either bill of receivable or promissory note .

How disposed -The process of the collection done should be recorded for futureverification in settling the dues of the customer.. Bills PayableBook: It is a book of bills payable or promissory notes acceptedby the enterprise to the suppliers at the moment of carrying outthe credit purchase.

Proforma of the Bills Payable Book

The following are the some of the important components normally included in the book:

Name of the drawer - Name of the person or concern , who or which draws the billnothing but either seller or manufacturer or supplier of the goodsor raw materials.

Payee - To whom the payment has to be paid

Date of the bill - Normally included to know the date at when the bill was draftedwhich is under the possession of the seller or supplier.

Date of Maturity - It is the date at when the payment has to be made as per theterms of trade.

Where payable - At where the amount of the bills to paid

2.7 WHAT IS MEANT BY THE CASH TRANSACTION?

The Cash transaction is a transaction carried out only out of cash . The cash transactionsare recorded in the subsidiary book known as cash book. The cash book can be classifiedinto three categories

l Single columnar cash book

l Double columnar cash book

Sl.No. Date Name of the Drawer

Payee Date of the bill

Term Date of the Maturity

Where Payable

Amt Rs

Remarks

Sl.No. Date From whom Received

Acceptor Date of the bill

Term Date of the Maturity

Where Receivable

Amt Rs

How Disposed

40


l Three columnar cash book

Single columnar cash book: It is a book generally records the transactions into twoclassification viz Payments and Receipts. The receipts and payments are recorded inthe debit and credit side of the cash book respectively. The debit and credit sidetransactions of the cash book are prefixed with "To" and "By" respectively.

Proforma of the Single columnar Cash Book

2.7.1 Double Columnar Cash Book

It is another kind of cash book which is nothing but extension of earlier versioned singlecolumnar cash book. The double columnar cash book includes the operations of theenterprise into two different categories viz transactions through Cash and Bank. Itmeans that the entire receipts and payments of the business routed through cash andbank. The transaction of the business with the bank either at the moment of cashwithdrawal or cash deposit leads to register the movement of cash from one entity toanother through the contra entries.

The contra entries are posted in two different occasions viz cash withdrawal and cashdeposit.

During the cash withdrawal, the movement of cash is depicted below for easierunderstanding, which is nothing but the movement of asset from bank to firm.

Firm Bank

Transaction No 1

Jan 5, 2006, Cash withdrawal Rs.10,000 from the bank is having the following journal entry

Cash A/c Dr Rs.10,000

To Bank A/c Cr Rs.10,000

(Being cash withdrawn from the bank A/c)

From the above entry, it is obviously understood that the bank is the giver of the cashresources from the savings bank a/c and cash receipts are made only due to withdrawalof cash from the bank

There are two different angles of cash withdrawal one is in the dimension of firm andanother is bank.

Firm Bank

Dr Proforma of Double columnar cash book Cr

* Bank overdraft

Date Receipts Bank Cash Date Payments Bank Cash Jan 5 Jan 20

To Balance B/d To Bank C1 To Cash C2

5,000

10,000

Jan 5 Jan 20

By Balance c/d* By cash C1 By Bank C2

By Balance B/d

10,000

5,000

Date Receipts Rs Date Payments Rs To Opening Balance B/d

By Closing Balance B/d

Bank SAVINGS BANK A/c

Firm OPERATIONS

Cash receipts Cash Payments

41

Trial BalanceThe above table of double columnar cash book clearly elucidates the contra entry processtaken place in between two entities viz firm and bank .

2.7.2 Three Columnar Cash Book

It is another dimension of cash book which has three component of operations of theenterprise viz Cash, Bank and Discount. This cash book is extension of the early one, notonly which incorporates the receipts and payments of the firm through cash and bankbut also discount allowed and received.

Dr Proforma of Three columnar cash book Cr

Why discount allowed is brought under the debit side?

The discount is allowed at the time of receipts out of sale . The discounts are categorizedinto two categories viz cash discount and trade discount.

Cash discount is the discount allowed by the firm only at the moment of making thepayment with in the stipulated time frame i.e. 7% @ 10 days means that 7% discountwill be given to the parties who are able to make the payment of dues within 10 days ofstipulated time period.

Trade discount is the discount allowed by the firm to encourage the regular customers tobuy more and more. This type of discount is allowed by the firm only on the total valueof the invoice. The discount is granted on the gross value of the goods purchased by theregular customer from the enterprise.

Why discount received is brought under the credit side?

The reason for showing the discount received under the credit side of the cash book isthat the amount of discount received availed only during the moment of payment ofoverdue only due to credit purchase

2.7.3 Multi columnar Cash Book

The regular receipts and payments on various heads require the firm to design not onlya most suited cash book which is in a position to incorporate all the entries of cash innature but also to reduce the excessive labour involved in the process of sorting outthem. To replace the bottlenecks of the three columnar cash book, multi columnar cashbook is developed which is in a position to highlight the receipts and payments of a firmunder various accounting heads within a specified period. Under this system of cashbook, the firm is required to register the payments and receipts of the respective headsonly in the columns especially provided for determining the balance under each at theend of the specified month.

2.7.4 Petty cash Book

It is a book maintained by the petty cashier who is especially appointed for the purposeto assist the cashier of the business enterprise in order to meet the day to day expensesof meager in volume. The cashier normally hands over a certain sum of money to thepetty cashier to meet out tiny expenses of the enterprise based on the early estimation onthe daily requirement e.g., postage, refreshment charges. The meager amount which is

Date Receipts Bank Cash Discount Allowed

Date Payments Bank Cash Discount Received

To Balance B/d

By Balance

c/d By

Balance B/d

42


given by the cashier is known in other words as petty cash or float. The vouchers andreceipts are finally examined by the cashier based on the presentation of petty cashbook balance.

Check Your Progress

(1) Subsidiary books are:

(a) Additional records of accounting for future reference

b) To administer only few transactions of the business

(c) Accounting record for the administration of voluminous transactions


(2) Subsidiary books are prepared for:

(a) Cash transactions only

(b) Both cash and Non-cash transactions

(c) Non cash transactions only


(3) Sales book is the record to enter:

(a) Regular credit sale transactions

(b) Regular cash sale transactions

(c) Regular credit and cash sale transactions


(4) The monthly closing balance of purchase book Rs.10,000 to be posted at:

(a) Credit side of the purchase a/c

(b) To be added with the final closing balance

(c) Debit side balance of the purchase a/c


Example 1: The following are extracted information from the books of M/s Brown &Co. Prepare the trial balance

The first step is to determine the debit and credit balance of the business transactions interms of Expense, Revenue, Assets and Liabilities

Particulars Rs Particulars Rs Sundry Debtors 30,600 Carriage inwards 1,750 Sundry Creditors 10,000 Carriage outwards 1,000 Bills receivable 5,000 Bad debts 950 Plant and machinery 75,000 Bad debts provision 350 Purchases 1,90,000 Office general expenses 1,500 Capital 70,000 Cash at bank 5,300 Free hold premises 50,000 Cash in hand 800 Salaries 21,000 Bills payable 7,000 Wages 24,400 Reserve 20,000 Postage and stationery 1,750 Sales 3,31,700 Closing stock 30,000

43

Trial BalanceTrial Balance M/s Brown

Particulars Rs Nature of balance

Particulars Rs Nature of balance

Sundry Debtors 30,600 Debit Carriage inwards 1,750 Debit Sundry Creditors 10,000 Credit Carriage outwards 1,000 Debit Bills receivable 5,000 Debit Bad debts 950 Debit Plant and machinery

75,000 Debit Bad debts provision 350 Credit

Purchases 1,90,000 Debit Office general expenses 1,500 Debit Capital 70,000 Credit Cash at bank 5,300 Debit Freehold premises 50,000 Debit Cash in hand 800 Debit Salaries 21,000 Debit Bills payable 7,000 Debit Wages 24,400 Debit Reserve 20,000 Credit Postage and stationery

1,750 Debit Sales 3,31,700 Credit

Closing stock 30,000 Debit

Particulars Debit Rs Credit Rs Sundry Debtors 30,600 Bills receivable 5,000 Plant and machinery 75,000 Sundry Creditors 10,000 Carriage inwards 1,750 Carriage outwards 1,000 Bad debts 950 Bad debts provision 350 Purchases 1,90,000 Capital 70,000 Freehold premises 50,000 Salaries 21,000 Wages 24,400 Postage and stationery 1,750 Closing stock 30,000 Office general expenses 1,500 Cash at bank 5,300 Cash in hand 800 Bills payable 7,000 Reserve 20,000 Sales 3,31,700 Total 4,39,050 4,39,050

44


Annexure-I

Proforma Trial Balance

14. Purchases N TE 14. 15. Purchases N TE 15. 16. Wages N TE 16. 17. Water N TE 17. 18. Return Inward(to be

deducted from Sales) 18.

Profit & Loss Accounting Heads 19. Audit fees N PE 19. Commission received N PI 20. Bad Debt N PE 20. Discount received N PI 21. Advertisement N PE 21. Donation N PI 22. Bank Charges N PE 22. Interest received N PI 23. Clearing charges-

Cheque N PE 23. Rent received N PI

24. Commission Paid N PE 24. Trading profits N PI 25. Depreciation N PE 25. 26. Discount Paid N PE 26. 27. Donation Paid N PE 27. 28. Electricity N PE 28. 29. General Expenses N PE 29. 30. General Expenses N PE 30. 31. Interest on capital N PE 31. 32. Interest N PE 32.

33. Legal charges N PE 33. 34. Lighting charges N PE 34. 35. Miscellaneous expenses N PE 35. 36. Office expenses N PE 36. 37. Packaging charges N PE 37. 38. Printing & Stationery N PE 38. 39. Postage N PE 39. 40. Rent, Rates, Taxes N PE 40. 41. Stable expenses N PE 41. 42. Subscription paid N PE 42. 43. Sundry expenses N PE 43. 44. Travelling expenses N PE 44. 45. Telephone charges N PE 45.

Balance sheet 46. Bank balance P BA 46. Bank loan P BL 47. Bank Deposit P BA 47. Bank overdraft O BL 48. Bill Receivable P BA 48. Bills payable P BL

Debit / Payment Balances Credit / Receipt Balance Sl. No.

Expenses or Asset A/c Final A/c

Sl. No.

Incomes or Liabilities A/c Final A/c

Trading Accounting Heads 1. Carriage Inward N TE 1. Sales N TI

2. Carriage N PE 2. 3. Clearing charges-

Import Authority N TE 3.

4. Coal & Coke N TE 4. 5. Energy N TE 5. 6. Factory Expenses N TE 6. 7. Freight charges N TE 7. 8. Fuel & Power N TE 8. 9. Gas & Water N TE 9. 10. Manufacturing

Expense N TE 10.

11. Motive Power N TE 11. 12. Octroi N TE 12. 13. Oil N TE 13.

Contd...

45

Trial Balance49. Cash in deficit P BA 49. Capital P BL 50. Cash in Hand R BA 50. Cash excess P BL 51. Copy right N BA 51. Debentures P BL 52. Deferred Revenue

Expenses N BA 52. Donation - Building N BL

53. Drawings – Deducted from the capital

P BL 53. Loan received P BL

54. Finished goods R BA 54. Loan from Mr Y P BL 55. Fixtures and Fittings R BA 55. Mortgage Loan P BL 56. Furniture R BA 56. Net profit N PL 57. Freehold property R BA 57. Outstanding expenses P BL 58. Goodwill N BA 58. Pre received Income P BL 59. Investment P BA 59. Suppliers P BL 60. Leasehold property R BA 60. Share premium N BL 61. Livestock R BA 61. Suspense receipt P BL 62. Loose Tools R BA 62. Unpaid dividend P BL 63. Outstanding Incomes P BA 63. 64. Patent N BA 64. 65. Petty cash R BA 65. 66. Plant & Machinery R BA 66. 67. Preliminary expenses N BA 67. 68. Prepaid expenese N BA 68. 69. Raw materials N BA 69. 70. Sundry debtors P BA 70. 71. Suspense payment P BA 71.

2.8 LET US SUM UP

Purposes of preparing the Trial Balance include:

To prepare a statement of disclosure of final accounting balances of various ledgeraccounts on a particular date.

The classification of the transactions not only on the basis of accounts but also on the basisof payments and receipts. These payments and receipts classification further segmentedinto categories. The subsidiary journals or books are developed by the firms only based onthe occurrence of the transactions. Normally the frequent occurrence of the transactionsof the firm are major formation of the subsidiary books of the accounting system.

The Cash transaction is a transaction carried out only out of cash. The cash transactionsare recorded in the subsidiary book known as cash book. The cash book can be classifiedinto three categoriesl Single columnar cash bookl Double columnar cash bookl Three columnar cash book


Prabhat Kumar is very disturbed. “Who says consistent accounting?” He asks, “ Lookat these two statements!” Two retailers with identical delivery trucks. I know – I soldthem both to these guys less than a week apart. They cost Rs. 6,00,000 and would youbelieve it? After one year Kiran Store has depreciated it Rs. 1,00,000. The exclusiveMadam’s shop took Rs. 2,00,000 depreciation the first year. How can you wear out atruck hauling around women’s clothing so much in one year? It doesn’t make sense”.

Explain how and why the differences could be justified.

2.10 KEYWORDS

Trial Balance

Subsidiary Journals

46


Purchase books

Acceptor

Cash Transaction

Double Columnar Cash book

Petty Cash book


1. Write short notes on

(a) Credit balance

(b) Trial Balance

(c) Transaction

(d) Receiver

2. What is the need of having subsidiary Account?

3. What is outward invoice no. meant for?

4. Explain why?

(a) Discount allowed is brought under the debit side

(b) Discount received is brought under the credit side

5. What are the elements of Non cash Transaction?


M.P. Pandikumar, “Accounting & Finance for Managers”, Excel Books, New Delhi.

R.L. Gupta and Radhaswamy, “Advanced Accountancy”


Khan and Jain, “Management Accounting”

S.N.Maheswari, “Management Accounting”

S. Bhat, “Financial Management”, Excel Books, New Delhi.



Nitin Balwani, “Accounting & Finance for Managers”, Excel Books, New Delhi.

LESSON

3FINAL ACCOUNTS

CONTENTS3.0 Aims and Objectives

3.1 Introduction

3.2 Trading Account

3.2.1 Balancing Process

3.3 Profit & Loss Account

3.4 Balance Sheet

3.4.1 Cash Method of Accounting

3.4.2 Mercantile Method of Accounting

3.5 Let us Sum up


3.7 Keywords

3.8 Questions for Discussion

3.9 Suggested Readings


In this lesson we shall discuss about final accounts. After going through this lesson youwill be able to:

(i) analyse trading account

(ii) discuss profit and loss account and balance sheet

3.1 INTRODUCTION

The preparation of Final accounts the business firm involves two different stages viz Preparationof Accounting and Positional Statements of the enterprise. The preparation of Accountingstatements involve two different categories viz Trading account and Profit & Loss account.

The preparation of the positional statement involves only one statement viz Balancesheet. In this chapter the accounting statements as well as Balance sheet will be elaboratelydiscussed to the tune of adjustments. First the trading account contents and format arediscussed to determine the Profit and Loss under the trading account of the businessfirm, i.e. Gross profit.

Second part of this chapter deals with the preparation of Profit & Loss account in orderto determine the operating profit & loss of the enterprise.

Third part of the chapter involves in the preparation of financial position of the enterprisein terms of Liabilities and Assets.

3.2 TRADING ACCOUNT

This is first financial statement prepared by the owner of the enterprise to determine thegross profit during the year through the matching concept of accounting. The gross

48


profit of the enterprise is calculated through the comparison of purchase expenses,manufacturing expenses, and other direct expenses with the sales.

It is prepared normally for one year in accordance with accounting period concept i.e.,operating cycle of the enterprise which should not exceed 15 months with reference tothe Companies Act 1956.

Dr Trading Account for the year ended ………………. Cr

3.2.1 Balancing Process

* Gross profit is the resultant of an excess of the credit side total over the total of debitside. It means that the gross profit is the excess of incomes in the credit side over theexpenses in the debit side.

** Gross Loss is the outcome of an excess of the debit side total over the total of creditside. It means that the gross loss is the excess of expenses in the debit side over theincomes in the credit side.

Illustration 1 with no opening stock and closing stock

Prepare the trading account for M/s Shan &Co Ltd., for the year ended 31st Mar, 2006

Total Purchases during the year Rs. 10, 000

Total Sales during the year Rs. 15, 000

In this problem, the Gross profit is simply found by deducting the sales volume from thepurchases.

Gross profit = Sales – Purchases

First step open the Trading account for the year ended 31st Mar, 2006

Solution 1

Trading Account for the ended 31st Mar, 2006

Dr Rs Rs Cr

*Gross profit Rs. 5, 000 is the resultant of excess income over the expenses.

The total of the credit side more than the debit side total of the trading account.

Illustration 2 with Opening stock, various kinds of purchases and sales, Closingstock

From the following information, prepare the trading account for the year ended 31stMar, 2006.

Gross Profit = [INCOMES (CREDIT)> EXPENSES(DEBIT)]

Gross Loss = [EXPENSES (DEBIT)> INCOMES(CREDIT)]

To Purchases 10,000 To Sales 15,000 To Gross profit c/d 5,000* Balancing figure(Rs.15,000-Rs.10,000)

To Opening Stock XXXX By Cash Sales XXXX To Cash Purchases XXXX Add Credit Sales XXXX Add Credit Purchases XXXX By Total Sales XXXX To Total Purchases XXX Less Sales Return XXX Less Purchase Return XXX By Net Sales XXXX To Net Purchases XXXX By Closing Stock XXXX To Wages XXXX To Carriage Inward XXXX To Factory lighting XXXX To Fuel, Coal, Oil XXXX To duty on Import of Materials XXXX To Octroi duty XXXX To Gross Profit* C/d XXXX

By Gross Loss C/d** XXXX

49

Final Accounts Rs.

Stock on 1st April 2005 (Opening stock) 4, 000

Purchases

i. Cash purchases 20, 000

ii. Credit purchases 50, 000

Sales

i. Cash sales 20, 000

ii. Credit sales 60, 000

Stock on 31st Mar, 2006 (Closing Stock) 6, 000

In this problem, the sales and purchases are given in two different categories viz. cashand credit. The credit and cash purchases and sales of a firm should be added todetermine the total volume of purchases and sales made during the year.

The purpose of crediting the closing stock in the trading account is to find out the materialsor goods consumed for trading purposes. In order to find out the total amount of goods ormaterials consumed during a year, three different components to be separately considered.

l Opening Stock

l Purchases and

l Closing Stock

Opening Stock: It is a stock of goods or raw materials available at the opening of theaccounting period, which is nothing but a closing stock of the yester accounting periodutilized for trading during the current year.

Purchases: Purchase of goods or raw materials is either for resale or manufacturing.

Closing Stock: It is a stock nothing but an outcome of lesser volume of sales than theaggregate of opening stock and purchases

Material consumed could be calculated

Material consumption=Opening stock + Purchases - Closing stock

The closing stock is credited in the trading account in stead of deducting it directly fromthe aggregate of opening stock and purchases during the year. The posting of the closingstock under the credit side of the trading account not only facilitates the firm to find outthe consumption during the year as well as reduces the cost of goods sold incurredduring the year.

Solution

Trading Account for the year ended 31st Mar, 2006

Dr Rs Rs Cr

By Gross profit B/d 12, 000

Illustration 3

Prepare trading account of M/s Sundar & Sons as on 31st Mar, 2005 from the followinginformation extracted from the book of accounts

Rs

Opening stock on 1st April 12004 50, 000

Purchases

To Opening stock 4,000 By Credit sales 20,000 To Credit purchases 20,000 By Cash sales 60,000 To Cash purchases 50,000 By Total sales 80,000 To Total purchases 70,000 By Closing stock 6,000 To Gross profit c/d 12,000

86,000 86,000

50


Cash 1, 20, 000

Credit 1, 00, 000

Sales

Cash 40, 000

Credit 1, 00, 000

Purchase Returns 20, 000

Carriage Inwards 10, 000

Marine insurance on purchase 6, 000

Other direct expenses 4, 000

Sales Returns 30, 000

Stock as on 31st Mar, 2005 10, 000

In this problem, Return out wards and in wards are given in addition to cash and creditpurchases and sales of a firm to find out the Net purchases and the Net sales of thefirm.

Net Sales = Cash Sales + Credit Sales - Sales Returns

Net Purchases = Cash Purchases + Credit Purchases - Purchase Returns

Solution

Trading Account for the year ended 31st Mar, 2005

Dr Rs Rs Cr

To Gross Loss B/d 1, 50, 000

Gross Loss is due to en excess of the debit side total over the credit side total

3.3 PROFIT & LOSS ACCOUNT

It is a second statement of accounting in connection with the earlier to determine the Netprofit/loss of the enterprise out of the early found Gross profit/loss. This is an accountingstatement matches the administrative, selling and distribution expenses with the grossprofit and other incomes of the enterprise.

This is an account prepared for one operating cycle of the firm i.e. 12 months in period.The transactions are recorded in accordance with golden rules of nominal account. Inthe profit & loss account, the expenses and losses are debited and incomes and gainsare credited. The reason for bringing down the gross loss /gross profit of the tradingaccount into the debit and credit side of Profit & Loss A/c respectively, are only to thetune of nominal accounting ruling with reference to debit all expenses and losses andcredit all incomes and gains.

The expenses which are matched with the credit total of the profit and loss account.Classified into various categories

i. Administrative Expenses

To opening stock 50,000 By Cash sales 40,000 To Cash Purchaes 1,20,000 Add:Credit Sales 1,00,000 Add: Credit purchase 1,00,000 By total Sales 1,40,000 To total purchase 2,20,000 Less: Sales Return 30,000 Less: Purchase Return 20,000 By Net Sales 1,10,000 To Net Purchase 2,00,000 By Closing stock 10,000 To carriage Inwards 10,000 By Gross Loss c/d 1,50,000 To Marine Insurance 6,000 To other direct expenses 4,000 2,70,000 2,70,000

51

Final Accountsii. Selling & Distribution Expenses

iii. Financial Expenses

iv. Legal Expense.

Profit and Loss Account for the year ended………………..

Dr Rs Rs Cr

The balancing process of the profit and loss account leads to two different categories

*Net profit is the resultant of excess of income in the credit side over the expenses inthe debit side of the Profit and Loss account

** Net Loss is an outcome of excess of expenses in the debit side over the incomes inthe credit side

Illustration 4

From the following information, Prepare the Profit and Loss account

Debit Credit

Rs Rs

Gross profit from the trading account 1, 00, 000

Manager Salary 30, 000

Office lighting 5, 000

Office Rent 15, 000

Local Taxes 1, 000

Salary paid to salesmen 20, 000

To Gross Loss B/d Balancing figure

XXXX By Gross Profit B/d XXXX

Office and Administrative Expenses To Salaries

To Rent , Rates and Taxes By Rent received To Office Lighitng To Printing and Stationery To Insurance premium To postage To General expenses To miscellaneous expenses Selling and Distribution Expenses To Salary to sales staff

To commission charges By commission received To Advertising expenses To Carriage outward To Bad debts To Packing expenses Financial Expenses To interest on capital

By interest on drawings

To interest on loans By interest on investments To trade discount allowed By trade discount received To cash discount allowed By cash discount received Maintenance Expenses To Depreciation on Fixed assets

To Repairs and maintenance of Productive assets

To loss on sale of assets To profit on sale of assets Other Expenses To Provision for debts

To Net profit c/d* By Net loss c/d**

52


Commission charges paid 10, 000

Legal charges paid 3, 000

Bad debts 1, 500

Advertising charges 25, 000

Package charges 7, 500

Discount allowed 3, 000

Discount received 4, 000

Dividend received 2, 000

Rent received 1, 000

Depreciation charges 10, 000

Repairs and Maintenance 2, 500

Interest on loans 1, 500 500

Dr Profit and Loss account for the year ended …………………………… Cr

Rs Rs

* Net loss is the excess of the expenses total in the debit side Rs. 24, 500 over theincomes total in the credit side of the profit and loss account.

3.4 BALANCE SHEET

Balance sheet is the third financial statement which reveals the financial status of theenterprise through the total amount of resources raised and applied in the form of assets.This is the fundamental statement of the firm which explores the firm financial staturethrough the resources mobilized and investments applied i.e. Liabilities and Assetsrespectively. From the early, according to double entry concept or Duality concept, thebalance sheet can be divided into two distinct sides, known as liabilities and assets.

The balance sheet can be disclosed in two different orders

(i) in the order of long lastingness - permanence

(ii) in the order of liquidity

Proforma Balance Sheet as on dated…………………….

(In the order of Long lastingness)

To Manager Salary 30,000 By Gross profit B/d 1,00,000 To Office lighting 5,000 By Discount received 4,000 To Office Rent 15,000 By Dividend received 2,000 To Salary paid salesman 20,000 By Rent received 1,000 To commission charges 10,000 By Interest received 500 To Legal charges 3,000 By Net Loss c/d* 24,500 To Bad debts 1,500 To Advertising charges 25,000 To Package charges 7,500 To Depreciation charges 10,000 To Repairs and maintenance 2,500 To Interest on loan 1,500 To Local taxes 1000 1,32,000 1,32,000

53

Final Accounts

The downward arrow shows the order / arrangement of the assets and liabilities on thebasis of permanence or long lastingness

The upward arrow shows the order /arrangement of the assets and liabilities on thebasis of liquidity.

Methods of determining the accounting income includes:

i. Cash method of accounting

ii. Mercantile method of accounting

3.4.1 Cash Method of Accounting

Under this method, cash receipts are matched with the cash payments irrespective ofthe time period in order to determine the income.

3.4.2 Mercantile Method of Accounting

Under this method, time period is given greater importance than the actual receipts andpayments. It records the receipts and expenses pertaining to the specified period whetherthem are actually received /paid or not. The receipts as well as payments of the otherperiods should be ignored /eliminated in determining the income of the stipulated duration.It is popularly known in other words as "Accrual Accounting System".

Next stage is to classify the types of income of the enterprise:

To determine income of the business, what should be in character ? Either in accountingincome or taxable income.

Taxable income can be computed from the transactions of the enterprise but they aresubject to frequent modifications on the tax provisions from one year to another year.This cannot be uniquely found out unlike the accounting income. The accounting incomeshould have to be found out only to the tune of accounting principles and concepts.

The process of final accounts diagram is illustrated in the next page for easierunderstanding not only to adopt the mercantile system of accounting but also to implementthe duality principle of accounting throughout the transactions.

Check Your Progress

1. Why land and building is given greater priority under the order of permanence?

2. Why cash in hand is given greater priority under the order of liquidity?

Adjustment entries

The adjustment entries are classified into three segments viz on expenses, incomes and others.

Liabilities Rs Assets Rs Capital XXXX Land & Building XXXX Less: Drawings XXX Plant & Machinery XXXX Add: Net profit XXXX Furniture& fittings XXXX XXXX Fixtures& tools XXXX Long-term borrowings XXXX Marketable securities XXXX Sundry creditor XXX Closing stock XXXX Bills payable XXX Sundry debtors XXXX Bank overdraft XXX Bills receivable XXXX Outstanding expenses XXX Pre paid expenses XXXX Pre received income XXX Cash at Bank XXXX Cash in hand XXXX Total liabilities XXXX Total Assets XXXX Cash in hand XXXX Total liabilities XXXX Total Assets XXXX

54


On expenses

The adjustment entries on expense can be classified into two categories

(i) Outstanding Expenses: These are incurred expenses but not paid in cash

E.g. Rent of the office is Rs. 22, 000 for 11 months only The enterprise has failedto remit the payment of last month rent amounted Rs. 2, 000. According to mercantilesystem of accounting, the rent of the office, whether fully paid or not, it should betotally considered for the entire duration to determine the income of the enterprise.

Finally, what is to be done ? The amount of actual rental should be added with therent which has not been paid by the enterprise i-e (Rs. 22, 000+Rs. 2, 000=Rs. 24,000)

Treatment of the transaction

Debit the expense account

Credit the liability i-e of the person to whom the amount to be paid

(ii) Prepaid expenses: Normally, some of the expenses paid for availing the servicesare not fully extracted during the term; which left / unused should be normallycarried forward to the next term. It means that the expense which is paid inadvance to make use of the service for forthcoming period to whom is known asdebtor; the person who keeps the money of the enterprise for the definite durationis nothing but an asset.

Debit the asset - Advance payment for service

Credit the expense

Next major segment in the adjustment entry is on Incomes

l Income Outstanding

l Perceived Income

(iii) Income outstanding: It happens during the enterprise then and there ; which meansincome earned but not received. It happens in the case of certain income of dividendon shares, interest on loans granted not yet received. The income earned but notreceived is also an income that should be credited in the income account to knowthe total volume of the income pertaining to the accounting period. The incomeearned but not received is nothing but an asset not yet received. The income notyet received from whom should be debited as an asset due to the enterprises'money income with the other person / institution.

(iv) Income received in advance: Any income received in advance cannot be consideredas an income which should be calculated and deducted from the total incomereceived; known as advance receipt. It is the income of the other period; should beeliminated from the income received in accordance with the mercantilist accountingsystem in determining the income. The income which is received in advancepertaining to the period of non rendered service should removed from the totalincome received, in order to determine the original income of the period should beknown exactly. The amount received in advance of non rendered service is theresponsibility to return nothing but the liability of the firm.

Profit &Loss A/c :- Deduct the prepaid amount from the total expenses already paid Balance sheet:-Include it as an item of application under the assets side

Profit &Loss A/c :- Add the income outstanding amount to the total incomes already received Balance sheet:-Include it as an item of unrealized income under the assets side i.e the firms’ money with the others

Profit &Loss A/c :- Add the outstanding amount with the total expenses already paid Balance sheet:-Include it as an item of responsibility under the liabilities side

55

Final Accounts

Profit &Loss A/c :- Deduct the Income received in advance from the total incomes which were already received. Balance sheet:-Include it as an item of responsibility for non rendered service under the liabilities side

Debit the Income account

Credit the Income received in advance - Liability of the balance sheet

(v) Bad debts: Bad debts is the result of credit sales which only due to the inability ofcustomers / consumers to settle the overdue. The inability may be due to poorrepaying capacity or insolvent during the moment of the sales. The bad debt due tothe inability cannot be deducted from the sales volume which was already transacted.The debts cannot be recovered has to be treated as a loss of the firm.

Debit all losses of the firm. The losses due to bad debts should be appropriatelyeffected as well as adjusted in the individuals' account i-e in the consumers' accountwho received the goods on credit

Check Your Progress

1. If the closing stock is given, the effect of the entry is

(a) Profit & Loss A/c –Credit Balance Sheet- Liabilities

(b) Profit & Loss A/c-Debit Balance Sheet- Liabilities

(c) Trading A/c- Credit Balance Sheet-Assets

(d) Trading A/c- Debit Profit & Loss A/c- Credit

2. The income received in advance is

(a) Asset of the enterprise

(b) Income of the enterprise

(c) Liability of the enterprise

(d) Expense of the enterprise

3. The depreciation charge is only to the tune of

(a) Convention of consistency

(b) Time period concept

(c) Business entity concept

(d) Convention of conservatism

4. The value of the asset shown in the balance sheet is

(a) Book Value

(b) Market value

(c) Realisable value

(d) Original value

5. Rent paid in advance is to be effected

Profit &Loss A/c :- Non recovery of credit sales is deemed to be a losses – should be debited to Profit & Loss A/c Balance sheet:-Non recovery of credit sales should be deducted from the volume of credit sales transacted by the firm under the Assets side in order to determine the original amount of credit outstanding

Contd...

56


(a) Deduct the amount from the Original rent paid – P&L A/c

(b) Include the rent paid in advance as an item of current asset- Balance sheet

(c) Deduct the rent paid in advance in the Trading A/c

(d) Both (a) & (b)

Illustration 5

From the following information extracted from the books of Jain & Co, Prepare Trading,Profit & Loss A/c for the year ended and Balance sheet as on that date.

Additional Information:

1. Value of the stock on 31. 12. 96 Rs. 65, 000

2. Goods worth Rs 800 for his personal use of the proprietor

3. Rs. 400 of insurance paid is nothing but advance payment

4. Salary Rs. 1000 for the month of Dec 1996 has not yet paid outstanding

5. Charge depreciation

a. Building 2% per annum

b. Machinery 10% per annum

c. Furniture 15% per annum

6. Maintain provision for doubtful debts @ 5% on sundry debtors. Prepare Tradingand Profit & Loss Account of Jain & Co for the year ended 1995-96

Dr Rs Rs Rs Rs Cr

Particulars Debit Rs Credit Rs Purchase 90,300 Sales 1,37,200 Return inward 2,200 Stock 1.1.96 40,000 Drawing 5,000 Building 30,000 Machinery 20,000 Furniture 8,000 Debtors 25,000 Wages 3,000 Carriage inwards 2,000 Rent and Rates 1,500 Bad debts 1,000 Cash 3,500 Investment 10,000 Postages 2,500 Insurance 2,000 Return outwards 1,300 Capital 50,000 Creditors 24,000 Interest 500 Commission 3,250 Provision Bad debts 750 Bank O/d 40,000 Salaries 11,000 Total 2,57,000 2,57,000

To Opening stock 40,000 By Sales 1,37,200 To Purchases 90,300 (-) Return Inward 2,200 (-)Purchase Return 1,300 1,35,000 (-) Goods taken by proprietor

800 By Closing Stock 65,000

Contd...

57

Final Accounts

Balance Sheet as on 31st Dec, 1996

Illustration 6

From the following information drawn from the books of M/s Sundaran & Co prepareTrading, Profit & Loss account for the year ended 31st Mar, 2004 and Balance sheet ason dated

To Net purchases 88,200 To Wages 3,000

To Carriageinward 2,000 To Gross Profit c/d (Balancing figure)

66,800

2,00,000 2,00,000 To Rent & Rates 1,500 By Gross profit B/d 66,800 To Bad Debts 1000 By Commission 3,250 To Postages 2,500 By Interest 500 To Insurance 2,000 (-) Prepaid 400

1,600 To Salaries 11,000 (+)O/s of Salary 1,000

12,000 To New Provision 5% on Sundry Debtors- Rs.25,000

1,250

(-)Old Provision 750 500 To Depreciation Building 2% 600 Machinery 10% 2,000 Furniture15% 1,200 3,800 To Net profit c/d (Balancing figure)

47,650

70,550 70,550

Liabilities Rs Rs Assets Rs Rs Capital 50,000 Building 30,000 (+)Net Profit transferred from P&L Account

47,650 (-)Depreciation 2% 600

(-)Drawings Cash + Goods Rs5000+Rs.800

5,800

29,400

91,850 Machinery 20,000 Bank OD 40,000 (-)Depreciation 10% 2,000 Creditors 24,000 18,000 Salary O/s 1,000 Furniture 8,000 (-)Depreciation 15% 1,200 6,800 Debtors 25,000 (-)Provision 1,250 23,750 Investment 10,000 Closing stock 65,000 Prepaid Insurance 400 Cash in hand 3,500 1,56,850 1,56,850

Particulars Debit (Rs.) Credit (Rs.) Sundaran’s Capital 1,81,000 Sundaran’s Drawings 36,000 Plant and Machinery Balance on 1st April 2003 1,20,000 Plant and machinery additions on 1st Oct,2003 25,000 Stock opening 95,000 Purchases 7,82,000 Return Inwards 12,000

Contd...

58


Additional Information

1. Stock on 31st Mar, 2004 Rs. 94, 600

2. Write off Rs. 600 as bad debts

3. Provision for doubtful debts 5%on debtors

4. Create a provision on for discount on debtors & Reserve for creditors 2%

5. Provide a depreciation on furniture and fixture at 5% per @

6. Plant machinery depreciation 20%

7. Insurance unexpired Rs. 100

8. A fire occurred on 25th Mar 2004 in God own and the stock of the value of the 5000destroyed fully insured the insurance admitted claim fully yet to be paid.

Trading account M/s. Sundaran &Co for the year ended 2003-04

Dr Rs Rs Rs Rs Cr

Profit & Loss Account of M/s. Sundaran &Co for the year ended 2003-04

Dr Rs Rs Rs Rs Cr

Sundry debtors 20,600 Furniture & Fixture 15,000 Freight duty 2,000 Rent Rate and Taxes 24,600 Printing stationery 3,800 Trade expenses 5,400 Sundry creditors 40,000 Sales 9,80,000 Return outwards 3,000 Postage & Telegsundaram 800 Provision for bad debts 400 Discounts 1,800 Rent of the premises sub let for the year upto 30th Sept2004

7,200

Insurance charge 2,700 Salaries & wages 31,300 Cash in hand 6,200 Cash at bank 30,500 Carriage outwards 500 Total 12,13,400 12,13,400

To opening stock 95,000 By sales 9,80,000 To Purchase 7,82,000 (-) Return 12,000 9,68,000 (-)Returns 3000 Closing stock 94,600 To Net purchases 7,79,000 Goods

destroyed by fire

5,000

Freight Duty 2,000

To Gross Profitc/d 1,91,600 10,67,600 10,67,600

Contd...

To Carriage Outwards 500

By Gross profit B/d Transferred from trading account

1,91,600

To rent, rate and taxes 24,600 By discount 1,800

To painting & stationery

3,800 By Rent of Sublet 7,200

Trade expenses 5,400 (-) Advance receipt rent of sublet for 6 months:7,200/12 monts= Rs.600 P.M For 6 months

3,600

Postage and telegram 800 3,600

Insurance charge 2,700 By 2% reserve on sundry creditors

800

59

Final Accounts

Balance sheet of M/s. Sundaran &Co as on dated 31st Mar, 2004

Rs Rs Rs Rs

Illustration 7

From the following figures extracted from the books of M/s Amal &Vimal 31st Mar, 02

(-) unexpired 100

2,600

Salaries and wages 31,300

ToDepreciation Furniture and Fixture @5% on Rs.15,000

750

Plant and machinery 1st April 2003@20% on Rs.1,20,000 (12 months)

24,000

Plant and machinery 1st Oct,2003 @20% on Rs.25,000(6 months)

2,500

26,500

To Bad debts write off 600

To New provision 1000

(-)Old provision 400

To provision to be created

600

To discount on debtors 2%

380

To Net profit c/d Transferred to Balance sheet

99,970

1,97,800 1,97,800

Liabilities Assets Capital 1,81,000 Furniture & fixture 15,000 (+)Net profit 99,970 Depreciation @ 5% 750 (-)Drawings 36,000 14,250 2,44,970 Plant Machinery

1,20,000

Sundry creditors 40,000 Depreciation @ 20%

24,000 96,000

(-)2% Reserve 800 Plant Machinery 25,000 39,200 Depreciation @20%

for 6 months 2,500

Pre received rental income

3,600 22,500

Closing stock 94,600 Insurance unexpired 100 Sundry debtors 18,620 Goods fire –insurance 5,000 Cash at bank 30,500 Cash in hand 6,200 2,87,770 2,87,770

Contd...

Particulars Debit(Rs) Credit (Rs) Opening stock 30,000 Purchases 1,10,000 Sales 2,50,000 Building 55,000 Wages 23,000 Carriage inwards 3,000 Bills payable 10,000 Furniture 9000 Salaries 42,000 Advertisement 24,000

60


Adjustment entries:

a. The partners share profit and losses Amal 2/5 and Vimal 3/5

b. closing stock Rs. 15, 000

c. stock valued at Rs. 10, 000 was destroyed by fire but insurance company admitteda claim of 8, 500 only and the claim is not yet paid.

d. Wages include Rs. 2, 000 for installation of anew machinery on 1st Dec., 2005

e. Depreciate the machinery at 10% per annum

Trading account of M/sVimal & Amal & Co for the year ended 2001-02Dr Rs Rs Rs Rs Cr

Profit & Loss account of M/s Vimal& Amal &Co for the year ended 2001-02

Dr Rs Rs Rs Rs Cr

Coal and coke 2,000 Cash at bank 14,000 Pre paid wages 1,000 Depreciation fund investment 25,000 Machinery at cost(Rs.10,000 New) 60,000 Sundry debtors 20,000 Bad debts 3,000 Depreciation fund 25,000 Sundry creditors 24,000 Rent rate and taxes 4,000 Trade expense 4000

Amal 50,000 Capital Vimal 40,000

Petty expenses 4,000 Provision for doubtful debts 1,000 Gas and water 1,200 Cash in hand 800 Outstanding rent 400

Bank loan 34,600 4,35,000 4,35,000

To opening stock 30,000 By sales 2,50,000 To purchases 1,10,000 By closing stock 15,000 To wages 23,000 By goods destroyed 10,000 (-)Erection 2,000 21,000 To Coal and coke 2,000 To Gas and water 1,200 To Carriage inwards 3,000 To Gross profitc/d 1,07,800 2,75,000 2,75,000

To Salaries 42,000 By Gross profitB/d

1,07,800

To Advertisement 24,000 To Bad debts 3,000 To Trade expenses 4,000 To Rent, rates & Taxes 4,000 To Depreciation(d) 5,400 To Insurance Loss 10,000 Admitted claim 8,500 1,500 To petty expenses 4,000 To Net profit l Amal 7,960 Vimal 11,940 19,900 Total 1,07,800 Total 1,07,800

61

Final AccountsBalance sheet of M/s Vimal & Amal &Co as on dated 31st Mar, 2002

SS Jain Bros for the year ended 31st Dec., 2003

Due to the difference in the trial balance, an examination of the goods was conductedwhich reveals following errors.

Rs. 25 paid to the conveyance was debited to motor van maintenance account

Rs. 2, 000 drawn from bank towards for establishment charges was omitted to posted into ledger.

Cash column in the cash book on the receipt side stands excess total by Rs. 400

Adjustment entries:

a. Establishment of charges have been paid only up to Nov & provision of Rs 2, 000has to be made for Dec.

Liabilities Rs .Rs Assets Rs Rs Capital Amal 50,000 Depreciation

investment 25,000

(+) Net profit 7,960 Plant and Machinery 62,000 57,960 (-) Depreciation 5,400 Capital Vimal 40,000 56,600 (+) Net profit 11,940 Furniture 9,000 51,940 Building 55,000 Closing stock 15,000 Depreciation fund 25,000 Sundry debtors 20,000 Bank loan 34,600 Provision for bad

debts 1000

Sundry creditors 24,000 19,000 Out standing

Insurance claim 8,500

Outstanding rent 400 Pre paid wages 1000 Bills payable 10,000 Cash at bank 14,000 Cash in hand 800 2,03,900 2,03,900

Particulars Debit Rs Credit Rs Capital 6,00,000

Drawings 12,000

Buildings 2,00,000

Furniture and fittings 30,000

Depreciation on Reserve

Buildings 10,000

Furniture 3,000

Depreciation for the year 13,000

Purchases 4,00,000

Sundry creditors 40,000

Sales 5,00,000

Debtors 1,20,000

Establishment charges 20,000

Electricity charges 6,575

Postage and telegram 1,284

Travelling and conveyance 3,816

Advance for sales commission 1,000

Insurance 2,500

Rent received 12,000

Motor van (purchased 1.1.03) 80,000

Motor van maintenance 23,425

Fixed deposit (1.9.2003) 1,00,000

Cash in hand 1,823

Cash at bank 1,47,977

62


b. Electricity charges are O/s Rs. 25

c. (½) commission on total sales is payable to salesmen, towards which Rs. 1000 aspaid in advance.

d. Fixed deposit earns interest at 9% per annum

e. Provide depreciation 20% per annum on motor car

f. Closing stock 31st Dec., 2003

To prepare the trial balance, the following necessary corrections should be made on therespective accounting heads given.

I. Rs. 25 paid to the conveyance was debited to motor van maintenance account-The errors to be rectified which is known as error without affecting the trial balance.

Rs. 25 should be deducted from the Motor maintenance account for the wrongentry debited already but at the same time right entry has to be made under theconveyance account through the addition of Rs. 25 i.e., Rs. 25 to be debited.

To put it in to nutshell, Rs 25 should be deducted from the total of Motor maintenanceaccount in order to cancel the wrong debit entry i.e.

Rs. 23, 425-Rs. 25=Rs. 23, 400

To effect the correct entry, Rs. 25 should be to the original conveyance accounti.e.

Rs. 3, 816+Rs. 25= Rs. 3, 841/-

II. Rs. 2, 000 was drawn from the bank omitted in the establishment charges account;which is meant for the purpose. -

Rs. 2, 000 should be added to the establishment charges account total in order toidentify the total of establishment charges.

Total establishment charges = Rs. 22, 000+ Rs. 2000= Rs. 24, 000

III. Cash column in the cash book on the receipt side excess total Rs. 400 i.e. Rs. 400excess total should corrected on the given balance of cash in hand in order todetermine the real volume of cash in hand.

Real volume of cash in hand = Rs. 1, 823-Rs. 400 = Rs, 1423

Now we have to illustrate the corrected trial balance by incorporating the abovegiven changes.

Trial BalanceParticulars Debit Rs Credit Rs Capital 6,00,000

Drawings 12,000

Buildings 2,00,000

Furniture & Fittings 30,000

Depreciation Reserve 13,000

Purchases 4,00,000


Sales 5,00,000

Debtors 1,20,000

Establishment charges Rs.20,000 22,000

Electricity charges 6,575

Postage & telegram 1,284

Traveling& Conveyance 3,841

Advance for salesmen commission 1,000

Insurance 2,500

Rent received 12,000 Contd...

63

Final Accounts

Dr Trading account for the year ended 31st Dec, 2003 Cr

Rs Rs Rs Rs

Profit & Loss account for the year ended 31st Dec, 2003

Balance sheet as on dated 31st Dec, 2003

Motor van (purchased 1.1.2003 80,000

Motor van maintenance 23,400

Fixed deposit 1,00,000

Cash in hand 1,423

Cash at bank 1,47,977

Depreciation 13,000

Total 11,65,000 11,65,000

To Purchases 4,00,000 By Sales 5,00,000 By Closing stock 1,00,000

To Gross profit c/d 2,00,000 6,00,000 6,00,000

To Insurance 2,500 By Gross profitB/d

2,00,000

To motor maintenance

23,400 By Rent received 12,000

To establishment charge

22,000 Interest received 3,000

Dec provision 2,000 24,000 To Traveling & conveyance

3,841

To Postage and telegram

1,284

To electricity charges 6,575 O/s E.B charges 25 6,600 To depreciation 13,000 To sales commission paid

1,000

To commission O/s 1,500 2,500 To Depreciation of motor van @ 20%

16,000

To Net profit c/d 1,21,875 2,15,000 2,15,000

Liablities Rs Rs Assets Rs Rs Capital 6,00,000 Cash in hand 1,423

(+)Net profit 1,21,875 Cash at bank 1,47,977

7,21,875 Fixed Deposit 1,00,000

(-)Drawings 12,000 Interest 3,000

7,09,875 Motor van 64,000

Sundry creditors 40,000 Sundry debtors 1,20,000

Provision for establishment

charges

2,000 Building 2,00,000

Electrical charges 25 (-)Reserve 10,000 1,90,000

O/s Commission 1,500 Furniture 30,000

(-) Reserve 3,000 27,000

Closing stock 1,00,000

7,53,400 7,53,400

64


Pandit Broths for the year ended 31st Mar, 2006

Adjustment:

a. Closing stock Rs. 1, 14, 500

b. There was fire in the premises on 25th Nov, 2005, which damaged the portion ofthe stock the loss was estimated Rs. 17, 500

c. A. Pandit is the in-charge of purchases of stock item & he is to be paid 2. 5% onsuch purchases

d. A steel table purchased 1st Feb Rs. 3, 000 debited to purchase account

e. B. Pandit who looks after all aspect other than purchases is entitled to thecommission of 5% on Net profits of after charging commission

f. Depreciation is to be charged at 2. 5% per annum on building & 10% on furniturefittings profits or losses or share equally for the partners.

Dr Trading account for the year ended 2005-06 Cr

Rs Rs Rs Rs

Dr Profit & Loss account for the ended 2005-06 Cr

Particulars Debit Rs Credit Rs A.Pandit 1,00,000 Capital

B.Pandit 1,00,000

A Pandit 16,000 Drawings

B.Pandit 16,000

Buildings 80,000

Furniture & fittings 20,000

Purchases 2,00,000

Sales 3,00,000

Stock 1.4.2005 50,000

Wages & salaries 44,000

Rates & Taxes 1,600

Office expenses 60,000

Sundry debtors 25,000


Cash in hand 400

Cash at Bank O/D 29,000

Freight inwards 28,000

Total 5,41,000 5,41,000

To Opening Stock 50,000 By Sales 3,00,000 Purchases 2,00,000 By Closing stock 1,14,500 (-)Purchase of table 3,000 By Goods Loss by fire 17,500 1,97,000 (+)Commission to A.Pandit

4,925

2,01,925 To Carriage inwards 28,000 To Wages & Salary 44,000 To Gross profit c/ d

1,08,075

Total 4,32,000 Total. 4,32,000

To Rates & Taxes 1,600 By Gross profitB/d 1,08,075

To office expenses 60,000

To Depreciation Building 2,000

To Depreciation

Existing Furniture 20,000×10/100

2,000

Contd...

65

Final Accounts


3.5 LET US SUM UP

Trading Account is first financial statement prepared by the owner of the enterprise todetermine the gross profit during the year through the matching concept of accounting.The purpose of crediting the closing stock in the trading account is to find out the materialsor goods consumed for trading purposes. In order to find out the total amount of goods ormaterials consumed during a year, three different components to be separately considered.

l Opening stock

l Purchases and

l Closing Stock

Profit & Loss Account is a second statement of accounting in connection with the earlierto determine the Net profit/loss of the enterprise out of the early found Gross profit/loss.Balance sheet is the third financial statement which reveals the financial status of theenterprise through the total amount of resources raised and applied in the form of assets.


If it is uncertain whether an expenditure will benefit one or more than one accountingperiod, or whether it will increase the capacity or useful life of an operational asset, mostfirms will expense rather than capitalise the expenditure. Why?

3.7 KEYWORDS

Trading account: It is the accounting statement of revenues and expenses

Liabilities Assets Capital(A.Pandit) 1,00,000 Building 80,0000

(+) Commission 4,925 Depreciation 2.5% 2,000

1,04,925 78,000

(+)Net profit 11,869 Furniture 23,000

1,16,794 Depreciation 10% 2,050

(-)Drawings 16,000 20,950

1,00,794 Closing stock 1,14,500

Capital( B.Pandit) 1,00,000 Sundry Debtors 25,000

(+)Commission 1,187 Cash in hand 400

1,01,187

(+) Net profit 11,869

1,13,056

(-)Drawings 16,000 97,056

Bank overdraft 29,000


2,38,850 2,38,850

New Furniture 3000×10/100×2/12

50

2050

To Loss on fire 17,500

To commission B.Pandit 1187

To Net profit C/d A.Pandit

11,869

B.Pandit 11,869 23,738

1,08,075 1,08,075

66


Balance Sheet: It is nothing but a positional statement of assets and liabilities of the firmon a particular date

G. P- Gross profit: Resultant of excess of trading incomes over the expenses

G. L-Gross Loss: Resultant of excess of trading expenses over the incomes/ revenues

N. P- Net profit: Resultant of excess of Profit & Loss incomes /revenues over theexpenses

N. L-Net Loss: Resultant of excess of Profit & Loss expenses over the incomes


1. Illustrate the interrelationship in between the accounting statements and statementof position.

2. Highlight the effect of the following entries in the

(a) Closing stock

(b) Interest received in advance

(c) Rent outstanding

3. Explain the various accounting concepts and conventions through additionalinformation or adjustments.

4. Illustrate various kinds of drawing and their treatment in the financial statements.


M. P Pandikumar “Accounting & Finance for Managers”, Excel Books, New Delhi.

R. L. Gupta and Radhaswamy, “Advanced Accountancy”

V. K. Goyal, “Financial Accounting”, Excel Books, New Delhi.


S. N. Maheswari, “Management Accounting”



I. M. Pandey, “Financial Management”, Vikas Publishing, New Delhi.


CHAPTER

4DEPRECIATION ACCOUNTING

CONTENTS


4.1 Introduction

4.2 Meaning of Depreciation

4.3 Reasons and Aims of Depreciation

4.3.1 Reasons for Depreciating

4.3.2 Aims of Charging Depreciation

4.4 Methods for Charging Depreciation

4.4.1 Straight Line Method

4.5 Diminishing Balance/Written Down Value Method

4.6 Dissimilarities in between the Straight Line Method and Written Down Value Method

4.7 Let us Sum up


4.9 Keywords




In this lesson we shall discuss about depreciation accounting. After studying this lessonyou will be able to:

(i) discuss meaning of depreciation

(ii) analyse reasons and aims of depreciation

(iii) understand methods for charging depreciation

4.1 INTRODUCTION

The depreciation accounting is mainly based on the concept of income. The concept ofincome is matching of revenues with expenses. The goods purchased are frequentlymatched through immediate sale or within a year. The crux of the concept of income isthat the expenses are to be matched against the revenues. The ultimate aim of matchingis done in order to determine the volume of profit or loss of the transaction. If the assetsare nothing but long term assets procured by the enterprise should be matched against

68


the revenues of them. The matching of expenditure of the assets incurred by the firm atthe time of purchase against the revenues is the hard core task of the firm. Why it isbeing considered as a cumbersome task in matching ? The benefits/revenues of thefixed assets expected to accrue for many number of years but not within a year. Theinitial investment on the assets at the time of purchase should be matched against therevenue pattern of the same year after year in order to find out the profitability of thelong term investment. To have an effective matching against the revenues on everyyear, the amount of purchase has to be stretched. The stretching of expenses into manyyears is known as depreciation.

4.2 MEANING OF DEPRECIATION

It is a matching in between the fixed charge expense against the current year’s revenue.

The remaining /left which is unrecovered portion should be carried forward to forthcomingyears in order to match against the respective revenues

What is the ultimate of the purpose of the depreciation?

The ultimate purpose of the depreciation is to replace the fixed assets only at the momentof becoming useless through the current revenues.

According to Dickens, “depreciation is the permanent and continuous diminution inthe quality /quantity / value of the asset. ”

In simple words to understand the terminology depreciation is the permanent decrease inthe value of the fixed assets.

4.3 REASONS AND AIMS OF DEPRECIATION

4.3.1 Reasons for Depreciation

(1) Wear and Tear of the Asset: The long term assets are becoming less efficient andpoor quality in operations due to the continuous usage of the asset.

(2) Exhaustion: Nothing will be remaining due to the continuous extraction ofresources. The resources in the oil wells, mine fields will become nothing due tocontinuous extraction should be replaced by new exploration. To invest on the newexploration in order to have continuous exploration which requires the depreciationas a charge against the revenues of the fields.

Example, Oil & Natural Gas Corporation Ltd. (ONGC) indulges in the process ofnew oil exploration projects through research projects. Then the new projects shouldbe identified and invested by huge initial investment outlay through the currentrevenues out of the existing projects on account of replacement due to depletion ofresources..

(3) To Face Technological Obsolescence: To replace the old machinery with newmachinery before the expiry of the economic life period of the asset in order tomaintain the efficiency and economy of the asset. The type writer was replaced bythe electronic typewriter during the yester periods of office automation. To replacethe old type writer which is not efficient as well as economical, should be replacedby the new electronic typewriter through the depreciation charge on the old one.

(4) Accident: The value of the asset mainly depends upon the efficiency and economy;which gets affected due to the accident.

69

Depreciation Accounting4.3.2 Aims of Charging Depreciation

l To recover the cost: The depreciation charge is a mean to recover the cost ofoperations of the enterprise. More specifically to recover the cost of asset procuredwhich is in usage.

l To facilitate the induction of new asset: To replace the old one, the new asset hasto be purchased only with the help of depreciation charge

l To find out the correct P&L accounting balance

l To know the original position of the enterprise through proper adjustments on thefixed assets

Check Your Progress

(1) Depreciation is

(a) Capital expenditure (b) Revenue expenditure

(c) Expense (d) Non recurring expenditure

(2) Depreciation accounting facilitates to know

(a) Original value of the asset (b) Realisable value of the asset

(c) Book value of the asset (d) Both (a) & (c)

(3) Depreciation is an item to be recorded finally in the

(a) Trading account (b) Profit & Loss account

(c) Balance sheet (d) Profit & Loss A/c and Balance Sheet

4.4 METHODS FOR CHARGING DEPRECIATION

There are various methods of depreciation:

1. Straight line method

2. Depletion or Output method

3. Machine hour rate method

4. Diminishing Balance or Written down method

5. Sum of digits method

6. Annuity method

7. Sinking fund method

8. Insurance policy method

Among the above mentioned methods, Straight line method and Diminishing balance orwritten down method are more important methods. These two methods are preferableand renowned methods among the industrialists in charging the depreciation on the fixedassets. The first method is as follows

4.4.1 Straight Line Method

This method, depreciation is calculated as a fixed proportion on the original value of theasset. The depreciation is charged as fixed in volume on the original value of the assetat which it was purchased. The original value of the asset is nothing but the purchasevalue of the asset.

70


Illustration 1

I. Cost of Machine – Rs. 1, 00, 000

Estimated life of the machine – 5 years

Scrap value-Nil

Cost of the machine -Scrap valueDepreciation =

Economic Life period of the asset in years

According to the concept of depreciation, the value of the asset is dispersed throughoutthe life of the period in order to match against the respective earnings of the year afteryear The purchase value of the asset is an expenditure to be stretched to many numberof years in order to equate with the revenues. To equate the revenues, the scrap value ofthe asset at the end of the life period is realized should be deducted and apportioned tothe total number of the economic life period of the asset. The aim of deducting the scrapvalue of the asset is reducing the original value of the investment

Rs. 1,00,000Deprecation = = Rs. 20,000

5

To understand the above calculation, the following table is most inevitable

From the above table, Rs. 20, 000 is charged on every year to recover Rs. 1, 00, 000during its life period i.e. 5 years

Illustration 2

Original value of the investment- Rs. 1, 00, 000

Scrap value – Rs. 10, 000

Life of the asset -5 years

Rs. 1,00,000 - Rs.10,000 Rs. 90.000Deprecation = Rs. 18.000

5 year 5 year= =

To understand the methodology of straight line depreciation, the following table will illustratethe process

Value of the asset (Begin) Rs Depreciation Rs Value of the asset End Rs

1st year –.1,00,000 18,0000 .82,000

2nd year-.82,000 18,0000 .64,000

3rd year-.64,000 18,0000 46,000

4th year-.46,000 18,0000 28000

5th year-.28,000 18,0000 10,000(Scrap value )*

Value of the asset (Begin) Rs

Col.1

Depreciation Rs

Col.2

Value of the asset End Rs

Col 3=Col.1-Col.2

1st year –.1,00,000 20,000 80,000

2nd year-.80,000 20,000 60,000

3rd year-.60,000 20,000 40,000

4th year-.40,000 20,000 20,000

5th year-.20,000 20,000 “0”

71

Depreciation Accountingl The scrap value of the asset is expected to realize only at the end of the life periodof the asset i.e. 5 years.

Illustration 3

Mr. Shankar purchased machine for Rs. 90, 000 on 1st April 1999. It probable workinglife was estimated at 5 years and its probable scrap value at the end of that time is Rs.10, 000. You are required to prepare necessary account based on straight

line method of depreciation for five years

To prepare the various accounts of the enterprise connected to depreciation is as follows

The depreciation charge process is carried out in three stages

l The asset to be initially purchased- Purchase entry has to be carried out. How thepurchase is made ? While making the purchase there are two different accountsget affected which are normally known as real accounts. At the moment of purchaseon one side the asset is coming inside the firm ; on the other side the cash resourcesare depleted due to the payment of purchase bill of the asset.

