ANNAMALAI UNIVERSITY

DIRECTORATE OF DISTANCE EDUCATION

M.Sc.PLANT AND MACHINERY VALUATION

First Year

FINANCIAL AND BUSINESS MANAGEMENT

LESSONS : 1 - 15

Copyright Reserved

(For Private Circulation Only)

886E180

1 - 15

M.Sc. PLANT AND MACHINERY VALUATION

FIRST YEAR

FINANCIAL AND BUSINESS MANAGEMENT

Editorial Board

Members

Dr. C. Antony Jeyasehar

Dean Faculty of Engineering & Technology

Annamalai University Annamalainagar

Dr. G. Ganesan

Professor and Head

Manufacturing Engineering Faculty of Engineering & Technology

Annamalai University

Annamalainagar

Dr. A. Prabaghar

Associate Professor & Wing Head

Engineering Wing, DDE Annamalai University

Annamalainagar

Internals

Mr. S. Natarajan

Assistant Professor Manufacturing Engineering

Engineering Wing, DDE Annamalai University

Annamalainagar

Mr. B. Neelakandan

Assistant Professor Manufacturing Engineering

Engineering Wing, DDE Annamalai University

Annamalainagar

Externals

Dr. K. Kumar

Associate Professor Department of Commerce

National College

Trichy

Dr. N. Arumugam

Assistant Professor Department of Commerce

Government Arts College

Kumbakonam

Lesson Writer

Dr. M. G. Jayaprakash

Assistant Professor

Department of Business Administration Wing, DDE Annamalai University

Annamalainagar

ii

M.Sc. PLANT AND MACHINERY VALUATION

FIRST YEAR

FINANCIAL AND BUSINESS MANAGEMENT

SYLLABUS

Chapter-1

Goals and functions of finance, financial control– planning and budgeting,

Project Report, Techno Economic Viability Report.

Chapter-2

Financial analysis for management decisions - ratio analysis – fund flow, cash

flow analysis, Capital expenditure – recognition & accounting - assessment,

Working capital – definitions, management – assessment.

Chapter-3

Investment decision – decision rule, discounted cash flow - NPV & IRR,

marginal costing, life cycle costing.

Chapter-4

Mergers and acquisitions for corporate restructuring – Enterprise Value, Risk

assessment – External / Internal threats –SWOT analysis.

Chapter-5

Management of Business Enterprises.

References:

1. Prasanna Chandra, Financial Management – Theory and Practice, Tata

McGraw Hill

2. Charles J. Corrado, Investment Valuation and Management, McGraw Hill

iii

M.Sc. PLANT AND MACHINERY VALUATION

FIRST YEAR

FINANCIAL AND BUSINESS MANAGEMENT

CONTENT

Lesson

No. Title Page No.

1 Finance Function 1

2 Financial Forecasting 14

3 Introduction to Budget 19

4 Types of Budgets 23

5 Reporting to Management 54

6 Financial Analysis 61

7 Ratio Analysis 70

8 Fund Flow analysis 106

9 Cash Flow Analysis 120

10 Working Capital Management 131

11 Working Capital Forecasting Techniques and Financing Policy 147

12 Importance of Capital Budgeting 164

13 Methods of Evaluating Capital Investment Proposal 169

14 Marginal Costing and Break –Even Analysis 197

15 Mergers and Acquisitions, and Swot Analysis 223

1

LESSON – 1

FINANCE FUNCTION

1.1 INTRODUCTION

Finance is regarded as the life blood of business enterprise. It is one of the

basic foundations of all kinds of economic activities. A firm’s success depends upon

how efficiently it is able to generate funds as and when needed. Finance holds the

key to all activities. Productive utilisation of money is essential for the profitability

of the organisation.

The word ‘finance’ has been interpreted differently by different authorities.

More significantly, the concept of finance has changed markedly from time to time.

For the convenience of analysis different viewpoints on finance have been

categorised into three major groups.

Finance means cash only: starting from the early part of the present century,

finance was described to mean cash only. The emphasis under this approach is

only on liquidity and financing of the firm. Since nearly every business transaction

involves cash, directly, finance is concerned with everything that takes places in the

conduct of the business. However, it must be noted that this meaning of finance is

too broad to be meaningful.

1.2 OBJECTIVES

The students can understand meaning and definition of finance, objectives and

functions of business finance by studying this lesson.

1.3 CONTENT

1.3.1 Objectives of business function

1.3.2 Scope of finance function

1.3.3 Finance function

1.3.4 Functions of finance controller

1.3.5 Duties of financial manager

1.3.1 OBJECTIVES OF BUSINESS FUNCTION

(a) Profit Maximization: Traditionally, the business has been considered as

an economic institution and profit has come to be accepted as a rationally valid

criterion of measuring efficiency. As a goal, however, profit maximization suffers

from certain basic weaknesses: (1) it is vague, (2) it is a short-run point of view, (3) it

ignores risk, and (4) it ignores the timing of returns.

An unambiguous meaning of the profit maximization objective is neither

available nor possible. It is rather very difficult to know about the following: Does it

mean short-term profits or long-term profits? Does it refer to profit before or after

tax? Does it refer to total profits or profit per share? Besides it is being ambiguous,

the profit maximization objective takes a short-run point of view. Prof. Drucker and

2

Prof.Galbraith contradict the theory of profit maximization and observe that exclusive

attention on profit maximization misdirects managers to the point where they may

endanger the survival of the business. Prof.Galbraith gives the following points to

argue his line of reasoning: (1) it undermines the future for today's profit; (2) it

short changes research promotion and other investments; (3) it may shy away from

any capital expenditure that may increase the invested capital base against which

profits are based, and the result is dangerous obsolescence of equipment. In other

words, the managers are directed into the worst practices of management. Risk and

timing factors are also ignored by this objective. The streams of benefits may

possess different degrees of certainty and uncertainty. Two firms may have same

total expected earnings, but if the earnings of one firm fluctuate considerably as

compared to the other, it will be more risky. Also, it does not make a difference

between returns received in different time periods i.e., it gives no consideration to

the time value of money and value benefits received today and benefits after six

months or one year.

For the reasons given above the profit maximization objective cannot be taken

as the objective of financial management.

(b) Wealth Maximization: The maximization of wealth is a more viable

objective of financial management. The same objective, if expressed in other terms,

would convey the idea of net present worth maximization. Any financial action which

creates wealth or which has a net present worth is a desirable one and should be

undertaken. Wealth of the firm is reflected in the maximization of the present value

of the firm i.e., the present worth of the firm. This value may be readily measured if

the company has shares that are held by the public, because the market price of

the share is indicative of the value of the company. And to a shareholder, the term

'wealth* is reflected in the amount of his current dividends and the market price of

share.

Ezra Solomon has defined wealth maximization objective in the following

manner: "The gross present worth of a course of action is equal to the capitalized

value of the flow of future expected benefits, discounted (or capitali zed)at a rate

which reflects the certainty or uncertainty. Wealth or net present worth is the

difference between gross present worth and the amount of capital investment

required to achieve the benefits."

From the above clarification, one thing is certain that the wealth maximi zation

is a long-term strategy that emphasises raising the present value of the owner's

investment in a company and the implementation of projects that will increase

the; market value of the firm's securities. This criterion, if applied, meets the

objections raised against earlier criterion of profit maximization. The financial

manager also deals with the problem of uncertainty by taking into account the trade-

off between the various returns and associated levels of risks. It also takes into

account the payment of dividends to shareholders. All these ingredients of the

3

wealth maximization objective are the result of the investment, financing and

dividend decisions of the firm.

1.3.2 SCOPE OF FINANCE FUNCTION

The question of 'scope of finance function' determines the decisions or

functions to be carried out by the financial manager in pursuit of achieving the

objective of wealth maximization. The various functions of the financial manager

relate to the estimation of financial requirements, investment of funds in long-term

and short-term assets, determining the appropriate capital structure, identification

of the various sources of finance, decision regarding retention of earnings and

distribution of dividend, and administering proper financial controls. In the following

discussion, these decisions have been categorized into two broad groupings:

(1) Long-term financial decisions:

(i) Investment decision (capital allocation for fixed and current assets),

(ii) financing decision (capital sourcing), and (iii) dividend decision

(2) Short-term financial decisions: (Working capital management):

(i) Cash, (ii) Investments (marketable securities),

(iii) Receivables, and (iv) Inventory.

A brief description of these financial decisions is given below.

1. Long-Term Financial Decisions: The long term financial decisions

pursued by the financial manager Lave significant long term effects on the value of

the firm. The results of these decisions are not confined to a few months but extend

over several years and these decisions are mostly irreversible. It is, therefore,

necessary that before committing the scarce resources of the firm a careful

exercise is done with regard to the likely costs and benefits of the various decisions.

(i) Investment Decisions: Investment decisions are also known as Capital-

budgeting decisions. It is concerned with the allocation of given amount of capital

to fixed assets of the business. The important characteristic of fixed assets is that

their benefits are realized in the future (generally after one year). Thus, capital-

budgeting decision adds to the total fixed assets of the concern by selecting and

investing in new investments. It must be properly understood at this stage that

because the future benefits are not known with certainty, investment proposals

necessarily involve risk. Consequently, they must be evaluated in relation to their

expected income and risk they add to the firm as a whole. Obviously, the

management will select investments adding something to the value of the firm. The

criteria of judging the profitability of projects is the difference between the cost of the

investment proposals and its expected earnings. The important methods employed to

judge the profitability of the investment proposals and its expected earnings. The

important methods employed to judge the profitability of the investment proposals

are: (a) Pay back method, (b) Average rate of return method, (c) Internal-rate of

4

return method, and (d) Net present value method. A careful employment of these

methods helps in determining the contribution of investment projects to owners'

wealth.

(ii) Financing Decisions: Financing Decisions (also known as Capital

Structure decisions) is intimately tied with the investment decisions. To undertake

investment decision the firm needs proper finance. The solution to the question of

raising finance is solved by financing decision. There are number of sources from

which funds can be raised. The most important sources of financing are equity

capital and debt capital. The central tasks before the financial manager is to

determine the proportion of equity capital and debt capital. He must endeavour to

obtain that financing mix or optimal capital structure for the firm where overall cost

of capital is the minimum or the value of the-firm is Maximum. In taking this

decision, the financial manager must bear in -mind the likely effects on

shareholders and the firm. The use of debt capital, for instance, affects the return

and risk of the shareholders. The return on equity will not only increase, but also the

risk. A proper balance will have to be struck between return and risk. When the

shareholder's return is maximized with minimum risk, the market value per share

will be maximized and firm's capital structure would be optimum. Once the

financial manager is able to determine the best combination of debt and equity, he

must raise the appropriate amount through best available sources.

Fig. 1.1 Decisions, Return, Risk, and Market Value

(iii) Dividend Decisions: The next crucial financial decision is the dividend

decision. This decision is the basis of dividends payment policy, reserves policy, etc.

The dividends are generally paid as some percentage of earnings on the paid-up

capital. However, the policy pursued by management concerning dividends

payment is generally stable in character. Stable dividends policy implies the

payment of same earnings percentage with only small variations depending upon the

pattern of earnings. The stable dividends policy among other things increases the

market value of the share. The amount of undistributed profits is called 'retained

earnings'. In other words, dividends payout ratio determines the amount of earnings

retained in the firm. The amount of earnings or profit to be kept undistributed with

the firm must be evaluated in the light of the objective of maximizing shareholders'

wealth.

(2) Short-Term Financial Decisions: The job of the financial manager is not

just limited to the long-term financial decisions, but also extends to the short-term

Capital Budgeting

Decisions

Capital Structure Decisions

Dividend Decisions

Working Capital

Decisions

Market Value

of the firm

Return

Risk

5

financial decisions aiming at safeguarding the firm against illiquidity or insolvency. Surveys indicate that the largest portion of a financial manager's time is devoted to the day to day internal operations of the firm; this may be appropriately subsumed

under the heading Working Capital management.

Working capital management requires the understanding and proper

appreciation of its two concepts-gross and net working capital. Gross working

capital refers to the firm's investment in current assets such as cash, short-term

securities, debtors, bills receivable and inventories. Current assets have the

distinctive characteristics of being convertible into cash within an accounting year.

Net working capital refers to the difference between current assets and current

liabilities. Current liabilities are those claims of outsiders which are expected to

mature for payment within an accounting year and include trade creditors, bills

payable, bank overdraft and outstanding expenses. For the financial manager both

these concepts of gross and net working capital are relevant.

Investment in current assets affects firm's profitability, liquidity and solvency. In

order to ensure the neither insufficient nor unnecessary funds are invested in

current assets, the financial manager should develop sound techniques of

managing current assets. He should estimate firm's working capital needs and

make sure that funds .would be made available when needed.

The cost of capital acts as the core in the framework for financial management

decision-making. In has a two-way effect on the investment, financing and

dividend decisions. It influences and is in turn influenced by them. The cost of

capital leads to the acceptance or rejection of projects, as it is the cut-off criterion

in investment decisions. In turn, the profitability of projects raises or lowers

the cost of capi tal . The financing decisions affect the cost of capital because it is

the weighted average of the cost of different sources of capital. The need to raise or

lower the cost of capital, in turn, influences the financing decisions. The

dividend decisions try to meet the expectations of the investors raise or lower the

cost of capital. The following figure explains the components of finance functions

and their interrelation.

INVESTMENT DECISION

Allocation & Rationing the Resources

Risk vs Return 1. Framing (Fixed & Current)

Assets Management Policies

Risk vs Return

External Financing

Debt/Equity Ratios

2. Forecasting and controlling

cash flows, requirements etc.

Internal financing Debt/Equity Ratios

Financing Decisions Dividend Decisions

Planning for a Balanced Capital Structure

Determination of the Quantum & Timing of

Dividend Payment

6

1. Deciding upon

requirements and

sources of new external financing

1. Determining the allocation of net profits

2. Carrying on negotiations of new outside financing etc.

2. Checking the financial performance etc.

Debt / Equity Ratios Cost of Capital Payout Ratios

Core in Framework of Financial Management

Decision Making

1. Financing Decisions

2. Investment Decisions

3. Dividend Decisions Fig. 1.2 Relationship between Finance Functions

1.3.3 FINANCE FUNCTIONS

FINANCE FUNCTIONS

Executive Function

a. Financial forecasting

b. Investment policy

c. Dividend policy

d. Cash flows& requirements

e. Deciding upon borrowing policy

f. Negotiations for new outside

financing

g. Checking upon financial

performance

Incidental Function

a. Cash receipts and payments

b. Custody of valuable papers

c. Keeping mechanical details of

financing

d. Record keeping & reporting

e. Cash planning

f. Credit management

Financial Controls: The long-term and short-term decisions, together,

determine the value of the firm to its shareholders. In order to maximize this value,

7

the firm should strive for optimal combination of these decisions. In an endeavour

to make optimal decisions, the financial manager makes use of certain tools in the

analysis, planning and control activities of the firm. Some of such important tools are

a. Financial Accounting Statements

b. Analysis of financial ratios

c. Funds Flow Analysis and Cash Flow Analysis

d. Financial forecasting

e. Analysis or operating and financial Leverage

f. Capital Expenditure Budgeting.

g. Operating Budgeting and Budgetary control

h. Costing and Cost Control Statement

i. Variance Analysis Reports

j. Cost – Volume – profit Analysis

k. Profitability Index

l. Financial Reports

Organisation for Finance Function: Almost anything in the financial realm

falls within such a committees realm, including questions of financing, budgets,

expenditures, dividend policy, and future planning. Such is the power of financial

committee that in most cases their recommendations are approved as a matter of

course by the full board of directors. On the operational level, the financial

management team may be headed up by a financial Vice-President. This is a

recent development, the financial Vice-President answers directly to the president.

Serving under him are a treasurer and a controller. An Illustrative organisation

chart of finance function of management in a large organisation is given below:

Fig. 1.3. Organization Chart of Finance Functions of Management

Vice-President

Marketing

Vice-President

Production

Board of Directors

President

Vice-President

Finance

Vice-President

Personnel

Vice-President

Purchase

Controller Controller

8

The above chart shows that the Vice-President (Finance) exercises his

functions through his two deputies known as : 1. Controller - concerned with

internal matters, 2. Treasurer - basically handles external financial matters.

Fig. 1.4 Functions of Controller and Treasurer

The controller is concerned with the management and control of the firm's

assets. His duties include providing information for formulating the accounting

and financial policies, preparation of financial reports, direction of internal

auditing, budgeting, inventory control, taxes, etc. While the treasurer is mainly

concerned with management of the firm's funds, his duties include the following:

Forecasting the financial needs; administering the flow of cash; managing

credit; floating securities; maintaining relations with financial institutions and

protecting funds and securities.

A brief description of the functions of the Controller and the Treasurer, as

given by the Controllers Institute of America, is given below.

1.3.4 FUNCTIONS OF FINANCE CONTROLLER

1. Planning and Control : To establish, coordinate and administer, as part of

management, apian for the control of operations. This plan would provide to

the extent required in the business, profit planning, programmes for capital

investing and for financing, sales forecasts and expense budgets.

2. Reporting and Interpreting : To compare actual performance wi th

operating plans and standards, and to report and interpret the results of

operations to all levels of management and to the owners of business.

To consul t wi th the management about the financial implications of its

actions.

Controller

Vice-President Finance

Treasure

1. Planning and Control

2. Reporting and Interpreting

3. Tax Administration

4. Government Reporting

5. Protection of Assets

6. Economic Appraisal

1. Provision of Finance

2. Investor Relations

3. Short-term Financing

4. Banking and Custody

5. Credit and Collections

6. Investments

7. Insurance

9

3. Tax Administration: To establish and administer tax policies and

procedures.

4. Government Reporting: To supervise or co-ordinate the preparation of

report to government agencies.

5. Protection of Assets: To ensure protection of business assets through

internal control, internal auditing and assuring proper insurance coverage.

6. Economic Appraisal : To appraise economic and social forces and

government influences and interpret their effect upon business.

Functions of Treasurer

1. Provision of Finance: To establish and execute programmes for

the provision of the finance required by the business, including

negotiating its procurement and maintaining the required financial

arrangements.

2. Investor Relations: To establish and maintain adequate market for

the company's securities and to maintain adequate contact wi th

the investment community.

3. Short-term Financing: To maintain adequate sources for the

company's current borrowings from the money market.

4. Banking and Custody: To maintain banking arrangements, to receive,

have custody of and disburse the company's moneys and securities and

to be responsible for the financial assets of real estate transactions.

5. Credit and Collections: To direct the granting of credit and the

collection of accounts receivables of the company.

6. Investments: To invest the company's funds as required and to

establish and coordinate policies for investment in pension and other

similar trusts.

7. Insurance: To provide insurance coverage as may be required.

Another way of looking at these functions is this : The controller

function generally concentrates on the asset side* of the balance sheet,

while the treasurer function concentrates on the claims side i.e.,

identifying the best sources of finance to utilize in the business and

timing the acquisition of funds.

Controller's and Treasurer's Functions in the Indian Context

The terms 'controller' and 'treasurer' are essentially used in U.S.A. However,

this pattern is not popular in India. Some companies do use the term 'Controller'

for the official who performs the functions of the chief accountant or the

management accountant. However, in most cases, in case of Indian companies,

the term 'General Manager (Finance) or Chief Finance Manager is more popular.

Some of the functions of the Controller and the Treasurer such as government

10

reporting, insurance coverage, etc., are taken care of by the Secretary of the

company. The function of the treasurer of maintaining relations with its investors

is also not much relevant in the Indian context since by and large Indian

investors/shareholders are indifferent towards attending the general meetings.

The finance manager in Indian companies is mainly concerned with the

management of the firm's financial resources. His duties are not compounded with

other duties generally in large companies. It is a healthy sign since the management

of finances is an important business activity requiring extraordinary, skill and

attention. He has to ensure that the scarce financial resources are put to the-^

optimum use keeping in view various constraints. It is, therefore, necessary that

the: finance manager devotes his full time attention and energies only in

raising and utilizing the financial resources of the firm.

1.3.5 ROUTINE DUTIES OF FINANCIAL MANAGER

Apart from the three broad functions of financial management mentioned ;

above, the financial manager has to perform certain routine or recurring functions.

These are stated below:

(i) Keeping track of actual and projected cash outflows and making adequate

provision in time for any shortfall that may arise.

(ii) Managing of cash centrally and supplying the needs of various divisions

and departments without keeping idle cash at many points.

(iii) Negotiations and relations with banks and other financial institutions,

(iv) Investment of funds available and free for a short period.

(v) Keeping track of stock exchange prices in general and prices of the

company's shares in particular,

(vi) Maintenance of liaison with production and sales departments for seeing

that working capital position is not upset because of inventories, book debts, etc.

(vii) Keeping management informed of the financial implication of various

developments in and around the company.

Non-Routine Duties; The non-recurring duties of the financial executive may

involve preparation of financial plan at. The time of company promotion, expansion

diversification, readjustments in times of liquidity crisis, valuation of the enterprise at

the time of acquisition and merger thereof, etc.

Today’s financial manager has to deal with a variety of developments that affect

the firm's liquidity and profitability, including:

(a) High financial cost identified with risk-bearing investments in a capital-

intensive environment;

(b)Diversification by firms in to differing businesses, markets, and product

lines;

11

(c) High rates of inflation that significantly affect planning and forecasting the firms operations;

(d) Emphasis on growth, with its requirements for new sources of funds and improved uses of existing funds;

(e) High rates of change in technology, wi th an accompanying need for expenditures on research and development;

(f) Speedy dissemination of information, employing high speed computers and

nationwide and worldwide networks for transmitting financial and operating data.

Social Responsibility of Financial Manager

Another point that deserves consideration is social responsibility: should

businesses operate strictly in the stockholders' best interest, or are firms also partly

responsible for the welfare of society at large? In tackling this question, consider first

the firms whose rates of return on investment are close to normal, that is, close to

the average for all firms. If such companies attempt to be socially responsible,

thereby increasing their costs over what they otherwise would have been, and if the

other business in the industry do not follow suit, then the socially oriented firms

will probably be forced to abandon their efforts. Thus, any socially responsible acts

that raise costs will be difficult, if not impossible, in industries subject to keen

competition.

What about firms with profits above normal levels - can they not devote

resources to social projects? Undoubtedly they can many large, successful firms do

engage in community projects, employee benefit programmes, and the like to a greater

degree than would appear to be called for by pare profit or wealth maximization. Still,

publicly owned firms are constrained in such actions by capital market factors.

Suppose a saver who has funds to invest is considering two alternative firms. One

firm devotes a substantial part of its resources to social actions, while the other

concentrates on profits and stock prices. Most investors are likely to shun the socially

oriented firm, which will put if to a disadvantage in the capital market. After all,

why should the stockholders of one corporation subsidise society to a greater extent

than stockholders of other businesses? Thus, even highly profitable firms (unless

they are closely held rather than publicly owned) are generally constrained against

taking unilateral cost-increasing social action.

Does all this mean that firms should not exercise social responsibility? Not at

all - it simply means that most cost-increasing actions may have to be put on a

mandatory rather than a voluntary basis, at least initially, to insure that the burden

of such action fails uniformly across all businesses. Thus, fair hiring practices,

minority training programmes, product safety, pollution abatement, antitrust

actions, and are more likely to be effective if realistic rules are established initially

and enforced by government agencies. It is critical that industry and government

cooperate in establishing the rules of corporate behaviour and that firms follow the

spirit as well as the letter of the law in their actions. Thus, the rules of the game

become constraints, and firms should strive to maximize stock prices subject to

these constraints.

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1.4 REVISION POINTS

Financing is the process of organizing the flow of funds so that a business

firm can carry out its objectives in the efficient manner and meet its obligation as

they fall due.

Function of finance – guide and regulate investment decisions- to determine the

proportion of equity and debenture in the capital structure.- to determine the

portion of dividend- Estimating the financial needs.

Objectives of the business finance–profit maximation and maximization of

wealth.

1.5 INTEXT QUESTION

1. "Finance is the oil of wheel, marrow of bones and spirit of trade, commerce

and industry'-Elucidate.

2. Discuss the role and significance of financial management in the functional

areas of modern management.

3. Some of the early concerns of financial management are related to

preservation of capital, maintenance of liquidity and reorganization .Do you

think these topics are still important in our current unpredictable

economic environment?

4. Who discharges the finance function and what are his specific

responsibilities?

5. Contrast profit maximization and value maximization as criteria for

financial management decisions in practice,

6. Why is it inappropriate to seek profit maximization as the goals of

financial decision making? How do you justify the adoption of present value

maximization as an apt substitute for it?

7. "The operative objective of financial management is to maximize wealth or

net present worth"-Ezra Solomon. Explain the statement and explain the

finance function performed by a Finance Manager to achieve this goal.

8. Explain the scope of finance function and suggest an organisational

structure that you consider suitable for an effective financial control of a

large manufacturing concern.

9. Discuss the respective roles of Treasurer' and 'Controller' in the financial

set-up of a large corporation. Out of these two finance officers who is more

important in the modern contest and why?

10. As a Financial Manager of a company, how would you reconcile between

financial goals and social objectives of the concern?

1.6 SUMMARY

This lesson covers the functions and objectives of business finance, various

approaches in business fines are explained in this lesson. The objectives of

business finance have been now diversified according to the nature of the firm.

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1.7 TERMINAL EXERCISES

1. Reporting and interpreting is a

(a) Finance Functions (b) Functions of Controller (c) Administration Function.

2. Investments (marketable securities) is a

(a) Long – term decision (b) medium term decision (c) Short – term decision.

1.8 SUPPLEMENTARY MATERIAL

Business India, Economics Times of India

1.9 ASSIGNMENT

Read various magazines and journals. Collect published audit report, profit &

loss account and balance sheet of various reputed firms. Prepare an essay on the various function of finance.

1.10 SUGGESTED READINGS / REFERENCE BOOKS

• Fundamentals of Financial Management, New Delhi, Tata McGraw Hill Co.

Financial Decision Making, New Delhi, Prentice Hall of India.

• Financial Management, I.M. pandey., New Delhi , Vikas Publishing House

• Financial Management and Policy, New Delhi, Prentice Hall of India

1.11 LEARNING ACTIVITIES

1. Visit various firms and collect information regarding the capital information regarding the capital structure.

2. Visit the financial institutions and know the lending process.

3. Meet the share brokers or their agents or staffs to get more information about the capital market.

1.12 KEY WORDS

Cut off rate – vague – financial decisions – profit maximization and wealth maximization.

14

LESSON – 2

FINANCIAL FORECASTING

2.1 INTRODUCTION

Financial forecasting involves systematic projection of expected actions of

management in the form of financial statements, budgets etc., The process of

financial forecasting involves use of past records, funds flow behaviour, financial

ratios and expected economic conditions in industry as well as in the firm. It is a

sort of working plan formulated for a specified period by arranging future activities.

It is a tool for appraising the real worth of a growing concern. It provides an insight

into two important areas of management- return on investment and soundness of

the company’s financial problems. The financial analysis is the process of

determining the significant financial characteristics of a firm. It may be internal or

external. The internal analysis is performed by the various department of a firm.

The external analysis is performed by creditors, stockholders and investment

analysis.

2.2 OBJECTIVES

Financial forecasting is the core function of financial management students

can know the meaning of the financial forecasting and various techniques

used in financial forecasting from this lesson.

2.3 CONTENT

2.3.1 Advantages

2.3.2 Disadvantages

2.3.3 Tools for financial forecasting

2.3.4 Forecasting future income and expenditure

2.3.5 Long term financial planning

2.3.1 ADVANTAGES

Financial manager derives several benefits out of financial forecasting. Some of

them are as follows.

1. Financial forecasting forms the basis of coordinated thinking for optimum utilization of funds and thus excess cash can be invested profitably.

2. It is useful to fix standards for measuring performance and evaluating results.

3. It is useful to anticipate the financial needs and effects of new policies and

reduce emergency decisions.

4. It serves as a basis for estimating funds requirements within the company.

5. It helps the corporate managers for negotiating confidently with the

suppliers of funds.

6. It is used to protect the financial feasibility of various programmes.

15

2.3.2 DISADVANTAGES

There is no technique by which the future can be fore told. Single

attempt to forecast the future is very hard. A forecast is based on certain

assumptions, which it is difficult to state clearly. Since future is always uncertain,

no constant technique is used to estimate the funds requirements of future.

2.3.3 TOOLS FOR FINANCIAL FORECASTING

Forecasting profit

The following are the stages in profit planning

1. Forecasting sales. This forecasting, whether long term or short term is

concerned with sales. It relates to:

(a) Growth polices (b) Man power planning (c) Policy for research and

development and (d) Financial policy providing for cash flows.

2. Forecasting production

a. Pricing

b. Profits from products and from the business as a whole.

Forecasting variations

It is concerned with asking why the targeted profit has not been achieved and

taking action to prevent further deterioration. All the functions which affect profit

should be part of the system which detects deviation from standard. It makes a

diagnosis of how these deviations have occurred, and which ensures that steps are

taken to correct the situation.

Effective financial Forecasting

Many firms operate in an atmosphere of change and uncertainty and they are

sometimes highly vulnerable, to sharp fluctuations in sales, which are dependent

on the vagaries of weather. They face difficulties in forecasting. They are required to

pay attention to the following.

1. Management should recognize the likely margin of errors inherent in its

forecasts.

2. Financial executives should prepare few sets of projected financial

statements and cash budgets under different key figures like sales,

inventory, debtors etc. It is undesirable to prepare one set.

3. Forecasts should be flexible as the firm is working in changing

environment.

4. Firms should maintain more cash balances to minimize the risk.

5. Key assumptions of forecast i.e., on what basis forecasts are made should

be mentioned for better understanding.

6. One should not forecast in greater details than what situation permits.

16

7. Forecasting for a longer period is undesirable in the days of uncertainly as

they are going to be not useful much in times of change.

2.3.4 FORECASTING FUTURE INCOME AND EXPENDITURES

Budgets are estimates of future income and expenses arising out of and

incurred on, the activities of an enterprise. The actual performance is measured in

terms of budget expectation; budgetary control involves an overall supervision of

activities. It directs the way for securing the desired ends. There are many kinds of

budgets;

Sales Budgets: it contains a forecast of sales

Production Budget: it indicates the quality of production and the time limit by

which production may be completed to meet the sales targets.

Revenue and expense Budget: this is prepared by the top management to

determine the profitability of a budgetary programme.

Capital Expenditure Budget: this budget contains a programme for the

acquisition of fixed assets in the years to come. This budget points out the future

cash inflows in respect of particular capital expenditure.

2.3.5 LONG TERM FINANCIAL PLANNING

It examines the effect of the proposed capital investment and is known as

capital budgeting or investment appraisal. It refers to the decision-making

procedure in a firm and concerned with the allocation of capital among competing

investment opportunities. The followings are very important in evaluating the any

investment proposal,

1. To examine the total investment period.

2. To decide the time of capital expenditure.

3. To estimate the life of the project.

4. To determine future realizable receipts.

The following procedure may be adopted to estimate future cash flows of the long term investment.

1. Forecasting long term cash flows.

2. Estimating the cast of a proposal.

3. Evaluating investment proposal.

The following are considered in a long-range Financial planning.

1. The total investment: it covers not only the financial costs (total price of the

investments), but also the installation expenses and working capital

requirements.

2. Timing of capital expenditure: the entire cost of the investment is payable at

different point of time.

3. Estimated life of project: the period of life for which a project is likely to

exist.

17

4. Economic life of the assets: the management should attempt to evaluate the

period of time in which the proposed project would operate efficiently and

economically. The technological obsolescence, market trend, availability of

materials and operating and maintenance cost etc., are to be considered.

The management experience, while evaluating these items.

2.4 REVISION POINTS

Advantages of financial forecasting—optimum utilization of funds – Evaluating

the results and financial performance – Anticipate the financial needs and effects of

new policies -- Tools of financial forecasting – forecasting profit – long term financial

planning.

2.5 INTEXT QUESTIONS

1. Explain the advantages of financial forecasting.

2. What are the factors to be considered while long term financial planning?

3. Point out the essentials of a good financial fore casting.

4. Explain the importance of financial forecasting.

5. How would you forecast the profits?

6. What are the steps in long term financial planning?

2.6 SUMMARY

In this lesson financial forecasting is clearly defined. It is an estimation of

future funds requirements. Advantages of financial forecasting are explained.

Various tools of financial forecasting are- (1) forecasting future incomes and

expenditures (2) Long term financial planning. Various factors to be considered

while estimating the financial requirements.

2.7 TERMINAL EXERCISES

1.Sales budget refers

2 To forecast the profit (b) to forecast the sales (c) to forecast the sales expenses (d) to forecast the cost of sales

3. Long term financial planning is related with

4. Capital profit (b) Capital structure (c) capital budgeting (d) issues of shares.

2.8 SUPPLEMENTARY MATERIALS

http://dosen.narotama.ac.id/

http://www.osbornebooksshop.co.uk/

http://www.fao.org/

2.9 ASSIGNMENT

Refer the suggested materials and collect the information of various methods of

financial forecasting. Do, some home work of preparation of financial forecasting

with the help of suggested reference books. Prepare an essay on long term financial

planning and point out its features.

18

2.10 SUGGESTED READINGS /REFERENCE BOOKS

1. Cost and Management Accounting ---- V K Saxena

2. Financial Management ----- Kulkarni

3. Financial Management --- Krishna Reddy.

2.11 LEARNING ACTIVITIES

Students may collectively have some discussion on financial forecasting with

the help of suggested books and examine the relevant methods financial

forecasting. The techniques used in financial forecasting may be changed according

to the nature of the firm. Students may analyse the various methods of financial

forecasting and suggest new ideas for effective financial forecasting

2.12 KEY WORDS

Forecasting – fore see prediction

Uncertain – not sure

Standard – an accepted measure of quantity

Vulnerably – capable of being wounded

Vagaries – change.

19

LESSON 3

INTRODUCTION TO BUDGET

3.1 INTRODUCTION

To achieve the organizational objectives, an enterprise should be managed

effectively and efficiently. It is facilitated by chalking out the course of action in

advance. Planning, the primary function of management helps to chalk out the

course of actions in advance. But planning has to be followed by continuous

comparison of the actual performance with the planned performance, i. e.,

controlling. One systematic approach in effective follow up process is budgeting.

Different budgets are prepared by the enterprise for different purposes. Thus,

budgeting is an integral part of management.

In the business world, a budget is a statement showing the expected income

and expenditure for a specific future period. Thus, budgeting is required

everywhere in national, domestic and business affairs.

3.2 OBJECTIVES

After completing this Lesson you should be able to Know

What is Budget

Meaning of budgeting

Important elements of Budgeting

3.3 CONTENT

3.3.1 Definition of Budget

3.3.2 Elements of Budgets

3.3.3 Characteristics of a Budget

3.3.4 Budgeting

3.3.5 Elements of Budgeting

3.3.1 DEFINITION OF BUDGET

Budget is a systematic plan for utilization of all types of resources, at its

command. It acts as a barometer of a business as it measures the success from

time to time, against the standard set for achievement.

‘A budget is a comprehensive and coordinated plan, expressed in financial

terms, for the operations and resources of an enterprise for some specific period in

the future’. (Fremgen, James M – Accounting for Managerial Analysis)

‘A budget is a predetermined detailed plan of action developed and distributed

as a guide to current operations and as a partial basis for the subsequent

evaluation of performance’. (Gordon and Shillinglaw)

‘A budget is a financial and/or quantitative statement, prepared prior to a

defined period of time, of the policy to be pursued during the period for the purpose

of attaining a given objective’. (The Chartered Institute of Management

Accountants, London)

20

3.3.2 ELEMENTS OF BUDGET

The basic elements of a budget are as follows:-

1. It is a comprehensive and coordinated plan of action.

2. It is a plan for the firm’s operations and resources.

3. It is based on objectives to be attained.

4. It is related to specific future period.

5. It is expressed in financial and/or physical units.

3.3.3 CHARACTERISTICS OF A BUDGET

The main characteristics of a budget are:

A Comprehensive Business Plan showing what the enterprise wants to

achieve.

Prepared in Advance.

For a Definite Period of Time.

Expressed in quantitative form, physical or monetary terms, or both.

For achieving a given objective.

A proper system of Accounting is essential.

System of Proper Fixation of Authority and Responsibility has to be in

place.

Need of Budget

A budget is prepared to have effective utilization of resources and for the

realization of objectives, as efficiently as possible.

3.3.4 BUDGETING

Budgeting is the process of preparing and using budgets to achieve

management objectives. It is the systematic approach for accomplishing the

planning, coordination, and control responsibilities of management by optimally

utilizing the given resources. In other words Budgeting is a technique of

formulating budgets.

Budgeting is the whole process of designing, implementing and operating

budgets. The main emphasis in this is short – term budgeting process involving the

provision of Resources to support plans which are being implemented.

‘The entire process of preparing the budgets is known as Budgeting’(J. Batty)

‘Budgeting may be said to be the act of building budgets’ (Rowland&Harr)

3.3.5 ELEMENTS OF BUDGETING

1. A good budgeting should state clearly the firm’s expectations and

facilitate their attainability.

2. A good budgeting system should utilize various persons at different

levels while preparing the budgets.

3. The authority and responsibility should be properly fixed.

4. Realistic targets are to be fixed.

21

5. A good system of accounting is also essential.

6. Wholehearted support of the top management is necessary.

7. Budgeting education is to be imparted among the employees.

8. Proper reporting system should be introduced.

9. Availability of working capital is to be ensured.

3.4 REVISION POINTS

1. 1. Budget is a Pre-determined Statement of Management Policy During a

Given Period Which provide a standard for comparison with the results

Actually achieved

2. Budgeting is a technique of formulating budgets.

3. Elements of Budget It is a comprehensive plan for the firm resources,

It is related Specific future period and expressed in financial or physical

unit

4. Characteristic of a budget It is prepared in advance for a definite period of

time

5. Elements of Budgeting Should express the firms expectation, realistic

target are fixed, good accounting system is essential, top management

support is necessary, working capital is to be ensured

3.5 INTEXT QUESTIONS

1. Define Budget

2. What do you mean by Budgeting?

3. What are the Basic elements of budgets

3.6 SUMMARY

Budget is a systematic plan for utilization of all types of resources, at its

command. It acts as a barometer of a business as it measures the success from

time to time, against the standard set for achievement. A budget is prepared to

have effective utilization of resources and for the realization of objectives, as

efficiently as possible. Budgeting is the process of preparing and using budgets to

achieve management objectives. It is the systematic approach for accomplishing the

planning, coordination, and control responsibilities of management by optimally

utilizing the given resources. In other words Budgeting is a technique of

formulating budgets. Elements of Budget It is a comprehensive plan for the firm

resources, It is related Specific future period and expressed in financial or physical

unit. Elements of Budgeting Should express the firms expectation, realistic target

are fixed, good accounting system is essential, top management support is

necessary, working capital is to be ensured.

3.7 TERMINAL EXERCISE

1 ………………………..is a detailed plan of operations for specific future period.

22

2. …………………………is a technique of formulating budgets.

3. The entire process of preparing the budgets is known as…………………

3.8 SUPPLEMENTARY MATERIAL

Pillai.R.S.N, Bagavathi Management Accounting S. Chand & company LTD

Antony Robert.N and Reece, James.S

Management Accounting Principles Tata McGraw Hill

3.9 ASSIGNMENTS

1. What are the important points to be considered for a good budget?

2. Narrate the characteristics of a budget

3. Explain the Elements of a budgeting.

3.10 SUGGESTED READINGS / REFERENCE BOOKS

http://dosen.narotama.ac.id/

http://www.osbornebooksshop.co.uk/

http://www.fao.org/

http://www.icaiknowledgegateway.org/

3.11 LEARNING ACTIVITIES

Go to the nearby organization and observe how budgets are Prepared?

3.12 KEYWORDS

Budget, Budgeting, Budgetary Control

23

LESSON 4

TYPES OF BUDGETS

4.1 INTRODUCTION

The budgets are classified according to their nature. The budgets may be

classified according to function, flexibility, time. Functional budget is one which

relates to a function of the business. Flexible budget is one which is designed to

change in relation to the level of activity attained. On the basis of time, the budget

can be classified as Long term budget, Short term budget ,Current budget ,Rolling

budget .

4.2 OBJECTIVES

After completing this Lesson you should be able to know

Classification of Budgets According to Function, Flexibility and Time

How to prepare different types of Budgets

Advantages and Disadvantages of Budgetary Control

4.3 CONTENT

4.3.1 Types/Classification of Budget

4.3.2 Classification according to Function

4.3.3 Classification according to Flexibility

4.3.4 Classification according to Time

4.3.5 Advantages of Budgetary Control

4.3.6 Limitations of Budgetary Control

4.3.7 Preparation of Budgets

4.3.1 TYPES/CLASSIFICATION OF BUDGETS

Budget can be classified into three categories from different points of view.

They are:

1. According to Function

2. According to Flexibility

3. According to Time

4.3.2 CLASSIFICATION ACCORDING TO FUNCTION

a.Sales Budget

The budget which estimates total sales in terms of items, quantity, value,

periods, areas, etc is called Sales Budget.

b.Production Budget

It estimates quantity of production in terms of items, periods, areas, etc. It is

prepared on the basis of Sales Budget.

c.Cost of Production Budget

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This budget forecasts the cost of production. Separate budgets may also be

prepared for each element of costs such as direct materials budgets, direct labour

budget, factory materials budgets, office overheads budget, selling and distribution

overheads budget, etc.

d.Purchase Budget

This budget forecasts the quantity and value of purchase required for

production. It gives quantity wise, money wise and period wise particulars about

the materials to be purchased.

e.Personnel Budget

The budget that anticipates the quantity of personnel required during a

period for production activity is known as Personnel Budget

f.Research Budget

This budget relates to the research work to be done for improvement in

quality of the products or research for new products.

g.Capital Expenditure Budget

This budget provides a guidance regarding the amount of capital that may

be required for procurement of capital assets during the budget period.

h.Cash Budget

This budget is a forecast of the cash position by time period for a specific

duration of time. It states the estimated amount of cash receipts and estimation of

cash payments and the likely balance of cash in hand at the end of different

periods.

i.Master Budget

It is a summary budget incorporating all functional budgets in a capsule

form. It interprets different functional budgets and covers within its range the

preparation of projected income statement and projected balance sheet.

4.3.3 CLASSIFICATION ACCORDING TO FLEXIBILITY

On the basis of flexibility, budgets can be divided into two categories. They are:

1. Fixed Budget

2. Flexible Budget

1.Fixed Budget

Fixed Budget is one which is prepared on the basis of a standard or a fixed

level of activity. It does not change with the change in the level of activity.

2. Flexible Budget

A budget prepared to give the budgeted cost of any level of activity is

termed as a flexible budget. According to CIMA, London, a Flexible Budget is, ‘a

budget designed to change in accordance with level of activity attained’. It is

prepared by taking into account the fixed and variable elements of cost.

25

4.3.4 CLASSIFICATION ACCORDING TO TIME

On the basis of time, the budget can be classified as follows:

1. Long term budget

2. Short term budget

3. Current budget

4. Rolling budget

1.Long-Term Budget

A budget prepared for considerably long period of time, viz., 5 to 10 years is

called Long-term Budget. It is concerned with the planning of operations of the

firm. It is generally prepared in terms of physical quantities.

2.Short-Term Budget

A budget prepared generally for a period not exceeding 5 years is called Short-

term Budget. It is generally prepared in terms of physical quantities and in monetary units.

3.Current Budget

It is a budget for a very short period, say, a month or a quarter. It is adjusted to

current conditions. Therefore, it is called current budget.

4.Rolling Budget

It is also known as Progressive Budget. Under this method, a budget for a year

in advance is prepared. A new budget is prepared after the end of each

month/quarter for a full year ahead. The figures for the month/quarter which has

rolled down are dropped and the figures for the next month/quarter are added.

This practice continues whenever a month/quarter ends and a new month/quarter

begins.

4.3.5 ADVANTAGES OF BUDGETARY CONTROL

The following are the advantages of budgetary control system.

1.Profit Maximization

The resources are put to best possible use, eliminating wastage. Proper control

is exercised both on revenue and capital expenditure. To achieve this, proper

planning and co-ordination of various functions is undertaken. So, the system

helps in reducing losses and increasing profits.

2.Co-ordination

Co-ordination between the plans, policy and control is established.

The budgets of various departments have a bearing with each other, as

activities are interrelated. As the size of operations increases, co-ordination

amongst the different departments for achieving a common goal assumes more

importance. This is possible through budgetary control system.

As all the personnel in the management team are involved and coordinated,

there is bound to be maximum profits.

26

Budgetary control system acts as a friend, philosopher and guide to the

management.

1.Communication

A budget serves as a means of communicating information throughout the

organisation. A sales manager for a district knows what is expected of his

performance. Similarly, production manager knows the amount of material, labour

and other expenses that can be incurred by him to achieve the goal set to him. So,

every department knows the performance expectation and authority for achieving

the same.

1.Tool for Measuring Performance

Budgetary control system provides a tool for measuring the performance of various departments. The performance of each department is reported to the top

management.

The system helps the management to set the goals. The current performance is compared with the pre-planned performance to ascertain deviations so that corrective measures are taken, well at the right time.

It helps the management to economise costs and maximise profits.

1.Economy

Planning at each level brings efficiency and economy in the working of the

business enterprise. Resources are put to optimum use. All this leads to

elimination of wastage and achievement of overall efficiency.

2.Determining Weaknesses

Actual performance is compared with the planned performance, periodically,

and deviations are found out. This shows the variances highlighting the

weaknesses, where concentration for action is needed.

3.Consciousness

Budgets are prepared in advance. So, every employee knows what is expected

of him and they are made aware of their responsibility. So, they do their job

uninterrupted for achieving, what is set to him to do.

4.Timely Corrective Action

The deviations are reported to the attention of the top management as well as

functional heads for suitable corrective action, in time. In the absence of budgetary

control, deviations would be known only at the end of the period. There is no time

and opportunity for necessary corrective action.

5.Motivation

Success is measured by comparing the actual performance with the planned

performance. Suitable recognition and reward system can be introduced to motivate

the employees, at all levels, provided the budgets are prepared with adequate

planning and foresight.

27

6. Management by Exception

The management is required to exercise action only when there are

deviations. So long as the plans are achieved, management need not be alerted.

This system enables the introduction of ‘Management by Exception’ for effective

delegation and control.

6.Overall Efficiency

Everyone in the management is associated with the preparation of budget.

There is involvement from the top functionaries and each one knows how the target

fixed can be achieved. Budgets once, finally, approved by the Budget Committee, it

represents the collective decision of the organisation. With the implementation of

budgetary control, there would be over all alertness and improved working in all the

departments, with better coordination.

Budgetary Control acts like an impersonal policeman to bring all round

efficiency in performance.

7.Optimum Utilisation of Resources

As there is effective control over production, the resources of the

organisation would be put to optimum utilisation.

4.3.6 LIMITATIONS OF BUDGETARY CONTROL

Budgetary control is a sound technique of control but is not a perfect tool.

Despite many good points, it suffers from the following limitations:

1.Uncertainty of Future

Budgets are prepared for the future periods. So, budgets are prepared, with

certain assumptions. There is no certainty that all the assumptions prevail in

future. With the change in assumptions, the situation, in future, changes. Due to

this, the utility of budgetary control reduces.

2.Problem of Co-ordination

The success of budgetary control, largely, depends upon effective co-

ordination. The performance of one department depends on the performance of the

other department. To ensure necessary co-ordination, organisation appoints a

budget officer. All organisations cannot afford the additional expenditure involved

with the appointment of a budget officer, separately. In case, budget officer is not

appointed, lack of co-ordination results in poor performance.

3.Not a Substitute for Management

Budgetary control helps in decision-making, but is not a substitute for

management. A budgetary programme can be successful, if there is proper

administration and supervision.

4.Discourages Efficiency

Every person is given a target to achieve. So, everyone is concerned only

achieving the target of his own. This is the common tendency. Even capable and

competent people too would concentrate just to achieve their individual targets. So,

28

budgets may become managerial constraints, unless suitable award or incentive

system is introduced. In the absence of award system to recognise efficiency and

exceptional talents, budgets may dampen the people, with initiative and

enthusiasm.

5.Timely Revision Required

Budgets are prepared on certain assumptions. When those conditions do not

prevail, it becomes inevitable to revise the budget. Such frequent revision of

budgets reduces reliability and value. Revision of budgets involves additional

expenditure too.

6.Conflict among Different Departments

For the success of budgetary control, co-ordination of the different departments

is essential. Every department is concerned with the achievement of the individual

department’s goal, not concerned with the final goal of the enterprise. In this

process, each department tries to secure maximum fund allocation and this creates

conflict among the different departments.

7.Depends upon Support of Top management

The success of budgetary control depends upon the support of top

management. If the top management is not enthusiastic for its success, the

budgetary control collapses. So, the wholehearted interest of top management is

highly essential for its implementation, in its true spirit, to make it workable and

succeed.

4.3.7 PREPARATION OF BUDGETS

I. Sales Budget

Sales budget is the basis for the preparation of other budgets. It is the forecast

of sales to be achieved in a budget period. The sales manager is directly responsible

for the preparation of this budget. The following factors are taken into

consideration:

a. Past sales figures and trend

b. Salesmen’s estimates

c. Plant capacity

d. General trade position

e. Orders in hand

f. Proposed expansion

g. Seasonal fluctuations

h. Market demand

i. Availability of raw materials and other supplies

j. Financial position

k. Nature of competition

l. Cost of distribution

m. Government controls and regulations

29

n. Political situation.

Example

1. The Royal Industries has prepared its annual sales forecast, expecting to

achieve sales of 30,00,000 next years. The Controller is uncertain about the pattern

of sales to be expected by month and asks you to prepare a monthly budget of

sales. The following is the sales data pertained to the year, which is considered to

be representative of a normal year:

Month Sales Month Sales

January 1,10,000 July 2,60,000

February 1,15,000 August 3,30,000

March 1,00,000 September 3,40,000

April 1,40,000 October 3,50,000

May 1,80,000 November 2,00,000

June 2,25,000 December 1,50,000

Prepare a monthly sales budget for the coming year on the basis of the above data.

Answer

Sales Budget

Month Sales(given)

Sales estimation

based on cash sales ratio given

January 1,10,000 (1,10,000/25,00,000) x 30,00,000 = 1,32,000

February 1,15,000 (1,15,000/25,00,000) x 30,00,000 = 1,38,000

March 1,00,000 (1,00,000/25,00,000) x 30,00,000 = 1,20,000

April 1,40,000 (1,40,000/25,00,000) x 30,00,000 = 1,68,000

May 1,80,000 (1,80,000/25,00,000) x 30,00,000 = 2,16,000

June 2,25,000 (2,25,000/25,00,000) x 30,00,000 = 2,70,000

July 2,60,000 (2,60,000/25,00,000) x 30,00,000 = 3,12,000

August 3,30,000 (3,30,000/25,00,000) x 30,00,000 = 3,96,000

September 3,40,000 (3,40,000/25,00,000) x 30,00,000 = 4,08,000

October 3,50,000 (3,50,000/25,00,000) x 30,00,000 = 4,20,000

November 2,00,000 (2,00,000/25,00,000) x 30,00,000 = 2,40,000

December 1,50,000 (1,50,000/25,00,000) x 30,00,000 = 1,80,000

Total 25,00,000 30,00,000

Note: Sales budget is prepared based on last year’s month-wise sales ratio.

30

2. M/s. Alpha Manufacturing Company produces two types of products, viz.,

Raja and Rani and sells them in Chennai and Mumbai markets. The following

information is made available for the current year:

Market Product Budgeted Sales Actual Sales

Chennai Raja 400 units @ 9 each 500 units @ 9 each

Rani 300 units @ 21 each 200 units @ 21 each

Mumbai Raja 600 units @ 9 each 700 units @ 9 each

Rani 500 units @ 21 each 400 units @ 21 each

Market studies reveal that Raja is popular as it is under priced. It is observed

that if its price is increased by1 it will find a readymade market. On the other hand,

Rani is overpriced and market could absorb more sales if its price is reduced to ̀

20. The management has agreed to give effect to the above price changes.

On the above basis, the following estimates have been prepared by Sales

Manager:

Product

% increase in sales over current budget

Chennai Mumbai

Raja +10% + 5%

Rain + 20% + 10%

With the help of an intensive advertisement campaign, the following additional

sales above the estimated sales of sales manager are possible:

Product Chennai Mumbai

Raja 60 units 70 units

Rani 40 units 50 units

You are required to prepare a budget for sales incorporating the above estimates.

31

Answer:

Sales Budget

Area Product

Budget for

current year Actual sales

Budget for

future period

Units Price Value Units Price Value Units Price Value

Chennai

Raja 400 9 3600 500 9 4500 500 10 5000

Rani 300 21 6300 200 21 4200 400 20 8000

Total 700 9900 700 8700 900 13000

Mumbai

Raja 600 9 5400 700 9 6300 700 10 7000

Rani 500 21 10500 400 21 8400 600 20 12000

Total 1100 15900 1100 14700 1300 19000

Total

Raja 1000 9 9000 1200 9 10800 1200 10 12000

Rani 800 21 16800 600 21 12600 1000 20 20000

Total

Sales 1800 25800 1800 23400 2200 32000

Workings

1. Budgeted sales for Chennai

All in Units Raja Rani

Budgeted Sales 400 300

Add: Increase

(10%)

40 (20%) 60

440 360

Increase due to advertisement 60 40

Total 500 400

2. Budgeted sales for Mumbai

All in Units Raja Rani

Budgeted Sales 600 500

Add: Increase (5%) 30 (10%) 50

630 550

Increase due to advertisement 70 50

Total 700 600

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II. Production Budget

The production budget is an estimate of the quantity of goods that must be

produced during the budget period. The aim of the production function will

presumably be to supply finished goods of a specified quality to meet marketing

demands. The sum of sales requirements plus changes in stock levels of finished

goods gives the production requirements for the period being budgeted. In order to

construct the production budget we need the level of sales expected and the desired

levels of stock of finished goods. The following formula is used for calculation of

units to be produced.

Production = Sales + Closing stock – Opening stock

Production budget should be developed keeping in view the optimal balance

between sales, inventories and production so as to result in minimum cost. Once

the production level is determined, it becomes the starting point for the direct

materials, direct labour and manufacturing overhead budgets.

Production = Sales + Closing Stock – Opening Stock

Example

3 The sales of a concern for the next year is estimated at 50,000 units. Each

unit of the product requires 2 units of Material ‘A’ and 3 units of Material ‘B’. The

estimated opening balances at the commencement of the next year are:

Finished Product : 10,000 units

Raw Material ‘A’ : 12,000 units

Raw Material ‘B’ : 15,000 units

The desirable closing balances at the end of the next year are:

Finished Product : 14,000 units

Raw Material ‘A’ : 13,000 units

Raw Material ‘B’ : 16,000 units

Prepare the materials purchase budget for the next year.