Dr. Rs Cr. Rs

l The next account involved in the process of accounting is depreciation account.Before transacting the depreciation entry in the books of accounts, we must findthe amount of depreciation to be charged against on every year’s revenue.

l The amount of depreciation is to be calculated as follows:

Original value of the asset -Scrap valueDeprecation =

Estimated life of the asset in years

Rs. 90,000 -10,000Rs. 16,000

5 year = =

l Depreciation is a fixed charge to be calculated on the value of the asset on everyyear and deducted from the original value. Depreciation is nothing but charged asan expenditure against the revenues in accordance with the matching concept.Hence the depreciation non recurring expenditure account and the plant &machinery account should be debited and credited respectively

l For the accounting entry I year depreciation Rs Rs

l For the accounting entry II year depreciation Rs Rs

Plant & Machinery A/c 90,000 1 April,1999

To Cash A/c 90,000

Being plant & machinery purchased

Depreciation A/c Dr 16,000 31st March, 2000

To Plant Machinery A/c Cr 16,000

Being the first year depreciation is charged


To Plant Machinery A/cCr 16,000

Being the second year depreciation is charged

72


l For the accounting entry III year depreciation Rs Rs

l For the accounting entry IV year depreciation Rs Rs

l For the accounting entry V year depreciation Rs Rs

l The next account involved is the scrap value account which amounted Rs 10, 000

While selling the residual portion of the asset, the firm is able to receive Rs. 10, 000as receipt as cash. The sale of residual part of the machinery leads to bring cashresources inside the firm and inturn the plant and machinery is going out of thefirm.

l For the accounting entry of scrap value Rs Rs

l The next transaction is the final transaction pertaining to the posting of depreciationaccounting balance under the P& L account

l It is nothing but the transfer of Depreciation accounting balance into P&L accountAt the end of every year immediately after finalizing the accounting balance ofdepreciation is regularly posted under the P&L account.

l The journal entry transfer is carried out as follows

l For the I year depreciation transfer to P&L A/c Rs Rs

l For the II year depreciation transfer to P&L A/c Rs Rs

P&L A/c Dr 16,000 31st March, 2000

To Depreciation A/c Cr 16,000

Being the first year depreciation is transferred to P&L A/c

P&L A/c Dr 16,000 31st March, 2001


Being the second year depreciation is transferred to P&L A/c

Cash A/c Dr 10,000 31st March, 2004


Being the residual part of the machinery is sold



Being the Third year depreciation is charged



Being the fourth year depreciation is charged



Being the fifth year depreciation is charged

73

Depreciation Accountingl For the III year depreciation transfer to P&L A/c Rs Rs

l For the IV year depreciation transfer to P&L A/c Rs Rs

l For the V year depreciation transfer to P&L A/c Rs Rs

The preparation of Plant & Machinery account : It is very simple to prepare the machineryLedger account

Dr Plant & Machinery I Yr Cr

To Balance B/d 74, 000

Dr Plant & Machinery A/c II Yr Cr


Date Particular Rs Date Particulars Rs

1 April,2000 To Balance B/d 74,000

(transferred from I Yr

Plant & Machinery)

31st Mar,2001

By Depreciation 16,000

By Balance c/d

transferred to

III Yr Plant & Machinery A/C 58,000

74,000 74,000


1 April,1999 To Cash A/c 90,000 31st Mar,2000


By Balance c/d

transferred to

Second year Plant & Machinery A/C 74,000

90,000 90,000

P&L A/c Dr 16,000 31st March, 2002


Being the third year depreciation is transferred to P&L A/c

P&L A/c Dr 16,000 31st March, 2003


Being the fourth year depreciation is transferred to P&L A/c

P&L A/c Dr 16,000 31st March, 2004


Being the fifth year depreciation is transferred to P&L A/c

74


Dr Plant & Machinery A/c III Yr Cr


Dr Plant & Machinery A/c IV Yr Cr


Dr Plant & Machinery A/c VYr Cr

The next ledger account to be prepared is Depreciation A/c

Depreciation A/c


1st April,

2003


(transferred from IV Yr Plant & Machinery)

31st Mar,2004


By Cash 10,000

26,000 26,000

Date Particulars Amount Rs Date Particulars Amount Rs

31st Mar,2000

To Plant & Machinery

16,000 31st Mar,2000

By P& L A/c 16,000

31St Mar,2001


16,000 31St Mar,2001

By P& L A/c 16,000

31St Mar,2002


16,000 31St Mar,2002

By P& L A/c 16,000

31St Mar,2003


16,000 31St Mar,2003

By P& L A/c 16,000

31St Mar,2004


16,000 31St Mar,2004

By P& L A/c 16,000


1 April,

2001


(transferred from II Yr Plant & Machinery)

31st Mar,2002


By Balance c/d

(transferred to IV Yr

Plant &

Machinery A/C) 42,000

58,000 58,000


1 April,

2002


(transferred from III Yr

Plant & Machinery)

31st Mar,2003


By Balance c/d

(transferred to V Yr Plant &

Machinery A/C) 26,000

42,000 42,000

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Depreciation AccountingIllustration 4

M/s Muruganand &Co is a trader bought furniture costing Rs 2, 20, 000 for his newbranch on 1st April, 2000. As the furniture bought was superior quality material. Theauditors estimated its residual valued at Rs. 20, 000 after a working life of ten years.Further additions were made into the same category on 1st Oct, 2001 and 1st April, 2002which costing Rs 16, 800 and Rs. 19, 000 (with a scrap value of Rs 800 and Rs. 1000respectively). The trader closed his accounts on 31st Mar every year and wanted toapply straight line method of depreciation. Show the furniture a/c for four years.

First step is to find out the depreciation of the furniture for various number of years i-e 4years. The depreciation is to be calculated on every year.

The most important point to be borne in our mind while calculating depreciation, thefollowing points to be taken into consideration

First, is there any % of depreciation charge given. If given, the depreciation to becalculated on the volume of available balance at the end.

Secondly, if the % of depreciation charge is not given in our problem, How the volume ofdepreciation can be calculated ?

The depreciation can be calculated as follows

In this problem, due to absence of depreciation %, the above illustrated formula shouldhave to be applied throughout the problem

Date of Purchase

Particulars

First Furniture

2000

Rs

Second furniture

2001

Rs

Third Furniture

2002

Rs

Total Depreciation cost

Rs

Cost of the furniture R1 2,20,000 16,800 19,000

Scrap value at the end (-) R2

20,000 800 1000

Depreciable value of the furniture R3

2,00,000 16,000 18,000

Life of the furniture R4 10 years 10 years 10 years

Depreciation R5=R3/R4 20,000 1,600 1,800

Depreciation for 2000-01 20,000 ------ ------- 20,000

Depreciation for 2001-02 20,000 For 6 months

800

------- 20,800

Depreciation for 2002-03 20,000 1,600 1,800 23,400

Depreciation for 2003-04 20,000 1,600 1,800 23,400

Original value of the asset -Scrap valueDeprecation =

Life period of the asset

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Accounting Entries are as follows:

ACCOUNTING ENTRIES FOR THE ACCOUNTING YEAR2000-2001

During the year 1st April 2, 000; Rs. 2, 20, 000 worth of furniture was bought

Rs Rs

Depreciation for the year 2000 for the first furniture Rs Rs

ACCOUNTING ENTRIES FOR THE ACCOUNTING YEARFOR 2001-02

Second new furniture bought during the month 1st Oct, 2001 Rs Rs

Depreciation for the first furniture

Depreciation for the second furniture

ACCOUNTING ENTRIES FOR THE ACCOUNTING YEARFOR 2002-03

Third new furniture bought during the month of 1st April, 2002

Furniture A/c Dr 2,20,000 1 April,2000

To Bank A/cCr 2,20,000

Being the furniture is purchased

Depreciation A/cDr 20,000 31st Mar,2001

To Furniture A/c 20,000

Being depreciation charged

Furniture A/c Dr 16,800 1 April, 2001

To Bank A/c 16,800

Being new furniture procured

Depreciation A/c Dr 800 31st March, 2002

To Furniture A/c 800

Being the depreciation charged for the second furniture for 6 months



Being the depreciation charged

Furniture A/c 19,000 1st April, 2002

To Bank A/c 19,000

Being the furniture purchased during the year

77

Depreciation AccountingDepreciation charged for the first furniture

Depreciation charged for the second furniture

Depreciation for the third furniture

ACCOUNTING ENTRIES FOR THE FOURTH YEAR 2003-04

Depreciation charged for the first furniture

Depreciation charged for the second furniture

Depreciation for the third furniture

In the next step, the furniture account to be prepared for every year

Furniture A/c (2000-01)

31st Mar, 2001 To Balance B/d 2, 20, 000



Being the depreciation charged for the first furniture



Being the depreciation charged for the second furniture



Being the depreciation charged for the third furniture



Being the depreciation charged for the first furniture



Being the depreciation charged for the second furniture



Being the depreciation charged for the third furniture

Date Particulars Amount Rs


1April,2000 To Bank 2,20,000 By Depreciation 20,000

31 Mar,2001

By Balance c/d 2,00,000

2,20,000 2,20,000

78


Furniture A/c (2001-02)


Furniture (2002-03)


Furniture (2003-04)

31 Mar, 2004 To Balance B/d 1, 68, 200

Merits

l It is simple to calculate only due to fixed depreciation charge on the value of theasset

l The value of the asset is depleted to either zero or scrap value of the asset

l This method is most suited for patents trade marks and so on

Date Particulars Amount

Rs


Rs

1st April, 2003

To Balance B/d 1,91,600 31st March, 2004





1,91,600 1,91,600

31 March, 2004

To Balance B/d 1,68,200



1April,2001 To Balance B/d 2,00,000 By Depreciation 20,000

1st Oct ,2001 To Bank 16,800

31 Mar,2002

By Depreciation 800


2,16,800

2,16,800

31st Mar, 2002



Rs


Rs

1st April, s2002

To Balance B/d 1,96,000 31st Mar,2003


1St April, 2002

To Bank 19,000 By Depreciation 1,600



2,15,000 2,15,000

31st Mar,2003


79

Depreciation AccountingDemerits

l The utility of the asset is not considered at the moment of charging constantdepreciation over the asset

l During the later years of the asset, the efficiency will automatically come downand simultaneously the maintenance cost of the asset will rigger up which is illogicalin charging fixed charge throughout the life period of the asset

4.5 DIMINISHING BALANCE/WRITTEN DOWN VALUEMETHOD

This method also having the same methodology in charging depreciation on the fixedassets like fixed percentage Though it is bearing similar approach in chargingdepreciation but different in application from the straight line method. Under this method,the depreciation is charged on the value of the asset available at the beginning of theyear.

The following formula highlights the application of this method in charging depreciation

= 1-(S/C)1/n

The meaning of the above illustrated formulae is discussed through the explanation oftwo different components.

First one is (S/C)1/n , the ration of the scrap value of the asset on the original value ofthe asset is appropriately apportioned throughout the life period of the assets. It is nothingbut the percentage of scrap value widened across the life period of the asset. Once thescrap value percentage is known, the next important step is to determine the depreciablevalue of the asset. The depreciable value of the asset can be derived by deducting thepercentage from No 1.

Illustration 5

Life of the asset (n)=3 years

Expected scrap value at the end of 3 years= Rs. 12, 800

Original Investment=Rs. 2, 00, 000

Find out the percentage of depreciation to be charged

Under this method, to charge depreciation as well as to find out the value of the asset ason a particular date, the depreciation percentage must be given. In this problem,depreciation % is not given, in order to determine the above illustrated formulae shouldbe applied

= 1-(S/C)1/n

=1-(Rs. 12, 800/Rs. 2, 00, 000)(1/3)

=1-4/10=6/10=60%

The following workings will obviously facilitate to understand the charge of depreciation

The value of the Asset at the beginning of 1st Year = Rs. 2, 00, 000

(-) Depreciation 60% on Rs. 2, 00, 000 (Original value ) = Rs. 1, 20, 000

Value of the asset at the beginning of 2nd Year = Rs. 80, 000

(-)Depreciation 60% on Rs 1, 20, 000. (Book Value) = Rs. 48, 000

80


Value of the asset at the beginning of 3rd Year = Rs. 32, 000

(-)Depreciation 60% on Rs 32, 000( Book Value) = Rs. 19, 200

Value of the asset at the end of the year = Rs. 12, 800

Check Your Progress

(1) Treatment of Depreciation in the Profit &Loss A/c is

(a) Profit & Loss A/c Dr (b) Fixed Asset A/c Dr

To Depreciation A/c To Profit & Loss A/c

(c) Depreciation A/c Dr (d) Depreciation A/c Dr

To Fixed Asset A/c To Profit & Loss A/c

(2) Under straight line method, depreciation is charged on

(a) The value of the asset at the beginning (b) The average value of the asset

(c) The value of the asset at the end (d) None of the above

4.6 DISSIMILARITIES IN BETWEEN THE STRAIGHTLINE METHOD AND WRITTEN DOWN VALUE METHOD

Under this method of charging depreciation unlike the straight line method, the percentageis usually given for calculation.

While calculating this method, the depreciation is calculated on two different values

Illustration 6

On 1st April, 2000, a firm purchases machinery worth Rs. 3, 00, 000. On 1st Oct, 2002 itbuys additional machinery worth Rs. 60, 000 and spends Rs. 6, 000 on its erection. Theaccounts are closed normally on 31 Mar. Assuming the annual depreciation to be 10%Show the machinery account for 3 years under the written down value method.

ACCOUNTING JOURNAL ENTRIES FOR THE YEAR 2000-01

During the year 1st April 2, 000; Rs. 3, 00, 000 worth of machinery was bought

Rs RsMachinery A/c Dr 3,00,000 1 April, 2000

To Bank A/c Cr 3,00,000

(Being the machinery is purchased)

Depreciation

Depreciation for initial year Depreciation for sub sequent years

Depreciation on original value - at the beginning

Depreciation on Book value – during

later period

81

Depreciation AccountingDepreciation for the year 2000 for the first machinery Rs Rs

ACCOUNTING JOURNAL ENTRIES FOR THE YEAR 2001-02

Depreciation for the year 2001 for the first machinery Rs Rs

JOURNAL ENTRIES FOR THE YEAR 2002-03

During the year 2002 new machinery worth of Rs. 60, 000 was purchased. Beforedetermining the volume of depreciation, the amount of original value of the machineryshould be found out.

Original value of the asset = The purchase price of the asset + Erection charges incurred

= Rs. 60, 000 + Rs. 6, 000 = Rs. 66, 000

Rs Rs

Depreciation for the year 2002 for the first machinery Rs Rs

Depreciation for the year 2002 for the second machinery Rs Rs

After passing the journal entries, the next step is to prepare ledger account of machinery

Machinery A /c (2000-01)

Dr Cr

Machinery A/c Dr 66,000 1 April,2002

To Bank A/c Cr 66,000

(Being the machinery is purchased)

Depreciation A/c Dr 24,300 31st Mar,2003

To Machinery A/c 24,300

(Being depreciation charged )

Depreciation A/cDr 3,300 31st Mar,2003


(Being depreciation charged)



(Being depreciation charged )



(Being depreciation charged)



1st April,2000

To Bank 3,00,000 31st Mar,2001



3,00,000 3,00,000

31st Mar,2001

To Balance B/d Transfer to Machinery A/c (20001-02)

2,70,000

82


MachineryA/c (2001-02)

Dr Cr

Machinery A/c (2002-03)

Dr Cr


Merits:

l The depreciation is charged under this method only in line with the efficiency. Itmeans that during the early years of the usage, the efficiency of the asset is morethan that of the later part of the life of the asset.

l The depreciation volume under this method is greater during the early years of theasset than the later periods of the asset.

l It evades the possibility of incurring losses due to obsolescence.

Demerits:

l It is a tedious method in computation.

l Under this method, the book value of the asset at end of the economic life period isnever equivalent to zero.

Suitability: This method is most suitable in the case of depreciating the worth of patentwhich is subject greater risk of technological obsolescence. This method is most suitablein the case of patent design of a car, cellular phone design, pharmaceutical patent and soon. These are having greater technological risk which prefers the firms to write off theexpenditures in more volume during the early years in order to recover the investmentthrough matching early period revenues. “Early recovery is better the principle”

4.7 LET US SUM UP

Depreciation is the permanent and continuous diminution in the quality /quantity / valueof the asset. The long term assets are becoming less efficient and poor quality inoperations due to the continuous usage of the asset. The value of the asset mainly



1st April,2000


By Depreciation First machinery

24,300

1st Oct,2002 To Bank 66,000 By Depreciation Second machinery

3,300


3,09,000

31st Mar,2003




Rs

1st April,2000




2,70,000 2,70,000

31st Mar,2001

To Balance B/d

Transfer to Machinery A/c (2002-03)

2,43,000

83

Depreciation Accountingdepends upon the efficiency and economy; which gets affected due to the accident.According to the concept of depreciation, the value of the asset is dispersed throughoutthe life of the period in order to match against the respective earnings of the year afteryear The purchase value of the asset is an expenditure to be stretched to many numberof years in order to equate with the revenues. The value of the asset after deducting thedepreciation from the value of the asset at the beginning.


Companies usually depreciate assets such as buildings even though those assets may beincreasing in value. Give your opinion as an expert.

4.9 KEYWORDS

Depreciation: Continuous reduction/ decrease /diminution in the value of the asset

Depreciation accounting: Recording the entries of depreciation through journal, ledgeraccounts of Depreciation, Fixed asset and Profit & Loss account.

Original Value of the asset: The value of the asset at the time of purchase or acquisition

Book Value of the asset: The value of the asset after deducting the depreciation fromthe value of the asset at the beginning.

Scrap value of the asset: It is the value at the end of the life period of the asset; atwhen the asset cannot be put for further usage.


1. Define Depreciation. Explain the meaning of the term “ Depreciation”.

2. Elucidate the process of Depreciation Accounting.

3. Explain the various methods of depreciation and their merits and demerits.

4. Highlight the suitability of depreciation method to the tune of business environment.


M. P. Pandikumar, “Accounting & Finance for Managers”, Excel Books, New Delhi.

R. L. Gupta and Radhaswamy, “Advanced Accountancy”.


Khan and Jain, “Management Accounting”.

S. N. Maheswari, “Management Accounting”.




Nitin Balwani “Accounting & Finance for Managers”, Excel Books, New Delhi.

UNIT-II

LESSON

5FINANCIAL STATEMENT ANALYSIS

CONTENTS


5.1 Introduction

5.2 Definition & Classification of Financial Statement Analysis

5.3 Comparative Financial Statements

5.4 Trend Percentage Analysis

5.5 Let us Sum up


5.7 Keywords




In this lesson we shall discuss about financial statement analysis. After going throughthis lesson you will be able to:

(i) understand definition and classification of financial statement analysis

(ii) analyse comparative financial statements and trend percentage analysis

5.1 INTRODUCTION

The financial statements are affording many facts though they are absolute and concretein terms; but not in a position to interpret and analyse the stature of the enterprise. Toanalyse and interpret, the financial statement analysis is being applied across the financialstatements viz Trading, Profit & Loss Account and Balance sheet.

Under the financial statement analysis, the information available are grouped together inorder to cull out the meaningful relationship which is already available among them; forinterpretation and analysis.

5.2 DEFINITION & CLASSIFICATION OF FINANCIALSTATEMENT ANALYSIS

According to Kennedy and Muller

“ The analysis and interpretation of financial statements are an attempt to determine thesignificance and meaning of financial statement data so that the forecast may be madeof the prospects for future earnings, ability to pay interest and debt maturities andprofitability and sound dividend policy”

The entire financial statement analysis can be classified into various categories

l Comparative financial statements

l Common size financial statements

88


l Trend percentages

l Fund flow statements

l Cash flow statements

l Ratio analysis

5.3 COMPARATIVE FINANCIAL STATEMENTS

Objectives of comparative financial statements

l Changes taken place in the financial performance are taken into consideration forfurther analysis

l To reveal qualitative information about the firm in terms of solvency, liquidityprofitability and so on are extracted from the analysis of financial statements

l With reference to yester financial data of the enterprise, the firm is facilitated toundergo for the preparation of forecasting and planning.

The major part of financial statement analysis is mainly focused on the comparativeanalysis.

The comparative analysis classified into four different analyses viz

l Comparative Balance sheet

l Comparative Profit and Loss account

l Common Size statement

l Trend percentage

First we will discuss the comparative Balance sheet.

The first and foremost important step is to have the following information and shouldtake preparatory steps

i. While preparing the comparative statement of balance sheet, the particulars forthe financial factors are required

ii. The second most important for the preparation of the comparative balance sheet isyester financial data extracted from the balance sheet or balance sheets

iii. The next most important requirement to have an effective comparison with theyester financial data is current year information extracted from the balance sheetor balance sheet of the firms.

iv. After having been procured the financial data pertaining to various time periodsare ready for comparison; to determine or identify the level of increase or decreasetaken place in the financial position of the firms

v. To determine the level of increase or decrease in financial position, the percentageanalysis to carried out in between them.

⇒ :

Comparative financial statements

Comparative study of Profit & Loss Accounts and Balance sheets

Comparison in between financial statements of two or more years

Comparison in between the financial statements of various firms or industrial average

Intra firm comparison Inter firm comparison

89

Financial Statement AnalysisIllustration 1

From the following information, Prepare comparative Balance sheet of X Ltd.

The first step we have to segregate the available information into two different categoriesviz Assets and Liabilities

N. C = No change in the position during the two years

From the above table, the following are basic inferences

l The fixed assets volume got increased 20% from the year 2004 to 2005, amountedRs. 12, 00, 000

l Rs 9, 00, 000 worth of current assets decrease from the year 2004 to 2005 recorded30%

l The total volume of assets recorded 3% increase from the year 2004 to 2005

l It obviously understood that 20% increase taken place on the reserves and surpluses

l It clearly evidenced that the current liabilities of the firm increased 10% from theyear 2004 to 2005

l The firm has not recorded any changes in the investments, equity share capitaland long-term loans

The next one in the comparative financial statement analysis is that Income statementanalysis

Comparative (Income) financial statement analysis: This analysis is being carried out inbetween the income statements of the various accounting durations of the firm, withother firms in the industry and with the industrial average.

This will facilitate the firm to know about the stature of itself regarding the financialperformance. It facilitates to understand about the changes pertaining to various financialdata which closely relevantly connected with the financial performance

l Change in the gross sales

l Change in the net sales

Particulars 31st Mar,2004 31st Mar,2005 Equit share capital 50,00,000 50,00,000 Fixed Assets 60,00,000 72,00,000 Reserves and surpluses 10,00,000 12,00,000 Investments 10,00,000 10,00,000 Long-term loans 30,00,000 30,00,000 Current assets 30,00,000 21,00,000 Current liabilities 10,00,000 11,00,000

Particulars 2004 Rs 2005 Rs Absolute Change Rs

% Increase

% Decrease

Fixed Assets 60,00,000 72,00,000 12,00,000 20 -

Investments 10,00,000 10,00,000 N.C - -

Current assets 30,00,000 21,00,000 (9,00,000) 30

Total Assets 1,00,00,000 1,03,00,000 3,00,000 3 -

Equity share capital 50,00,000 50,00,000 N.C - -

Reserves & surpluses 10,00,000 12,00,000 2,00,000 20 -

Long-term loans 30,00,000 30,00,000 N.C - -

Current liabilities 10,00,000 11,00,000 1,00,000 10 -

1,00,00,000 1,03,00,000 3,00,000 3 -

90


l Change in gross profit and net profit

l Change in operating profit

l Change in operating expenses

l Change in the volume of non operating income

l Change in the non operating expenses

The ultimate purpose of the comparative (Income) financial statement analysis is asfollows

i. To study the income earning and expenditure spending pattern of the firm for twoor more years

ii. To identify the changing pattern of the income and expenditure of the firms. Thepreparatory steps for the preparation of the comparative financial statement(Income) analysis

The first and foremost important step is to have the following information and shouldtake preparatory steps

i. While preparing the comparative statement of Profit and Loss Account, theparticulars for the financial factors are required

ii. The second most important for the preparation of the comparative Profit & Lossaccount is yester financial data extracted from the Profit & Loss A/c orProfit & Loss Accounts

iii. The next most important requirement to have an effective comparison with theyester financial data is current year information extracted from the balance sheetof the firm or of the other firms

iv. After having been procured the financial data pertaining to various time periodsare ready for comparison ; to determine or identify the level of increase or decreasetaken place in the operating financial performance of the firms

v. To determine the level of increase or decrease in financial performance, thepercentage analysis to be carried out in between them.

Illustration 2

Prepare the comparative income statement from the following:

Comparative Income Statement

Particulars 2004 Rs 2005 Rs

Sales 2,00,000 2,50,000

Cost of goods sold 1,00,000 1,30,000

1,00,000 1,20,000

Operating expenses 10,000 10,000

Net profit 90,000 1,10,000

Particulars 2004 Rs 2005 Rs Absolute Change Rs

% Increase

%

Decrease

Sales 2,00,000 2,50,000 50,000 25 -

(-)Cost of goods sold 1,00,000 1,30,000 30,000 30 -

1,00,000 1,20,000 20,000 20 -

(-)Operating expenses 10,000 10,000 N.C - -

Net profit 90,000 1,10,000 20,000 22.22

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Financial Statement AnalysisFrom the above table, the following inferences can be had:

l The firm has registered 25% increase in sales from the year 2004 to 2005

l Cost of goods sold raised 30% from the year 2004 to 2005

l There is no change in the level of operating expenses

l The firm has got 22. 22% increase in the level of net profits from the year 2004 to2005

Illustration 3

From the following information, prepare a comparative income statement:

Comparative Income Statement

For this problem, the inferences could be enlisted according to the comparative statementanalysis on Profit & Loss Accounts of two different year viz 2001 and 2002.

The next important tool of financial statement analysis is a common size statementanalysis which known as predominant tool in intra firm analysis in studying the share ofeach component.

The components are translated into percentage for analysis and interpretations. Forprofit and loss account, Net sales is considered as a base for the computation of a shareof each financial factor available.

For Balance sheet, total volume of assets and liabilities are taken into consideration forthe computation of a share of each financial factor available under the heading of assetsand liabilities.

Illustration 4

Prepare the common size statement analysis for the firm ABC ltd

Particulars 2001 Rs 2002 Rs

Sales 10,00,000 8,00,000

Cost of goods sold 6,00,000 4,00,000

Administration Expenses 2,00,000 1,40,000

Other Income 40,000 20,000

Income tax 1,20,000 1,40,000

Particulars 2001 Rs 2002Rs Absolute Change Rs

% Increase

%

Decrease

Sales 10,00,000 8,00,000 (2,00,000) - 20

(–)Cost of goods sold 6,00,000 4,00,000 (2,00,000) - 33.33

4,00,000 4,00,000 - -

(–) Administration Expenses

2,00,000 1,40,000 (60,000) - 30

Operating Income 2,00,000 2,60,000 60,000 30 -

(+)other income 40,000 20,000 (20,000) - 50

Total Net Income Before tax

2,40,000 2,80,000 40,000 - 16.66

Income tax 1,20,000 1,40,000 20,000 16.66 -

Net Income after the tax 1,20,000 1,40,000 20,000 16.66 -

Liabilities 1990Rs 1991Rs Assets 1990Rs 1991 Rs Share capital 2,00,000 3,00,000 Fixed assets 2,25,000 4,00,000 Reserves and surpluses

1,00,000 2,00,000 Stock 1,29,000 2,00,000

Bank overdraft 60,000 2,00,000 Quick assets 46,000 2,00,000 Quick liabilities 40,000 1,00,000 4,00,000 8,00,000 4,00,000 8.,00,000

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Common size statement analysis of the Balance sheet of the firm ABC Ltd.

The above illustration highlights the share of every component in the balance sheet outof the total volume of assets and liabilities.

This will certainly facilitate the firm to easily understand not only the share of everycomponent but also facilitates to have a meaningful and relevant comparison with varioustime horizons.

From the following table, prepare the common size statement analysis:

Common size statements Profit & Loss Account

Particulars Amount % of Balance sheet total Assets 1990 Rs 1991 Rs 1990 1991 Fixed assets 2,25,000 4,00,000 56.25 50

Stock 1,29,000 2,00,000 32.25 25

Quick assets 46,000 2,00,000 11.5 25

Total 4,00,000 8,00,000 100 100

Liabilities

Share capital 2,00,000 3,00,000 50 37.5

Reserves and surpluses 1,00,000 2,00,000 25 25

Bank overdraft 60,000 2,00,000 15 25

Quick liabilities 40,000 1,00,000 10 12.5

4,00,000 8,00,000 100 100

2000 Rs. 2001 Rs. Sales 20,00,000 24,00,000

Miscellaneous Income 20,000 16,000

20,20,000 24.16,000

Materials consumed 11,00,000 12,96,000

Wages 3,00,000 4,08,000

Factory expenses 2,00,000 2,16,000

Office expenses 90,000 1,00,000

Interest 1,00,000 1,20,000

Depreciation 1,40,000 1,50,000

Profit 90,000 1,26,000

20,20,000 24,16,000

Particulars 2000 Rs. % Percentage 2001 Rs. Percentage %

Sales 20,00,000 100 24,00,000 100 Miscellaneous Income 20,000 .9 16,000 .67 20,20,000 100.9 24.16,000 100.67 Materials consumed 11,00,000 54.46 12,96,000 53.64 Wages 3,00,000 14.85 4,08,000 16.82 Factory expenses 2,00,000 9.90 2,16,000 8.92 Office expenses 90,000 4.47 1,00,000 4.95 Interest 1,00,000 4.95 1,20,000 4.92 Depreciation 1,40,000 6.94 1,50,000 6.21 Profit 90,000 4.47 1,26,000 5.21 20,20,000 100.9 24,16,000 100.67

93

Financial Statement AnalysisCheck Your Progress

(1) Financial statement analysis is to

(a) Inter firm comparison only

(b) Intra firm comparison only

(c) Industrial average comparison

(d) (a), (b) & (c)

(2) Intra firm analysis is

(a) With in a year

(b) In between the years

(c) Comparison with the projected

(d) (a), (b) & (c)

(3) Comparative financial statement analysis is into

(a) Comparison of Income& Position statements

(b) Common size statements

(c) Trend percentage analysis

(d) (a), (b) & (c)

(4) Main objectives of the Financial statements analysis are

(a) To study the changes in the financial performance

(b) To study the liquidity, solvency of the firm

(c) To undergo financial planning based upon the yester financial performance

(d) (a), (b) & (c)

5.4 TREND PERCENTAGE ANALYSIS

The next important tools of analysis is trend percentage which plays significant role inanalyzing the financial stature of the enterprise through base years’ performance ratiocomputation. This not only reveals the trend movement of the financial performance ofthe enterprise but also highlights the strengths and weaknesses of the enterprise

The following ratio is being used to compute the trend percentage

100year Base

yearCurrent ×=

This trend ratio is being computed for every component for many number of yearswhich not only facilitates comparison but also guides the firm to understand the trendpath of the firm.

5.5 LET US SUM UP

Under the financial statement analysis, the information available are grouped together inorder to cull out the meaningful relationship which is already available among them; forinterpretation and analysis. To reveal qualitative information about the firm in terms of

94


solvency, liquidity profitability and so on are extracted from the analysis of financialstatements. Comparative (Income) financial statement analysis is being carried out inbetween the income statements of the various accounting durations of the firm, withother firms in the industry and with the industrial average. After having been procuredthe financial data pertaining to various time periods are ready for comparison ; to determineor identify the level of increase or decrease taken place in the operating financialperformance of the firms.


In financial statement analysis, what is the basic objective of observing trends in dataand ratios? Suggest some other standards of comparison.

5.7 KEYWORDS

Balance Sheet

Financial Statement

Financial data

Assets

Firm


1. Write elaborative note on the financial statement analysis.

2. Elucidate the common size statement analysis.

3. List out the objectives of the financial statement analysis.

4. Explain the steps involved in the process of comparative statement of balancesheet.

5. Write brief note on the trend analysis.

5. 9 SUGGESTED READINGS









LESSON

6RATIO ANALYSIS


6.1 Introduction

6.2 Definition

6.3 How the Accounting Ratios are Expressed?

6.4 Purpose, Utility & Limitations of Ratio Analysis

6.5 Classification of Ratios

6.6 Short-term Solvency Ratios

6.6.1 Current Assets Ratio

6.7 Standard Norm of the Current Ratio

6.7.1 Implication of High Ratio of Current Assets over the Current Liabilities

6.7.2 Limitation of the Current Ratio

6.7.3 Acid Test Ratio

6.7.4 Super Quick Assets Ratio

6.8 Capital Structure Ratios

6.9 Debt–equity Ratio

6.9.1 Long-Term Debt-equity Ratio

6.9.2 Standard Norm of the Debt-equity Ratio

6.9.3 Total Debt–equity Ratio

6.10Proprietary Ratio

6.11Fixed Assets Ratio

6.12Standard Norm of the Ratio

6.13Coverage Ratios

6.13.1 Interest Coverage Ratio

6.13.2 Dividend Coverage Ratio

6.14Return on Capital Employed

6.15Stock Turnover Ratio

6.16Debtors Turnover Ratio

6.16.1 Debtors Velocity

6.16.2 Creditors Turnover Ratio

6.17Dupont Analysis

6.18Let us Sum up

6.19Lesson-end Activity

6.20Keywords



9 6


In this lesson we shall discuss about ratio analysis. After going through this lesson youwill be able to:

(i) understand purpose, utility and limitations of ratio analysis

(ii) analyse classifications of ratios and Du pont analysis

6.1 INTRODUCTION

The ratio analysis is an one of the important tools of financial statement analysis to studythe financial stature of the business fleeces, corporate houses and so on.

How the ratios are able to facilitate to study the financial status of the enterprise ?

What is meant by ratio?The ratio illustrates the relationship between the two related variables

What is meant by the accounting ratio?The accounting ratios are computed on the basis available accounting informationextracted from the financial statements which are not in a position to reveal the status ofthe enterprise.

The accounting ratios are applied to study the relationship between the quantitativeinformation available and to take decision on the financial performance of the firm.

6.2 DEFINITION

According to J. Betty, “The term accounting is used to describe relationshipssignificantly which exist in between figures ratio shown in a balance sheet, Profit& Loss A/c, Trading A/c, Budgetary control system or in any part of the accountingorganization. ”

According to Myers “Study of relationship among the various financial factors ofthe enterprise”

6.3 HOW THE ACCOUNTING RATIOS ARE EXPRESSED?

To understand the methodology of expressing the ratios, the expression of ratios arehighlighted in the following discussion

6.4 PURPOSE, UTILITY & LIMITATIONS OFRATIO ANALYSIS

Purposes of the Ratio Analysis are:

l To study the short term solvency of the firm – liquidity of the firm

l To study the long term solvency of the firm – leverage position of the firm

l To interpret the profitability of the firm – Profit earning capacity of the firm

l To identify the operating efficiency of the firm. – turnover of the ratios

Quotient Percentage Time Fraction

Current Ratio

/Leverage Ratio Net Profit Ratio Stock Turnover Ratio Fixed assets to

capital

Expression

9 7

Ratio AnalysisUtility of the Ratio Analysis are:

i. Easy to understand the financial position of the firm: The ratio analysis facilitatesthe parties to read the changes taken place in the financial performance of the firmfrom one time period to another.

ii. Measure of expressing the financial performance and position: It acts as ameasure of financial position through Liquidity ratios and Leverage ratios and alsoa measure of financial performance through Profitability ratios and Turnover Ratios.

iii. Intra-firm analysis on the financial information over many number of years:The financial performance and position of the firm can be analysed and interpretedwith in the firm in between the available financial information of many number ofyears; which portrays either increase or decrease in the financial performance.

iv. Inter-firm analysis on the financial information within the industry: Thefinancial performance of the firm is studied and interpreted along with the similarfirms in the industry to identify the presence and status of the respective firmamong others.

v. Possibility for Financial planning and control: It not only guides the firm to earnin accordance with the financial forecasting but also facilitates the firm to identify themajor source of expense which drastically has greater influence on the earnings.

Limitations of the Ratio Analysis are:

i. It is dependant tool of analysis: The perfection and effectiveness of the analysismainly depends upon the preparation of accurate and effectiveness of the financialstatements. It is subject to the availability of fair presentation of data in the financialstatements.

ii. Ambiguity in the handling of terms: If the tool of analysis taken for the study ofinter firm analysis on the profitability of the firms lead to various complications. Tostudy the profitability among the firms, most required financial information areprofits of the enterprise. The profit of one enterprise is taken for analysis is ProfitAfter Taxes (PAT) and another is considering Profit Before Interest and Taxes(PBIT) and third one is taking Net profit for study consideration. The term profitamong the firms for the inter firm analysis is getting complicated due to ambiguityor poor clarity on the terminology.

iii. Qualitative factors are not considered: Under the ratio analysis, the quantitativefactors only taken into consideration rather than qualitative factors of the enterprise.The qualitative aspects of the customers and consumers are not considered at themoment of preparing the financial statements but while granting credit on sales isnormally considered.

iv. Not ideal for the future forecasts: Ratio analysis is an outcome of analysis ofhistorical transactions known as Postmortem Analysis. The analysis is mainlybased on the yester performance which influences directly on the future planningand forecasting ; it means that the analysis is mainly constructed on the pastinformation which will also resemble the same during the future analysis.

v. Time value of money is not considered: It does not give any room for time valueof money for future planning or forecasting of financial performance ; the mainreason is that the fundamental base for forecasting is taken from the yester periodswhich never denominate the timing of the benefits.

Check Your Progress

(1) Ratio is an expression of

(a) Quotient

(b) Time

(c) Percentage

(d) Fraction

(e) (a), (b), (c) & (d)

(2) Accounting ratios are to study

(a) Accounting relationship among the variablesContd...

9 8


(b) the relationship in between the variables of financial statements

(c) The relationship in between the variables of financial statements for analysisand interpretations


(3) Accounting ratios are

(a) Income statement ratios

(b) Positional statement ratios

(c) Both (a) & (b)


6.5 CLASSIFICATION OF RATIOS

The accounting ratios are classified into various categories on the basis of

1. Financial statements

2. Functions

On the basis of Financial Statements:

I. Income statement Ratios: These ratios are computed from the statements ofTrading, Profit & Loss account of the enterprise. Some of the major ratios are:GP ratio, NP ratio, Expenses Ratio, and so on.

II. Balance sheet or Positional Statement Ratios: These type of ratios are calculatedfrom the balance sheet of the enterprise which normally reveals the financial statusof the position i.e. short term, Long term financial position, Share of the owners onthe total assets of the enterprise and so on.

III. Inter statement or Composite Mixture of Ratios: Theses ratios are calculatedby extracting the accounting information from the both financial statements, inorder to identify stock turnover ration, debtor turnover ratio, return on capitalemployed and so on.

On the basis of Functions:

I. On the basis of Solvency position of the firms: Short term and Long term solvencyposition of the firms.

II. On the basis of Profitability of the firms: The profitability of the firms arestudied on the basis of the total capital employed, total asset employed and so on.

III. On the basis of Effectiveness of the firms: The effectiveness is studied throughthe turnover ratios – Stock turnover ratio, Debtor turnover ratio and so on.

IV. Capital Structure ratios: The capital structure position are analysed throughleverage ratios as well as coverage ratios.

6.6 SHORT-TERM SOLVENCY RATIOS

To study the short term solvency or liquidity of the firm, the following are various ratios

l Current Assets Ratio

l Acid Test Ratio or Quick Assets Ratio

l Super Quick Assets Ratio

l Defensive Interval Ratio

6.6.1 Current Assets Ratio

It is one of the important accounting ratios to find out the ability of the business fleecesto meet out the short financial commitment This is the ratio establishes the relationship

9 9

Ratio Analysisin between the current assets and current liabilities.

What is meant by current assets /Current assets are nothing but available in the form ofcash, equivalent to cash or easily convertible in to cash.

What is meant by the current liabilities?

Current liabilities are nothing but short term financial resources or payable in short spanof time within a year.

Current Assets

LiabilitiesCurrent

Current=

:

6.7 STANDARD NORM OF THE CURRENT RATIO

The ideal norm is that 2:1; which means that every one rupee of current liability isappropriately covered by Two rupees of current assets.

6.7.1 Implication of High Ratio of Current Assets over theCurrent Liabilities

High ratio leads to greater the volume of current assets more than the specified normdenotes that the firm possess excessive current assets than the requirement portraysidle funds invested in the current assets.

6.7.2 Limitation of the Current Ratio

Under this ratio, the current assets are equally weighed each other to match the currentliabilities. Under the current ratio, One rupee of cash is equally weighed at par with theone rupee of closing stock, but the closing stock and prepaid expenses cannot beimmediately realized like cash and marketable securities.

6.7.3 Acid Test Ratio

It is a ratio expresses the relationship in between the quick assets and current liabilities.This ratio is to replace the bottleneck associated with the current ratio. It considers onlythe liquid assets which can be easily translated into cash to meet out the financialcommitments.

M arketable Secuities

Inventory

Debtors

B ill Receivable

Pre paid expenses

Outstanding Incomes

Cash at Bank

Cash in Hand

Trade creditors

Bank overdraft

B ills Payable

Provision for taxation

Outstanding expenses

P re received incomes

Current Ratio

Current Assets Current Liabilities

100


sLiabilitie Current

Assets LiquidRatio) AssetsQuick ( RatioTest Acid =

Liquid Asset = Current Assets – ( Closing Stock +Pre paid expenses)

Ratio Assets Liquid

Quick

Standard norm of the ratio;

The ideal norm is that 1:1 means; One rupee of current liabilities is matched with onerupee of quick assets.

6.7.4 Super Quick Assets Ratio

It is the ratio which establishes the relationship in between the super quick assets andquick liabilities of the firm.

The super quick assets are nothing but the current assets which can be more easilyconverted into cash to meet out the quick liabilities.

The super quick liabilities are the current liabilities should have to be met out at fasterpace within shorter span in duration.

Super Quick Assets = Cash + Marketable Securities .

Super Quick Liabilities= Current Liabilities – Bank Over Draft

Super Quick Assets RatiosLiabilitieQuick Super

AssetsQuick Super=

Standard norm of the ratio

Higher the ratio is the better the position of the firm

Illustration 1

From the following calculate current ratioCurrent Assets:

Rs

Cash in hand 4,00,000

Sundry Debtors 1,60,000

Marketable Securities

Debtors

Bill Receivable

Cash at Bank

Cash in Hand

Trade creditors

Bank overdraft

Bills Payable

Provision for taxation

Outstanding expenses

Pre received incomes

Quick Assets Current liabilities

101

Ratio AnalysisStock 2,40,000

Current Liabilities:

Sundry creditors 3,00,000

Bills Payable 1,00,000

24,00,000 .Rs

8,00,000 Rs.

sLiabilitie Current

AssetsCurrent Ratio Current ===

Illustration 2

The firm satisfies the standard norm of the current asset ratio and Liquid assets ratioM/s Shanmuga &Co


2

000,16.Rs

32,000 Rs.

sLiabilitie Current

AssetsCurrent Ratio Current

=

=

=

It satisfies the standard norm of the current asset ratio

1.225 16,000 .Rs

19,600 Rs.

sLiabilitieCurrent

Stock Closing-AssetsCurrent

sLiabilitie Current

assetsQuick ratio assets Liquid

==

==

The firm financial position satisfies the standard norm of the Liquid assets ratio.

Illustration 3

Liquid Assets Rs. 65,000; Stock Rs. 20,000; Pre paid expenses Rs. 5,000; Workingcapital Rs. 60, 000

Calculate current assets ratio and liquid assets ratio

For the computation of current assets ratio, current assets volume must be known. It isnot available in our problem, instead the liquid assets and prepaid expenses are giventogether which will facilitate to find the total volume of current assets.

Current Assets= Liquid Asset + Prepaid expenses + closing stock

= Rs. 65,000 + Rs. 5,000+20,000

= Rs. 90,000

The next step is to find out the current liabilities. The volume of current liabilities couldbe found out through the available information of working capital.

Net working capital= Current Assets- Current Liabilities

Particulars Rs. Particulars Rs. Share capital 42,000 Fixed Assets Net 34,000

Reserve 3,000 Stock 12,400

Annual Profit 5,000 Debtors 6,400

Bank overdraft 4,000 Cash 13,200


Total 66,000 Total 66,000

102


Rs. 60,000 = Rs. 70,000 - Current liabilities

Current liabilities = Rs. 90,000 - Rs. 60,000= Rs. 30,000

From the above, the current ratio could be found out

23 30,000 .Rs

90,000 Rs.Ratio Current >==

The firm satisfies the more than the norm of the current ratio. It means that the firmkeeps excessive current assets more than that of requirement.

2.17 000 30, .Rs

65,000 Rs.Ratio Assets Quick ==

The firm keeps more liquid assets than that of the specified norm means that excessive liquidassets are held by the firm than the requirement in the form of idle not productive in utility.

Illustration 4

The current ratio of Bicon Ltd. is 4.5 :1 and liquidity ratio is 3:1 stock is Rs. 6,00,000 Findout the current liabilities.

To find out the volume of current liabilities, initially the share of closing stock should befound out in the total of current assets.

Share of stock =Current Assets Ratio – Liquid Assets Ratio

=4.5-3. 0=1.5

Share of the stock=1.5

If the share of the stock is 1.5 which amounted Rs. 6,00,000

What is the volume of current liabilities for the ration of 1?

Rs. 6,00,000Current Liabilities = = 4,00,000

1.5

6.8 CAPITAL STRUCTURE RATIOS

The capital structure ratios are classified into two categories

l Leverage Ratios – Long term solvency position of the firm – Principal repayment

l Coverage Ratios – Fixed commitment charge solvency of the firm – Dividendcoverage and Interest coverage

Capital Structure

Coverage Ratios Leverage Ratios

Debt – Equity Ratio Total Debt – Equity Ratio Proprietary Ratio Fixed assets Ratio

Interest Coverage Ratio Dividend Coverage

103

Ratio AnalysisUnder the capital structure ratios, the composition of the capital structure is analysedonly in the angle of long term solvency of the firm.

6.9 DEBT-EQUITY RATIO

It is the ratio expresses the relationship between the ownership funds and the outsiders’funds. It is more specifically highlighted that an expression of relationship in between thedebt and Shareholders’ funds. The debt–equity ratio can be obviously understood intotwo different forms

l Long term debt–equity ratio

l Total debt–equity ratio

6.9.1 Long-term Debt-equity Ratio

It is a ratio expresses the relationship in between the outsiders’ contribution through debtfinancial resource and Share holders’ contribution through equity share capital, preferenceshare capital and past accumulated profits. It reveals the cover or cushion enjoyed bythe firm due to the owners’ contribution over the outsiders’ contribution.

Debt (Long term debt = Debentures/Term Loans)Debt - Equity Ratio =

Net worth/Equity (Shareholders' fund)

Higher ratio indicates the riskier financial status of the firm which means that the firmhas been financed by the greater outsiders’ fund rather than that of the owners’ fundcontribution and vice versa.

6.9.2 Standard Norm of the Debt-equity Ratio

The ideal norm is that 1:2 which means that every one rupee of debt finance is covered bythe 2 rupees of shareholders’ fund

The firm should have a minimum of 50% margin of safety in meeting the long termfinancial commitments. If the ratio exceeds the specification, the interest of the firm willbe ruined by the outsiders’ during the moment at when they are unable to make thepayment of interest in time as per the terms of agreement reached earlier. During themoment of liquidation, the greater ratio may facilitate the creditors to recover the amountdue lesser holding held by the owners.

6.9.3 Total Debt-equity Ratio

The ultimate purpose of the ratio is to express the relationship total volume of debtirrespective of nature and shareholders’ funds. If the owners’ contribution is lesser involume in general irrespective of its nature leads to worse situation in recovering theamount of outsiders’ contribution during the moment of liquidation.

Short term debt + Long term debtTotal Debt – Equity Ratio =

Equity (Shareholders' fund)

6.10 PROPRIETARY RATIO

The ratio illustrates the relationship in between the owners’ contribution and the totalvolume of assets. In simple words, how much funds are contributed by the owners infinancing the assets of the firm. Greater the ratio means that greater contribution madeby the owners’ in financing the assets.

104

Accounting and Financefor Managers Owners' Funds or Equity or Shareholders' funds

Proprietary RatioTotal assets

=

Standard Norm of the ratio

Higher ratio is better position for the firm as well as safety to the creditors.

6.11 FIXED ASSETS RATIO

The ratio establishes the relationship in between the fixed assets and long term source offunds. Whatever the source of long term funds raised should be used for the acquisitionof long term assets; it means that the total volume of fixed assets should be equivalent tothe volume of long term funds i.e. , the ratio should be equal to 1

Assets Fixed Net

funds Outsiders' funds holders' shareRatio Assets Fixed

+=

If the ratio is lesser than one means that the firm made use of the short term fund for theacquisition of long term assets. If the ratio is greater than one means that the acquiredfixed assets are lesser in quantum than that of the long term funds raised for the purpose.In other words, the firm makes use of the excessive funds for the built of current assets.

6.12 STANDARD NORM OF THE RATIOThe ideal norm of the ratio is 1:1 which means that the long term funds raised only utilisedfor the acquisition of long term assets of the enterprise

It facilitates to understand obviously about the over capitalization or under capitalizationof the assets of the enterprise.

6.13 COVERAGE RATIOS

These ratios are computed to know the solvency of the firm in making the periodicalpayment of interest and preference dividends. The interest and preference dividends areto be paid irrespective of the earnings available in the hands of the firm. In other words,these are known as fixed commitment charge of the firm.

6.13.1 Interest Coverage Ratio

The firms are expected to make the payment of interest on the amount of borrowingswithout fail This ratio facilitates the prospective lender to study the strength of theenterprise in making the payment of interest regularly out of the total income. To studythe capacity in making the payment of interest is known as interest coverage ratio ordebt service coverage ratio.

The ability or capacity is analysed only on the basis of Earnings before interest and taxes(EBIT) available in the hands of the firms.

Greater the ratio means that better the capacity of the firm in making the payment ofinterest as well as greater the safety and vice versa

Interest coverage ratioInterest

taxesandinterest before Earning=

Lesser the times the ratio means that meager the cushion of the firm which may lead toaffect the solvency position of the firm in making payment of interest regularly.

105

Ratio Analysis6.13.2 Dividend Coverage Ratio

It illustrates the firms’ ability in making the payment of preference dividend out of theearnings available in the hands of the firm after the payment of taxation. If the size of theProfits after taxation is greater means that greater the cushion for the payment ofpreference dividend and vice versa.

The preference dividends are to be paid without fail irrespective of the profits availablein the hands of the firm after the taxation.

Dividend coverage ratio Earnings after taxatation

=Preference Dividend


Higher the ratio means that the firm has greater cushion in meeting the needs of preferencedividend payment against Earnings after taxation(EAT) and vice versa

Profitability Ratios

The ratios are measuring the profitability of the firms in various angles viz

l On sales

l On investments

l On capital employed and so on

While discussing the measure of profitability of the firm, the profits are normally classifiedinto various categories

l Gross Profit

l Net Profit

l Earnings before interest and taxes

l Earnings after taxation and so on

All profitability ratios are normally expressed only in terms of (%). The return is normallyexpressed only in terms of percentage which warrant the expression of this ratio to bealso in percentage.

GP Ratio: The ratio elucidates the relationship in between the Gross profit and salesvolume.

It facilitates to study the profit earning capacity of the firm out of the manufacturing orTrading operations.

Gross Profit Ratio Gross Profit ×100=

Sales

Standard Norm of the ratio:

Higher the ratio is better the position of the firm which means that the firm earns greaterprofits out of the sales and vice versa.

NP Ratio: The ratio expresses the relationship in between the Net profit and salesvolume. It facilitates to portray the overall operating efficiency of the firm. The netprofit ratio is an indicator of over all earning capacity of the firm in terms of return outof sales volume.

Net Profit RatioNet Profit ×100

=Sales

106


Standard Norm of the Ratio:

Higher the ratio is better the operating efficiency of the firm which means that the firmsearns greater volume of both operating as well as non operating profit out of sales and Viceversa.

Operating profit ratio: The operating ratio is establishing the relationship in betweenthe cost of goods sold and operating expenses with the total sales volume.

Operating ratio Cost of goods sold + Operating expenses×100=

Net sales


Lower the ratio is better as well as favourable position for the firm, which highlights % ofabsorption cost of goods sold and operating expenses out of sales and vice versa. Thelower ratio leads to have the higher margin of operating profit.

Return on Assets: This ratio portrays the relationship in between the earnings and totalassets employed in the business enterprise. It highlights the effective utilization of theassets of the firm through the determination of return on total assets employed.

Return on AssetsNet Profit After Taxes×100

=Average Total Assets

Standard norm of the ration

Higher the ratio illustrates that the firm has greater effectiveness in the utilization of assets,means greater profits reaped by the total assets and vice versa.

6.14 RETURN ON CAPITAL EMPLOYED

The ratio illustrates that how much return is earned in the form of Net profit after taxesout of the total capital employed. The capital employed is nothing but the combination ofboth non current liabilities and owners’ equity. The ratio expresses the relationship inbetween the total earnings after taxation and the total volume of capital employed.

Return on total capital employed Net profit after taxes × 100

=Total capital employed


Higher the ratio is better the utilization of the long term funds raised under the capitalstructure means that greater profits are earned out of the total capital employed.

Activity turnover ratio: It highlights the relationship in between the sales and variousassets. The ratio indicates that the rate of speed which is taken by the firm for convertingthe assets into sales.

6.15 STOCK TURNOVER RATIO

The ratio expresses the speed of converting the stock into sales. In other words, howfast the stock is being converted into sales in a year? The greater the ratio of conversionleads to lesser the number of days /weeks /months required to convert the stock intosales.

Stock turnover ratioCost of Goods Sold Sales

= Or Average stock Closing stock

107

Ratio AnalysisStandard norm of the ratio:

Higher the ratio is better the firm in converting the stock into sales and vice versa

The next step is to find out the number of days or weeks or months taken or consumedby the firm to convert the stock into sales volume.

Stock velocity 365 days/52 weeks/12 months

=Creditors Turnover Ratio


Lower the duration is better the position of the firm in converting the stock into sales andvice versa.

6.16 DEBTORS TURNOVER RATIO

This ratio exhibits the speed of the collection process of the firm in collecting the overduesamount from the debtors and against Bills receivables. The speediness is being computedthrough debtors velocity from the ratio of Debtors turnover ratio.

Debtors turnover ration Net Credit Sales Net Credit Sales

= OrAverage Debtors Debtor + Bills Receivable


Higher the ratio is better the position of the firm in collecting the overdue means theeffectiveness of the collection department and vice versa.

6.16.1 Debtors Velocity

This is an extension of the earlier ratio to denote the effectiveness of the collectiondepartment in terms of duration.

Debtors velocity 365days/52weeks/12months

=Debtor turnover ratio


Lesser the duration shows greater the effectiveness in collecting the dues which meansthat the collection department takes only minimum period for collection and vice versa.

6.16.2 Creditors Turnover Ratio

It shows effectiveness of the firm in making use of credit period allowed by the creditorsduring the moment of credit purchase.

Creditors Turnover ratio Credit Purchase Credit Purchase

= OrAverage creditors Bills payable + Sundry


Lesser the ratio is better the position of the firm in liquidity management means enjoyingthe more credit period from the creditors and vice versa.

Creditors velocity 365 days/52 weeks/12 months

=Creditors Turnover Ratio

108



Greater the duration is better the liquidity management of the firm in availing the creditperiod of the creditors and vice versa.

Check Your Progress

(1) Solvency position of the firm studied and interpreted through

(a) Short-term solvency ratios

(b) Long-term solvency ratios

(c) Coverage ratios

(d) (a) (b) & (c)

(2) Efficiency and effectiveness of the firm is studied through

(a) Liquidity ratios

(b) Leverage ratios

(c) Turnover ratios

(d) Profitability ratios

(3) Profitability ratios to study the potential to earn profits on

(a) On Assets

(b) On Capital employed

(c) On Sales

(d) (a) (b) & (c)

Illustration 5

Sundaram &co sells goods on cash as well as credit basis. The following particulars areextracted from the books of accounts for the calendar 2005

Calculate average collection period

To find out the average collection period, first Debtors turnover ratio has to computed

Debtors turnover ratioNet Credit sales

=Bills receivable + Debtors

Net credit sales= Gross sales – cash sales – sales return

= Rs. 2, 00, 000 – Rs. 40, 000 – Rs. 14, 000=Rs. 1, 46, 000

Debtor turnover ratio Rs. 1,46,000

=Rs. 4,000 + Rs. 18,000

= 6.64 times

Debtors velocity 365 days 365 days

= =Debtors turnover ratio 6.64 times

= 55 days

Particulars Rs Total Gross sales 2,00,000 Cash sales ( included in above) 40,000 Sales returns 14,000 Total Debtors 18,000 Bills receivable 4,000 Provision for doubtful debts 2,000 Total creditors 20,000

109

Ratio AnalysisIllustration 6

Find out the value of creditors from the following

Sales Rs. 1,00,000 Opening stock Rs10,000

Gross profit on Sales 10% Closing stock Rs. 20,000

Creditors velocity 73 days Bills payable Rs. 16,000

Note: All purchases are credit purchases

To find out the volume of purchases, the formula of cost of goods sold should taken intoconsideration

Cost of goods sold = Opening stock +Purchases- Closing stock

X = Rs. 10,000 + Y – Rs. 20,000

Cost of goods sold = Sales – Gross profit

= Rs. 1,00,000 – 10% on Rs 1,00,000

= Rs. 90,000

The next step is to apply the found value in the early equation

Purchases = Rs. 90,000 – Rs. 10,000 +Rs. 20,000

= Rs. 1,00,000

To find out the value creditors, the creditor velocity and creditors turnover ratio

Creditors velocity 365 days

=Creditors turnover ratio

Creditors turnover ratioCredit purchases

=Bills payable + Sundry creditors

Rs.1,00,000=

Rs.16,000 + Sundry creditors

The next step is to find out the sundry creditors, the reversal process to be adopted

73 days 365 days

=Creditors turnover ratio

Creditors turnover ratio365 days

= = 5 times73 days

The next step is to substitute the found value in the equation of creditors turnover ratio

Rs. 16,000 + Sundry creditorsRs. 1,00,000

=5

Sundry creditors= Rs. 20,000 – Rs. 16, 000= Rs. 4,000

Illustration 7

From the following information, prepare a balance sheet show the workings

1. working capital Rs. 75,000

2. Reserves and surplus 1,00,000

3. Bank overdraft 60,000

110


4. Current ratio 1.75

5. Liquid Ratio 1,15

6. Fixed assets to proprietors’ fund .75

7. Long term liabilities Nil

(B.Com. Madras, April 1980)

First step is to find out the current liabilities

Current ratioCurrent assets 1.75

= =Current liabilities 1

Working capital = Rs. 75,000 =1.75–1= 0.75

If 0.75 is the share of working capital, what would be the share of current assets ?

Current assets Rs. 75,000× 1.75

= = Rs.1,75,000.75

Working capital = Current assets – current liabilities

Current liabilities = Current assets – working capital

CL= Rs. 1, 75, 000 – Rs. 75, 000=Rs. 1, 00, 000

Quick assets ratio = 1. 15 1.15 = Quick assets

=Quick liabilities

Quick assets=

Current liabilities – BOD

1.15(Rs. 1,00,000–Rs. 60,000) = Quick assets

1.15(Rs. 40,000)= Quick assets

Rs 46, 000= Quick assets

The next step is to find out the amount of the closing stock. This can be found outthrough finding out the difference in between the current assets and quick assets.

Closing stock = Current assets – Quick assets

= Rs. 1,75,000 – Rs. 46,000= Rs. 1,29,000

The next one is to find out the proprietors’ fund

The fixed assets to proprietors’ fund is 0.75

This has to be found out on the basis of Double Entry Accounting Concept

Total liabilities = Total Assets....................(1)

Long term funds + Short term financial resources = Total liabilities

In the long term funds, there is no long term liabilities, which means the structure of longterm funds consist of the share holders’ funds The share holder funds are known asproprietors’ fund

Short term financial resources are known as current liabilities

Proprietors’ fund + Current liabilities = Total liabilities

Current assets + Fixed assets = Total assets

To substitute the values in the equation (1)

111

Ratio AnalysisProprietors’ fund + Current liabilities= Current assets + Fixed assets

Proprietors’ fund – Fixed assets= Current assets – Current liabilities

1– 0.75=Rs. 1,75,000 – Rs. 1,00,000

0.25=Rs. 75,000

If 0. 25 is bearing the volume of Rs 75, 000; what would be the volume of investment offixed assets for 0. 75 and proprietor’s fund for 1

3,00,000 Rs. 25.0

000 75, Rs.fund s'proprietor =

0.75 portion of the owners’ funds are contributed to fixed assets i.e. 0.75 on Rs. 3,00,000

= Rs. 2,25,000

To find out the exact share of the equity share capital, the following formula has to beused.