Answer

Production Budget (All in Units)

Estimated Sales 50,000

Add: Estimated Closing Finished Goods 14,000

64,000

Less: Estimated Opening Finished Goods 10,000

Production 54,000

Materials Purchase Budget

33

Material ‘A’ Material ‘B’

(all in Units)

Material Consumption 1,08,000 1,62,000

Add: Closing stock of materials 13,000 16,000

1,21,000 1,78,000

Less: Opening stock of materials 12,000 15,000

Materials to be purchased 1,09,000 1,63,000

Workings

Materials consumption: Material ‘A’ Material ‘B’

Material required per unit of production 2 units 3 units

For production of 54,000 units 1,08,000 1,62,000

III. Cash Budget

It is an estimate of cash receipts and disbursements during a future period

of time. “The Cash Budget is an analysis of flow of cash in a business over a future,

short or long period of time. It is a forecast of expected cash intake and outlay”

(Soleman, Ezra – Handbook of Business administration)

Procedure for Preparation of Cash Budget

1. First take into account the opening cash balance, if any, for the beginning

of the period for which the cash budget is to be prepared.

2. Then Cash receipts from various sources are estimated. It may be from

cash sales, cash collections from debtors/bills receivables, dividends,

interest on investments, sale of assets, etc.

3. The Cash payments for various disbursements are also estimated. It may

be for cash purchases, payment to creditors/bills payables, payment to

revenue and capital expenditure, creditors for expenses, etc.

4. The estimated cash receipts are added to the opening cash balance, if any.

5. The estimated cash payments are deducted from the above proceeds.

6. The balance, if any, is the closing cash balance of the month concerned.

7. The closing cash balance is taken as the opening cash balance of the following month.

8. Then the process is repeatedly performed.

9. If the closing balance of any month is negative i.e the estimated cash

payments exceed estimated cash receipts, then overdraft facility may also

be arranged suitably.

34

Example:

From the following budgeted figures prepare a Cash Budget in respect of

three months to June 30, 2006.

Additional Information

1. Expected Cash balance on 1st April, 2006 – 20,000

2. Materials and overheads are to be paid during the month following the

month of supply.

3. Wages are to be paid during the month in which they are incurred.

4. All sales are on credit basis.

5. The terms of credits are payment by the end of the month following the

month of sales: Half of credit sales are paid when due the other half to

be paid within the month following actual sales.

6. 5% sales commission is to be paid within in the month following sales

7. Preference Dividends for30,000 is to be paid on 1st May.

8. Share calls money of 25,000 is due on 1st April and 1st June.

9. Plant and machinery worth10,000 is to be installed in the month of

January and the payment is to be made in the month of June.

Answer:

Cash Budget for three months from April to June, 2006

Particulars April Rs.

May Rs.

June Rs.

Opening Cash Balance 20,000 32,600 (-) 5,600

Add: Estimated Cash Receipts:

Sales Collection from debtors 60,000 72,000 82,000

Share call money 25,000 25,000

TOTAL ------- A 1,05,000 1,04,600 1,01,400

Month Sales Materials Wages Overheads

January 60,000 40,000 11,000 6,200

February 56,000 48,000 11,600 6,600

March 64,000 50,000 12,000 6,800

April 80,000 56,000 12,400 7,200

May 84,000 62,000 13,000 8,600

June 76,000 50,000 14,000 8,000

35

Less: Estimated Cash

Payments:

Materials 50,000 56,000 62,000

Wages 12,400 13,000 14,000

Overheads 6,800 7,200 8,600

Sales Commission 3,200 4,000 4,200

Preference Dividend --- 30,000

Plant and Machinery --- --- 10,000

TOTAL ------- B 72,400 1,10,200 98,800

Closing Cash Balance (A-B) 32,600 (-) 5,600 2,600

WORKINGS:

1. Sales Collection: Payment is due at the month following the sales. Half is

paid on due and other half is paid during the next month. Therefore, February sales ` 50,000 is due at the end of March. Half is given at the end of March and other half

is given in the next month i.e., in the month of April. Hence, the sales collection for the month of April will be as follows:

For April – Half of February sales (56,000 x ½)= 28,000 Plus

Half of March Sales (64,000 x ½)= 32,000

Total Collection for April= 60,000

Similarly, the sales collection for the months of May and June may be

calculated

2. Materials and Overheads: These are paid in the following month. That is

March is paid in April, April is paid in May and May is paid in June

3. Sales Commission: It is paid in the following month. Therefore

For April – 5% of March Sales (64,000 x 5 /100) = 3,200

For May – 5% of March Sales (80,000 x 5 /100) = 4,000

For April – 5% of March Sales (84,000 x 5 /100) = 4,200

IV. Flexible Budget

A flexible budget consists of a series of budgets for different level of activity.

Therefore, it varies with the level of activity attained. According to CIMA, London, A

Flexible Budget is, ‘a budget designed to change in accordance with level of activity

attained’. It is prepared by taking into account the fixed and variable elements of

cost. This budget is more suitable when the forecasting of demand is uncertain.

Points to be remembered while preparing a flexible budget

1. Cost has to be classified into fixed and variable cost.

2. Total fixed cost remains constant at any level of activity.

36

3. Total Variable cost varies in the same proportion at which the level of activity varies.

4. Fixed and variable portion of Semi-variable cost is to be segregated.

Example

5. The following information at 50% capacity is given. Prepare a flexible budget

and forecast the profit or loss at 60%, 70% and 90% capacity.

Particulars Expenses at 50% capacity

Fixed expenses: Rs.

Salaries 5,000

Rent and taxes 4,000

Depreciation 6,000

Administrative expenses 7,000

Variable expenses:

Materials 20,000

Labour 25,000

Others 4,000

Semi-variable expenses:

Repairs 10,000

Indirect Labour 15,000

Others 9,000

It is estimated that fixed expenses will remain constant at all capacities.

Semi-variable expenses will not change between 45% and 60% capacity, will rise by

10% between 60% and 75% capacity, a further increase of 5% when capacity

crosses 75%.Estimated sales at various levels of capacity viz.,60%. 70% and 90%

respectively of Rs.1,10,000 1,30,000 and Rs.1,50,000.

Answer

Flexible Budget (Showing Profit & Loss at various capacities)

Particulars

Capacities

50% 60% 70% 90%

Fixed Expenses: Rs. Rs. Rs. Rs.

Salaries 5,000 5,000 5,000 5,000

Rent and taxes 4,000 4,000 4,000 4,000

Depreciation 6,000 6,000 6,000 6,000

Administrative expenses 7,000 7,000 7,000 7,000

Variable expenses:

Materials 20,000 24,000 28,000 36,000

Labour 25,000 30,000 35,000 45,000

Others 4,000 4,800 5,600 7,200

37

Semi-variable expenses:

Repairs 10,000 10,000 11,000 11,500

Indirect Labour 15,000 15,000 16,500 17,250

Others 9,000 9,000 9,900 10,350

Total Cost 1,05,000 1,14,800 1,28,000 1,49,300

Profit (+) or Loss (-) (-) 4,800 (+) 2,000 (+) 700

Estimated Sales 1,10,000 1,30,000 1,50,000

Example

6. The following information relates to a flexible budget at 60% capacity. Find

out the overhead costs at 50% and 70% capacity and also determine the overhead

rates:

Particulars Expenses at60% capacity

Variable overheads:

Indirect Labour 10,500

Indirect Materials 8,400

Semi-variable overheads:

Repair and Maintenance(70% fixed; 30% variable) 7,000

Electricity(50% fixed; 50% variable) 25,200

Fixed overheads:

Office expenses including salaries 70,000

Insurance 4,000

Depreciation 20,000

Estimated direct labour hours 1,20,000 hours

Answer Flexible Budget

50 % 60% 70%

Capacity Capacity Capacity

Variable overheads:

Indirect Labour 8,750 10,500 12,250

Indirect Materials 7,000 8,400 9,800

Semi-variable overheads:

Repair and Maintenance (1) 6,650 7,000 7,350

Electricity(2) 23,100 25,200 27,300

Fixed overheads:

Office expenses including salaries 70,000 70,000 70,000

Insurance 4,000 4,000 4,000

38

Depreciation 20,000 20,000 20,000

Total overheads 1,39,500 1,45,100 1,50,700

Estimated direct labour hours 1,00,000 1,20,000 1,50,000

Overhead rate per hour 1.395 1.21 1.077

Workings:

The amount of Repairs and maintenance at 60% Capacity is 7,000. Out of

this, 70% (i.e4,900) is fixed and remaining 30% (i.e2,100) is variable. The fixed

portion remains constant at all levels of capacities. Only the variable portion will

change according to change in the level of activity. Therefore, the total amount of

repairs and maintenance for 50% and 70% capacities are calculated as follows:

Repairs and maintenance 50% 60% 70%

Fixed (70%) 4,900 4,900 4,900

Variable (30%) 1,750 2,100 2,450

Total 6,650 7,000 7,350

2. Similarly, electricity expenses at different levels of capacity are calculated as

follows:

Electricity 50% 60% 70%

Fixed (50%) 12,600 12,600 12,600

Variable (50%) 10,500 12,600 14,700

Total 23,100 25,200 27,300

Exercise

1. With the following data for a 60% activity, prepare a budget for production at

80%

and 100% capacity

Production at 60% activity 600 units

Material Rs. 100 per unit

Labour Rs. 40 per unit

Expenses Rs. 10 per unit

Factory Expenses Rs. 40,000 (40% fixed)

Administration Expenses Rs. 30,000 (60% fixed)

39

{ Ans: Total Variable Cost at 60% Rs.1,68,000 at 70% Rs.2,10,000 and Fixed

cost Rs.34,000}

2. The expenses for the production of 5,000 units in a factory are given as follows:

Per Unit Rs.

Materials 50

Labour 20

Variable Overhead 15

Fixed Overhead (Rs. 50,000) 10

Administrative Expenses (5% Variable) 10

Selling Expenses (20% fixed) 6

Distribution Expenses (10% fixed) 5

Total Cost of Sales per Unit 116

You are required to prepare a budget for the production of 7,000 units and

9,000 units.

{ Ans: Total Variable Cost for 7,000 Units Rs.6,63,600 for 9,000 units

Rs.8,53,200 and Fixed cost Rs.1,06,000}

Note: 1.

In the problem, expenses per unit are calculated on the production level of

5,000 units. So, administrative expenses were Rs. 10 per unit, when the production

level was 5,000 units. So, total administrative expenses were Rs. 50,000. Out of

which, 5% was variable cost (Rs. 0.50 per unit) and balance 95% was fixed cost,

which works out to Rs. 47,500. Fixed costs Rs. 47,500 are constant, whatever be

the level of activity.

Note 2:

Total Selling Expenses are Rs. 30,000. Out of which, 20% were fixed costs,

which works out Rs. 6,000. Balance amount was variable cost Rs. 24,000, which

works out to Rs. 4.80 per unit.

Note 3:

Total Distribution costs were Rs. 25,000. Out of which 10% were fixed costs,

which works out to Rs. 2,500. Balance amount was variable cost Rs. 22,500, which

works out to Rs. 4.50 per unit.

3. Prepare a Production Budget for each month and summarized Production Budget

for the six months period ending 31st Dec., 1989 from the following of product X.

40

(i) The units to be sold for different months are as follows:

July-1989 1,100

August 1,100

September 1,700

October 1,900

November 2,500

Dec-1989 2,300

Jan-1990 2,200

(ii) There will be no work in progress at the end of any month.

(iii) Finished units equal to half the sales for the next month will be in stock at

the end of each month (including June 1989).

(iv) Budgeted production and production cost for the year ending 31st

December, 1989 are as follows:

Production Units 22,000

Direct Materials Per Unit Rs. 10

Direct Wages Per Unit Rs. 4

Total Factory Overheads Apportioned to Product Rs. 88,000

Answer:

July Aug Sep Oct Nov Dec

Opening Stock 550 550 850 950 1250 1150

Closing Stock 550 850 950 1250 1150 1100

Production 1100 1400 1800 2200 2400 2250

4. Following are the budget estimates of a repairs and maintenance department,

which are to be used to construct a flexible budget for the ensuing year.

Details of Cost

Planned at 6,000

Direct Hours

Planned at 9,000

Direct Hours

All in Rs.

Employees salaries 28,000 28,000

indirect Repair Material 42,000 63,000

Miscellaneous Cost 16,000 20,500 i. Prepare a flexible budget for the department up to activity level of

10,000 direct repair hours using increment of 1,000 hours.

ii. What would be the budget allowance for 9,500 direct repair hours?

41

Ans: Note 1: Indirect Repair Material is a Variable Overhead, so absorbed @ of Rs.7 per Direct Hours

Note 2: Miscellaneous cost is a semi-variable cost, containing fixed cost and

variable cost components. Fixed cost is Rs. 16,000. Balance amount Rs. 4,500

(20,500 – 16,000) is variable cost component, which works out to Rs. 1.50 per hour

(4,500/3,000).

Note 3: At 9,500 hours, for the incremental increase of 500 hours, the cost increases by Rs. 4,250 due to the following:

Variable Cost

Indirect Repair Material (@ Rs. 7 per hour) = 500 × 7 = 3,500

Semi-fixed cost miscellaneous cost

(@ Rs. 1.50 per hour Variable cost component) = 500 × 1.50 = 750

Total incremental cost= 4,250

Direct Hours 6000 7000 8000 9000 9500 10000

Total cost 86000 94500 103000 111500 115750 120000

5. Prepare a Cash-Budget of a company for April, May and June 2015 in a

columnar

form using the following information:

(All in Rs.)

Month, 2015 Sales Purchases Wages Expenses

January (Actual) 80,000 45,000 20,000 5,000

February (Actual) 80,000 40,000 18,000 6,000

March (Actual) 75,000 42,000 22,000 6,000

April (Budgeted) 90,000 50,000 24,000 7,000

May (Budgeted) 85,000 45,000 20,000 8,000

June (Budgeted) 80,000 35,000 18,000 6,000 You are further informed that:

(a) 10% of the purchases and 20% of the sales are for cash;

(b) The average collection period of the company ½ month and the credit

purchases are paid off regularly after one month;

(c) Wages are paid half monthly, and the rent of Rs. 500 included in expenses

is paid monthly;

(d) Cash and Bank Balance as on April, was Rs. 15,000 and the company wants to keep it at the end of every month approximately this figure, the excess

cash being put in fixed deposits in the bank.

6. From the following forecast of income and expenditure, prepare a cash budget for

the months January to April 2016.

42

(All in Rs.)

Months Sales

(Credit)

Purchases

(Credit)

Wages Manufacturing

Expenses

Administrative

Expenses

Selling

Expenses Nov-15 30,000 15,000 3,000 1,150 1,060 500 Dec-15 35,000 20,000 3,200 1,225 1,040 550

Jan-16 25,000 15,000 2,500 990 1,100 600 Feb 30,000 20,000 3,000 1,050 1,150 620

March 35,000 22,500 2,400 1,100 1,220 570 April 40,000 25,000 2,600 1,200 1,180 710

Additional information is as follows:

1. The customers are allowed a credit period of 2 months.

2. A dividend of Rs. 10,000 is payable in April.

3. Capital expenditure to be incurred: Plant ‘purchased on 15th January for

Rs. 5,000, a Building has been purchased on 1st March and the payments

are to be made in monthly installments’ of Rs. 2,000 each.

4. The creditors are allowing a credit of 2 months.

5. Wages are paid on the 1st on the next month.

6. Lag in payment of other expenses is one month.

7. Balance of cash in hand on 1st January, 2016 is Rs. 15,000

Other Exercise for practice

1. M.K. Exports Ltd. wishes to arrange overdraft facilities with its bankers

during the period April-June 2006 when it will be manufacturing mostly for stocks.

Prepare a cash budget for this period from the following data, indicating the extent

of the bank facilities the company will require at the end of each month.

Period (2006) Sales (Rs.) Purchases (Rs.) Wages (Rs.)

February 180000 124000 12000

March 192000 144000 14000

April 108000 243000 11000

May 174000 246060 10000

June 126000 268000 15000

50% of the sales are realised in the following the sales and the remaining 50%

in the second month following. Creditors are paid in the month following the month

of purchase. Cash at bank on 1st April 2006 is Rs.25000.

2. Prepare a flexible budget for production at 80% and 100% activity on the

basis of the following information:

Production at 50% capacity 5000 Units

Raw Materials Rs.80 per unit

43

Direct Labour Rs.50 per unit

Direct Expenses Rs.15 per unit

Factory Expenses Rs.50000 (50% fixed)

Administration Expenses Rs.60000 (60% variable)

3. Draw up a flexible budget for overhead expenses on the basis of the following

data and determine the overhead rates at 70%, 80% and 90% plant capacity.

At 80% Capacity

Rs. Variable Overheads:

Indirect labour 12,000

Stores including spares 4,000

Semi-variable Overheads:

Power (30% fixed, 70% variable) 20,000

Repairs and maintenance (60% fixed, 40% Variable) 2,000

Fixed Variable:

Depreciation 11,000

Insurance 3,000

Salaries 10,000

Total Overheads 62,000

Estimated direct labour hours 1,24,000 hrs.

4. The expenses budgeted for production of 10000 units in a factory are

furnished below:

Rs. per Unit

Material 70

Labour 25

Variable Overheads 20

Fixed overheads (Rs.100000) 10

Variable expenses (direct) 5

Selling expenses (10% direct) 13

Distribution expenses (20% fixed) 7

Administration Expenses (Rs.50000) 5

Total 155

Prepare a budget for the purpose of (a)8000 units and (b)6000 units.

Assume that administration expenses are rigid for all levels of production.

44

5. From the following data, prepare a flexible budget for production of 40000

units and 75000 units, distinctly showing variable cost and fixed cost as well as

total cost. Also indicate element-wise cost per unit. Budgeted output is 100000

units and budgeted cost per unit is as follows:

Rs.

Direct Material 95

Direct Labour 50

Production overhead (variable) 40

Production overhead (fixed) 5

Administration overhead (fixed) 5

Selling overhead (10% fixed) 10

Distribution overhead (20% fixed) 15

6. Z limited has prepared the budget for the production of 100000 units from a

costing period as under:

Per Unit (Rs.)

Raw Materials 10.08

Direct Labour 3.00

Direct Expenses 0.40

Works overhead (60% fixed) 10.00

Administration overhead (80% fixed) 1.60

Sales overhead (50% fixed) 0.80

Actual production in the period was only 60000 units. Prepare budgets for the

original and revised levels of output.

7. A department of AXY company attains sales of Rs.600000 at 80% of its

normal capacity. Its expenses are given below:

Rs.

Office salaries 90,000

General expenses 2% of sales

Depreciation 7,500

Rent and rates 8,750

Selling Costs:

Salaries 8% of sales

Travelling expenses 2% of sales

Sales office 1% of sales

45

General expenses 1% of sales

Distribution Costs:

Wages 15,000

Rent 1% of sales

Other expenses 4% of sales

Draw up Flexible Administration, Selling and Distribution Costs Budget,

operating at 90%, 100% & 110% of normal capacity.

8. A company is expecting to have Rs.25000 cash in hand on 1st April 2006 and

it requires you to prepare cash budget for the three months. April to June 2006.

The following information is supplied to you.

Period (2006) Sales (Rs.) Purchases (Rs.) Wages (Rs.) Expenses (Rs.)

February 70000 40000 8000 6000

March 80000 50000 8000 7000

April 92000 52000 9000 7000

May 100000 60000 10000 8000

June 120000 55000 12000 9000

Other Information:

a) Period of credit allowed by suppliers is two months:

b) 25% of sale is for cash and the period of credit allowed to customers for

credit sale is one month;

c) Delay in payment of wages and expenses one month

d) Income tax Rs.25000 is to be paid din June 2006.

9.The following data relate to bookshop Ltd: The financial manager has made

the following sales forecasts for the first five months of the coming year,

commencing from 1st April, 2006:

Month Sales (Rs.)

April 40,000

May 45,000

June 55,000

July 60,000

August 50,000

Other data:

i. Debtor’s and Creditor’s balance at the beginning of the year are

Rs.30000 & Rs.14000 respectively. The balance of other relevant assets

and liabilities are:

46

ii. Cash Balance(Rs). 7,500; StockRs.51,000; Accrued Sales Commission

Rs. 3,500

iii. 40% sales are on cash basis. Credit sales are collected in the month

following the sale .

iv. Cost of sales is 60% on sales

v. The only other variable cost is a 5% commission to sales agents. The

Sales commission is paid in a month after it is earned.

vi. Inventory(stock) is kept equal to sales requirements for the next two

months budgeted sales.

vii. Trade creditors are paid in the following month after purchases.

viii. Fixed costs are Rs.5000 per month including Rs.2000 depreciation.

You are required to prepare a Cash Budget for the months of April, May and

June,2006 respectively.

10.Prepare a Clash Budget for the three months ending 30 th June 2006 from

the information given below:

Period

(2006)

Sales

(Rs.)

Materials

(Rs.)

Wages

(Rs.)

Overheads

(Rs.)

February 14000 9600 3000 1700

March 15000 9000 3000 1900

April 16000 9200 3200 2000

May 17000 10000 3600 2200

June 18000 10400 4000 2300

(b). Credit terms are: sales and debtors – 10% sales are on cash, 50% of the

credit sales are collected next month and the balance in the following month.

Creditors – Materials 2 Months

Wages ¼ month

Overheads ½ month

(c). Cash and bank on 1st April, 2006 is expected to be Rs.6000

(d). Other relevant information are:

i. Plant and machinery will be installed in February 2006 at a cost of

Rs.96000. The monthly instalment of Rs.2000 is payable from April

onwards.

ii. Dividend @ 5% on Preference Share capital of Rs.200000 will be paid

on 1st June.

47

iii. Advance to be received for sale of vehicles Rs.9000 in June.

iv. Dividends from investments amounting to Rs.1000 are expected to be

received in June.

v. Income tax (advance) to be paid in June is Rs.2000

11. The following information relates to Rs. ‘000

Month Wages incurred Materials

Purchased

Overhead Sales

February 6 20 10 30

March 8 30 12 40

April 10 25 16 60

May 9 35 14 50

June 12 30 18 70

July 10 25 16 60

August 9 25 14 50

September 9 30 14 50

1. It is expected that cash balance on 31st May will be Rs.22000

2. The wages may be assumed to be paid within the month they are incurred

3. It is the company’s policy to pay creditors for materials three months after

receipt.

4. Debtors are expected to pay creditors for materials three months after

receipt

5. Included in the overhead figure is Rs.2000 per month which represents

depreciation on two cars and one delivery van.

6. There is a one month delay in paying the overhead expenses.

7. 10% of the monthly sales are for cash and 90% are sold on credit.

8. A commission of 5% is paid to agents on all the sales on credit but, this is

not paid until the month following the sales to which it relates; this

expense is not included in the overhead figure shown.

9. It is intended to repay a loan of Rs.25000 on 30 th June.

10. Delivery is expected in July of a new machine costing Rs.45000 of which

Rs.15000 will be paid on delivery and Rs.15000 in each of the following

months.

11. Assume that overdraft facilities are available, if required.

You are required to prepare a cash budget for the three months of June, July

and August.

48

12. With the following data at 60% activity, prepare a budget at 80% and 100%

activity.

Production at 60% capacity 600units

Materials Rs.120 per unit

Labour Rs.50 per unit

Expenses Rs.20 per unit

Factory Expenses Rs.60000 (40% fixed)

Administration Expenses Rs.40000 (60% fixed)

13. For production of 10000 Electrical Irons, the following are budgeted

expenses:

Per Unit Rs.

Direct materials 60

Direct labour 30

Variable overhead 25

Fixed overhead (Rs.150000) 15

Variable expenses (direct) 5

Selling expenses (10% fixed) 15

Administration expenses (Rs.50000

rigid of all levels of production) 5

Distribution expenses (20% fixed) 5

Total cost of sales per unit 160

Prepare a budget for production of 6000, 7000 & 8000 irons, showing distinctly

marginal cost and total cost.

14. A company produces a standard product. The estimated costs per unit are

as follows:

Raw materials Rs.4; Wages Rs.2; Variable overhead Rs.5

The semi-variable costs are:

Indirect materials Rs.235; Indirect labour Rs.156; Repairs Rs.570

The variable costs per unit included in semi-variable are:

Indirect materials Re.0.05; Labour Re.0.08 and Repaire.0.10.

The fixed costs are Factory Rs.2000; Administration Rs.3000; Selling Rs.2500.

The above cost are 70% of normal capacity production i.e. 700units. The selling

price is Rs.30 per unit. Prepare Flexible Budget for 80% and 100% normal

capacities from the above information.

49

15. The following data are available in a manufacturing company for a yearly

period:

Fixed Expenses:

Rs. Lakhs

Wages & salaries 9.5

Rent, rates & taxes 6.6

Depreciation 7.4

Sundry administration expenses 6.5

Semi-variable expenses (At 50% of capacity):

Maintenance and repairs 3.5

Indirect labour 7.9

Sales department salaries, etc 3.8

Sundry administration salaries 2.8

Variable expenses (At 50% of capacity):

Materials 21.7

Labour 20.4

Other expenses 7.9

Total Cost 98.0

Assume that the fixed expenses remain constant for all levels of production;

semi-variable expenses remain constant between 45% and 65% of capacity,

increasing by 10% between 65% and 80% capacity and by 20% between 80% and

100% capacity.

Sales at various level are:

50% capacity Rs. Lakhs 100 75% capacity Rs. Lakhs 150

60% capacity Rs. Lakhs 120 90% capacity Rs. Lakhs 180

100% capacity Rs. Lakhs 200

Prepare a flexible budget for the year and forecast the profit at 60%, 75%,

90% and 100% of capacity.

16. A company expects to have Rs.37500 cash in hand on 1 st April, and

requires you to prepare an estimate of cash position during the three months, April,

May & June. The following information is supplied to you:

50

Sales

(Rs.)

Purchases

(Rs.)

Wages

(Rs.)

Factory

expenses

(Rs.)

Office

expenses

(Rs.)

Selling

expenses

(Rs.)

February 75000 45000 9000 7500 6000 4500

March 84000 48000 9750 8250 6000 4500

April 90000 52000 10500 9000 6000 5250

May 120000 60000 13500 11250 6000 6570

June 135000 60000 14250 14000 7000 7000

Other Information:

1. Period of credit allowed by suppliers – 2 months

2. 20% of sales is for cash and period of credit allowed to customers for

credit is one month.

3. Delay in payment of all expenses – 1 month

4. Income tax of Rs.57500 is due to be paid on June 15 th.

5. The company is to pay dividends to shareholders and bonus to workers

of Rs.15000 and Rs.22500 respectively in the month of April.

6. Plant has been ordered to be received and paid in May. It will cost

Rs.120000.

4.4 REVISION POINTS

1. Sales Budget The budget which estimates total sales in terms of items,

quantity, value, periods, areas, etc is called Sales Budget.

2. Production Budget It estimates quantity of production in terms of items,

periods, areas, etc. It is prepared on the basis of Sales Budget.

3. Cost of Production Budget This budget forecasts the cost of

production

4. Purchase Budget This budget forecasts the quantity and value of purchase

required for production.

5. Personnel Budget The budget that anticipates the quantity of personnel

required during a period for production activity is known as Personnel

Budget

6. Research Budget This budget relates to the research work to be done for

improvement in quality of the products or research for new products.

7. Capital Expenditure Budget This budget provides a guidance regarding the

amount of capital that may be required for procurement of capital assets

during the budget period.

8. Cash Budget This budget is a forecast of the cash position by time period for

a specific duration of time..

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9. Master Budget It is a summary budget incorporating all functional budgets

in a capsule form.

10. Fixed Budget Fixed Budget is one which is prepared on the basis of a

standard or a fixed level of activity.

11. Flexible Budget A budget prepared to give the budgeted cost of any level

of activity is termed as a flexible budget.

12. Long-Term Budget A budget prepared for considerably long period of time,

viz., 5 to 10 years is called Long-term Budget.

13. Short-Term Budget A budget prepared generally for a period not exceeding

5 years is called Short-term Budget.

14. Current Budget It is a budget for a very short period, say, a month or a

quarter. It is adjusted to current conditions.

15. Rolling Budget. Under this method, a budget for a year in advance is

prepared.

4.5 INTEXT QUESTIONS

1. What do you mean by cash Budget?

2. What do you mean by flexible Budget?

3. What do you mean by Performance Budget?

4. What do you mean by capital Expenditure Budget?

5. What do you mean Rolling Budget?

4.6 SUMMARY

Sales Budget which estimates total sales in terms of items, quantity, value,

periods, areas, etc is called Sales Budget. Production Budget estimates quantity of

production in terms of items, periods, areas, etc. It is prepared on the basis of Sales

Budget.

Cost of Production Budget forecasts the cost of production. Separate budgets

may also be prepared for each element of costs such as direct materials budgets,

direct labour budget, factory materials budgets, office overheads budget, selling and

distribution overheads budget, etc.

Purchase Budget forecasts the quantity and value of purchase required for

production. It gives quantity wise, money wise and period wise particulars about

the materials to be purchased.

Personnel Budget that anticipates the quantity of personnel required during a

period for production activity is known as Personnel Budget. Research Budget

relates to the research work to be done for improvement in quality of the products

or research for new products. Capital Expenditure Budget provides a guidance

regarding the amount of capital that may be required for procurement of capital

assets during the budget period. Cash Budget is a forecast of the cash position by

52

time period for a specific duration of time. It states the estimated amount of cash

receipts and estimation of cash payments and the likely balance of cash in hand at

the end of different periods. Master Budget is a summary budget incorporating all

functional budgets in a capsule form. It interprets different functional budgets and

covers within its range the preparation of projected income statement and projected

balance sheet. Fixed Budget is one which is prepared on the basis of a standard or

a fixed level of activity. It does not change with the change in the level of activity.

Flexible Budget is prepared to give the budgeted cost of any level of activity is

termed as a flexible budget. According to CIMA, London, a Flexible Budget is, ‘a

budget designed to change in accordance with level of activity attained’. It is

prepared by taking into account the fixed and variable elements of cost. Long-Term

Budget is prepared for considerably long period of time, viz., 5 to 10 years is

called Long-term Budget. It is concerned with the planning of operations of the

firm. It is generally prepared in terms of physical quantities. Short-Term Budget is

prepared generally for a period not exceeding 5 years is called Short-term Budget. It

is generally prepared in terms of physical quantities and in monetary units.

Current Budget is a budget for a very short period, say, a month or a quarter. It

is adjusted to current conditions. Therefore, it is called current budget. Rolling

Budget is also known as Progressive Budget. Under this method, a budget for a

year in advance is prepared. A new budget is prepared after the end of each

month/quarter for a full year ahead. The figures for the month/quarter which has

rolled down are dropped and the figures for the next month/quarter are added.

This practice continues whenever a month/quarter ends and a new

month/quarter begins.

4.7 TERMINAL EXERCISE

1. ……………………. prepared to give the budgeted cost of any level of

activity is termed as a flexible budget.

2. .The budget which estimates total sales in terms of items, quantity,

value, periods, areas, etc is called ……………………………..

3. The budget that anticipates the quantity of personnel required during a

period for production activity is known …………………………….

4. .………………………………., a budget for a year in advance is prepared.

5. …………………..budget relates to the research work to be done for

improvement in quality of the products or research for new products

4.8 SUPPLEMENTARY MATERIALS

https://ocw.mit.edu

http://kesdee.com/

http://simplestudies.com/

http://repository.um.edu.my/

53

http://www.cimaglobal.com/

4.9 ASSIGNMENTS

1. 1.Explain the points to be taken care while preparing the Flexible

Budget.

2. Enumerate the importance of research Budgets

3. Highlight the advantages of cash budgets which is prepared by a

seasonal manufacturing company.

4. Throw a light on production Budget

4.10 SUGGESTED READINGS / REFERENCE BOOKS

1. Oswal, Maheshwari, Modi — Cost accounting. Cost Accounting ( RBD,

Jaipur)

2. Pandey. I. M. — Management Accounting (S. Chand & Sons.)

3. Agrawal, Shah, Mendiratta, Agarwal, Sharma, Tailor — Cost and

Management Accounting (Malik and Co.)

4.11 LEARNING ACTIVITIES

Visit the different types of Manufacturing company and take a note on how

they are preparing the different types of budgets.

4.12 KEYWORDS

Sales Budget, Production Budget, Cost of Production Budget, Purchase Budget,

Personnel Budget, Research Budget, Capital Expenditure Budget, Cash Budget,

Master Budget, Fixed Budget, Flexible Budgets, Long term Budget, Short Term

Budget, Current Budget, Rolling Budget.

54

LESSON –5

REPORTING TO MANAGEMENT

5.1 INTRODUCTION

The success or otherwise of any business undertaking depends primarily on

earning revenue that would generate sufficient resources for sound growth. To

achieve this objective, the management should discharge its functions efficiently

and effectively. The reporting systems are highly useful to the management for

effective planning and control. A regular system of reporting is considered as a

better guidance for prompt decision making. Hence, it is necessary to have a good

management reporting system.

5.2 OBJECTIVES

After completing this Lesson you should be able to know

The meaning of management reporting

Objectives of management reporting

Different types of management reporting

5.3 CONTENT

5.3.1 Definition of Management Reporting

5.3.2 Objectives of Management Reporting

5.3.3 Essentials of Good Reporting System

5.3.4 Classification of Management Report

5.3.1 DEFINITION OF MANAGEMENT REPORTING

According to Kohler reporting refers to "A body of information organized for

presentation or transmission to others. It often includes interpretations,

recommendations and findings with supporting evidence in the form of other

reports."

'Management Reporting' may be defined as "A system of communication,

normally in the written form, of facts which should be brought to the attention of

various levels of management who use them to take suitable action." In other words

the process of providing information to the management is known as Management

Reporting. The word "Information" refers to the data processed or evaluated for a

specific purpose.

Dr. Maheshwari has also defined Management reporting system as "an

organized method of providing each manager with all the data and only those data

which he needs for his decisions, when he needs them and in a form which aids his

understanding and stimulates his action."

5.3.2 OBJECTIVES OF MANAGEMENT REPORTING

1. To obtain the required information relating to the business to discharge

its managerial functions of planning. organizing, controlling. directing,

and decision making etc. efficiently and effectively.

55

2. To ensure the operational efficiency of the concern.

3. To facilitate the maximum utilization of resources.

4. To secure industrial understanding among people who are engaged in

various aspects of work of enterprise.

5. To enable to motivating improving discipline and morale.

6. To help the management for effective decision making.

5.3.3 ESSENTIALS OF GOOD REPORTING SYSTEM

The following are the essentials of a good management reporting system:

Proper Form: A good report should have a comprehensive form with suggestive

title, heading, sub heading and number of paragraphs as and where necessary for

easy and quick reference.

1. Contents: Simplicity is one of the requisites of reporting in relation to the

contents of a report. Further the contents should follow a logical sequence.

Wherever necessary the contents should be represented in the form of

visual aids such as charts and diagrams etc.

2. Promptness: It means that the system should ensure the preparation and

submission of report at the proper time. It facilitates business executives to

make suitable decisions based on quick reports without delay.

3. Accuracy: Information conveyed should be accurate. This means that the

person responsible for reporting should have sufficient care in preparing

the report as correctly as possible within the parameters of possible

accuracy in this regard.

4. Comparability: In order to ensure that the furnished information is useful,

it is essential that reports are also meant for comparison. The report should

provide information about both the actual and the budgeted performance of

the budget period. So that meaningful comparison can be made to find out

the deviations and to initiate appropriate action.

5. Consistency: In order to make a meaningful and useful comparison,

uniform accounting principles and procedures should be followed on

consistent basis over a period of time for collection, classification and

presentation of accounting information.

6. Relevancy: The report should be presented with relevant data to disclose

the fact in unambiguous terms. Because, inclusion of both the relevant and

the irrelevant data in the management reports may result in faulty

decisions. Therefore, the contents expressed therein should reveal the

reporter's greater consciousness of expression with reference to length and

time in particular.

56

7. Simplicity: The report should be as far as possible in simple form. In other

words, the report should avoid technical jargons, duplication of work and

presented in a simple style.

8. Flexibility: The system should be capable of being adjusted according to

the requirement of the users.

9. Cost-Benefit Analysis: Cost-Benefit Analysis should be made and the cost

of reporting should commensurate with the expenditure involved.

10. Principle of Exception: Since the time and effort of managerial personnel

are precious, the principle of management by exception has become the

rule of the day instead of exception. It is necessary therefore to draw the

attention of management, through reports, only towards exceptional

matters.

11. Controllability: It is necessary that every report should be addressed to a

responsibility centre and analysed the factors into controllable and

uncontrollable separately. So that the head of the responsibility centre can

be held responsible only for controllable variance but not for variances

which are beyond his control.

Further, in order to assist the management to imitate remedial measures,

probable reasons for the factors of uncontrollable should also be incorporated in

the reports.

5.3.4 CLASSIFICATION OF MANAGEMENT REPORTING

Basically, there are two ways to report to the management. They are :

Oral Report and

Written Report.

The Written Reports may be classified into number of ways. The following are

the important types:

I. According to Objects:

(A) External Reports

(B) Internal Reports

(1) Reports Meant for Top Management

(2) Reports Meant for Middle Level Management

(3) Reports Meant for Junior Level Management

II. According to Period:

(1) Routine Reports

(2) Special Reports

I. According to Functions:

(A) Operating Reports

(1) Control Reports

(2) Information Reports

57

(3) Venture Measurement Reports

(B) Financial Reports

(1) Static Reports

(2) Dynamic Reports

According to Object or Purposes

(A) External Reports: These reports prepared for persons outside the business

such as Government. shareholders. bankers. investors and financial institutions

etc. External Reports usually represent published annual reports. Annual Reports

of Trading. Profit and Loss Accounts and Balance Sheet of the Indian Companies

are to be prepared in terms of Schedule VI of the Indian Companies Act of 1956.

(B) Internal Reports : Internal Reports are those which are prepared for internal

uses of different level of management. It is also called as Management Reports.

These reports are not meant for disclosure to those who are outsiders to the

business. They do not have to comply with any statutory requirements. From the

managerial point of view the reports can be classified into the following categories :

(1) Report Meant for the Top Level of Management

(2) Report Meant for the Middle Level of Management

(3) Report Meant for the Junior Level of Management

(1) Report Meant for the Top Level of Management

Top Level Management is concerned with the formulating policies planning and

setting goals and objectives. This level of management consisting of the Boa rd of

Directors including Chairman. Managing Directors. General Manager or any other

chief executive as the case may be. The report to this level of management should

be specifically summarized with all aspects of operating performance together with

a comparison of actual with budgeted performance. The usual reports sent to this

level of management are:

(a) Reports on budgeted and actual profit

(b) Reports on sales and production

(c) Capital budget

(d) Master budget

(e) Periodical financial reports

(f) Plant utilization report

(g) Machine and labour utilization report

(h) Reports on research and development activities

(i) Project evaluation report

(j) Report on stock of raw materials, work in progress and finished goods

(k) Overhead cost absorption and efficiency reports

(l) Reports on selling and distribution overhead.

58

(2) Reports Meant for Middle Level Management

The Middle Management is constituted of the heads of all departments such as

production department headed by production manager. marketing department

headed by marketing manager and so on. This level of management is concerned

with the functioning and control of their departments. They act mainly as

coordinating executives to administer policies directly through operating

supervisors and evaluate their performance. Hence, they may require more detailed

information about their departments and at frequent intervals. Generally, the

middle level management should receive the following reports at different intervals:

(a) Purchase Manager:

(1) Reports on material price and usage variance

(2) Reports on material carrying cost, loss of material in the storage etc.

(3) Reports on trends in the pertaining of various items of materials.

(b) Materials Manager

(1) Reports on stock of raw materials, work in progress and finished goods

(2) Reports on material wastage and losses

(3) Reports on stock of materials planning and control

(4) Reports on level of materials stock at the stores

(5) Reports on surplus and deficiency report.

(c) Production Manager

(1) Reports on budgeted and actual production

(2) Reports on overtime work and ideal time

(3) Reports on labour utilization statement

(4) Reports on machine utilization statement

(5) Reports on scrap production cost

(6) Reports on any accident causing dislocation of activity.

(d) Sales Manager

(1) Reports on budgeted and actual sales

(2) Reports on sales efficiency

(3) Reports on orders received and orders executed

(4) Reports on cash sales and credit sales

(5) Reports on stock of finished goods

(6) Reports on market share and market potential

(7) Reports on sales promotion efficiency.

(8) Reports Meant for Junior Level Management

The lower level management is directly responsible for executing various

policies assigned by top management. This level of management is constituted of

Foremen, Supervisors and sectional in charges etc. They are in touch with the day-

to-day performance of their section. The report meant for this level are mainly in

terms of physical units. The usual reports sent to this level are:

59

(1 ) Reports on labour efficiency variance

(2) Reports on ideal time, overtime and machine utilization

(3) Reports on materials usage variance

(4) Reports on credit collections and outstanding

5.4 REVISION POINTS

1. Objectives of Management reporting

2. Essentials of Good reporting system

3. Classification of management Reporting

5.5 INTEXT QUESTIONS

1. What is meant by management reporting?

2. What do you mean by Eternal Reports?

3. What do you mean by Internal Reports?

4. What do you mean by financial Reports?

5. What do you mean by Operating reports

5.6 SUMMARY

Good management reporting system should have the following things proper

form, contents, promptness, accuracy, comparability, consistency, relevancy,

simplicity, flexibility, cost benefit analysis , principle of exception, comfort ability.

Objectives of Management Reporting system are given below; To obtain the

required information relating to the business to discharge its managerial functions

of planning. organizing, controlling. directing, and decision making etc. efficiently

and effectively. To ensure the operational efficiency of the concern. To facilitate the

maximum utilization of resources. To secure industrial understanding among

people who are engaged in various aspects of work of enterprise. To enable to

motivating improving discipline and morale. To help the management for effective

decision making. Basically, there are two ways to report to the management.

They are :Oral Report and Written Report.

The Written Reports may be classified into number of ways. The following are

the important types(A)According to Objects: External Reports ,Internal Reports,

Reports (B) According to Period: Routine Reports, Special Reports(C)According to

Functions: Operating Reports, Financial Reports.

5.7 TERMINAL EXERCISE

1. ………………………reports prepared for persons outside the business

such as Government. shareholders. bankers. investors and financial

institutions etc.

2. ……………………………….Reports are those which are prepared for

internal uses of different level of management.

5.8 SUPPLEMENTARY MATERIALS

http://dosen.narotama.ac.id/wp-content/uploads/2013/02/Chapter-31-

Reporting-to-Management.pdf

60

https://www.treasury.qld.gov.au/publications-resources/financial-

accountability-handbook/5-1-management-reporting.pdf

5.9 ASSIGNMENTS

1. What do you understand by the term reporting to management?. What

matters would you include for reporting to board of directors.

2. What are the points to be kept in mind while preparing the report?.

5.10 SUGGESTED READINGS /REFERENCE BOOKS

1. Agrawal & Agrawal — Management Accounting (RBD. Jaipur)

2. Jain, Khandelwal, Pareek — Cost Accounting (Ajmera Book depot,

Jaipur)

3. Khan, Jain — Management Accounting (S. Chand & Sons.)

4. Oswal, Maheshwari, Modi — Cost accounting. Cost Accounting ( RBD,

Jaipur)

5. Pandey. I. M. — Management Accounting (S. Chand & Sons.)

6. Agrawal, Shah, Mendiratta, Agarwal, Sharma, Tailor — Cost and

Management Accounting ( Malik and Co.)

7. Agrawal, Jain, Sharma, Shah, Mangal — Cost Accounting ( RBD, Jaipur)

8. Agarwal. M.R. — Managerial Accounting (Garima Publications)

9. Agrawal & Agrawal — Management Accounting (RBD. Jaipur)

10. Jain, Khandelwal, Pareek — Cost Accounting (Ajmera Book depot,

Jaipur)

11. Khan, Jain — Management Accounting (S. Chand & Sons.)

12. Oswal, Maheshwari, Modi — Cost accounting. Cost Accounting ( RBD,

Jaipur)

13. Pandey. I. M. — Management Accounting (S. Chand & Sons.)

5.11 LEARNING ACTIVITIES

Choose an organisation of your choice and see how reports are prepared and

identify how it was reporting to the management

5.12 KEYWORDS

Oral Report, Written Report, External Reports, Internal Reports, Routine

Reports, Special Reports, Operating Reports, Financial Reports.

61

LESSON - 6

FINANCIAL ANALYSIS

6.1 INTRODUCTION

In any form of organisations the financial analysis is very common. Raw

financial data has no meaning. The data are being interpreted to find out the

conclusions and to know the financial position. These analysis are indifferent

forms. A firm may select the particular method of financial analysis according to

the nature of the firm.

6.2 OBJECTIVES

After reading the lesson students can understand the – Meaning of the

financial analysis- its importance – procedure for financial analysis – objectives of

financial analysis.

6.3 CONTENT

6.3.1Meaning

6.3.2 Users of financial analysis

6.3.3 Information needed and steps in financial analysis

6.3.4 Procedure in financial analysis

6.3.5 Meaning and type of financial statements

6.3.6 Objectives of financial analysis

6.3.7 Types of financial analysis

6.3.8 Tools of financial analysis

6.3.9 Limitations of financial analysis

6.3.1 MEANING

The technique of financial analysis is typically devoted to evaluate the past,

current and projected performance of a business firm. In general business usage,

financial analysis is concerned with the analysis of financial statements such as

balance sheet, profit and loss account, etc., Broadly, the term financial analysis is

applied to almost any kind of detailed inquiry into financial data. A financial

executive has to evaluate the past performance, present financial position, liquidity

situation, enquire into profitability of the firm and to plan for future operations. For

all this, they have to study the relationship among various financial statements.

The analysis of financial statements is an attempt to determine the significance and

meaning of the financial statements data, so that the forecast may be made of the

future prospects for earnings, ability to pay interest and debt maturities(both

current and long term) and profitability.

Financial analysis is very general managerial activity. Financial managers may

attempt to analysis the historical financial records of a firm in order to indentify the

factors which are having a significant influence upon the wealth of shareholders.

(e.g) Debt- Equity ratio. He must analyse both the risk and return aspect of past

and present financial decisions. He must also evaluate the financial decisions i.e.,

62

what has happened to the firm, to control what is happening and to assist what will

happen.

6.3.2 USERS OF FINANCIAL ANALYSIS

Financial analysis is the process of indentifying the financial strengths and

weakness of the firm. It is made by properly establishing relationship between the

items of the balance sheet and profit and loss account. It can be undertaken by the

management of the firm or by the outsiders.

Trade Creditors: are interested in firm’s ability to meet their claims over a very

short period of time. They mainly evaluate the firm’s liquidity position.

Financial institutions: are interested to know the long term profitability of the

concern. They want to know the safety of their loan granted to the firms. Before

granting the loan they analyse the income statement of the applicant firm’s for the

last 5 or 6 years.

Debenture holders: are concerned about the firm’s long – term solvency and

survival. They analyse the firm’s profitability and track record over time. They want

to know, whether the firm is able to repay the principal with agreed interest.

Financial statements are used to analyse the profitability of the firm.

Investors: who have invested their money in the firm’s shares are most

concerned about the firm’s and the risk faced by the firm.

Management of the firm would be interested in every aspect of the financial

analysis. It is their responsibility to see that the resources of the firm are used most

effectively and efficiently.

Purchasers of the business want to know the real worth of the concern, which

they want to buy. He also wants to know the earning capacity of the firm.

6.3.3 INFORMATION NEEDED AND STEPS FOR FINANCIAL ANALYSIS

The balance sheet and income statement information are supreme in financial

analysis. These are readily available for interpretation. A financial analysis assist in

identifying and indicating whether a firm has enough cash to meet obligation. A

reasonable accounts receivable collection period, an efficient inventory management

policy, sufficient plant, property and equipment and an adequate capital structure

all of which are necessary if the firm is to achieve the goal of maximising

shareholder wealth. Financial analysis is also used to determine whether a

satisfactory return is being earned for the risk taken.

Financial analysis follows a series of interrelated steps are (1) to specify the

purpose of analysis (2) identify the measurement base and fix standard (3) to collect

necessary data (4) to classify and process the data (5) to compare the processed

data with a standard (6) to make inferences.

The usefulness of financial information is increased when it can be compared

with related data. Comparison may be internal (within one firm) or external (with

another same category firm). External comparison may be difficult to make in

practice since financial statements of many firms may not be readily comparable

because of the use of different generally acceptable accounting principle.

63

6.3.4 PROCEDURE IN FINANCIAL ANALYSIS

Comparison of financial statement data are frequently expressed as

percentages or ratios. These comparisons may represent (1) percentage increases

and decreases in an item in comparative financial statements (2) percentages

relationship of individual components to an aggregate total in single financial

statement. (3) Ratios of one amount to another in the financial statements.

6.3.5. MEANING AND TYPES OF FINANCIAL STATEMENTS

A financial statement is an organised collection of data according to logical and

consistent accounting procedures. It will convey an understanding of financial

aspects of a business firm. It shows the financial position at a point of time.

The term financial statements generally refers to there basic statements.

i. The Income statement.

ii. The Balance sheet.

iii. Statement of retained earnings

Some times, a business may prepare another forms of statements also namely

statement of changes in Financial position in addition to the above three

statements

The meaning and significance of these statements are explained below.

Income Statement

The Income Statement (also termed as profit and loss Account) is generally

considered to be the most useful of all financial statements. It explains what has

happened to a business as a result of operation between two dates. For this

purpose it matches the revenues and costs incurred during the given period and

also shows the net profit earned or loss suffered.

The nature of the ‘income’ which is the focal item of the income

statement can be well understood from the ‘Inputs’ and ‘outputs’ of business in

the goods and services that the business providing to its customers. The values of

these outputs are the amount paid by the customers for them. Such amounts are

called ‘Revenues’ in accounting. The inputs are the economic resources used by the

business in providing these goods and services. Their values are termed as

‘expenses’ in accounting.

Balance Sheet

It is a statement of financial position of a business at a point of time. It

represents all assets owned by the firm at particular time and the claims (or

equities) of the owners and outsiders against these assets at that time. It is in a way

snapshot of the financial position of the business at that time.

The important distinction between an Income statement and Balance Sheet is

that the Income Statement is for a period while Balance is on a particular date.

Income Statement is therefore, a flow report as contrasted with the Balance Sheet

which is a static report.

64

Statement of Retained Earnings

The term retained earnings means the accumulated excess of earnings over

losses and dividends. The balance shown by the income statement is transferred to

the Balance Sheet through this statement, after making necessary appropriations

thus, a connection link between the Balance Sheet and the Income Statement. The

statement is also termed as ‘profit and loss appropriation account’ in case of

companies.

6.3.6 OBJECTIVES OF FINANCIAL ANALYSIS

The following are the main objectives of the analysis of financial statements:

i. To estimate the earning capacity of the firm.

ii. To gauge the financial position and financial performance of the firm,

iii. To determine the long term liquidity of the funds as well as solvency,

iv. To determine the debt capacity of the firm,

v. To decide about the future prospects of the firm, etc.

vi. To know the effect9ve utilisation of resources

vii. To know the comparative advantages of return on investment.

viii. To ascertain the market trends.

ix. To identify the areas which are to be concentrated more i.e. key areas?

As a matter of fact, the objectives of analysis of these statements, depend to a

large extent on the point of the view of the analyst, the degree of interest in the

company and the need for depth of enquire and finally on the amount and quality

of the data available. A trade creditor considering what action to take on a long

overdue account may well focus his inquire on the immediate financial condition of

the firm and its liquidity. In contrast, a security analysis considering a purchase of

equity shares may tend to centre his effort on the measurement of financial

condition and future profitability of the firm, if a thorough analysis is desired and

the full data needed are not available or if the suspicion exists that the firm is

trying to hide or confuse its real position, the financial analyst must be a virtual

detective in order to find out the truth.

6.3.7 TYPES OF FINANCIAL ANALYSIS

External Analysis

This analysis is only made by the outsiders of the firm. External analysis of

financial statement is made by those who do not have access to the detailed

accounting records of the company, i.e., banks, creditors and general public. Those

people depend almost entirely on published financial statements. The main

objective of such analysis varies from party to party. Some agencies are deployed to

perform the functions

Internal Analysis

Such analysis is made by the finance and accounting department to help the

top management. These people have direct approach to the relevant financial

records so they can keep behind the two basic financial statements (Balance Sheet

65

and Income Statement) and narrate the inside story. Such analysis emphasizes on

the performance appraisal and assessing the profitability of different activities.

Short – term Analysis

The short-term analysis of financial statement is mainly concerned with the

working capital analysis. In the short run a company must have ample funds

readily available to meet its current needs and sufficient borrowing capacity to meet

the contingencies. Hence in short – term analysis the current assets and the

current liabilities are analysed and cash position (liquidity) or the concern is

determined.

Long term Analysis

In the long- term analysis the company must earn a minimum amount

sufficient to maintain a suitable rate of return on the investment to provide for the

necessary growth and development of the company and to meet the cost of capital.

Financial planning is also necessary for the continued success of a company.

Thus, in the long – run analysis, the stress is on the stability and earning

potentiality of the concern. In long – term analysis the fixed assets, long – term debt

structure and the ownership’s interest are analysed.

The short – term and long – term both type of analysis are important proper

planning for the future, requires fairly sufficient knowledge of the company’s

current position which may be determined from short – term financial analysis

only. The need of short – term analysis for long – term planning is useful in the

same way as driver, consulting a road map for the best route to his destination,

must know his present location exactly.

1. Horizontal Analysis

When financial statement for a number of years of a company reviewed and

analyzed the analysis is called ‘horizontal analysis’. The preparation of comparative

statement is an example for horizontal analysis. As it is based on data from year to

year, rather than on one date or period to time as a whole, this is also known as

‘Dynamic Analysis’.

2. Vertical Analysis

Vertical analysis is also known as ‘static’ analysis, when ratios are calculated

from the balance sheet of one year, it is called vertical analysis. It is not very useful

for long-term planning as it does not include the trend study for future.

6.3.8 TOOLS OF FINANCIAL ANALYSIS

1.Comparative Analysis

It is a method of training periodic changes in the financial performance of a

company to prepare comparative statements.

The financial data for the current year is compared with the financial data of

the one or more previous years. This is the simplest form of comparative analysis.

The absolute amount of changes of each item in the current financial statements

with the corresponding items in previous years.

66

Seshu Manufacturing Company: comparative Balance Sheet

2002 2003 Change Percentage of Change Capital and Liabilities Rs. Rs. Rs. Rs.

Currently Liabilities 1123.57 1555.74 (+) 432.17

(+) 38.75

Long term Liabilities 361.65 389.14 (+) 27.49 (+) 7.6

Share Capital 225.00 225.00 0 0

Reserves 357.95 447.81 (+) 89.86 (+) 25.1

Total 2068.17 2617.69 (+)549.52 (+) 26.6

Assets

Current Assets 1404.55 1870.92 (+)466.37 (+) 33.2

Net Fixed Assets 647.18 686.11 (+) 38.93 (+) 6.0

Other Assets 16.44 60.72 (+)44.28 (+)269.3

Total 2068.17 2617.74 549.57 26.6

In this example, the information of the year 2013 are treated as the current

year data. These data are compared with the previous year 2012 data. The exact

item wise amount of changes and the percentages of changes are clearly exhibited.