Share holder’s funds = Equity share capital + Reserves and surpluses

In this problem, reserves and surpluses is given

Rs. 3,00,000=Equity share capital +Rs 1,00,000

Equity share capital= Rs. 2,00,000

The balance sheet of the company as on dated

Check Your Progress

(1) Standard norm of the current ratio is

(a) 2:1

(b) 1:. 5

(c) 1:2

(d) 3:1

(2) Super quick assets do not include

(a) Closing stock

(b) Prepaid expenses

(c) Sundry debtors

(d) Both (a) & (b)

(3) Standard norm of the Debt to Capital

(a) 1:2

(b) 1:1

(c) 2:1

(d) 1:5

Liabilities Rs Assets Rs Share capital 2,00,000 Fixed assets 2,25,000 Reserves and surpluses 1,00,000 Stock 1,29,000 Bank overdraft 60,000 Quick assets 46,000 Quick liabilities 40,000 4,00,000 4,00,000

112


Illustration 8

Debtors velocity 3 months

Creditors velocity 2 months

Stock velocity 8 times

Capital turnover ratio 2. 5 times

Fixed assets turnover ratio 8 times

Gross profit turnover ratio 25%

Gross profit in a year amounts to Rs. 1, 60, 000. There is no long term loan or overdraft.Reserves and surplus amount to Rs. 56, 000. Liquid assets are Rs. 1, 94, 666. Closingstock of the year is Rs. 4, 000 more than the opening stock Bill receivable amount to Rs.10, 000 and bills payable to Rs. 4, 000

Find out

Sales Closing stock

Sundry debtors Fixed assets

Sundry creditors Proprietors’ fund

Draft the balance sheet with as many as details possible.

The first step is to find out the sales

Gross profit ratio = 25%

The total volume of gross profit is given = Rs. 1,60,000

6,40,000 .Rs%25

000,60,1.RsSaels

100Sales

1,60,000 Rs. 25%

100Sales

Profit Grosratio GP

==

×=

×=

The next step is to find out the closing stock value

In our problem, two important information given are stock velocity and details about theclosing stock in terms of opening stock

Stock velocity = 8 times

Closing stock is Rs. 4, 000 excess of opening stock

The information stock velocity given denotes that the stock turnover ratio.

Stock Average

sold goods ofcost ratio trunover Stock =

Now the volume of cost of goods sold has to be found out from the early availableinformation i.e., sales and gross profit

Cost of goods sold= Sales – Gross profit

= Rs. 6,40,000 – Rs. 1,60,000= Rs. 4,80,000

The next step is to find out the volume of average stock through the earlier formula

stock Average

4,80,000 Rs. times8 =

113

Ratio AnalysisAverage stock = Rs. 60,000

The next step is to apply the conditionality with regards to closing stock

60,000 Rs. 2

000 4, Rs. stock Opening stock Opening

60,000 Rs. 2

Stock Closing Stock Opening

=++

=+

2 Opening stock +Rs. 4, 000= Rs. 1, 20, 000

2 Opening stock = Rs. 1, 20, 000 – Rs. 4, 000

Opening stock = Rs. 58, 000

Closing stock = Opening stock + Rs. 10, 000= Rs. 58, 000+ Rs. 10, 000=Rs. 68, 000

The next fact is to be found that sundry debtors

To find out the debtors, the most information given debtors velocity and bills receivablehave to be made use of

4

6,40,000 Rs. debtorsSundry 10,000 .Rs

debrorsSundry receivable Bills

salesCredit times4

times4months 3

months 12ratio turnover Debtors

ratio turnover Debtors

months 12Velocity Debtors

=+

+=

==

=

Sundry debtors = Rs. 1, 60, 000–Rs. 10, 000= Rs. 1, 50, 000

The next important stage is to find out the sundry creditors

To find out the sundry creditors, the creditors velocity has to be applied in the formula

In addition to the earlier, one missing information has to be found out i-e Credit purchases

The volume of purchase to be found out through the formula of cost of goods sold

Cost of goods sold= Opening stock +Purchases – Closing stock

Rs. 4,80,000 = Rs. 58,000+Purchases – Rs. 68,000

Purchases = Rs. 4,80,000–Rs. 58,000+Rs. 68,000

= Rs. 4,80,000+Rs. 10,000= Rs. 4,90,000

ratio turnover Creditors

months 12 velocity Creditors =

times6 months 2

months 12ratio turnover Creditors =

creditors Sundry4,000 .Rs

4,90,000 Rs. times6 +=

Rs. 4,000+ Sundry creditors= Rs. 81,667

Sundry creditors = Rs 77,667

114


The next step is to find out the volume of fixed assets

This could be found out with the help of fixed assets turnover ratio =5 times

Fixed assets turnover ratio = 5 timesAssets Fixed

Sales=

000 28, 1, Rs. times5

6,40,000 .Rs ==

Proprietors’ fund

Proprietor’s fund = Fixed assets+ Current Assets – Current liabilities

The above equation is coined on the basis of Double accounting concept

Fixed assets + Current assets = Total assets = Total Liabilities

Total Assets – Current liabilities = Total Liabilities – Current liabilities

Current assets volume is not known, In such cases the stock volume should be addedwith the Liquid assets to derive the early mentioned.

Current assets= Closing stock + Liquid Assets

= Rs. 68,000+ Rs. 1,94,666 = Rs2,62,666

Proprietor’s fund = Rs. 1,28,000+ Rs. 2,62,666 – Rs. 81,667

= Rs. 3,08,999

Share capital = Proprietor’s fund – Reserves and surpluses

= Rs. 3,08,999 – Rs. 56,000= Rs. 2,52,999

Cash and Bank Balances to be found out in the next stage

Liquid Asset = Rs. 1,94,666

Less : Debtors Rs. 1,50,000

Bills receivable 10,000 Rs. 1,60,000

Rs. 34,666

From the above found information the detailed balance sheet with as many as informationpossible to portray

Balance sheet as on dated ——————————————-

Illustration 9

From the following particulars, prepare trading, profit and loss account and a balancesheet

Current ratio -3

Liquid ratio -1.8

Bank overdraft –Rs. 20,000

Liabilities Rs Assets Rs Share capital 2,52,999 Fixed assets 1,28,000 Reserves and surpluses 56.000 Stock 68,000 Bills receivable 4,000 Debtors 1,50,000 Sundry creditors 77,667 Bills receivable 10,000 Cash and Bank Balance 34,666 3,90,666 3,90,666

115

Ratio AnalysisWorking capital – Rs. 2,40,000

Debtors velocity -1 month ; Gross profit ratio -20%

Proprietary ratio (Fixed assets / share holders’ fund) - .9

Reserves and surpluses -. 25 of share capital

Opening stock – Rs. 1,20,000; 8% Debentures –Rs. 3,60,000

Long term investments –Rs. 2,00,000

Stock turnover ratio -10 times

Creditors velocity -1/2 month

Net profit to share capital -20%

(B. Com Bharathidasan, April 1989)

First step is to find out the current assets and current liabilities through current ratio

3sLiabilitie Current

AssetsCurrent ratio Current ==

Current Assets- Current Liabilities = Working capital

3 – 1 = 2 = Rs. 2, 40, 000

The volume of working capital Rs 2,40,000 is equated to share 2

What is the volume of current liabilities for the share of 1

Current liabilities = Rs. 2, 40, 000 = Rs. 1,20,000

2

The volume of current assets = Rs. 1,20,000× 3= Rs. 3,60,000

The next step is to find out the volume of liquid assets

sLiabilitie Liquid

assetss Liquid1.8ratio assets Liquid ==

When the Bank overdraft is given, the liquid liabilities should be computed.

Liquid liabilities = Current liabilities – Bank overdraft

= Rs. 1,20,000 – Rs. 20,000 = Rs. 1,00,000

Liquid assets is 1.8 times greater than the Liquid liabilities

Liquid assets = 1.8 × Rs. 1,00,000 = Rs. 1,80,000

To find out the volume of the stok

Stock = Current assets – Liquid assets

=Rs. 3,60,000 – Rs. 1,80,000

= Rs. 1,80,000

The next step is to find out the cost of goods sold

To find out the cost of goods sold, the stock turnover ratio has to be found out

1,50,000 .Rs2

000,80,1.Rs000,20,1.Rs

2

stock Closing stock Openingstock Average

stock Average

sold goods ofcost times10

=+=+=

=

116


Cost of goods sold = Rs. 1,50,000 × 10= Rs. 15,00,000

Next step is to find out the volume of sales in order to find out the volume of debtors

The volume of sales could be found out through Gross profit ratio

Sales – Profit = Cost of goods sold

100 – 20=80

The Rs15, 00, 000 worth of cost of goods sold is equated to share of 80

What would be the volume of sales?

000,75,18.Rs80

15,00,000 .RsSales ==

Gross profit = Rs. 18, 75, 000 – Rs. 15, 00, 000= Rs. 3,75,000

The next step is to find out the volume of debtors

The debtors could be found out with the help of debtors turnover ratio and collectionperiod

250,56,1.Rs12

18,75,000 Rs.Debtors Average

debtors Average

SalesCredit times12

times12 month 1

months 12ratio turnover Debtors

ratio turnover Debtors

months 12period collectionor velocity Debtors

==

=

==

=

The next step is to find out the creditors. The volume of creditors ; to find out the volumeof the creditors, the creditors turnover ratio and creditors average payment period shouldhave to be applied

Creditors average payment periodratio turnover Creditors

months 12=

Creditors turnover ratio 12 months

= = 24times0.5

Creditors turnover ratio creditors Average

purchase credit=

Average creditors times 24

purchase credit=

Now the volume of credit purchase to be found out with the help of cost of goods soldformula

Cost of goods sold= Opening stock+ Purchases- Closing stock

Rs. 15,00,000–Rs. 1,20,000+Rs. 1,80,000= Purchases

Rs. 15,60,000 = Purchases

Average creditors = Rs. 65,000

117

Ratio AnalysisThe next step is to find out the proprietary fund ; this could be found out by using the ratioproprietary fund to fixed assets ratio

Total Assets= Total Liabilities

Long term liabilities + Short term liabilities = Fixed assets + Current assets + Investments

Share holders’ fund – Fixed assets = Current assets + Investment – Current liabilities–Debenture

1– 0.9= Rs. 2,00,000+Rs. 3,60,000–Rs. 1,20,000–Rs. 3,60,000

1– 0.9= Rs. 80,000

0.1=Rs. 80,000

If 0.1 share is the volume of Rs. 80,000 what is the volume of proprietary fund for theshare of 1?

The volume of proprietary fund = Rs. 8,00,000

The volume of fixed assets = Rs. 80,000× 0.9= Rs. 7,20,000

The next step is to find out the volume of the share capital. This could be found out onlywith the help of the ratio given Reserves and surpluses to share capital

Reserves and surpluses = 25 % of share capital

It means that % is Share capital.

Share capital + Reserves and surpluses = Shareholders’ fund

100+25=125

To find out the share of share capital from the shareholders’ fund, the following is thecomputation

6,40,000 .Rs100125

000,00,8.Rs =× = share capital

Reserves and surpluses = 25% on the Share capital

= 25% on Rs. 6,40,000 =Rs. 1,60,000

The last step is to find out the Net profit, which could be found out through the Net profitto share capital

Net profit is 20% on share capital

Net profit = 20% on Rs. 6,40,000= Rs. 1,28,000

Next stage is to prepare the Trading, Profit & Loss A/c for the year ended and Balancesheet as on dated

Trading Profit & Loss Account for the year ended ——————————————

Dr CrParticulars Rs Particulars Rs To opening stock 1,20,000 By sales 18,75.000 To purchases 15,60,000 By closing stock 1,80,000 To Gross profit c/d 3,75,000 20,55,000 20,55,000 To Debenture Interest 8% Rs.3,60,000

28,800 By Gross profit B/d 3,75,000

To Balancing figure other expenses

2,18,200

To Net profit c/d* 1,28,000 3,75,000 3,75,000

118


Balance sheet as on dated

6.17 DUPONT ANALYSIS

This was an analysis established by the DUPONT INC. , USA to study the Return oninvestment. It was the first company developed the chart which depicted the influencesof Return on Investment. The company underwent for the consideration two importantratios for the return on investment is Net profit ratio and Capital turnover ratio A changein the any one of the two ratios that will immediately reflect on the Return on investment.The various associated factors are considered to study the impact of the profitability ofthe firm. This type of analysis to correct the problems not only to identify the withspecific cause which drastically affects the profitability but also to find the possible waysand means to improve the profitability. Having developed the chart for analysis wascalled as DUPONT Chart.

6.18 LET US SUM UP

The accounting ratios are applied to study the relationship in between the quantitativeinformation available and to take decision on the financial performance of the firm. Thefinancial performance and position of the firm can be analysed and interpreted with inthe firm in between the available financial information of many number of years; whichportrays either increase or decrease in the financial performance. The perfection andeffectiveness of the analysis mainly depends upon the preparation of accurate andeffectiveness of the financial statements. It is subject to the availability of fair presentationof data in the financial statements. Current liabilities are nothing but short term financialresources or payable in short span of time within a year. The super quick assets arenothing but the current assets which can be more easily converted into cash to meet out

Liabilities Rs Rs Assets Rs Rs Share capital 6,40,000 Fixed assets 7,20,000

Reserves and Surpluses

32,000 Investments 2,00,000

Profit during the year

1,28,000 1,60,000

8% Debentures 3,60,000 Current liabilities Current Assets

Overdraft 20,000 Stock 1,80,000 Creditors 65,000 Debtors 1,56,250 Others 35,000 1,20,000 Other current asset 23,750 3,60,000

12,80,000 12,80,000

Roce

Return on capital

employed

Net profit ratio

Net profit

Sales

Sales

Expenses

Cost of goods sold

Administrative, Selling and distribtution

expense

Capital turnover ratio

sales

Capital employed

Working capital

Fixed asset

Current assets

Current liabilities

119

Ratio Analysisthe quick liabilities. Under the capital structure ratios, the composition of the capitalstructure is analysed only in the angle of long term solvency of the firm. All profitabilityratios are normally expressed only in terms of (%). The return is normally expressedonly in terms of percentage which warrant the expression of this ratio to be also inpercentage.


Identity four ratios or other analytical tools used to evaluate profitability. Explain brieflyhow each is computed.

6.20 KEYWORDS

Ratio

Stock term over ratio

Acid Test ratio

Fixed assets ratio

Accounting ratio

GP ratio

Coverage ratio

Stock velocity

Du analysis


1. Define ratio.

2. Define Accounting ratio.

3. What is meant by Accounting ratio analysis ?

4. Elucidate the importance of the ratio analysis.

5. Explain the Liquidity ratios.

6. Highlight the Leverage ratios.

7. Discuss in detail about the Profitability ratios.

8. Illustrate the various kinds of Turnover ratios.

9. List out the limitations of the ratio analysis.


R. L. Gupta and Radhaswamy, “Advanced Accountancy”



S. N. Maheswari, “Management Accounting”





120

Accounting and Financefor Managers LESSON

7FUND FLOW STATEMENT ANALYSIS


7.1 Introduction

7.2 Meaning & Objectives of Fund Flow Statement Analysis

7.3 Methods of Preparing Fund Flow Statement

7.3.1 Schedule of Changes in Working Capital

7.3.2 Net Profit Method

7.3.3 Sales Method

7.3.4 First Method

7.3.5 Second Method

7.4 Advantages of Preparing Fund Flow Statement

7.4.1 Illustrative Statement of Financing

7.4.2 To fulfil the Primary Objective of the Financial Management

7.4.3 Facilitation through Financial Planning

7.4.4 Guide to Working Capital Management

7.4.5 Indicator of Yester Track Path of the Firm

7.5 Let us Sum up


7.7 Keywords




In this lesson we shall discuss about fund flow statement analysis. After going throughthis lesson you will be able to:(i) understand meaning and objectives of fund flow statement analysis(ii) analyse methods of preparing fund flow statement

(iii) discuss advantages of preparing fund flow statement.

7.1 INTRODUCTION

Every business establishment usually prepares the balance sheet at the end of the fiscalyear which highlights the financial position of the yester years It is subject to change inthe volume of the business not only illustrates the financial structure but also expressesthe value of the applications in the liabilities side and assets side respectively. Normally,Balance sheet reveals the status of the firm only at the end of the year, not at thebeginning of the year. It never discloses the changes in between the value position of thefirm at two different time periods/dates.

The method of portraying the changes on the volume of financial position is the statementfund flow statement. To put them in nutshell, fund between two different time periods. It isfurther illustrated that the changes in the financial position or the movement or flow of fund.

121

Fund Flow Statement Analysis7.2 MEANING & OBJECTIVES OF FUND FLOWSTATEMENT ANALYSIS

A report on the movement of funds or working capital. In a narrow sense the term fundmeans cash and the fund flow statement depicts the cash receipts and cash disbursements/payments. It highlights the changes in the cash receipts and payments as a cash flowstatement in addition to the cash balances i.e., opening cash balance and closing cashbalance. Contrary to the earlier, the fund means working capital i.e., the differencesbetween the current assets and current liabilities.The term flow denotes the change. Flow of funds means the change in funds or inworking capital. The change on the working capital leads to the net changes taken placeon the working capital i.e., especially due to either increase or decrease in the workingcapital. The change in the volume of the working capital due to numerous transactions.Some of the transactions may lead to increase or decrease the volume of workingcapital. Some other transactions neither registers an increase nor decrease in the volumeof working capital.According Foulke “A statement of source and application of funds is a technical device designedto analyse the changes to the financial condition of a business enterprise in between two dates”

Various Facets of Fund flow statement are as follows:l Statement of sources and application of fundsl Statement changes in financial positionl Analysis of working capital changes andl Movement of funds statement

Objectives of fund flow statement analysis:(1) It pinpoints the mobilization of resources and the further utilization of resources(2) It highlights the financing of the general expansion of the business firms(3) It exemplifies the utilization of debt finance in the structure of financing(4) It portrays the relationship between the financing, investment, liquidity and dividend

decision of the firm during the given point of time.

7.3 METHODS OF PREPARING FUND FLOWSTATEMENT

Steps in the preparation of Fund Flow Statement:

l First and fore most method is to prepare the statement of changes in workingcapital i.e., to identify the flow of fund / movement of fund through the detectionof changes in the volume of working capital.

l Second step is the preparation of Non- Current A/c items-Changes in the volumeof Non current a/cs have to be prepared only in order to quantify the flow fund i-eeither sources or application of fund.

l Third step is the preparation Adjusted Profit& Loss A/c, which already elaboratelydiscussed in the early part of the chapter.

l Last step is the preparation of fund flow statement.

7.3.1 Schedule of Changes in Working CapitalThe ultimate purpose of preparing the schedule of changes in the working capital is toillustrates the changes in the volume of net working capital which envisages eithersources or application of fund. The schedule of changes are focused as follows:

Increase in Current Assets

Decrease in Current Assets

Increase in Current Liabilities

Decrease in Current Liabilities

Increase in Working Capital

Decrease in Working Capital

Decrease in Working Capital

Increase in Working Capital

122


The next important step is to prepare that Adjusted profit and loss account

The first method is widely used method by all in determining the volume of Fund fromOperations (FFS)

Under the Net Profit Method, Fund flow from operations can be computed

7.3.2 Net Profit Method

Under this method, Fund from operations can be determined in two different ways .Thefirst method is through the statement format

Net Profit from the Profit & Loss A/c xxxxx

Add:

(A) Non Funding Expenses:

Loss on Sale of Fixed Assets xxxx

Loss on Sale of Long Term Investments xxxx

Loss on Redemption Debentures/Preference Sharesxxxx

Discount on Debentures /Share xxxx

(B) Non Operating Expenses:

Depreciation of fixed Assets xxxx

(C) Intangible Assets:

Amortization of Goodwill xxxx

Amortization of Patent xxxx

Amortization of Trade Mark xxxx

(D) Fictitious Assets:

Writing off Preliminary expense xxxx

Writing off Discount on Shares/Debentures xxxx

Method of Fund From Operations

Net Profit Method Add Non Operating Expenses Less Non Operating Incomes

Sales Method

Less-Payments(Application)

Particulars Previous Year

Current Year

Increase inWorking Capital (+)

Decrease in inWorking Capital (–)

(A) Current Assets: Cash In Hand Cash at Bank Marketable Securities Bills Receivable Sundry Debtors Closing Stock Prepaid Expenses

(B) Current Liabilities: Creditors Bills Payable Outstanding expenses Pre received Income Provision for doubtful and bad debts

Net Working Capital(A-B) Increase/Decrease Working Capital

123

Fund Flow Statement Analysis(E) Profit AppropriationTransfer to General Reserve xxxxLess:

(F) Non funding Profits:Profit on Sale of Fixed Assets xxxxProfit on Sale of Long Term Investments xxxxProfit on Redemption Debentures/Preference Sharesxxxx

(G) Non Operating Incomes:Dividend Received xxxxInterest Received xxxx

Rent Received xxxx

Fund From operations / Fund Lost in Operations xxxxx

The second method of determining the fund from operations under the first classificationis the Accounting Statement Format.

Adjusted Profit & Loss A/cDr Cr

7.3.3 Sales Method

Under this method, the following is the statement format is used to arrive fund flowfrom operations:

Sources:Sales xxxxxStock at the end xxxxxLess:

Application:Stock at Opening xxxxNet Purchases (Purchase-Returns) xxxxWages xxxxSalaries xxxxTelephone expenses xxxxElectricity charges xxxxOffice stationery expenses xxxxOther operating cash expenses xxxxFund from operationsFrom the following details calculate funds from operations:

Rs.Salaries 10,000Rent 6,000

To Depreciation xxxx To Goodwill Written off xxxx To Patent Written off xxxx To Loss on Sale of Fixed Asset xxxx To Loss on Sale of Investment xxxx To Loss on redemption of Liability xxxx To Preliminary Expenses off xxxx To Proposed Dividend xxxx To Transfer to General Reserve xxxx To Current Year Provision for Taxation xxxx To Current Year Provision for Depreciation xxxx To Balancing Figure xxxx (Fund Lost in Operations)

By Opening Balance Profit xxxx By Profit on sale of Fixed Assets xxxx By Profit on Sale of Investments xxxx By Profit on redemption of Liability xxxx By Transfer from General Reserve xxxx By Balancing Figure xxxx Fund From Operations(FFS)

124


Refund of Tax 6,000Profit on Sale of Building 10,000Depreciation on Plant 10,000Provision for Taxation 8,000Loss on Sale of plant 4,000Closing Balance of Profit & Loss A/c 1,20,000Opening balance on Profit & Loss A/c 50,000Discount on Issue of Debentures 4,000Provision for bad debts 2,000Transfer to general reserve 2,000Preliminary expenses written off 6,000Good will written off 4,000Dividend Received 10,000Proposed Dividend 12,000Calculation of fund from operation7.3.4 First MethodClosing balance of Profit & Loss A/c 1,20,000Less Opening Balance 50,000Balance Forward 70,000Add: Non Fund / Non Operating Charges:Depreciation on Plant 10,000Provision for Taxation 8,000Loss on Sale of Plant 4,000Discount on issue of debentures 4,000Provision for bad debts 2,000Transfer to general reserve 2,000Preliminary expenses off 6,000Good will written off 4,000Proposed Dividend 12,000

1,22,000LessRefund of Tax 6,000Profit on Sale of Building 10,000Dividend Received 10,000

Fund from operations 96,000

7.3.5 Second Method

Adjusted Profit & Loss A/c

Depreciation on Plant 10,000 Provision for Taxation 8,000 Loss on Sale of Plant 4,000 Discount on issue of debentures 4,000 Provision for bad debts 2,000 Transfer to general reserve 2,000 Preliminary expenses off 6,000 Good will written off 4,000 Proposed Dividend 12,000 To Closing Profit B/d 1,20,000 1,72,000

By Opening Balance B/d 50,000 By Profit on Sale of Building 10,000 By Dividend Received 10,000 By Refund of Tax 6,000 By Balancing Figure 96,000 Fund From operations 1,72,000

125

Fund Flow Statement AnalysisThe next step is to prepare the fund flow statement. The proforma of the fund flowstatement

Check Your Progress

(1) Fund flow means a study of

(a) working capital change

(b) Cash position change

(c) Long investment change

(d) Change in the current liabilities

(2) Normally Working capital means

(a) Current assetscurrent liabilities

(b) Current assets

(c) Gross working capital

(d) Net working capital

(3) Increase in working capital

(a) Increase in current assets

(b) Increase Net working capital

(c) Increase in current liabilities

(d) Increase in long term source of financing

7.4 ADVANTAGES OF PREPARING FUND FLOWSTATEMENT

Structured analysis on the Working capital of a firm:

It is the only statement to study the changes in the working capital in between twodifferent periods from the balance sheet of a firm through structured analysis on thebasis of working capital position.

7.4.1 Illustrative Statement of FinancingIt is a statement which highlights the role of various kinds of financing not only in thedimension of project development and expansion but also growth rate of the organization.

Sources of funds Uses of funds • Funds from Business Operation • Non trading Incomes • Sale of Non-Current Assets • Sale of Long Term Investments • Issue of shares • Acceptance of deposits • Long Term Borrowings • Decrease in Working Capital

• Funds Lost in Operations • Redemption of Preference Share Capital • Repayment of Loans • Purchase of Long Term Investments • Purchase of Fixed Assets • Payment of Taxes • Payment of Dividends • Drawings • Loss of Cash • Increase in Working Capital

Financial Structure

Capital Structure-Long Term Financial Resources

Medium &Short term Financial Resources

Institutional lending: Banker-Loans & Advances

Money Market: Public Deposit, Commercial paper

External Sources Share Capital and so on

Internal Sources: Retained Earnings

126


7.4.2 To fulfil the Primary Objective of the Financial Management

It not only elucidates the mode of financing but also the application of resources afterraising. It answers to the following queries viz:

l How the outsider's liabilities are redeemed?

l What is the role of the fund from operation generated?

l How the raised funds applied into business?

l How the decrease in working capital was applied?

l What is the mode of raising of financial resources for an increase in the workingcapital?

7.4.3 Facilitation through Financial Planning

The projected fund flow statement from the past performance facilitates the firm toanticipate the future requirement of financial resources. It guides the management toprioritize the application in the future to the tune of scarce resources.

7.4.4 Guide to Working Capital Management

It acts as a guide to the management to maintain the working capital at optimum levelthrough either purchase or sale of marketable securities during the periods of adequateand inadequate working capital respectively.

7.4.5 Indicator of Yester Track Path of the Firm

The insight on the financial performance of the firm can be had by the lending institutionsthrough fund flow statement at the time of extending financial assistance to the firm.

Limitations:

l It is an extension of financial statements but it cannot be leveled with the emphasisof them.

l It is not a resultant of the transaction instead it is an arrangement of among theavailable information.

l Projected fund flow statement ever only to the tune of financial statements whichare historic in feature.

Check Your Progress

(1) Adjusted profit and loss account is prepared for

(a) Determining the fund from operations

(b) Determining the fund lost in operations

(c) (a) or (b)


(2) Fund flow statement is categorized into two parts

(a) Fund in flow & Fund out flow

(b) Cash in flow & Cash out flow

(c) Sources & Applications


(3) Fund from operations is

(a) Sources of the firm

(b) Applications of the firm

(c) Neither sources nor applications


127

Fund Flow Statement AnalysisIllustration 1

Form the following details prepare a statement showing changes in working capital during1985:

Balance sheet of Pioneer ltd. as on 31st December

(B.com., Bharathidasan November, 1986)

The first step is to prepare the schedule of changes in working capital.

Schedule of changes in working capital

Illustration 2

From the following two balance sheet as at December 31, 2004 and 2005. Prepare thestatement of sources and uses of funds.

The first step is to prepare the schedule of changes in working capital.


Liabilities 1984 Rs 1985 Rs.

Assets 1984 Rs.

1985 Rs.

Share capital 5,00,000 6,00,000 Fixed assets 10,00,000 11,20,000 Reserves 1,50,000 1,80,000 Less:Depreciation 3,70,000 4,60,000 Profit and Loss A/c 40,000 65,000 6,30,000 6,60,000 Debentures 3,00,000 2,50,000 Stock 2,40,000 3,70,000 Creditors for goods 1,70,000 1,60,000 Book Debts 2,50,000 2,30,000 Provision for tax 60,000 80,000 Cash in hand 80,000 60,000 Preliminary expeneses 20,000 15,000 12,20,000 13,35,000 12,20,000 13,35,000

1984 1985 Increase In working capital

Decrease In working capital

Current asset: Stock 2,40,000 3,70,000 1,30,000 ------------ Book debts 2,50,000 2,30,000 ------- 20,000 Cash in hand 80,000 60,000 20,000 5,70,000 6,60,000 1,30,000 40,000 Current liability Creditors for goods 1,70,000 1,60,000 10,000 ------- Working capital 4,00,000 5,00,000 1,40,000 40,000 Increase in working capital 1,00,000 ------------ 1,00,000 5,00,000 5,00,000 1,40,000 1,40,000

2004 2005 2004 2005 Liabilities Rs. Rs. Rs. Rs. Share capital 80,000 90,000 Trade creditors 20,000 46,000 Profit & Loss a/c 4,60,000 5,00,000 Assets Cash 60,000 94,000 Debtors 2,40,000 2,30,000 Stock in trade 1,60,000 1,80,000 Land 1,00,000 1,32,000 5,60,000 6,36,000 5,60,000 6,36,000

2004 2005 Increase In working captial


Current asset: Cash 60,000 94,000 34,000 Debtors 2,40,000 2,30,000 10,000 Stock in trade 1,60,000 1,80,000 20,000 4,60,000 5,04,000 Current liability Trade creditors 20,000 46,000 26,000 Working capital 4,40,000 4,58,000 54,000 36,000 Increase in working capital 18,000 ------------- ---------- 18,000 4,58,000 4,58,000 54,000 54,000

128


The next step is to prepare the non current accounts of the firm.

Dr Land A/c Cr

Next non-current account item is the share capital account in the liability side.

The closing balance of the share capital is more than that of the opening balance whichmeans that the firm has undergone the issue of further more share capital.

During the issue of share capital, the cash resources are raised by the firm through thesale of shares.

Dr Share capital A/c Cr

Then the next step is to prepare the adjusted profit and loss account to determine thefund from the operations

Dr Adjusted Profit & Loss A/c Cr

The next step is to prepare the fund flow statement of the firm

Fund flow statement

Illustration 3

From the following relating to Panasonic ltd., prepare funds flow statement.

Balance sheet of Pioneer ltd. as on 31st December

Additional information:

l The company issued bonus shares for Rs.1,00,000 and for cash Rs.1,00,000

l Depreciation written off during the year Rs.30,000

The first step is prepare the statement of changes in working capital


Rs. Rs. To Balance B/d 1,00,000 To Cash(Purchase) balancing fig. 32,000 By Balance c/d 1,32,000 1,32,000 1,32,000

Rs. Rs. To Balance c/d 90,000 By Cash( Issue of shares)

Balancing fig. 10,000

By Balance b/d 80,000 90,000 90,000

Rs. Rs. By Balance B/d 4,60,000 To Balance c/d 5,00,000 By Fund from operation

Balancing fig. 40,000

5,00,000 5,00,000

Sources Rs. Applications Rs. Issue of Shares 10,000 Purchase of Land 32,000 unds from operation 40,000 Increase in working capital 18,000 50,000 50,000

Liabilities 1994 Rs

1995 Rs

Assets 1994 Rs

1995 Rs

Share capital 6,00,000 8,00,000 Fixed assets 3,80,000 4,20,000 Reserves 2,00,000 1,00,000 Accounts

receivable 2,10,000 3,00,000

Retained earnings 60,000 1,20,000 Stock 3,00,000 3,90,000 Accounts payable 90,000 2,70,000 Cash 60,000 1,80,000 9,50,000 12,90,000 9,50,000 12,90,000

Contd...

1994 1995 Increase In working captial

Decrease in working capital

Current asset:

Cash 60,000 1,80,000 1,20,000 ----------

129

Fund Flow Statement Analysis

The next step is to prepare the non - current account

First non-current asset account should have to be prepared

Dr Fixed Assets A/c Cr

The next non-current account is that non-current liability which is nothing but Sharecapital.

Dr Share capital A/c Cr

And another non current account is to be prepared that General reserve account.

Dr General Reserve A/c Cr

The next step is to prepare the Adjusted Profit & Loss A/c

Dr Adjusted Profit & Loss A/c Cr

The next step is to prepare the fund flow statement of the enterprise

Fund flow statement

Illustration 4

Balance sheets of M/s Black and White as on 1-1-1986 and 31-12-1986 were as follows:

Stock in trade 3,00,000 3,90,000 90,000 ----------

Accounts receivable 2,10,000 3,00,000 90,000 ----------

5,70,000 8,70,000

Current liability

Accounts payable 90,000 2,70,000 1,80,000

Working capital 4,80,000 6,00,000 3,00,000 1,80,000

Increase in working capital 1,20,000 1,20,000

6,00,000 6,00,000 3,00,000 3,00,000

Rs Rs To Balance B/d 3,80,000 By Depreciation(Adjusted Profit

&Loss A/c ) 30,000

To Cash (Purchase) Balancing fig.

70,000 By Balance c/d 4,20,000

4,50,000 4,50,000

Rs Rs To Balance c/d 8,00,000 By Cash( Issue of shares) 1,00,000 By General reserve 1,00,000 By Balance b/d 6,00,000 8,00,000 8,00,000

Rs Rs To Share capital 1,00,000 By Balance b/d 2,00,000 To Balance c/d 1,00,000

2,00,000 2,00,000

Rs Rs To (Fixed Assets) depreciation 30,000 By Balance B/d(Retained

Earnings) 60,000

To Balance c/d 1,20,000 By Fund from operation Balancing fig.

90,000

1,50,000 1,50,000

Sources Rs Applications Rs Issue of Shares 1,00,000 Purchase of Land 70,000 Funds from operation 90,000 Increase in working capital 1,20,000 1,90,000 1,90,000

Liabilities 1-1-86 Rs

31-12-1986 Rs

Assets 1-1-86 Rs

31-12-1986 Rs

Creditors 40,000 44,000 Cash 10,000 7,000 Mrs.Whites’Loan 25,000 - Debtors 30,000 50,000 Loan from P.N.Bank

40,000 50,000 Stock 35,000 25,000

Captial 1,25,000 1,53,000 Machinery 80,000 55,000 Land 40,000 50,000 Building 35,000 60,000 2,30,000 2,47,000 2,30,000 2,47,000

130


Additional information

During the year machine costing Rs.10,000 (accumulated depreciation Rs.3,000) wassold for Rs.5,000 . The provision for depreciation against machinery as on 1-1-1986 wasRs.25,000 and on 31-12-1986 Rs.40,000 Net profit for the year 1986 amounted toRs.45,000. You are required to prepare funds flow statement (M.Com MKU April 1980).

The very first step is to prepare the statement of changes in working capital

Changes in working capital in between the various current assets and current liabilitiesare as follows:

Statement of changes in working capital

The next step is to determine the cost of the machinery before the charge of depreciationi.e., to find out the Gross value of the assets, in other words Original cost of the assets tobe found out at the moment of purchase.

The ultimate aim is to find out the original cost of the machinery for the preparation ofthe machinery account:

Before preparing the Machinery account, the worth of the sale transaction of themachinery should be found out .

Original cost of the Machinery Rs.10,000

(-)Depreciation Rs.3,000

Machinery worth for sale Rs.7,000

(-)Machinery sold Rs.5,000

Loss on sale of the portion of the machinery sold Rs.2,000

Dr Machinery A/c Cr

The next one is the provision for depreciation account or Accumulated depreciationaccount.

1-1-86 Rs

31-12-1986 Rs

Increase In working capital


Current asset: Cash 10,000 7,000 ----------- 3,000 Debtors 30,000 50,000 20,000 ---------- Stock 35,000 25,000 --------- 10,000 75,000 82,000 Current liability Sundry creditors 40,000 44,000 ----------- 4,000 Working capital 35,000 38,000 20,000 17,000 Increase in working capital 3,000 3,000 38,000 38,000 20,000 20,000

1-1-1986 31-12-1986

Written down value of the machinery extracted from the balance sheet as on dated

Rs.80,000 Rs.55,000

Add: Accumulated depreciation or Provision for depreciation

25,000 40,000

Original Cost of Machinery

1,05,000

95,000

Rs Rs To Balance B/d 1,05,000 By Cash (Sales) 5,000 By Provision for machinery 3,000 By loss on sale(Adjusted profit

and loss account) 2,000

By Balance c/d 95,000 1,05,000 1,05,000

131

Fund Flow Statement AnalysisDr Provision for Depreciation A/c Cr

Dr Capital A/c Cr

Dr Loan P.N. Bank Cr

Dr Mr. White's A/c Cr

The next step is to prepare the Adjusted Profit & Loss Account.

Adjusted Profit & Loss Account

The next step is to prepare the fund flow statement.

Fund flow statement

Illustration 5

From the following balance sheets of A Ltd on 31st Dec, 1982 and 1983, you are requiredto prepare Fund flow statement

The following are additional information has also been given

l Depreciation charged on plant was Rs.4,000 and on building Rs.4,000

l Provision for taxation of Rs.19,000 was made during the year 1983

l Interim Dividend of Rs.8,000 was paid during the year 1983

Balance sheet

(M.Com.Madras,1984)

Rs Rs To Machinery A/c 3,000 By Balance B/d 25,000 To Balance c/d 40,000 By depreciation provided during

the current year 18,000

43,000 43,000

Rs Rs To Drawings (Balancing fig) 17,000 By Balance B/d 1,25,000 To Balance c/d 1,53,000 By Net profit 45,000 1,70,000 1,70,000

Rs Rs By BalanceB/d 40,000 To Balance c/d 50,000 By Cash (Balancing fig) 10,000 50,000 50,000

Rs Rs To Cash( Loan paid) 25,000 By Balance B/d 25,000 To Balance c/d ----------- 25,000 25,000

Rs Rs To Machinery (Loss on sale) 2,000 By Balance B/d -----------

To Provision for taxatio 18,000 By fund from operations 65,000 To Balance c/d(Net profit) 45,000 65,000 65,000

Sources Rs Applications Rs Sale of machinery 5,000 Purchase of land 10,000 Loan from P.N.Bank 10,000 Purchase of Building 25,000 Fund from operation 65,000 Drawings 17,000 Repayment of Mr White Loan 25,000 Increase working capital 3,000 80,000 80,000

Liabilities 1982 Rs 1983 Rs Assets 1982 Rs 1983 Rs Share capital 1,00,000 1,00,000 Good will 12,000 12,000 General Reserve 14,000 18,000 Building 40,000 36,000 Profit & Loss A/c 16,000 13,000 Plant 37,000 36,000 Sundry creditors 8,000 5,400 Investments 10,000 11,000 Bills payable 1,200 800 Stock 30,000 23,400 Provision for taxation 16,000 18,000 Bill receivable 2,000 3,200 Provision for doubtful debts 400 600 Debtors 18,000 19,000 Cash 6,600 15,200 1,55,600 1,55,800 1,55,600 1,55,800

132


The first step is to prepare the Statement of changes in the working capital

Statement of changes in working capital

The next step is to prepare the non current accounts.

First, Non current asset account to be prepared.

The first non-current asset account is Building account.

Dr Building account Cr

The next non- current asset account is Plant account

Dr Plant account Cr

The next non-current asset account is Investments account.

Dr Investments account Cr

The next one is the non-current liability account.Dr General Reserve account Cr

The next non-current liability account is Provision for taxation accountDr Provision for taxation account Cr

1982 Rs

1983 Rs

Increase In working

capital

Decrease In working

capital Current asset: Stock 30,000 23,400 6,600 Bill receivable 2,000 3,200 1,200 Debtors 18,000 19,000 1,000 Cash 6,600 15,200 8,600 56,600 60,800 Current liability Sundry creditors 8,000 5,400 2,600 Bills payable 1,200 800 400 Provision for doubtful debts 400 600 200 9,600 6,800 Working capital 47,000 54,000 13,800 6,800 Increase in working capital 7,000 7,000 54,000 54,000 13,800 13,800

Rs Rs To Balance B/d 40,000 By (Depreciation)Adjusted profit &

Loss A/c 4,000

By Balance c/d 36,000 40,000 40,000

Rs Rs To Balance B/d 37,000 By (Depreciation)Adjusted profit &

Loss A/c 4,000

To Cash (Purchase) balancing fig.

3,000 By Balance c/d 36,000

40,000 40,000

Rs Rs To Balance B/d 10,000 To Cash(purchase) Balancing figure

1,000 By Balance c/d 11,000

Rs Rs By Balance B/d 14,000 To Balance B/d 18,000 By Adjusted profit and loss A/c

(Profit transferred during the current year)

4,000

18,000 18,000

Rs Rs To Cash(Tax paid previous year taxation) Balancing figure

17,000 By Balance B/d 16,000

To Balance B/d 18,000 By Adjusted profit & Loss A/c (provision for taxation made during the year)

19,000

35,000 35,000

133

Fund Flow Statement AnalysisThe next step is to prepare the Adjusted profit and loss account.


The next step is to prepare the fund flow statement.

Fund flow statement

Check Your Progress

(1) Purchase of plant & machinery Rs.10 lakh through the issue of 1 Lakhshares at Rs.10 per share ; affect the following accounts

(a) Non current asset and Non current liability accounts

(b) Non current asset and Current liability accounts

(c) Current asset account and Non current liability accounts

(d) Current asset and current liability accounts

(2) XYZ Ltd. has made a credit purchase of Rs.1 lakh worth of goods led toRs.1 lakh worth of additional stock of tradable goods for the enterprise,leads to

(a) Increase in the working capital - Applications

(b) No change in the working capital position -Neither an application nor resource

(c) Decrease in the working capital-Resource


(3) The meaning of the "To cash ( Tax paid)" entry posted in the Provision fortaxation account is

(a) Last year taxation is paid through the current year provision

(b) Current year taxation is paid through the current year provision

(c) Last year tax is paid through the last year taxation

(d) Current year taxation is paid through the last year provision

(4) Profit on sale of the fixed assets are considered to be

(a) Resource to the enterprise

(b) Non operating income

(c) Application of the enterprise


(5) The treatment of current year depreciation with the closing balance of profitin determining the fund from operations

(a) To be added

(b) To be multiplied

(c) To be deducted

(d) To be divided

Rs Rs To Depreciation Building 4,000 By Balance B/d 16,000 To Depreciation Plant 4,000 By Fund from operations 36,000 To Transfer to General Reserve 4,000 To Provision for taxation 19,000 To Interim dividend 8,000 To Balance c/d 13,000 52,000 52,000

Sources Rs Applications Rs Fund from operations 36,000 Purchase of the plant 3,000 Purchase of the Investment 1,000 Increase working capital 7,000 Tax paid 17,000 Interim dividend 8,000 36,000 36,000

Contd...

134


(6) The redemption bank term loan leads to change in the

(a) Non current liability account and current asset account

(b) Current asset account and current liability account

(c) Non current asset account and current liability account

(d) Non current asset account and current liability account

7.5 LET US SUM UP

Normally, Balance sheet reveals the status of the firm only at the end of the year, not atthe beginning of the year. It never discloses the changes in between the value position ofthe firm at two different time periods/ dates. A report on the movement of funds orworking capital. In a narrow sense, the term fund means cash and the fund flowstatement depicts the cash receipts and cash disbursements/payments. The projectedfund flow statement from the past performance facilitates the firm to anticipate thefuture requirement of financial resources. It guides the management to prioritize theapplication in the future to the tune of scarce resources.


In the long run, is it more important for a business to have positive cash flows from itsoperating activities, investing activities, or financing activities? Why? Give your opinion.

7.7 KEYWORDS

Fund: Fund means working capital

Flow: Flow means changes occurred in between two different time periods

Statement of changes in working capital: Enlisting the changes taken place in betweenthe Current assets and current liabilities of two different time horizons

Current assets: Assets which are in the form of cash, equivalent to cash or easilyconvertible into cash .

Current liabilities: Short term financial resources of the firm

Non-current assets: Long term assets

Non current liabilities: Long term financial resources

Increase in working capital: Increase in Net working capital i.e. Excess of currentassets over the current liabilities- Applications side of the fund flow

Decrease in working capital: Decrease in Net working capital i.e. Excess of currentliabilities over the current assets - Resources side of the fund flow

Fund from operations: Income generated from only operations

Fund lost in operations: Loss incurred in the operations


1. Define fund.

2. Define flow.

3. What is meant by fund flow ?

4. List out the various objectives of preparing the fund flow statement.

135

Fund Flow Statement Analysis5. Enumerate the various advantages in the preparation of fund flow statement.

6. Briefly explain the limitations of fund flow statement.

7. What are the steps involved in the process of fund flow statement ?

8. Explain the various methods of determining the fund from/lost (in ) operations.

9. Explain the process of preparing the statement of changes in working capital.

10. Draft the pro forma of the Fund flow statement.

11. Explain any non current account transactions affecting the fund position of thefirm.


R.L. Gupta and Radhaswamy, "Advanced Accountancy".

V.K. Goyal, "Financial Accounting", Excel Books, New Delhi.

Khan and Jain, "Management Accounting".

S.N. Maheswari, "Management Accounting".

S. Bhat, "Financial Management", Excel Books, New Delhi.

Prasanna Chandra, "Financial Management - Theory and Practice", Tata McGrawHill, New Delhi (1994).

I.M. Pandey, "Financial Management", Vikas Publishing, New Delhi.

Nitin Balwani, "Accounting & Finance for Managers", Excel Books, New Delhi.

136


8CASH FLOW STATEMENT ANALYSIS

CONTENTS


8.1 Introduction

8.2 Meaning & Motives of Cash Flow Statement

8.3 Utility of Cash Flow Statement

8.4 Steps in the Preparation of Cash Flow Statements

8.4.1 Preparation of Adjusted Profit and Loss Account

8.4.2 Comparison of Current Items to determine the Inflow of Cash or Outflow of Cash

8.4.3 Preparation of Cash Flow Statement

8.5 Let us Sum up


8.7 Keywords




In this lesson we shall discuss about cash flow statement analysis. After going throughthis lesson you will be able to:

(i) discuss meaning and motives of cash flow statement.

(ii) analyse utility of cash flow statement and steps in the preparation of cash flowstatements.

8.1 INTRODUCTION

Cash is considered one of the vital sources of the firm to meet day to day financialcommitments. The cash is considered to be as most important source of life blood of thebusiness. The day to day financial commitments are met out only out of the availableresources. The cash resources are availed through two different type of receipts viz.sales, dividends, interests known as regular receipts and sale of assets, investmentsknown as irregular receipts of the business enterprise. To have smooth flow of businessenterprise, it should have ample cash resources for its operations. The availability ofcash resources is mainly depending on the cash inflows of the enterprises. The smoothnessin operations of the enterprise is obtained through an appropriate matching of cash inflowsand cash outflows.

To have smoothness in the operations of the enterprise, the firm should have an appropriatevolume of cash resources at speedier rate as well as more than the financial commitmentsof the firm. This smoothness could be attained by way of an appropriate planning analysison the cash resources of the firm. The meaningful analysis is only possible through cashflow statement analysis which facilitates the firm to identify the possible sources of cashas well as the expenses and expenditures of the firm.

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Cash Flow Statement Analysis8.2 MEANING & MOTIVES OF CASH FLOW STATEMENT

The cash flow statement is being prepared on the basis of an extracted information ofhistorical records of the enterprise. Cash flow statements can be prepared for a year, forsix months , for quarterly and even for monthly. The cash includes not only means thatcash in hand but also cash at bank.

Motives of preparing the cash flow statement:

l To identify the causes for the cash balance changes in between two different timeperiods, with the help of corresponding two different balance sheets.

l To enlist the factors of influence on the reduction of cash balance as well as toindicate the reasons though the profit is earned during the year and vice versa.

8.3 UTILITY OF CASH FLOW STATEMENT

Utility of cash flow statements are as follows:

l To identify the reasons for the reduction or increase in the cash balances irrespectivelevel of the profits earned by the firm.

l It facilitates the management to maintain an appropriate level of cash resources.

l It guides the management to take futuristic decisions on the prospective demandsand supply of cash resources through projected cash flows.

v How much cash resources are required?

v How much cash requirements could be internally settled?

v How much cash resources are to be raised through external sources?

v Which type of instruments are going to be floated for raising the requiredresources?

l It helps the management to understand its capacity at the moment of borrowing forany further capital budgeting decisions.

l It paves way for scientific cash management for the firm through maintenance ofan appropriate cash levels i-e optimum level cash of resources.

l It avoids in holding excessive or inadequate cash resources through proper planningof cash resources.

l It moots control through identification of variations occurred in the cash expensesand expenditures.

Cash flow statement vs Fund flow statementCash flow statement Fund flow statement

Cash inflow and outflow are only considered Increase or decrease in the working capital is registered

Causes & changes of cash position Causes & changes of working capital position Considers only most liquid assets pertaining to cash resource ; which fosters only for very short span of planning

Considers in general i-e current assets ; the duration of the liquidity of the current assets are longer in gestation than the liquid assets ; which paves way for long span of planning

Opening and closing balances of cash resources are considered for the preparation

Increase or decrease of working capital is considered but not the opening and closing balance for preparation

The flow in the statement means real cash flow The flow in the statement need not be real cash flow

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Accounting and Financefor Managers 8.4 STEPS IN THE PREPARATION OF CASH FLOW

STATEMENTS

8.4.1 Preparation of Adjusted Profit and Loss Account


Accounting Profit to be adjusted

To find out the cash Profit/Loss

Addition of Non cash & Non Operating Expenses

Deduction of Non cash & Non operating Incomes

Net profit method

Cash from operations or Cash lost in operations

Prepare Non – current accounts to identify the flow cash

Sale of Assets or Investments, Raising of financial resources

Purchase of Assets or Investments, Redemption of financial resources

Cash Inflows Cash out flows

Balancing Figure

139

Cash Flow Statement Analysis

Alternate method:

Net Profit

( +)

(-)

8.4.2 Comparison of Current items to determine the inflow of cash or outflowof cash

8.4.3 Preparation of cash flow statement

The cash flow statement can be prepared either in statement form or in accountingformat.

Inflow cash Outflow cash Opening cash balance XXXX Redemption of preference shares XXXX Cash from in operations XXXX Redemption fo debentures XXXX Sale of assets XXXX Repayment of loans XXXX Issue of shares XXXX Payment of dividends XXXX Issue of debentures XXXX Payment of tax XXXX Raising of loans XXXX Cash lost in operations XXXX Collection from debentures XXXX Refund of tax XXXX XXXX XXXX

Sales Method

Cash Sales

Deduct Cash Purchases & Cash Operating Expenses

Cash from operations or Cash lost in operations

Decrease in current assets & Increase in current liabilities

Increase in current assets & Decrease in current liabilities

Increase in current assets Outflow of cash

Decrease in current assets

Decrease in current liabilities

Increase in current liabilities

Inflow of cash

Outflow of cash

Inflow of cash

140


December 31 Particulars 1992 Rs 1993 Rs

Debtors 1,00,000 94,000 Bills receivable 20,000 25,000 Creditors 40,000 50,000 Bills payable 16,000 12,000 Outstanding expenses 2,000 2,400 Prepaid expenses 1,600 1,400 Accrued Income 1,200 1,500 Income received in advance 600 500 Profit made during the year - 2,60,000

Decrease in current assets & Increase in current liabilities

Increase in current assets & Decrease in current liabilities

Check Your Progress

(1) Cash flow means

(a) Change in cash position

(b) Change in working capital position

(c) Change in current assets position

(d) Change in current liabilities position

(2) Adjusted profit and loss account is to determine

(a) Cash from operations

(b) Cash lost in operations

(c) Cash from operations or Cash lost in operations


(3) Comparison in between the current assets and current liabilities to determine

(a) Cash inflow

(b) Cash out flow

(c) Both (a) & (b)


(4) Non current accounts are prepared for the cash inflows and cash outflowson the basis of which of the following relationship

(a) Non current asset account and Cash

(b) Non current liability account and Cash

(c) Both (a) & (b) only


Illustration 1

From the following balances you are required to calculate cash from operations:

According to net profit method , the cash from operation has to be found out

Cash from operations

= Net profit (+) (-)

The next step is to quantify the decrease in current assets and increase in current liabilities,in order to add with the closing net profit of the given statements and then the addedvolume should be deducted from the increase in current assets and decrease in currentliabilities.

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Cash Flow Statement Analysis

Illustration 2

From the following profit and loss account you are required to compute cash fromoperations

Profit and loss account for the year ending 31st Dec, 1983

Cash from operations Rs Rs

Illustration 3

The comparative balance sheets of M/s Ram Brothers for the two years were as follows

Cash from operations Rs Rs Profit made during the year s Add Decrease in debtors 6,000 Increase in creditors 10,000 Outstanding expenses 400 Prepaid expenses 200 16,600 Less Increase in Bills receivable 5,000 Decrease in Bills payable 4,000 Increase in accrued income 300 Income received in advance 100 9,4000 Cash from operations 2,67,200

Rs Rs To salaries 10,000 By Gross profit 50,000 To Rent 2,000 By profit on sale of land 10,000 To Depreciation 4,000 By income tax refund 6,000 To loss on sale of plant 2,000 To Good will written off 8,000 To proposed dividend 10,000 To provision for taxation 10,000 To Net profit 20,000 66,000 66,000

Net profit made during the year 20,000 Add: Non cash expenses Depreciation 4,000 Loss on sale of plant 2,000 Good will return off 8,000 Non operating expenses Proposed dividend 10,000 Provision for taxation 10,000 34,000 Less Non cash income Profit on sale of land 10,000 Non operating income Income tax refund 6,000 16,000 38,000

Mar,31 Mar,31 Liabilities 1984 1985

Assets 1984 1985

Capital 3,00,000 3,50,000 Land &Building 2,20,000 3,00,000 Loan from Bank 3,20,000 2,00,000 Machinery 4,00,000 2,80,000 Creditors 1,80,000 2,00,000 Stock 1,00,000 90.000 Bills payable 1,00,000 80,000 Debtors 1,40,000 1,60,000 Loan from SBI 50,000 Cash 40,000 50,000 9,00,000 8,80,000 9,00,000 8,80,000

142


Original cost of the Asset Rs.50,000 Accumulated Depreciation Rs.20,000 Rs.30,000 Sale price Rs.26,000 Loss on sale of the assets Rs.4,000

Rs Rs To Balance B/d (Opening) 5,00,000 By cash sale 26,000 By Profit and loss a/c Loss

Balancing Fig 4,000

By Depreciation Provision 20,000 By Balance c/d(Closing )

2,80,000+1,70,000 4,50,000

5,00,000 5,00,000

Additional Information

i. Net profit for the year 1985 amounted to Rs. 1,20,000

ii. During the year a machine costing Rs.50,000 ( accumulated depreciation Rs. 20,000)was sold for Rs. 26,000. The provision for depreciation against machinery as on 31Mar, 1984 was Rs.1,00,000 and 31st Mar, 1985 Rs.1,70,000

You are required to prepare a cash flow statement

First step is to prepare non current accounts

Non current account includes both non current liability and asset

First start with non current liability

Dr Capital A/c Cr

The next step is to find out the depreciation provided during the year, which affects noncurrent asset account of the firm is Machinery account.

Before discussing the accounting transactions, the journal entry for provision fordepreciation should be known.

Provision for depreciation Account

Dr Cr

Cash sale of the machinery amounted Rs.26,000

What happens during the cash sale of a machinery ?

Debit what comes in - Cash resources are coming in

Credit what goes out- Machinery is going out of the firm

While selling the machinery, it is most important to identify the worth of the sale transactionof the machinery ?

Once the loss of the transaction is found out, the amount of the loss should be appropriatelyrecorded

Machinery Account

Dr Cr

Rs Rs To Drawings. Balancing Fig. 70,000 By Balance B/d (Opening) 3,00,000 To Balance c/d(Closing ) 3,50,000 By Net profit 1,20,000

4,20,000 4,20,000

Rs Rs To Machinery 20,000 By Balance B/d 1,00,000 To Balance C/d 1,70,000 By Adjusted profit and loss

account ( Depreciation provided during the year)

90,000

1,90,000 1,90,000

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Cash Flow Statement AnalysisDr Land and Building Cr

The next step is to prepare adjusted profit and loss account

Dr Adjusted profit and loss account Cr

The next most important step is to compare the current assets

Increase in creditors -Rs.20,000 - cash inflow

Loan from SBI -Rs 50,000 -cash inflow

Decrease in stock -Rs.10,000 - cash inflow

Loan repaid -Rs.1,20,000 -cash outflow

Decrease in Bill payable -Rs.20,000 - cash outflow

Cash flow statement

Illustration 4

Data ltd, supplies you the following balance on 31st Mar 1995 and 1996

Additional information

i. Dividends amounting to Rs 7,000 were paid during the year 1996

ii. Land was purchased for Rs. 20,000

iii. Rs.10,000 were written off on good will during the year

iv. Bonds of Rs.12,000 were paid during the course of the year

v. You are required to prepare a cash flow statement

The first step is to prepare non current accounts

The first step is to prepare non current assets and liabilities account

As far as non current asset account - Land account has to be prepared

Dr Land Cr

Rs Rs To Balance B/d(Opening) 2,20,000 To Purchase 80,000 By Balance c/d(Closing ) 3,00,000

3,00,000 3,00,000

To Machinery A/c(Loss on sale ) Rs. 4,000

By Balance B/d Rs.

To Depreciation provided during the year

90,000 By cash from operations 2,14,000

To Balance c/d 1,20,000 2,14,000 2,14,000

Inflow Rs Out flow Rs Opening cash balance 40,000 Loan repaid 1,20,000 Creditors 20,000 Bills payable 20,000 Loan from SBI 50,000 Debtors 20,000 Stock 10,000 Land and buildings purchased 80,000 Machinery cash sale 26,000 Drawings 70,000 Cash from operations 2,14,000 Closing cash balance 50,000 3,60,000 3,60,000

Liabilities 1995 1996 Assets 1995 1996 Share capital 1,40,000 1,48,000 Bank balance 18,000 15,600 Bonds 24,000 12.000 Accounts

Receivable 29,800 35,400

Accounts payable 20,720 23,680 Inventories 98,400 85,400 Provision for debts 1,400 1,600 Land 40,000 60,000 Reserves and Surpluses

20,080 21,120 Good will 20,000 10,000

2,06,200 2,06,400 2,06,200 2,06,400

Rs Rs To Balance B/d(Opening) 40,000 To Purchase (Given) 20,000 By Balance c/d(Closing ) 60,000

60,000 60,000

144


The non current liability account to be prepared

The first non current liability account got affected is Share capital account

Dr Share capital account Cr

The next non current liability account is that Bonds account

Dr Bond account Cr

The next step is to prepare the Adjusted profit and loss account

Dr Adjusted profit and loss account Cr

The next most important step is to compare the current assets during the two years

Increase in Accounts payable - Rs. 2,960 - Cash inflow

Decrease in Inventories -Rs. 7,000 - Cash inflow

Increase in Bank Balance - Rs. 2,400 -Cash outflow

Increase in accounts receivable -Rs. 5,600 - Cash outflow

The next step is to draft the Cash flow statement

Cash flow statement

Check Your Progress

(1) Cash flow statement analysis is an analysis of short span of analysis due to

(a) Current assets position is only considered

(b) Super quick assets position only considered

(c) Working capital position is considered


(2) How cash flows are denominated in terms of both current assets and currentliabilities?

(a) Increase in current assets & Decrease in current liabilities

(b) Decrease in current assets & Increase in current liabilities

(c) Increase in current assets & Increase in current liabilities

Rs Rs By Balance B/d(Opening ) 1,40,000 To Balance c/d (Closing ) 1,48,000 By cash Balancing figure 8,000

1,48,000 1,48,000

Rs Rs To cash redemption (Given) 12,000 By Balance B/d(Opening ) 24,000 To Balance c/d(Closing ) 12,000

24,000 24,000

To provision for doubtful debts

200 By Balance B/d 20,080

To Good will written off 10,000 By cash from operations 18,240 To dividends paid 7000 To Balance c/d 21,120

38,320 38,320

Inflow Rs Out flow Rs Opening cash balance 18,000 Increase in Bills receivable 5,600 Issue of shares 8,000 Purchases of land 20,000 Increase in Bills payable 2,960 Dividends paid 7,000 Decrease in stock 13,000 Bonds repaid 12,000 Cash from operations 18,240 Closing cash balance 15,600

60,200 60,200

Contd...