2.Common and Analysis

Every item on a financial statement is expressed as a percentage of single base

amount. State is commonly used as the base for analysis of an income statement.

Figures reported are converted into percentages to some common base. In this

income statement the sales figure is assumed to be 100 and all figures are

expressed as percentages of this total.

Example

Common – Size Income Statement

For the year ended 31 December 2014 and 2015 (Figures in percentage)

From this example cost of goods sold percentage has been increased from 75%

to 80% from the year 2014 to 2015 and gross profit percentage has been decreased

by 5%. The percentage of each item to the total in each period is explained but not

the variation in respective items from period to period. It does not give information

2014 2015

Net sales 100 100

Cost of goods sold 75 80

Gross profit 25 20

Less: Operating expenses

Administration Expenses 2.50 2

Selling Expenses 3.75 2

Total operating Expenses 6.25 4

Operating profit 18.75 16

67

about the trend of individual items, but the trend of their relationship to total. This

analysis helps to identify the items which occupy the major portion to the total.

3.Trend Analysis (percentage)

This method is helpful in making a comparative study of the financial

statements for several years. Under this method, the calculation of percentage

relationship that each item bears to the same item in the base year, each item of

base year is taken as 100 and on that basis the percentage for each of the items of

each of the years are calculated. Any year may be taken as base year. The object of

trend analysis is to highlight the relative changes of the major items over the year

as percentage.

4.Cost-Volume Profit Analysis

It is an important tool of profit planning. It studies the relationship between

cost, volume of production, sales and profit. It tells the volume of sales at which the

firm will break even (no profit or no loss), the effect on profit on account of

variations in output, selling price, and cost. It is also helpful to ascertain the

quantity to be produced and sold to reach the target profit level.

5.Ratio Analysis

An accounting ratio shows the relationship in mathematical terms between two

interrelated accounting figures. The figures have to be interrelated (eg) gross profit

and sales, current assets and current liabilities etc. If the ratios and calculated

between the two figures which are not at all related to each other, there will be no

meaning to calculate ratios.

6.Fund Flow Analysis

It reveals the changes in working capital position. It tells about the sources

from which the working capital or found was obtained and the purposes for which

it was used. Fund flow statement focuses on major financial changes. It is a

detailed study about the financial changes between the balance sheets of the two

successive years.

7.Cash Flow Analysis

It is useful for short run planning. A firm needs sufficient cash to pay debt

maturing in the near future, to pay interest and other expenses and to pay dividends to shareholders. It is statement of changes in the financial position on

cash basis. It summarises the cause of changes in cash position between dates of the two balance sheets.

6.3.9 LIMITATIONS OF FINANCIAL ANALYSIS

1. Financial analysis is not a final result ie., it is treated as starting point in

financial decisions. It requires external support for effective

implementation.

2. It ignores the price level changes. It is prepared on the concept of historical

costs.

3. The exact value of the assets or profits may not be available.

68

4. Financial statements are prepared on the basis of certain accounting

concepts and convention. On account of this reason the financial position

as disclosed by these statements may not be realistic.

5. Personal judgement of the accountant is influencing in valuation of assets

and liabilities.

6. Financial statements do not depict those facts which cannot be expressed

in terms of money.

6.4 REVISION POINTS

1. Financial analysis is concerned with the analysis of financial statements.

This analysis is made to evaluate the past performance, present financial

position and to plan the future. This analysis is made.

2. User of financial analysis: trade creditors, financial institutions, debenture

holders, investors and management are the users of financial analysis.

3. The balance sheet and income statement information are needed for

financial analysis.

4. Types of financial analysis: External analysis, internal analysis, short term

analysis, long term financial analysis, horizontal analysis and vertical

analysis.

5. Tools of Financial Analysis: Comparative analysis, Common size analysis,

trend analysis, cost-volume profit analysis, ratio analysis, fund flow

analysis, cash flow analysis.

6.5 INTEXT QUESTIONS

1. What is meant financial analysis? Explain its advantages.

2. Who are the users of financial analysis?

3. Elucidate the procedure for financial analysis.

4. Explain the various types of financial statements.

5. Point out the ad vantages of common size statement.

6. What are the various tools used in the financial analysis? Explain

briefly.

7. Explain any four types of financial analysis.

8. Point out the weakness of the financial analysis.

6.6 SUMMARY

The financial executive has to evaluate the performance of the firm in the

particular period, it is a managerial activity. Trade creditors, financial institutions,

debenture holders, investors and management are the beneficiaries of the financial

analysis.

Procedures in financial analysis are using percentages, rations, etc. Income

statement, balance sheet and statement of retained earnings are the financial statements, financial analysis is used in the firm for various objectives.

This lesson covers the various types of financial analysis. Like external analysis for outsiders, internal analysis for the management. Current needs are analyzed

69

through short term analysis, long term requirements are analyzed through long term analysis. If the analysis is made for number of years for a single unit it is known as horizontal analysis. When ratios are calculated from the accounts records

of one year it is known as vertical analysis.

This lesson also includes the various tools used in the financial analysis.

6.7 TERMINAL EXERCISES

1. Which one of the following is not a user of Financial Analysis?

a. Sundry debtors (b) Trade creditors (c) Financial institutions (d) Debenture holders.

2. 2.Which one of the following is not a financial statement?

a. The income statement (b) the balance sheet (c) statement of retained earnings (d) cash book.

6.8 SUPPLEMENTARY MATERIALS

http://dosen.narotama.ac.id/

http://www.osbornebooksshop.co.uk/

http://www.fao.org/

6.9 ASSIGNMENTS

1. Collect the various published audited accounts and compare with each other, Students must compare one firm’s account with other firms’

accounts in the same line and critically analyse the performance.

2. Prepare an essay on distinctive features of various tools in financial

analysis collect various published accounting records or statements and use the above tools. Read various unpublished research report about the

financial analysis.

6.10 SUGGESTED READING / REFERENCE BOOKS

1. Management Accounting- S.N.Maheswari

2. Management Accounting – R.S.N. Pillai and Bhavathi.

3. Financial Management – Khan and Jain

6.11 LEARNING ACTIVITIES

Students may read various journals and unpublished research reports and gain some practical knowledge about financial analysis.

Student may organize a group discussion to discuss about the various types of financial analysis and the nature of tools used in the financial analysis.

6.12 KEY WORDS

Market trend

Suspicion

Long term liquidity

Solvency

Focal

Deployed

Dynamic Analysis

70

LESSON -7

RATIO ANALYSIS

7.1 INTRODUCTION

Ratio analysis is a powerful tool of financial analysis. It is used as a

benchmark for evaluating the financial position and performance of a firm. It is

known as the relationship between two accounting figures expressed

mathematically. Ratio help to summarise large quantities of financial data and to

make judgement about the firm’s financial performance

7.2 OBJECTIVES

The students can know the uses of the ratio analysis. This lesson also

explains the difficulties in ratio analysis. Students can also know some precautions

before using the ratio analysis techniques. More over in this lesson, students can

know various ratios and their significances.

7.3 CONTENT

7.3.1 Objectives and utility of ratio analysis

7.3.2 Difficulties in ratio analysis

7.3.3 Nature of ratio analysis

7.3.4 Precautions in using ratio analysis

7.3.5 Types of Ratios

7.3.6 Significance of important Ratios

7.3.1 OBJECTIVES AND UTILITY OF RATIO ANALYSIS

Ratio analysis is an important and useful technique to check upon the

efficiency with which working capital is being used in the enterprise. Some ratios

indicate the trend or progress or down fall of the firm. It helps the financial

manager in evaluating the financial position and performance of the firm. The use

of ratio analysis is not confined to the financial manager only. The credit supplier,

bank, lending institution and experienced investor all use ratio analysis as their

initial tool in evaluating the firm as a desirable borrower or as potential investment

outlet. With the help of ratio analysis financial executive can measure whether the

firm is at present financially healthy or not. The following are important managerial

uses of ratio analysis.

1. Aid in financial forecasting: Ratio analysis is very helpful in financial

forecasting. Ratio relating to past sales, profits and financial position are

based for future trend.

2. Aid in Comparison: Ratio analysis can be used for comparison for a

particular firm’s progress and performance.

3. Aid in Cost Control: Ratios are very useful for measuring the performance

and in cost control.

71

4. Communication value: different financial ratios communicate the strength and financial standing of the firm to the internal and external parties.

5. Financial ratios are very helpful in the diagnosis of the financial health of a

firm. They highlight the liquidity, solvency, profitability and capital gearing

etc., of the firm. They are useful for analysing financial performance.

6. The ability of the firm to meet its current obligations.

7. The extent to which the firm has used its long term solvency by borrowing

fluids.

8. The efficiency with which the firm is utilising its assets in generative sales

revenue.

9. The overall operating efficiency and performance of the firm are measured

through ratio analysis.

7.3.2 DIFFICULTIES IN RATIO ANALYSIS

1.Decide proper Basis for Comparison

Ratios of a company have meaning only when they are compared with some

standards. It is difficult to find out a proper basis of comparison. Usually it is

recommended that ratios should be compared with the industry averages. But the

industry averages are not easily available. In India, for example, no systematic and

comprehensive industry ratios are compiled.

2.Comparison Becomes Difficult Because of Different Situations:

The situations of two companies are never same. Similarly, the factors

influencing the performance of a company in one year may change in another year.

Thus , the comparison of the ratios of two companies becomes difficult and

meaningless when they are operating in different situations.

i.Ratio analysis becomes meaningless if the data in the financial statements are

window dressed. No fixed standards can be laid down for ideal ratio.

ii. The differences in the definitions of items in the balance sheet and profit and

loss statement makes the interpretation difficult.

iii.Ratio alone are not adequate. They are only indicators. They cannot be taken

as final regarding good or bad financial position of the business. Other factors are

to be considered.

iv.Ratios are only mathematical expression of financial data. Average people

may not understand the facts without explanation.

v.External factors which affect the financial performance of a firm are not

considered in Ratio analysis.

Price change:

The interpretation and comparison of ratios are also rendered invalid by the

changing value of money. The accounting figures, presented in the financial

statements, are expressed in the monetary unit which is assumed to remain

72

constant. In fact, prices change over years and, as a result, assets acquired at

different times will be expressed at different rupees (values) in the balance sheet.

This makes comparison meaningless. For example, two firms maybe similarly in

every respect except the age of plant and machinery. If one firm purchased its plant

and machinery at a time when prices were high, the equal rates of return on

investment of the two firms cannot be interpreted to mean that the firms are

equally profitable. The return of the first firm is over- stated because its plant and

machinery have a low book value.

Definitional Difference:

In practice, differences exist as to the meaning of certain terms. Diversity of

views exists as to what should be included in calculating net worth or shareholder’s

equity, current assets or current liabilities. Whether preference share capital chould

be included in debt or should current liabilities to included in debt in calculating

the debt equity ratios? Should intangible assets be excluded to calculate the rate of

return on investment? If intangible assets have to be included how will they be.

Similarly, profit means different things to different people.

Short term changes:

The ratios do not have much use, if they are not analysed over years. The

balance sheets prepared at different points of time, are static in nature. They do not

reveal the changes which have taken place between dates of two balance sheets.

The statements of changes in financial positions reveal this information, but these

statements are not available to outside analysis.

No Indicators of Future

The basis of calculated ratios are financial statements. The financial analyst is

more interested in what happens in future, while the ratios indicate what happened

in the past. Management of the company has information about the company’s

future plans and policies and, therefore, is able to predict future happenings to a

certain extent. But the outside analyst has to rely o the past ratios, which may not

necessarily reflect the firm’s financial position and performance in future.

7.3.3 NATURE OF RATIO ANALYSIS

Time series analysis

The easiest way to evaluate the performance of a firm direction of firm is to

compare its present ratio with the past ratio. It gives an indication of the direction

of change and reflects whether the firm’s financial of performance has improved or

deteriorated.

Cross sectional Analysis:

The ratio of one firm is compared with some selected firms in the same industry

at the same point of few carefully selected competitors, who have similar

operations. This type of comparison indicates the relative financial position and

performance of the firm.

73

Industry Analysis

To determine the financial condition and performance of a firm its ratio may be

compared with average ratios of the industry of which the firm is member.

Pro – forma Analysis:

Sometimes future ratios are used as the standard of comparison. Future ratios

can be developed from the projected financial statements. The comparison of

current or past ratios with future ratios with future ratios shows the firm relative

strengths and weakness in the future.

7.3.4 PRECAUTIONS IN USING RATIO ANALYSIS

The ratio analysis is widely used technique to evaluate the financial position

and performance of a business. But there are certain considerations to be

considered while using the ratios.

It is difficult to decide on the proper basis of comparison. If there is no proper

comparison, the ratio analysis became meaningless. Generally rations should be

compared with industry averages.

Situation of two companies are never same. Similarly, the factors influencing

the performance of a company in one year may change in another year. So separate

norms may be used for each year comparison since the influenced factors are

changed from year to year.

The price level changes should be considered in the ratio analysis. The

accounting figures presented in the financial statements which are used in the ratio

analysis, are expressed in the monetary unit. The price level changes over years,

affects the real worth of earnings.

In practice, differences exist as to meaning of certain terms. Different views

exist as to what should be included in Net Worth, current assets or current

liabilities, similarly how to treat intangible assets.

The ratio does not have much use if they are not analysed over years. The

ratio at a moment of time may suffer from temporary changes. The trends of ratios

over years is more helpful to solve this problem.

The sources of information for ratio analysis are from historical records of

financial accounts. Such scattered information in the financial records be properly

consolidated or adjusted or modified before using in ratio analysis.

The assets and liabilities should be properly valued before applying the ratio

analysis for which a common norm should be followed. (Eg.) whether to include the

fictitious assets in the value of total assets.

Some organisations are having huge amounts of sundry debtors without

adequate provision for doubtful debts and write off of bad debts. Similarly showing

the fixed assets in the balance sheet without adequate provisions for depreciation.

These are the cause for window dressing.

74

7.3.5 TYPES OF RATIOS

Various ratio, calculated from the accounting data, can be grouped into various

classes according to financial activity or function to the evaluated. Short term

creditors are main interest in the liquidity position or the short – term solvency of

the firm. Long term creditors on the other hand are more interested in the long

term solvency and profitability and finance condition.

Various types of ratios are

Liquidity Ratios

(a) Current Ratio

(b) Liquid Ratio

(c) Absolute Liquid Ratio

(d) Over-due Liability Ratio

Profitability Ratios

(a)

(a)

Gross Profit Ratio.

(b) Operating Profit Ratio.

(c) Net Profit Ratio,

(d) Earning Power,

(e) Return on Investment

(f) Return on the Total Assets

(g) Return on the Total Equity

(h) Return on Common Equity "

(i) Earnings per Share

(j) Dividends per share

(k) Dividend-Pay out ratio

(l) Price-Earning ratio.

(m) Dividend yield ratio.

(n) Earnings yield ratio.

(o) Net profit to Net Worth

Leverage Ratios

(a) Debt-Equity Ratio

(b) Total Debt-Equity Ratio

(c) Debt to total capital ratio

75

(d) Equity Ratio

(e) Fixed Assets to Net Worth Ratio

(f) Current Assets to Net Worth Ratio

(g) Long-term Debt to Net Working Capital Ratio

(h) Current liabilities to net Worth

(i) Total Liabilities to Net Worth

(j) Capital gearing ratio

(k) Fixed Assets to Long-term funds.

(1)

n

terest

coverage

ratio

Interest coverage ratio

(m) Preference Dividend Coverage Ratio

Operating Rations

i. Operating Ratio

ii. Expenses Ratio

iii. Net sales to Fixed Assets

iv . Net sales to current Assets

v . Net sales to Net Worth

vi. Net sales to Net profit

Turn over Ratios

a) Inventory Turnover Ratio

b) Debtors Turn over Ratio

c) Creditors Turn over Ratio

d) Fixed Assets Turn over

e) Total Assets Turn over

f) Working Capital to Inventory

g ) Working Capital to Inventory

h) Working Capital to Total Assets

i ) Cash Turn Over Ratio

j) Current Assets Turn over

k) Inventory to working capital

l) Debtors to working capital

m) Cash to Working capital

n) Capital out-put ratio

76

Distinguish Current Ratio and Liquidity Ratio

Current Ratio (CR)

Donald Miller describes the current ratio as one which is generally recognised

as the patriarch among ratios. He states at that one time, it commanded such

widespread respect that many businessmen regarded it as being endowed with the

infallibility of nature's laws - it was a law of gravity applied to the Balance Sheet. By

using the current ratio, a credit manager or lending officer can lay aside his

"flipping coin" and arrive at decisions based on some figures of logic and accuracy.

Formula

Current Ratio = Current Assets

Current Liabilities

The ratio should be 2:1. But depending on each industry's own peculiar

problems, the ratio may vary between 1.5 : 1 to 3 : 1. If cash and marketable

securities constitute 10% of total current assets, even a current ratio of 1.5 : 1

will be satisfactory.

Liquid Ratio (LR)

Christy and Roden define the liquidity of an asset as moneyness. A firm's

liquidity may vary over the business cycle. Liquidity Radio indicates the firm's

ability to pay its current liabilities.

Current ratio is a liberal test of liquidity where as liquid ratio is a more

stringent test of a firm's ability to meet its current liabilities. It is also called as Acid

Test Ratio (ATR) or Quick Ratio (QR). As the conversion of inventory into cash will

take time, it i s excluded from current assets in order to arrive at' the amount of

liquid assets. Prepaid expenses are also excluded as these are already spent.

Formula

𝐿𝑖𝑞𝑢𝑖𝑑 𝑟𝑎𝑡𝑖𝑜 = 𝐿𝑖𝑞𝑢𝑖𝑑 𝐴𝑠𝑠𝑒𝑡𝑠

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

𝐿𝑖𝑞𝑢𝑖𝑑 𝑟𝑎𝑡𝑖𝑜 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − (𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 + 𝑝𝑟𝑒𝑝𝑎𝑖𝑑 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠)

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

The ratio should be 1:1. If current ratio is more than 2:1 but liquid

ratio is less than 1:1, it indicates excessive inventory.

As the bank overdraft is a permanent arrangements with the banker it may

be excluded to find out the liquid ratio.- In such case, the formula will be as

follows:

𝐿𝑖𝑞𝑢𝑖𝑑 𝑟𝑎𝑡𝑖𝑜 = 𝐿𝑖𝑞𝑢𝑖𝑑 𝐴𝑠𝑠𝑒𝑡𝑠

𝐿𝑖𝑞𝑢𝑖𝑑 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

i.e.

.

77

Absolute Liquid Ratio (ALR)

It is still stringent test of liquidity. It may not be possible to realise amounts

from all the debtors and hence the amount of debtors also is treated non -liquid

assets.

Absolute Liquid Ratio (ALR)

It is still stringent test of liquidity. It may not be possible to realise amounts

from all the debtors and hence the amount of debtors also is treated non-liquid

assets.

𝐴𝑏𝑠𝑜𝑙𝑢𝑡𝑒 𝐿𝑖𝑞𝑢𝑖𝑑 𝑟𝑎𝑡𝑖𝑜 = 𝑐𝑎𝑠ℎ + 𝑀𝑎𝑟𝑘𝑒𝑡𝑎𝑏𝑙𝑒 𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠

𝑞𝑢𝑖𝑐𝑘 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

The ratio should be 0.5 : 1.

Overdue Liability Ratio (OLR)

The ratio should be 1.5 : 1. If OLR is lower but current ratio is good, it

indicates excessive debtors and delay in realization of cash from debtors..

Profitability Ratios

Christy and Roden state that profit is the figure at the bottom of the income

statement - what is left for shareholders after all the changes have been paid.

Profit is an absolute figures and profitability is a ratio.

Gross profit ratio = Gross profit

Sales× 100 or Gross profit ratio =

EBIT

Sales× 100

𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑟𝑎𝑡𝑖𝑜 = 𝑁𝑒𝑇 𝑝𝑟𝑜𝑓𝑖𝑡 𝑜𝑟 𝑃𝑟𝑜𝑓𝑖𝑡 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥

𝑆𝑎𝑙𝑒𝑠× 100

𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑝𝑜𝑤𝑒𝑟 = 𝐸𝐵𝐼𝑇

𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠× 100

EBIT= Earning, before interest tax.

Return on the Investment (ROI)

𝑅𝑂𝐼 = 𝑝𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑇𝑎𝑥

𝐶𝑎𝑝𝑡𝑖𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑 × 100

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 = 𝑝𝑟𝑜𝑓𝑖𝑡 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥

𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠× 100

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑡𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑃𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥

𝑡𝑜𝑡𝑎𝑙 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 𝑒𝑞𝑢𝑖𝑡𝑦× 100

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐶𝑜𝑚𝑚𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑙𝑒𝑠𝑠 𝑝𝑒𝑟𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑

𝐶𝑜𝑚𝑚𝑜𝑛 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝐸𝑞𝑢𝑖𝑡𝑦𝑆𝑎𝑙𝑒𝑠× 100

𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 (𝐸𝑃𝑆) = 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑙𝑒𝑠𝑠 𝑝𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑

𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒𝑠

Current Assets- (Inventory + Prepaid expenses)

Current Liabilities - Bank Overdraft

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𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑦 𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜 = 𝐷𝑃𝑆

𝐸𝑃𝑆× 100

𝑃𝑟𝑖𝑐𝑒 𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑅𝑎𝑡𝑖𝑜(𝑃𝐸𝑅) = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝐸𝑃𝑆

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑌𝑖𝑒𝑙𝑑 𝑟𝑎𝑡𝑖𝑜(𝐸𝑌𝑅) = 𝐷𝑃𝑆

𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑡𝑜 𝑛𝑒𝑡 𝑤𝑜𝑟𝑡ℎ = 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑙𝑒𝑠𝑠 𝑝𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑

𝐸𝑢𝑖𝑡𝑦 𝐶𝑎𝑝𝑖𝑡𝑎𝑙+𝑅𝑒𝑠𝑒𝑟𝑣𝑒𝑠× 100

Leverage Ratios

Liquidity ratios are calculated to know the current financial position of the

firm. In order to know the long-term financial position, leverage ratios are

calculated. These are also called "capital structure ratios" and "Solvency Ratios".

These ratios will indicate the proportion of debt and equity in the capital

structure of an organisation. These are also calculated to know the extent to

which operating profits are sufficient to cover the fixed interest charge.

Debt Equity Ratio =long trem debt

share holder Equity=

loan funds

Own funds

This ratio is generally 1 : 1 in Public Sector and 2 : 1 in Private Sector. The

Controller of Capital issues prescribes that debt-equity 12 years, share premium,

general reserve, P & L account balance, and development rebate reserve,

shareholders equity is equal to net worth. Debt includes preference shares

redeemable within 13 years, fixed interest bearing securities such as debentures,

secured loans and unsecured loans etc. The Controller of Capital issues treat

redeemable preference shares as part of the relative interest of creditors and

owners.

Barges and Alexander mention "The treatment of preference presents different

risk to shareholders. In one case failure to meet payments presents no such risk."

A high ratio is unfavourable and margin of safety for creditors will be less. "It

will be di fficult for the firm to meet the fixed interest charges in case of high

promotion of debt in the capital structure. Though a low ratio provides a higher

margin of safety for the creditors, Earnings per share (ESP) will be lower on the

basis of large equity base. Hence a finance manager has to work out an optimum

capital structure in order to ensure that EPS will be lower on the basis of large

equity base. Hence a finance manager has to work out an optimum capital

structure in order to ensure that EPS will be higher and shareholder's wealth will

be maximum.

Debt Equity ratio, an important tool of financial analysis, depicts an

arithmetical relation between loan funds and owners funds. This is a popular

measure in the hands of investors and creditors to assess the lenders and owners

against the company's assets.

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The optimum mix of debt and equity ensures maximum return for equity

shareholders and also guarantees the servicing of debt in the interest of creditors.

The following factors may be considered for working out the optimum debt-equity

ratio:

a) Profitability Potential

b) Debt-servicing potential i.e. Interest-coverage ratio

c) Current Capi tal market conditions, and

d) The Economic situation in the country.

Debt-equity ratio is one of the most critical parameters that, an investor should

look at for the following reasons:

(i) A medium/high ratio (in the range of 1.5 : 1 to 4 : 1) would indicate that

the Capital base is low and this would mean higher earnings per share in the future

once the debt is redeemed,

(ii) A debt component also ensures that a financial institution appraises the

project. The later would also monitor the utilisation of funds during the project

implementation stage as also once the company commences commercial

operations,

(iii) In a contrast situation, when a project is entirely financed by equity, the

company loses the flexibility of rescheduling funds in future,

(iv) Then again, when a project is entirely financed by equity, the risk to the

shareholders is higher as there is no financial appraisal as the investors are not

equipped or have access to monitor the course of the project.

(v) The general norm for debt to equity is 1.5 : 1, But capital -intensive projects

are allowed a debt/equity of 4:1 while finance companies can have a ratio as high

as 9:1.

2. 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 = 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡

𝑆ℎ𝑎𝑟𝑒 ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝐸𝑞𝑢𝑖𝑡𝑦

i.e 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 = 𝐿𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝑑𝑒𝑏𝑡 +𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦

𝑆ℎ𝑎𝑟𝑒 ℎ𝑜𝑙𝑑𝑒𝑟𝑠′ 𝐸𝑞𝑢𝑖𝑡𝑦

3. 𝐷𝑒𝑏𝑡 𝑡𝑜 𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑅𝑎𝑡𝑖𝑜 = 𝐿𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝐷𝑒𝑏𝑡

𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

Note : The widely – held approach and adopted by C.C.I. and financial

institutions is that of relating the long – term debt to shareholders’ Equity i.e. 1.

Ratio.

𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 = 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝐸𝑞𝑢𝑖𝑡𝑦

𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

It is also called “ proprietary Ratio”

𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 𝑡𝑜 𝑛𝑒𝑡 𝑊𝑜𝑟𝑡ℎ 𝑅𝑎𝑡𝑖𝑜 = 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 𝑎𝑡 𝑊𝐷𝑉

𝑁𝑒𝑡 𝑊𝑜𝑟𝑡ℎ

80

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 𝑡𝑜 𝑁𝑒𝑡 𝑊𝑜𝑟𝑡ℎ 𝑅𝑎𝑡𝑖𝑜 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠

𝑁𝑒𝑡 𝑊𝑜𝑟𝑡ℎ

𝐿𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝐷𝑒𝑏𝑡𝑡𝑜 𝑁𝑒𝑡𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 𝐿𝑜𝑛𝑔 − 𝑡𝑒𝑟𝑚 𝐷𝑒𝑏𝑡

𝑁𝑒𝑡 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

This ratio should be 1: 1 long – term debt should not exceed net working

capital.

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑡𝑜 𝑁𝑒𝑡 𝑤𝑜𝑟𝑡ℎ = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑏𝑖𝑙𝑖𝑡𝑦

𝑁𝑒𝑡 𝐸𝑜𝑟𝑡ℎ

𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑡𝑜 𝑁𝑒𝑡 𝑤𝑜𝑟𝑡ℎ = 𝑇𝑜𝑡𝑠𝑙 𝐿𝑖𝑏𝑖𝑙𝑖𝑡𝑦

𝑁𝑒𝑡 𝐸𝑜𝑟𝑡ℎ

1. Capital Gearing ratio(CGR)

Capital gearing ratio indicates the relationship between fixed interest bearing

securities (FIBS) and Equity Share Capital plus Reserves.

(i) If FIBS are higher than equity Highly-geared capital structure. Capital

plus reserves i.e. ratio is more than 1 : 1 .

(ii). If FIBS are lower than equity Low-geared capital structure. Capital plus

reserves i .e . ratio is more than 1 : 1 .

I f both are equa l p roport ion. Evenly-gea red cap ita l structure,

i.e. ratio is 1:1.

𝐹𝐼𝐵𝑆

𝐸𝑄𝑢𝑖𝑡𝑦 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

𝐷𝑒𝑏𝑒𝑛𝑡𝑢𝑟𝑒𝑠

𝐸𝑄𝑢𝑖𝑡𝑦 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

𝐷𝑒𝑏𝑒𝑛𝑡𝑢𝑟𝑒 + 𝑃𝑒𝑟𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

𝐸𝑄𝑢𝑖𝑡𝑦 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

𝐹𝐼𝐵𝑆

𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑

𝐹𝐼𝐵𝑆

𝐸𝑄𝑢𝑖𝑡𝑦 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝑓𝑢𝑛𝑑𝑠 𝑖. 𝑒. 𝑁𝑒𝑡 𝑊𝑜𝑟𝑡ℎ𝑙

FIBS include the Debentures, Term loans and preference shares (especially

when they are cumulative ). The last formula is a better one.

A highly geared company may give higher return to equity shareholders, if

profits are good and rate of return of capital is more than the rate of interest on

preference dividend. After meeting the interest charges and preference dividend out

of profits, the balance of profits will be available to the Equity Shareholders.

(iii

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The following factors may affect the decision of the firm about capital gearing.

a) Trading on Equity

b) Exercise of control

c) Attitude towards risk

d) Statutory requirements

e) Capi tal market condi tions

f) Fixed cost of financing

g) Rate of return on capital

The following factors may affect the decision of the firm about capital gearing.

a) Trading on Equity

b) Exercise of control

c) Attitude towards risk

d) Statutory requirements

e) Capital market conditions

f) Types of inventors

g) Period of financing

h) Fixed cost of financing

i) Rate of return on capital

Fixed Assets to long-term funds

Fixed Assets to long-term funds= 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 𝑎𝑡 𝑊𝐷𝑉

𝑙𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝑓𝑢𝑛𝑑𝑠𝑙

Long-term funds include shareholders' equity and long-term debt. The ratio

should not exceed 1:1, it means that working capital is nil. Then current assets are

financed fully by current liabilities only.

Interest Coverage Ratio (ICR)

ACR =𝐸𝐵𝐼𝑇

𝐹𝑖𝑥𝑒𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐ℎ𝑟𝑔𝑒𝑠

It is also called "Debt-service Ratio".

The ratio shows how many times the interest of the earnings cover charges

before interest and tax (EBIT). It indicates the ability of a firm to pay the interest

charges. It is also an important test of satisfactory. If the ratio is 1:1, EBIT will be

just sufficient to pay the interest charges. Then net profit will be nil and tax need

not be paid.

DSCR mean Debt Service Coverage Ratio. The company has to satisfy the

lender by calculating DSCR which should indicate clearly as to what extent it will

be able to discharge loan obligations. Each company should work out is own DSCR for

proper planning and monitoring which should be part of internal financial

discipline.

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If the internal generation of funds (i.e. cash in flow) is diverted for expansion,

modification or diversification of activities, it may result into default of payment of

interest and repayment of loan.

Preference Dividend Coverage Ratio (PDCR)

PDCR= 𝑷𝒓𝒐𝒇𝒊𝒕 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙

𝒑𝒓𝒆𝒇𝒆𝒓𝒆𝒏𝒄𝒆 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅

Operating Ratio

These ratios are calculated to show the variations of different expenses in the

operating cost. Generally these are expressed as percentages to net sales.

Cost of goods sold + Operating expenses . Operat ing ratio = —------------------------------------------------------ x 100

Net Sales If the operating ratio shows 90%, the balance 10% will be operating profit ratio.

This should cover interest, income tax, dividends and retained earnings.

Each item of expenses Expenses Ratio = ------------—----------------------- x 100

Net Sales In indicates the percentage of each item of expense in relation to net sales.

𝐸𝑥𝑝𝑒𝑛𝑠𝑒 𝑅𝑎𝑡𝑖𝑜 = 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠

𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 𝑡𝑜 𝑁𝑒𝑡 𝑤𝑜𝑟𝑡ℎ = 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

𝑁𝑒𝑡 𝑊𝑜𝑟𝑡ℎ

𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 𝑡𝑜 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 = 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 𝑡𝑜 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 × 100

Turnover Ratios

Turnover ratios indicate the effectiveness with which the assets are utilised in a

firm. These are also called "Activity Ratios".

Inventory Turnover Ratio (ITR)

It is also called Stock Turnover Ratio. It is the number of times its average

inventory is sold during a year. There are 3 alternative formulas for this ratio as

given below:

i) ITR = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑎𝑡 𝑐𝑜𝑠𝑡

(ii) ITR = 𝑆𝑎𝑙𝑒𝑠

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑎𝑡 𝑐𝑜𝑠𝑡

(iii) ITR = 𝑆𝑎𝑙𝑒𝑠

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑎𝑡 𝑠𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒

83

A ratio of 6 or 7 times is considered satisfactory. But there is "on rule of

thumb". A high inventory turnover is an indication of good inventory slow-moving

and absolute i tems resul ting in blocking of funds. Too high frequent stock-

outs. These situations should be avoided. Significance of important ratios

Holding of inventory may be expressed in number of days also as follows:

Average holding period of inventory = 𝐷𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟

𝐼 .𝑇.𝑅

Debtors Turnover Ratio (DTR)

This ratio indicates the speed at which the debtors are converted into cash. It

is also called "Receivable Turnover Ratio".

𝐷𝑇𝑅 = 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠 𝑖𝑛 𝑎𝑦𝑒𝑎𝑟

𝐷𝑒𝑏𝑡𝑜𝑟𝑠

The optimum ratio is dependent on the credi t policy of the fi rm and

credi t period allowed to the customers. If the credit period is 30 days, the ratio

should be 12:1. Suppose if the ratio is 12:2 i.e., 6:1 the realisation from debtors is

taking two months instead of credit policy of one month. Hence lower

The debtors include the gross amount of debtors (i.e. without deducting the

provisions for bad and doubtful debts and provision for discount on debtors) and

outstanding bills receivable which have not been discounted with the bankers.

Sometimes, we have to calculate the average collection period of debtors. In

such case, the formula is as follows:

Average Collection Period = --- 𝐷𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟

𝐷𝑇𝑅-

Or

Average Collection Period =𝐷𝑒𝑏𝑡𝑜𝑟𝑠 ×Days in a year

𝐶𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟

𝑖𝑒 𝐷𝑒𝑏𝑒𝑡𝑜𝑟𝑠

𝐶𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠 𝑝𝑒𝑟 𝑑𝑎𝑦

Creditors Turnover Ratio (CTR)

Similar to debtors Turnover Ratio, Creditors Turnover Ratio also can be

calculated.

𝐶𝑇𝑅 = 𝐶𝑟𝑒𝑑𝑖𝑡 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 𝑖𝑛 𝑎𝑦𝑒𝑎𝑟

𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠

This ratio indicates the speed at which the creditors are paid. The ratio here

also is dependent on the credit period allowed by suppliers. The creditors include

84

the gross amount of creditors (i.e. without deducting the provision for discount on

creditors) and bills payable.

Average payment period = Days in ayear

CTR

or Creditor × Days in ayear

Credit Purchases in a year

or Creditors

CreditPurchases per year

Fixed Assets Turnover = Sales

Fixed Assets

This ratio indicates the frequency with which the fixed assets are utilized

Total Assets Turnover = Sales

Total Assets

Working Capital Turnover = Turnover

Working Capital

Working Capital to inventory = Working Capital

Inventory

Working Capital to Total Assets = CWoriking CApital

Total Assets

Total Assets Turnover = Total Cash & Bank Payment

Average cash & Bank Balance

Current Assets Tournover = Turn over

Current Assets

Inventory to Working Capital = Inventory

Working Capital

Debtors to Working Capital = Debtors

Working Capital

Cash to Working Capital = Cash

Working Capital

Capital out put ratio = Capital

Value of produsction

7.3.6 SIGNIFICANCE OF IMPORTANT RATIOS

Current Ratios:

a) Current Ratio indicates the firm’s ability to pay its current liabilities; i.e.

day to day financial obligations.

85

b) It Shows short-term financial strength.

c) It is a test of credit strength and solvency of a firm.

d) It indicates the strength of working of capital

e) It indicates the capacity to canyon effective Operations.

f) It discloses the over-trading or under-capi talisation.

g) It shows the tendency of over-investment in inventory.

h) Higher ratio, ie., more than 2:1 indicates sound solvency position ,

i) Lower ratio, ie., less than 2:1 indicates inadequate working capital ,

j) It discloses the quantity of working capital position and not its quality.

k) By using the current ratio, a credit manager, or lending officer can lay

aside his "flipping coin" and arrive at decisions based on some figures of login and accuracy.

Liquid Ratio

a) It is a more stringent test of a firm's ability to meet its intermediate

liabilities.

b) It is true test of business solvency.

c) It is more of a qualitative concept whereas current ratio discloses

quantitative aspect of working capital.

d) It indicates the inventory build-up when studied along with current ratio

because of the following formula: Liquid Assets=Current Assets-

Inventory

e) Because of eliminating inventory in its calculations, it is a stringent test

of liquidity.

f) It is a more important ratio for financial institutions.

g ) Higher ratio, i.e., more than 1:1 indicates sound financial position

h) Lower ratio, i.e., less than 1:1 indicates financial difficulty.

Gross Profit Ratio

a) It indicates the basic profitability of a firm, i.e., trading results of a firm.

b) It indicates the degree of efficiency of the production department,

purchase department, sales department and the degree of cost control

(i.e. material control labour efficiency and overheads control).

c) A comparison of G.P. ratios over 5 to 10 years will indicate the trend of

trading results.

d) It shows whether the percentage of "mark up" on the goods is

maintained or not.

e) Higher ratio indicates the higher profitability.

f) Low ratio indicates the lower profitability and unfavourable mark-up

policy.

86

Net Profit Ratio

a) It indicates the relationship between net profit and net sales.

b) It is the most significant of all revenue ratios as it indicates the ultimate

profitability of the firm.

c) It is useful to the share holders for knowing the earnings per share

(EPS).

d) It is useful to investors in judging the prospects of return on their

investments.

e) A study of operating ratio and N.P. ratio indicate the degree of efficiency

and profitability of the firm.

f) A study of operating net profit ratio and N.P. ratio will indicate scale of

company's non-operating expenses and non-operating income.

g) A study of G.P. ratio and N.P. ratio will indicate scale of company's non-

operating expenses and non-operating income.

h) It is described as an index of "Operational Efficiency".

i) Higher ratio indicates higher profitability.

j) Lower ratio indicates lower profitability.

Note: A high N.P. ratio is not always a favourable indication of a firm's

profitability. For a detailed study of the firm's profitability, the following factors are

also to be studied:

1) Market Conditions, 2) Sales Volume 3) Pricing policy 4) Sales Mix 5)

Stock turnover ratio 6) Debtors turnover ratio 7) Cost of capital 8) Return on

investment (ROI) of other firms in the same industry etc.

Earning Power or Return on Total Resources

a) It is an index of earning power of a firm. .

b) It is an index of optimum utilisation of funds or economic productivity of

capital.

c) It indicates the degree of efficiency of management.

d) It provides a standard measure of operating efficiency.

e) Capital investment decisions are made on the basis of this ratio.

f) Higher ratio is favourable and lower ratio is unfavourable

Note : Total Resources : Total Assets Employed

Earning Power = EBIT

Total Assets× 100

Return on Total Equity

87

= Profit after Tax (PAT)

Total Shareholders Equity (or)total proproetprs Funds× 100

a) It shows the earnings capacity of proprietors funds (including

preference shareholders).

b) It is important to prospective investors and shareholders.

c) High ratio will improve the market price of the share in stock

exchange.

d) High ratio enables the management to raise finances easily even from

external resources.

e) A high ratio gives scope for more retained earnings which can be used

for expansion, diversification and consequential development of

business.

f) When the ratio has been high for a period of 4 or 5 years, shareholders

can expect the company to issue bonus share

g) Note: While calculating the above ratio, the preference dividend need

not be deducted.

Return on common equity

= PAT Less Perference Dividend

Equity Shareholders Funds× 100

a) It shows the efficiency in the management of equity share holders funds,

b ) Higher ratio indicates higher profitability and higher EPS

c) Lower ratio indicates lower profitability and ineffective utilisation of

equity share holders funds,

d ) If EPS is higher than the market value of equity shares will be higher in

stock exchange and issue of bonus shares will also be feasible.

Note : The Preference shares are considered as "Non-participating."

Earnings Per Share (EPS) = 𝑃𝐴𝑇 𝑙𝑒𝑠𝑠 𝑝𝑟𝑒𝑓𝑒𝑟𝑒𝑐𝑒 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑

𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑆ℎ𝑎𝑟𝑒𝑠

a) It indicates the earning power of equity share capital,

b) Dividend declaration is based on this ratio.

c) EPS is of considerable importance in estimating the market price of

shares,

d ) If EPS is higher, market value of equity share will be higher in the stock

exchange,

e) If EPS has been high for a period of 4 to 5 years, issue of bonus share

will also be feasible,

f) This ratio can be improved by use of borrowed funds to a greater extent.

88

NOTE: Dividend Per Share(DPS) = Dividend Declared / No of Equity shares.

Dividend pay Out Ratio =𝐷𝑃𝑆

𝐸𝑃𝑆× 100

Proprietary Ratio

i) It indicates long-term financial solvency of the firm.

i i ) It shows the general financial strength of the firm.

i i i ) It shows the proportion of assets financed by the proprietors.

iv) It measures the extent of protection available to the creditors.

v) It is a test of long-term credit strength.

vi ) It determines the extent of trading on equity.

vii) Higher Ratio i.e. more than 75% shows lesser dependence on external

sources, sound financial position; greater security available to creditors, no trading

on equity and low EPS(EPS=Earnings per Share), viii) Lower ratio i.e., less than

60% shows more dependence on external sources and unsound financial position.

It is dangerous during the period of depression.

Note: The Proprietary ratio can never exceed 1:1 i.e., 100%. When there are

outside liabilities, the ratio would he 1:1, standard ratio would, he 60% to 75%.

Capital Gearing Ratio

i. It analyses the capital structure of a company effectively.

ii. It is useful to ascertain whether a company is practicing "trading on

equity " and if so to what extent is done.

iii. Low gearing indicates trading on equity, over capitalization and low EPS,

iv. It aids in regulating a balanced capital structure in a company.

v. High gearing is favourable for a company earning high profits and it

indicates under capitalization. Earning per share(EPS) will be higher but

it will fall disproportionately against a slight fall in net profits.

vi. It affect the dividend policy of the company.

Note: According to capital issues control act a ratio of 1:4 between equity and

preference capital is reasonable.

Operating Ratio

i. It brings out. the relationship between cost of goods sold + operating

expenses and net sales.

ii. It is useful to ascertain the administration efficiency.

ii i . It is a test of operational efficiency of the business.

iv. It is useful for detecting the areas of inefficiency and consequential

lower profits.

v. Low ratio indicates operational efficiency and higher profits,

89

vi . High ratio indicates the lower profits.

vii. A trend analyses of operating ratios can be made for a period of 5 to 10

years and reasons analysed for any rise or fall in operational efficiency.

Expense Ratios

i . Expenses ratios bring out the relationship between various elements of

operating costs and net sales,

i i . A study of these ratios will enable the management in controlling costs

and improving the managerial efficiency,

iii. A study of these ratios over a perioft of 5 to 10 years will indicate trend

analysis and according to the ratio will improve the profitabili ty .

Inventory Turnover Ratio (ITR)

i. It indicates the number of times its averages inventory has been sold

and replaced during the year.

i i . It is an important factor that controls profitability of firm,

i i i . It indicates whether investment in inventory is high or not. This ratio

can be useful for introducing effective inventory management in the

areas mentioned below,

iv. Controlling inventory levels to avail! over-stocking and stock-outs,

avoiding slow-moving, non-moving inventories and surplus or obsolete

stores etc.

v. It indicates whether capital is blocked in slow-moving inventories and

thereby indicates the possibility of reducing selling prices of those items,

vi . This ratio reflects excess stock and/or accumulation of obsolete items in

stock,

vii. A study of inventory turnover ratio and inventory to working capital

ratio will be more significant.

viii. A ratio of six or seven times is considered satisfactory. A high inventory

turnover is an indication of good inventory management and favourable

trading situation. A low ratio indicates excessive inventory including

slow-moving and obsolete items resulting in blocking of funds.

Note: A too high inventory turnover ratio may be the result of low

level including frequent stock-outs. This situation should be avoided.

Debtors Turnover Ratio (DTR)

(i)If the credit period is 30 days, the ratio should be 12. If the ratio is 6:1, the

realization from debtors is taken 2 months instead of credit policy of one month.

Hence, Lower ratio indicates poor collection from the debtors. Then the bad debts

also will increase and profits will be lower. Hence, suitable measures are to be

taken to improve the credit collection.

90

(ii) It indicates the quality of debtors also, i.e. good, doubtful or bad etc.

(iii) It is useful in the preparation of working capital budgets.

(iv) It is a very useful supplementary test to the current ratio.

(v) It shows the effectiveness of credit control.

It indicates the speed at which the debtors are converted into cash.

Inventory to Working Capital Ratio

i. It shows the extent to which working capital is blocked in inventory.

Working capital is required for the firm but it should not be blocked up

in inventory.

ii. Higher ratio of more than 1:1 indicates unsound working capital, i.e,

iii. Lower ratio i.e, less than1:1 indicates sound working capital position and effective inventory management.

iv. It indicates whether working capital is adequate or not.

v. It is related to current ratio as well as liquid ratio.

Illustration:

1. The following is the balance sheet of Rajan limited as on 31st March 2000.

Liabilities Rs. Assets Rs.

Equity share Capital

7 % preference Share

Capital

Reserve and Surplus

3 % Mortgage

Debentures

Creditors

Bills payable

Outstanding expenses

Taxation provision

1,00,000

20,000

80,000

1,40,000

12,000

20,000

2,000

26,000

Fixed Assets 3,60,000

Less: Depre., 1,00,000

_________

Current Assets:

Cash

Investments

(Government securities

@ 10 % interest)

Sundry debtors

Stock

2,60,000

10,000

30,000

40,000

60,000

4,00,000 4,00,000

Other information:

(i) Net sales Rs.6,00,000

(ii) Cost of Goods sold Rs.5,16,000

Net income before tax 40,000

Net income after tax 20,000

91

Calculate appropriate ratios from the given information.

Solution:

(a) Short – term solvency ratios:

(1) Current ratio =𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠

𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠=

1,40,000

60,000= 2.33 : 1

(2) liquid ratio =𝐿𝑖𝑞𝑢𝑖𝑑 𝑎𝑠𝑠𝑒𝑡𝑠

𝐿𝑖𝑞𝑢𝑖𝑑 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠=

80,000

60 ,000= 1.33 : 1

(b) Long term Solvency ratios:

(3) Proprietary ratio =𝑃𝑟𝑜𝑝𝑟𝑖𝑒𝑡𝑜𝑟 𝑠′ 𝑓𝑢𝑛𝑑

𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠=

2,00,000

4,00,000= 0.5 : 1

Proprietary funds or

shareholder’s funds = Equity share capital + preference share

capital + Reserve & surplus

= 1,00,000+20,000+80,000

(4) Debt – Equity ratio = 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑖𝑒𝑠

𝐼𝑛𝑡𝑒𝑟𝑛𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑖𝑒𝑠=

𝐷𝑒𝑏𝑡

𝐸𝑞𝑢𝑖𝑡𝑦=

=2,00,000

2,00,000= 1 : 1

(5) Ratio of Fixed Assets to proprietors, funds:

= 𝐹𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠 (𝑎𝑓𝑡𝑒𝑟 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛)

𝑃𝑟𝑜𝑝𝑟𝑖𝑒𝑡𝑜𝑟 𝑠′ 𝑓𝑢𝑛𝑑𝑠=

2,60,000

2,00,000

= 1.3 : 1

(6) Interest coverage ratio= 𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 +𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 +𝑇𝑎𝑥

𝐹𝑖𝑥𝑒𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐ℎ𝑎𝑔𝑒𝑠=

=48,400

8,400= 5.7 𝑡𝑖𝑚𝑒𝑠

Fixed interest charges = 6 % on debentures of Rs.1,40,000

= Rs. 8,400

(c) Profitability ratios:

(7) Gross Profit ratio = 𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡

𝑠𝑎𝑙𝑒𝑠× 100 =

84,000

6,00,000× 100 = 14 %

Gross profit = Sales – Cost of goods sold

= 6,00,000 – 5,16,000

= 84,000

(8) Net profit ratio =𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡

𝑠𝑎𝑙𝑒𝑠× 100 =

20 ,000

600 ,000× 100 = 3.33

92

(9) Return of share holders’ funds

=𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥

𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 𝑠′𝑓𝑢𝑛𝑑× 100

=20,000

2,00,000× 100 = 10 %

(10) Return of capital employed

=𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 +𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 +𝑡𝑎𝑥

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑× 100

Capital Employed Rs.

Share Capital 1,00,000

7% preference share capital 20,000

Reserve and surplus 80,000

6% Debentures 1,40,000

3,40,000

Less: Investment (out side the business 30,000

Net capital employed at the end 3,10,000

Average capital employed = Net profit employed at the end- ½ of

Net profit after tax.

= Rs. 3,10,000- ½ of Rs. 20,000

= Rs. 3,00,000

Return of capital employed

=𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 +𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 +𝑡𝑎𝑥

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑× 100

= 40,000+8,400 −3,000 (10% 𝑜𝑛 30,000 )

3,00,000× 100

= 45 ,400

3,00,000× 100 = 15.13 %

(c) Activity ratios:

(11). Stock turnover ratio =𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑠𝑡𝑜𝑐𝑘

As there is no opening stock, closing stock is taken as the average

stock.

93

=5,16,000

60 ,000= 8.6 𝑡𝑖𝑚𝑒𝑠

(12). Average collection period = 𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡𝑜𝑟𝑠

𝐶𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠×

𝑁𝑜. 𝑜𝑓 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑑𝑎𝑦𝑠

All sales are assumed as credit sales and number of working days.

=40 ,000

6,00,000× 360 = 24 𝑑𝑎𝑦𝑠

(13). Capital structure ratio:

Capital gearing ratio

=𝑝𝑟𝑒𝑓.𝑠ℎ𝑎𝑟𝑒 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 +𝑓𝑖𝑥𝑒𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑏𝑒𝑎𝑟𝑖𝑛𝑔 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠

𝐸𝑞𝑢𝑖𝑡𝑦 𝑐𝑎𝑝𝑖𝑡𝑎𝑙+𝑅𝑒𝑠𝑒𝑟𝑣𝑒 𝑎𝑛𝑑 𝑠𝑢𝑟𝑝𝑙𝑢𝑠

=20,000+1,40,000

1,00,000 +80,000=

1,60,000

1,80,000= 0.89 ∶ 1

2. from the following information, prepare a balance sheet show the workings.

1. working capital Rs. 75,000

2. Reserve and surplus Rs. 1,00,000

3. Bank overdraft Rs. 60,000

4. Current ratio 1.75

5. Liquid ratio 1.15

6. Fixed assets to proprietor’s funds 0.75

7. Long – term liabilities Nil

Solution:

(a) Current Assets:

Current ratio =𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠= 1.75 ∶ 1

Working capital = Current Assets – Current Liabilities

= 1.75 – 1 = 0.75

If working capital is 0.75 , Current assets are 1.75 If working capital is Rs. 75,000, current assets are

= 75,000

0.75× 1.75 = 𝑅𝑠. 1,75,000

(b) Current Liabilities: If working capital is 0.75, current liabilities = 1

94

If working capital is Rs. 75,000, current liabilities are

75,000

0.75 × 1 = 𝑅𝑠. 1,00,000

(c) Quick assets:

Quick ratio = 𝑄𝑢𝑖𝑐𝑘 𝑎𝑠𝑠𝑒𝑡𝑠

𝑄𝑢𝑖𝑐𝑘 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠= 1.15

Quick liabilities = Current liabilities – Bank overdraft

= Rs.1,00,000 – Rs. 60,000 = Rs.40,000

= 𝑄𝑢𝑖𝑐𝑘 𝑎𝑠𝑠𝑒𝑡𝑠

𝑄𝑢𝑖𝑐𝑘 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠= 1.15

= 𝑄𝑢𝑖𝑐𝑘 𝑎𝑠𝑠𝑒𝑡𝑠

40,000= 1.15

Quick Assets = 40,000 × 1.15 = Rs. 46,000

(d) Stock :

Stock = Current assets – Quick assets = Rs. 1,75,000 – Rs. 46,000

= Rs. 1,29,000 (e) Proprietors’ funds:

Fixed assets to proprietor’s fund=

= 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠

𝑃𝑟𝑜𝑝𝑟𝑖𝑒𝑡𝑜𝑟 𝑠′ 𝑓𝑢𝑛𝑑𝑠= 0.75 ∶ 1

In the absence of long term loans, following equation can be had from the

Balance Sheet.

Total Assets = Total Liabilities

i.e., proprietors’ funds + Current liabilities = Fixed assets + Current assets

proprietors funds – fixed assets = Current assets – Current Liabilities

1 – 0.75 = Rs. 1,75,000 – Rs. 1,00,000

0.25 = Rs. 75,000

Proprietors’ fund 1 = Rs. 3,00,000

Fixed Assets 0.75 = Rs. 2,25,000

Share Capital :

Proprietors’ funds = Rs. 3,00,000

Less: Reserve and Surplus = Rs. 1,00,000 ____________

Share Capital = Rs. 2,00,000

___________

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The Balance Sheet will appear as follows:

Balance sheet as on .......

Liabilities Rs. Assets Rs.

Share Capital

Reserve and Surplus Current Liabilities:

Bank overdraft Quick liabilities

2,00,000

1,00,000

60,000 40,000

Fixed Assets

Current assets: Stock

Quick Assets

2,25,000

1,29,000

46,000

4,00,000 4,00,000

Illustration: 3

The following are the summarized profit and loss account of Sun India Ltd. For the year ending 3151Dec.2003 and the Balance sheet as on that date:

Dr. Profit and Loss Account Cr.

Particulars Rs. Particulars Rs. Rs.

To Opening Stock 10,000 By Sales 1,20,000

1,10,000 To Purchases 60,000 Less: Sales Return 10,000

To Freight Expenses 5,000 By Closing Stock

15,000 To Gross Profit c/d 50,000

To Operating Expenses:

1,25,000 By Gross Profit b/d

1,25,000

5,000

50,000

Office Expenses By Non-Trading Income:

5,000

Administrative Expenses 15,000 Interest on Investment

1,000

Selling and Distribution Expenses 5,000

To

Non-Operating Expenses:

1,000

Dividend Received

4,000 Loss on Sale of Fixed Assets

To Net Profit 34,000

60,000 60,000

96

Balance Sheet for the year ending 31"'Dec.2001

Liabilities Rs. Assets Rs.