145

Cash Flow Statement Analysis(d) Both (a) & (b)

(3) Cash position at the opening and closing comprises of

(a) Cash in hand

(b) Cash at bank

(c) Both cash in hand and at bank


(4) Cash flow analysis superior than the fund flow analysis due to

(a) Shorter span of cash resources are considered

(b) Real cash flows only taken into consideration

(c) Opening & closing cash balances are only considered

(d) (a), (b) & (c)

(5) Sale of the Plant & Machinery falls under the category of

(a) Non current asset sale- cash in flow

(b) Current asset sale - cash out flow

(c) Non current asset sale -cash out flow


8.5 LET US SUM UP

The cash resources are availed through two different type of receipts viz sales, dividends,interests known as regular receipts and sale of assets , investments known as irregularreceipts of the business enterprise. Cash flow statements can be prepared for a year, forsix months , for quarterly and even for monthly The cash includes not only means thatcash in hand but also cash at bank.


Parle Food Products experiences a considerable seasonal variation in its business. Thehigh point in the year’s activity comes in November, the low point in July. During whichmonth would you expect the company’s ratio to be higher? If the company was choosinga fiscal year for accounting purposes, what advice would you give?

8.7 KEYWORDS

Cash

Cash Flow Statement

Fund Flow Statement


1. Define cash flow.

2. Highlight the steps involved in the process of Cash flow statement analysis.

3. Draw the proforma of the Adjusted profit and loss account.

4. Illustrate the impact of the changes taken place on the current assets and currentliabilities to the tune of cash flows determination of the firm.

146


5. Briefly explain the objectives of preparing the cash flow statement.

6. Explain the various utilities of the cash flow statement analysis.

7. Illustrate the various differences in between the cash flow and fund flow statementsanalysis.


R.L. Gupta and Radhaswamy, "Advanced Accountancy".

V.K. Goyal, "Financial Accounting", Excel Books, New Delhi.

Khan and Jain, "Management Accounting".

S.N. Maheswari, "Management Accounting".

S. Bhat, "Financial Management", Excel Books, New Delhi.

Prasanna Chandra, "Financial Management - Theory and Practice", Tata McGrawHill, New Delhi (1994).

I.M. Pandey, "Financial Management", Vikas Publishing, New Delhi.

Nitin Balwani, "Accounting & Finance for Managers", Excel Books, New Delhi.

UNIT-III

LESSON

9 COST ACCOUNTING & PREPARATION OF COSTSTATEMENT

CONTENTS


9.1 Introduction

9.2 Meaning of Cost Accounting

9.2.1 What is a Cost of a Product?

9.3 Cost Classification

9.3.1 By Nature or Element or Analytical Segmentation

9.3.2 By Functions

9.3.3 Direct and Indirect Cost

9.3.4 By Variability

9.3.5 By Controllability

9.3.6 By Normality

9.3.7 By Time

9.3.8 For Planning and Control

9.3.9 For Managerial Decisions

9.4 Distinction between Financial Accounting & Cost Accounting

9.5 Unit Costing

9.5.1 Cost Sheet - Definition

9.5.2 Direct Material

9.5.3 Direct Labour

9.5.4 Direct Expenses

9.5.5 Indirect Material

9.5.6 Indirect Labour

9.5.7 Indirect Expenses

9.6 Direct Cost Classification

9.7 Indirect Cost Classification

9.8 Stock of Raw Materials

9.9 Stock of Semi Finished Goods

9.10Stock of Finished Goods

9.11Let us Sum up


9.13Keywords



150


In this lesson we shall discuss about cost accounting and preparation of cost statement.After going through this lesson you will be able to:

(i) discuss meaning of cost accounting and distinction between financial accountingand cost accounting.

(ii) analyse unit costing and direct, indirect and classification

9.1 INTRODUCTION

Cost accounting is that branch of the accounting information system, which records,measures and reports information about costs. The primary purpose of cost accountingis cost ascertainment and its use in decision-making and performance evaluation. It isalso useful in planning and controlling.

9.2 MEANING OF COST ACCOUNTING

It is the process of classifying, recording and appropriate allocation of expenditure forthe determination of costs of products or services through the presentation of data forthe purpose to take decisions and guide the business organization.The next one important aspect is the differences between the cost accounting andmanagement accounting.

9.2.1 What is a cost of a product ?Cost denominates the use of resources only in terms of monetary terms. In brief, cost isnothing but total of all expenses incurred for manufacturing a product or attributable togiven thing. In clear, the cost is nothing but ascertained expression of expenses in termsof monetary, incurred during its production and sale.To ascertain a cost, the firm should atleast smallest division of activity or responsibilityfor which costs are accumulated, at where the costs ascertained and controlled. In brief,cost centre normally a location where a specified activity takes place.Accumulation of all cost incurred for an activity leads to ascertainment of cost for thespecified activity, but the control is being done by the head or incharge of that activity isresponsible for control of costs of his centre.

Sl.No. Point of Difference Cost Accounting Management Accounting

1. Objectives Its main purpose is to ascertain the cost and control

Its major objective is to take decisions through supplement presentation of accounting information

2. Scope It deals only with the cost and related aspects

It not only deals with the cost but also revenue. It is wider than the cost accounting

3. Utilization of Data It uses only quantitative information pertaining to the transactions

It uses both qualitative and quantitative information for decision making

4. Utility It ends only at the presentation of information

But it starts from where the cost accounting ends; means that the cost information are major inputs for decision-making

5. Nature It deals with the past and present data

But it deals with future policies and course of actions

Cost Centre

Product Centre Service Centre

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Cost Accounting &Preparation of Cost Statement

Product centre is a centre at where the cost is ascertained for the product whichpasses through the process.

Service centre is the centre or division which normally incurs direct or indirect costs butdoes not work directly on products. Normally, Maintenance dept. and general factoryoffice are very good examples of the service centre.

Apart from the above classification, one more important centre is profit centre.

What is meant by profit centre?

It is a centre not only responsible for both revenue as well as expenses but also for theprofit of an activity.

9.3 COST CLASSIFICATION

The costs are classified into various categories according to the purpose and requirementsof the firm. Some of the most important classifications are as follows.

i. By nature or Element or Analytical segmentation

ii. By functions

iii. Direct and Indirect cost

iv. By variability

v. By controllability

vi. By normality

vii. By time

viii. According to planning and control

ix. For Managerial Decisions

9.3.1 By Nature or Element or Analytical segmentation

The costs are classified into three major categories Materials, Labour, and Expenses.

9.3.2 By Functions

Under this methodology, the costs are classified into various divisions or functions of theenterprise. viz Production cost, Administration cost, Selling & Distribution cost and so on.

The detailed classification is that total of production cost sub classified into cost ofmanufacture, fabrication or construction.

And another classification of cost is commercial cost of operations; which is other thanthe cost of manufacturing and production.

The major components of commercial costs are known as administrative cost of operationsand selling and distribution cost of operations.

9.3.3 Direct and Indirect Cost

Direct cost: This classification of costs are incurred for the manufacture of a product orservice ; can be conveniently and easily identified.

Raw materials Cost centre Finished goods

Cost Ascertainment

152


Material cost for the product manufacture- Direct material-For garments factory- clothis the direct material for ready made garments.

Labour cost for production- Labour who directly involved in the production of a productas well as attributable to single product expenses and so on.

Indirect cost: The costs which are incurred for and cannot be easily identified for anysingle cost centre or cost unit known as indirect cost.

Indirect material cost, Indirect labour cost and Indirect expenses are the three differentcomponents of the indirect expenses.

Indirect material- Cost of the thread cannot be conveniently measured for single unit ofthe product.

Indirect Labour-Salary paid to the supervisor.

9.3.4 By Variability

The costs are grouped according to the changes taken place in the level of production oractivity.

It may be classified into three categories:

Fixed cost: It is cost which do not vary irrespective level of an activity or production

Rent of the factory, salary to the manager and so on.

Variable cost: It is a cost which varies in along with the level of an activity or production.

e.g. Material consumption and so on.

Semi variable cost: It is a cost which is fixed upto certain level of an activity, then laterit fluctuates or varies in line with the level of production. It is known in other words asstep cost. e.g. Electricity charges.

9.3.5 By Controllability

The cost are classified into two categories in accordance with controllability, as follows:

Controllable costs: Cost which can be controlled through some measures known ascontrollable costs. All variable cost are considered to be controllable in segment to someextent.

Uncontrollable costs: Costs which cannot be controlled are known as uncontrollablecosts. All fixed costs are very difficult to control or bring down; they rigid or fixedirrespective to the level of production.

9.3.6 By Normality

Under this methodology, the costs which are normally incurred at a given level of outputin the conditions in which that level of activity normally attained.

Normal cost: It is the cost which is normally incurred at a given level of output in theconditions in which that level of output is normally achieved.

Abnormal cost: It is the cost which is not normally incurred at a given level of output inthe conditions in which that level of output is normally attained.

9.3.7 By time

According to this classification, the costs are classified into Historical costs andPredetermined costs:

153


Historical costs: The costs are accumulated or ascertained only after the incurrenceknown as Past cost or Historical costs.

Predetermined costs: These costs are determined or estimated in advance to anyactivity by considering the past events which are normally affecting the costs.

9.3.8 For Planning and Control

The following are the two major classifications viz standard cost and budgetary control:

Standard cost is a cost scientifically determined by way of assuming a particular level ofefficiency in utilization of material, labour and indirect expenses.

The prepared standards are compared with the actual performance of the firm in studyingthe variances in between them. The variances are studied and analysed through anexclusive analysis.

Budget: A budget is detailed plan of operation for some specific future period. It is anestimate prepared in advance of the period to which it applies. It acts as a businessbarometer as it is complete programme of activities of the business for the period covered.

The control is exercised through continuous comparison of actual results with the budgets.The ultimate aim of comparing with each other is to either to secure individuals' actiontowards the objective or to provide a basis for revision.

9.3.9 For Managerial Decisions

The major classifications are sunk cost and marginal cost.

Marginal cost is the amount at any given volume of output by which aggregate costs arechanged if the volume of output is decreased or increased by one unit.

9.4 DISTINCTION BETWEEN FINANCIAL ACCOUNTING& COST ACCOUNTING

The next one important aspect is the differences in between the Financial accounting,cost accounting and management accounting.

Check Your Progress

1. Fixed cost is the cost under the classification of

(a) Variability (b) Normality

(c) Controllability (d) Functions

Sl. No. Point of Difference

Financial Accounting Cost Accounting

1. Objectives To determine the volume of earnings and financial position

Its main purpose is to ascertain the cost and control

2. Scope It deals with only the monetary transactions of the business

It deals only with the cost and related aspects

3. Utilization of Data

It uses only the financial transactions alone

It uses only quantitative information pertaining to the transactions

4. Utility It reveals the capacity & status of the firm

It ends only at the presentation of information

5. Nature It deals only the past of the firm

It deals with the past and present data

Contd...

154


2. Standard costing is brought under the classification of

(a) Controllability (b) Functions

(c) Planning and control (d) Both (a) & (c)

3. Marginal costing is classified on the basis of

(a) Variability (b) Managerial decisions

(c) Time (d) Both (a) & (b)

4. Electricity charges incurred by the firm is

(a) Fixed cost (b) Semi-Variable cost

(c) Variable cost (d) None of the above

9.5 UNIT COSTING

Under costing, the role of unit costing is inevitable tool for the industries not only toidentify the volume of costs incurred at every level but also to determine the rationalprice on the commodities in order to withstand among the competitors. The determinationof the selling price is being done through the process of determining the cost of theproduct. After having been finalized the cost of the product, the profit margin has to beadded in order to derive the final selling price of the product.

9.5.1 Cost Sheet - Definition

"It is a statement of costs incurred at every level of manufacturing a product or service".

"It is a statement prepared to depict the output of a particular accounting period alongwithbreak up of costs".

How to find a total cost of the product or service ?

To find the total cost of the product or service, the costs incurred are grouped undervarious categories.

The cost of the product or service should have to come across many stages. Thedetermination of the unit cost involves two different major stages viz Direct and Indirectcosts.

Cost

Material Labour Expenses

Direct

Indirect

. Direct

Indirect

. Direct

Indirect

O V E R H E A D S

Production Overheads

Administrative Overheads

Selling Overheads Distribution Overheads

155


What is meant by direct cost ?

Direct cost is the cost incurred by the firm which can be ascertained and measured fora product.

Direct cost of the product can be classified into three major categories.

9.5.2 Direct Material

Direct material which is especially used as a major ingredient for the production of aproduct. For Example: The wood is a basic raw material for the wooden furniture. Thecost of the wood procured for the furniture is known direct material cost.

The cotton is a basic raw material for the production of yarn. The cost of procuring thecotton is known as direct material for the manufacturing of yarn.

9.5.3 Direct Labour

Direct labour is the cost of the labour which is directly involved in the production ofeither a product or service. For e.g. The cost of an employee who is mainly working forthe production of a product /service at the centre, known as direct labour cost.

9.5.4 Direct Expenses

Direct expenses which are incurred by the firm with the production of either a productor service. The excise duty, octroi duty are known as direct expenses in connection withthe production of articles and so on.

Indirect cost is the cost whatever incurred by the firm can be ascertained but not measuredmore specifically for a product.

9.5.5 Indirect Material

The material which is spent cannot be measured for a product is known as indirectmaterial. For e.g. the thread which is used for tailoring the shirt cannot be measured orquantified in specific length as well as ascertained the cost.

9.5.6 Indirect Labour

Indirect labour is the cost of the labour incurred by the firm other than the direct labourcannot be apportioned. For e.g: Cost of supervisor, cost of the inspectors and so on.

9.5.7 Indirect Expenses

Indirect expenses are the expenses other than that of the direct expenses in the productionof a product. The expenses which are not directly part of the production process of aproduct or service known as indirect expenses. For e.g.: Rent of the factory, salesmensalary and so on.

Advantages of preparing the cost sheet:1. It is a only statement reveals the cost of the output as well as unit cost of the

output2. It facilitates the manufacturer to access the control on the costs through breakups

in the cost3. It extends room for the management to study the variations of the cost with the

help of an effective comparison of standard costs4. The businessman is able to get an insight on the various components of cost as well

as able to exercise the control on the excessive costs incurred5. It poses the firm to supply the goods against the orders with reasonable accuracy

in submitting the orders.

Check Your Progress

1. Cost is

(a) An expense incurred (b) An expenditure incurred

(c) An income received (d) None of the aboveContd...

156


2. Cost is

(a) Direct cost only (b) Indirect cost only

(c) Both (a) & (b) (d) None of the above

3. Direct cost is

(a) Direct Materials (b) Direct labour

(c) Direct Expenses (d) Prime cost

To find out the unit cost of the product, the statement of cost plays pivotal role indetermining the cost of production, cost of goods sold, cost of sales and selling price ofthe product at every stage.

During the preliminary stage of preparing the cost statement of the product, there aretwo things to be borne in our mind at the moment of classification.

1. Direct cost classification

2. Indirect cost classification

9.6 DIRECT COST CLASSIFICATION

Under this classification, the direct costs of the product or service are added together toknow the volume of total direct cost. The total volume of direct cost is known as "PrimeCost"

Direct Materials +Direct Labour+ Direct Expenses = Prime cost

The next stage in the unit costing to find out the factory cost. The factory cost could becomputed by the combination of the indirect cost classification.

9.7 INDIRECT COST CLASSIFICATION

Among the classification of the overheads, the first and foremost is factory overheads.The factory overheads and work overheads are synonymously used. The factoryoverheads are nothing but the indirect costs incurred at the factory site. To find out thetotal factory cost or works cost incurred in the factory could be derived by adding theboth direct cost and indirect cost incurred during the factory process.

Factory overheads are nothing but the indirect expenses incurred during the industrialprocess.

Factory Cost =Prime cost + Factory overheads

Prime cost

Direct Material

Direct Labour

Direct Expenses

157


Check Your Progress

1. Direct materials is

(a) Opening stock + Purchases

(b) Purchases + Closing stock

(c) Opening stock + Purchases – closing stock

(d) Purchases – Closing stock

2. Salary paid to Supervisor

(a) Manufacturing overheads

(b) Administrative overheads

(c) Direct labour

(d) Selling & Distribution overheads

The next stage in the process of the unit costing is to find out the cost of the productionThe cost of production is the combination of both the factory cost and administrativeoverheads.

Administrative overheads is the indirect expenses incurred during the office administrationfor the smooth flow production of finished goods.

Cost production = Factory cost + Administrative overheads

Factory cost

Factory overheads Prime cost

Wages for foreman

Electric power

Storekeeper’s wages

Oil and water

Factory rent

Repairs and Renewals

Depreciation

Cost of Production

Administrative Overheads Factory Overheads

Office Rent

Repairs – Office

Office lighting

Depreciation-office

Manager salary

Telephone charges

Postage and telegram

Stationery

158


Immediate next stage to determine in the process of unit costing is the component ofcost of sales. The cost of sales is the blend of both viz. Selling overheads and cost ofproduction.

What ever the cost involved in the production process in the factory as well in theadministrative proceedings are clubbed with the selling overheads to determine the costof sales.

Selling overheads are nothing but the indirect expenses incurred by the firm at the momentof selling products. In brief, whatever the expenses in relevance with the selling anddistribution are known as Selling overheads.

The last but most important stage in the unit costing is determining the selling price of thecommodities. The selling price of the commodities is fixed by way of adding both thecost of sales and profit margin out of the product sales.

Under the unit costing, the selling price of the product can be determined through thestatement form.

The cost sheet or cost statement is as follows in the determination of the selling price ofthe product.

Check Your Progress

1. Overheads is

(a) Manufacturing expenses (b) Administrative expenses

(c) Selling & Distribution expenses (d) a,b, & c

2. Cost of the Cloth incurred at the moment of purchase made by the Readygarments manufacturer is

(a) Direct materials (b) Indirect materials

(c) Direct expenses (d) Indirect expenses

Cost of sales = Cost of production + Selling overheads

Cost of sales

Selling Overheads Cost of production

Salesman salary

Carriage outward

Salesmen commission

Travelling expenses

Advertising

Free samples

Ware housing

Delivery charges

Sales = Cost of sales + Margin of Profit

Contd...

159


3. Salesman salary given by the firm to promote the sales is

(a) Direct labour (b) Indirect expenses

(c) Direct expenses (d) Indirect labour

4. Selling price is

(a) Cost of sales (b) Cost of production

(c) Profit margin + Cost of goods sold (d) Profit margin + Cost of sales

Illustration 1

Calculate the prime cost, factory cost, cost of production cost of sales and Profit formthe following particulars:

Rs. Rs.

Cost statement /Cost Sheet

Direct Materials 2,00,000 Office stationery 1000

Direct wages 50,000 Telephone charges 250

Direct expenses 10,000 Postage and telegrams 500

Wages of foreman 5,000 Salesmens’ salaries 2500

Electric power 1,000 Travelling expenses 1,000

Lighting :Factory 3,000 Repairs and renewal Plant 7,000

Office 1,000 Office premises 1,000

Storekeeper’s wages 2,000 Carriage outward 750

Oil and water 10,00 Transfer to reserves 1,000

Rent: Factory 10,000 Discount on shares written off

1000

:Office 5,000 Advertising 2,500

Depreciation Plant 1000 Warehouse charges 1000

office 2,500 Sales 3,79,000

Consumable store 5,000 Income tax 20,000

Managers’ salary 10,000 Dividend 4,000

Directors’ fees 2,500

Particulars Rs Rs

Direct Materials 2,00,000

Direct wages 50,000

Direct expenses 10,000

PRIME COST 2,60,000

Factory Overheads:

Wages of foreman 5,000

Electric power 1,000

Lighting :Factory 3,000

Storekeeper’s wages 2,000

Oil and water 1000

Rent:Factory 10,000

Depreciation Plant 1000

Consumable store 5,000

Repairs and renewal Plant 7,000

35,000

Factory cost 2,95,000

Administration overheads

Rent Office 5,000

Depreciation office 2,500 Contd...

160


The Next stage in the preparation of the cost statement is to induct the stock of rawmaterials, work in progress and finished goods.

9.8 STOCK OF RAW MATERIALS

The raw materials stock should be taken into consideration for the preparation of thecost sheet. The cost of the raw materials is nothing but the direct materials cost of theproduct. The cost of the materials is in other words cost of the materials consumed forthe production of a product.

9.9 STOCK OF SEMI FINISHED GOODS

The treatment of the stock of semi finished goods is mainly depending upon the twodifferent approaches viz prime cost basis and factory cost basis. The factory cost basisis considered to be predominant over the early one due to the consideration of factoryoverheads at the moment of semi finished goods treatment. The indirect expenses arethe expenses converting the raw materials into semi finished goods which should berelatively considered for the treatment of the stock valuation rather than on the basis ofprime cost.

Managers’ salary 10,000

Directors’ fees 2,500

Office stationery 1000

Telephone charges 250

Postage and telegrams 500

Office premises 1,000

Lighting Office 1,000

23,750

Cost of production 3,18,750

Selling and distribution overheads

Carriage outward 750

Sales mens’ salaries 2500

Travelling expenses 1,000

Advertising 2500

Warehouse charges 1000

7,750

Cost of sales 3,26,500

Profit 52,500

Sales 3,79,000

Particulars Rs

Opening stock of Raw materials XXXXX

(+)Purchases of Raw materials XXXXX

(-)Closing stock of Raw materials XXXXX

Cost of Materials consumed XXXXX

Particulars Rs

Prime cost XXXXXX

(+)Factory overheads incurred XXXXXX

(+)Opening work in progress XXXXXX

(-)Closing work in progress XXXXXX

Factory cost XXXXXX

161

Cost Accounting &Preparation of Cost Statement9.10 STOCK OF FINISHED GOODS

The treatment of the stock of finished goods should carried over in between the openingstock and closing stock and adjusted among them before the finding the cost of goodssold.

Illustration 2

The following data has been from the records of Centre corporation for the period fromJune 1 to June 30, 2005

Draft the cost sheet

Cost Sheet

Particulars Rs

Cost of production XXXXX

(+)Opening stock of finished goods XXXXX

(-)Closing stock of finished goods XXXXX

Cost of goods sold XXXXX

2005 1st Jan

2005 31st Jan

Cost of raw materials 60,000 50,000

Cost of work in progress 24,000 30,000

Cost of finished good 1,20,000 1,10,000

Transaction during the month

Purchase of raw materials 9,00,000

Wages paid 4,60,000

Factory overheads 1,84,000

Administration overheads 60,000

Selling overheads 40,000

Sales 18,00,000

Particulars Rs Rs

Opening stock of raw materials 1sr Jan 60,000

(+)Purchase of raw materials 9,00,000

(–)Closing stock of raw materials 31st Jan 50,000

Raw materials consumed during the year 9,10,000

(+)Wages paid 4,60,000

Prime cost 13,70,000


(+)Opening stock of semi goods 24,000

(–)Closing stock of semi goods 30,000


Factory or Works cost 15,48,000

(+)Administration overheads 60,000

Cost of Production 16,08,000

(+)Opening stock of finished goods 1,20,000

(–)Closing stock of finished goods 1,10,000

Cost of goods sold 16,18,000

(+)Selling overheads 40,000

Cost of Sales 16,58,000

Net profit 1,42,000

Sales 18,00,000

162

Accounting and Financefor Managers Check Your Progress

1. The cost classifications in the cost sheet is

(a) Functions (b) Variability

(c) Controllability (d) Functions

2. Rs.10,000 paid on every month to the owner of the factory site is

(a) Fixed cost (b) Semi-Variable cost

(c) Variable cost (d) Semi-Fixed cost

Illustration 3

From the following information extracted from the records of the M/s sundaram &co

Stock position of the firm

Prepare cost statement of the M/s Sundaram & Co

Cost Sheet

Contd...

Particulars Rs 1-4-1994 Rs 31-3-1995

Stock of raw materials 80,000 1,00,000

Stock of finished goods 2,00,000 3,00,000

Stock of work in progress 20,000 28,000

Particulars Rs Particulars Rs

Indirect labour 1,00,000 Administrative expenses 2,00,000

Oil 20,000 Electricity 60,000

Insurance on fixtures 6,000 Direct labour 6,00,000

Purchase of raw materials 8,00,000 Depreciation on Machinery 1,00,000

Sale commission 1,20,000 Factory rent 1,20,000

Salaries of salesmen 2,00,000 Property tax on building 22,000

Carriage outward 40,000 Sales 24,00,000

Particulars Rs Rs

Opening stock of raw materials 1st April,1994 80,000

(+)Purchase of raw materials 8,00,000

(-)Closing stock of raw materials 31st Jan 1,00,000

Raw materials consumed during the year 7,80,000

(+)Direct labour 6,00,000


Factory overheads: Indirect labour

1,00,000

Oil 20,000

Insurance on fixtures 6,000

Electricity 60,000

Depreciation on machinery 1,00,000

Factory rent 1,20,000

Property tax on factory building 22,000 4,28,000

(+)Opening stock of semi goods 2,0,000

(–)Closing stock of semi goods 28,000

Factory cost 18,00,000

(+)Administration overheads 2,00,000

163


Note: Property tax on the plant is to included under the factory overheads. The tax ispaid by the firm on the plant which is engaging in the production process.

Illustration 4

Prepare the cost sheet to show the total cost of production and cost per unit of goodsmanufactured by a company for the month of Jan, 2005. Also find the cost of sale andprofit.

The number of units produced during Jan 2005 was 6,000

The stock of finished goods was 400 and 800 units on 1st Jan, 2005 and 31st Jan, 2005respectively. The total cost of the units on hand on 1st Jan 2005 is Rs. 5,600. All thesehad been sold during the month.

The first and foremost step is to find out the cost per unit i.e. cost production per unit.The opening stock and their values are given, but at the same time the value of theclosing stock is ascertained by Rs. 3. The total number of units are almost

Contd...

Cost of Production 20,00,000

(+)Opening stock of finished goods 2,00,000

(-)Closing stock of finished goods 3,00,000


Selling overheads: Sales commission

1,20,000

Salaries of salesmen 2,00,000

Carriage outward 40,000


Profit margin 1,40,000

Sales 24,00,000

Particulars Rs Partiuclars Rs

Stock of raw materials1.1.2005 6,000 Factory rent and rates 6,000

Raw materials procured 56,000 Office rent 1,000

Stock of raw material31.1.2005 9,000 General expenses 4,000

Direct wages 14,000 Discount on sales 600

Plant depreciation 3,000 Advertisement expenses 1,200

Loss on the sale of plant 600 Income tax paid 2000

Sales Rs.,1,50,000

Particulars Units Rs

Stock of Raw materials 1.1.2005 6,000

(+)Raw materials procured 56,000

(–)Closing stock of raw material 9,000

Materials consumed 71,000

Direct wages 14,000

Prime cost 85,000

Factory overheads: Depreciation on plant

3,000

Factory rent and rates 6,000

Factory cost 94,000

Office and Administration overheads: Office rent

1,000

General expenses 4,000

Cost of production =Rs. 3 per unit 3,000 99,000

(+)Opening stock of finished goods 400 5,600

164


Illustration 5

XYION Co Ltd., is an export oriented company manufacturing internal -communicationequipment of a standard size. The company is to send quotations to foreign buyers ofyour product. As the cost accounts chief you are required to help the management in thematter of submission of the quotation of a cost estimate based on the following figuresrelating to the year 1984

Total output (in units ) 20,000

Note:

i. Local raw materials now cost 10% more

ii. A profits margin of 20% on sales is kept

iii. The government grants subsidy of Rs. 200 per unit of exports

Prepare the cost statement in columnar form

Cost Statement of XYION Ltd.

Rs Rs

(-)closing stock of finished goods 800 2,400


Selling and distribution expenses Advertisement expenses

600


Net profit 47,200

Sales 1,50,000

Rs. Rs.

Local Raw materials 20,00,000 Excise duty 4,00,000

Imports of raw materials 2,00,000 Administrative office expenses 4,00,000

Direct labour in works 20,00,000 Salary of the managing director 1,20,000

Indirect labour in works 4,00,000 Salary of the joint managing director

80,000

Storage of raw materials and spares

1,00,000 Fees of directors 40,000

Fuel 3,00,000 Expenses on advertising 3,20,000

Tools consumed 40,000 Selling expenses 3,60,000

Depreciation on plant 2,00,000 Sales depots 2,40,000

Salaries of works personnel 2,00,000 Packaging and distribution 2,40,000

Particulars Cost Rs Rs Unit/Price Cost20,000

Local raw materials 20,00,000

(+) Increase in local raw materials 2,00,000

22,00,000

(+)Imports of raw materials 2,00,000

Direct Materials 24,00,000

Direct labour 20,00,000


Factory overheads: Indirect labour in works

4,00,000

Storage of raw materials and spares 1,00,000

Fuel 3,00,000

Tools consumed 40,000 Contd...

165


9.11 LET US SUM UP

Cost denominates the use of resources only in terms of monetary terms. In brief, cost isnothing but total of all expenses incurred for manufacturing a product or attributable togiven thing. In clear, the cost is nothing but ascertained expression of expenses in termsof monetary, incurred during its production and sale. Service centre is the centre ordivision which normally incurs direct or indirect costs but does not work directly onproducts. Normally, Maintenance dept. and general factory office are very good examplesof the service centre. Costs which cannot be controlled are known as uncontrollablecosts. All fixed costs are very difficult to control or bring down ; they rigid or fixedirrespective to the level of production. A budget is detailed plan of operation for somespecific future period. It is an estimate prepared in advance of the period to which itapplies. It acts as a business barometer as it is complete programme of activities of thebusiness for the period covered. Under costing, the role of unit costing is inevitable toolfor the industries not only to identify the volume of costs incurred at every level but alsoto determine the rational price on the commodities in order to withstand among thecompetitors. Direct labour is the cost of the labour which is directly involved in theproduction of either a product or service. For e.g. The cost of an employee who ismainly working for the production of a product /service at the centre, known as directlabour cost. Indirect expenses are the expenses other than that of the direct expenses inthe production of a product. The expenses which are not directly part of the productionprocess of a product or service known as indirect expenses. For e.g.: Rent of the factory,salesmen salary and so on.


Once standard costs are established, what conditions would require the standards to berevised? Give your opinion.

9.13 KEYWORDS

Cost: Expense incurred at the either cost centre or service centre.

Cost sheet: It is a statement prepared for the computation of cost of a product/service.

Depreciation on plant 2,00,000

Salaries of works personnel 2,00,000

Excise duty 4,00,000 16,40,000

Works cost 60,40,000

Administrative & office Expenses 4,00,000

Salaries of Managing director 1,20,000

Salaries of Joint Managing Director 80,000

Fees of directors 40,000 6,40,000

Cost of Production 66,,80,000

Selling & Distribution expenses Expenses of Advertising

3,20,000

Selling expenses 3,60,000

Sales depots 2,40,000

Packaging and distribution 2,40,000 11,60,000

Cost of sales 80% 78,40,000

Profit Margin 20% 19,60,000

Sales 100% 98,00,000/20,000units 98,00,000 490

Export subsidy per unit 40,00,000 200(–)

Selling price for local market sales

58,00,000/20,000units 58,00,000 290

166


Direct cost: cost incurred which can be easily ascertained and measured for a product.

Indirect cost: cost incurred cannot be easily ascertained and measured for a product.

Cost centre: The location at where the cost of the activity is ascertained.

Product centre: It is the location at where the cost is ascertained through which theproduct is passed through.

Service centre: The location at where the cost is incurred either directly or indirectlybut not directly on the products.

Profit centre: It is responsibility centre not only for the cost and revenues but also forprofits for the activity.

Prime cost: combination of all direct costs viz Direct materials, Direct labour and Directexpenses.

Factory cost: It is the total cost incurred both direct and indirect at the work spot duringthe production of an article.

Cost of production: It is the combination of cost of manufacturing an article or a productand administrative cost.

Cost of sales: It is the entire cost of a product.

Selling price or Sales: The summation of cost of sales and profit margin.


1. What is cost classification? Classify it, in detail.

2. What do you mean by unit costing?

3. Explain Direct and Indirect Costing.

4. What is cost-sheet definition?

5. Express Indirect and Direct Expenses.





S.N. Maheswari, “Management Accounting”.





LESSON

10 BUDGETARY CONTROL


10.1 Introduction

10.2 Types of Budget

10.3 Cash Budget

10.4 Fixed & Flexible Budget

10.4.1 Fixed Budget

10.4.2 Flexible Budget

10.5 Master Budget

10.6 Zero Base Budgeting (ZBB)

10.6.1 Traditional Budgeting vs Zero Base Budgeting

10.6.2 Steps involved Zero Base Budgeting

10.6.3 Benefits of Zero Base Budgeting

10.6.4 Criticism

10.7 Let us Sum up


10.9 Keywords




In this lesson we shall discuss about budgetary control. After going through this lessonyou will be able to:

(i) understand types of budget and cash budget

(ii) analyse fixed and flexible budget

(iii) discuss zero base budgeting (ZBB)

10.1 INTRODUCTION

Budget is an estimate prepared for definite future period either in terms of financial ornon financial terms. Budget is prepared for any course of action or business or state orNation, as a whole. The budget is usually expressed in terms of total volume.

According to ICMA, England, a budget is as follows "a financial and or quantitativestatements prepared and approved prior to a defined period of time, of the policy to bepursed during the period for the purpose of attaining a given objective".

It is in other words as " detailed plan of action of the business for a definite period of time".

What is meant by Budget?

It is a statement of financial affairs/quantitative terms of an activity for a defined period,to achieve the enlisted objectives.

168

Accounting and Finance forManagers

What is budgeting?

Budgeting is the course involved in the preparation of budget of an activity.

What is Budgetary Control?

Budgetary control contains two different processes one is the preparation of the budgetand another one is the control of the prepared budget.

According to ICMA, England, a budgetary control is " the establishment of budgetsrelating to the responsibilities of executives to the requirements of a policy and thecontinuous comparison of actual with budgeted results, either to secure by individualaction the objectives of that policy or to provide a basis for its revision".

According to J.Batty "Budgetary control is a system which uses budgets as a mans ofplanning and controlling all aspects of producing and/or selling commodities and services".

Check Your Progress

Choose the appropriate answer:

1. Budget is a statement of

(a) Qualitative affairs (b) Quantitative affairs

(c) Financial affairs (d) Both (b) & (c)

2. Budgets can be classified into

(a) By functions (b) By time

(c) By flexibility (d) (a), (b) & (c)

Preparation of the Budget for definite future

Actual performance has to be recorded

Comparison in between the actual and budget figures

Corrective steps – Deviations in between Actual & Budget

Revision of the budget

169

Budgetary Control10.2 TYPES OF BUDGET

The budgets can be classified into three categories:

10.3 CASH BUDGET

Cash budget is nothing but an estimation of cash receipts and cash payments for specifiedperiod. It is prepared by the head of the accounts department i.e., chief accounts officer.

The utility of the cash budget is as follows:

l To meet the revenue and capital expenditures with adequate funds

l It should highlight the additional requirement cash whenever the need arises

l Keeping of excessive funds available in the business firm wont fetch any return tothe enterprise but this estimate of future cash needs and resources will guide thefirm to plan for an effective investment out of the surplus funds estimated ; enhancesthe wealth of the investors through proper investment planning out of the futurefunds available.

Cash budget can be prepared in three different ways:

1. Receipts and payments method

2. Adjusted profit and loss account

3. Balance Sheet Method

Cash receipts can be classified into various categories

Cash Receipt

Budgets

Functions Flexibility Time

Sales Budget

Production Budget

Material Budget

Labour Budget

Manufacturing overhead budget

Selling overheads budget

Cash budget

Fixed Budget

Flexible Budget

Long Term

Medium Term

Short Term

Sales Debtors Bills receivable Dividends Sale of Investments

Other Incomes

170


Cash payments are as follows:

Illustration 1

From the following information prepare a cash budget for the months of June and July

Additional Information:

1. Advance tax of Rs 4,000 payable in June and in December 1994

2. Credit period allowed to debtors is two months

3. Credit period allowed by the vendors or suppliers

4. Delay in the payment of other expenses one month

5. Opening balance of cash on 1st June is estimated as Rs. 20,000/-

Solution:

First step is in the preparation of a cash budget is to open the statement with the openingcash balance available.

Secondly, if any cash receipts are available that should be added one after another. Inthis problem, Sales can be bifurcated into two classifications, the first one is cash sales.If the cash sales is given, the amount of cash receipt due to cash sales should have to beimmediately brought under the respective period i-e during the same month or week.

The next is the credit sales of the firm, the volume of sales should only be effected onlyat the amount of realization of sales or collection of credit sales from the consumers andcustomers. If cash sales is not given instead credit sales only the component given, thatshould be added in the list of cash receipts ; by registering the credit period involved forthe customers and consumers. Being as credit sales, the amount of sales realizationshould only relevantly be considered during the specified period.

Third step is to list out the various items of cash expenses expected to incur during thespecified period. The text of the problem deals with the delay of making the payment ofexpenses is one month in all cases; It means the expenses like Manufacturing overheads,selling overheads are expected to pay one month later i-e these expenses will be paidone month after. It means that the May month of other expenses are paid only in themonth of June and during the month of June month expenses are met out.

The purchases requires same kind of treatment in the case of sales. Normally, thepurchases are classified into two divisions viz cash purchases and credit purchases.

The cash purchases should be given effect only at the moment of cash payment is paidon the volume of purchase, but, if the credit purchases are made by the firm, the credit

Cash payments

Purchase of Assets Materials bought Salary paid

Rent paid Other payments

Month Credit sales Rs

Credit purchase Rs

Manufacturing Overheads Rs

Selling overheads Rs

April 80,000 60,000 2,000 3,000

May 84,000 64,000 2,400 2,800

June 90,000 66,000 2,600 2,800

July 84,000 64,000 2,000 2,600

171

Budgetary Controlallowed by the vendor/supplier to make the payments should be relatively considered forthe expected outflow of cash i-e payment of purchase one month later or two monthslater.

The expected time period occurrence of a either cash receipt or cash payment should beconsidered for the preparation of the cash budget.

The cash budget should be prepared separately in the statement to derive the closingbalance of the specified year/month. The closing balance of the yester period or previousperiod has to be carried forward to the next period as opening balance of the preparationof a budget. The closing balance of the month June will be the opening balance of themonth July. Once the statement has been completed in the preparation of budget ofrespective periods should be consolidated for the specified periods.

Cash Budget for the Months of June and July 1998

Illustration 2

From the estimates of income and expenditure, prepare cash budget for the months fromApril to June.

i. Plant worth Rs. 20,000 purchase in June 25% payable immediately and the remainingin two equal installments in the subsequent months

ii. Advance payment of tax payable in Jan and April Rs 6,000

iii. Period of credit allowed

a. By suppliers 2 months

b. To customers 1 month

iv. Dividend payable Rs.10,000 in the month of June

v. Delay in payment of wages and office expenses 1 month and selling expenses½ month. Expected cash balance on 1st April is Rs. 40,000.

Solution:

a. Plant worth Rs 20,000/ purchased, payable immediately is 25% i-e Rs.5,000 shouldbe paid in the month of June. The remaining cost of the machine has to be paid inthe subsequent months, after June. The payments whatever are expected to makeafter June is not relevant as far as the budget preparation concerned.

Month Sales Rs Purchases Rs Wages Rs Office Exp. Rs

Selling Exp. Rs

Feb 1,20,000 80,000 8,000 5,000 3,600

Mar 1,24,000 76,000 8,400 5,600 4,000

Apr 1,30,000 78,000 8,800 5,400 4,400

May 1,22,000 72,000 9,000 5,600 4,200

June 1,20,000 76,000 9,000 5,200 3,800

Particulars June Rs July Rs

Opening balance 20,000 26,800

Receipts: Sales

80,000 84,000

Total Cash Receipts I 1,00,000 1,10,800

Payments: Purchases

64,000 66,000

Manufacturing Overheads 2,400 2,600

Selling Overheads 2,800 2,800

Tax payable 4,000 -------------

Total Payments II 73,200 71,400

Balance I-II 26,800 39,400

172


b. Delay in the payment of wages and office expenses is only one month. It meanswages and office expenses of Feb month are paid in the next month, March.

Selling expense From the above coloured boxes, it is obviously understood thatduring the months of April, May and June ; the following will be stream of paymentof selling expenses.

April= Rs. 2,000 of Mar (Previous Month) and Rs. 2,200 of April (Current month)=Rs.4,200/

May= Rs. 2,200 of April (Previous Month) and Rs.2,100 of May (Current month)=Rs.4,300/

June= Rs. 2,100 of May (Previous Month) and Rs.1,900 of June (Currentmonth)=Rs. 4,000/

c. Selling expenses is having the delay of ½ month, which means 50% of the sellingexpenses is paid only in the current month and the remaining 50% is paid in the next

Every month 50% of the selling expenses of the current month and 50% of the previousmonth selling expenses are paid together ; the above coloured boxes depict the paymentof 50% of the current selling expenses along with 50% expenses of previous month.

Cash Budget for the Periods ( April and June)

10.4 FIXED & FLEXIBLE BUDGET

10.4.1 Fixed Budget

It is a budget known as constant budget, never registers the changes in the preparationof a budget, being prepared for irrespective level of output or production. This budget ismainly meant for the fixed overheads of the firm which are constant in volume irrespectivelevel of production. The ultimate utility of the budget is to control the cost as a costcontrolling measure, but the fixed budget is meaningless in having comparison with theactual performance.

Particulars April Rs May Rs June Rs

Opening Cash Balance 40,000 59,800 95,300

Cash Receipts Sales

1,24,000

1,30,000

1,22,000

Total Receipts (A) 1,64,000 1,89,800 2,17,300

Payments Plant Purchased

----------

---------

5,000

Tax payable 6,000 --------- --------

Purchases 80,000 76,000 78,000

Dividend payable --------- --------- 10,000

Wages 8,400 8,800 9,000

Office expenses 5,600 5,400 5,600

Selling expenses 4,200 4,300 4,000

Total Payments(B) 1,04,200 94,500 1,11,600

Balance (A-B) 59,800 95,300 1,05,700

Particulars Feb Mar April May June

Selling Expenses

3,600 4,000 4,400 4,200 3,800

Payment 50% in the current month

1,800 2,000 2,200 2,100 1,900

Delay 50%- will be paid in the subsequent month

1,800 2,000 2,200 2,100 1,900

173

Budgetary Control10.4.2 Flexible Budget

Flexible budget is prepared for any level of production as an estimate of statement of allexpenses i-e the expenses are classified into three categories viz variable, semi-variableand fixed expenses. The structure of the budget for any output is only to the tune of theactual performance achieved. This is the budget facilitates not only to have comparison inbetween various levels of production but also to identify the level of lowest production cost.

Utilities of the flexible budget:

l This budget is most useful tool of analysis in studying the sales at when thecircumstances are not warranting to predict

l It is mostly suited to the seasonal business, where the sales volume is getting differedfrom one period to another due to changes taken place in the taste and preferencesof the buyers

l The production is being done on the basis of demand of the products in the market.The demand of the products is studied only through demand forecasting. The flexiblebudget is more applicable in the case of products, which are greatly finding difficultto forecast the demand

l The budget is prepared only during the time of acute shortage of resources ofproduction viz Men, Material and so on

Illustration 3

Draft a flexible budget for overhead expenses on the basis of following information anddetermine the overhead rates at 70% 80% and 90% plant capacity.

Solution:Flexible Budget for the various capacities

Particulars 70% capacity 80% capacity Rs 90% capacity

Variable Overheads Indirect Labour

-----------------

24,000

----------------

Stores including spares ----------------- 8,000 ----------------

Semi-variable overheads Power( 30% fixed ,70%)

----------------- 40,000 ----------------

Repairs and maintenance 80% fixed and 20% variable

----------------- 4,000 ----------------

Fixed Overheads Depreciation

----------------- 22,000 -----------------

Insurance ----------------- 6,000 -----------------

Salaries ----------------- 20,000 -----------------

Total overheads ----------------- 1,24,000 -----------------

Particulars 70% capacity 80% capacity 90% capacity

Variable overheads Indirect labour

21,000

24,000

27,000

Stores including spares 7,000 8,000 9,000

8,000

8,000

8,000

Semi- variable Expenses - Power* Fixed 30% **Variable 28,000 32,000 36,000

3,200

3,200

3,200

Repairs and mainternance ***Fixed 80% ****Variable 20% 700 800 900

Fixed Overheads Depreciation

22,000

22,000

22,000

Insurance 6,000 6,000 6,000

Salaries 20,000 20,000 20,000

Total Overheads 1,15,900 1,24,000 1,32,100

174


Illustration 4

The expenses for budgeted production of 10,000 units in a factory are furnished below

Prepare a budget for production of

i. 8,000 units

ii. 6,000 units

iii. Calculate the cost per unit at both levels

Assume that administration expenses are fixed for all level of production

Illustration 5

From the following information relating to 1963 and conditions expected to prevail in1964, prepare a budget for 1964:

State the assumption you have made, 1963 actuals

Sales 1,00,000 (40,000 units)

Raw materials 53,000

Wages 11,000

Variable overheads 16,000

Fixed overheads 10,000

10,000 units 8,000 units 6,000 units

Per Unit Rs

Amount Rs

Per Unit Rs

Amount Rs

Per Unit Rs

Amount Rs

Production Expenses: Material

70.00 7,00,000 70.00 5,60,000 70.00 4,20,000

Labour 25 2,50,000 25.00 2,00,000 25.00 1,50,000

Overheads 20 2,00,000 20.00 1,60,000 20.00 1,20,000

Direct Variable expenses

5 50,000 5 40,000 5 30,000

Fixed Overheads Rs.1,00,000

10 1,00,000 12.5 1,00,000 16.667 1,00,000

Selling Expenses: Fixed

1.3

13,000

1.625

13,000

2.167

13,000

Variable 11.7 1,17,000 11.7 93,600 11.7 70,200

Distribution Expenses: Fixed

1.4

14,000

1.75

14,000

2.334

14,000

Variable 5.6 56,000 5.6 5.6 30,600

Administration Expensses

5.0 50,000 6.25 50,000 8.333 50,000

Total Cost 155.00 15,50,000 159.425 12,75,400 166.801 10,00,800

Particulars Per unit

Material 70

Labour 25

Variable overheads 20

Fixed overheads (1,00,000) 10

Variable expenses (Direct) 5

Selling expenses (10% fixed) 13

Distribution expenses(20% fixed) 7

Administration expenses(Rs.50,000) 5

Total cost per unit 155

175

Budgetary Control

Basis of Difference Traditional Budgeting Zero Base Budgeting Emphasis It is accounting oriented;

emphasis on “How Much” It is more decision oriented; emphasis on “Why”

Approach It is monitoring towards the expenditures

It is towards the achievement of objectives

Focus To study the changes in the expenditures

To study the cost benefit analysis

Communication It operates only Vertical communication

It operates in both directions horizontally and vertically

Method It is based on the extrapolation i.e. from the yester figures future projections are carried out

Its decision package is totally based on the cost benefit analysis.

1964 prospects

Sales 1,50,000(60,000 units)

Raw Materials 5 per cent price increase

Wages 10 per cent increase in wage rates

5 per cent increase in productivity

Additional plant One lathe Rs. 25,000

One drill Rs,12,000

(I.C.W.A Inter)

Budget for the year 1964 Rs Rs

10.5 MASTER BUDGET

Immediately after the completion of functional or departmental level budgets, the majorresponsibility of the budget officer is to consolidate the various budgets together, whichis detailed report of all operations of the firm for a definite period

10.6 ZERO BASE BUDGETING (ZBB)

Zero base budgeting is one of the renowned managerial tool, developed in the year 1962in America by the Former President Jimmy Carter. The name suggests, it is commencingfrom the scratch, which never incorporates the methodology of the other types of budgetingin determining the estimates. The Zero base budgeting considers the current year as anew year for the preparation of the budget but the yester period is not considered forconsideration. The future activities are forecasted through the zero base budgeting inaccordance with the future activities.

Peter A Pyher “A planning and budgeting process which requires each manager tojustify his entire budget request in detail from scratch (Hence zero base) and shifts theburden of proof to each manger to justify why he should spend money at all. The approachrequires that all activities be analysed in “decision packages” which are evaluated bysystematic analysis and ranked in order of importance”

This type of budgeting requires the manager to reason out the aim of spending , but in thecase of traditional budgeting is unlike , which are never emphasize the reasons of spendingin terms of expenses.

10.6.1 Traditional Budgeting vs Zero Base Budgeting

Sales for 60,000 units @ Rs. 2.50 1,50,000

Less: Cost production

Raw materials 83,475

Wages 17,286

Variable overhead 24,000

Fixed Overheads 13,700

1,38,461

Estimated Profit 11,539

176


10.6.2 Steps involved Zero Base Budgeting1. The very first step is to prepare the Zero Base Budgeting is to enlist the objectives.

2. The extent of application should be decided in the next phase of the ZBB.

3. The next important stage is to prioritize the activities.

4. The Most important step involved in the process of ABB is cost benefit analysis.

5. The final step is to select, approve the decision packages and finalise the budget.

10.6.3 Benefits of Zero Base Budgeting1. It acts as guide for the management to allocate the resources more accurately

depends upon the priority for an effective implementation.

2. It enhances capability of the managers who prepares the budget for future action.

3. It paves way for optimum utilization of resources available.

4. It is a technique of utilitarian of the resources with reference to the activity involved

5. It is dome shaped only towards the achievement of organizational goals.

10.6.4 Criticism1. Non financial matters cannot be considered for the cost & benefit analysis

2. Difficulties involved in the process of ranking of the decision packages

3. It needs more time span for preparation and cost of operations is more and more

10.7 LET US SUM UP

Budgeting is the course involved in the preparation of budget of an activity. Budgetarycontrol contains two different processes one is the preparation of the budget and anotherone is the control of the prepared budget. "Budgetary control is a system which usesbudgets as a mans of planning and controlling all aspects of producing and/or sellingcommodities and services". Cash budget can be prepared in three different ways:

1. Receipts and payments method

2. Adjusted profit and loss account

3. Balance Sheet Method

Fixed Budget is a budget known as constant budget, never registers the changes in thepreparation of a budget, being prepared for irrespective level of output or production.


Identify at least three roles budgeting plays in helping managers control a business.

10.9 KEYWORDS

Budget: A financial statement prepared for specified activity for future periods

Budgeting: Activity of preparing the budget is known as budgeting

Budget control: Quantitative controlling technique to assess the performance of theorganization

Cash Budget: It is a statement prepared by the organization to identify the future needsand receipts of cash from the yester activities

Flexible Budget: It is a financial statement prepared on the basis of principle of flexibilityto identify the cost of the unknown level of production from the existing level of operationalcapacity.

177

Budgetary Control10.10 QUESTIONS FOR DISCUSSION

1. Define budget.

2. Define budgetary control.

3. Highlight the various types of budget.

4. Elucidate the process of production budget.

5. Illustrate the methodology of purchase budget.

6. Draw the process of preparing the cash budget.










178

Accounting and Finance forManagers LESSON

11 MARGINAL COSTING

CONTENTS


11.1 Introduction

11.2 Meaning & Definition of Marginal Costing

11.3 Why Marginal Cost is called as Incremental Cost?

11.4 Why Marginal Cost is called in other words as Variable Cost?

11.4.1 Fixed Cost

11.4.2 Variable Cost

11.4.3 Semi-variable Cost

11.4.4 Method of Difference

11.4.5 Method of Coverages

11.5 Break Even Point Analysis

11.5.1 Break Even Point in Units

11.6 Verification

11.6.1 Selling Price Method

11.6.2 PV Ratio Method

11.6.3 Graph Method

11.7 Margin of Safety

11.8 Determination of Sales Volume in Rupees at Desired Level of Profit

11.9 Applications of Marginal Costing

11.9.1 Make or Buy Decision

11.9.2 Worth of Production

11.9.3 Worth of Purchase

11.10 Accepting the Export Offer

11.11 Key Factor

11.12 Selecting the Suitable Product Mix

11.13 Determining Optimum Level of Operations

11.14 Alternative Method of Production

11.15 Let us Sum up


11.17 Keywords



179

Marginal Costing11.0 AIMS AND OBJECTIVES

In this lesson we shall discuss about marginal costing. After going through this lessonyou will be able to:

(i) understand meaning and definition of marginal costing

(ii) analyse break even point analysis

(iii) discuss applications of marginal costing and selecting the suitable product mix.

11.1 INTRODUCTION

It is one of the premier tools of management not only to take decisions but also to fix anappropriate price and to assess the level of profitability of the products/services. This isa only costing tool demarcates the fixed cost from the variable cost of the product/service in order to guide the firm to know the minimal point of sales to equate the cost ofproduction. It is a tool of analysis highlighting the relationship in between the cost, volumeof sales and profitability of the firm.

11.2 MEANING & DEFINITION OF MARGINAL COSTING

Definition: According to ICMA, London "Marginal cost is the amount at any givenvolume of output, by which aggregate costs are charged, if the volume of output isincreased or decreased by one unit."

Meaning: Marginal cost is the cost nothing but a change occurred in the total cost dueto changes taken place on the level of production i.e., either an increase / decrease byone unit of product..

The firm XYZ Ltd. incurs Rs 1000/- for the production of 100 units at one level ofoperation. By increasing only one unit of product i.e. 101 units, the firm's total cost ofproduction amounted Rs 1010.

Total cost of production at first instance (C')=Rs. 1000/

Total cost of production at second instance (C")=Rs. 1010/-

Total number of units during the first instance (U')=100

Total number of units during the second instance (U")=101

Increase in the level of production and Cost of production:

Change in the level of production in units= U"-U'= U

Change in the total cost of production = C"-C, prime= C

Marginal Cost = Change (Increase) in the total cost of production

Change (Increase) in the level of production =

C

U =

Rs. 10

1= Rs. 10

If the same firm reduces the total volume from 100 units to 99 units. The total cost ofproduction Rs. 990.

Decrease in the Level of production and Cost of production:

Marginal Cost = Change(Decrease) in the total cost of production

Change(Increase) in the level of production =

C

U =

Rs.10

1

= Rs. 10

180

Accounting and Finance forManagers 11.3 WHY MARGINAL COST IS CALLED AS

INCREMENTAL COST?

From the above example, it is obviously understood that marginal cost is nothing but acost which incorporates the incremental changes in the cost of production due to eitheran increase or decrease in the level of production by one unit, meant as incremental cost.

11.4 WHY MARGINAL COST IS CALLED IN OTHERWORDS AS VARIABLE COST?

From the following classifications of cost, the inter twined relationship in between thevariable cost and marginal cost is explained as below

Table 11.1: Statement of Fixed, variable and total costs and per unit

11.4.1 Fixed Cost

It is a cost remains constant or fixed irrespective level of production.

Example: Rent Rs 5,00 is to be paid irrespective level of production. It remains constant/fixed irrespective of changes taken place on the level of production.

X'- Units

Y'- Cost in Rupees

11.4.2 Variable Cost

It is a cost which varies with level of production.

Sl.No. Units Fixed Cost Rs

Fixed cost per unit

Rs

Variable Cost Rs

Variable Cost per unit

Rs

Marginal Cost Rs ?C/?U

Total Cost Rs

1. 1 500 500 10 10 10 510

2. 50 500 100 500 10 10 1000

3. 100 500 5 1000 10 10 1500

4. 150 500 3.333 1500 10 10 2000

Y’

Total fixed Cost Line

Fixed Cost per unit Line

X’

Variable Cost

Variable cost per unit

181

Marginal CostingX'- Units

Y'- Cost in Rupees

The following are the various components of variable cost.

l Direct Materials: Materials cost consumed for the production of goods

l Direct Labour: Wages paid to the labourers who directly involved in the productionof goods.

l Direct Expenses: other expenses directly involved in the production stream.

l Variable portion of Overheads: Generally the overheads can be classified intotwo categories. Viz- Variable overheads and Fixed overheads.

The variable overheads is the cost involved in the procurement of Indirect materialsIndirect labour and Indirect Expenses.

Indirect Material- cost of fuel, oil and soon

Indirect Labour- Wages paid to workers for maintenance of the firm.

From the above table -1 the marginal cost is equivalent to the variable cost per unit of thevarious levels of production. The fixed cost of Rs.500 is the cost remains the same at not onlyirrespective levels of production but also already absorbed at the initial level of production.The initial absorption of fixed overhead led the marginal cost to become as variable cost.

11.4.3 Semi-Variable Cost

Another major classification is semi variable/fixed cost which is a cost partly fixed /variable to the certain level of production or consumption e-g Electricity charges, telephonecharges and so on.

It jointly discards the importance of the fixed cost and the semi- variable cost for analysiswhile ascertaining the marginal cost.

Marginal Costing is defined as "the ascertainment of marginal cost and of the effect onprofit of changes in volume or type of output by differentiating between fixed and variablecosts."

In marginal costing, the change in the level of cost of operation is equivalent to variablecost due to fixed cost component which is fixed irrespective level of outputs.

Importance of Marginal costing:

l The costs are classified into two categories viz fixed and variable cost.

l Variable cost per unit is considered as marginal cost of the product.

l Fixed costs are charged against contribution of the transaction.

l Selling price of the product = marginal cost + contribution.

Marginal costing profitability statement as follows:

Sales xxxx

Variable Cost xxxx

Contribution

Method of Difference Sales- Variable Cost

Method of Meeting Fixed cost+Profit

182


Contribution xxxx

Fixed Cost xxxx

Profit xxxx

Sales Rs.100,000/-, variable cost Rs.25,000/- and fixed cost Rs.20,000/- find-out thecontribution and profit.

Rs.

Sales 1,00,000

Variable Cost 50,000

Contribution 50,000

Fixed Cost 20,000

Profit 30,000

11.4.4 Method of DifferenceUnder this method, the contribution can be computed through finding the differences inbetween Sales and Variable Cost

i.e. Contribution= Sales – Variable Cost= Rs.1,00,000 – 50,000= Rs.50,000

11.4.5 Method of CoveragesIn this method, the contribution is equated with the summation of Fixed cost and Profit.i.e. Contribution=Fixed Cost+ Profit =Rs.20000+30000=Rs.50,000

11.5 BREAK EVEN POINT ANALYSIS

This meaning of the analysis is explained through three different components viz.

Break Even Point is the point at which the Total Cost is equivalent to Total Revenue. Atthe break even point the business neither earns profit nor incurs a loss. It means that thefirm's cost is recovered at the minimum level of production.

Marginal Costing(MC)

Cost Volume Profit Analysis (CVP)

Break Even Point Analysis (BEP)

Break

Even

Point

Divide

Equal

Place (or) Position

183

Marginal Costing

If Sales > BEP Sales æÆ earn profit i.e. Total Sales> Total Cost which leads to earnprofit.

If Sales< BEP Sales æÆ incur loss i.e. Total Sales< Total Cost which registers incurrenceof loss.

This Break even point analysis can be interpreted into two classifications. The firstclassification is narrow sense of BEP, which mainly emphasizes on BE Point.

The second segment is the broader sense which elucidates the role of BEP towardsmanagerial decisions

l Fixation of Selling price

l Acceptance of Special / Foreign order

l Incremental Analysis- On cost as well as revenue

l Make or Buy Decision

l Key factor analysis

l Selection of production mix

l Maintaining the specified level of profit and so on

The enlisted decisions will be discussed immediately after the preliminary aspects ofmarginal costing i.e. Break even analysis.

Check Your Progress

1. Marginal costing is a study on

(a) Variable costing (b) Profit

(c) Fixed costing (d) Volume of sales

2. BEP means

(a) Break even point (b) Bright even point

(c) Break event point (d) Bright even position

3. BEP is the point at which

(a) Profit & No Loss (b) No Profit & Loss

(c) No profit & No Loss (d) Profit & Loss

4. CVP analysis is the combination of three predominant factors of influence

(a) Cost, Value and Profit (b) Component, Value and Profit

(c) Cost, Volume and Profit (d) None of the above

=

Break Even Point

Total Cost Total Revenue/ Total Sales

No Profit / No Loss

Contd...