Share Capital

Reserve

Debentures

Current Liabilities

Profit and Loss A/c

15,000

3,000

12,000

20,000

5,000

5,000

Cash in Hand

Cash at Bank

Marketable Securities

Inventories

Sundry Debtors

Prepaid Expense

Land and Building

2,000

3,000

5,000

15,000

6,000

4,000

20,000

55,000 55,000

You are required to calculate:

a) Current Ratio

b) Liquid Ratio

c) Gross Profit Ratio

d) Operating Ratio

e) Operating Profit Ratio

f) Net Profit Ratio

Solution: a. Current Ration

Current Ration = Current Assets/Current Liabilities

= `2000+3000+5000+15000+6000+4000

= `35000

= `20000

= 1.75 (or) 1.75:1

b. Liquid Ratio

Liquid Ratio = Liquid Assets/Current Liabilities

Liquid Assets = Current Assets–(Stock and Prepaid

Expenses)

= `35000-(15000+4000)

= `16000

= `20000

= 0.8 (or) 0.8:1

97

c. Gross Profit Ratio

Gross Profit Ratio = 100

SalesNet

Profit Gross

= 100

110000

50000

= 45.45%

d. Operating Ration

Operating Ration = 100

SalesNet

Cost Operating Total

Total Operating Cost = Opening Stock + Purchases-Closing

Stock

= `10000+60000-15000

= `55000

Operating Expenses = Office Expenses + Administrative

Exp.o+

Selling and Distribution Exp.

= `5000+150000-5000

= `250000

Total Operating Cost = `55000+25000

= `80000

Operating Ratio = 100

10000

80000

= 72.72%

e. Operating Profit Ratio

Operating Profit Ratio = 100

SalesNet

Profit Operating Net

Net Operating Profit = Net Sales – Total Operating Cost

= `110000-80000

= `30000

Operating Profit Ration = 100

110000

30000

98

= 27.27%

Alternatively

Net Operating Profit = Net Profit + Non-Operating Expenses –

Non operating Income

= `34000-10000-(5000+1000+4000)

= `35000-10000

= `25000

Operating Profit Ration = 100

110000

25000

= 22.72%

f. Net Profit Ration

Net Profit Ratio = 100

SalesNet

tax) (After Prifit Net

= 100

110000

34000

= 30.90%

Answers

(a) Current Ratio = 1.75(or) 1.75:1

(b) Liquid Ratio = 0.8 (or) 0.8:1

(c) Gross Profit Ratio = 45.45%

(d) Operating Ratio = 72.72%

(e) Operating Profit Ratio = 27.27 % Or 22.72%

(f) Net Profit Ration = 30.90%

This ratio is also termed as ROI. This ratio measures are turn on the owner's or

share holders' investment. This ratio helps to the management for important

decisions making.

This ratio highlights the success of the business from the owner's point of view.

It helps to measure an income on the share holders' or proprietor's investments.

This ratio helps to the management for important decisions making.

It facilitates in determining efficiently handling of owner's investment

99

This ratio shown the relationship between net profit after interest and taxes

and the owner's investment. Usually this is calculated in percentage. This ratio,

thus. Can be calculated as:

Return on Investment Ratio Shareholder's Investments

Net Profit (after interest and tax) Net Profit =------------X 100

Shareholders' Fund(or)Investments

= Equity Share Capital + Preference Share Capital + Reserves and Surplus

-Accumulated Losses

= Net Profit-Interest and Taxes

Illustration :4

The following information is given : Current ratio : 2.5, Fixed assets turnover ratio : 2 times

Liquidity ratio : 1.5, Average debt collection period : 2 months Working capital :Rs. 300000 Stock turnover ratio : 6 times, Fixed assets : shareholders networth 1 : 1

(cost of sales / closing stock)

Gross profit ratio : 20%, Reserves : share capital 0.5 : 1

Draw up a balance sheet from the above information

Solution

1. current liabilities and current assets :

Net working capital = current assets – current liabilities

Current ratio = 2.5

Let current liabilities be x to current assets will be 2.5 x

Net working capital = 2.5 x – x

Rs. 300000 = 2.5x – x

Rs. 300000 = 1.5x

X = Rs.300000/1.5 = Rs.200000

When current liabilities are Rs.200000, current assets will be

200000 x 2.5 = Rs.500000

Liquid assets = 200000 x 1.5 = Rs.300000

2. Stock :

Stock = current assets – liquid assets

Stock = Rs.500000 – Rs.300000 = Rs.200000

3. Cost of sales

100

Stock turnover ratio = cost of sales / stock

6 = cost of sales / Rs.200000

Cost of sales = Rs.200000 x 6 = Rs.120000

4. Sales

Cost of sales + gross profit

Gross profit = Rs.1200000 x 6 / 80 = Rs..300000

Sales = Rs.1200000 + Rs.300000 = Rs.1500000

5. Fixed assets

Fixed assets turnover ratio = sales / fixed assets

2 = Rs.1500000 / fixed assets

Fixed assets = Rs.1500000 / 2 = Rs.750000

6. Debtors:

Average debt collection period = total debtors x no. of months / sales

2 = total debtors x 12 / 1500000

Total debtors = 1500000 x 2 / 12 = Rs.250000

7. Shareholders net worth

Fixed assets : shareholders net worth

1 : 1

Rs.750000 : Rs.750000

8. Share capital:

Reserves : share capital

0.5 : 1

Shareholders net worth = share capital + reserves

Rs.750000 = 1 + 0.5

Share capital = Rs.750000 x 1 / 1.5 = Rs.500000

Reserves = Rs.750000 – Rs.500000 = Rs.250000

9. Long term debts :

Long term debts = total assets – (shareholders net worth + current liabilities)

= Rs.1250000 – Rs.950000

Long term debts = Rs.300000

Note : sales have been used for fixed assets turnover ratio, cost of sales

could also be used here

Balance sheet

Liabilities Rs. Assets Rs.

Share capital 500000 fixed assets 750000

Reserves 250000 liquid assets 300000

Long term debts 300000 stock 200000

Current liabilities 200000 ……….

1250000 1250000

101

102

Practical Problems: 1. Pushpa enterprises present you the following income statement and request

you to calculate (i) Gross profit ratio (ii) Net profit ratio (iii) Operating ratio (iv)

Operating profit ratio (iv) Expenses ratio.

Income statement

Particulars

Sales Less: Sales Returns

Net sales Less: Cost of Goods sold

Gross profit

Add: Non operating income: Profit on sale of building

Income from investments

Less: Operating Expenses: Administration exp.

Selling expenses Distribution expen.

Non-operating

Expenses: Finance expenses

Loss on sale of plant Provision for Income tax

Rs.

8,60,000 60,000

Rs.

8,00,000 3,50,000

30,000

20,000

4,50,000

50,000

40,000

60,000 20,000

30,000

20,000 30,000

5,00,000

2,00,000

3,00,000

2. You are given the following information

Cash

Debtors Closing Stock

Bills payable Creditors Outstanding expenses

Taxes payable

Rs. 18,000

1,42,000 1,80,000

27,000 50,000 15,000

75,000 Calculate (a) Current ratio (b) Liquidity ratio (c) Absolute liquidity ratio.

3.Given below is the summarized balance sheet and profit and loss of s.s.mills

Ltd., as on 31.12.2010. you are required to calculate.

103

(1) current ratio (2) quick ratio (3) Fixed assets ratio

Debt equity ratio (5) proprietary ratio (6) stock turn over ratio (7) Fixed assets

turnover ratio (8) Return on capital employed (9) Debtors turnover ratio (10)

Creditors turnover ratio (11) Gross profit ratio (12) operating ratio (13) Net profit

ratio.

Balance sheet as on 31.12.2010

Liabilities Rs. Assets Rs.

Issued Capital

4,000 shares of Rs.10 each

Reserves

Creditors

Profit and loss Account

40,000

18,000

26,000

6,000

Land & building

Plant and Machinery

Stock

Debtors

Cash at Bank

30,000

16,000

29,600

14,200

6,200

96,000 96,000

Profit and Loss Account

Particulars Rs. Particulars Rs.

To Opening stock

To Purchase

To Direct expenses

To Gross profit

To administration expenses

To selling expenses

To Financial expenses

To Other non- operating

expenses

To Net profit

19,900

1,09,500

2,850

68,000

By Sales

By Closing stock

By Gross profit

By non – operating income

1,70,000

29,800

1,99,800 1,99,800

30,000

6,000

3,000

800

30,000

68,000

1,800

69,800 69,800

104

4. Following ratios are the related to the trading activities of National traders Ltd.,

Debtor’s velocity 3 months

Stock velocity 8 months

Creditors velocity 2 months

Gross profit ration 25 per cent

Gross profit for the ended 31st December,2009 amounts to Rs.4,00,00. Closing

Stock of the year is Rs.10,000 above the opening stock. Bills receivable amount to

Rs. 25,000 and Bills payable to Rs.10,000.

Find out (a) Sales (b) Sundry debtors (c) Closing Stock and (d) Sundry

creditors.

5. With the help of the following ratios regarding ABC Ltd., draw the balance

sheet of the company for the year 2009.

Current ratio 2.5

Liquidity ratio 1.5

Net working capital Rs. 3,00,000

Stock turnover ratio(cost of sales/ Closing stock) 6 times

Gross profit ratio 20%

Debt collection period 2 months

Fixed assets turnover ratio (on cost of sales) 2 times

Fixed assets to shareholders’ net worth 0.80

Reserve and Surplus to share capital 0.50

7.4 REVISION POINT

Ratio analysis is known as the relationship between two accounting figures

expressed mathematically. It help to make a qualitative judgement about the firm’s

financial performance.

Objectives of Ratio: financial forecasting , comparison, cost control,

communication, diagnose of the financial health of a firm, to know the overall

operating efficiency of the firm.

Difficulties in ratio Analysis – Nature of Ratio Analysis – Types of rario

analysis.—Solvency Ratio, Operating ratio, Turnover ratio, Capital gearing ration.

7.5 INTEXT QUESTION

1. What are the uses of ratio analysis?

2. Explain the various practical difficulties in using ratio analysis.

3. Explain the precautions in the ratio analysis.

4. Explain the nature of ratio analysis.

5. What are the objectives of ratio analysis?

6. Explain any three liquidity ratios and its importance.

7. Explain importance of return on capital employed ratio.

105

8. What are the uses of the profitability ratios?

7.6 SUMMARY

In recent times, ratio analysis, has emerged as key tool in analyzing the

financial statements. Accounting data are expressed in mathematical terms, which

carry vast data. This method not only helps the management in taking decisions

but also to the outsiders. The money lenders or the creditors or the investors may

use ratio analysis to evaluate the financial stability and earning power of the firm.

The ratio analysis should be followed with some precautions, since it has some

drawbacks like no proper basis for comparison, the situation may change from time

to time but this will not be considered in the ratio analysis, price level changes are

which also considered definitional differences of items which are used in ratio

analysis etc.,

According to the functions and nature of the accounting data, the ratios are

grouped into various sub titles. Important ratios are liquidity ratio, profitability

ratios, insolvency ratios, return on investment ratios on equity capital ratio.

Different ratios have different significances. According to the nature of the

financial information every ratio has its own unique nature and specific advantages

which are essential in evaluating the performance of the firm. The firm’s overall

performance are evaluated through every aspect.

7.7 TERMINAL EXERCISE

1. Higher debtors turnover ratio indicates

a. More cash sales (b) more credit sales (c) Efficient collection of

debts.

b. Expenses ratios are calculated

c. On the basis of expenses with net sales

d. On the basis of expenses with profit

e. On the basis of expenses with capital

f. On the basis of sales with capital

2. Which one is not included with shareholder funds

a. Reserves b. preference Capital c. Equity share capital

d. long term liability.

7.8 SUPPLEMENTARY MATERIALS

Indian journal of Accounting

Charted Accountant

7.9 ASSIGNMENTS

Apply those ratios into various accounting data, which are published in the

newspapers or magazines. Workout the exercises, from suggested Reading books.

106

7.10 SUGGESTED READINGS / REFERENCE BOOKS

Management Accounting ---- S.N.Maheswari

Management Accounting ---- R. S. N. Pillai and Bhavathi

7.11 LEARNING ACTIVITIES

Students may organize a group discussion and critically examine the use of

various ratios. They should be clear in what are the items to be included under the

particular title (eg) what are the items comes under net worth.

The ratio analysis does not cover all the transactions, the students may identify

such areas and suggest new guidelines which develop the reliability of the ratio

analysis.

7.12 KEYWORDS

Bench mark

Solvency

Industry average

Consolidated

Liquid ratio

107

LESSON 8

FUND FLOW ANALYSIS

8.1 INTRODUCTION

The movement of funds from one period plays a vital role in making decisions

on working capital. Hence a detailed study of Fund Flow analysis is essential to

identify the sources and application of the particular period

8.2 OBJECTIVES

The student can understand the meaning, concept of Fund Flow Analysis from

this. This lesson also explains the techniques of preparing the fund flow analysis.

8.3 CONTENT

8.3.1 Fund Flow analysis Meaning

8.3.2 Concept of fund flow analysis

8.3.3 Uses of fund flow analysis

8.3.4 Funds flow statement and income statement

8.3.5 Preparation of funds flow statement

8.3.6 Techniques of funds flow statement

8.3.1 FUND FLOW ANALYSIS - MEANING

The fund flow analysis is a method by which we study the net funds – flow

between two points of time. The points confirm to beginning and ending financial

statement dates for whether period of examination is relevant a quarter of a year.

‘A statement of sources and application of Funds is a technical device designed

to analyse the change in the financial conditions of a business enterprise between

two dates’.

Thus a funds flow analysis is a flexible device designed to disclose and

emphasize all significant changes and transactions within the current asset or

liability group. Fund flow analysis is a report on financial operations changes Flows

are moving the period. Here the term funds denote the working capital. Working

capital is often regarded as the difference of current assets and current liabilities.

Hence the term’ fund and working capital’. Both are synonymous. Various titles are

used for this statement such as statement of Sources and Applications of funds,

summary of Financial Operations; Changes in Financial position Statement; Funds

Received and Disbursed; Funds Generated and expended. Financial Expansion and

Replacement, Money provided and its Disposition Statement, etc. It is really difficult

to find short title for any statement which conveys much to the students as to the

contents and functions. The title of a funds flow statements can be modified from

time to time in order to emphasis a particular event.

Funds refers to the net effect of all changes in sources and uses in cash flows.

It may mean change in cash only or change in working capital only. Funds may

mean change in financial resources arising from changes in working capital items

108

and from financing and investing activities of the enterprise, which may involve

only non-current items.

The term “Fund” generally refers to cash, and equivalents or to working capital.

There are two concepts of working capital-gross concept and net concept. Gross

working capital refers to firms investment incurrent assets while the term net

working capital means excess of current assets over current liabilities.

8.3.2 CONCEPT OF FUND FLOW ANALYSIS

The fund flow arise when the net effect of a transaction is to increase or

decrease the amount of working capital. Normally a firm will have some

transactions that will change net working capital and some that will cause no

change in net working capital. Transactions which change net working capital

include most of the items of the profit and loss account and those business events

which simultaneously affect both current and noncurrent balance sheet items.

For (eg) if a company issues ordinary shares for cash. Two accounts are

involved in this case – the cash account, which is a current (assets) account and

share capital account, which is not current assets account. Working capital gets

increase. Similarly a company purchase machinery for cash, the cash account

(current assets) and machinery account (fixed assets) are affected. This has the

effect of decreasing working capital.

Some transactions do not change working capital. For (eg) if a company receive

cash from its debtors. It represents increase of cash that is one current account

(cash) increased and another current assets (debtors) decreased. So there is no

change in the amount of working capital although the composition of working

capital will change.

8.3.3 USES OF FUNDS FLOW ANALYSIS

It is useful tool in the financial manager’s analytical kit. The basic purpose of

this statement is to indicate where funds came from and where they were used

during the given period.

1. It shows the past performance of the firm and future possible expansion

of the firm. He can detect imbalances in the uses of funds and

undertake appropriate actions.

2. It helps to evaluate the firm’s financing. An analysis of the major

sources of funds in the past reveals what positions of the firm growth

was financed internally and what position externally.

3. It clearly defines the past flow of funds and gives insight into the

evaluation of the present situation. The financial manager of the

company uses it to spot-light the causes of present financial strain.

4. It provides certain useful information to banker, creditors and

governments etc., for which they do not require to approach the top

management specially.

109

5. An analysis of fund statement for the future is extremely valuable in

long term financing. It tells the firms total prospective need for funds,

the expected timing of these needs and their nature.

6. It shows the exact liquidity position of the firm. It can be verified

through fund flow statement.

7. It enriches the planning function of the firm.

8. It gives clear picture of funds, the shareholders are satisfied and

motivated. It helps to distribute possible dividend.

9. It helps to allocate the resources, ie., scarce resources for meeting the

productive requirement of the business.

10. It is a test of effective use of working capital by the management during

a particular period.

11. Fund flow analysis is also helpful in preparing the budgets.

8.3.4 FUNDS FLOW STATEMENT AND INCOME STATEMENT

1. A funds Flow Statement deals with the financial resources required for

running the business activities. It explains how were the funds obtained

and how were they used. Where as an Income Statement disclose the

results of the business activities, i.e., how much has been earned and how

it has been spent.

2. A funds Flow Statement matches the “Funds raised” and “ funds applied”

during a particular period. The sources and applications of funds may be of

capital as well as of revenue nature. An Income Statement matches the

income of a period with the expenditure of that period which are both of a

revenue nature. For example, where shares are issued for cash, it becomes

a source of funds while preparing a funds flow statement but it is not an

item of income for an income statement.

3. Sources of funds are many besides operations such as share capital

debentures, sale of fixed assets, etc. An Income Statement which discloses

the results of operations cannot even accurately tell about the funds from

operations alone because of non fund items (such as depreciation, writing

off of fictitious assets, etc.,) being include therein.

4. Thus both Income Statement and Funds Flow Statement have different

functions to perform. Modern management needs both. One cannot be a

substitution for the other rather they are complementary to each other.

8.3.5 PREPARATION OF FUNDS FLOW STATEMENT

In order to prepare a Funds Flow Statement, it is necessary to find out the

“sources’ and “Application” of funds.

Sources of Funds

The sources of funds can be both internal as well as external.

110

Internal Sources

Funds from operations, is the only internal sources of funds. However,

following adjustments will be required in the figure of Net Profit for finding out real

funds from operations.

Add the following items as they do not result in outflow of funds

1. Depreciation of fixed assets.

2. Preliminary expenses or goodwill, etc., written off.

3. Contribution to debenture redemption fund, transfer to general reserve,

etc., if they have been deducted before arriving at the figure of net profit

4. Provision for taxation and proposed dividend are usually taken as

appropriations of profits only and not current liabilities for the purposes

of Funds Flow Statement. This is being discussed in detail later. Tax or

dividends actually paid are taken as applications of funds. Similarly,

interim dividend paid is shown as an application of funds. All these

items will be added back to net profit, if already deducted, to find funds

operations.

5. Loss on sale of fixed assets.

Deduct the following items as they do not increase funds:

1. 1.profit on sale of fixed assets since the full sale proceeds are taken as a

separate source of funds and inclusion here will result in duplication.

2. profit on revaluation of fixed assets.

3. non-operating income such as dividend received or accrued dividend

refund of income tax, rent received or accrued rent. These items

increase funds but they are non-operating incomes. They will be shown

under separate heads as “sources of founds” in the Funds Flow

Statement.

In case the profit and loss account shows “Net Loss” this should be taken as an

item which decreased the funds.

External Sources

These sources include:

i. Funds from long term loans

Long term loans such as debentures, borrowing from financial institutions will

increase the working capital and, therefore, there will be flow of funds. However, it

the debentures have been issued in consideration of some fixed assets, there will be

no flow of funds.

ii. Sale of fixed assets

sale of land, building, long term investments will result in generation of funds.

111

iii. Funds from increase in share capital

Issue of shares for each or for any other current assets results in increase in

working capital and hence there will be a flow of funds.

Application of funds

The uses to which funds are put are called ‘application of funds’. Following

are some of the purposes for which funds may be used:

i. Purchase of fixed assets

Purchases of fixed assets such as land, building, plant, machinery, long

term investments, etc., results in decrease of current assets without any

decrease in current liabilities. Hence, there will be a flow of funds. But

in case shares or debentures are issued for acquisition of fixed assets,

there will be no flow of funds.

ii. Payment of dividend

Payment of dividends results in decrease of a fixed liability and,

therefore, it affects funds. Generally, recommendation of directors

regarding declaration of dividend (ie., proposed dividends) is simply,

taken as an appropriation of profits and not as an item affecting the

working capital. This has been explained in detail

iii. Payment of fixed liabilities

Payment of a long term liability, such as redemption of debentures or

redemption of redeemable preference shares, results in reduction of

working capital and hence it is taken as an application of funds.

iv. Payment of tax liability

Provision for taxation is generally taken as an appropriation of profits

and not as an application of funds. But if the tax has been paid, it will

be taken as an application of funds.

8.3.6 TECHNIQUE FOR PREPARING A FUNDS FLOW STATEMENT

A fund flow statement depicts change in working capital. It will, therefore, be

better for the students to prepare first a Schedule of Changes in working capital

before preparing a Funds Flow Statement.

Schedule of Changes in Working Capital

The schedule of changes in working capital can be prepared by comparing the

current assets and the current liabilities of two periods. It may be in the following

form.

112

Schedule of Changes in Working Capital

Items As on .... As on... Changes

increase decrease Current Assets (add) Cash balance

Bank balance Marketable securities Accounts receivable

Stock in trade Pre paid Expenses

Less Current Liabilities Bank overdraft Outstanding expenses

Accounts payable

Net increase/ Decrease in working capital

Rules for preparing the schedule

1. Increase in a current assets, results in crease (+) in “working capital”

2. Decrease in a current asset, results in decrease (-) in “working capital”

3. Increase in a current liability, results in decrease (-) in “working capital”

4. Decrease in a current liability, result in increase (+) in “working capital”

Funds Flow Statement

While preparing a funds flow statement, current assets and current liabilities

are to be ignored. Attention is to be given to change in Fixed Assets and Fixed

Liabilities. The statement may be prepared in the following form.

Sources of funds:

Issue of shares .............

Issue of debentures .............

Long term borrowings .............

Sale of fixed assets .............

Operating profit .............

If net decrease in working ............

_______________

Total Sources ............

_______________

113

Application of funds

Redemption of redeemable

Preference shares .....................

Redemption of debentures ................

Purchase of fixed assets ................

Operating loss ................

Payment of dividends, tax, etc. .................

If net increase in working

Capital ................

_________________

Total Uses ..................

_________________

Practical problems:

1. The balance sheets of Sun and Moon Ltd. For the year ended 31st December

2008 and 2009 are as follows:

Balance Sheet

Liabilities 31.12.2008 31.12.2009 Assets 31.12.2008 31.12.2009

Share capital 80,000 1,20,000 Freehold

premises

55,400 1,13,200

Share Premium 8,000 12,000 Plant & Machinery

35,600 51,300

General reserve 6,000 9,000 Furniture &

Fixtures

2,400 1,500

Profit and Loss A/c

19,500 20,800 Stock 22,100 26,000

5% Debentures 26,000 Debtors 36,500 39,100

Creditors 33,500 36,400 Bank 4,800 4,000

Income tax

provision

9,800 10,900

1,56,800 2,35,100 1,56,800 2,35,100 Depreciation written off during the year 2009 was as under.

Plant & Machinery Rs.12,800

Furniture & Fittings Rs. 400

Prepare a statement of sources and uses of funds.

Solution:

114

Schedule of changes in working capital

particulars 2008 2009 Increase Decrease

Current Assets:

Stock

Debtors

Bank balance

Less: Current Liabilities:

Creditors

Income tax provision

Working Capital

Increase in working

capital

22,100

36,500

4,800

26,000

39,100

4,000

3,900

2,600

800

2,900

1,100

63,400

33,500

9,800

69,100

36,400

10,900

43,300 47,300

20,100

1,700

21,800

6,500

4,800

1,700

21,800 21,800 6,500 6,500

Statement of sources and uses of funds

Sources Rs. Uses Rs.

Issue of shares

Share premium

Issue of debentures

Sale of furniture and

fixtures

Funds from operations

40,000

4,000

26,000

500

17,500

Purchase of freehold

premises

Purchase of plant and

machinery

Increase in working capital

57,800

28,500

1,700

88,000 88,000

115

Plant and Machinery Account

Rs. Rs.

To balance b/d

To cash (purchase)

35,600

28,500

By adjusted profit and loss

a/c (depreciation)

By balance c/d

12,800

51,300

61,400 61,400

Furniture and Fitting Account

Rs. Rs.

To balance b/d

2,400

By adjusted profit and loss

a/c (depreciation)

By cash (sale)

By balance c/d

400

500

1,500

2,400 2,400

General Reserve Account

Rs. Rs.

To balance c/d

9,000

By balance b/d

By adjusted profit and loss

a/c

6,000

3,000

9,000 9,000

Adjusted Profit & loss account

Rs. Rs.

To plant & machinery

(depreciation)

To furniture and fixtures

(depre)

To General Reserve

To balance c/d

12,800

400

3,000

20,800

By balance b/d

By Funds from operations

(?)

19,500

17,500

37,000 37,000

116

2. Balance sheets of M/s Black and White as on 1.1.2009 and 31.12.2009 were

as follows.

Balance Sheet

Liabilities 1.1.2009 31.12.2009 Assets 1.1.2009 31.12.2009

Creditors 40,000 44,000 Cash 10,000 7,000

Mrs. White’s loan 25,000 ---

-

Debtors 30,000 50,000

Loan from

P.N.Bank

40,000 50,000 Stock 35,000 25,000

Capital 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

During the year a machine costing Rs. 10,000 (accumulated depreciation Rs.

3,000) was sold for Rs.5,000. The provision for depreciation against machinery as

on 1.1.2009 was Rs.25,000 and on 31.12.2009 Rs.40,000. Net profit for the year

2009 amounted to Rs.45,000. You are requested to prepare funds flow statement.

Solution:

Schedule of changes in working capital

particulars 2008 2009 Increase Decrease

Current Assets:

Cash

Debtors

Stock

Less: Current Liabilities:

Creditors

Working Capital

Increase in working

capital

10,000

30,000

35,000

7,000

50,000

25,000

20,000

3,000

-----

10,000

4,000

75,000

40,000

82,000

44,000

35,000

3,000

38,000 20,000 17,000

3,000

38,000 38,000 20,000 20,000

117

Funds Flow Statement

Sources Rs. Uses Rs.

Issue of shares

Loan from P.N.Bank

Funds from operations

5,000

10,000

65,000

Purchase land

Purchase building

Drawings

Repayment of Mrs. White’s loan

Increase in working capital

10,000

25,000

17,000

25,000

3,000

80,000 80,000

Plant and Machinery Account

Rs. Rs.

To balance b/d

1,05,000 By Cash (sale)

By provision for

Depreciation a/c

By adjusted profit and

loss a/c (Loss)

By balance c/d

5,000

3,000

2,000

95,000

1,05,000 1,05,000

Provision for Depreciation on Mechinery

Rs. Rs.

To Machinery

(depreciation of machinery

sold)

To balance b/d

3,000

40,000

By balance b/d

By adjusted profit and loss

a/c (depreciation)

25,000

18,000

43,000 43,000

Capital Account

Rs. Rs.

To Drawings

To balance c/d

17,000

1,53,000

By balance b/d By Net profit

1,25,000 45,000

1,70,000 1,70,000

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Adjusted Profit & loss account

Rs. Rs.

To Machinery (loss on sale)

To provision for depreciation To balance c/d

2,000

18,000 45,000

By balance b/d By Funds from operations

(?)

65,000

65,000 65,000

Exercise: 1.From the summarized balance sheets of kissan industries Ltd., prepare a

Fund flow statement for the year ended 31st March 2008

Balance Sheet

Liabilities 31.3.2007 31.3.2008 31.3.2007 31.3.2008

Share capital 10,000 10,000 Good will 1,200 1,200

P & L account 1,600 1,300 Land 4,000 3,600

General reserve 1,400 1,300 Building 3,700 3,600

Creditors 800 600 Investments 1,000 1,100

Outstanding expenses

120 180 Bills receivable 2,000 2,300

Provision for taxation

1,600 1,800 Bank 700 1,500

Provision for bad debts

80 100 Inventories 3,000 2,400

15,600 15,700 15,600 15,700 Additional Information:

1. A piece of land has been sold for Rs. 400

2. depreciation of Rs. 700 has been charged on building.