184


5. In BEP analysis, which cost is to be considered to meet out

(a) Fixed cost (b) Semi variable cost

(c) Variable cost (d) None of the above

The Break even point in accordance with narrow sense can be classified into twocategories

l Break Even Point in Units

l Break Even Point in Sales

11.5.1 Break Even Point in Units

Illustration 1:

Assume the selling price of product Rs.20/-per unit and variable cost per unit Rs.10/-and the fixed cost Rs.1000/- Find out the break even point.

Sales Rs.20/-

Variable Cost Rs.10/-

Contribution Rs 10/-

Fixed Cost Rs.1000/-

Profit (-) Rs. 990/-

If the firm produces only one unit, the amount of loss is Rs.990/-. To avoid the amount ofloss how many units are to be produced ?

As already highlighted, BEP is the point at which the firm neither earns profit nor incurs loss.

Profit/Loss is a resultant out of Contribution while meeting out the fixed cost volume ofthe transaction. From the above example, the contribution per unit is Rs.10/ not sufficientto meet out the fixed cost volume of Rs.1000/-. The purpose of finding out the BEP inunits is to identify the level of contribution which is not only equivalent as well as to meetfixed cost of the transaction but also to avoid loss. To raise the volume of contribution atpar with the fixed cost volume, fixed cost has to be related to the contribution margin perunit through the ratio given below

Fixed cost= "X" units x Contribution Margin Per Unit

"X" units can be found out from the following

"X" units = Fixed Cost

Contribution Margin Per Unit

The total number of units "X" which equate the contribution volume of "X" units with thetotal fixed cost is the Break Even Point (Units).

Break Even Point (Units) = Fixed Cost


= Rs.1000/-

Rs.10/- = 100 Units

The above illustration reveals that how many number of times the contribution marginper unit should be equivalent to the total fixed cost volume. Hence the number of timesis nothing but the units required to have equivalent volume of contribution to the tune offixed cost.

185

Marginal Costing11.6 VERIFICATION

At the level of 100 units

Sales 100×Rs.20 Rs.2,000/

Variable Cost 100×Rs.10 Rs.1,000/

Contribution 100×Rs.10 Rs.1,000/

Fixed Cost Rs.1,000/

Profit/Loss 0 d

Break Even Point ( Sales Volume Rs):

Break even point in sales can be found out in two methods.

1. Selling Price Method

2. PV Ratio Method.

11.6.1 Selling Price Method

Under this method Break even sales volume in rupees is found out through the productof Break Even Point in Units and Selling price per unit

BEP (Rs)=Break Even Point (units) × Selling price per unit

11.6.2 PV Ratio Method

Under this method, Break even sales volume in rupees can be determined through thefollowing ratio.

BEP(Rs) = Fixed Cost

PV ratio

What is PV ratio?

PV ratio is Profit Volume ratio which establishes the relationship in between the profitand volume of sales. It is a ratio normally expressed in terms of contribution towardsvolume of sales. It is expressed in terms of percentage.

Utility of PV ratio:

l To find out the Break Even Point in sales volumel To identify the desired level of profit at any sales volumel To determine the sales volume to earn required level of profit

l To identify better product mix among the alternatives available etc.

Profit Volume Ratio (PV ratio) = Sales-Variable Cost

Sales =

Contribution

Sales

From the above example

PV ratio at the level of 100 units

PV ratio = Rs.1000/-

Rs. 2000/- ×100 = 50%

PV ratio at the level of one unit

PV ratio = Rs.10/-

Rs. 20/- × 100 = 50%

From the above workings, it obviously understood that every unit of sale contributes50% towards in covering the fixed cost and profit.

186

Accounting and Finance forManagers Break Even Sales:

Fixed Cost

PV ratio

At the level of 100 units In Percentage

Sales 100×Rs.20 Rs. 2,000/ 100%

Variable Cost 100×Rs.10 Rs.1,000/ 50%

Contribution 100×Rs.10 Rs.1,000/ 50%


Profit/Loss 0 f

PV Ratio = Rs.1000/Rs.2000 = 50%

50 % of what ?

If Rs.100 is Sales ; Rs.50 is Contribution and the remaining Rs.50 variable cost.

Break even sales = Fixed cost Rs.1000

50% = Rs.2000/ =

Contribution Rs.1000/

50%

At Break even level, the fixed cost volume is equivalent to contribution; the later whichis related in terms of sales i.e. PV ratio will be applicable to the earlier i.e. fixed cost.

At Break even sales, Fixed Cost = Contribution; Contribution

Contribution × Sales = Sales

is the volume which neither earns nor incurs loss.

Illustration 2:

Calculate Break Even Point from the following particulars

Fixed Cost Rs.3,00,000

Variable Cost Per Unit Rs.20/-

Selling Price Per Unit Rs.30/-

Break Even Point (Units) = Fixed Cost


First Step to find out Contribution margin per unit

Contribution Margin Per Unit = Selling Price Per Unit – Variable Cost Per Unit

= Rs.30 – Rs.20 = Rs. 10

= Rs.3,00,000

Rs.10 = 30,000 units

Break Even (Rupees) can be found out in two ways

Method I:

= B.E.P (Units) × Selling Price

= 30,000 units × Rs.30= Rs.9,00,000/-

(Or)

Method II:

Under this method PV ratio component has to be found out

PV ratio = Contribution

Sales × 100

187

Marginal Costing

= Rs 10

Rs.30 × 100 = 33.33%

= Fixed Cost

PV ratio =

Rs.3,00,000/

33.33% = 9000 × 100 = 900,000/-

Illustration 3:

Calculate Break even point Rs.

Sales 6,00,000/-

Fixed Cost 1,50,000/-

Variable Expenses

Direct Material 2,00,000/-

Direct Labour 1,20,000/-

Overhead Expenses 80,000/-

First step to find out the total volume of Variable expenses

Variable Expenses = Direct Material + Direct Labour + Overhead Expenses

= Rs.2,00,000 + 1,20,000 + 80,000 = Rs.4,00,000/-

Second Step to find out the contribution

Contribution = Sales- Variable Expenses

= Rs.6,00,000- 4,00,000= Rs. 2,00,000/-

Third step to find out PV ratio

PV ratio= Contribution/ Sales= Rs,2,00,000/Rs.6,00,00= 1/3

Final Step to find out Break even sales

Break Even Point (Rupees) = Fixed Cost

PV ratio =

Rs.1,50,000

1/3 = Rs.4,50,000/-

Note: Break even point in units is not possible to find out due to non availability of sellingprice and variable cost per unit ; which constrained the computation of contributionmargin per unit.

Illustration 4:

From the following particulars find out the BEP. What will be the selling price per unit ifBEP is brought down to 900 units?

Variable Cost Rs 75/


Selling price per unit Rs.100/

First step is to find out the Break even Point in Units

BEP (Units) = Fixed Cost

Contribution Margin per unit

Second step is to find out Contribution margin per unit

Contribution margin per unit = Selling price per unit- variable cost per unit

188


= Rs.100-75 = Rs.25

= Rs.27,000

Rs.25 = 1080 units

If break even point is reduced to the level of 900 units; what is the new selling price?

First step to find out the contribution margin per unit; contribution margin per unit will becomputed from the BEP (units) formula.

BEP (Units) = 900 = Rs.27,000

Contribution Margin per unit

Contribution margin per unit = Rs. 27,000/900 units = Rs.30

The second step is to determine the new selling price through the following equation

Contribution = selling price-variable cost; X = Selling Price

Rs.30 = X-Rs.75 ; X = 30+75 = Rs.105/-

The new selling price for new break even level of 900 units is Rs.105/-

11.6.3 Graph Method

Statement of Fixed, variable and total costs and per unit

11.7 MARGIN OF SAFETY

Margin of safety is the excess volume of sales over the break even sales. It is highlighted in theform absolute sales or in percentage. It is the difference in between the actual sales and breakeven sales. It elucidates the extent in which sales can be reduced without incurring a loss.

Sl.No Units Fixed Cost Rs

Variable Cost Rs

Sales Rs

Total Cost Rs

1) 1 500 10 20 510

2) 50 500 500 1000 1000

3) 100 500 1000 2000 1500

4) 150 500 1500 3000 2000

Cost/ Volume Rs 3000 TS 2000 1500 TC BEP 1000 Margin of Safety 500 FC 10 50 100 150 Units

189

Marginal CostingMargin of Safety = Actual Sales - Break Even Sales

(Or)

= Profit

PV ratio

The greater the margin of safety leads to soundness of the firm's business.

11.8 DETERMINATION OF SALES VOLUME IN RUPEESAT DESIRED LEVEL OF PROFIT

To determine the sales volume (Rupees) at desired level of profit, the existing formulafor finding out the break even sales has to be redesigned.

Break Even Sales (Rupees) = Fixed Cost

PV ratio

The above formula is in accordance with the method of coverage i-e covering the fixedcost and profit.

Contribution = Fixed Cost + Profit

To earn desired level of profit, which the firm intends to earn should have to be combinedwith the fixed cost, are the two different components to be covered only in order to findout the contribution level to the tune of unchanged selling price and variable cost per unit.

New volume of Sales (Rupees) = Fixed Cost + Desired Level Profit

PV ratio

Illustration 5:

From the following information relating to quick standards ltd., you are required to findout i) PV ratio ii) break even point iii) margin of safety iv) calculate the volume of salesto earn profit of Rs.6,000/

Total Fixed Costs Rs.4,500/

Total Variable Cost Rs.7,500/

Total Sales Rs.15,000/-

First step to find out the Contribution volume

Sales Rs 15,000/

Variable Cost Rs. 7,500/

Contribution Rs.7,500/

Fixed Cost Rs.4,500/-

Profit Rs.3,000

(i) Second step to determine the PV ratio


Sales × 100 =

7,500

15,000 × 100 = 50%

Third step to find out the Break even sales

(ii) Break even sales = Fixed cost

PV ratio =

4,500

50% = 9,000/-

190


(iii) Margin of safety can be found out in two ways

(a) Margin of Safety = Actual sales- Break even sales

= Rs.15,000-Rs.9,000 = Rs.6,000

(b) Margin of Safety = Profit

PVratio =

Rs.3,000

50% = Rs.6,000/-

(iv) Sales required to earn profit = Rs.6,000/

To determine the sales volume to earn desired level of profit

= Fixed cost + Desired Profit

PV ratio

= Rs.4,500 + Rs.6,000

50% = Rs.21,000/-

Illustration 6:

Break even sales Rs.1,60,000

Sales for the year 1987 Rs.2,00,000

Profit for the year 1987 Rs.12,000

Calculate

(a) Profit or loss on a sale value of Rs.3,00,000

(b) During 1988, it is expected that selling price will be reduced by 10%. What shouldbe the sale if the company desires to earn the same amount of profit as in 1987 ?

The major aim to compute fixed expenses.

In this problem, the profit volume is given which amounted Rs.12,000

Profit = contribution- Fixed expenses

From the above equation, the volume of contribution only to be found out

To find out the volume of contribution, the PV ratio has to be found out

Before finding out the PV ratio, the margin of safety should be found out

Margin of safety = Actual sales - Break even sales

= Rs.2,00,000-Rs.1,60,000 = Rs.40,000

Another formula for to find out the Margin of safety is as follows

Margin of safety = Profit

PV ratio

PV ratio = Profit

Margin of safety =

Rs.12,000

Rs.40,000 = 30%

What is PV ratio ?


Sales × 100

30% = Contribution

Rs.2,00,000

191

Marginal CostingContribution = Rs.2,00,000 × 30% = Rs.60,000

Now with the help of the available information, the fixed expenses to be found out fromthe illustrated formula

Fixed expenses = Contribution- Profit = Rs.60,000 – Rs,12,000 = Rs.48,000

The next one is to find out the corresponding variable cost. The variable cost could befound out with the help of the following formula

Sales- Variable cost = Contribution

Rs.2,00,000- Rs.60,000= Variable cost= Rs.1,40,000

(a) Profit or loss on the sale value of Rs 3,00,000

For a sale value of Rs.3,00,000 what is the contribution ?

Contribution for Rs.3,00,000 sale= Rs.3,00,000 × 30%= Rs.90,000

Profit or Loss= Contribution – Fixed expenses= Rs.90,000–Rs,48,000=Rs 42,000 (Profit)

(b) Sales to be found out to earn same level of profit

Sale value reduced 10% from the actual

Rs. 2,00,000–Rs.20,000 Rs.1,80,000

Variable cost Rs.1,40,000

Contribution Rs.40,000

For the new level of sale volume in rupees, the new PV ratio has to be found out


Sales × 100 =

Rs.40,000

Rs.1,80,000 × 100 = 2/9 times

The next important step is to determine the volume of the sales to earn the desiredlevel of profit

= Fixed expenses + Desired level profit

PV ratio

= Rs.48,000 + Rs.12,000

2/9 = Rs.2,70,000

Illustration 7:

SV ltd a multi product company, furnishes you the following data relating to the year1979

Assuming that there is no change in prices and variable costs that the fixed expenses areincurred equally in the two half year periods calculate for the year 1979

Calculate

(a) PV ratio

(b) Fixed expenses

(c) Break even sales

(d) Margin of safety

(C.A. Inter May, 1980)

Particulars First half of the year Second half of the year

Sales Rs.45,000 Rs.50,000

Total cost Rs40,000 Rs.43,000

192


(a) The first step is to find out the PV ratio

Formula for PV ratio = Change in Profit

Change in Sales × 100

To identify the change in profit, the profits of the two different periods should beknown

Profit= Sales-Total cost

Profit of the first half of the year = Rs.45,000–Rs.40,000 = Rs.5,000

Profit of the second half of the year= Rs.50,000–Rs.43,000 = Rs.7,000

Change in profit= Rs.7,000–Rs.5,000= Rs.2,000

Change in sales= Rs.50,000–Rs.45,000=Rs.5,000

PV ratio = Rs.2,000

Rs.5,000 × 100 = 40%

(b) Fixed expenses, to find out the contribution should be initially found out

Contribution = Sales × PV ratio

= Rs.50,000 × 40% = Rs.20,000

The fixed expenses to be found out through the following equation

Contribution-Fixed expenses= Profit

Rs.20,000–Rs.7,000= Rs.13,000= Fixed expenses

The fixed expenses found only for six months ; for the entire year

= Rs.13,000× 2=Rs. 26,000

(c) BE Sales

= Fixed expenses

PV ratio =

Rs. 26,000

40% = Rs.65,000

(d) Margin of safety

= Total sales- BE sales

The next component to be found out is total sales

Total sales = Sale of the first half of the year + Sale of the second half of the year

= Rs.45,000 + Rs.50,000 = Rs.95,000

Margin of safety= Rs.95,000 – Rs.65,000= Rs.30,000

Margin of safety in percentage of sales = Rs. 30,000

Rs. 95,000 × 100= 31.578%

11.9 APPLICATIONS OF MARGINAL COSTING

11.9.1 Make or Buy Decision

The firms which are routinely in need of spares, accessories are bought from the outsidersinstead of any production or manufacturing, though the requirement is at regular intervals.Most of the automobile manufacturers are usually buying the components from outsideinstead of producing them on their own. The Maruthi Udyog ltd had given a contract tothe Nettur Technical Training Foundation, Bangalore to design the tool for the panel andto manufacture regularly to the tune of the orders.

The leading four wheeler manufacture in India is buying the panel from the NTTF oncontract basis instead of manufacturing.

193

Marginal CostingWhy don't they manufacture in spite of buying them from the NTTF ?

The main reason of buying is cheaper than the production of an article.

Illustration 8

The management of a company finds that while the cost of making a component part isRs. 20, the same is available in the market at Rs. 18 with an assurance of continuoussupply.

Give a suggestion whether to make or buy this part. Give also your views in case thesupplier reduces the price from Rs. 18 to Rs. 16.

The cost information is as follows

Material Rs 7,00

Direct Labour Rs. 8.00

Other variable expenses Rs. 2.00

Fixed expenses Rs. 3.00

Total Rs.20.00

The first point to be found out that the contribution of the transaction. The cost ofmanufacturing should be compared with the price of the product which is available in themarket.

To find out the worth of the transactions, first the cost of manufacturing should be foundout

Material Rs. 7.00

Direct Labour Rs. 8.00

Other variable expenses Rs. 2.00

Total Rs.17.00

The cost of manufacturing a component is Rs.17.00. While calculating the cost ofmanufacturing a component, the fixed expenses was not considered. The fixed expenseswere not considered for computation. Why?

The costs will be incurred irrespective of the production status of the firm; for which theexpenses should not be added.

If the company manufactures the product/ component at Rs.17 which will facilitate tobook profit Rs. 1 from the price of Rs.18 which is available from the market.

The next stage is decision criteria.

11.9.2 Worth of Production

Cost of the production < Price of the product available in the market

The firm is better advised to take the course of production rather than purchase of theproduct.

11.9.3 Worth of Purchase

Cost of the production > Price of the product available in the market

The product available in the market is dame cheaper than the manufacturing of a product.The firm is better advised to buy the product rather than the manufacturing of a productIf the product price comes down to the price of Rs.16 facilitates the firm to save Re 1from the cost of manufacturing.

194


Illustration 9

A refrigerator manufacturer purchases a certain component @ Rs.50 per unit. If hemanufactures the same product he has to incur a fixed cost of Rs.20,000 and variablecost per unit is Rs. 40/- when can the manufacturer make on his own or when he canbuy from outside ?

When the requirements is Rs. 5,000 units, will you advise to make or buy?

The very first point to be found that Break even point in units.

The break even point in units at which the cost of buying is equivalent to the cost ofmanufacturing.

The cost of purchase per unit - Rs 50/-

If the same product is manufactured, what would be the total cost of manufacture ?

Total cost of manufacture= Total fixed cost + Variable cost

The cost of buying is felt that an exorbitant one than the cost of manufacturing. Havingobserved, as a manufacturer undergoes for the manufacturer of a component. If hemanufactures a component, he could save Rs.10=( Rs.50–Rs.40) Which in other wordsknown as contribution per unit

Before finding out the Break even point in units, the contribution of the product should befound out.

Contribution margin per unit= Selling price in the market – Cost of manufacture

Contribution margin per unit is nothing but the amount of savings to the manufacture.

Amount of savings out of the manufacture = Purchase price – Variable cost

Though the firm enjoys savings, it is required to additionally incur fixed cost of operationsRs.20,000

Break even point in units = Fixed cost

Purchase price- Variable cost

= Rs.20,000

Rs.50–Rs.40 = 2,000 units

At 2,000 units, the firm considers both alternatives are incurring equivalent volume ofCost in manufacturing.

Cost of buying for 2,000 units

=2,000 units × Rs.50 per unit= Rs. 1,00,000

Cost of Buying Break even in Rupees

= Rs.20,000 + 2,000 units × Rs.40 = Rs.1,00,000

From the above, it obviously understood that both are bearing equivalent amount ofcosts. It means both are neither profitable nor non- profitable.

Which one is better for the firm?

No of Units Manufacturing cost Buying cost Decision

@ 2,001 units Rs.20,000+ Rs.80,0040 =Rs.1,00,040

2001 × Rs.50 = Rs.1,00,050

Manufacturing cost < Buying cost Advisable to manufacture

@1,999 units Rs.20,000+Rs.79,960 =Rs.99,960

1,999 × Rs.50 Rs.99,950

Manufacturing cost > Buying cost Advisable to Buy

195

Marginal CostingThe next step is to identify the worth of either manufacturing the units or buying the unitsat 5,000

If the manufacturer buys from the outsider= 5,000 × Rs.50= Rs.2,50,000

If the same manufacturer produces the component instead of buying

=Rs.20,000+ Rs.2,00,000= Rs.2,20,000

From the above, the company is finally advised to manufacture the component due tolow cost of manufacture.

11.10 ACCEPTING THE EXPORT OFFER

Illustration 10

The cost statement of a product is furnished below

Direct material Rs.10.00

Direct wages Rs.6.00

Factory overhead

Fixed Rs1.00

Variable Rs.1.00 Rs.2.00

Administrative expenses Rs.1.50

Selling or distribution overheads

Fixed Rs.0.50

Variable Rs.1.00

Rs.1.50

Selling price per unit Rs.24.00 Rs.21.00

The above figures are for an output of 50,000 units. The capacity for the firm is 65,000units A foreign customer is desirous of buying 15,000 units a price of Rs.20 per unit.

Advise the manufacturer whether the order should be accepted, what will be youradvise if the order were from the local merchant?

The acceptance of the order is mainly based on the two important covenants viz Additionalcost and Additional revenue.

If the additional demand of the foreign buyer is able to generate the additional revenuemore than the additional cost of the operations, the firm should have to accept the foreignorder.

Decision criteria

Marginal/Additional cost for the additional order of 15,000 units

The acceptance of the order will generate marginal profit of Rs.30,000 which should beaccepted. The fixed portion of the factory and selling overheads were already met out

Per unit (Rs) 15,000 units

Selling price 20 3,00,000

Less:Marginal cost Rs

Direct material 10.00

Direct wages 6.00

Variable overhead

Factory 1.00

Selling & Distribution 1.00 18 2,70,000

2 30,000

196


which should not be included again in the computation of the marginal or additional costof the foreign order placed by the business enterprise.

Instead, If the firm accepts the local order at the rate of Rs.20 which automatically willspoil the relationship with the very good customers who regularly purchase at the rate ofRs.24. This will lead to cannibalization of the existing pricing strategy.

11.11 KEY FACTOR

Key factor is nothing but a limiting factor or deterring factor on sales volume, production,labour, materials and so on.

The limiting factor normally differs from one to another

Volume of sales- the limiting factor is that production of required number of articles

Volume of production- the limiting factors are as follows in adequate supply of rawmaterials, labor, inability to sell the produced articles and so on

The limiting factors are studied in the lights of the contribution. The limiting factor isbearing the inverse relationship with the volume of contribution. To study the worth ofthe business proposals among the limiting factors, the contribution is considered as aparameter to rank them one after another.

Illustration 11

From the following data, which product would you recommend to be manufactured in afactory, time being the key factor?

(I.C.W.A.Inter)

The product is being chosen by the manufacturer based on the ability of generatinghigher contribution. The higher the contribution leads to a better the position for the firmThe worth of the product is being selected on the basis of

From the above calculation, it is obviously understood that the firm is having highercontribution margin per hour in the case of product A over the other one, portrays theproduct A is better than B.

Illustration 12

The following particulars are obtained from costing records of a factory:

Particulars Per unit of Product A Rs Per unit of Product B Rs

Direct Material 24 14

Direct Labor @ Re 1per hr 2 3

Variable overhead Rs.2 per hr 4 6

Selling price 100 110

Standard time to produce 2 Hours 3 Hours


Selling price 100 110

Less :Direct Material 24 14


Variable overhead Rs.2 per hr 4 30 6 23

Contribution 70 87

Standard time to produce 2 Hours 3 Hours

Contribution per hour per product Rs.70/2 Hrs= Rs.35 Rs.87/3 Hrs= Rs 29


Direct Material Rs.20 per Kg 80 320

Direct Labor @ Re 10per hr 100 200 Contd...

197

Marginal Costing

Comment on the profitability of each product during the following conditions:

(a) In adequate supply of raw material

(b) Production capacity is limited

(c) Sales quantity is limited

(d) Sales value limited

The first step is to determine the Contribution per product.

According to the constraints given in the problem, contribution of two products should becompared.

Now the contribution per unit has found out with the help of above given information thenext step is to study the contribution margin per unit to the tune of given constraints ofthe firm.

(a) The first constraint is in adequate supply of the raw material: The raw materialsare considered to be precious due to insufficient supply to the requirement of thefirm. Having considered the scarcity of the raw material, the constraint in availingthe raw material is denominated in terms of ability of contribution generation.

It obviously understood that the firm enjoys greater contribution margin per k.g inthe case of Product A during the scarcity of raw material than the product B.

(b) Then the production capacity of the firm is subject to the availability of the labour andthe hours normally consumed by them for the production of a single product. Due toshortage of the labour, the firm should identify the product which requires lesserlabour hours as well as able to generate more contribution margin per labour hour.

In the next step, Contribution margin per hour should be calculated.


Selling price 400 1,000

Direct Material Rs.20 per Kg 80 320


Variable overhead 40 220 80 600

Contribution margin per unit 180 400



Consumption of raw material per unit Cost of raw material per unit Cost of material per Kg

Rs 80 = 4 Kgs Rs.20

Rs.320 = 16 Kgs Rs20

Contribution per Kg Rs. 180 = Rs.45 4 Kgs

Rs.400 = Rs.25 16 Kgs



Consumption of Labor Hrs Cost of Labor per unit Cost of Labor per Hour

Rs100 = 10 Hrs Rs.10

Rs.200 = 20 Hrs Rs10

Contribution per Hr of the product

Rs. 180 = Rs.18 10 Hrs

Rs.400 = Rs. 20 20 Hrs

Variable overhead 40 80

Selling price 400 1,000

Total fixed overheads Rs.30,000

198


The contribution per hour is greater in the case of the product B, considered to beas a better product among the given. It means that the firm has better opportunityto earn greater contribution in the case of product B than A.

(c) The next one is that sale of the quantities is the major limiting factor. It means thatthe vendor finds some what difficulties in selling the articles. While considering thedifficulties in selling the quantities, the firm should identify the product which is ableto generate greater contribution.

From the earlier calculation, it is clearly understood that, the product B is bearinggreater value of contribution margin per unit than the product.

(d) If the sales value is considered to be a limiting factor, to choose one among thegiven products PV ratio is being applied as a measure. It means that the salesvalue of the products are ignored for comparison in between them. To identify thebetter product, irrespective of the price, PV ratio should be applied. The PV ratioof the Product A & B are calculated as follows

Profit volume ratio = Contribution

Sales × 100

For A = 45%

For B = 40%

The PV ratio is greater in the case of product A than B. The product A has to bechosen

Check Your Progress

1. Which is the following factor equated to the Contribution at the level of Break EvenPoint ?

(a) Fixed cost (b) Sales

(c) Variable cost (d) Semi-Variable cost

2. What is the change to be made on the BEP formula to find out the volume of sales atthe desired level of profit ?

(a) Desired profit (b) Fixed cost

(c) Desired profit with Fixed cost (d) Desired cost + Fixed profit

11.12 SELECTING THE SUITABLE PRODUCT MIX

In the market, dealership is offered by the various companies to the individual intermediariesin promoting the sale of products. Before reaching an agreement with the company to actas a dealer, normally every individual consider the profitability of the product mix offeredby the firm. For e-g There are two different companies brought forth their advertisementsin offering the dealership to the individual trading firms viz HCL and IBM.

The profitability under the dealership banner should be appropriately considered prior totake decision. To take rational decision, the firm should compare the profitability of bothdifferent dealership of two different giant industrial brands. The greater the share of theprofitability in volume will be selected and vice versa.

Check Your Progress

1. If the supply of the material is considered to be scared in the market for two differentunits of production of ABC ltd. How the worth of the units of production could bestudied through Key factor analysis?

Contd...

199

Marginal Costing(a) Contribution per unit (b) Contribution per labour

(c) Contribution per hour (d) None of the above

2. While accepting export order, which component of influence should not be taken intoconsideration?

(a) Direct material (b) Direct expenses

(c) Direct labour (d) Fixed cost

3. If Licon co ltd wants to induct a product B along with the existing product line, whatwould be the deciding factor to undertake or reject?

(a) Composite contribution (b) Fixed cost

(c) Contribution margin per unit (d) None of the above

Illustration 13

From the following information has been extracted of EXCEL rubber products ltd

The directors want to be acquainted with the desirability of adopting any one of thefollowing alternative sales mixes in the budget for the next period.

(a) 250 units of A and 250 units of B

(b) 400 units of B only

(c) 400 units of A and 100 units of B

(d) 150 units of A and 350 units of B

State which of the alternative sales mixes you would recommend to the management?

The first step is to determine the contribution margin per unit of A and B.

The determination of the contribution of product A and B are through the preparation ofMarginal costing statement.

The next step is to determine the profit level of every mix.

(a) 250 units of A and 250 units of B

The first step is to determine the total contribution of the mix. Why the totalcontribution has to be found out?

The main reason is to determine the profit level of the mix through the deduction ofthe fixed overheads

Direct materials A Rs 16

Direct materials B Rs12

Direct wages A 24 Hrs at 50 paise per hour

Direct wages B 16 Hrs at 50 paise per hour

Variable overheads 150% of wages

Fixed overheads Rs. 1,500

Selling price A Rs.50

Selling price B Rs.40

Particulars Product A Rs Product B Rs

Selling price 50 40

Less: Direct Materials 16 12

Direct wages 12 8

Variable overheads 18 12

Variable cost 46 32

Contribution 4 8

200


Product of A 250 units× Rs.4= Rs.1,000

Product of B 250 units× Rs.8= Rs.2,000


Fixed overheads Rs.1,500

Profit Rs.1,500

(b) 400 units of B only

Product B Contribution 400 units× Rs.8 = Rs.3,200


Profit Rs.1,700

(c) 400 units of A and 100 units of B

Product of A 400 units× Rs.4 Rs.1,600

Product of B 100 units× Rs.8 Rs. 800



Profit Rs.900

(d) 150 units of A and 350 units of B

Product A × 150 units Rs.4 Rs.600

Product B 350 units× Rs.8 Rs.2,800



Profit Rs.1,900

The profit level among the given various mixes, the mix (d) is able to generatehighest volume of profit over the others

11.13 DETERMINING OPTIMUM LEVEL OFOPERATIONS

Under this method, the level has to be found out which is having lesser selling price, costof operations and greater profits known as optimum level of operations.

Illustration 14

A factory engaged in manufacturing plastic buckets is working at 40% capacity andproduces 10,000 buckets per annum.

The present cost break up for bucket is as under

Material Rs.10

Labour Rs.3

Overheads Rs.5(60% fixed)

The selling price is Rs 20 per bucket

If it is decided to work the factory at 50% capacity, the selling price falls by 3%. At 90 %capacity the selling price falls by 5% accompanied by a similar fall in the prices of material.

Mix A B C D

Contribution Rs.1,500 1,700 900 1,900

201

Marginal CostingYou are required to calculate the profit at 50% and 90% capacities and also calculatebreak even point for the same capacity productions. (C.A.Inter May,1976)

The very first step is to compute number of units at every level of capacity i.e. 50% and90%.

But in this problem, 40 % capacity utilization given which amounted 10,000 units.

For 50% = 10,000

40 units × 50 = 12,500 units

For 90 % = 10,000 units

40 × 90 = 22,500 units

The important information is that the changes taken place in the selling price of theproduct.

Selling price = Rs.20 @ 40% i.e., 10,000 units

Selling price @ 50% i.e. 12,500 units = Rs.20–3% on Rs.20 = Rs.19.40

Selling price @90% i.e. 22,500 units=Rs.20–5% on Rs.20 = Rs.19

While preparing the marginal costing statement, the fixed cost portion should not beincluded for the computation of the contribution.

The next step is to prepare the marginal costing statement.

The last step is to determine that the break even point

11.14 ALTERNATIVE METHOD OF PRODUCTION

It is a method to identify the best method of production to generate greater contributionas well as profit. The method which is able to earn greater profit only will be considered,known as limiting factor method.

Illustration 15

Product X can be produced either by machine A or machine B. Machine A can produce100 units of X per hour and machine B 150 units per hour. Total machine hours availableduring the year are 2,500. Taking into account the following data determine the methodof profitable manufacture.

Particulars 50 % capacity(12,500 Units) 90% capacity Rs(22,500 units

Per unit Rs Total Rs Per unitRs TotalRs

Selling price 19.40 2,42,500 19.00 4,27,500

Less: Direct Materials 10 1,25,000 9.50 2,13,750

Direct wages 3 37,500 3 67,500

Variable overheads 2 25,000 2 45,000

Variable cost 15 14.50

Contribution 4.40 55,000 4.50 1,01,250

Fixed costs 30,000 30,000

Profit 25,000 71,250

Particulars 50 % capacity 12,500 units 90% capacity 22,500 units

Break even point in units = Fixed cost Contribution margin per unit

Rs.30,000 Rs.4.40 =6,818 units

Rs.30,000 Rs.4.50 =.6,667units

Break even point in value BEP in units × Selling price

6,818 units× Rs 19.40

=Rs.1,32,269.2

6,667units × Rs.19

=Rs.1,26,673

202

Accounting and Finance forManagers 11.15 LET US SUM UP

"Marginal cost is the amount at any given volume of output, by which aggregate costsare charged, if the volume of output is increased or decreased by one unit." MarginalCosting is defined as "the ascertainment of marginal cost and of the effect on profit ofchanges in volume or type of output by differentiating between fixed and variable costs."

In marginal costing, the change in the level of cost of operation is equivalent to variablecost due to fixed cost component which is fixed irrespective level of outputs. BreakEven Point is the point at which the Total Cost is equivalent to Total Revenue. At thebreak even point the business neither earns profit nor incurs a loss. It means that thefirm's cost is recovered at the minimum level of production. PV ratio is Profit Volumeratio which establishes the relationship in between the profit and volume of sales. It aratio normally expressed in terms of contribution towards volume of sales. It is expressedin terms of percentage. Key factor is nothing but a limiting factor or deterring factor onsales volume, production, labour, materials and so on.

The limiting factor normally differs from one to another

Volume of sales- the limiting factor is that production of required number of articles

In the market, dealership is offered by the various companies to the individual intermediariesin promoting the sale of products. Before reaching an agreement with the company to actas a dealer, normally every individual consider the profitability of the product mix offeredby the firm.


Should we evaluate a manager’s performance on the basis of controllable or non-controllable costs? Why? Give your opinion.

11.17 KEYWORDS

Marginal cost: Change occurred in the cost of operations due to change in the level ofproduction.

B E P (Units): It is the level of units at which the firm neither incurs a loss nor earnsprofit.

BEP (Volume): It is the level of sales in Rupees at which the firm neither incurs a lossnor earns profit.

Fixed cost: It is a cost which is fixed or remains the same for irrespective level ofproduction.

Variable cost: It varies along with the level of production.

Contribution: It is an amount of balance available after the deduction of variable costfrom the sales.

Key factor: Factor of influence on the component of contribution.

PV ratio: Profit volume ration which is nothing but the ratio in between the contributionand sales.

Desired profit: It is a profit level desired by the firm to earn at the given level of salesvolume.


1. Define marginal cost.

2. Define marginal costing.

203

Marginal Costing3. What is Break Even Point Analysis?

4. Explain the Graphic approach of BEP analysis.

5. Briefly explain the profit volume ratio.

6. Explain the various kinds of managerial decisions.

7. Elucidate the key factor analysis.

8. List out the advantages of marginal costing.

9. Highlight the limitations of marginal costing.


R.L. Gupta and Radhaswamy, “Advanced Accountancy”.








UNIT-IV

LESSON

12 FINANCIAL MANAGEMENT

CONTENTS


12.1 Introduction

12.2 Finance and Related Disciplines

12.2.1 Finance and Economics

12.2.2 Finance and Accounting

12.3 Profit Maximization

12.3.1 Criticism

12.4 Wealth Maximization

12.5 Objectives & Functions of Financial Management

12.6 Let us Sum up


12.8 Keywords




In this lesson we shall discuss about financial management. After going through thislesson you will be able to:

(i) discuss finance and related disciplines

(ii) analyse profit maximisation and wealth maximisation

(iii) understand objectives and functions of financial management

12.1 INTRODUCTION

The financial management was initially perceived that the study with reference to onlyprocurement of funds but later it was extended to one more additional feature that efficientutilization of funds.

It is imperative to understand the meaning of the term “Finance”

l Money with objective

l Money with purpose

l Money with direction

l Money with target

l Money with achievement

l Money with aim

The above explanation is able to understand the real meaning of the term finance which isnothing but effective utilization raised money with some purpose to achieve in desired direction.

208

Accounting and Financefor Managers 12.2 FINANCE AND RELATED DISCIPLINES

The study of role of finance in the organization is with reference to financial management.The financial management is the course which has drawn major focus points from themany more disciplines. To study them, the inter relationship in between the financialmanagement and other related disciplines.

The following are the related disciplines viz

l Finance and Economics

l Finance and Accounting

l Finance and Marketing

l Finance and production

l Finance and Quantitative Methods

12.2.1 Finance and Economics

The relationship in between these two disciplines are studied in two different headingsviz Micro and Macro economics

The major part of the financial management is to raise the financial resource to therequirements. While raising the financial resources, the availability is subject to the macroeconomic influences.

l Banking system

l Money and capital markets

l Financial intermediaries

l Monetary and credit policies

12.2.2 Finance and Accounting

The two are embedded with different disciplines. The finance is the discipline which ismainly based on the cash basis of operations but the accounting is totally governed bythe accrual system.

Accounting is mainly vested with the collection and presentation of data, but the financeis closely connected with the decision making of the organization.

Till this moment, the differences are discussed only to know the role of finance over theaccounting of any organization. The following is the major relationship which lies inbetween the finance and accounting as follows "Finance begins where accounting ends"

l Finance and Marketing: These two are disciplines are interrelated to plan forintroduction of new product. The major reason is that the introduction of newproduct normally warrants huge sum of money for research and development ;which needs immense planning and execution to succeed over the other competitors

l Finance and Production: The changes in the production policy of the organizationwill impact the capital expenditures. The fixed assets of the organization should beeffectively utilized which neither over capitalization nor under capitalization

l Finance and Quantitative methods: These are inter related to solve complexproblems in order to take decisions.

The objectives of the financial management are classified into two categories viz

l Profit maximization

l Wealth maximization

Let us discuss these two one after the another. The objectives of the financial managementis discussed only to the tune of normative framework in between the financing, investmentand dividend functions of the management.

209

Financial ManagementCheck Your Progress

Financial management is the course which has drawn major focus pointsfrom the many more disciplines. Discuss.

12.3 PROFIT MAXIMIZATION

The projects are considered on the basis of the following criterion:

If the project is having the scope to have an increase in the volume of profits, the projectis suggested to accept and vice versa.

The financing, investment and dividend decisions of the enterprise is dome shaped towardsthe profit maximization.

Under this, the profit is defined in two different angles viz. Owner's and Operationalperspective.

Owners' perspective definition of profit is the share of national income paid to the owners.

Operational perspective defines the term profit as when the output exceeds the inputs ofthe process.

The testing, selecting of the assets and projects are normally on the basis of the profitabilityof the firm. If the firm is found to be profitable, suggested to accept, otherwise, thedecision is vice versa.

Profit is a test of economic efficiency which is individual aim to achieve at alwaysthough it is closely associated with the social welfare.

12.3.1 Criticism

There is misapprehension about the workability of the private enterprise which normallystrives for the profit maximization but not by considering the welfare of the society

The next most important criticism is that in ability to fit into the practical considerations

The second set of criticism is that the set of technical flaws or set backs associated withthe financial management.

The technical flaws of the profit maximization is studied under three different headings viz:

Ambiguity

Timing of benefits

Quality of benefits

Ambiguity: Profit is to be maximized; which profit has to be maximized? Either Net profitor Gross profit is to be maximized? Whether the short term or long term profit is to bemaximized? Whether total profit or rate of profit is to be maximized? Whether the returnon the total assets employed or the return on the total capital employed is to be maximized?The maximization of profit is vague due unclear definition of the term profit.

Timing of Benefits

From the above table, the two alternative projects A and B are found to be identical withreference to profit maximization due to equivalent volume of profits of them.

Really speaking, these two projects are not identical, why?

Project Alternative A Rs Lakh

Alternative B Rs Lakh

Period 1 50 -------

Period 2 100 100

Period 3 50 100

Total 200 200

210


One missing phenomenon is that timing of benefits.

The timing of benefits should be relatively given greater importance for weighing theproject at the moment of consideration.

Project alternative A is better than the project alternative B, why?

Project alternative A is able to generate the benefits during the period 1 which is knownas earlier benefits, facilitating the A alternative to go for reinvestment, but in the case ofreinvestment opportunity is denied due to non availability of profits during the early seasoni.e. period 1

Quality of Benefits

Under the profit maximization, the quality of benefits are not considered what is meantby the quality of benefits?

It means the certainty of benefits. The more certain the benefits is better the quality ofbenefits and vice versa. The profit maximization failed in its attempt to consider thequality of benefits. It has considered the both project are identical but really they are not.Alternative B project is more volatile returns in other words they are more uncertainunlike the project A. The project A is having only least volatility in the earning patternduring the three seasons. A is the better project which has greater certainty in accruingbenefits over the others, are normally preferred by the risk averters.

12.4 WEALTH MAXIMIZATION

The next important set of objectives taken for discussion is Wealth maximization

Only in order to replace bottlenecks which were associated with the profit maximization.

Wealth maximization means that value / net worth maximization.

The Worth of Action normally happens only at when the Value of benefits are more thanthe Cost of its undertaking. In other words, the wealth maximization is defined in theangle of the concept of cash flows. The Cash flows are clearly dealt only in accordancewith the "CASH SYSTEM"-Definite Connotation

l It eliminates the ambiguity associated with accounting profits

l Second feature - timing of benefits and quality of benefits are jointly considered

l Operational implications of timing of benefits and quality of benefits

The timing and quality of benefits are given greater importance under the wealthmaximization through the incorporation of capitalization rate which is applied to the tuneof risk and timing of benefits associated with the project.

The discounting component mainly depends upon the time and risk preferences of theowners of the capital

The importance of the wealth maximization is explained through the discount ratecomponent

Higher the discount Rate reveals that Higher Risk and Higher uncertainty

Lower the discount Rate portrays that Lower Risk and Lower uncertainty

Project Alternative A Rs Lakh

Alternative B Rs Lakh

Recession 9 0

Normal 10 10

Boom 11 20

Total 30 30

211

Financial ManagementThe Decision Criterion is based on the comparison in between the Value and Cost

The Creation of Value takes place only at when the economic benefits are more thanCost

The Reduction of wealth just contrary to the earlier which normally produces lesserEconomic Benefits than Cost

The decision of either acceptance or rejection is subject to the net present value

It is imperative to refer the words of Ezra's Solomon to illustrate the importance of thewealth maximization

"The gross present worth of a course of action is equal to the capitalised value of theflow future expected benefit, discounted at a rate which reflects theircertainty/uncertainty. Wealth or net present worth is the difference between gross presentworth and the amount of capital investment required to achieve the benefits beingdiscussed. Any financial action which rates wealth or which has a net present worthabove zero is a desirable one and should be undertaken. Any financial action which doesnot meet this test should be rejected. If two or more desirable courses of action aremutually exclusive, then the decision should be to do that which creates most wealth orshows the greatest amount of net present worth"

l W = V-C

l W = Net present worth

l V = Gross present worth

l C = Investment required to acquire the asset/purchase the course of action

l V = E/K

l E = Size of the benefits available to the suppliers of capital

l K = capitalization rate reflecting quality and

Timing of benefits attached to E

l E = G–(M+I+T)

l G = Average future flow of gross earnings expected from the course of action,before the maintenance charges, taxation, expected flow of interest, preferencedividend

l M = Average annual required investment to maintain G

l I =Expected flow of annual payments of Interest, Preference Dividend and otherprior charges

l T=Expected annual outflow of taxes

Alternate method:

l 1 2 3 n

A1 A2 A3 An....... C

(1 K) (1 K) (1 K) (1 K)+ + + -

+ + + +

A1, A2, A3--------depicts the flow of cash resources from a course of action over theperiod of time

K=is an appropriate discount rate

C=Initial outlay to acquire the asset

If the out come is positive means that net present worth is positive i.e., more than theinitial investment, considered to be fruitful for the investment and vice versa

Wealth of the investors= market value of the shareholding of the investors

If net worth is positive then the wealth of the investors will go up ; it means that themarket value of the share holding of the investors will pile up.

It is called in other words as Maximization of market value of the shares.

212

Accounting and Financefor Managers 12.5 OBJECTIVES & FUNCTIONS OF FINANCIAL

MANAGEMENT

The next aspect is that organization of finance function.

The finance function is classified into two categories viz routine functions and functionsof special importance.

The routine functions are normally Accounting aspects of transactions of the businessenterprise which mainly given controller of the finance department.

The functions of special importance are normally involved in the process of preparingthe policies of the organization with reference to finance administration ; which is mainlyearmarked to the Treasurer of the finance department of the organization

The following are the important functions of the Treasurer which normally have specialimportance in characteristics:

l Obtaining finance

l Banking relationship

l Investor relationship

l Short-term financing

l Cash management

l Credit administration

l Investments

l Insurance

The following are the vital functions of the Controller which regularly include:

l Financial accounting

l Internal audit

l Taxation

l Management accounting and control

l Budgeting, planning and control

l Economic appraisal and so on

Check Your Progress

1. Finance is the

(a) Money with motive (b) Money with purpose

(c) Money with objective (d) (a), (b) and (c)

2. Wealth is defined as

(a) Gross cash flow (b) Net cash flows

(c) Initial investment (d) None of the above

3. Why profit maximization is sidelined ?

(a) Ambiguous (b) Lack of quality of benefits

(c) Timing of benefits (d) (a), (b) and (c)

4. Which of the following function is the treasurer of the organisation?

(a) Obtaining finance (b) Financial accounting

(c) Internal audit (d) None of the above

213

Financial Management12.6 LET US SUM UP

The major part of the financial management is to raise the financial resource to therequirements. While raising the financial resources, the availability is subject to the macroeconomic influences. Accounting is mainly vested with the collection and presentation ofdata. But the finance is closely connected with the decision-making of the organization.

The objectives of the financial management are classified into two categories viz

l Profit maximization

l Wealth maximization

Profit is defined in two different angles viz. Owner's and Operational perspective.

Owners' perspective definition of profit is the share of national income paid to the owners.

Operational perspective defines the term profit as when the output exceeds the inputs ofthe process. "The gross present worth of a course of action is equal to the capitalisedvalue of the flow future expected benefit, discounted at a rate which reflects theircertainty/uncertainty. Wealth or net present worth is the difference between gross presentworth and the amount of capital investment required to achieve the benefits.


What factors would you look at while taking capital structure decisions? Give your opinion.

12.8 KEYWORDS

Finance: A study of money with objective and desired direction

Profit: In terms of operations - Input < Output

Treasurer: Who carries out the financial management operation with special importance

Controller: Who carries out the routine functions of finance

Wealth maximization: Net present worth maximization; maximization of the marketvalue of the shares


1. What is meant by finance?

2. Explain the relationship in between the finance and their related disciplines.

3. Explain the objectives of financial management.

4. Elucidate the profit maximization in detail.

5. List out the drawbacks associated with the profit maximization.

6. Highlight the importance of Wealth maximization.





S.N. Maheswari, “Management Accounting”





214


13 TIME VALUE OF MONEY

CONTENTS


13.1 Introduction

13.2 Foundations of The Time Value of Money

13.3 Classifications of The Time Value of Money

13.3.1 Rule of 72

13.3.2 Rule of 69

13.4 Frequency of Compounding

13.5 Effective Rate of Interest

13.6 Future Value of an Annuity

13.6.1 Future Value of Annuity Due

13.6.2 Sinking Fund Factor Method

13.7 Present Value of Single Cash Flow

13.8 Present Value of Annuity

13.9 Capital Recovery Factor Method

13.10Let us Sum up


13.12Keywords




This lesson is intended to discuss the concept of time value of money and its role instudying the viability of the project by comparing the initial investment future benefits.After studying this lesson you will be able to:

(i) describe concept and components of the time value of money

(ii) classify the time value of money and describe rules of 72 and 69

(iii) understand effective rate of interest and future value of an annuity

13.1 INTRODUCTION

The time value of money has gained greater importance in studying the viability of theproject by comparing the initial investment with the anticipated future benefits. If theanticipated future benefits are more than the initial investment then the investment isfound to be viable in generating the economic benefits.

215

Time Value of MoneyWhy the time value of money principle is warranted to study under the financialmanagement ?

The following are the many reasons involved:

To determine the real rate of return

l With reference to Money employment on productive assets

l In an inflationary period, a rupee today has greater purchasing power than rupee inthe future

l The future is uncertain- Individuals prefer current consumption rather than futureconsumption

13.2 FOUNDATIONS OF THE TIME VALUE OF MONEY

There are two, one is the time preference of money and another one is reinvestmentopportunity which are identified and inter related with each other.

Early receipt of money paves way for the reinvestment opportunity but the later receiptdoes not carry the things.

Time value of money normally contains three different components viz:

Real rate of return: It is the return which consider original return of the investment butit never considers the inflation rate.

Expected/Anticipated rate of return: It is the positive rate of return normally expectedby every one on the amount of investment from the future.

Risk premiums: This an allowance is normally given to the investors to compensate theuncertainty.

13.3 CLASSIFICATIONS OF THE TIME VALUE OFMONEY

The concept of time value of money can be classified into two major classifications:

l Future value of money

l Present value of money

Future value of money: It is further bifurcated into two different categories viz

Future value of single sum and Future value of an Annuity

Present value of money: It is further classified into two major classes viz

Present value of single sum and Present value of and Annuity

Future value of single sum:

l It could be found from the inbound relationship in between the future value ofmoney and present value of money.

l FVn = PV(1+K)n

FVn = Future Value of Cash Inflow

PV = Initial Cash Flow

K = Annual Rate of Return

N = Life of Investment

Illustration 1

If you deposit Rs.1,000 today in a Indian bank which pays 10% interest, find out thefuture value of money after 3 years.

216


Future value of Rs.1,000 after three years will be = Rs.1,000(1+.10)3

= Rs.1,000(1.331)= Rs. 1,331

Doubling period: It is the period which makes the investment as "Doubled"

There are two different approaches viz

l Rule of 72

l Rule of 69

13.3.1 Rule of 72

The initial amount of investment gets Doubled within which 72/I

I = Interest Rate of the investment

Illustration 2

The amount of the investment is Rs.1,000. The annual rate of interest is 12%. When thisamount of Rs.1,000 will get doubled ?

= 72/12 = 6 years

13.3.2 Rule of 69

The amount method is found to crude method in determining the doubling period whichhas its own limitations. The Rule of 69 was developed only in order to remove thebottlenecks associated with the early model of doubling period.

The rule of 69 is found to be a scientific method as well as rational method in determiningthe doubling period of the investment

=.35+ 69/I

Illustration 3

The amount of the investment is Rs.1,000. The annual rate of interest is 11% When thisamount of Rs 1,000 will get doubled?

=.35+ 69/11= 6.6227 yrs

Check Your Progress

1. State Bank of India announces that your money is getting doubled in 99 months.What is the rate of interest payable ?

2. The next aspect in the Future value of money is interest frequency ofcompounding.

13.4 FREQUENCY OF COMPOUNDING

Whenever any compounding is taking place, the following methodology has to be adoptedfor the determination of the future value of money.

FV = PV(1+k/m)mxn

M = Number of Times Compounding is done during the year

N = number of years

K = compounding rate

217

Time Value of MoneyIllustration 4

How much does a deposit of Rs. 5,000 grow to at the end of 6 years. If the nominal rateof interest is 12% and frequency is 4 times a year?

The future value of Rs. 5,000 will be

= Rs.5,000(1+.12/4)4×6

= Rs.5,000(2.033)= Rs.10,165

13.5 EFFECTIVE RATE OF INTEREST

It is the rate of interest at which mount of the principal grows with regards to the rate ofcompounding.

r = (1+K/m)m - 1

K = Nominal Rate of Interest

r = Effective Rate of Interest

m = Frequency of Compounding

Illustration 5

A bank offers 8% nominal rate of interest with quarterly compounding.

What is the effective rate of interest ?

R = (1+.08/4)4 -1=1.082-1=.082 i.e 8.2%

13.6 FUTURE VALUE OF AN ANNUITY

l Annuity may be a series of either payments or receipts

l The annuity can be classified into two categories

v Annuity at the end of the period- Regular / Deferred Annuity

v Annuity at the beginning of the period - Annuity Due

Annuity at the end of the period

FVAn =

[ ]k

1nK)(1 A −+= Future Value Interest Factor Annuity (FVIFA)

Illustration 6

Suppose you deposit Rs.1,000 annually in a bank for 5 years and your deposits earn acompound interest rate of 10% What will be value of the deposit at the end of 5 years?Assuming the each deposit occurs at the end of the year, the future value of this annuity?

FVAn = Rs.1,000(FVIFA) for 10% and 5 years

= Rs.1,000 5[(1 .10) -1]

.10

+

= Rs.1,000 × 6.105 = Rs.6,105

13.6.1 Future Value of Annuity Due

FVAn =

[ ]k

1nK)(1 A −+= × (1+k)

218


Illustration 7

If you invest Rs 1,000 at the beginning of every year, for four years. What will be thevalue of the investment finally.

FVAn = Rs.1,000

[ ]10.

1)10.1( 5 −+ × (1+.10)

= Rs.1,000 × 6.7155= Rs.6,715.5

Check Your Progress

1. Four annual equal payments of Rs.2,000 are made into a deposit accountthat pays 8% interest per year. What is the future value of this annuity at theend of 4 years ?

2. You can save Rs.2,000 a year for 5 years, and Rs.3,000 a year for 3 yearsthereafter. What will these savings cumulate to at the end of 8 years. If therate of interest is 10?

13.6.2 Sinking Fund Factor Method

It means that the amount to be deposited at the end of every year for the period of "n"years at the rate of interest "K" in order to aggregate Re.1 at the end of the period.

A = FVA [K/(1+K)n -1]

Illustration 8

How much you should save annually to accumulate Rs.20,000 by the end of 10 years. Ifthe saving earns an interest of 12 %?

A = Rs.20,000[.12/(1+.12)10 -1]

= Rs.20,000(.05698)=Rs.1,139

The next most important segment is present value of money. First we will discuss thepresent value of single cash flow

Check Your Progress

1. How much you should save annually to accumulate Rs.20,000 by the end of10 years. If the saving earns an interest of 12%?

2. Mr vinay plans to send his son for higher studies abroad after 10 years. Heexpects the cost of these studies to be Rs.1,00,000. How much should hesave annually to have a sum of Rs 1,00,000 at the end of 10 years. If theinterest rate is 12%?

13.7 PRESENT VALUE OF SINGLE CASH FLOW

It is the process in which the future value of single cash flow is reckoned to "0" timehorizon i.e on today.

PVn = FV

n /(1+R)

n

Illustration 9

Find the present value of Rs.1,000 receivable 6 years hence if the rate of discount is 6 percent

PVn = Rs.1,000/(1+.06)6

= Rs.1,000(.705)

= Rs.705

219

Time Value of MoneyShorter Discounting Periods

l The discounting may be frequent in times like intra year compounding, intra monthcompounding and so on.

l Subject to

v Number of periods in the analysis- increases

v Discount rate applicable per period decreases

v PV= FV m xn

1

1 + k /mÊ ˆÁ ˜Ë ¯

v M = number of times discounting

v K = Discount rate

Illustration 10

Consider the following cash inflow of Rs.10,000 at the end of four years. The presentvalue of cash inflow when the discount rate is 12% and discounting quarterly.

PV = Rs.10,000 × (.623)=Rs.6,230

Check Your Progress

To get Rs.20,000, how much should be invested per year (at the end). The importantinformation of the banking investment reveals the following are the rate of interestis 10% and the normal compounding process is once in 6 months.

13.8 PRESENT VALUE OF ANNUITY

l Present value of an annuity - Present value of future cash series - To identify thevalue of future cash flows on present value

l PVAn,k

= n 1

n

(1 K)

K(1 k)

-Ê ˆ+Á ˜+Ë ¯

æÆ Present value factor annuity

Illustration 11

If you expect to receive Rs.1,000 annually for 3 years, each receipt is expected to be atthe end of the years. What would be the present value of future cash inflows @ discountrate of 10% ?

PVA n,k

= Rs.1,000 × (2.487)= Rs.2,487

Check Your Progress

1. What is the present value of an annuity of Rs.2,000 at 10% ?

2. What is the present value of a 4 year annuity of Rs.10,000 discounted at10 % ?

3. A 10 payments annuity of Rs.5,000 will begin 7 years hence. (The first paymentoccurs at the end of 7 years) what is the value of this annuity now if thediscount rate is 12 per cent ?

13.9 CAPITAL RECOVERY FACTOR METHOD

A = PVA n 1

K(1 k)

(1 K) -

Ê ˆ+Á ˜+Ë ¯

æÆ Reciprocal to Present value of an annuity

220


Illustration 12

If your father deposits Rs.1,00,000 on retirement in a bank which pays 10% annualinterest. How much can be withdrawn annually for a period of 10 years?

A = PVA(1/PVIFA)

A = Rs.1,00,000 (1/6.145)= Rs.16,273

Present Value of Perpetuity

Perpetuity means that series with indefinite duration

P? = A × PVIFA k, ?

Illustration 13

The present value of perpetuity of Rs.10,000@ 10%, how much should be invested ontoday ?

A = P?/ PVIFA k, ?

= Rs.10,000/.10= Rs.1,00,000

Check Your Progress

1. Time value of money is applicable in

(a) Pay back period method (b) Accounting rate of return method

(c) Discounted cash flows method (d) None of the above

2. Compounding factor is to determine

(a) Present value (b) Future value

(c) Present value and Future value (d) None of the above

3. Annuity due means that

(a) Series at the end (b) Series at the beginning

(c) Neither at the beginning nor at the end (d) None of the above

4. Capital recovery factor method is to find out the value of annuity through

(a) Present value of an annuity

(b) Reciprocal to the present value of annuity

(c) Future value of annuity


5. Rule of 72 is for

(a) To determine the present value of the cash flows

(b) To find out future value of cash flows

(c) To find out the doubling period


13.10 LET US SUM UP

The time value of money has gained greater importance in studying the viability of theproject by comparing the initial investment with the anticipated future benefits. Real rateof return is the return which consider original return of the investment but it never considersthe inflation rate. Expected/Anticipated rate of return is the positive rate of return

221

Time Value of Moneynormally expected by every one on the amount of investment from the future.

Risk premiums is an allowance is normally given to the investors to compensate theuncertainty.


How much would you invest now at 5% per annum compounded annual if you want toget Rs. 5,00,000 after 20 years.

13.12 KEYWORDS

Time value of money: Money value in terms of time, money value in between thepresent and future

Future value of money: Present value of money in terms of future through compoundingprocess

Present value of money: Future value of money is reckoned to "0" time period horizon

FVIF: Future value interest factor component for compounding

FVIFA: Future value interest factor component for compounding the series of cashpayments or receipts

PVIF: Present value interest factor of single cash flow

PVIFA: Present value of interest factor of multiple cash flows

Regular annuity: Series which normally happen at the end of the specified horizon

Annuity Due: Series which normally happen at the beginning

Doubling period: During which the amount of the investment gets doubled within thegiven compounding factor component

Effective rate of interest: It is the rate of interest which the investment grows


1. Define time value of money

2. Explain the foundations of the time value of money

3. Explain the classifications of the time value of money

4. Illustrate the rule of 69 with live example from the banking industry

5. Explain the applications of the time value of money in the banking companies

6. Which method is applied for EMI calculation by the financing companies?










M.P. Pandikumar “Accounting & Finance for Managers” Excel Books, New Delhi.

222


14 SOURCES OF LONG TERM FINANCE


14.1 Introduction

14.2 Equity Shares

14.2.1 Sweat Security

14.2.2 Non Voting Shares

14.2.3 Bonus Issue

14.3 Preference Shares

14.3.1 Cumulative Preference Shares

14.3.2 Non Cumulative Preference Shares

14.4 Debentures

14.5 Bonds

14.6 Warrants

14.7 Let us Sum up


14.9 Keywords




In this lesson we will study about long term finances of companies. After studying thislesson you will be able to:

(i) describe the concepts of equity share, sweat security, non-voting shares and bonusissues.

(ii) distinguish between cumulative and non-cumulative preference share.

(iii) explain the features of debentures, bonds and warrants.

14.1 INTRODUCTION

The sources of long-term finance could be classified into the following categories:

l Equity shares

l Preference shares

l Debentures

l Bonds

l Warrants

223

Sources of Long Term FinanceThe combination of the sources of long-term finance is known as capital structure. Fromthe above classification, we will discuss one after the another.

14.2 EQUITY SHARES

Shares and Stock are synonymous in usage. Shares are the expression of smaller unitsof Share capital of the organization. The raising of equity share capital from the investorsin various segments viz Application money, First call money and Subsequent calls moneyare collected subject to the capital clause of the Memorandum of Association of theorganization.

After the issue, the share certificates are issued which normally depicts the expressionof right of shares.

Right of Equity Shares:

Sec. 85(2) of the Companies Act, 1956 expresses the right of the equity shareholderswho hold the equity shares

l To vote

l To control the management

l To share the profits

l To claim on the residual portion during the winding up

l To exercise pre-emptive

l To apply the court

l To receive the copy of the statutory report, copy of the annual accounts

l To apply the central government for AGM - failure on the part of the company

l To apply company law board for Extraordinary general meeting

14.2.1 Sweat Security

l It is one kind of Equity share, which was introduced in the Ordinance 1998,facilitating the companies to acquire the technical know-how, intellectual propertythrough the issue of equity shares.

l Definition

l The equity shares which are issued at discount to employees and directors andconsideration other than cash for Technical know-how, intellectual property areknown as sweat security.

Normally the sweat security is issued by the companies in two different categories:

l Sweat security which is issued at preferential pricing more specifically for employees

l Sweat security which is issued at face value, that may be either at par or above par

14.2.2 Non Voting Shares

These type of equity shares never carry any voting rights. These type of shares are alsoeligible to enjoy the bonus issue and exclusive listing for the holding of the shares. WhenTwo year Dividends are continuously missing, the nature of the non voting shares willautomatically become as Voting shares. The Non voting shares are to be declared 20%dividend more than the ordinary dividend. The issue size of the Non voting shares shouldnot exceed the maximum limit of the voting stock i.e. 25%.

224


14.2.3 Bonus Issue

This type of issue is merely considered as book entry in between the two differentsources of long term finance viz Free Reserves and Equity Share capital. This type ofissue is normally restricted to the companies which are having the partly paid equityshares. The bonus issue is permitted by making the partly paid up shares into fully paidshares. The bonus issue is normally decided in the board meeting.

14.3 PREFERENCE SHARES

These type of shares are annexed with preferential rights over the equity shares insharing the benefits organization at the moment of declaration. It is nothing but thecombination of both equity shares and debentures; why ? It has some features of equityshares and debenture through redemption. The dividends are normally paid only to thetune of fixed rat which was agreed only at the moment of issue in between the issuingcompany and investors. The dividends are normally declared by them only subject to theavailability of profits.

Type of Preference Shares: The following are the various type of preference shareswhich the company normally issues:

14.3.1 Cumulative Preference Shares

The unpaid preference dividends are paid before anything paid to equity shareholders.The unpaid preference dividends are called in other words as Arrearages. The arrearagesshould not go beyond three years. The arrearages never carry any interest rate. If anyprovision is available in the Articles of Association, the arrearages are paid to preferenceshareholders at the moment of liquidation.

14.3.2 Non Cumulative Preference Shares

The dividends are paid subject to the availability of profits. If the availability of profitsare not sufficient for the declaration of preference dividend, which do not bear any rightto receive. Due to non declaration of dividends during the previous years, these types ofshareholders are not entitled to share in the surplus benefits of the company, but they arehaving the right to receive the dividend prior to the equity shareholders in any particularyear.

No Rights to Share in the Surplus Profitsl Right to receive the dividend prior to the equity shareholders in any particular year.

The repayment of share capital normally takes place only at the moment of windingof the companies.

l Convertible preference shares: These types of shares are issued by the companyalong with the right of conversion to convert the holding into equity shares at thespecified period. Normally, during the process of conversion, the companies chargehigher premium from the shareholders. The voting powers, bonus issue, higherdividends and so on are subject to the availability of rights out of the conversion.

l Redeemable preference shares: Under this category, the amount of raised capitalis subject to redemption/repayment, which means that when any preference sharesare revealing the definite time period of repayment is known as redeemablepreference shares.

l Non redeemable preference shares: These types of preference share nevercarry any definite period of repayment but at the moment of winding up therepayment is made immediately after the creditors.

l Participating preference shares: The type of preference shares facilitates theholders to share the surplus benefits immediately after declaring the dividend benefitsto preference shareholders and equity shareholders.

225

Sources of Long Term Financel Non Participating preference shares: Except the earlier, all are nothing but nonparticipating preference shares in category.

14.4 DEBENTURES

Sec 2(12) of the Companies Act defines "Debenture includes debenture stock, bondsand any other securities of a company whether constituting a charge on the assets of thecompany". Debenture is an evidencing document i.e., long-term promissory note.

Unique Features of the Debentures

l Debentures are issued on indebtedness

l It is an instrument which indicates the time/date schedule of repayment of principalor interest

l The Charge is created on the assets of the company ; to protect the interest oflenders. If any default arises - the due amount of either principal or interest will beclaimed through direct or debenture trustees action for the realization assets inorder to secure the debt

Debentures are classified on the following basis:

l On the basis of security

l On the basis of holding

l On the basis of redemption

l On the basis of convertibility

On the basis of Security: Under this type the debentures are further classified into twocategories viz secured and unsecured debentures:

Secured/Naked Debentures: There is no charge on the assets of the company whichmeans that there is no claim on the company at the moment of default. These debenturesare normally issued by the company through their well built good will during the past.

Secured or Mortgage Debenture: The type of the debentures bearing the securitythrough the creation of charge either whole or part of the assets of the company areknown as secured or mortgage debentures. These types of debentures warrant registrationand finally immediately after the registration process the title deeds should be depositedunder the custody of the lender.

On the basis of holding: These types of debentures are further divided into two categoriesviz Bearer and Registered Debentures.

l Bearer Debenture: The interest periodical is payable to the bearer and transferableby mere delivery. It never requires registration to enter in the books. The holder issimply having the eligibility for redemption

l Registered Debentures: The holders are required to register in the register inaccordance with the Sec 152 of the Companies Act.

On the basis of redemption: This classification has two types viz Redeemable andIrredeemable:

Redeemable Debentures: Redeemable after the expiry period - Re issuance is possiblewith reference to Sec 121 of the companies act 1956

Irredeemable Debentures: These debentures are issued to redemption of specific eventwhich is non happening in nature for indefinite period for e.g. Winding up of the company.

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On the basis of Conversion: This type of debentures are trifurcated into the followingviz Fully convertible, Partly convertible and Non convertible:

Fully Convertible Debentures

This type of debentures are fully converted into Equity shares with premium or withoutpremium. The Conversion is normally takes after expiry of the period. The conversion isoptional purely left with the discretion of the debentureholders which normally ranges inbetween 18 and 36 months. The interest periodical is payable till the process of conversionis over.

Non Convertible Debentures: This type of debentures never carry any option ofconversion to avail the equity shares of the company immediately after conversion. Inother words, these debentures are denial of option of conversion.

Partly Convertible Debentures: Under this category, there are Two parts involved, onepart is meant for conversion; second part is non convertible portion:

l Convertible portion is the portion which can be availed for conversion at or after 18months upto 36 months, it is at the optional right of the debentureholders.

l Non convertible portion - It does not carry any convertible portion instead it bearsthe redeemable portion for redemption after the expiry period.

The next important classification under the long-term sources of finance is Bonds

14.5 BONDS

It is a long-term debt instrument issued by the company to raise the financial resourcesfrom the market, for specific period and it carries fixed rate of interest which has its ownsalient features

l Issued at face value i.e Par value and Par or Discount.

l Rate of interest is fixed or flexible i.e. variable / floating rate of bond - coupon rateof bond.

l Maturity date is specified but not in the case of perpetual bonds.

l Redemption value - in the bond certificate - may be par or premium - terms of theissue.

l Bonds are traded in the market.

Type of Bonds

l Secured Bond: Issued on the assets of the issuer.

l Unsecured Bond: Issued by the issuer on the basis of name and fame.

l Perpetual bond: Bonds do not have maturity.

l Redeemable bond: Redemption or Repayment of the principal is specified by theissuer.

l Fixed rate bonds: Rate of Interest is fixed at.

l Flexible/Floating rate bonds: Rate of interest is subject to prefixed norms.

The further more classification of bonds are available. They are following:

Zero Coupon bonds: These bonds are sold at discounted value and will be given at theface value after the maturity period.

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Sources of Long Term FinanceDeep discount bonds: It is another kind of zero coupon bond. Large discount is madeon their nominal value. Interest is paid only at the time of maturity - 3-25 years.

Pay in kind bonds: This another kind of long-term instrument of raising funds. Duringthe First three years, these bonds need not pay any interest to the holders of the bonds,in stead the interest bonds are issued which are known as additional bonds. These additionalbonds are called as baby bonds or kid bonds which are derived out of the parent bond. Itis identified by the many of the companies as wonderful instrument to raise the capitalfrom the market at the early stage of commencement of business.

The next type long-term instrument is that Warrants.

14.6 WARRANTS

These are nothing but Bearer documents which are title to buy the specified number ofequity shares at specified price during the future period. The life period of the warrantsare normally too long.

The warrants are normally issued by the company only in order to attract the issue offixed bearing securities viz preference shares and debentures.

The following are the various type of warrants:

l Detachable warrants: Warrants which are issued along with the host securities;detachable

l Puttable warrants: The warrants issued are sold back to company before expirydate

l Naked warrants: Warrants issued without any host securities

Advantages of the warrants

l Making other host securities more attractive

l It facilitates the companies to stand on its own leg and reduces the rate to dependon the intermediaries

l The exercise of the warrants only during the future period which fosters betterplanning for the company

l Lower cost of debt due to greater attraction towards warrants - denominated interms of equity shares - which are at later date

l Warrants are highly liquid which means they are traded in the Stock Exchangesprovided the warrants should not be exercised.

Check Your Progress

Select the most appropriate one:

1. Equity share means

(a) Equal share in the volume

(b) Equal share in the assets claim

(c) Equal and Small units of the share capital


2. Preferential share is

(a) Issued at preferential price

(b) Preferential rights over the debentures

(c) Preferential rights over the equity shares

(d) None of the aboveContd....

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3. When non voting share will become as a voting shares

(a) For the continuous payment of dividends

(b) For the continuous non payment of dividends for the period of 3 years

(c) For the continuous payment of dividends


4. In which case the bond are issued instead of interest payment

(a) Naked bonds (b) Pay in kind bonds

(c) Cumulative bonds (d) Secured bonds

5. Non convertible portion of the debenture is

(a) Convertible at later date (b) Irredeemable

(c) Redeemable (d) None of the above

6. Warrants are

(a) Title to buy the preference shares (b) Title to buy debentures

(c) Title to buy the equity shares (d) Title to buy bonds

14.7 LET US SUM UP

Shares and Stock are synonymous in usage. Shares are the expression of smaller unitsof Share capital of the organization. The raising of equity share capital from the investorsin various segments. Normally the sweat security is issued by the companies in twodifferent categories:

l Sweat security which is issued at preferential pricing more specifically for employees

l Sweat security which is issued at face value, that may be either at par or above par

The unpaid preference dividends are paid before anything paid to equity share holders.The unpaid preference dividends are called in other words as Arrearages.

Debentures are classified on the following basis:

l On the basis of security

l On the basis of holding

l On the basis of redemption

l On the basis of convertibility

Bond is a long-term debt instrument issued by the company to raise the financial resourcesfrom the market, for specific period and it carries fixed rate of interest which has its ownsalient features. Warrants are nothing but Bearer documents which are title to buy thespecified number of equity shares at specified price during the future period. The lifeperiod of the warrants are normally too long.


Distinguish between preference and non-preference shares. What are the advantagesof preference share?

14.9 KEYWORDS

Share: smaller unit of the share capital of the company

Preference share: Preferential rights are pegged with this type of a share to shareanything from the company prior to the equity shareholders

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Sources of Long Term FinanceBond: Long-term debt instrument

Debenture: Long-term debt instrument floated by the company with or without chargeon the assets of the company.

Security: The amount of lending is secured through the charge on the assets

Redemption: Time period of repayment and payment of the principal and interestrespectively are known

Warrants: Title to buy equity shares at the specified price in the future date

Host securities: These are the securities which are normally issued by the companyalong with the warrants viz preference share and debenture

Naked warrants: Without any host securities, if any warrants are issued


1. Define equity share.

2. Define debentures.

3. Briefly explain the sweat security.

4. What is meant by preference shares?

5. Explain various types of preference shares.

6. Explain the various types of debentures.

7. Define bonds.

8. Explain the various types of bonds.

9. Define warrants.

10. Explain the advantages of issuing the warrants.

11. Elucidate the various classifications of warrants.

12. Why warrants are issued?










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15 CAPITAL MARKET DEVELOPMENTS IN INDIA

CONTENTS


15.1 Introduction

15.2 Capital Market Reforms - In General

15.3 Reforms in Primary Market

15.3.1 Reforms in the Primary Market: 1996-97

15.3.2 Reforms in 1997-98

15.3.3 Reforms in 1998-2001

15.4 Reforms in the Secondary Market

15.4.1 Capital Market Reforms: 1996-97




15.5 Let us Sum up


15.7 Keywords




This lesson is intended to discuss about primary and secondary capital markets in India.After studying this lesson you will be able to:

(i) describe overall capital market reforms

(ii) explain reforms in primary market

(iii) discuss reforms in secondary market

15.1 INTRODUCTION

The capital market is one of the important constituents of the economy to groom anddevelop to attain the required growth rate through the attraction of corpus from not onlyin domestic market but also from international markets. In India, the capital market ismore vibrant in the modern days due to many more developments routed through thestructured mechanism of the market. The structured market facilitates to bring forthmany developments in the capital market only in order to facilitate the companies toattract more investors to contribute financial resources to the requirement.

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Capital MarketDevelopments in India

The participation of the investors is subject to the market environment conditions. Toattract more investors from the various corners of the market, the developments areinevitable. The development of the capital market in India are many fold and multistructured. The series of development could be studied one after the another.

15.2 CAPITAL MARKET REFORMS - IN GENERAL

l Replacement of the office of CCI by the SEBI guidelines during the year 1992,February

l Exchange of powers of the SCRA/1956 57,2000 were transferred to office ofSEBI - notification issued

l Inducement for investor claims through consume courts and redressal forum ofinvestor associations

l Permission of the foreign equity participation

l With the permission of RBI, NRIs were permitted to invest in the equity shares anddebentures

l Norms relaxed for the Indian firms to raise financial resources

l Sebi's autonomy reinforced through the Section of 30 - without any consultation ofthe central govt

l Introduction of OTCEI and NSE - electronic nationwide trading

15.3 REFORMS IN PRIMARY MARKET

l Merchant banking and banking code installed

l Due diligence certificate from the lead managers

l Disclosure norms

l Companies details - facts and risk factors associated with their projects

l Stock exchanges required to ensure the formalities with the companies during theissues

l Restriction in the usage of Stock invest - institutional investors

l Disclosure norms for the advertisement

l Underwriting is optional and if it is not carried out due to bring down the issuecost – 90% of the amount offered to the public - should be refunded

l Bonus guidelines were relaxed

l New system introduced for preferential issue - pertaining to pricingShri Y H Malegam – disclosure requirements and issue procedures

l SEBI to vet the prospectus within 21 days from the date of issue and approval bythe registrar companies is given a time period of 14 days

l Abridged prospectus - should be vetted by the SEBI

15.3.1 Reforms in the Primary Market: 1996-97

l Norms were tightened - to enhance the quality of the paper

l First time issuers - dividend payment record in three of the immediately precedingfive years

l If this requirement is not applicable in the case of companies - appraisal should bedone through commercial banks or financial institutions -10% contribution from theissuer out of the total size of the issue

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l For banks - no restriction but if the issues are premium priced - two years profitabilityrecord

l Prohibition on direct or indirect discounts during the moment of allotment

l 90% of the subscription waived due to minimum share holding

l Housing finance companies allowed to function as registered issue facilitatingcompanies in along with the refinancing from the National housing bank

l The promoters contribution should be in a phased manner if it crosses Rs.100 cr

l Debt securities could be listed in the stock exchanges without any listing of equityshares.

15.3.2 Reforms in 1997-98l Entry for unlisted companies modified

l Partly paid up shares should be either fully converted or forfeit

l 3 years profitability required for the unlisted companies for the issuance of sharecapital

l For rights issue - Registrar should be separately deputed

l Details of the promoters should be given in the offer document

l Only body corporates allowed to function as merchant bankers

l Merchant bank classifications abolished

l Merchant banks are not permitted to carry out the fund related activities; if anycorporates are available - suitable breathing time was given to restructure the activities

15.3.3 Reforms in 1998-2001l Entry norms revised

l Pre issue net worth should not be less than 1 cr in 3 preceding years out of 5

l Merchant banks registered with RBI as NBFCs eligible to trade Govt securities

l Mutual funds permitted to derivatives

l Further updating was made in the companies act to protect the investors

l Additional power granted to SEBI for the violation of the companies act

l SEBI compendium 2000 issued

l On line offerings were encouraged by SEBI

l Regulation of rating agencies framed

l ESOP guidelines

l Changes introduced on mutual funds the P.K.Kaul committee

l Issue freedom is given to companies but not less than Re 1

l 100% book building route introduced

15.4 REFORMS IN THE SECONDARY MARKET

l Guidelines with reference to substantial takeovers and acquisitions - disclosures

l Guidelines with regards to mandatory public offer to the investors

l Several mutual funds were allowed

l UTI brought under the sebi

l Advertising code was initiated as well as the requirements of pre-vetting ofadvertisement removed

l To improve the role of the Mutual fund as well as to develop the market of mutualfund in India, mutual funds were given - right to underwrite the public issues and tomake investments in the money market

l Jumbo transfer was introduced for the institutions

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Capital MarketDevelopments in India

l Carry forward system of transactions are permitted to SEs after getting the consentand surveillance

l Carry forward transactions are limited in the case of lenders of the transactions

l Carry forward transactions should be disclosed on the basis of scrip and broker atthe beginning of carry forward session

l Capital adequacy norms were introduced

l Depositories were introduced during the year 1995 Sept.; to record the ownershipin the book form

l The introduction of depository requires the changes in the following enactments

v Companies Act

v Stamp Duty Act

v Income Tax Act

15.4.1 Capital Market Reforms: 1996-97l Depositories Act 1996 - promulgated in order to reduce the problems associated

with the handling of securities

l Guidelines for the custodian of securities were clearly drafted

l Custodian of securities- compliance officer should be appointed - to bridge the gapin between

l Changes are expected to discuss during the monthly meetings of Association ofCustodian of security services

l Bad delivery cell was set up and code was specified

l System of clearing house or clearance corporation to be set up in the stock exchange

l Separate committee has been set up for surveillance - inter stock exchangetransactions

l Mumbai and other stock exchanges were allowed to install terminals - where noexchange exists - to have on line trading

l Norms of the OTCEI were eased to promote more transactions

15.4.2 Capital Market Reforms: 1997-98l Daily carry forward margin reduced to 10% from 15%

l Over all carry forward increased to Rs.20 crs per broker

15.4.3 Capital Market Reforms: 1998-2001l Buy back of securities were permitted

l Circuit breaker system was introduced to control volatility

l Dematerialized trading was installised

l Rolling settlement introduced

l Internet trading was introduced

l Guidelines were issued in the angle of maintaining the transparency

l Clause 49 - to maintain corporate governance introduced

l Stock watch system was introduced

l Steps introduced to reduce the transaction costs

l Trading of stock index and futures - BSE and NSE commenced

l For trading of debt securities - to promote debt market - steps taken


l Golden pegged return funds permitted

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l IPO norms are tightened

l Grading of IPOs are suggested

15.5 LET US SUM UP

In India, the capital market is more vibrant in the modern days due to many more developmentsrouted through the structured mechanism of the market. The development of the capitalmarket in India are many fold and multi structured. Dematerialisation is Transforming thephysical securities into electronic transformation sheets through the maintenance of DematA/c. Book building is a process for identifying the right price of the process.


Discuss critically about the reforms initiated in capital market in India.

15.7 KEYWORDS

IPO: Initial Public offering

BSE: Bombay Stock Exchange

NSE: National Stock Exchange

OTCEI: Over the Counter Exchange of India

SEBI: Securities Exchange Board of India

SCRA: Securities Contract Regulation Act

Grading: Rating from the credit rating agencies

Dematerialisation: Transforming the physical securities into electronic transformationsheets through the maintenance of Demat A/c

Book building: It is a process for identifying the right price of the process

CCI: Controller of Capital Issues Act

ESOP: Employees Stock Option Scheme


1. Give brief introduction about the capital market reforms in India.

2. Write an elaborate note on the primary market reforms in India.

3. Elucidate the secondary market reforms in India.

4. Why SEBI requires the IPOs to obtain grading from the agencies?


M.P Pandikumar “Accounting & Finance for Managers”, Excel Books, New Delhi.









LESSON

16 INDIAN FINANCIAL SYSTEM

CONTENTS


16.1 Introduction

16.2 Organised Capital Market

16.3 Un-organized Capital Market

16.4 Organized Money Market

16.4.1 Market for Banking Financial Institutions

16.4.2 Market for Non Banking Financial Institutions

16.5 Un-organized Money Market

16.6 Let us Sum up


16.8 Keywords




The purpose of this lesson is to discuss the typical structure of the Indian financialsystem. After studying this lesson you will be able to:

(i) describe components of financial markets

(ii) understand organised and unorganised capital markets

(iii) explain various segments of money market

16.1 INTRODUCTION

The Indian financial system coined more particularly immediately after the independence1947. Since 1947, the role of the financial system is more vibrant in meeting the needsand demands of not only the country but also the corporate sectors. It outperformed inthe economy for the development of the nation through the collection of saving from thehouseholds for development of the nation as well as the corporate sectors. The Indianfinancial system could be bifurcated into two different segments viz.

Capital Market and Money market

These two markets are further classified into organized and unorganized.

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16.2 ORGANISED CAPITAL MARKET

The capital market which was initially controlled and organized by the Controller ofCapital Issues act and then it was replaced by the Securities Exchange Board of Indiafor the governance of capital market in India. The capital market in India is known asregulated in spheres by SEBI then and there.

The organised capital market is bifurcated into two categories viz Primary market andSecondary market.

Primary market: It is the market for the fresh issuance of securities by the new as wellas existing companies, in order to raise the capital from the investors.

The Primary market is further classified into many segments

Initial Public offering: As a new company registered under the Companies Act 1956 ispermitted to raise the capital from the market through the abridged prospectus.

Public issue: It is another mode of raising the capital from the common public by theexisting companies.

Private placement: During the issue, the larger investment houses are invited for thesubscription of the issue of securities in bulk quantities at a discount price prior to theissue. After the issue, according to the investment policy of the Institutional investors,they sell them at higher price to the individual investors. This facilitates the institutionalinvestors to book profits through the process of private placement.

Underwriting: It is another mode of issuing the securities during the issue, moreparticularly this mode of issue is found to be an avenue to off-load the risk of managingthe issue of securities as well as to secure the issue as fully subscribed.

Secondary market: It is the market for the securities which are already available in themarket, to buy and sell among the players. This is the market further classified into twodifferent categories viz mutualisation and demutualisation of stock exchanges.

Mutualised Stock exchanges: These are the exchanges never have any distinctionamong the members, management and governing body of the stock exchange. Theseare purely administered by the members/brokers of the stock exchange, e.g.,. Traditionalstock exchanges.

Demutualised stock exchanges: These are separate distinct faces among themselves.The roles and responsibilities of the brokers, governing body members and people in themanagement are clearly defined and performed by them without any ambiguity e.g.OTCEI, NSE and so on.

Indian financial System

Capital market Money market

Organised Un organized Organised Un organized

Primary market

Secondary

Kerb trading

Bills Market

Discount Market

Gilt edged

Short term

Pawn Brokers

Chit funds IPOs

Public Issues

Private Placement

Institutional offer

Underwriting

Short term financialinstruments market

237

Indian Financial System16.3 UN-ORGANIZED CAPITAL MARKET

Due to stringent guidelines of SEBI, unofficial market trading activities are banned onlyin order to safeguard the interest of the investors.

Kerb trading which was taken place among the players of the stock market during thenon working hours of the stock exchange. This trading is known in other words as un-official trading or black trading among the players.

The next segment is nothing but the money market which controlled and monitored bythe Reserve Bank of India.

16.4 ORGANIZED MONEY MARKET

The organised money market can be further segmented into two categories:

16.4.1 Market for Banking Financial Institutions

Under this the entire banking network is administered by RBI, which has the followingmany more classification viz Public sector banks, Scheduled banks, Private sector bank,Co-operative banks, Regional Rural banks and Land development banks

16.4.2 Market for Non Banking Financial Institutions

The non banking financial institutions are nothing but development banks, state financialinstitutions

The money market is further divided into various segments viz

Bills market

Discounting market

Acceptance market

Marketable securities market

Gilt edged securities market and so on

Bill market: In this market only, the bills are bought and sold among the players. It is themarket for both commerce bill and finance bill. The commerce bill is nothing but the billof exchange defined in accordance with the Sec. 5 of the Negotiable Instruments Act. Itarises only due to credit sales among the parties, only in order to safeguard the interestof the suppliers who supplied the goods and articles on credit.

Discounting market: It is another most important market for discounting of the bills ofthe trade. These are normally carried out by the banking and financial institutions inaddition to Discounting Housing Finance of India which is the apex body for rediscountingin India next to Reserve Bank of India. The bills are discounted by the banking and nonbanking financial institutions only on the basis of the credibility of the parties involved inthe bill who has accepted to make the payment on the maturity of the bill.

Acceptance market: In India, there is no separate acceptance market for accepting thebills before discounting, but in U.K., there is greater scope for accepting the bill beforethe process of discounting. Normally, the discounting is carried out only on the basis ofthe extent of acceptance given by the acceptance houses on the bills produced.

Govt Securities market: The govt securities are also tradable in the secondary marketimmediately after the issuance. According to the Public debt act, the central and stategovt are empowered to issue the securities to raise financial resources from the publicfor developmental aspects of the state or region.

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The treasury bills are mainly traded in the market immediately after the issuance

The following are the major type of treasury bills traded in the market are 91 daystreasury bills, 182 days treasury bill and 364 days treasury bill

Bonds market: It is a separate market available to raise the financial resources throughlong term debt instrument. The bonds are normally issued by the corporate sectors andgovt organizations. They are many in categories viz

Secured and unsecured bonds

Pay in kind bonds

Redeemable bonds and irredeemable bonds and so on.

16.5 UN-ORGANIZED MONEY MARKET

This particular market is dominated by the pawn brokers, chit funds, nidhis, and so on.There is no stringent guidelines prevailing to control and monitor the role of the abovementioned players.

In addition to the above classifications, one more classification is that of insurancecompanies which are separately governed by the IRDA

Which has got its own segments as following:

Life insurance sector

Non life insurance sector

Pension funds

Health insurance and so on.

Check Your Progress

What are the main components of Indian financial system?

16.6 LET US SUM UP

The Indian financial system could be bifurcated into two different segments viz. CapitalMarket and Money Market.

The money market is further divided into various segments viz

Bills market

Discounting market

Acceptance market

Marketable securities market

Gilt edged securities market and so on.


Examine critically the role of Financial markets in industrial development of India.

16.8 KEYWORDS

Organised Capital Market

Primary market

239

Indian Financial SystemInitial Public offering

Public issue

Secondary market

Mutualised Stock exchanges

Demutualised Stock exchanges

Unorganized Capital market

Bill market

Discounting market

Acceptance market

Govt Securities market

Bonds market

Un-organized money market


1. Write elaborate note on the organized capital market. Explain the role of SEBI incontrolling the capital market.

2. Draw the role of RBI in controlling and monitoring the various entities in the regulatedmoney market environment.

3. Explain the various steps involved in the bills market.

4. Illustrate the role of acceptance market.

5. Explain the various type of bonds and treasury bills under the organized moneymarket.










240


17 SEBI IN CAPITAL MARKET ISSUES

CONTENTS


17.1 Introduction

17.2 Objectives of the SEBI

17.3 Entity of SEBI

17.4 Organisational Grid of the SEBI

17.5 Powers and Functions of SEBI

17.6 Role of SEBI

17.6.1 Promoter’s Contribution

17.6.2 Disclosures

17.6.3 Book Building

17.6.4 Allocation of Shares

17.6.5 Market Intermediaries

17.6.6 Debt Market Segment

17.6.7 Brokers

17.6.8 Suspension of a Broker

17.6.9 Recent Developments

17.7 Critical Review of SEBI

17.8 Let us Sum up


17.10 Keywords




This lesson is intended to discuss the role of SEBI in regulating the Indian capital market.After studying this lesson you will be able to:

(i) describe objectives behind instituting SEBI(ii) know the organisational structure of SEBI(iii) understand powers and functions of SEBI

(iv) examine the role of SEBI in Indian financial market

17.1 INTRODUCTION

During the late 80, the GOI decided to replace the Controller of Capital Issues Act, byway of inducting the Securities Exchange Board of India, in order to introduce theregulatory environment in the Indian capital market, to pave way for the promotion ofcongenial and conducive climatic condition for the investing public. Hence the Government

241

SEBI in Capital Market Issuesof India has instituted the supreme authority SEBI to monitor and control the proceedingsof the capital market in the country.

17.2 OBJECTIVES OF THE SEBI

l To replace the office of the following major acts of implementation and to attainthe following objectives:

v Control of Capital Issues Act (1947)

v The Companies Act (1956) - issue, allotment of the securities and disclosures

v Securities contract regulation Act (1956) - to control over the stock exchanges

l In May, 1992 - the controller of issue of capital, pricing of the issues, fixing premiaand rates of debentures were ceased in operation, provided the SEBI waspromulgated.

v Protecting the interest of the investors

v Promoting the development of the securities market

v Regulating the securities market

17.3 ENTITY OF SEBIl It was registered with the common seal and with the power to acquire, hold and

dispose any propertyl Power to sue or to be sued in its own namel The Head office is situated in Mumbai; in addition the regional offices were

established in the following metropolitan cities viz Kolkata, Chennai and Delhi, tomonitor and control the capital market operations across the country

17.4 ORGANISATIONAL GRID OF THE SEBI

l Six members in the committee

l Headed by the chairman

l One member each from the ministries of Law and Finance

l One member from the officials of Reserve Bank of India

l Two nominees from the central government

l It contains 4 different departments viz Primary department, Issue management andintermediaries department, Secondary department and Institutional Investment department

17.5 POWERS AND FUNCTIONS OF SEBI

Section 11 of the Act Chapter IV highlights the Powers and Functions of SEBI

l Regulating the business of the stock exchanges

l Regulating the role of the intermediaries

l Registering and regulating of depositories, participants and custodian of securities,credit rating agencies

l Regulating of mutual funds and venture capital funds

l Prohibiting the unfair trade practices

l Prohibiting of insider trade activities

l Regulating substantial takeovers and acquisitions

l Frequent conduct of research activities

l To conduct any enquiry which warrants the situation to safeguard the interest ofthe investors

242


Civil Court Procedure 1908: The SEBI has been given additional powers andfunctionswith reference to Civil Court Procedure 1908 to regulate the capital market inaddition to the above enlisted powers and functions

l Discovery and production of books of account of the errant during the inspectionand enquiry.

l Summoning and enforcing the attendance of the persons to stand before for theexamination of oath.

l Acc to Sec 12 SEBI is empowered to conduct Inspection of books.

17.6 ROLE OF SEBI

l Entry norms for the companies at the moment of raising the capital from themarket:

v The companies are expected to produce 3 years dividend track record ofpreceding the issue.

v At the entry level, immediately after listing, important point to be ensured isthat Post issue of networth should be 5 times greater than the Pre issuenetworth.

v If it is a manufacturing company without any track record, wants to raise anycapital from the market, the appraisal has to be done through developmentbanks or commercial banks.

v Having three years track record, the SEBI never vets offer document of theissue of capital.

17.6.1 Promoter's Contribution

l Promoter's contribution should not be less than 20% and should be made beforethe issue.

l If the size of the issues is Rs. 100 cr -50% of the contribution should be madebefore the opening of issue and the remaining should be paid before the calls aremade to the investors.

17.6.2 Disclosures

l Acc.Bhave committee- Financial results i.e., unaudited and audited financial resultsshould be published.

l Risk factors and positions of the company should be highlighted in detail in theprospectus .

17.6.3 Book Building

l 75% route was specified at the early moment in the process of book building. Thenthe book building process was opened to 100% route to the public.

l Sufficient opportunities are to be furnished to the investors to represent through theterminal to take part in the process of Book building.

l The company during the process requires 30 centers atleast for book building processto raise the share capital from the market.

17.6.4 Allocation of Shares

l The Minimum application was -100 Nos for subscribing the issue of share capital.Then the Minimum application was hiked to 500 Nos. Then SEBI has felt that theMinimum application was too high, which did not pave the small investors to withinthe available surplus, then the minimum application brought down to 200 Nos.

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SEBI in Capital Market Issuesl Small investors are who hold 1000 shares or few securities

l Allotment should be done within 30 days from the date of closure of the issue.During the non allotment of the shares, the company should refund the amount ofthe application money.

17.6.5 Market Intermediaries

l The various merchant bank categories were abolished. Each category of issueintermediary is required to undergo for specific registration process.

l Lead managers who manage the issue of capital should have a networth of Rs.5 cr.

17.6.6 Debt Market Segment

l Depository system for the debt securities were introduced

l Demat facility was specifically introduced for the government securities

l Listing of debt securities need not rely upon the equity listing in the respectivestock exchange

l FIIs were permitted to invest 100% in the debt instruments of the Indian companies

l For the issuance of debt instruments the rating has been mandatory

l Minimum two ratings should be obtained for the issue of debt instrument more thanRs. 500 cr.

l Rating agency should not be associated with the firm of issuing company

17.6.7 Brokers

l Registration is given - Member of any stock exchange - key factors ofregistration - office space, previous experience, man power, selling or buying in securities

l Code of conduct-execution of orders, fairness of deals with the investors, issue ofcontract note

l Financial statements - should be submitted within 6 months of the accounting period

l Book of accounts - A minimum of 5 years to be preserved

l Regional offices - Establishment only with reference to attend the complaints ofthe small investors at speedy rate - Kolkata, Chennai and Delhi

l SEBI's final controlling measure is suspension and cancellation of the registrationsubject to certain conditions

17.6.8 Suspension of a Broker

l Suspension - permanent - dismissal is leading to cancellation of registration - due tothe problem caused

l Violation of rules and regulations

l Fails to submit the true and fair information according to the norms of disclosures

l Untoward conduct with the investor

l Guilt of misconduct

l Poor financial status of the brokers-deterioration

l Stock exchange fees - fail to pay on time to the requirement

l Suspension of the membership

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l Indulges in any act of insider trading of securities

l Convicted of a any criminal offence

l Sub-Broker

l Sub- broker- to obtain the registration

l Agreement in between broker & sub-broker

l Deposit should be made with - Broker

l Transfer of securities - without registration of bearing stamps - considered as baddeliveries in the angle of stock exchanges -July 1, 1997.

17.6.9 Recent Developments

l RBI approval copy is exempted

l FIIs are permitted to invest upto 100% in debt market funds

l FIIs which have securities worth of Rs 100 cr or more than mandatory requirementis to settle the transaction only through demat mode

l FIIs/NRIs/OCB -30% of the equity of the company in accordance with the unionbudget - 1997-98

l It was hiked by the Union Finance Minister during the budget 2000

Check Your Progress

What steps have been taken by SEBI regarding allocation of shares?

17.7 CRITICAL REVIEW OF SEBI

l Disclosures- To present information only for the interest of investors

l Dissemination process - to disclose the information required which leads to unduedelay. The route of dissemination of the information should be through SEBI topublic and by considering the time wastage, the web sites were suggested forfacilitating the investors.

l The Settlement for NSE are - Wednesday - Tuesday, and in the case of BSE-Monday-Friday

l Leads to more arbitrage transactions which lead to greater fluctuations in the openingand closing prices of the securities

l Badla trade has been banned due to detrimental to the investors

l Special watch system has to be introduced to the international standards

l Capital adequacy: The capital required to be maintained is less than for intermediariesbut at the same time the capital adequacy should be to the trading volume of themonly in order to avoid the default risk of the investors.

17.8 LET US SUM UP

The Govt of India has instituted the supreme authority SEBI to monitor and control theproceedings of the capital market in the country. The SEBI has been given additionalpowers and functions with reference to civil court procedure 1908 to regulate the capitalmarket. Recent Developments RBI approval copy is exempted. FIIs permitted to investupto 100% in debt market funds. FIIs which have securities worth of Rs 100 cr or more

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SEBI in Capital Market Issuesthan mandatory requirement is to settle the transaction only through demat mode, FIIs/NRIs/OCB -30% of the equity of the company in accordance with the union budget -1997-98. It was hiked by the union finance minister during the budget 2000.


Discuss critically the power and functions of SEBI.

17.10 KEYWORDS

Broker: member of the stock exchange, facilitates the client to buy and sell on behalf inthe stock market

Sub-broker: who assists the broker and does the buying and selling transactions for theclient through the broker in the stock exchange

Arbitrage: Buying the security at lesser price at one stock exchange and disposing themoff at higher price at another stock exchange during the same moment

Lead manager: Who takes active role in the process of issue management.


1. When SEBI was established ? For what ?

2. Briefly highlight the objectives of the SEBI.

3. Explain the role of SEBI in administering the primary market.

4. Explain the important enactments on the market intermediaries of the stock market.

5. Elucidate the recent developments with the help of SEBI mandate.

6. What are the steps taken by SEBI to suspend the registration of a broker?

7. Why the companies are expected to highlight about the prospects and risk factorsof the issue with relevance to the project?


M.P. Pandikumar, “Accounting & Finance for Managers”, Excel Books, New Delhi.









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18 CAPITAL BUDGETING


18.1 Introduction

18.2 Aim of Capital Budgeting

18.3 Methods of Capital Budgeting

18.3.1 Pay Back Period Method

18.3.2 Accounting or Average Rate of Return

18.3.3 Discounted Cash Flows Method

18.4 Present Value Method

18.5 Capital Rationing

18.6 Divisible Project

18.7 Indivisible Project

18.8 Risk Analysis in Capital Budgeting

18.9 Let us Sum up


18.11 Keywords




After studying this lesson you will be able to:

(i) decide why capital budgeting is most important decision of the financial management

(ii) describe various objectives and methods of capital budgeting

(iii) distinguish between divisible and indivisible projects.

18.1 INTRODUCTIONThe capital budgeting is one of the important decisions of the financial management of theenterprise. The decisions pertaining to the financial management of the firm are following:

Decisions of Financial Management

Financing Investment Dividend Liquidity

Long Term Investment Short Term Investment

Capital Budgeting Working Capital Management

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Capital BudgetingWhy the capital budgeting is considered as most important decision over the others?

The capital budgeting is the decision of long term investments, which mainly focuses theacquisition or improvement on fixed assets. The importance of the capital budgeting isonly due to the benefits of the long term assets stretched to many number of years in thefuture. It is a tool of analysis which mainly focuses on the quality of earning pattern ofthe fixed assets.

The capital budgeting decision is a decision of capital expenditure or long term investmentor long term commitment of funds on the fixed assets.

Charles T. Horngreen “A long-term planning for making and financing proposed capitaloutlays”.

18.2 AIM OF CAPITAL BUDGETING

To make rational investment: The study of capital budgeting on capital expendituresevades not only over capitalization but also under capitalization. The long-term investmentnormally demands heavy volume of investment which is met out by the firm either throughexternal or internal source of financing. Hence, the amount of capital raised by the firmshould neither greater nor lesser than the investment.

Locking up of capital: The amount invested is requiring longer gestation to recover.The longer gestation is connected with future horizon in getting back the investment.The future is uncertain unlike the present. If the longer is the gestation in the future leadsto greater risk involved.

Effect on the profitability of the enterprise: The profitability of the enterprise is mainlydepending on the proper planning of the capital expenditure.

Nature of Irreversibility: The improper/ unwise capital expenditure decision cannot beimmediately corrected as soon as it was found. Once it is invested is invested whichcannot be reversed. The poor investment decision will require the firm either to keep itas an idle in the form of investment or to unnecessarily meet out fixed commitmentcharge of the capital which excessively raised more than the requirement.

18.3 METHODS OF CAPITAL BUDGETING

The methods are the nothing but the instruments of the capital budgeting to study thequality of the investments/fixed assets. The investments are studied by the firms in thefollowing angles:

l Based on the number of years taken for getting back the investment – Pay BackPeriod Method

l Based on the profits accrued out of the investment – Accounting Rate of Return/Average Rate of Return

l Based on the timing of benefits – Present value of future benefits of the investment–Discounted cash flow methodsv Based on the comparison in between the cash outlay and receipts discounted

with the help of minimum rate of return - Net present value methodv Based on the identification of maximum rate of return, in between the initial

cash outlay and discounted expected future receipts - Internal Rate of returnmethod

v Based on the ration in between the present values of cash inflows and outflows– Present value index method

Check Your Progress

(1) Capital budgeting means a study of

(a) Budgeting of long-term capital

(b) Budgeting of short-term capital

Contd....

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(c) Budgeting of short-term assets

(d) Worthiness of long-term assets

(2) Capital budgeting tools are classified into(a) Yearly basis

(b) On the basis of return

(c) On the basis of present value of money

(d) (a), (b) & (c)

(3) Selection criterion are classified into(i) Acceptance of the investment proposal

(ii) Rejection of investment proposal

(iii) Neither can be accepted nor rejected

(a) (i) only(b) (ii) only(c) (iii) only

(d) (iv), (ii) & (iii)

The classification of methods are generally in two categories:

l Traditional methodsv Pay Back Period methodv Accounting Rate of Return

l Discounted cash flow methodsv Net present value methodv Internal Rate of Return methodv Present value index methodv Discounted pay back period method

18.3.1 Pay Back Period Method

What is pay back period?

The pay back period is the period taken by the firm to get back the investment. The payback period is nothing but number of years/months/days required by the firm to get backits investment invested in the project.

To find out the pay back period, the following are two important covenants required:

l Initial outlay / Initial investment/ Original investment

l Cash inflows

How the pay back period is calculated?The pay back period is calculated by way of establishing the relationship between thevolume of investment and the annual earningsWhile calculating the pay back period, the nature of annual earnings should be identified.The nature of the annual earnings can be classified into two categories:

l Cash flows are equivalent or constant

l Cash flows are not equivalent or constant

If the cash flows are equivalent, How the pay back period is to be calculated ?

The cost of the project is Rs.1,00,000. The annual earnings of the project is Rs.20,000.Calculate the pay back period.

Years 5 20,000 .Rs

1,00,000 Rs.

Earnings Annual Average

Investment Initialperiodback Pay

==

=

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Capital BudgetingIt is obviously understood that, Rs.20,000 of annual earnings (cash inflows) requires 5years time period to get back the original volume of the investment.

If the cash flows are not equivalent, How the pay back period is to be calculated ?

The cost of the project is Rs.1,00,000. The annual earnings of the project are as follows

The ultimate aim of determining the cumulative cash inflows to find out how manynumber of years taken by the firm to recover the initial investment.

The next step under this method is to determine the cumulative cash flows

The uncollected portion of the investment is Rs,10,000. This Rs.10,000 is collected fromthe 4th year Net income / cash inflows of the enterprise. During the 4th year the totalearnings amounted Rs.20,000 but the amount required to recover is only Rs.10,000. Forearning Rs.20,000 one full year is required but the amount required to collect it back isamounted Rs.10,000. How many months the firm may require to collect Rs.10,000 outof the entire earnings Rs.20,000?

Pay back period consists of two different components

l Pay back period for the major portion of the investment collection in full course -E.g.: 3 years

l Pay back period for the left /uncollected portion of the investment

For the second category years 5.0 20,000 .Rs

10,000 .Rs ==

Total pay back period= 3 Years +.5 year = 3.5 years

Criterion for selection: If two or more projects are given for appraisal, considered to bemutually exclusive to each other for selection, the pay back period of the projects shouldtabulated in accordance with the ascending order. The project which has lesser payback period only to be selected over the other projects given for scrutiny.

Why lesser pay back has to be chosen?

The reason behind is that the project which has lesser pay back period got faster recoveryof the initial investment through cash inflows/Net income.

Selection criterion

Lesser the pay back period is better for acceptance of the project

Illustration 1: A project costs Rs.2,00,000 and yields and an annual cash inflow ofRs.40,000 for 7 years. Calculate pay back period

First step is identify the nature of the annual cash inflows

Year 1st 2nd 3rd 4th 5th Net Income Amount Rs

40,000 30,000 20,000 20,000 20,000

Year Annual Net Incomes Rs

Cumulative cash flows Rs.

1. 40,000 40,000

2. 30,000 70,000

3. 20,000 90,000

4. 20,000 1,10,000

5. 20,000 1,30,000

3 years full time required to recover the major portion of investment Rs.90,000

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In this problem, the annual cash inflows are equivalent throughout life period of theproject

Pay Back Period = years540,000 .Rs

2,00,000 .Rs

InflowsCash Annual

Investment Initial ==

Illustration 2: Calculate the pay back period for a project which requires a cash outlayof Rs.20,000 and generates cash inflows of Rs 4,000 Rs.8,000 Rs. 6,000 and Rs. 4,000in the first, second, third, and fourth year respectively

First step is to identify the nature of the cash inflows

The cash inflows are not equivalent/constant

Year Cash Inflows CumulativeRs Cash Inflows

Rs1. 4,000 4,0002. 8,000 12,0003. 6,000 18,0004. 4,000 22,000

Cost of the project is to be recovered Rs.20,000. The project takes 3 full years timeperiod to recover the major portion of the initial investment which amounted Rs.18,000out of Rs.20,000

The remaining amount of the initial investment is recovered only during the fourth year.The left portion Rs.2,000 has to be recovered only from the fourth year cash inflows ofRs.4,000.

Pay Back Period = Pay Back period of the major portion + Pay Back period of theremaining portion

Pay Back period of the major portion = 3 years

Pay Back period of the remaining portio: For the entire earnings of Rs.4,000, thefirm consumed one full year/12 months time period. How many number of monthsrequired to recover Rs.2,000 ?

months 6 months 125.04,000 .Rs

2,000 .Rs =×=

Total pay back period = 3 years + 6 months = 3 years 6 months

Illustration 3: A project cost of Rs.10,00,000 and yields annually a profit of Rs.1,60,000after depreciation and depreciation at 12% per annum but before tax 50% calculate payback period.

Pay Back PeriodinflowCash Annual

Investment Initial=

In this problem, the initial investment is given which amounted Rs.5,00,000.

The annual cash inflow is not given directly; to determine the cash inflow; what is meantby the cash inflow ?

Cash inflow = Profit after tax + Depreciation

Profit Before taxation =Rs.1,60,000

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Capital Budgeting(-)Taxation = Rs. 80,000

Profit after taxation = Rs. 80,000

(+)Depreciation 12% on = Rs. 10,00,000= Rs. 1,20,000

Annual Cash Inflow = Rs. 2,00,000

Pay Back Period = Rs.10,00,000 = 5 years

= Rs.2,00,000

Illustration 4: A company proposing to expand its production can go in either for anautomatic machine costing Rs.2,24,000 with an estimated life of 5 ½ years or an ordinarymachine costing Rs.60,000 having an estimated life of 8 years. The annual sales andcosts are estimated as follows:

Particulars Automatic Machine OrdinaryRs Machine Rs

Sales 1,50,000 1,50,000

CostsMaterial 50,000 50,000

Labour 12,000 60,000

Variable overheads 24,000 20,000

Compute the comparative profitability of the proposals under the pay back period method.Ignore Income Tax (I.C.W.A.Final)

The first step is to find out the Annual profits of the two different machines

The next step is to find out the pay back period of the two different machines respectively

Profitability Statement

Automatic Machine Rs Ordinary Machine Rs

Sales 1,50,000 1,50,000

Less : Material 50,000 50,000

Labour 12,000 60,000

Variable overheads 24,000 20,000

Annual profit 64,000 20,000

Pay Back Period

Particulars Automatic Machine Rs Ordinary Machine Rs

Cost of the Machine 2,24,000 60,000

Annual Profit 64,000 20,000

Pay Back Period Rs.2,24,000 Rs 60,000

Initial Investment Rs.64,000 Rs 20,000

Annual profit = 3½ years = 3 years

The pay back period method highlights that the ordinary machine is more ideal than theautomatic machine due to lesser pay back period i.e., 3 years. It means that the ordinarymachine is bearing the faster rate in getting back the investment invested than theautomatic machine.

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The another method to discuss is post pay back impact of the two different machines

Post pay back profit is the profit of the two different machines after the recovery of theinitial investment. The machine which has greater post pay back profit construe.

Post Pay Back Profit

Particulars Automatic Machine Rs Ordinary Machine Rs

Annual Profit R.No.1 64,000 20,000

Estimated Life R.No.2 5½ years 8 years

Pay Back Period R.No.3 3½ years 3 years

Post Pay Back Period

R.No. 4=R.No.2-R.No.3 2 years 5 years

Post Pay Back Profit = Rs.64,000×2 years = Rs.1,28,000

R.No5=R.No.1×R.No.4 = Rs.20,000×5years = Rs.1,00,000

Post pay back profit of the Automatic machine is higher than the Ordinary machine ;which amounted Rs.1,28,000.. It means that the profit of the automatic machine afterthe recovery of the initial investment is greater than that of the ordinary machine.

Illustration 5: A company has to choose one of the following two mutually exclusiveprojects. Investment required for each project is Rs 30,000. Both the projects have to bedepreciated on straight line basis The tax rate is 50%.

Year Profit Before Depreciation

Project A Rs Project B Rs

1. 8,400 8,400

2. 9,600 9,000

3. 14,000 8,000

4. 14,000 10,000

5. 4,000 20,000

Calculate pay back period

First step is to find out the depreciation under the straight line method

The next step is to determine the pay back period of the both projects A and B respectively

The next step is to compare both pay back periods of two different projects.

The depreciation under the straight line method is as follows

For Project A

000,6.Rsyears 5

30,000 .Rs

Project theof Life


For Project B

000,6.Rsyears 5

30,000 .Rs

Project theof Life


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Capital BudgetingProject A

1. 8,400 6,000 2,400 1,200 1,200 6,000 7,200 7,200

2. 9,600 6,000 3,600 1,800 1,800 6,000 7,800 15,000

3. 14,000 6,000 8,000 4,000 4,000 6,000 10,000 25,000

4. 14,000 6,000 8,000 4,000 4,000 6,000 10,000 35,000

5. 4,000 6,000 -(2000) 0 -(2000) 6,000 4,000 39,000

Pay back period = Pay back period of a major portion + Pay back period for remaining

Pay back period of the major portion= the firm has recovered a major portion of theinitial investment of Rs.25,000 within 3 full years out of Rs.30,000

The second half of the equation is that pay back period for the remaining i.e., Rs.5000 ofinitial investment which is to be recovered during the fourth year out of Rs.10,000

If Rs.10,000 earned throughout the year /12 months, how many months taken by thefirm in recovering Rs.5,000 out of Rs10,000

months 6months 125.000,10.Rs

5,000 .Rs =×==

Pay back period (Project A) = 3.6 years

The next stage to find out the pay back period of the project B

Project B

1. 8,400 6,000 2,400 1,200 1,200 6,000 7,200 7,200

2. 9,000 6,000 3,000 1,500 1,500 6,000 7,500 14,700

3. 8,000 6,000 2,000 1,000 1,000 6,000 7,000 21,700

4. 10,000 6,000 4,000 2,000 2,000 6,000 8,000 29,700

5. 20,000 6,000 14,000 7,000 7,000 6,000 13,000 42,700

Pay back period of the project B= 4 years + 13,000 Rs.

300 .Rs

= 4 years +.02 × 365 days = 4 years + 8 days = 4 years and 8 days

Pay back period of the project B is greater than that of the earlier Project A. It meansthat the Project A is bearing the faster rate in getting back the investment invested.

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Merits

l It is a simple method to calculate and understand

l It is a method in terms of years for easier appraisal

Demerits:

l It is a method rigid

l It has completely discarded the principle of time value of money

l It has not given any due weight age to cash inflows after the pay back period

l It has sidelined the profitability of the project.

18.3.2 Accounting or Average Rate of Return:

Under this method, the profits are extracted from the book of accounts to denominatethe rate of return. The profits which are extracted are nothing but after depreciation andtaxation and not cash inflows.

Selection criterion of the projects:

Highest rate of return of the project only is given appropriate weightage.

The Accounting rate of return can be computed as follows

Accounting Rate of Return (ARR)= 100Investment Original

Return Annual ×

Accounting Rate of Return (ARR)= 100Investment Average

Return Annual Average ×

Average annual return= Average profit after depreciation and taxation of the entire lifeof project i.e. for many number of years

Average Investment = Opening Investment + Closing Investment

2

=2

Scrap–Investment Opening

Illustration 6

Calculate the average rate of return for Projects X and Y from the following

Project X Project Y

Investments Rs.40,000 Rs.60,000

Expected Life 4 years 5 years

Projected net income ( after interest, depreciation and taxes)

Year Project X Rs Project Y Rs

1. 4,000 6,000

2. 3,000 6,000

3. 3,000 4,000

4. 2,000 2,000

5. ——- 2,000

12,000 20,000

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Capital BudgetingIf the required rate of return is 10% which project should be undertaken?

Average Rate of Return = 100Investment Original

Income Annual Average ×

The first step is to find out the average annual income of the two different projectsX and Y

Average Annual Income = Project theof Life

Project t the throughouincome Total

Average Annual Income( Project X) = 3,000 .Rsyears 4

12,000 .Rs =

Average Annual Income ( Project Y) = 4,000 .Rsyears 5

20,000 .Rs =

The next step is to find out the Average rate of return :

Average rate of return ( Project X) = %5.7100000,40.Rs

3,000 .Rs =×

Average rate of return ( Project Y) = %33.810060,000 .Rs

000,5.Rs =×

Both the projects are lesser than the given required rate of return. These two projectsare not advisable to invest only due to lesser accounting rate of return.

Illustration 7

The alpha limited is considering the purchase of a machine to replace a machine whichhas been in operation in the factory for the last 5 years.

Ignoring interest pay but considering tax at 50% of net earnings suggest which on thetwo alternatives should be preferred. The following are the details

Particulars Old Machine New Machine

Purchase price Rs.80,000 Rs,1,20,000

Economic life of the machine 10 years 10 years

Machine running hours per annum 2,000 2,000

Units per hour 24 36

Wages running per hour 3 5.25

Power per annum 2,000 3,500

Consumable stores per annum 6,000 7,500

Other charges per annum 8,000 9,000

Material cost per unit .50 .50

Selling price per unit 1.25 125

First step is to consider that few assumptions to proceed the problem without any technicaldifficulties.

First assumption is that there is no closing stock i.e. what ever goods produced are soldout in the market.

Second assumption is that the volume of the sales is expected to be remain throughoutthe life of the period.

Third assumption is that the depreciation charged by the firm is on the basis of straightline method.

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Steps involved in the computation of the accounting rate of return

The first is to compute the total number of units expected to produce

Total number of units of production = Total machine hours per annum × Units per hour

For old machine = 2,000 Hrs× 24= 48,000 units

For new machine = 2,000 Hrs × 36= 72,000 units

The second step is to determine the volume of annual sale of units:

Total volume of sales = Total number of units × Selling price per unit

For old machine = 48,000 units × Rs 1.25= Rs.60,000

For new machine = 72,000 units× Rs.1.25= Rs.90,000

According to the second assumption, the volume of sales is known as unaffectedthroughout the life period of the projects.

The next step is to find out the volume of the wages

Total wages = wages per hour × Machine running hours

For old machine = Rs.3× 2000 Hrs= Rs.6,000

For new machine = Rs5.25× 2000 Hrs=Rs.10,500

The next step is to find out the total material cost

Total material cost per unit = Total number of units × Material cost per unit

For old machine = 48,000× .5= Rs.24,000

For new machine = 72,000× .5=Rs.36,000

The last step is to find out the depreciation

Depreciation under straight line method asset theof period life Economic

investment Initial=

For old machine = Rs.8,000

For new machine = Rs.12,000

The next step is to draft the profitability statement of the enterprise under the head oftwo different machine viz old and new. To find out the annual income of the enterpriseunder two different machines

Profitability Statement

The Average rate of return

100Investment Average

Return Annual Average

100Investment Original

Return Annual Average

×=

×=

Old Machine New Machine Particulars Rs Rs Rs Rs

Sales 60,000 90,000 Less Direct Material

24,000

36,000

Wages 6,000 10,500 Power 2,000 4,500 Consumable stores 6,000 7,500 Other charges 8,000 9,000 Depreciation 8,000 12,000 54,000 79,500 Profit before tax 6,000 10,500 Tax at 50% 3,000 5,250 Profit after tax 3,000 5,250

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Capital Budgeting

Merits

l It is simple method to compute the rate of return

l Average return is calculated from the total earnings of the enterprise through outthe life of the firm

l The entire rate of return is being computed on the basis of the available accountingdata

Demerits

l Under this method, the rate of return is calculated on the basis of profits extractedfrom the books but not on the basis of cash inflows

l The time value of money is not considered

l It does not consider the life period of the project

l The accounting profits are different from one concept to another which leads togreater confusion in determining the accounting rate of return of the projects

18.3.3 Discounted Cash Flows Method

The discounted cash flows method is the only method nullifies the drawbacks associatedwith the traditional methods viz Pay back period method and Accounting rate of returnmethod. The underlying principle of the method is time value of money. The value of 1Re which is going to be received on today bears greater value than that of 1 Re expectedto receive on one month or one year later. The main reason is that "Earlier the benefitsbetter the principle". It means that the benefits whatever are going to be accrued duringthe present will be immediately reinvested again to maximize the earnings, so that theearlier benefits are weighed greater than the later benefits. The later benefits are expectedto receive only during the future which is connected with the future i.e., future is uncertain.It means that there is greater uncertainty involved in the receipt of the benefits connectedwith the future.

Why the time value of money concept is inserted on the capital budgeting tools?

The main reason is that the capital expenditure is expected to extend the benefits formany number of years. The 1 Re is expected to receive one year later cannot be treatedat par with the 1 Re of 2 years later. This is the only method considers the profitability aswell as the timing of benefits. This method gives an appropriate qualitative considerationto the benefits of various time periods.

Particulars Old Machine New Machine Average Rate of Return On the basis of original investment

Rs3,000 × 100 Rs.80,000 =3.75%

Rs.5,250 Rs.1,20,00 =4.375%

Average Rate of Return On the basis of average investment

Rs.3,000 × 100 Rs.40,000 =7.5%

Rs.5,250 Rs.60,000 =8.75%

Discounted cash flows method

Net Present value method Internal Rate of Return method Present value Index Method

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The time value of money principle is used for an analysis to study about the quality of theinvestments in receiving the future benefits.

There are general classifications which are as follows

l Net present value method

l Present value index method

l Internal rate of return method

18.4 PRESENT VALUE METHOD

Under this method, the initial outlay or initial investment available in terms of presentvalue is compared with the present value of future earnings of the enterprise.

Why the present value of the future earnings are found out?

The ultimate reason to find out the present value future earnings is that the comparisonin between inflows and outflows should be meaningful as well as effective. The presentvalue of the initial outlay cannot be converted into the future value for comparison, evenotherwise the conversion takes place, the comparison cannot be meaningful. To bemeaningful comparison, the future earnings are converted into the present value whichis known as discounting process through the discount rate. The rate at which the futureearnings are discounted is known as required rate of return.

Selection criterion of Net present value method

If the present value of future cash inflows are greater than the present value of initialinvestment ; the proposal has to be accepted.

If the present value of future cash inflows are lesser than the present value of initialinvestment ; the proposal has to rejected.

Initial Outlay <Present value of Benefits=> +ve NPV:- Project can be accepted

Initial Outlay>Present value of Benefits=>-ve NPV:-Project can be rejected

What is present value index?

The major lacuna of the Net present value method is unable to rank the projects oneafter the another, only due to the volume of the investment involved. To rank the projectsmeaningfully, the present value index method is adopted. The present value index of theinvestment can be calculated with the help of following formula:

Present value index methodoutflowscash theof valueesentPr

inflowscash theof valueesentPr=

Selection criterion

If the present value index is greater than one, accept the proposal; otherwise vice versa

Present value index>1:- Accept the investment proposal

Present value index<1:-Reject the investment proposal

What is internal rate of return method?

IRR is the rate at which initial investment is equal to the Present Value of future case in-flows. Under this method, while matching, these two are known but the rate which istaken for equation not given or known. The rate of discounting for matching should bedetermined through trial and error method.

259

Capital BudgetingOnce the Internal rate of return is found out, the found IRR should be compared with therequired rate of return.

Decision criterion

If the IRR is more than the Required rate of return, the project has to be accepted

If the IRR is less than the Required rate of return, the project has to be rejected

Check Your Progress

(1) The utility of discounting principle is

(a) To determine the future value of the cash inflow

(b) To convert the Present value of Initial outlay into Future value

(c) To determine the present value of the future cash inflows for comparison withthe Initial Outlay


(2) Why Discounted cash flows method is considered to be a superior than theTraditional method ?

(a) Simple to understand

(b) Accuracy

(c) Time value of money

(d) Easy to calculate

Illustration 8

Project ABC Ltd. costs Rs 1,00,000. It produces the following cash flows

Advise either the project to be accepted or not.

The investment proposal has to be accepted only due to positive Net present value.

It means that the present value of the cash inflows are greater than the present value ofthe outlay. It means the discounted future earnings are greater than the present initialinvestment outlay.

Illustration 9

The Alpha Co Ltd., is considering the purchase of a new machine. Two alternativemachines (A and B) have been suggested, each having an initial coast of Rs.4,00,000and requiring of Rs.20,000 an additional working capital at the end of 1st year. Earningsafter taxation are expected to be follows

Year 1 2 3 4 5 Cash Inflows Rs 40,000 30,000 10,000 20,000 30,000 Present value of Re1 at 10%

.909 .826 .751 .683 .621

Year Cash inflows Rs

Present value factor @10%

Present value of cash inflows Rs

1. 40,000 .909 36,360 2. 30,000 .826 24,780 3. 10,000 .751 7,510 4. 20,000 .683 13,660 5. 30,000 .621 18,630

Total Present value of cash inflows 1,00,940 Total present value of cash outlay 1,00,000 Net present value 940(+ve)

260


(CA Final Nov, 1972)

The profitability statement of Two machines -Alpha company

In the above problem, among the given machines, the firm is required to chose only onemachinery. To chose the ideal machinery among the given two, the net present valueshould be ranked.

The Machine B has been considered as preferable over the machine A due to higher netpresent value. The ranking of the machines do not indulge any difficulties. Why it so ?The main reason is that both machines are having equivalent volume of investmentoutlay. Out of the same initial outlays, we can rank that both machines one after theanother based upon the net present value.

Illustration 10

The initial cost of an equipment is Rs. 50,000. Cash inflows for 5 years are estimated tobe Rs.20,000 per year. The management's desired minimum rate of return is 15%.Calculate Net present value and Excess present value index.

At the end of every year, the firm expects to earn Rs.20,000. The amount expects toearn Rs.20,000 on every year is nothing but future value of money. The future value ofmoney should be converted into the present value for having comparison with the initialinvestment.

On every Rs.20,000 expected to receive forms a series of future cash inflows whichshould be converted into present value.

This conversion process i.e the process of converting the future value into present valueis known as discounting process. For discounting, the rate which is used for the processpronounced as discount rate or minimum rate of return. The conversion process can bedone in two different ways.

Discounting process :- PV= FV/ (1+r)n

For first year cash inflow Rs.20,000:-

PV=20,000/(1.15)=20,000×.870 =Rs.17,400

For second year cash inflow Rs.20,000;-

PV=20,000/(1.15)2 =20,000×.756 =Rs.15,120

Cash inflows Year Machine A Rs Machine B Rs

Present value factor 10%

1. 40,000 1,20,000 .91 2. 1,20,000 1,60,000 .83 3. 1,60,000 2,00,000 .75 4. 2,40,000 1.,20,000 .68 5. 1,60,000 80,000 .62

Machine A Machine B Year Present value factor@ 10%

Cash Inflow

Rs

Present Value

Rs

Cash Inflow

Rs

Present Value

Rs

1. .91 40,000 36,400 1,20,000 1,09,200 2. .83 1,20,000 99,600 1,60,000 1,32,000 3. .75 1,60,000 1,20,000 2,00,000 1,50,000 4. .68 2,40,000 1,63,200 1.,20,000 81,600 5. .62 1,60,000 99,200 80,000 49,600

Present value cash inflows 5,18,400 5,23,200 Present value cash outflows= Rs.4,00,000+ 20,000 X.91

4,18,200 4,18,200

Net present value 1,00,200 1,05,000

261

Capital BudgetingFor third year cash inflow Rs.20,000:-

PV=20,000/(1.15)3=20,000×.658 =Rs.13,160

For fourth year cash inflow Rs.20,000:-

PV=20,000/(1.15)4=20,000×.572 =Rs.11,440

For fifth year cash inflow Rs.20,000:-

PV=20,000/(1.15)5=20,000×.497 =Rs.9,940

Rs.67,060

OR

Alternately, the discounting can be done as follows

Being Rs.20,000 is nothing but as common cash inflow throughout 5 years of theproject, considered to be a series of cash inflows

Rs.20,000(.870+.756+.658+.572+.497) =Rs.67,060

Net present value = Present value of cash inflows - Present value of cash outlay

=Rs.67,060- Rs.50,000= Rs.17,060

The net present value of the project is +ve. Hence, the project can be accepted.

Illustration 11

A project costs Rs.36,000 and is expected to generate cash inflows of Rs.11,200 annuallyfor 5 years. Calculate the IRR of the project.

First step is to find out the fake pay back quotient

Pay back 214.311,200 .Rs

36,000 Rs.

return average Annual

Investment Initial ===

The next step is to locate the pay back quotient in the table M-4. The present value of 1Re should be computed for 5 number of years.

The location of the pay back quotient is in between the values of table M-4

The value 3.214 which lies in between 3.274 of 16% and 3.199 of 17%

The next step in the IRR calculation is that locating the maximum rate of return whichequates the initial outlay with the cash inflows of various time periods.

While equating the initial outlay with discounted cash inflows at certain percentage willderive the original rate of return. The process may be started from two different anglesviz

l Low discount rate

l High discount rate

The computation of IRR can be had through either low discount rate or high discountrate. This is further extended to different methods of calculation., which are as follows

l On the basis of values extracted from the table

l On the basis of volume

262


Calculation on the basis of discount rate table value

On the basis of Lower % of discount rate

=Lower discount rate

+

Discount rate difference ×

%8.16%2.%17199.3274.3

199.3214.3%1%17

rate)discount Higher -discount Lower(

rate)discount Higher -quotientBack Pay(

=−=−−×−=

Alternately, on the basis of volume, the methodology to be adopted for the determinationof IRR

The cash inflows of Rs.11,200 for 5 years are discounted @ 16% which amountedRs.36,668.8. Like wise the cash inflows of the same should be discounted at the rate of17% which amounted Rs.35,828.8

The next step is to find out the IRR. The IRR can be found out either on the basis oflower discounted cash inflows or higher discounted cash inflows.

On the basis of discounted cash inflows at lower rate @16%

=16% + 1% × )840(

)8.668(%%16

35.828.8)-36.668.8 .Rs(

36,000) .Rs8.668.36.Rs( ×+=−

=16%+.796=16.796%

On the basis of discounted cash inflows at higher rate @ 10%

(840)

(172)1%-17%

35,828.8)-36.668.8 .Rs(

35.828.8) Rs.-36,000 .Rs( =

== 17% -.204=16.796%

Merits of DCF methods

l It is only the best method incorporates the timing of benefits - time value of money

l It considers the economic life of the project

l It is a best method for both even and uneven cash inflows

Demerits of DCF methods

l It involves with tedious method of computation

l It is very difficult to locate or identify the exact discounting factor

l It never performs functions of discounting to the tune of accounting concepts.

(+) (-)

On the basis of discounted cash inflows – Lower rate –

Rs.36.668.8

Rs.36,000-Origin value- @ IRR

On the basis of discounted cash inflows – Higher

rate-Rs.35.828.8

Lower discount Rate 3.274

Origin value i.e., unknown IRR -3.214

Higher discount rate 3.199

263

Capital BudgetingIllustration 12

XYZ company is considering an investment proposal to install new drilling controls at acost of Rs.1,00,000. The facility has a life expectancy of 5 years and no salvage value.The tax rate is 35%. Assume the firm uses straight line depreciation and the same isallowed for tax purposes. The estimated cash flows before depreciation and tax formthe investment proposal are as follows:

Calculate the following

1. Pay back period

2. Average rate of return

3. Net present value at 10 percent discount rate

4. Profitability index at 10 percent discount rate

The first and foremost step is to find out the Cash Flows After Taxation

For finding out the Cash flows after taxation, the amount of depreciation i.e non recurringexpenditure should be appropriately considered for calculation. The depreciation has tobe computed in accordance with the stipulation given in the problem. The depreciationcharged by the firm is nothing but straight line method.

Straight line method of depreciation

20,000 .RsYears 5

000,00,1.Rs

machine theof period life Economic

valueScrap-Investment Initial

==

=

The depreciation has to be deducted initially from the cash flows before taxation, afterthe deduction of taxation, the earnings after taxation should be added with the depreciationwhich was already deducted in order to find out the total cash flows after taxation. Thepurpose of deducting the depreciation is nothing but an amount to be charged under theProfit & Loss account against the total revenue. Being as a non-recurring expenditurenot created any outflow cash resources. When there is no cash outflow, the amount ofdepreciation should be added finally to derive CFAT(Col 7)

Table

1. Pay back period method: Under this, method most important step is to identifythe nature of the cash flows after taxation. Are they uniform ? No, they are noteven cash flows. Hence, the cumulative cash flows after taxation has to be foundin order to find out the pay back period of the investment.

Year Cash flows Before Tax Rs 1. 20,000 2. 21,384 3. 25,538 4. 26,924 5. 40,770

Year Col 1

CFBT Rs

Col 2

Depreciation Rs

Col 3

Profits Before Tax

Rs Col 4=Col2-

Col3

Taxes (.35) Col 5

Earnings After tax

Rs Col6=Col4

-Col5

Cash flows after tax Rs

Col7= Col6+Col3

1. 20,000 20,000 Nil Nil Nil 20,000 2. 21,384 20,000 1,384 484 900 20,900 3. 25,538 20,000 5,538 1,938 3,600 23,600 4. 26,924 20,000 6,924 2,423 4,500 24,500 5. 40,770 20,000 20,770 7,270 13,500 33,500

22,500 1,22,500

264


Pay back period= Pay back period for the major portion of the investment

+

Pay back period for the remaining portion unrecovered

= 4 year + year .328year 4 33,500 .Rs

11,000 .Rs +=

= 4.328 years

2. Average rate of return (ARR):

100Investment Average

Income AverageARR ×=

Average Income is the average of earnings after taxation of the entire duration.

Why earnings after taxation has to be taken into consideration ? Why not the cashflows after taxation to be taken for consideration ?

The main purpose of considering the earnings after taxation is that the amountextracted from the book of accounts and taken for the computation of ARR, andimmediately after the payment of taxation.

Average investment is the average of opening and closing investment. If thedepreciation charge given is nothing but straight line method, automatically finalvalue of the asset will become equivalent to zero. The closing balance of the asset/investment is zero.

How the closing balance of the investment could be adjudged as equivalent tozero?

Table of Depreciation

At the end of the year, the closing balance amounted Rs.0 after charging thedepreciation year after year constantly in volume

%9100000,50.Rs

4,500 Rs.return of rate Average

500,4.Rsyears5

22,500 Rs. Income Average

50.000 Rs. 2

0 Rs.1,00,000 Rs.

2

balance Closingbalance Opening Average

=×=

==

=

+=

+=

Year Cash flows After Tax Rs Cumulative CFAT Rs 1. 20,000 20,000 2. 20,900 40,900 3. 23,600 64,500 4. 24,500 89,000 5. 33,500 1,22,500

Year Opening balance of the year Rs Closing balance of the year Rs 1. 1,00,000 80,000

2. 80,000 60,000

3. 60,000 40,000

4. 40,000 20,000

5. 20,000 0

265

Capital Budgeting3. Net present value method:

Under this method, the future cash flow after taxation should be discounted at therate 10%

The net present value is negative due to excessive investment more that of thepresent value of future earnings of the enterprise. Under this method, the investmentis not advisable to procure for the firm's requirements.

4. Profitability Index

The profitability index method is more useful in the case of more number ofinvestments, having uneven investment outlays, but this problem comes with onlyone investment proposal It is much easier to assess even in the case of Netpresent value method.

Profitability Index (PI) 100,000 .Rs

704,90.Rs

outflowscash of valueesentPr

inflowscash of valueesentPr ==

=.90704

The present value index quotient is less than that of the norms which should begreater than one but it secures only 90704. It means that the present value earningsare not sufficient to meet the initial cost of the machine.

Check Your Progress

(1) Why the depreciation is added at the end of computation to derive the cashflow ?

(a) Being as recurring charge

(b) Being considered as tax shield

(c) Being as non recurring charge


(2) Why "0" value is taken as closing balance of the investment for the computationof Average investment ?

(a) No value for the closing balance

(b) No value due to the application of straight line method of depreciation

(c) No scrap value at the end of the life of the asset


18.5 CAPITAL RATIONING

The capital rationing means that selection of investment proposals with reference tocapital budget by considering the financial constraints. The selection of the investmentproposals should be to the tune of required NPV which the firm wants to earn during thefuture. Under the capital rationing, there are two stages involved viz

Year Cash flows after tax Present value factor @ 10% Total Present Value Rs 1. 20,000 .909 18,180 2. 20,900 .826 17,263 3. 23,600 .751 17,724 4. 24,500 .683 16,734 5. 33,500 .621 20,803

Total Present value 90,704 Less Initial outlay 1,00,000 Net present value ( 9,296)

266


(i) Identification of the investment proposals

(ii) Selection of investment proposals

The selection of the investment proposals are on the basis of Discounted cash flowsmethod. The selection of the investment proposals are subject to two different categoriesviz indivisible and divisible. The investment which is wholly accepted or rejected due todecision criterion which is known as indivisible project but the divisible projects are ableto either accept or reject in parts.

18.6 DIVISIBLE PROJECT

A company has Rs. 7 Crore available for investment. It has evaluated its options and hasfound that only 4 projects given below have positive NPV. All these investment aredivisible Advise the management which investments projects it should select.

Out of the available Rs. 7 Cr, the first two projects selected on the basis of Profitabilityindex viz Z and W. The total amount of investment required to invest in both the projectsamounted Rs 8.50 Cr but the financial constraint is Rs.7 Cr. By considering the constraint,the first project fully accepted and the part of the next project W accepted for theremaining amount of corpus available by considering to maximize the NPV of the projectas a whole.

18.7 INDIVISIBLE PROJECT

A company working against a self imposed capital budgeting constraint of Rs 70 Cr istrying to decide which of the following investment proposals should be undertaken by it.All these investment proposals are indivisible as well as independent. The list ofinvestments along with the investment required and the NPV of the projected cashflows are given below

The D, E and B are the project for making an investment which jointly amounted Rs 64Cr and the remaining the Rs 6 cr to be invested into the project.

18.8 RISK ANALYSIS IN CAPITAL BUDGETING

In capital budgeting decisions, the risk component of the investment is not taken intoconsideration. The risk which is nothing but the business risk of the investment variesfrom one to another, to be considered in the real world situations. The risk which isnothing but the variability in between the actual returns and expected returns. The risk inthe investment has to be incorporated in the discount rate for studying the worth of theproject. To incorporate the risk in the discount rate, the meaning of the term risk should

Project Initial Investment Rs Cr NPV Rs Cr PI Z 2.50 1.50 1.60 W 6.00 1.80 1.30 Y 2.00 .50 1.25 X 3.00 .60 1.20

Project Initial Investment Rs Cr NPV Rs Cr A. 10 6 B. 24 18 C. 32 20 D. 22 30 E. 18 20

Project Initial Investment Rs Cr NPV Rs Cr PI X 3.00 .60 1.20 Y 2.00 .50 1.25 Z 2.50 1.50 1.60 W 6.00 1.80 1.30

267

Capital Budgetingbe known and distinguished from the uncertainty. The risk situation is one in which theprobabilities of one particular event are known but the uncertainty is the situation inwhich the probabilities are not known. In the case of risk situation, the future losses canbe foreseen unlike the uncertainty situation.

The incorporation of the risk factor in the discount rate in accordance with the variabilityof the returns. If the variability of the returns are more, the investor may prefer higherreturn in the form of risk premium for risky project unlike in the case of governmentsecurities. The government securities are not having any variability in the returns whichrequire the risk free return to discount only in order to know the worth of the investmentbut the risky projects are to be discounted only with the help of higher discount rates.

There quite number of techniques available for incorporating the risk component in thecapital budgeting are follows:

Sensitivity analysis

Standard deviation

Coefficient of variation and so on.

18.9 LET US SUM UP

The capital budgeting is the decision of long term investments, which mainly focuses theacquisition or improvement on fixed assets. The importance of the capital budgeting isonly due to the benefits of the long term assets stretched to many number of years in thefuture. It is a tool of analysis which mainly focuses on the quality of earning pattern ofthe fixed assets. The methods are the nothing but the instruments of the capital budgetingto study the quality of the investments/fixed assets. The pay back period is the periodtaken by the firm to get back the investment. The pay back period is nothing but numberof years / months/days required by the firm to get back its investment invested in theproject. The capital rationing means that selection of investment proposals with referenceto capital budget by considering the financial constraints. The selection of the investmentproposals should be to the tune of required NPV which the firm wants to earn during thefuture. Under the capital rationing, there are two stages involved viz

(i) Identification of the investment proposals

(ii) Selection of investment proposals


Elucidate the advantages and disadvantages of the traditional methods of capital budgeting.

18.11 KEYWORDS

Capital budgeting: A study on Long term investment decision in terms of quality ofbenefits

Pay back period: It is a time period during which the initial investment is recovered

ARR: Accounting rate of return - It is being calculated in accordance with the financialstatements

PV: Present value

IO: Initial outlay which is nothing but initial investment

NPV: Net present value which is the difference in between the Initial investment andPresent value of future cash inflows

IRR: Internal rate of return which is nothing but highest rate of return expected to earn

268


PI: Profitability Index is the ratio in between the present value of future cash inflowsand present value of initial


1. Define capital budgeting.

2. Highlight the importance of capital budgeting.

3. "Success of the firm relies upon the rational capital budgeting decisions"- Discuss.

4. What are two different classification of capital budgeting tools?

5. Illustrate the Pay back period method with an example.

6. Explain the process of computing the Accounting rate of return and their meritsand demerits.

7. List out the various methods of discounted cash flows.

8. Explain the meaning of IRR and the process of calculating the IRR.

9. List out the merits and demerits of the Discounted cash flows method.


M.P. Pandikumar “According & Finance for Managers” Excel Books, New Delhi.









LESSON

19 RISK AND RETURN


19.1 Introduction

19.2 Meaning of Return & Rate of Return

19.3 Concept and Types of Risk

19.3.1 Interest Rate Risk

19.3.2 Market Risk

19.3.3 Inflation Risk

19.3.4 Business Risk

19.3.5 Financial Risk

19.3.6 Liquidity Risk

19.3.7 Measurement of Risk

19.4 Risk and Return of the Portfolio

19.4.1 Diversification of the Risk of Portfolio

19.5 Relationship between the Risk and Return

19.6 Let us Sum up


19.8 Keywords




This lesson is intended to study the various aspects of risk and return of investmentprojects. After studying this lesson you will be able to:

(i) distinguish between return and rate of return

(ii) describe meaning and types of risk

(iii) diversify the risk of portfolio

(iv) establish relationship between the risk and returns.

19.1 INTRODUCTION

Risk and Return of the investments are interrelated covenants in the selection anyinvestments, which should be studied through the meaning and definition of risk andreturn and their classification of themselves in the first part of this chapter and therelationship in between them is illustrated in the second half of the chapter.

19.2 MEANING OF RETURN & RATE OF RETURN

Return is the combination of both the regular income and capital appreciation of theinvestments.

270


The regular income is nothing but dividend/interest income of the investments. The capitalappreciation of the investments are nothing but the capital gains of the investments i.ethe difference in between the closing and opening price of the investments.

Return symbolized as follows

D1 + Pt – Pt – 1

Pt – 1

If the price of a share on April 1 (current year) is Rs 25 and dividend received at the endof the year is Re 1 and the year end price on Mar 31 is Rs. 30

Rate of Return = Re 1 + (Rs30 – Rs25)

Rs.25=. 24 = 24%

The next aspect is current yield which is nothing but denomination of the income of theinvestments only in terms of market price

These two categories, Earnings yield and Capital gains yield

l Annual Income + beginning price

l Annual Income = Rs. 1/Rs. 25 = .04 = 4%*

l Capital Gains = Rs. 5/Rs. 25 = 0.20 = 20%**

l *Earnings Yield = Earnings per share

Market price per share***

** Capital gains yield = Price Change

Market price per share***

***Beginning Price of the share/Investment

Stock & Debenture Rate of Return

l If it is a share - Dividend will be the annual income and the second one is a capitalappreciation

l If it is a Debenture - Interest will be the annual income, i.e., coupon rate of interest

And if any capital appreciation is available that could be considered.

19.3 CONCEPT AND TYPES OF RISK

l The variability of the actual return from the expected return which is associatedwith the investment /asset known as risk of the investment.

l Variability of return means that the Deviation in between actual return and expectedreturn which is in other words as variance i.e., the measure of statistics.

l Greater the variability means that Riskier the security/ investment.

l Lesser the variability means that More certain the returns, nothing but Least riskye.g. Treasury Bills, Savings Deposit.

The risk can be further classified into six different categories

l Interest rate risk

l Inflation risk

l Financial risk

l Market risk

l Business risk and

l Liquidity risk

271

Risk and Return19.3.1 Interest Rate Risk

l It is risk – variability in a security's return resulting from the changes in the level ofinterest rates.

l Security prices - inverse relationship with

v Recent announcement of the monetary policy by RBI- Hike in CRR 5. 50points to 6 points; change in the rate of interest - change in the prime lendingrate of the banks - Due to Rs. 14,000 cr. amount to be deposited in theReserve Bank of India by the Banks - to curtail the Inflation

Impact on the Security Pricesl If the rate of interest increases then the price of the existing securities will come

down due to more attraction on the new instruments due to lesser demand on theexisting securities more particularly during the periods of inflationary period

l If the rate of interest decreases means that the price of the existing securities willgo up due to lesser attraction on the new investment avenues which are found tobe greater demand for new securities during the periods of deflationary period.

19.3.2 Market Risk

l It refers to variability of returns due to fluctuations in the securities market which ismore particularly to equities market due to the effect from the wars, depressions etc.

l E.g., Greater/lesser investments by the mutual funds, banks, Foreign institutionalinvestors and so on due to entry into or out of the market reflects the market -index is the market risk.

19.3.3 Inflation Riskl Rise in inflation leads to Reduction in the purchasing power which influences only

few people to invest due to

l Interest Rate Risk which is nothing but the variability of return of the investmentdue to oscillation of interest rates due to deflationary and inflationary pressures.

19.3.4 Business Risk

l Risk of doing business in a particular industry / environment is known as businessrisk. Business risk is nothing but Operational risk which arises only due to thepresence of the fixed cost of operations. The Higher the fixed cost of operationsrequires the firm to have Greater BEP to avoid the firm to incur losses. It is normallytransferred to the investors who invest in the business or company, the major reasonis that EBIT of the firm is subject to the fixed cost of operations.

19.3.5 Financial Risk

Connected with the raising of fixed charge of funds viz Debt finance & Preferenceshare capital. More the application of fixed charge of financial will lead to Greater thefinancial Risk which is nothing but the Trading on Equity.

19.3.6 Liquidity Risk

l This is the risk pertaining to the secondary Market, in which the securities can be

Bought and sold quickly and without any concession in the price.

v Liquidity risk reflects only due to the quality of benefits with reference tocertainty of return to receive after some period which is normally revealed interms of quality of benefits. The more the certainty of benefits leads to lesserthe liquidity risk and vice versa.

272


The government & Treasury bills are bearing greater certainty to receive the benefitswhich have least probabilities to fail, denominates that is Lesser Liquidity Risk.

The Equity shares of the companies are bearing the Greater Liquidity Risk is subject tothe quality of benefits, due to the declaration of dividends, which is subject to the availabilityof earnings i.e., EBIT, EAT, EPS and DPS; which are nothing but the determinants ofDemand and supply them in the market among the investors.

19.3.7 Measurement of Risk

The first one is that sensitivity analysis taken for discussion. It considers all possibleoutcomes/return estimates in evaluating risk to study the deviation of the expected returnswhich is nothing but the Sense of Variability among return estimates.

It is being studied through the classification of the span of the investments into followingcategories viz pessimistic, most likely and optimistic. The above set of classifications areon the basis of cycle of the industry or product which it belongs or markets the product.

The next one is to highlight the risk component through the sensitivity analysis

The risk is nothing but the difference in between the optimistic and pessimistic returns,in other words range of the returns. The range of the returns is nothing but the differencein between highest and lowest returns which normally arise during the periods of boomand recession. The greater the range refers to the greater the amount of risk and viceversa. From this table we identify that Asset B is found to be more risky than the assetA, the reason is higher rang in the case of Asset B unlike Asset A; which highlights thedifference in between the returns of optimistic and pessimistic. This method is found tobe a crude method in studying the risk of the securities.

To nullify the bottlenecks associated with the sensitivity analysis, probability distributionis considered for the discussion of risk to study more in detail than the earlier sensitivityanalysis. The probabilities are assigned to reveal the possibilities of occurrence of theevent which ranges in between 1-100% of occurring.

If it is certain to occur means that P= 1

If is not certain to occur means that Q = 1

Based on the probabilities, the expected return of the investment could be found outthrough the multiplication of the respective returns of the horizon which in relevancewith possibility of occurrences.

l Expected rate of return of the security is as follows :- it is weighted average of allpossible returns multiplied by the respective probabilities.

l Probabilities of various Outcomes during the various seasons are known as weights

K × P

Particulars Asset A Asset B

Initial outlay (t = 0) 50 50

Pessimistic 14 8

Most Likely 16 16

Optimistic 18 24

Range 4 16

Assessment of risk

Behavioural Statistical

Sensitivity Probability Standard. Co.-variance Analysis Distribution Deviation

273

Risk and ReturnThe risk can be determined through the statistical measure of dispersion of returns of anexpected value of return of the security.

l Risk is the Standard deviation of returns from the mean/expected value of return

l Square root of squared deviations of the individual expected returns

(å (K–K)2 × P)1/2

Standard Deviation:

l Greater the standard deviation - Greater the risk

l Does not consider the variability of return to the expected value

l This may be misleading - if they differ in the size of expected values

In order to replace the bottlenecks associated with the standard deviation in studying therisk of the security, the co-variation is suggested to study the risk of the security

l It is a measure of dispersion/ measure of risk per unit of expected return

l It converts the standard deviation of expected values into relative values to enablecomparison of risks with assets having different expected values.

Coefficient of variation = S.D

Mean

19.4 RISK AND RETURN OF THE PORTFOLIO

l Portfolio is the Combination of two or more assets or investments.

l Portfolio Expected Return is the weighted average of the expected returns of thesecurities or assets in the portfolio.

l Weights are the Proportion of total funds in each security which form the portfolio

l Wj Kj.

l Wj = funds proportion invested in the security.

l Kj = expected return for security J.

l The risk of the portfolio could be determined what it was in the process of individualassets?

l Benefits of portfolio holdings are bearing certain benefits to single assets.

l Including the various type of industry securities - Diversification of assets.

l The portfolio construction leads to bring down the risk of the portfolio than the riskof single assets.

l It is not the simple weighted average of individual security.

l Risk is studied through the correlation/co-variance of the constituting assets of theportfolio. The Correlation among the securities should be relatively considered tomaximize the return at the given level of risk or to minimize the risk.

Correlation of the expected returns of the constituent securities in the portfolio.

l It is a Statistical expression which reveals the securities earning pattern in theportfolio as together.

l Positive correlation means that Return of the securities in the portfolio are movingtogether in same direction.

l Negative correlation which illustrates that the Return of the securities are movingin opposite direction.

l Zero correlation reveals that there is - No relationship in between the earningspattern among the securities of the portfolio.

l The Co-efficient of correlation normally ranges in between –1 and +1.

274


19.4.1 Diversification of the Risk of Portfolio

Diversification of the portfolio can be done through the selection of the securities whichhave negative correlation among them which formed the portfolio. The return of therisky and riskless assets are only having the possibilities to bring down the risk of theportfolio.

The following example will certainly facilitate to understand the diversification processof the securities in the portfolio through the correlation co efficient of the returns of thesecurities which formed the portfolio:

The above table reveals that Portfolio AB is the better one to diversify the risk as minimumas possible, the reason is that the returns of the respective securities are having negativecorrelation among A&B unlike A &C. The negative correlation of the returns betweenthe A&B only facilitated to reduce the risk to the levels of minimum.

The risk of the portfolio cannot be simply reduced by way adopting the principle ofcorrelation of returns among the securities in the portfolio. To reduce the risk of theportfolio, the another classification of the risk has to be studied, which are as follows:

The risk can be further classified into two categories viz Systematic and Unsystematicrisk of the securities

Systematic Risk - which cannot be controlled due to market influences which is knownas Uncontrollable risk, cannot be avoided

Unsystematic Risk-Which can be minimized or reduced this type of risk throughdiversification of the securities in the portfolio

l Systematic Risk- Unavoidable, Uncontrollable risk - finally Market risk War, inflation,political developments

l Unsystematic Risk- Avoidable, Controllable risk. Strike, Lock out, Regulation

Systematic Risk: Which only requires the investors to expect additional return/compensation to bear the

Unsystematic Risk: The investors are not given any such additional compensation tobear unlike the earlier.

The relationship could be obviously understood through the study of Capital Asset PricingModel (CAPM).

l Developed by William F. Sharpe

l Explains the relationship in between the risk and expected / required return

l Behaviour of the security prices

l Extends the mechanism to assess the dominance of a security on the total risk andreturn of a portfolio

l Highlights the importance of bearing risk through some premium

l Efficiency of the markets

v Investors are well informed

v No transaction costs - No intermediation cost during the transaction

Year Assets/Securities % Portfolio %

A B C AB AC

1 10 18 10 14 10

2 12 16 12 14 12

3 14 14 14 14 14

4 16 12 16 14 16

5 18 10 18 14 18

Expected return 14 14 14 14 14

Standard deviation 2.83 2.83 2.83 0 2.83

275

Risk and Returnv No single investor is to influence the market

l Investor preferences

v Highest return for given level of risk Or

v Lowest risk for a given level of return

v Risk - Expected value, standard deviation

19.5 RELATIONSHIP BETWEEN THE RISK AND RETURN

l Total Return - Risk free rate of return= Excess return (Risk premium)

l Total return = Risk free return + Risk premium

Kj = Rf + bj (Km–Rf)

Bj is nothing but Beta of the security i.e., market responsiveness of the security. Betadiffers from one security to another.

It is normally expressed as a b

b = Non Diversifiable risk of asset or Portfolio

Risk of the Market Portfolio

Risk of the portfolio = After diversification, the risk of the market portfolio is non diversifiable

Check Your Progress

1. Return means

(a) Regular income only (b) Capital appreciation income

(c) (a) & (b) (d) None of the above

2. Risk means

(a) Variability of returns (b) Non variability of returns

(c) Mean of the returns (d) None of the above

3. Interest rate risk means

(a) Affects the price of the existing securities due to change in the rate of interest

(b) Affects the price of the new securities due to change in the rate of interest

(c) Affects the price of the existing and new securities due to change in the rate ofinterest


4. Systematic risk is

(a) Controllable (b) Uncontrollable

(c) Neither controllable nor uncontrollable (d) None of the above

5. Beta is

(a) Diversifiable risk

(b) Undiversifiable risk

(c) Neither diversifiable nor undiversifiable


6. Return is

(a) Risk free return

(b) Risk premiumContd...

276


(c) Risk premium pegged with Beta

(d) Risk free return and Risk premium pegged with Beta

19.6 LET US SUM UP

The variability of the actual return from the expected return which is associated with theinvestment /asset known as risk of the investment. Variability of return means that theDeviation in between actual return and expected return which is in other words asvariance i.e., the measure of statistics. Greater the variability means that Riskier thesecurity/ investment. If the rate of interest increases then the price of the existing securitieswill come down due to more attraction on the new instruments due to lesser demand onthe existing securities more particularly during the periods of inflationary period. Thegovt & Treasury bills are bearing greater certainty to receive the benefits which haveleast probabilities to fail, denominates that is Lesser Liquidity Risk. The risk is nothingbut the difference in between the optimistic and pessimistic returns, in other wordsrange of the returns. The range of the returns is nothing but the difference in betweenhighest and lowest returns which normally arise during the periods of boom and recession.The greater the range refers to the greater the amount of risk and vice versa.

Systematic Risk only requires the investors to expect additional return/compensation tobear the Unsystematic Risk investors are not given to any such additional compensationto bear unlike the earlier.


How will you diversify the risk of portfolio? Elucidate your answer with your own example.

19.8 KEYWORDS

Risk: Deviation in between the actual return and expected return

Return: It is the combination of regular income and capital appreciation income

Yield: Total earnings in terms of market price

Income yield: Earnings in terms of market price

Interest risk: Deviation of return of the security due to fluctuations of interest

Inflation risk: Deviation of return of the security due fluctuations in the purchasingpower with reference to money supply

Operation risk: Risk which is due to fixed cost of operations

Finance risk: Risk due to the application fixed charge of funds

Beta: Co efficient of market responsiveness of the security

Systematic risk: Risk which cannot be diversified

Unsystematic risk: Risk which can be diversified

Risk free return: Return on risk less investments

Risk premium: Return for the undiversifiable risk to bear

CAPM: Capital Asset Pricing Model for the relationship in between Risk and Return


1. Define return.

2. Define risk.

277

Risk and Return3. Explain different types of risk.

4. Explain different types of return.

5. Explain the various statistical measures available for risk.

6. Define Beta.

7. Elucidate the systematic and unsystematic risk.

8. Highlight importance and assumptions of CAPM.




M. P. Pandikumar “Accounting and Finance for Managers”, Excel Books, New Delhi.







UNIT-V

LESSON

20 COST OF CAPITAL

CONTENTS


20.1 Introduction

20.2 Meaning and Assumptions of Cost of Capital

20.3 Measurement of Cost of Debt

20.4 Cost of Preference Share Capital

20.5 Cost of Retained Earnings

20.6 Weighted Average of Cost of Capital

20.7 Let us Sum up


20.9 Keywords




The purpose of this lesson is to discuss about the cost of capital which is used as aphenomenon for the decision criterion in the case of studying the worth of long-termassets. After studying this lesson you will be able to:

(i) understand meaning and assumptions of cost of capital

(ii) describes measurement of cost of debt

(iii) solve problems on cost of debt

(iv) solve problems on cost of preference share of capital

(v) describe cost of retained earnings.

20.1 INTRODUCTION

It is imperative to study the importance of cost of capital to the tune of financing decisionof the firm. The financing decision of the firm normally facilitates the firm to raise thefinancial resources to the requirements of the firm. The raising of the financial resourcesshould be carried out not only to the tune of financial requirements but also it shouldmind about the cost of availing the resource; which means that the cost of raising andapplying the resources in and of the organization. The cost is the most limiting factor ofinfluence for the success of the firm, the reason is that the cost of capital is the majordeterminant of success of the business firm. The firm must be facilitated to raise thefinancial resources at cheaper cost in order to earn more and more.

282


The cost of capital is used as a phenomenon for the decision criterion in the case ofstudying the worth of long-term assets, which have got greater importance in the successof the firm. The cost of capital is instrumented in the Net present value method andInternal rate of return method of studying the worth of long-term assets under the capitalbudgeting decisions of the enterprise.

20.2 MEANING AND ASSUMPTIONS OF COST OFCAPITAL

l It is the Minimum rate of return which the firm should or must earn only in order tomaintain the value of the shareholders.

Classification of the cost of capital: The cost of capital can be classified into twocategories viz specific cost of capital and weighted cost of capital.

Assumptions

l It is on the basis of Operating Risk i.e., Business Risk of the firm which is nothingbut determinant of influence is Fixed Cost of Operations. The cost of capital issubject to the volume of fixed cost of operations of the firm.

l On the basis of Financial Risk i.e., with reference to Financial Commitments ofthe firm which in other words as financial Risk. The Interest on debenture,Preference Dividend on Preference share capital should be paid without failirrespective of the firms' earnings according to the terms and conditions of theissue. The greater the fixed financial commitments require the firm to earn moreand more in order to retain the interest of the shareholders of the firm.

l Operational Terms - capital structure remain unchanged; unless the cost of capitalof the firm would change.

l For new projects, funds are raised only at same proportion.

How the cost of capital is to be denominated in terms ?

Whether the cost of capital is to be denominated in terms of after tax or before tax. Whyit has to be expressed in terms of after tax ? Why not the before tax cost should be takeninto consideration?

For appraising the projects, the return of the investments are considered for comparisonwhich are nothing but the resultant of earnings of the firm immediately after the paymentof tax. To study the quality of the projects, both factors must be at common at parlancefor comparison.

While computing the cost of capital, the cost of specific sources should be to the tune ofafter tax only in order to have an effective comparison.

v Then, the cost of capital is further bifurcated into two categories viz Explicitcost of capital and Implicit cost of capital.

v Explicit cost of capital: The discount rate that equates the present value ofthe cash inflows that are incremental to the taking of the financing opportunitywith the present value of its incremental cash outflows.

It is further explained that rate of return of cash flow of the financing opportunity. Itnormally takes place only at the moment of raising of financial resources.l Implicit cost of capital: It is nothing but the Opportunity cost of capital of the

firm to earn through investing elsewhere by the shareholders themselves or by thecompany itself. It is rate of return which is associated with the best investmentopportunity for the firm and its shareholders that would have to be forgone, whichwere presently considered by the firm.

l Specific cost of specific source of capital:Each source of capital has its owncost at the moment of raising which form part of the computation of total cost ofcapital of the firm.

283

Cost of Capital20.3 MEASUREMENT OF COST OF DEBT

The cost of the perpetual debt is nothing but the cost of raising the debt financial resource,in which the time period of repayment of the principal is not known.

This particular specific source has two different classifications viz cost of interest andcost of debt.

InterestCost of interest (Ki) =

Sale value

Tax adjusted InterestCost of Debt (Kd) =

Sale value

Problem on Cost of Debt

l A company has 10 percent perpetual debt of Rs.1,00,000. The tax rate is 35 percent. Determine the cost of capital (before tax as well as after tax) assuming thedebt is issued at i) at par ii) at 10% discount iii) at 10% premium.

Check Your Progress

1. A company is considering raising Rs 100 lakh by one of the two alternativemethods. viz 14 percent institutional term loan and 13 percent non - convertibledebentures. The term loan option would attract no major incidental cost. Thedebentures would have to be issued at a discount of 2.5 per cent and wouldinvolve Rs. 1 lakh as cost of issue.

Advise the company as to the better option based upon the effective cost ofcapital in each case. Assume tax rate of 35 per cent.

The next method of computing the cost of debt is only for the debt finance which knowsthe repayment period of the principal and the payment of the interest periodicals.

This process of computation could be divided into two categories

First one is the periodical repayment of the principal along with the periodical paymentof interest periodicals.

t)kd1(

COPnCOItCIo

++=

The second one is the lump sum repayment of the principally only at the end of the termof the debenture.

At par

Cost of Interest

Ki= Rs.10,000/Rs.1,00,000=10%

Cost of Debt

Kd= Rs.10,000(1-.35)/Rs.1,00,000= 6.5%

At Discount

Cost of Interest

Ki=Rs.10,000/ Rs.90,000= 11.11%

Cost of Debt

Kd= Rs.6,500/90,000= 7.22%

At Premium

Cost of Interest

Ki= Rs.10,000/Rs.1,10,000=9.09%

Cost of Debt

Kd=Rs 6,500/Rs.1,10,000=5.90%

284


t n

COIt COPnCIo = +

(1+kd) (1+Kd)

Problem on cost of debt

l A company issues a new 10 percent debentures of Rs.1,000 face value to beredeemed after 10 years. The debenture is expected to be sold at 5 percent discount.It will also involve flotation cost of 5 per cent of face value. The company’s taxrate is 35 per cent what would be the cost of debt be ? Illustrate the computationsi) trial and error approach and ii) shortcut method.

Trial Error approach:

The first step is to determine the cash flows involved in the process of the debentures issue

10

tT 1

n

Rs 65 Rs. 1,000Rs. 900 = +

(1+Kd)(1+kd)=

The present value of the future cashflows should be found out one after the another.

The determination of present value at 7% and 8%

The value of Cost of debt is 8%

The short cut method is as follows

lI(1– t) + (f + d + pred - pi)/N

Kd = (RV +SV)/2

I=Annual interest payment

T=tax rate

F=Flotation cost

d=Discount on debentures

pred=premium on redemption

pi=premium on issue of debentures

RV=Realisable value

SV=Sale value

Kd= 7.9%

Years Particulars

0 Rs.900 at the moment of raising i.e., cash in flow during the issue of debenture–Rs.1,000–Rs.50–Rs.50

1-10 Regular flow interest payment

The interest outflow which is subject to the adjustment of taxation Rs100(1– 0.35)=Rs.65

10 Final repayment of the principal

The last payment is nothing but the repayment of the principal Rs.1,000

Present value Total Present value Years Cash

@ 7% @ 8% @7% @ 8%

1-10 Rs.65(Annuity Table) 7.024 6.710 Rs.456.56 Rs.436.15

10 1,000(Single flow table) 0.508 .463 Rs.508.00 Rs.463.00

964.56 899.15

285

Cost of CapitalCheck Your Progress

A company issues 11 percent debentures of Rs.100 for an amount aggregatingRs.1,00,000 at 10 percent premium, redeemable at par after five years. Thecompany’s tax rate is 35 per cent. Determine the cost of debt using theshortcut method.

20.4 COST OF PREFERENCE SHARE CAPITAL

The next specific source of cost is cost of preference share capital

l Cost of preference share capital - From the angle of interest on the amount ofdebentures it is also like a fixed in charge but not contractual obligation, but theinterest payment is contractual in obligation in accordance with the terms andconditions of the issue agreement reached earlier with the company, irrespectiveof the profits earned.

l Preference dividend is to be paid only with reference to availability of profits.Normally the Expectations of the preference shareholders are nothing but thepreference dividends. The preference shares are classified into two categories vizRedeemable and Irredeemable

l Let us discuss at first about the Irredeemable preference shares during the issue

The first one is the methodology for the computation of the cost of irredeemablepreference share

l

Dividend preference share Kp =

P0 (1–f)

The second methodology incorporates the dividend taxation which is normallyborne by the company during the moment of declaration.

Kp=Dividend prefernce(1+Dt) Kp =

P0 (1–f)

ABC company issues 11 percent irredeemable preference shares of the face value ofRs. 100 each. Flotation costs are estimated at 5 per cent of the expected sale price a) parvalue b) 10% premium c) 5% discount and also compute the Dividend tax at 13.125%

The next methodology under the preference share capital is the cost computation forredeemable preference share capital. Under this the period of payment of capital isknown along with the payment periodical preference dividends.

At par

Cost of Preference share capital

Kp= Rs11./Rs 95.=11.57%

Cost of preference share with dividend tax

Kp = Rs.11(1+.13125) = 13.09%

Rs.95

At Discount


Kp=Rs.11/ Rs.110(.95).= 10.5%

Cost of preference share with dividend tax

Kp = Rs.11(1+.13125) = 13.81%

Rs 110(.95)

At Premium


Ki= Rs.11/Rs.95(.95)=12.2%

Cost of preference share capital with dividend tax

Kd = Rs.11(1+.13125) = 13.78%

Rs 95(.95)

286


l t n

Dp PnPo (1-f) = +

(1+kp) (1+kp)

Problem on the preference share capital

l Xion Ltd has issued 11% preference shares of the face value of Rs.100 each to beredeemed after 10 years. Floatation cost is expected to be 5% Determine the costof preference shares Kp

10

tT 1

10

Rs 11 Rs. 1,000Rs. 95 = +

(1+Kd)(1+kp)=

The value of the Kp is lying in between the two rates of discounts viz 11% and 12%

Determination of present value in between 11% and 12%

Cost of preference share capital is Kp= 11.9%

The next important cost to be determined is that cost of equity share capital:

l Equity dividends is not at par with Interest and Preference dividends, these twoare subject to fixed in principle. The payment of dividends are subject to the availabilityof earnings and the future prospects of the firm in the future to grow.

l Equity shareholders are the last claimants of the company not only in sharing theprofits of the company at the end of every year immediately after anything paid tothe preference shareholders. It never carries any fixed rate of dividends subjectto the availability of profits to disburse.

l Market value of shares are determined by the Equity dividends which are nothingbut the return expect to get.

l Ke= a minimum rate of return which the firm should earn from the equity portionof financing of the project in order to maintain the value of the share prices.

There are many more models in the computation of cost of equity

i) Dividend valuation model

ii) Capital Asset Pricing Model

l Dividend valuation model: The Cost of equity capital Ke is in terms of requiredrate of return to the tune of future dividends to be paid to the investors.

v It is discount rate which equates the present value of future dividends pershare with sale proceeds of a share (after adjusting the expenses of flotationof a share)

v

Dividend of the first year1Po =

Ke – g

Dividend of the first year1 + GKe =

Po

Year Cash outflow Present value @ Total Present value @ Rs

1 to 10 years Rs11 5.889 5.65 64.78 62.15

10th yr completion Rs.100 .362 .322 35.15 32.20

99.93 94.35

287

Cost of CapitalProblem:

Dividend per share Re 1 Growth rate = 6% Assuming the market price is Rs. 25

What would be market price of a share after 1 year and 2 year

Ke= Re.1/25+ 6%= 4%+ 6%= 10%

The market price at the end of 1 year

Rs.1.06P1 = = Rs.26.5

10%-6%

The market price at the end of 2nd year

Rs.1.12P2 = = Rs.28

10%-6%

l Capital Asset Pricing Model approach: The cost of equity share capital iscomputed by registering the Beta with reference to the non diversifiable risk inaddition to the diversifiable risk of the equity share with reference to marketresponsiveness.

The basic assumptions of the CAPM approach

(i) The efficiency of the security markets

(ii) Investor preferences

The efficiency of the security markets is embedded with the following assumptions:

(a) All investors are common expectations about the expected returns, variances andcorrelation of the expected returns among the various securities in the market

(b) All investors have equivalent amount of information

(c) All investors are rational

(d) No transaction costs

(e) No single investor influence the market

The investors' preference with reference to two different types of returns

(i) Highest level return at minimum level risk or

(ii) Lowest level of risk for given level of return

The above alternatives are subject to two different type of risk viz Systematic andUnsystematic risk.

Systematic risk which cannot be reduced i.e., undiversifiable risk for which allowancesare given to the investors.

Unsystematic risk which can be reduced to the level of minimum for which no otherallowances are given to the investors.

The allowances are given to the investors only subject to the market responsivenessBeta coefficient

Ke= Rf+ b(Km–Rf)

Problem

l The hypothetical ltd wishes to calculate the cost of equity capital using the CAPMapproach. From the information that the risk free rate of return equals 10% ; thefirms beta equals 1.50 and the return on the market portfolio equals 12.5% Computethe cost of equity capital

Ke= 10% + 1.5×(12.5%-10%)=13.75%

288

Accounting and Finance forManagers 20.5 COST OF RETAINED EARNINGS

The next important cost of specific source of capital is cost of retained earnings.

The cost of retained earnings is to be computed on the basis of opportunity cost. It doesnot have any direct cost, instead, the amount of retained earnings loses the opportunityof the investors to earn in the form of dividends due to retained earnings; which areforegone by them one side and on the other side the earnings which are retained areinvested in some other investments, would be in a position to yield the return, is the costof retained earnings.

It could be defined as "cost of retained earnings is the opportunity cost in terms ofdividends foregone by with held from the equity shareholders." The cost of retainedearnings is nothing but the external criterion which is equal to the Ke. Practically speaking,Ke is more than the Kr due to the floatation cost involved in the process of issue ofshares.

20.6 WEIGHTED AVERAGE OF COST OF CAPITAL

The term cost of capital is nothing but the overall cost of capital which is to be computedto the tune of the proportion of the funds in the mixture; should computed only to the tuneof assignment of weights. The weight average cost of capital has its own steps to followduring the process of computation.

l Assigning the weights

l Multiplying the weights with the specific cost of the fund

l Dividing the total cost immediately after adding them together by the summation ofweights

l It is denominated by Ko

The weights are normally classified into two major classification viz

l Marginal weights

l Historical weights

Marginal weights: Assignment of weights to the specific cost by the proportion of theeach fund to be raised to the total fund

Historical weights: The weights are assigned to the specific source of fund to the tuneof the proportion of the fund in the existing capital structure. This type of historicalweight is further classified into two different categories viz:

l Book value weights and Market value weights.

l Book value weights are assigned to the tune of book values to measure the proportionof each type of capital.

Market value weights are assigned to the tune of market value to measure the proportionof each type of capital.

Problem

A company has on its books the following amounts and specific cost of each type of capital.

Type of capital Book value Market value Specific cost Rs

Debt Rs.4,00,000 3,80,000 5

Preference 1,00,000 1,10,000 8

Equity 6,00,000 15

Retained earnings 2,00,000 12,00,000 13

13,00,000 16,90,000

289

Cost of CapitalDetermine the weighted average cost of capital using (a) Book value weights and (b)Market value weights.

The determination of the weighted average cost of capital using book value weights

Rs.1,44,000Ko = × 100 = 11.1%

Rs.13,00,000

The determination of Market value weights

Rs.2,01,000Ko = × 100=11.9%

Rs.13,00,000

20.7 LET US SUM UP

The cost is the most limiting factor of influence for the success of the firm, the reason isthat the cost of capital is the major determinant of success of the business firm. The costof capital is used as a phenomenon for the decision criterion in the case of studying theworth of long-term assets. Cost of capital is the minimum rate of return which the firmshould or must earn only in order to maintain the value of the shareholders. The cost ofthe perpetual debt is nothing but the cost of raising the debt financial resource, in whichthe time period of repayment of the principal is not known. This particular specific sourcehas two different classifications viz cost of interest and cost of debt.

The term cost of capital is nothing but the overall cost of capital which is to be computedto the tune of the proportion of the funds in the mixture; should computed only to the tuneof assignment of weights. The weight average cost of capital has its own steps to followduring the process of computation.


A company has issued 15% preference shares of the face value of Rs.100 each to beredeemed after 20 years. Flotation cost is expected to be 5% of the expected salesprice. Determine the cost of preference shares.

20.9 KEYWORDS

Cost of capital: It is the minimum rate of return to be earned at which the capital israised

Implicit cost of capital: It is the minimum rate of return to be earned by the firm, at themoment of retaining the earnings, towards the investment decision

Type of capital Book value Specific cost Rs Total costs BV* K

Debt Rs.4,00,000 5 19,000

Preference 1,00,000 8 8,000

Equity 6,00,000 15 1,35,000

Retained earnings 2,00,000 13 39,000

13,00,000 2,01,000

Type of capital Market value Specific cost Rs Total costs BV* K

Debt 3,80,000 5 Rs.20,000

Preference 1,10,000 8 8,000

Equity 9,00,000 15 90,000

Retained earnings 3,00,000 13 26,000

16,90,000 1,44,000

290


Explicit cost of capital: It is the cost incurred by the firm at the moment of raising

Specific cost of capita: It is the cost incurred at every moment for raising the specificresource of capital

Book value weights: Weights assigned to the tune of the book value of the capital

Weighted average cost of capital: The aggregate of the weighted specific resourcescost of capital is weighted average cost of capital


1. Define cost of capital.

2. Explain the various types of cost of capital.

3. Explain the methodology involved in the process of computing the weighted averagecost of capital.

4. Explain the meaning of assigning the weights on the specific sources of capital.






M.P. Pandikumar “Accounting & Finance for Managers”, Excel Books, New Delhi.





LESSON

21 LEVERAGE ANALYSIS

CONTENTS


21.1 Introduction

21.2 Operating Leverage

21.3 Financial Leverage

21.4 EBIT-EPS Analysis

21.5 Combined Leverage

21.6 Let us Sum up


21.8 Keywords




The main objective of this lesson is to discuss about operation and financial leveragesand their impact. After studying this lesson you will be able to:

(i) describe the concept of operating leverage and calculate the degree of operatingleverage

(ii) explain various aspects of financial leverage

(iii) describe EBIT-EPS analysis to study the impact of the leverage

21.1 INTRODUCTION

Leverage means the fixed commitment of the organization. The fixed commitment ofthe organization can be classified into two different categories viz fixed cost of operationsand fixed cost of servicing. The fixed cost of operations are pertaining to the investmentdecisions and the fixed cost of servicing with reference to the financing decision.

Fixed cost of operations – Investment decisions.

Fixed cost of servicing – Financing decisions.

If Revenues are more than the Variable Cost and Fixed Cost, that is called favorableor otherwise unfavorable.

21.2 OPERATING LEVERAGE

Operating Leverage is connected with the acquisition of assets where as the financialLeverage is connected with the Financing of activities.

292


Operating leverage:It is a relationship in between the Sales and Earnings beforeinterest and taxes.

Financial leverage: It is a relationship in between the Earnings before interest andtaxes and Earnings per share.

Operating and Financial: In the Operating and Financial leverages, the EBIT is foundas a common phenomenon. During the first part of the chapter, let us discuss about theoperating leverage. It emerges only due to Fixed operating expenses. By and large, theexpenses are classified into two categories viz Fixed and Variable in categories for theanalysis of leverage.

l Operating Leverage is defined as the ability to use fixed operating costs to magnifythe effects of changes in sales on its earnings before interest and taxes.

l Described as % change in profits accompanying the % change in volume.

l "The firms' ability to use fixed operating costs to magnify the effects of changes inthe sales on its earnings before interest and taxes".

l A firms sells products for Rs 100 per unit has variable operating costs of Rs. 50 perunit and fixed operating cost of Rs. 50,000 per year. Show the various levels ofEBIT that would result from sale of i) 1000 units ii) 2000 units iii) 3000 units.

From the above illustration, it is obviously understood that from the two different cases.

Case A illustrates that 50% increase in the volume of sales led to 100% increase in thevolume of profit.

Case B highlights that 50% reduction in the volume of sales led to 100% decrease in thevolume of profit.

It is clearly evidenced that % change in the volume of sales is less than the % change inthe volume of profit.

The next step is to define the Degree of Operating Leverage (DOL)

l DOL is the measure reveals the extent or degree of operating leverage.

l When Operating leverage exists ?

Proportionate change in EBIT of a given change in sales is greater than the Proportionatein sales

Percentage change in EBITDOL = > 1

Percentage change in Sales

Case A= 100%/50%= =+2

Case B=(–100%)/(–50%)=+2

Case B Base Case A

Level from the base –50% +50%

Sales in units 1,000 2,000 3,000

Sales volume in Rs 1,00,000 2,00,000 3,00,000

Variable cost 50,000 1,00,000 1,50,000

Contribution 50,000 1,00,000 1,50,000

Fixed cost 50,000 50,000 50,000

Profit Zero 50,000 1,00,000

–100% +100%

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Leverage AnalysisBy algebraically proven and the following formula has derived to determine the DOLthrough the alternate methodology

Total Contribution (Base Level)DOL =

EBIT ( Base Level)

To determine the degree of the operating leverage, from the above illustration which isapplied

DOL= Rs.1,00,000/Rs.50,000= +2

The answer of the DOL has been checked in both directions to the direct methodology.

If there is no fixed operating cost in the manufacturing enterprise ? What would be theDegree of Operating leverage ?

Calculate the Degree of operating leverage

Total contributionDOL =

EBIT

To find out the EBIT = Sales -VC=Contribution i.e. EBIT

R400DOL = = +1

Rs.400

In the alternate methodology, the DOL is as follows:

% change in EBIT 10%DOL = = = +1

% change in Sales 10

When there is no fixed cost in the cost of operations means that the firm does not haveoperating leverage in its operations.

The operating leverage is related to the operating risk of the investments, which meansthat fixed cost of operations of the enterprise. It highlights that greater the fixed cost ofoperations means that higher the operating risk; which means that greater will be breakeven point and vice versa. The greater volume of fixed cost of operations are found tobe more favorable only during the occasion of greater volume of earnings, unless otherwisethe dominance of fixed cost of operations are found to be undesirable to magnify thevolume of EBIT.

21.3 FINANCIAL LEVERAGE

The next leverage is Financial Leverage which arises due to servicing of financialresources.

l It results from the presence of fixed financial charges in the firms. The fixedfinancial charges are nothing but the preference dividend and interest on the fixedcharge financial resources.

l Financial leverage, how the fixed charge financial resources influence the EBITof the firm and finally provides earnings to the shareholders. It reveals the ability

Particulars Base Level New Level

Units sold 1,000 1,100

Sales price per unit Rs.10 Rs.10

Variable cost per unit 6 6

Fixed operating cost Nil Nil

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of the firm to make use of "fixed financial charges to magnify the effects of changesin EBIT on the earnings per share".

The other name of the financial leverage is Trading on Equity, which illustrates therelationship in between the application of the fixed charge of funds in the capital structureand Earning per share. It is the leverage analysis highlights the relationship in betweenthe financing decision and investment decision.

The fixed financial charge should pave way for the firm to not only to earn the greaterEBIT but also to magnify the EPS of the shareholders.

l The financial manager of the hypothetical ltd expects that its earnings beforeinterest and taxes (EBIT) in the current year would amount to Rs.10,000. Thefirm has 5 percent bonds aggregating Rs.40,000 while the 10 percent preferenceshares amount to Rs. 20,000 what should be the earnings per share (EPS)?Assuming the EBIT being i) Rs.6,000 Rs.14,000. How EPS is affected ? The firmtax bracket 35%. Ordinary number of shares 1,000

From the above illustration, 40% increase in the level of EBIT posed 81.25% increase inthe EPS and vice versa.

Financial leverage can be quantified through the Degree of Financial Leverage (DFL)

The degree of financial leverage is defined as the ratio of % change in the EPS and %change in the EBIT. Which always greater than 1. The degree of financial leverage ismore than one due to presence of fixed charge of financial resources. This profoundrelationship is algebraically proven and illustrated that

EBITDFL (Base) =

EBIT–I–Dp/1–t

DFL of the above firm is as follows:

% change in EPS 81.25%DFL = = = 2.03125

% Change in EBIT 40%

Alternately, the DFL is computed as follows through the following methodology

Rs. 10,000DFL =

Rs10,000 – Rs.2,000–Rs.2,000/.65

= 2.03125

The same example drawn for our better understanding by excluding the fixed charge offinancial resources

Case 2 Base Case 1 Level from the base –40% +40%

EBIT 6,000 10,000 14,000

Interest 2,000 2,000 2,000

Earnings Before Interest 4,000 8,000 12,000

Taxes 35% 1,400 2,800 4,200

EAT 2,600 5,200 7,800

Preference dividend 2,000 2,000 2,000

Earnings to share holders 600 3,200 5,800

EPS .6 3.2 5.8

Level –81.25% –81.25%

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Leverage Analysis

% change in EPS Degree of financial leverage =

% Change in EBIT

+ 40%Case A = = + 1

+40%

40%Case B = = + 1

40%

−−

Alternately, the DFL could be found out as follows:

Rs.10,000= = +1

Rs.10,000–0–0

It means that the higher Degree of financial leverage means that greater the financialrisk of the firm and vice versa. The greater degree of financial leverage is favorableonly during the greater volume of EBIT to meet the fixed charges unless otherwise, thefirm is required to undergo for liquidation. The interest of the firm may be brought underthe control of the debenture holders and preference shareholders.

21.4 EBIT-EPS ANALYSIS

It is an analysis to study the impact /effect of the leverage. This could be studied throughcomparison of various financing plans of EBIT.

(i) Exclusive use of debt

(ii) Exclusive use of Equity shares

(iii) Exclusive use of Preference shares

(iv) Combination of (i), (ii) & (iii)

(v) Combination of (i) & (ii)

(vi) Combination of (ii) & (iii)

(vii) Combination of (i) & (iii)

Among the various plans, we have to identify the best plan which has highest EPS overthe others.

The firm which has highest EPS normally has least volume of fixed financial chargeover the other firms.

What is meant by financial break even point ?

It is the level of EBIT to meet the fixed financial charge of the firm viz Interest on longterm borrowings/Debentures and Preference dividend on Preference shares.

The following formula is used to compute the financial break even point for the firm toearn at least to cover the fixed financial charges of the firm:

Case B Case A

Level of Change – 40% + 40%

EBIT 6,000 10,000 14,000

Taxes 35% 2,100 3,500 4,900

EAT 3,900 6,500 9,100

Earnings to share holders 3,900 6,500 9,100

EPS 3.9 6.5 9.1

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Financial break even point= I + PD/1–t

The next analysis is nothing but Indifference point.

Indifference Point:

It is the point at which the EPS and EBIT are nothing but the same for two differentfinancing plans known as the indifference point.

The indifference point could be found out through the following analyses:

(i) Algebraic approach

(ii) Graphic approach

The measures of the Financial leverage:

They are two in categories:

(i) Stock terms

(ii) Flow terms

Stock Terms: The following are the two ratios viz debt equity ratio and debt + preferenceshare capital to total capitalization ratio to measure the financial leverage.

Flow terms: The financial leverage means debt service ration and preference dividendcoverage ratio to measure the capacity of the firm in meeting the periodical fixed financialcommitments of the firm.

21.5 COMBINED LEVERAGE

It is the combination of both leverage viz Operating leverage and financial leverage. Thecombination means that the product of both leverages viz operating risk and financialrisk, which facilitates to determine the total risk of the firm.

DCL= DOL XDFL

% change in EPSDCL =

% change in Sales

The combined leverage is nothing but % change in the sales volume of the firm leads tocertain % change in the EPS.

DCL = Contribution/EBIT–I

Check Your Progress

1. Elucidate the Degree of Financial leverage.

2. Explain the detailed process of EBIT-EPS analysis.

21.6 LET US SUM UP

Leverage means the fixed commitment of the organization. The fixed commitment ofthe organization can be classified into two different categories viz fixed cost of operationsand fixed cost of servicing. Operating leverage is a relationship in between the Salesand Earnings before interest and taxes. Financial leverage is a relationship in betweenthe Earnings before interest and taxes and Earnings per share. The operating leverage isrelated to the operating risk of the investments, which means that fixed cost of operationsof the enterprise. It highlights that greater the fixed cost of operations means that higherthe operating risk; which means that greater will be break even point and vice versa.

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Leverage AnalysisThe greater volume of fixed cost of operations are found to be more favorable onlyduring the occasion of greater volume of earnings, unless otherwise the dominance offixed cost of operations are found to be undesirable to magnify the volume of EBIT. Theother name of the financial leverage is Trading on Equity, which illustrates the relationshipin between the application of the fixed charge of funds in the capital structure andEarning per share. It is the leverage analysis highlights the relationship in between thefinancing decision and investment decision. EBIT-EPS analysis is an analysis to studythe impact /effect of the leverage.


Discuss the role of EBIT-EPS analysis in studying the effect of leverage.

21.8 KEYWORDS

Leverage: Fixed commitments of the firm

Operating leverage: It is a measure in the expression of business risk throughquantification of fixed cost

Financial leverage: It is an expression of financial risk due to the presence of fixedfinancial commitment of the firm

Combined leverage: Combination of both leverages i.e. Product of Operating andFinancial leverages

Financial break even point: It is a level of EBIT to cover the fixed financial commitmentof the firm

Indifference point: It is the point at which the EBIT and EPS level of the two differentfinancing plans are nothing but the same.


1. What is leverage ?

2. Classify the type of leverages.

3. Define operating leverage.

4. Explain the Degree of operating leverage.

5. Define the financial leverage.

6. Describe the combined leverage.

7. Define Indifference point.

8. Define Financial break even point.










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22 CAPITAL STRUCTURE THEORIES

CONTENTS


22.1 Introduction

22.2 Assumption of the Capital Structure Theories

22.3 Net Income Approach

22.4 Net Operating Income Approach

22.5 Modigliani–Miller Approach

22.6 Traditional Approach

22.7 Types of Dividend Policies

22.7.1 Cash Dividend Policy

22.7.2 Bond Dividend Policy

22.7.3 Property Dividend Policy

22.7.4 Stock Dividend Policy

22.8 Let us Sum up


22.10 Keywords




The purpose of this lesson is to identify the optimum capital structure for business fleeces.After studying this lesson you will be able to:

(i) describe different theories of capital structure

(ii) explain aspects of capital structure decision-making

(iii) describe different types of dividend policies

22.1 INTRODUCTION

The capital structure theories are facilitating the business fleeces to identify the optimumcapital structure. The optimum capital structure of the organization differs from oneapproach to another due the assumption which are underlying with reference to manyfactors of influence. The success of the firm is normally depending upon the rate atwhich the financial resources are raised, differs from one organisation to another dependsupon the needs. The cost of capital is having greater influence on the EBIT level of the

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Capital Structure Theoriesfirm; which directs affects the amount of earnings available to the investors, that finallyreflects on the value of the firm. The more earnings available at the end will lead togreater return on investment holdings of the investors, would enhance the value of sharesdue to greater demand. There are two set of approaches with reference to capitalstructure; which normally influences the Value of the firm through the cost of overallcapital(Ko) is one approach called relevance approach capital structure theories andother do not have any influence on the value of the firm is known as irrelevance approach.The debt finance in the capital structure facilitates the firm to enhance the value of EPSon one side on the another side it is subject to the financial leverage with reference totrading on equity. The application of leverage in the capital structure enhances the valueof the firm through the cost of capital.

The following are the various capital structure theories:

(i) Net income approach

(ii) Net operating income approach

(iii) Modigliani and Miller approach

(iv) Traditional approach

22.2 ASSUMPTION OF THE CAPITAL STRUCTURETHEORIES

(i) There are only two resources in the capital structure viz Debt and Equity sharecapital

(ii) The dividend pay out ration 100% which means that there is no scope for theretained earnings

(iii) The life of the firm is perpetual

(iv) The total assets of the firm do not change

(v) The total financing remains constant through balancing taking place in between thedebt and share capital

(vi) No corporate taxes; this was removed later

22.3 NET INCOME APPROACH

Algebraically, the relationship between the cost of equity, cost of overall capital anddebt-equity ration are explained as follows:

Ke=Ko+ (Ko–Ki)B/S

Net income approach was developed by Durand, in this he has portrayed the influenceof the leverage on the value of the firm, which means that the value of the firm is subjectto the application of debt i.e., leverage.

In this approach, the cost of debt is identified as cheaper source of financing than equityshare capital. The more application of debt in the capital structure brings down theoverall capital, more particularly 100% application of debt finance leads to resemble theover all cost of capital as cost of debt. The weighted average cost of capital will comedown due to more application of leverage in the capital structure, only with reference tocheaper cost of raising than the equity share capital cost.

Ko= Ke(S/V)+Ki(B/V)

The value of the firm is more in the case of lesser overall cost of capital due to moreapplication of leverage in the capital structure. The optimum capital structure is that at

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when the value of the firm is highest and the overall cost of capital is lowest.

V=B+S

V= EBIT/Ko

This approach highlights that the application of leverage influences the overall cost ofcapital and that affects the value of the firm.

22.4 NET OPERATING INCOME APPROACH

This another approach developed by Durand, which has underlying principle that theapplication of leverage do not have any influence on the value of the firm through theoverall cost of capital. The more application of leverage leads to bring down the explicitcost of capital on one side and on the other side implicit cost of debt is expected to go up.How the implicit cost of debt will go up? The more application of debt leads to increasethe financial risk among the investors, that warranted the equity share holders to bearadditional financial risk of the firm. Due to additional financial risk, the share holders arerequiring the firm to pay additional dividends over the existing. The increase in theexpectations of the shareholders with reference to dividends hiked the cost of equity.

Under this approach, no capital structure is found to be a optimum capital structure. Themajor reason is that the debt-equity ratio does not influence the cost of overall capital,which always nothing but remains constant.

It is finally concluded that this approach highlights that application of leverage nevermakes an attempt to enhance the value of the firm, in other words which is known asunaffected by the application of leverage.

22.5 MODIGLIANI–MILLER APPROACH

It is the approach, attempts to explain the application of leverage does not have anyinfluence on the value of the firm through behavioural pattern of the investors. Thebehavioural pattern of the investors is taken into consideration for explaining the value ofthe firm which is unaffected by the application of debt/leverage in the capital structurethrough arbitrage process. The MM approach has three different propositions:

(i) The overall capital structure of the firm is unaffected by the cost of capital andegree of leverage

(ii) The cost of equity goes up and offset the increase of leverage in the capital structure

(iii) The cut off rate for the investment purposes is totally independent.

For discussion, the proposition is only considered for the study of usage of leverage inthe capital structure, which do not have any impact in the value of the firm.

Assumptions of the MM approach:

This approach is discussed under the perfect market conditions

(i) Securities are divisible infinitely.

(ii) Investors are allowed to buy and sell securities

(iii) Investors are rational to access the information

(iv) No transaction costs involved in the process of the buying and selling of securities

Arbitrage process: It is the process facilitates the individual investors to buy theinvestments at lower price at one market and sells them off at higher price in anothermarket. With the help of arbitrage process, the investors are permitted to shift holding ofthe Levered firm to the unlevered firm which is known as undervalued. These two firmsare identical in business risk except in the application of debt finance in the levered firm.In order to maintain the similar amount of the financial risk of the firm, the investor isrequired to undergo for personal leverage or home made leverage to maintain the same

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Capital Structure Theoriesproportion of investment in the unlevered firm. During this process, the investor couldsave something and this continuous arbitrage process will level the value of the bothfirms. It means that the value of the firm is unaffected by the application of leveragewhich is explained through the arbitrage process, nothing but behavioural pattern of theinvestors.

The same thing could be applied in the case of reverse arbitrage process in between theUnlevered and levered. This also another kind of process in which the investor couldgain through the transfer of the holdings from the unlevered firm to levered firm.

The value of the firm is unaffected by the application of the leverage in the capital structure.

22.6 TRADITIONAL APPROACH

The traditional approach is known as intermediate approach in between the Net incomeapproach and NOI approach. The value of the firm and the cost of capital are affectedby the NI approach but the assumptions of the NOI approach are irrelevant. The cost ofoverall capital will come down due to the application cheaper source of financing vizDebt financing to some extent, after certain usage, the application of debt will enhancethe financial risk of the firm, which will require the share holders to expect additionalreturn nothing but is risk premium. The risk premium which is expected by the investorswill enhance the overall cost of capital.

The optimum capital structure "the marginal real cost of debt, defined to include bothimplicit and explicit will be equal to the real cost of equity. For a debt-equity ratio beforethat level, the marginal cost of debt would be less than that of equity capital, whilebeyond that level of leverage, the marginal real cost of debt would exceed that of equity.

22.7 TYPES OF DIVIDEND POLICIES

The dividend policy is the policy that facilitates the firm to decide how much should bedeclared as a dividend. The declaration of dividend is normally to be taken with referenceto the future prospects of the firm. The dividends are normally decided by the board ofdirectors during the board meeting which may affect other important decisions of thefirm. Most of the companies never think off about the future prospects before thedeclaration of the dividends to the shareholders. As a finance manager should emphasizethe importance of declaring or non declaring the dividends which are having greaterinfluence on the futuristic decisions of the enterprise.

Types of dividend policies:

(i) Cash dividend

(ii) Bond dividend

(iii) Property dividend

(iv) Stock dividend

22.7.1 Cash Dividend Policy

The dividends are paid in terms of cash. This type of dividend normally leads to cashoutflow which has greater influence on the cash position of the firm. At the moment ofdeclaring the cash dividend, future cash needs should be predetermined and dividendsdeclared to the share holders.

22.7.2 Bond Dividend Policy

Instead of paying dividend in terms of cash, some companies are issuing bond dividends,which facilitate them to postpone the immediate cash outflows. Immediately after the

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issuance of bonds, the bond holders are receiving the interest on their holdings besidesthe bond values to be paid on the due date. This method is not popular in India.

22.7.3 Property Dividend Policy

Instead of paying dividends in cash, some assets are given to the shareholders as dividendpayments. This is also not existing in India.

22.7.4 Stock Dividend Policy

Instead of making the payment of cash dividend, the stock are issued to the existingshareholders. The company shares are issued to existing share holder which is knownother words as stock dividends.

Check Your Progress

1. Write a note on the Modigliani–Miller approach.

2. Explain the various types of dividend policies.

22.8 LET US SUM UP

The capital structure theories are facilitating the business fleeces to identify the optimumcapital structure. The optimum capital structure of the organization differs from oneapproach to another. The cost of capital is having greater influence on the EBIT level ofthe firm; which directs affects the amount of earnings available to the investors, thatfinally reflects on the value of the firm. Net income approach, the cost of debt is identifiedas cheaper source of financing than equity share capital. Net Operating income approachdeveloped by Durand, which has underlying principle that the application of leverage do nothave any influence on the value of the firm through the overall cost of capital. The moreapplication of leverage leads to bring down the explicit cost of capital on one side and onthe other side implicit cost of debt is expected to go up. Under this approach, no capitalstructure is found to be a optimum capital structure. Arbitrage process is the processfacilitates the individual investors to buy the investments at lower price at one marketand sells them off at higher price in another market. The traditional approach is knownas intermediate approach in between the Net income approach and NOI approach.


Assuming the condition of the original M & M (Miller-Modigliani) approach, state whetherthe following statement is true or false:

“In a world of perfect capital market, an increase in financial leverage will increase themarket value of the firm.”

Provide an intuitive explanation of your answer.

22.10 KEYWORDS

Arbitrage process

Dividend Policies

Cash dividend policy


1. Write the various assumption of the capital structure theories.

2. Explain the Net income approach.

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Capital Structure Theories3. Elucidate the Net operating approach.

5. Explain briefly about the traditional approach.

6. What is meant by the dividend policy?










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23WORKING CAPITAL MANAGEMENT

CONTENTS


23.1 Introduction

23.2 Objectives of the Working Capital Management

23.3 Approaches of the Working Capital

23.4 Determinants of Working Capital

23.5 Working Capital Policies

23.6 Estimation of Working Capital Requirement

23.7 Cash Management

23.7.1 Motives of Holding Cash

23.7.2 Objectives of Cash Management

23.7.3 Basic Problems of Cash Management

23.8 Management of Inventories

23.8.1 Meaning of Inventory

23.8.2 Why Inventory is to be Controlled?

23.8.3 Major Benefits of Inventory Control

23.8.4 Centralised Stores

23.8.5 Decentralised Stores

23.8.6 Central Stores and Sub Stores

23.8.7 Recording Level

23.8.8 Minimum Level/Safety Level

23.8.9 Maximum Level

23.8.10 Danger Level

23.8.11 Average Stock Level

23.8.12 Economic Ordering Quantity

23.8.13 ABC Analysis

23.8.14 VED Analysis

23.9 Receivables Management

23.9.1 Concept of Receivables Management

23.9.2 Objectives of Accounts Receivables

23.9.3 Cost of Maintaining the Accounts Receivables

23.9.4 Factors Affecting the Accounts Receivables

23.9.5 Management of Accounts Payable/Financing the Resources

23.10 Various Committee Reports on Working Capital

23.10.1 Dheja Committee Report 1969

Contd...

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Working Capital Management


After studying this lesson you will be able to:

(i) describe the objectives of working capital management

(ii) know how to analyse the needs of working capital

(iii) describe how to manage receivables and payables

(iv) explain how inventory is managed in a company.

23.1 INTRODUCTION

The working capital is the amount revolving capital to meet the day today requirementsof the firm. The other facets of the working capital is circulating capital, floating capitaland moving capital which are required to meet the immediate requirements of the firm.

The "working capital" means the funds available for day today operations of the enterprise.It also represents the excess of current assets over the current liabilities which includethe short-term loans.

Accounting standards Board, The institute of Chartered Accountant of India note theASB has used the term “working capital” and not “Net working capital”.

23.2 OBJECTIVES OF THE WORKING CAPITALMANAGEMENT

Estimating the working capital requirements

The working capital requirements are normally estimated to the tune of production policies,nature of the business, length of manufacturing process, credit policy and so on.

Sources of the working capital: The requirement of the working capital should be metwith the help of long term and shot term resources. The permanent and temporaryworking capital requirements should be met out of long term and short term financialresource respectively.

23.3 APPROACHES OF THE WORKING CAPITAL

The approaches of the working capital are classified into two categories viz the hedgingapproach and conservative approach:

The hedging approach: Under this approach, the maturity of the financial resourcesare matched with the nature of assets to be financed.

23.10.2 Tandon Committee

23.10.3 Chore Committee Report 1979

23.10.4 Marathe Committee Report 1984

23.11 Let us Sum up


23.13 Keywords



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Permanent working capital are financed by the long-term financial resources and theseasonal working capital requirements are met out through short term financial resources.

The conservative approach: Acc to this approach, all requirement of the funds should metout long-term sources. The short-term resources should be only for emergency requirements.

23.4 DETERMINANTS OF WORKING CAPITAL

Following are the major determinants of the working capital:

General nature of Business:The nature of the business should be considered for thedetermination of working capital only to the tune of i) cash nature of business ii) sale ofservices rather than commodities:

These are things considered only on the basis of stock , book volume of debts and so on.

Production cycle:The need of the working capital is determined on the basis of durationof the production cycle. The time duration taken by the manufacturing process should beconsidered from the stage of raw materials to the stage of finished goods. If the durationis lengthier may require the firm to keep more amount of working capital to meet out therequirements and vice versa.

Business cycle:The cycle of the business should be relatively considered for the needof working capital. The upswing of the business cycle requires the business venture toinvest more amount of working capital due more volume of sales, results out of hugevolume of stock, book debts and so on. During the downswing of the business requirethe business to have only lesser volume of working capital due lesser volume of businessand so on.

Production policy: The working capital requirement is determined on the basis ofproduction policy of the firm. Normally the production policy of the firm is classified onthe basis of two methodologies:

(i) The firm produces the goods then and there to the tune of immediate needs of themarket. This may require the firm to meet adversities due to lack of working capitalto meet out, due to in adequate planning. During the peak season, it requiresenormous working capital which may disturb working conditions of the businessventure.

(ii) The steady production policy by considering the futuristic demands, which will notdisturb the long-term prospects of the business venture due to effective planning.

Credit policy: The credit policy of the firm is another determinant for the determinationof the working capital. There are two different credit policies viz liberal and stringentcredit policies

(i) Liberal credit policy: The liberal credit policy may lead to have greater volume ofbook debts, greater credit period, huge amount required for the built of stock; requirethe firm to have greater amount of working capital

(ii) Stringent credit policy: Would not require that much of working capital like theearlier segment.

Growth and Expansion:The growth and expansion prospects of the firm should beappropriately determined in order to identify the volume of working capital requiredduring the future, unless otherwise that will badly affect the future development of thefirm.

Acute shortage of the raw materials supply:If the shortage of raw materials is acute,the firm is required to keep sufficient volume of working capital to have smooth flow ofproduction process without any interruptions. In such cases the firm should have additionalvolume of working capital not only to avoid interruptions during the production process

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Working Capital Managementdue lack of supply of raw materials, but also to enjoy greater trade discounts during thebulk purchase in order to bring down the purchase cost of the raw materials.

Net profit: It is one of the major sources of working capital and practically speaking it isone of the sources of cash from operations. To maintain the liquidity, the net profitearning capacity should be maintained forever.

Dividend policy: The cash dividend payment leads to greater amount of cash outflowswhich are more essential to the value of the firm to be maintained. The value of the firmcould also be alternately maintained by either through the declaration of bond dividend orstock dividend or property dividend. The later specified methodologies facilitate the firmto postpone the cash out flow which normally evade the immediate cash requirement.

Depreciation policy:The depreciation policy of the firm not only facilitates to bringdown the taxable liability but also brings down the profit which enhances the liquidity ofthe firm on the other side.

Price level changes:The price level changes require the firm to keep more amount ofworking capital to go hand in hand with the price changes which normally affect thefirm's liquidity position. During the periods of inflation, the firm is required to anticipatethe price level changes which drastically affect the working capital position of the firm.

23.5 WORKING CAPITAL POLICIES

The working capital has to be adequately managed by the firm , neither more nor lessthan its requirement to meet out the needs. If the working capital is more than therequirement means that the firm is expected to unnecessarily keep short-term assetsidle in state and vice versa. The maintaining of the working capital management is mainlydepending upon three major influences of the organizations

i) Profitability

ii) Liquidity and

iii) Structural health of the organisation

Why the study of Management of working capital is required ?

If the working capital is less than the requirement means that the volume of currentassets are inadequate to meet the short term obligations of the firm on time, which maylead to disrepute the name and fame of the organisation.

Contradictorily to the above, if the firm keeps more working capital that means morevolume of current assets are maintained in the investment structure to meet out the shortterm obligations of the firm which poses more liquidity but on the other hand it hurdlesthe righteous opportunity to invest in the fixed assets to earn more income. The excessivevolume of current assets drastically affects the profitability of the firm due to excessliquidity out of more amount of current assets.

As a firm should always maintain the righteous volume of working capital not only tomaintain the liquidity of the firm but also to earn adequately from the investment volumeof fixed assets.

The working capital management policies are studied in the following context viz

i) Concerned with profitability, liquidity and risk of the firm

ii) Concerned with the composition of the current assets

iii) Concerned with the composition of the current liabilities

There are two major types of working capital policies

Conservative policy of working capital:

Under this policy, the firm minimizes risk by maintaining a higher level of current assetsin meeting the liquidity of the firm.

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Aggressive policy of working capital:

Under this policy , the firm enhances the risk by way of reducing the working capital inorder to earn more and more profits.

23.6 ESTIMATION OF WORKING CAPITALREQUIREMENT

The following is the proforma of the working capital requirement

Statement of working capital required

Current Assets:

i) Cash XXXX

ii) Debtors XXXX

iii) Stocks XXXX

iv) Advanced payments XXXX

v) Others XXXX

Less:

Current liabilities

i) Creditors XXXX

ii) Lag in payment of expenses XXXX

iii) Outstanding expenses if any XXXX

Working capital (Current assets-Current liabilities) XXXX

Add: Provision for contingencies XXXX

Net working capital required XXXX

Prepare an estimate of working capital requirement from the following data of the XYZLtd.

a) Projected annual sales volume 2,00,000 units

b) Selling price Rs.10 per unit

c) % of net profit on sales 25%

d) Average credit period allowed to customers 8 weeks

e) Average credit period allowed by suppliers 4 weeks

f) Average holding period of the inventories 12 weeks

g) Allow 10% for contingencies

Statement of working capital requirements

Current Assets Rs

Debtors (8 weeks)Rs.15,00,000 × 8/52(At cost) 2,30,769.23 Stock (12 weeks) Rs.15,00,000 × 12/52 3,46,153.38 Less Current liabilities Creditors (4 weeks) Rs15,00,000 × 4/52 1,15,384.61 Net working capital 4,61,538.0 Add: 10% contingencies 46,153.8 Working capital required 5,07,691.8

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Working Capital ManagementCheck Your Progress

1. The recent release of the finance minister during the budget session on thespecial excise duty on the cement industry.

2. How the construction industry is affected ? In what way? Which factor ofinfluence affects the firm?

23.7 CASH MANAGEMENT

The management of cash resources should not be only in a position to afford liquidity butalso it should not require the firm to keep the cash resources simply idle; which should beinvested in the marketable securities to earn some rate of return whenever the firm feelexcessive holding of cash resources.

23.7.1 Motives of holding cash

Transaction Motive: If the cash outflows are more than that of the cash inflows, thefirms are expected to maintain the cash resources.

Precautionary Motive:Some times the firm may be required to meet out the contingentneeds which could not be foreseen during its life span; warrants the adequate maintenanceof working capital.

Speculative Motive:It is a motive holding the cash resources by the firm to exploit theopportunities available in the market. If the vendor of raw materials announces thatthere is a greater discount towards the bulky purchase of raw materials, may lead thefirm to bring down the cost of purchase. For which, the cash resources are required andmade use of to the tune of announcements.

Compensation motive:Banks provide certain services to the firms only on the basis ofthe certain amount of balances in the accounts. That is the motive holding cash resourcesto avail services from the banker viz compensation motive.

23.7.2 Objectives of Cash Management

(i) Meeting the cash requirement:Meeting of cash requirements on time whichnormally involves in the maintenance of the goodwill of the firm. The firm shouldkeep the adequate cash balances to meet the requirement which are greater inimportance.

(ii) Minimising the funds locked up in the cash balances:The funds locked up in theform of cash resources should be more, but it should only to the tune of the requirement.

23.7.3 Basic Problems of Cash Management

(i) Controlling level of cash

(a) Preparing the cash budget: Through the preparation of the budget, thecash requirement could be identified which would normally facilitate the firmto trim off the excessive cash in holding.

(b) Providing room for unpredictable discrepancies: The separate amountshould be maintained for the purpose to meet out the discrepancies which arenot easily foreseen.

(ii) Controlling of inflows of cash

(a) Concentration banking: The amount of collection from the local branchesare normally deposited in a particular account of the firm, as soon as the

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deposit has reached the certain limit , the amount in the respective branchaccount will be transferred to the account at where the firm maintains in thehead office. This process of transfer is normally taking place only throughtelegraphic transfer during the early days but on now a days the anywherebanking is facilitated to transfer the amount of deposit instantaneously.

(b) Lock box system: The process of collection is carried out with the help oflocal post offices only in order to avoid the postal delays in the transit . Thissystem enhances the speed of the collection at rapid and finally the localbranch messenger collects the cheques from the parties through specifiedpost box allocated for the process of collection.

(iii) Controlling of cash outflows

(a) Centralizing of disbursing the payments: The centralizing the process ofpayment may facilitate the enterprise to take advantage of time in settling thepayments i.e., reduces the need of immediate cash requirements.

(b) Stretching payment schedule: It is another methodology to avail themaximum possible credit period to postpone the payment by making use ofthe cash resources most effectively.

(iv) Investing the excessive cash surplus

(a) Determine the need of the surplus cash: Identify the excessive cashresources which are kept simply idle more than the requirement.

(b) Determination of the various avenues of investment:After identifyingthe various investment opportunities , the excessive cash resources should beinvested to earn appropriate rate of return during the slack season at whenthe firm does not require greater volume of working capital and vice versa.

Check Your Progress

1. Explain the modern instruments available in the financial market to entertainthe cash management strategies.

2. 1. Cash means

a) Cash in hand b) Cash in hand and at bank

c) Cash in hand, at bank and near d) None of the abovecash i.e marketable securities

2. To avail the trade discount at the moment of bulk purchase is

a) Transaction motive b) Speculative motive

c) Compensating motive d) Precautionary motive

3. Stretching cash payment is

a) Controlling the cash inflow b) Controlling cash outflows

c) a) & b) d) None of the above

23.8 MANAGEMENT OF INVENTORIES

23.8.1 Meaning of Inventory

The inventory includes the following :

l Stock of raw materials:It means that the value of the raw materials stored forthe purpose of production in the storage yard. The stock of raw materials can be

311

Working Capital Managementclassified normally into two categories viz opening stock and closing stock of rawmaterials.

l Stock of work in progress:During the production process, the firm usually storesthe semi finished goods which are neither a raw materials nor finished goods. Thepurpose of the storage of work in progress in order to shorten the time duration tomanufacture the finished goods. The value of the semi finished / work in progressstored in the storage house may be classified into two categories viz opening stockand closing stock. The finalizing the value of the stock of the work in progress isinevitable process in transfer pricing. The value of the work in progress normallyexpressed in two different ways viz on the basis of prime cost and works cost.

l Stock of finished goods:This is the stage at which the goods are readily availablefor selling in the market. The value of the stock of the goods is computed on thebasis of cost of production.

l Stock of Stores supplies, components and accessories.

23.8.2 Why inventory is to be controlled ?

The ultimate purpose of controlling the inventory arises only due to the conflicting andheterogeneous objectives of the various functional departments of the organizations.

How inventory influences the various department of the organization ?

Normally, the inventory influences on the following departments viz Production Purchase,Finance and Sales department How it influences the various departments at a timetogether.

On/of the Production department: The manager production frequently insists theorganisation to maintain the continuous and uninterrupted supply to have smooth flowproduction. This requires the production manager to build ample stock of raw materials.This is routed through the purchase requisition by the manager production to the purchasemanager.

Less the stock of raw materials and accessories - Risk of Lock out due toinsufficient quantities and vice versa

On/of the Purchase department: Due to the influence from the production manager,the purchase department is demanded to procure the requirements. As per the requisitionof the production department, meeting the requirements is not tough task but thedepartment should know about the financial intricacies of the organisation through thefinance department which is especially meant for the purpose.

Lesser the quantum of purchase will lead to lesser financial commitment but expected toloose the benefits out of the bulk procurement. Not advisable for the materials whichare in scarcity.

Lesser the quantum of purchase - Greater will be cost of procurement andlesser will the economic benefits and vice versa

Inventory

Raw materials Work in progress Finished goods

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On/of the Sales department: Due to the market pressure/greater demand of the productsrequire the sales department to supply the goods in time as well as to meet the needs anddemands of the intermediaries and consumers. To supply them in time, the sales managerneed not wait for the production cycle to be completed to produce the finished goods. Tosave time, the sales manager must be given ample facility to store the finished goods inthe depot not only to meet the needs but also traps and drags the existing customers andconsumers.

More the stock of the finished goods - Better the position for the firm to meetthe needs of the biz environment and more the cost of storage and investmenton the current assets and vice versa

On/of the Finance department : Due to influence from the department of the production,purchase and sales departments, the finance department is required to concentrate onthe various angles.

It is the only department bearing a difference of opinion in maintaining more volume ofinventory in the firm; which certainly slashes the earning capacity of the firm due to leastvolume of assets deploy on the productive purpose.

Lesser the inventory - Higher the risk in meeting the needs of production,purchase and sales - but better the return of the firm.

For e.g. The famous MNC Jindal Corporation Ltd. has wound up its operations atindustrial site in Bangalore due to the cost of raw materials cost. The transportation cost,acquisition cost of copper ore gone up due to escalated cost in the biz market. Theywere neither to store nor to transport more and more which led to the winding up ofoperations of the enterprise at Bangalore.

The following diagram will obviously facilitate the Inventory Control:

Inventory control: Inventory control means that maintenance of desired level of inventoryby way of taking into the economic interest of the firm.

The economic interest of the firm differs from one functional dept. to another due to theheterogeneous objectives. The economic desired benefits of the dept. are illustrated tothe tune of the preceding illustrated diagrams.

Production department: Benefits towards less production cost through mass production.

Purchase department: Benefits towards discounts, carrying cost and so on.

Sales department: Timely supply of the goods to the requirements, facilitates the firmto earn greater volume of earning. To reduce the operating cycle in duration in order torealize the economic benefits as early as possible.

Finance department: Benefits towards the carrying cost, storage cost of the entireinventory.

PurchaseDepartment

FinanceDepartment

ProductionDepartment

SalesDepartment

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Working Capital Management23.8.3 Major Benefits of Inventory Control

l It leads to effective utilization of funds only through an appropriate investment oninventory

l It facilitates to obtain the economic supply of raw materials

l It possess the firm comfortably to meet the needs and wants of the consumers intime

l It neither allows the firm to undergo the practices of overstocking nor understocking.

l It leads to effectiveness in the material handing which reduces the wastage, pilferageand so on.

Before discussing the methods of inventory control, every one must obviously understandthe organization of the stores department. The stores department is the only departmentwhich applies all the techniques of inventory control.

The organization of the inventory control are various in dimensions . The organization ofdiffers from one industry to another industry, one firm to another within the same industry,from one nature to another, from volume to another. They are as follows:

a) Centralised stores

b) Decentralised stores

c) Central and Sub stores

23.8.4 Centralised Stores

Under this type, the materials are received by and issued at one central place by thedepartment to the requirements of the other functional departments.

The following diagram will facilitate to understand the organisation structure of thecentralized stores of the manufacturing department. The materials are continuouslyreceived by the stores dept. through the purchase department and the received materialare distributed to the various assisting departments.

This type of organization of stores control has its own advantages and disadvantages inapplication

The major advantages are following:

l It requires less space

l It facilitates to minimize the stock investment

l The centralization leads to lower administrative and maintenance cost of stores

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In addition to the advantages, the present organization suffers with its own limitationwhile in applications; which are following:

l The centralization of stores leads to enhance the cost of transportation as well ashandling cost of materials.

l The centralized system leads to lot of inconvenience and delay to other departmentdue to distance

l There is a greater risk of calamity loss of materials which are stored under oneroof

l The success is subject to the effectiveness of the transportation

23.8.5 Decentralised Stores

Under this method, the separate stores are maintained by the departments on their ownas well as run by the exclusive store keeper. It ensures the smooth flow material to thetune of requirements and reduces the time involved in the transit of materials from thestores to the respective departments. The following diagram will facilitate to have aninsight on the organization of the stores.

23.8.6 Central stores and Sub stores

This is a method which attempts to discard the bottlenecks of the above mentioned aswell as brings forth unique organization of stores. Under this method, each department isgiven separate sub store which is within easier access and shorter in distance to supplythe material requirements through the store keeper. The sub store keeper should have tomake requisition to central stores where all the materials are centrally procured andsupplied then and there to the tune of the individual departments.

The role of the store keeper is most inevitable in controlling the stores. While controllingthe stores, the store keeper should neither disturb the production process nor undergothe practices of overstocking. By earmarking the above enlisted objectives, every storekeeper is led by the various methods of inventory valuation in addition to various methodsof requisitioning of material.

C e n t r a l S t o r e

S u b Sto re S u b Sto re

W e ld ing D ep t P lan nin g D ept

P ro d u ct ion D ep t

315

Working Capital ManagementFirst we will discuss, the various methods of requisitioning of materials.

23.8.7 Reordering Level

This is the level at which the firm should go for fresh purchase requisition of materialthrough the store keeper to meet the requirements. The reordering level which takesinto consideration of minimum level of consumption of raw material during the course ofproduction process as well as the amount material required by the firm during period ofpurchase and goods in transit immediately after the order.

Reordering level=Minimum level of stock for uninterrupted flow of production process

+

Amount of materials required during the periods of consumption

Or

Lead time stock level

Alternate method is available by using the maximum consumption and maximum re-order period

Re ordering level= Maximum consumption × Maximum Re- order period

This method registers the maximum consumption of the firm during the production aswell as the maximum time period required for the supply of required materials.

Under this alternate approach, the firm at any moment will not face any difficulties dueto short supply or insufficient amount of materials.

23.8.8 Minimum Level/Safety level

The firm should at always maintain minimum amount of material in its hands to facilitatethe flow of production process as unaffected .due to short fall in the quantum of materials.

The following points are most important in designing the minimum level of stock:

l Lead time should be predominantly considered to determine the time lag in betweenthe materials ordered and received. The firm should find out the practical difficultyof the vendor in supplying the material for the determination for minimum level ofstock.

l Amount of consumption of the material during the lead time

Minimum stock level=Reordering level- (Normal level consumption × Normal Reorderperiod)

Minimum level = Reorder level + (Average level of consumption × Average Reorderperiod)

Average and normal level of consumption are synonymous with each other. If normal oraverage consumption is not given, the formula is as follows

Minimum LevelAmount of materials required

during the periods of consumption

Reordering Level

316

Accounting and Finance forManagers Average consumption = Minimum level consumption + Maximum level consumption

2

23.8.9 Maximum Level

This is the level at which the firm holds maximum quantity of materials as stock duringthe process. The ultimate aim of fixing the level of maximum level is that to avoid theoverstocking. If the stock level of the firm exceeds the maximum level already fixed isknown as overstocking level of the firm, more than the requirement.

Why over stocking is considered not advisable ?

l It leads to excessive investment on inventory more than the requirement

l It leads to unnecessary wastage of the materials due to excessive stock

l The excessive storage of materials may certainly affect the price of the product

Maximum stock level= Reordering level+ Reordering quantity - (Minimum consumption× Minimum Reordering period)

23.8.10 Danger level

At this level, the firm should not further issue any materials to the various functionaldepartments .At the danger level, the purchase department is vested with greaterresponsibility to immediately arrange the supply of raw materials in order to maintain theflow of production as uninterrupted.

The consumption level of the materials is getting varied from one time period to another.During the specified period , there may be maximum consumption and minimumconsumption, which should be averaged to find the mid point in between the two, inorder to either fulfill the minimum consumption or maximum consumption to the extentpossible.

Why the maximum reorder period is taken into consideration?

The purpose of considering is that the greater period taken by the supplier to supply therequired materials

Danger Level= Average consumption × Maximum reorder period

23.8.11 Average Stock LevelAverage stock level =Minimum stock level + ½ of the reorder quantity

23.8.12 Economic Ordering QuantityThe ordering of materials usually tagged with three different component of costs viz:

l Acquisition cost of materials

l Ordering cost of materials

l Carrying cost of materials

The ordering quantity of materials may be either larger or meager in volume, whichcarries its own advantages and disadvantages.

If the quantity ordered is larger in volume, the following are some of the importantadvantages:

l The bulk purchase order reduces the ordering cost of the materials. The greaterthe size of the order which leads to reduce the number of the orders in procuringthe materials.

l Quantity discounts: The discount can be classified into two categories viz Tradediscount and Cash discount .

l What is trade discount ?

317

Working Capital ManagementTrade discount is the discount granted by the supplier to the buyer of materials at themoment of bulk purchase. This % of discount is greatly possible only during the periodsof greater volume of purchase; which reduces the over all cost of the acquisition.

If the quantity is procured in meager volume, the following are construed as advantages:

l The carrying cost will come down in the case of lesser inventories

l The cost of storage is lesser as far as the meager quantities of materials

l Loss due to deterioration, obsolescence, wastage will be minimum

l Insurance cost is less due to meager volume of materials

2AOEconomic Ordering Quantity =

1

A = Annual requirement in units

O = Ordering cost

I = Cost of storing per year or cost of carrying the inventory

Illustration 1

Annual Requirement =20,000 units

Ordering cost= Rs.100 per order

Cost per unit =Rs.4

Carrying cost =16%

Determine the EOQ of the firm and finally justify the EOQ

I

2AQ (EOQ)Quantity Ordering Economic =

2 20,000 Rs.100

0.16% on Rs.4

× ×=

= 2,500 units

Graph of EOQ:

Total cost Rupees

Cost of carrying Ordering cost Units per order Insert the picture anpve

318


The following Table 23.1 illustrates the justification of the EOQ at the 2,500 units level

Illustration 2

Calculate EOQ

Annual Requirement -1600 units

Cost of materials per unit Rs.40

Cost placing and receiving -Rs.50

Annual carrying cost of inventory -10% on value

2AOEconomic Ordering Quantity (EOQ)=

1

2 1600 Rs.50EOQ = = 200 units

10% on Rs.40

× ×

Illustration 3

Consumption during the year -600 units

Ordering cost Rs. 12 per order

Carrying cost 20%

Price per unit Rs. 20 B.Com. (Punjab)

2AOEconomic Ordering Quantity (EOQ)=

1

2 600 Rs.12EOQ =

20% on Rs.20

× ×

= 60 units

Illustration 4

A manufacturer purchases certain machinery from outside suppliers Rs.60 per unit.Total annual needs are 800 units. The following are the additional information

Annual return on investments 10%

Annual requirement of 20,000 units

Particulars 1 2 3 4 5

Size of the Orders 20,000 10,000 5000 2,500 500

Number of order to placed = Total Annual Need Size of the order

1 2 4 8 40

Average stock = Size of the order 2

10,000 5,000 2,500 1,250 250

Average stock value =Average stock × cost per unit Rs

40,000 20,000 10,000 5,000 1,000

Carrying cost = Average Stock value × 16% Rs

6,400 3,200 1,600 800 160

Ordering cost Rs 100 200 400 800 4,000

Total cost Rs 6,500 3,500 2,000 1,600 4,160

319

Working Capital ManagementRent, insurance, taxes per unit per year Rs 2

Cost of placing an order Rs.200

Determine the economic order unit

First step to find out the earnings= 10% Rs.60= Rs.6 to be earned from the investment

The amount of rent , insurance , taxes per unit year =Rs 2

I= 10% on Rs.60 + Rs.2= Rs.8

2AOEconomic Order Quantity (EOQ) =

1

2 800 Rs.200=

10% on Rs.60 +Rs.2

200 units

× ×

=

Illustration 5

Given the annual consumption of material is 1,800 units , ordering costs are Rs.2 perorder, price per order price per unit of material is 32 paise and storage costs are 25% perannum of stock value , find the economic order quantity.

(B.Com. Calicut)

2 A OEconomic Order Quantity (EOQ) =

1

2 1,800 Rs.2=

25% on 32 paise

= 300 units

× ×

Illustration 6

Find out the Re ordering level from the following information

a) Minimum stock 1000 units b) Maximum stock 2000 units c) Time required forreceiving the material 20 days d) Daily consumption of material 100 units

Reordering level = Minimum level + Lead time stock level

The first step is to find out the Lead time stock level

Lead time stock level is nothing but the amount of stock level required by the firm, till thenext fresh receipt of goods, subject to the time normally taken by the supplier to supply.

Lead time stock level= Time required for receiving the material × Daily consumption

Lead time stock level= 20 days × 100 units per day= 2000 units

Reordering level= 1,000 + 2,000 units= 3,000 units

Illustration 7

Calculate maximum level , minimum level and reordering level from the following data

Reorder quantity 2,000 units

Reorder period 8 to 12 weeks

Maximum consumption 800 units per week

320


Normal consumption 600 units per week

Minimum consumption 500 units per week

Reordering level = Minimum level + Lead time stock level

Or

= Maximum consumption × Maximum lead time

Minimum level= Reordering level – (Average consumption × Average lead time )

Maximum level= Reorder level + Reorder quantity – (Mini consumption × Mini Leadtime)

First step is to find out the Re ordering level

Reordering level = 800 units per week × 12 weeks= 9,600 units

The next step is to find out the Maximum level

Maximum level = 9,600 units + 2,000 units - (500 units × 8 weeks)

= 11,600 units- 4,000 units =7,600 units

The next step is to find out the minimum level . For that Average consumption has to befound out. The average consumption is nothing but normal consumption. The normallead time period is the average of minimum and maximum re order period of the firm ingetting the supply of the materials from the suppliers

Minimum level = 9,600 units – (600 units× 20/2)

= 9,600 units – 6,000 units= 3,600 units

Illustration 8

Two components A and B are used as follows

Normal usage 50 units per week each

Minimum usage 25 units per week each

Maximum usage 75 units per week each

Re order quantity A: 300 units

B: 500 units

Re order period A: 4 to 6 weeks

B: 2 to 4 weeks

Calculate for each component

(B.Com., Madras)

(a) Re order level (b) Minimum level (c) Maximum level and (d) Average stock levelFirst step is to find out the Reorder level for both A and B components

The maximum usage is common for both A and B components but the reorder period aredifferent from each other

Reorder level = Maximum consumption /usage × Maximum Reorder period

(A)= 75 units × 6 weeks= 450 units

(B)=75 units× 4 weeks= 300 units

The next step is to determine the Maximum level of both Components A and B

Maximum level = Reordering level + Reordering quantity – (Mini Consumption × MiniLead time)

321

Working Capital Management(A)= 450 units + 300 units – ( 25 units × 4 weeks) = 650 units

(B)=300 units + 500 units – (25 units × 2 weeks) = 750 units

Minimum Level = Reordering level – ( Average consumption × Average lead time)

2

6))(4 unit (50– unit 450

+×=

(A) = 450 units – 250 units = 200 units

(B)2

4))(2 unit (50– unit 300

+×=

=300 units – ( 150 units )=150 units

Average stock level = Minimum stock level + ½ Re order quantity

(A)= 2 00 units + ½ 300 units = 350 units

(B)=150 units+ ½ 500 units = 400 unit

Illustration 9

The following information is available in respect of components of R × 100

Maximum stock level 10,000 units

Budgeted consumption Maximum 3,000 units per month

Minimum 1,600 units per month

Estimated delivery period Maximum 4 months

Minimum 2 months

You are required to calculate

(i) Re-order level

(ii) Re-order quantity

Re order level = Maximum consumption × maximum lead time

= 3,000 units × 4 months=1,200 Units

The Reordering quantity could be found out with the help of Maximum level equation

Let us assume Re ordering quantity =X

Maximum level =Re-ordering level + Re-ordering quantity - (Minimumconsumption× Mini Re order period)

= 1,200 units+ (X)-(1,600 units × 2 months)

(-X) = 1,200 units-3,200 Units

= –2000 units

X = 2,000 units

In the stores control , there are two important documents viz Bin card system and stores ledger.

Bin Card: Bin card is a record prepared by the store keeper at the moment of issuingand receiving the materials. It is maintained by the store keeper for physical verificationwith accuracy and effectiveness. The inventory control can be accessed through physicalverification then and there, whenever the situation warrants.

The bin card system is adopted by many firms for their inventory control either in theform of bin tag or stock card hanging outside the rack in order to portray the information

322


immediately to facilitate the store keeper to understand the stock position of the storeroom.

The bin card system is available in two major categories viz:

Two Bin card system: Under this system two different bins are used. As soon as thegoods or materials received by the store keeper, that should be recorded in terms ofquantities. One among the two should be maintained for Re order level and minimumlevel another for Maximum stock level.

To alarm the firm neither to store more than the maximum level nor to issue less than theminimum level of the stock. If the firm once reaches the maximum level, it shouldimmediately caution the implications due to the overstocking. The same firm, if reachesthe minimum level of stock, it should not go for further issue of materials to functionaldepartment or otherwise, the firm's production may be disturbed due to the poor stocking.

Three Bin Card system: It is an extension of the early method, which incorporates thelead time stock level in addition to the other level viz Maximum, Reorder and Minimumlevel of the stock. Among the three , two cards are exclusively used by the firm in orderto maintain the appropriate stock level, i.e., for maximum stock level and minimum stocklevel. The firm should neither to store beyond the maximum level nor to issue less thanthe Minimum level. In between, a separate bin card is used only for the Reorder leveland Lead time stock level at which the firm should go for the placement of an order toget fresh delivery of materials and facilitate the firm to undergo production without anyinterruption by considering the time taken by the supplier to supply the ordered materials.

Bin card for Mini and Reorderlevel

Bin card for Maximum Level

Maximum Level

Maximum LevelReorder Level

Reorder level

Minimum stock level Lead time stock level Maximum stock level

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Working Capital ManagementSome other methods of the inventory control

There are few models exercise the inventory control , which facilitates the firm to avoideither under or over stocking.

l ABC Analysis

l VED Analysis

23.8.13 ABC analysis

Normally the materials are classified on the basis of the following covenants viz:

l Volume and

l Value

Based on the basis the materials are classified into three categories:

l Lesser percentage in volume and Greater percentage in Value- Category A

l Greater percentage in volume and Lesser percentage in Value - Category B and

l Percentage in volume and Percentage in value are more or less - Category C

This will be explained with the help of following example for insight.

A store has 4,000 items of consumption and a monthly consumption of Rs 20,00,000. 320items will have a consumption of Rs. 15,00,000. 500 items will account for Rs 4,00,000and 2,680 items consume material worth Rs.1,00,000 only.

Table of Items and value

The importance of the analysis is exercising the control on the inventory.

How the control of the inventory is being exercised ?

l Group A items are high valued items among the other items of the enterprise,require greater monitoring and controlling.

l Group B items are comparatively lesser in value among the three items given nextto the Group A, require less rigid control and monitoring.

l Group C items are the major volume of items among the 4000 items of the enterprisewhich are least in value, need very little control and monitoring.

The following of control of inventory on A, B and C items of the enterprise:

From the above table, it is obviously understood that the items which have greater %(75%) in the total value requires rigid control than any other quantity of materials. TheGroup C items are bearing 67% of total consumption amounted which 5% of total valueof the items procured by the enterprise.

Group No. of Items Level of Control % of Items

Value Rs % of Value

A 320 Rigid Control 8% 15,00,000 75%

B 1000 Moderate Control 25% 4,00,000 20%

C 2,680 Very little Control 67% 1,00,000 5%

Group No. of Items % of Items Value Rs % of Value

A 320 8% 15,00,000 75%

B 1000 25% 4,00,000 20%

C 2,680 67% 1,00,000 5%

Total 4,000 100% 20,00,000

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The Unique features of the ABC analysis:

Advantages

(1) It guides the management to exercise the control based on the value of goods tothe total composition.

(2) Systematic inventory control can be exercised through this analysis on the basis ofvalue of the materials. The high value materials of Group A are rigidly controlledwhich finally led to lesser investments.

(3) Scientific system facilitates to lessen the storage cost of the inventory.

23.8.14 VED analysis

VED analysis is applied for the inventory control of the manufacturing enterprise.

V-Vital

E-Essential and

D-Desirable

The spare parts are classified into vital, essential and desirable to the crucially to theproduction.

The non availability of certain spares for short time leads high cost stock out known asvital spares.

The non availability of spares cannot be tolerated even for few hours or one day and thecost of lost production is enormous, known as Essential spares to production.

The absence of spares even more than one week, not affecting the flow production,known as desirable spares.

Check Your Progress

1) Inventory means

a) Stock of Cash b) Stock of Raw materials, work inprogress and Finished goods

c) Stock of spares d) Both b) & c) only

Contd...

Nature A Group of Items B Group of Items C Group of Items

Level of Control Rigid control Moderate control Very little control

Order frequency Frequent ordering-weeks, Fortnights

Once in 2 months Once in 6 months

Lead time problem To be cut off drastically

To be reduced moderately

Lead time problem due to clerical should cut off

Safety stock level Due to greater value- least volume safety stock to be maintained

Due to moderate value-lesser safety stock is required

Due to lower value-High safety stock is required

System of Purchase Higher value demands centralized system of procurement

Moderate value requires centralized and decentralized system of purchase

Lower value needs decentralized system of purchase

Supervision By Senior officers By Middle level managers

By clerical staff

325

Working Capital Management2) Inventory control is for the maintenance of

a) High level of inventory b) Optimum level of inventory

c) Low level of inventory d) Average level of inventory

3) Excessive inventory holding is

a) Better for the firm b) Worse for the firm

c) Neither better nor worse for the firm d) Either better or worse forthe firm

4) The purpose of inventory control is

a) To minimize the excessive stock b) To meet the needs of theconsumer

c) To maintain liquidity d) a),b) & c)

5) Inventory control is in relevance with

a) Storage cost b) Carrying cost

c) Ordering cost d) (a), (b) and (c)

23.9 RECEIVABLES MANAGEMENT

23.9.1 Concept of Receivables Management

The receivables are normally arising out of the credit sales of the firm.

What is meant by the accounts receivable?

It is an asset owed to the firm by the buyer out of the credit sales with the terms andconditions of repayment on an agreed time period.

Meaning of the receivables management: The receivables out of the credit salescrunch the availability of the resources to meet the day today requirements. The acutecompetition requires the firm to sustain among the other competitors through more volumeof credit sales and in the intention of retaining the existing customers. This requires thefirm to sell more through credit sales only in order to encourage the buyers to grab theopportunities unlike the other competitors they offer in the market.

23.9.2 Objectives of Accounts Receivables

i) Achieving the growth in the volume of sales

ii) Increasing the volume of profits

iii) Meeting the acute competition

23.9.3 Cost of Maintaining the Accounts Receivables

Capital cost: Due to in sufficient amount of working capital with reference to morevolume of credit sales which drastically affects the existence of the working capital ofthe firm. The firm may be required to borrow which may lead to pay certain amount ofinterest on the borrowings . The interest which is paid by the firm due to the borrowingsin order to meet the shortage of working capital is known as capital cost of receivables.

Administrative cost: Cost of maintaining the receivables.

Collection cost: Whatever the cost incurred for the collection of the receivables areknown as collection cost.

Defaulting cost: This may arise due to defaulters and the cost is in other words as costof bad debts and so on.

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23.9.4 Factors Affecting the Accounts Receivables

i) Level of sales:The volume of sales is the best indicator of accounts receivables.It differs from one firm to another.

ii) Credit policies: The credit policies are another major force of determinant indeciding the size of the accounts receivable. There are two types of credit policiesviz lenient and stringent credit policies.

Lenient credit policy: Enhances the volume of the accounts receivable due toliberal terms of the trade which normally encourage the buyers to buy more andmore.

Stringent credit policy: It curtails the motive buying the goods on credit due stiffterms of the trade put forth by the supplier unlike the earlier.

iii) Terms of trade: The terms of the trade are normally bifurcated into two categoriesviz credit period and cash discount

Credit period: Higher the credit period will lead to more volume of receivables, on theother side that will lead to greater volume of debts from the side of buyers.

Cash discount: If the discount on sales is more , that will enhance the volume of saleson the other hand that will affect the income of the enterprise.

23.9.5 Management of Accounts Payable/Financing the Resources

It is more important at par with the management of receivable, in order to avail the shortterm resources for the smooth conduct of the firm.

23.10 VARIOUS COMMITTEE REPORTS ON WORKINGCAPITAL

The following committees were especially appointed for the purpose to administer theworking capital

i) Dheja Committee Report 1969

ii) Tandon Committee Report 1975

iii) Chore Committee Report 1980

iv) Marathe Committee Report 1984

The various committee report implications are the following:

23.10.1 Dheja Committee Report 1969

"The study carried out on the credit need of the industry and trade and how that needsinflated and such trends were checked" by the under the chairmanship of DhejaCommittee.

Findings

i) General tendency was found among the firms to avail the bank credit more thantheir requirements

ii) Another tendency was among them that the short term credit was generally madeuse of by thee for the acquisition of the long term assets

iii) The lending through cash credit should be done on the basis of security in order toassess the financial position of the firm

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Working Capital ManagementRecommendations

i) Appraisal should be done by the bankers on the present and future performance ofthe firms

ii) The total dealings are segmented into two categories viz core and short-term needs

iii) The committee suggested the firms to maintain only one account with the onebanker For huge amount of borrowing, consortium was suggested among thebankers to lend the corporate borrowers

23.10.2 Tandon Committee

The next committee was appointed Tandon Committee 1975, in an intention of grantingloans and advances to the industry on the need basis through the study of the developmentproceeds only in order to improve the weaker section of the people.

Findings of the Committee

i) The bank should not reveal this much only to lent to the requirements of the firm inaccordance with lending policy, in spite of that the banks were expected to lend tothe tune of firm's requirement

ii) It should be treated as supplementary source of finance but not as major source offinance

iii) Loans were lent only in accordance on the basis of the securities produced by theborrower but not on basis of level of operations

iv) Security compliance wont provide any safety to the banks but the periodical followup only should facilitate the banker to get back the amount of loans and advanceslent

Recommendations: It reached the land mark in studying the need of the industriestowards the requirements of the working capital. The committee has submitted its reporton 9th Aug , 1975 by studying the lending policies.

i) Necessary information about the future operations are to be supplied

ii) The supporting current assets should be shown to the banker at the moment ofborrowing

iii) The bank should understand that the bank credit is only for the purposes to meetout the needs of the borrower but not for any other.

23.10.3 Chore Committee Report 1979

This committee especially constituted only for the purpose to study the sanctionablelimits of the banker and the extent of the loan amount utilization of the borrower. Theanother purpose of the committee to appoint that to provide the alternate ways andmeans to afford credit facility to the industries to enhance the productive activities in thecountry.

i) Continuance of the existing three system of credits by the banker viz cash credit,loans and bills

ii) No need to bifurcate the cash credit accounts of the borrower for the implementationof the differential rate of interest

iii) According to the specifications of the borrower, the banker should come to oneconclusion which in normal peak level and non peak level of operations only to thetune of operations

iv) No frequent sanction of ad hoc limits of borrowing from the banker

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v) The overdependence on the bank credit should be lessened among the practices ofthe industrialists through emphasizing the need of term finance.

23.10.4 Marathe Committee Report 1984

The fourth committee is Marathe committee which was instituted by the Reserve bankof India and it submitted the report on 1983. The recommendations were implementedby the Government of India from April 1,1984.

Recommendations

i) Reasonability of the projection statements are to be studied by the banks morecarefully

ii) Current assets and liabilities are to be classified in accordance with the normsissued by the Reserve bank of India

iii) Maintenance of the current assets ratio 1.33:1

iv) Timely supply the information stipulated by the bankers

v) Apt supply of annual accounting information

Illustration

ABC Ltd. decides to liberalise credit to increase its sales . The liberalized credit policywill bring additional sales of Rs. 3,00,000. The variable costs will be 60% of sales andthere will be 10% risk for non-payment and 5% collection cost .Will the company benefitfrom the new credit policy ?

The new credit policy pave way for the firm to earn Rs.75,000 as an additional revenuethrough the volume of incremental sales.

23.11 LET US SUM UP

The "working capital" means the funds available for day today operations of the enterprise.It also represents the excess of current assets over the current liabilities which includethe short term loans". The working capital requirements are normally estimated to thetune of production policies, nature of the business, length of manufacturing process,credit policy and so on. The need of the working capital is determined on the basis ofduration of the production cycle. The time duration taken by the manufacturing processshould be considered from the stage of raw materials to the stage of finished goods. Thecycle of the business should be relatively considered for the need of working capital.The credit policy of the firm is another determinant for the determination of the workingcapital. There are two different credit policies viz liberal and stringent credit policies.The management of cash resources should be not only in a position to afford liquidity butalso it should not require the firm to keep the cash resources simply idle; which should beinvested in the marketable securities to earn some rate of return whenever the firm feelexcessive holding of cash resources. Banks provide certain services to the firms only onthe basis of the certain amount of balances in the accounts. That is the motive holdingcash resources to avail services from the banker viz compensation motive. Timely supply

Particulars Rs Additional sales volume 3,00,000 (-) Variable cost 1,80,000 Additional revenue 1,20,000 (-)Non payment risk 10% on additional sales volume 30,000 (-) 5% on collection 15,000 Additional revenue from increased sales due to liberal credit policy 75,000

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Working Capital Managementof the goods to the requirements, facilitates the firm to earn greater volume of earning.Reordering Level is the level at which the firm should go for fresh purchase requisitionof material through the store keeper to meet the requirements. There are few modelsexercise the inventory control, which facilitates the firm to avoid either under or overstocking

l ABC Analysis

l VED Analysis


Discuss inventory management as applicable in an industry of your choice.

23.13 KEYWORDS

Working capital: The short term asset meant for day today or immediate financialcommitments

Net working capital: Current assets - current liabilities

Temporary working capital: Which are of immediate importance

Permanent working capital: Which are regular in feature

Cash: coins, notes, currencies and near cash i.e., marketable securities

Cash management: maintain the adequate cash resource and excessive resourcesshould be invested in the marketable securities

Inventory: Stock of Raw materials, Stock of Work in Progress, Stock of Finished Goodsand Stock of Spares but not Stock of Loose tools.

EOQ: Economic Order Quantity of materials to be ordered/procured

Carrying cost: Cost is incurred for carrying the materials from the place of purchase toplace of production centre/profit centre

Ordering Cost: Cost incurred at the moment of placing the order of goods or materialse.g. Administration costs, cost of communication and so on.

Maximum level: The stock level of the firm should not be more than the determinedlevel

Minimum level: The further issues should not be done below the level of the stock ofthe firms

Reorder level: At this level, the firm should place an order for the materials to therequirement

Lead time stock level: This is level required by all the firms to maintain the stock till thenext delivery from the supplier

ABC Analysis: Analysis of exercising the control on the inventory on the basis of value.Always Better Control Analysis; A- High control for high value goods; B-Moderatecontrol for lesser value goods and C- Little control on the least value goods

VED Analysis: Vital, Essential and Desirable Analysis – Designed for Spares andaccessories

Bin card: Card or Tag used to illustrate the level of the stock position of the certainmaterials at the stores

Stores ledger: It is a official record of receipt and issuance of materials or goods interms of quantities with value of them

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Receivables: It is an asset arises at the moment of credit sales, owed to the firm

Collection cost: Cost of collection incurred by the firm due to collection of receivables

Agency charges, brokerage charges for collection

Default cost: Cost due to bad debts


1. Define the working capital management.

2. Explain the objectives of working capital management.

3. Explain the various components of working capital management.

4. Write detailed note on cash management.

5. Elucidate the various practices of Inventory management.

6. Highlight the importance of the receivable management through various strategies.





S.N.Maheswari, “Management Accounting”.





Accounting and Finance for Managers

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