3. provision for taxation Rs.2,000 has been made during the year.

2. Bata Ltd. Supplies you the following balance sheets on 31 st December

2007 and 2008

Balance Sheet

Liabilities 2007 2008 2007 2008

Share capital 70,000 74,000 Bank balance 9,000 7,800

Bonds 12,000 6,000 Accounts receivable

14,900 17,700

Accounts payable 10,360 11,840 Inventories 49,200 42,700

Provision for

doubtful debts

700 800 Land 20,000 30,000

Reserve and Surplus 10,040 10,560 Good will 10,000 5,000

1,03,100 1,03,200 1,03,100 1,03,200

119

Following additional information has also been supplied to you:

1. Dividend amounting to Rs. 3,500 was paid during the year.

2. Land was purchased for Rs. 10,000

3. Rs. 5,000 was written off on goodwill during the year.

4. Bonds of Rs. 6,000 were paid during the course of the year. You are required to prepare a statement of sources and uses of funds.

8.4 REVISION POINT

Fund flow analysis is a detailed study of how the funds moved from one point

of time to another point of time. Net flow of funds between two points of time.

Concept of Fund Flow Analysis.

The fund flow arise when the net effect of a transaction is to increase or decrease the amount of working capital.

Uses of the Funds Flow Analysis

It shows the past performance of the firm. It helps to know the major sources of

funds. This statement help in planning the working capital requirements.

8.5 INTEXT QUESTIONS

1. What are the uses of funds flow analysis?

2. Differentiate the term fund flow statement and income statement.

3. Explain any three internal sources and external sources of funds.

4. Is there any difference between funds and working capital – suggest your views.

8.6 SUMMARY

In this lesson, the nature of the fund flow is clearly discussed. The

meaning and definition of the fund flow is given.

Fund flow is a statement of sources and applications of funds. It is a

techniques device designed to analyse the change in the financial

conditions of a business enterprise between two dates. If refers to the

net effect of all changes in sources and uses in cash flow.

Funds flow analysis is major tool in financial analysis. It shows the past

performance of the firm. It help to evaluate the firm’s financing it shows

the exact liquidity of position of the firm. The techniques of preparation

of fund flow statement is also explained in this chapter.

8.7 TERMINAL EXERCISES

1. Issue of shares relate with

a. Application of funds b. Funds from operation

c. Sources of funds

2. Increase in current assets relate with

a. Decrease in working Capital b. Increase in working capital

c. Increase in the cash level

120

3. Operating loss relates with

a. Application of funds b. Sources of funds c. Non-current assets

8.8 SUPPLEMENTARY MATERIALS

https://ocw.mit.edu

http://kesdee.com/

http://simplestudies.com/

http://repository.um.edu.my/

http://www.cimaglobal.com

8.9 ASSIGNMENT

Students may visit the organisations and consult the financial experts

regarding the uses and methods of preparing the fund flow analysis, collect the

reports of fund flow analysis from various journal and unpublished reports help the

students to get some practical knowledge. Write a note on practical uses of fund

flow analysis.

8.10 SUGGESTED READING / REFERENCE BOOKS

1. Management Accounting ---------- S.N. Maheswari

2. Management Accounting ---------- R.S.N. Pillai and Bhavathi

3. Financial management ---------- Khan and Jain

8.11 LEARNING ACTIVITIES

Students may do some problem solving sums with regard to the fund flow

analysis and get practical knowledge. Students may also meet the financial analysis experts and get through knowledge about fund flow analysis.

8.12 KEY WORDS

Sport light

Scarce resources

Non-operating income

Operating income

Funds from operation

Operational profit

Operating loss.

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LESSON-9

CASH FLOW ANALYSIS

9.1 INTRODUCTION

The movement of cash level in organisation plays a significant role in

determining the working capital. The cash level may increase or decrease during

the particular period due to various reasons. For (eg) if assets are purchased, the

cash level will be decreased. Maintaining proper level of cash is essential to meet

the day to day expenses and maintaining the liquidity of the firm.

9.2 OBJECTIVES

The student can understand the meaning of the cash flow analysis. This lesson

also explains the nature of the cash flow analysis. This lesson also gives guidelines

to prepare the cash flow statement.

9.3 CONTENT

9.3.1 Meaning

9.3.2 Cash flow and fund flow

9.3.3 Utility of cash flow analysis

9.3.4 Preparation of cash flow analysis

9.3.5 Format of a cash flow statement

9.3.1 MEANING

A cash flow statement is a statement depicting change in cash position from

one period to another. For example if the cash balance of a business is shown by its

balance sheet on 31 December 2012 is Rs. 20,000/- while the cash balance as per

its balance sheet on 31 December 2013 is Rs. 30,000/- there has been in flow of

cash Rs. 10,000 in the year 2013 as compared to the year 2012.

The cash flow statement explains the reasons for such inflows or outfl ows of

cash as it also helps management in making plans for the immediate future. A

projected cash flow statement will help the management in ascertaining how much

cash will be available to meet obligations to trade creditors, to pay back loans and

to pay dividend to the share holders.

The cash flow have important role in the business’ firm’s there is constant

inflow and outflow of cash what blood is to human body, cash is to business

enterprises, so a major responsibility of financial management of firm is to maintain

an adequate balance of cash. In many respects, the essence of finance function is

found in the provision of cash in sufficient amount and in proper time to meet the

needs of business.

9.3.2 CASH FLOW VS FUND FLOW

CASH FLOW FUND FLOW

1 It is concerned only with the change

in cash position

It is concerned with changes in

working capital

122

2 It is merely record of cash receipts

and disbursements

It is not only the study of cash

but also the current assets which

are converted into cash.

3 It is a more useful tool to the

management for financial analysis in

short period ie to estimate the cash

position to meet the payments in

near future.

Fund flow analysis is useful to

estimate the funds availability to

meet long term commitments.

4 Cash is the part of the working

capital. Therefore an improvement in

cash position result in improvement

in the fund position.

Sound fund position does not

necessarily mean a sound cash

position

5 There is some technical difference

between cash flow and fund flow i.e.

Decrease in current liability decrease

cash level in cash flow analysis, since

cash paid out

Decrease in the current liability

leads to increase in the working

capital in fund flow analysis.

6 Changes in working capital level is

not considered

Changes in working capital level

is treated as an important source

for fund variations

7 It is useful for short run planning It is useful for medium term as

well as long – term planning

9.3.3 UTILITY OF CASH FLOW ANALYSIS

A cash flow statement is useful for short term planning. A business enterprise

needs sufficient cash to meet its various obligations in the near future, such as

payment for purchase of fixed assets, payment of debts maturing in the near

future, expenses of the business, etc. A historical analysis of the different sources

and applications for the immediate future. It may then plan out for investment of

surplus or meeting the deficit, if any. Thus cash flow analysis is an important

financial tool for the management. Its chief advantages are as follows.

1. Helps in Efficient Cash Management:

Cash flow analysis helps in evaluating financial policies and cash position.

Cash is the basis for all operation and hence a projected cash flow

statement will enable the management to plan and coordinate the financial

operations properly, the management can know how much cash is needed,

from which source it will be derived, how much can be generated internally

and how much would be obtained from outside.

2. Helps in Internal Financial Management:

123

Cash flow analysis provides information about funds which will be available

from operations. This will help the management in determining policies

regarding internal financial management, e.g. possibility of repayment of

long term debts, dividend policies, planning, replacement of plant and

machinery, etc

3. Disclose the Movement Of Cash:

Cash flow statement discloses the complete story of cash management. The

increase or decrease of cash and the reason therefore can be known. It

discloses the reasons for low cash balance in spite of low profits, however,

comparison of original forecast with the actual results highlights the trends

of movements of cash which may otherwise go undetected.

4. Disclose Success or Failure Of Cash Planning:

The extent of success or failure of cash planning can be known by

comparing the projected cash flow statement with the actual cash flow

statement and necessary remedial measures can be taken.

5. Other Utilities:

a. To know the liquidity position of the firm.

b. To know the causes of changes in the firm’s working capital or cash

position.

c. To know the amount of sales proceeds out of fixed assets.

9.3.4 PREPARATION OF CASH FLOW ANALYSIS

Cash flow statement is a statement which shows the inflows and outflow of

cash (or cash equivalent like bank balance, temporary investments) in a firm during

a particular period, usually one year. It indicates the cause for changes in cash

between two balance sheet dates.

The securities Exchange Board of India amended Clause 32 of the listing

agreement, in June 1995. It requires every listed company to give a cash flow

statement in the prescribed format along with the profit and loss account and

balance sheet.

Accounting Standard 3,

The institute of Chartered Accountants of India had issued Accounting

Standards 3(AS3): cash flow statement. As per the revised AS3, cash flows are

classified and reported under three heads

a. Cash Flows from Operating Activities

b. Cash Flows from Investing Activities

c. Cash Flows from Financing Activities

124

1. Cash Flows from Operating Activities:

It means net cash flows generated from the operations of the business.

2. Cash Flows from Investing Activities.

It includes cash flows from the sale or purchase of fixed assets and also cash

generated by way of dividend or interest

3. Cash Flows from Financing Activities:

These are cash flows caused by issue of shares and other securities, raising of

long term loans, repayment of dividend etc. The cash flow statement shows the net

cash inflow or outflow from each group of activities. It shows the reasons for

changes in cash balance during the period.

The revised AS3 is mandatory for all listed companies and other firms with an

annual turnover of more than Rs. 50 crores.

9.3.5 FORMAT OF CASH FLOW STATEMENT AS PER AS3:

A cash flow statement can be prepared in the following form:

Cash Flow Statement for the year ending as on ...............

A. Rs. Rs.

A. Cash Flow from Operating Activities:

Net profit before tax and extraordinary items

Adjustments for:

Depreciation

Gain / Loss on sale of fixed assets

Foreign exchange

Miscellaneous expenditure written off

Investment income

Interest

Dividend

Operating profit before working capital changes:

Adjustments for:

Trade and other receivables

Inventories

Trade payables

Cash generated from operations

Interest paid

Direct taxes paid

Cash flow before extraordinary items

Net Cash from operating Activities

125

B. Cash Flow from Investing Activities:

Purchase of fixed assets

Sale of fixed assets

Purchase of investments

Sale of investments

Interest received

Dividend received

Net Cash from / used in investing activities

C. Cash Flow from Financing Activities

Proceeds from issue of share capital

Proceeds from long – term borrowings/banks

Payment of long-term borrowing

Dividend paid

Net cash from / used in financing activities

Net increase / decrease in cash and cash equivalents

(A+B+C)

Cash and cash equivalents as at(opening balance)

Cash and cash equivalents as at(opening balance)

Practical problems:

From the balance sheet as on 31st March 2007 and 31st March 2008,prepare a

cash flow statement.

Balance Sheet

Liabilities 31.3.2007 31.3.2008 31.3.2007 31.3.2008

Share capital 1,00,000 1,50,000 Fixed assets 1,00,000 1,50,000

P & L account 80,000 1,20,000 Good will 50,000 40,000

10% debentures 50,000 60,000 Stock 30,000 70,000

Creditors 30,000 40,000 Debtors 50,000 90,000

Outstanding

expenses

10,000 15,000 Bills receivable 30,000 20,000

Bank 10,000 15,0000

2,70,000 3,85,000 2,70,000 3,85,000

Cash Flow Statement

As – 3 Revised Method

126

A. Cash Flows from

Operating Activities:

Net profit before tax 40,000

Add: Goodwill written off(W.N.2) 10,000

Cash operating profit 50,000

Working Capital Charges: increase in creditors (inflow)

10,000

Increase in outstanding expenses

(inflow)

5,000

Decrease in bills Receivable (inflow) 10,000

(5,000)

(50,000)

60,000

Increase in stock (outflow) (40,000)

Increase in debtors (outflow) (40,000)

Net cash used in operating activities

(50,000)

B. Cash Flows from Investing

Activities:

Purchase of fixed assets (outflow) (W.N.1)

Net Cash used in investing activities

C. Cash Flows from Financing

Activities

Issue of shares (inflow)(W.N.3) Issue of debentures (inflow) (W.N.4)

Net cash from financing Activities Net increase in cash & Cash

equivalents Cash and cash equivalents at the

beginning

50,000 10,000

5,000

10,000

Cash and Cash equivalents at the end 15,000

Working Notes: Opening balance Closing balance

1. Fixed assets 1,00,000 1,50,000

Purchase of fixed assets 50,000 outflow – investment activity

2. Good will 50,000 40,000

Goodwill written off Rs.10,000. It is added back to net profit to find out cash from

operations.

127

3. Share capital 1,00,000 1,50,000

Issues of shares Rs. 50,000. Inflow – financing activity

4. 10% Debentures 50,000 60,000

Issue of debentures Rs. 10,000 – inflow – financing activity.

1. The following are the summarized balance sheets of Anand & Bala as on

1.1.2008 and 31.12.2008 .

Balance Sheet

Liabilities 1.1.2008 31.12.2008 1.1.2008 31.12.2008

Share capital 1,25,000 1,53,000 Fixed assets 1,00,000 90,000

Loan from Anand 20,000 Land 40,000 50,000

Loan from Bank 40,000 50,000 Stock 35,000 30,000

Creditors 40,000 44,000 Debtors 30,000 50,000

Provision for

depreciation on machinery

25,000 40,000 Building 35,000 60,000

Bank 10,000 7,000

2,50,000 2,87,000 2,50,000 2,87,000 Machinery costing Rs. 10,000 was sold without any loss during the year. Net

profit for the year 2008 amounted Rs.50,000 prepare Cash Flow Statement.

Cash Flow Statement

As – 3 Revised Method

B. Cash Flows from Operating

Activities:

Net profit before tax Add: provision for depreciation during

the year(W.N.2)

50,000 15,000

Cash operating profit 65,000 4,000 5,000

Working Capital Charges: increase in creditors (inflow)

Increase in Stock (inflow)

Increase in debtors (outflow) (20,000)

54,000

Net cash used in operating activities

128

B. Cash Flows from Investing

Activities:

Sale of machineary (inflow)(W.N.1) Purchase of land (outflow)

Purchase of building (outflow)

Net Cash used in investing activities

10,000

(10,000) (25,000)

(25,000)

(32,000)

C. Cash Flows from Financing

Activities

Loan from bank (inflow)

Repayment of Mrs. Anand’s loan (outflow)

Drawings (outflow) (W.N.3)

Net cash from financing Activities

Net increase in cash & Cash equivalents Cash and cash equivalents at the

beginning

10,000

(20,000) (22,000)

(3,000)

10,000

Cash and Cash equivalents at the end 7,000

Working Notes: Opening balance Closing balance

1. Machinery at cost Rs. 1,00,000 Rs. 90,000

Sale of machinery Rs.10,000 – inflow – Investment activity.

2. Provision for depreciation Rs.25,000 Rs.40,000

Provision made during the year Rs.15,000. The amount is added back to net profit

to find out cash flow from operation.

3. Capital Account

To Drawings (?)

To balance (c/d)

Rs.

22,000

1,53,000

By balance b/d

By Net profit

Rs.

1,25,000

50,000

1,75,000 1,75,000

Drawings Rs. 22,000 – outflow – financing activity

4. Loan from bank Rs. 40,000 Rs.50,000

Loan from bank Rs.10,000 – inflow – financing activity

5. Loan from the Mrs. Anand Rs.20,000 ------

Repayment of the Mrs Anand’s loan Rs.20,000 outflow – financing activity.

129

Exercise:

1. The comparative balance sheets of Mr. White for the last two years were as

follows.

Liabilities 2007 2008 Assets 2007 2008

Loan from wife --- 20,000 Cash 11,000 15,000

Bills payable 12,000 8,000 Debtors 40,000 35,000

Creditors 25,000 52,000 Stock 25,000 30,000

Loan from bank 43,000 60,000 Machinery 20,000 14,000

Capital 66,000 34,000 Land & buildings 50,000 80,000

1,46,000 1,74,000 1,46,000 1,74,000 Additional information:

1. Net loss for the year 2008 amounted to Rs.13,000

2. During the year a machine costing Rs.5,000(accumulated depreciation Rs.2,000)

was sold for Rs.2,500. The provision for depreciation against machinery as on

31.12.2007 was Rs.6,000 and on 31.12.2008 Rs.7,000.

From the above information prepare a cash flow statement.

2. The comparative balance sheets of Royal Ltd for the last two years were as

follows.

Liabilities 2007 2008 Assets 2007 2008

Share Capital 1,00,000 1,60,000 Fixed assets @ cost 1,52,000 2,00,000

Retained earnings 70,250 85,300 Inventory 93,400 89,200

Accumulated

depreciation

60,000

40,000 Debtors 30,800 21,100

12% Debentures 50,000 -------- Prepaid expenses 3,950 3,000

Creditors 28,000 48,000 Bank 28,100 20,000

3,08,250 3,33,300 3,08,250 3,33,300

Additional Information:

1. Net profit during the year was Rs. 27,750

2. Depreciation charged Rs. 10,000

3. Cash dividend declared during the year Rs.12,000

4. An addition to building was made during the year at a cost of Rs.78,000: a

fully depreciated equipment costing Rs. 30,000 was discarded and no salvage value

was realised.

5. Prepare a cash flow statement.

9.4 REVISION POINTS

The cash flow statement explain the reasons for the inflows or outflows of

cash. It helps the management in taking decision with regarded to working capital

requirements. A major responsibility of the financial management of a firm is to

maintain a adequate balance of cash.

130

Cash Flow and Fund Flow

Cash flow is concerned only with the change in cash position. Fund flow is

concerned with changes in working capital. Cash flow is useful for short-run

planning. Fund flow is useful for medium and long terms planning.

Fund flow is useful for medium and long term planning but cash flow is merely

record of cash receipts and disbursements.

9.5 INTEXT QUESTIONS

1. What do you mean by cash flow? Explain its importance in managerial

decision making?

2. Explain the difference between cash flow analysis and fund flow analysis.

3. Explain the various sources for cash flow.

4. Define the term cash flow.

5. How would you determine the efficiency of cash management?

9.6 SUMMARY

Cash flow statement is a statement depicting change in the cash position. Cash

flow statement explains the reasons for changes in the cash level. There are lot of

difference between cash flow analysis and fund flow analysis. The cash flow

statement only depicts the cash level changes. The fund flow statement is

concerned with the level of changes in working capital i.e., currents assets. The

cash flow statement has more managerial uses i.e., efficient cash management and

evaluate the cash planning.

9.7 TERMINAL EXERCISES

1. Loss on account of operations will be

a. Result in inflow of cash

b. Result in outflow of cash

c. Result in no change in cash

2. Gains from sale of fixed assets will be

a. Add with the current year net profit

b. Added with the previous year net profit

c. Deducted from the current year net profit

3. Decrease in current assets relate with

a. Increase in cash level

b. Decrease in cash level

c. No change in cash level

131

9.8 SUPPLEMENTARY MATERIALS

http://kesdee.com/

http://simplestudies.com/

http://repository.um.edu.my/

9.9 ASSIGNMENTS

Do some home works with regard to cash flow statement from the suggested

books. Arrange group discussion among the students and identify the items which

impact the cash flow.

9.10 SUGGESTED READINGS / REFERENCE BOOKS

Principle of management Accounting--Man Mohan and S.N. Goyal

Management Accounting – S.N. Mahewsari

Accounting for Management ---- Bhattacharya & john

9.11 LEARNING ACTIVITIES

Read various journals and published, unpublished research report. Do more

home work on cash flow statements from the above mentioned supplementary

materials. Students may organise a group discussion with regard to the latest

development in cash flow analysis.

9.12 KEY WORDS

Obligations --- responsibility to assign

Projected cash flow – Estimated cash flow

Goodwill ---- Reputation gained from the public or shortage of assets in

the balance sheet assets side named as goodwill.

Preliminary expenses --- Expenses connected with the promotion of a

new firm (eg) Registration expenses.

132

LESSON -10

WORKING CAPITAL MANAGEMENT

10.1 INTRODUCTION

Proper management of working capital is very important, for the success of .an

'enterprise. It aims at protecting the purchasing power of assets and maximi zing

the return on investment. Constant management is required to maintain appropriate

levels in the various working capital components. Sales expansion, dividend

declaration, plant expansion, new product line, increased salaries and wages,

rising price levels etc., put added strain on working capital maintenance. Failure

of business is undoubtedly due to poor management and absence of a

management skill. Shortage of working capital, so often advanced as the main

cause for failure of concerns, is nothing but the clearest evidence of

mismanagement which is so common.

It has been found that the major portion of a financial manager's time is

utilized in the management of working capital. Current assets account for a very

large portion of the total investment of a firm. In some of the industrial current

assets on an average represent over three-fifth of-the total assets. In the case of

trading concerns they account for about 80 per cent, A firm may, sometimes, be able

to reduce the investment in fixed assets by renting or leasing plant and machinery.

But it cannot avoid Investment in cash, accounts receivable and inventory.. The

management of working capital also helps the management in evaluating various

existing or proposed financial constraints and financial offerings. All these factors

clearly indicate the importance of working capital management in a firm.

10.2 OBJECTIVES

After reading this lesson you should be able to:

Understand the concept of working capital

Classify the different types of working capital

Recognize the element of working capital

Assess the requirements of working capital

Identify the strength and weakness 'of inadequate or excess working

capital..

10.3 CONTENT

10.3.1 Concept of Working Capital

10.3.2 Classification of Working Capita!

10.3.3 Elements of Working Capital

10.3.4 Assessment of Working Capital Requirements

10.3.5 Problems of Inadequacy of Working Capital

10.3.6 Reasons for inadequacy of Working Capital

133

10.3.7 Excessive Working Capital

10.3.8 Principles of Working Capital

10.3.9 Sources of Working Capital

10.3.1 CONCEPTS OF WORKING CAPITAL

There are two concepts regarding the meaning of working Capital that is Net

Working Capital and Gross Working capital. According to one school of thought

(supported by distinguished authorities like Lincoin, Dorisl Stevens and Saliers)

Working Capital is the excess of current assets over current liabilities, as

designated in the following equation:

Working Capital = Current Assets — Current Liabilities

According to the other School of thought (supported by authorities like Mead

Baker, Mallot and Field), Working Capital represents only the current (capital)

assets. There is basis for both these contentions. To understand them, correct

conception of current assets and liabilities is essential. Current Assets are those

assets that in the ordinary course of business can be or will be turned into cash

within a brief period -(not exceeding one year, normally) without undergoing

diminution of value and without disrupting the organisation. Examples of current

assets are given below: (i)Cash in hand and in bank; (ii) Accounts receivable from

customers (less reserve); (iii) Promissory Notes, and Bills receivable from

customers (less reserve); (iv)Inventories comprising of raw materials, work-in-

progress, finished goods (of manufactures) (v) Marketable securities held as

temporary investment; (vi) Prepaid expenses; (vii) Maintenance materials; (viii)

Accrued income.

Current Liabilities are those liabilities intended at then inception to be paid in

ordinary course of business within a reasonable short time (normally within a year)

out of the current assets or by creating another current liability or the income of

the business. Its examples : (i) Accounts payable to creditors; (n) Notes or Bills

payable; (iii) Accrued expenses, such as accrued taxes, salaries and interest; (iv)

Bank over draft, cash credit; (v) Bonds to be paid within one year; (vi) Dividends

declared and payable.

The arguments of the first school of thought in regarding working capital as the

excess of current assets over current liabilities are as follows: (1) It is an established

definition of working capital which is in use since long; (2) This concept of working

capital enables the shareholders to judge the financial soundness of the concern

and the extent of protection afforded to them. It is particularly because with an

increase in short-term borrowings the working capital does not increase; it will

increase only by following the policy of ploughing back of profits or conversion of

fixed assets into liquid assets or by procuring fresh capital from shareholders; (3)

Any concern with an excess of current liabilities can successfully tide over periods

of emergency, e.g., depression; (4) Further, there is no obligation on the part of the

134

company to return the amount invested by the shareholder, (5) Such a definition

is of great use in ascertaining the true financial position of companies having

currents assets of similar amount.

Those who regard working capital and current assets as synonymous advance

the following arguments in support of their contention. (1) Earnings in each

enterprise are the outcome of both fixed as well as current assets. Individually

these assets have no significance. The points of similarity in these assets are that

both are borrowed and they yield profit much more than the interest cost. But the

distinction in the two lies in the fact that assets constitute the fixed capital of a

company, whereas current assets are of circulating nature. Hence, logic demands

that current assets should be considered as the working capital of the company; (2)

This definition takes into consideration the fact that there would be an automatic

increase in the working capital with every increase in the funds of the company; but

it is not so according to the net concept of working capital; (3) Every management is

interested in the total current assets out of which the operation of an enterprise is

made possible, rather Chan in the sources from where the capital is procured; (4)

The former concept of working capital may hold good only in the case of sole trader

or partnership organisation; but under the modern age of company organisation,

where there is divorce between ownership, management and control , the

ownership of current or fixed assets is of little significance.

10.3.2 CLASSIFICATION OF WORKING CAPITAL

Generally speaking, the amount of funds required for operating needs varies

from time to time in every business. But a certain amount of assets in the form of

working capital are always required, if a business has to carry out its functions

efficiently and without a break. These two types of requirements-permanent and

variable are the basis for a convenient classification of working capital:

Fig. Types of Working Capital (p.18)

Permanent

(or Fixed)

Working Capital

Temporary (or

Variable/ Fluctuating)

Seasonal Special Regular Reverse Margin(or Cushion)

135

1. Permanent or Fixed Working Capital: As is apparent from the adjective

'permanent' it is that part of the capital which is permanently locked up in the

circulation of current assets and in keeping it moving. For example, every,

manufacturing concern has to maintain stock of raw materials, works-in-progress

(work-in-process), finished products, loose tools and spare parts. It also requires

money for the payment of wages and salaries throughout the year.

The permanent or fixed working capital can again be subdivided into (i) Regular

Working Capi tal and (ii ) Reserve Margin or Cushion Working Capi tal . It is the

minimum amount of liquid capital needed to keep up the circulation of the capital

from cash to inventories to receivables and back again to cash. .This would

include a sufficient cash balance in the bank to discount all bills, maintain an

adequate supply of raw materials for processing, carry a sufficient stock of

finished goods to give prompt delivery and effect the lowest manufacturing costs,

and enough cash to carry the necessary accounts receivables for the type of business

engaged in. Reserve margin or cushion working capital is the excess over the need

for regular working capital that should be provided for contingencies that arise at

unstated periods. The contingencies included (a) raising prices, which may make it

necessary to have more money to carry inventories and receivables, or may make

i t advisable to increase inventories; (b)business depressions, which may raise

the amount of cash required to ride out usually stagnant periods; (c)strikes, fires

and unexpectedly severe competition, which use up extra supplies of cash; and

(d)special operations, such as experiments with new products or with new method of

distribution, war contracts, contractors to supply new businesses, and the like,

which can be undertaken only if sufficient funds are available, and which in many

cases mean the survival of a business.

2. Variable Working Capital : The variable working capital changes with the

volume of business. It may be sub-divided into (i) Seasonal and (ii) Special Working

Capital. In many lines of business (e.g., Gur or sugar and Fur industry operations

are highly seasonal and, as a result, working capital requirements vary greatly

during the year. The capital required to meet the seasonal needs of industry is

termed as Seasonal Working Capital. On the other hand, Special Working Capital

is that part of the variable working capital which is required for financing special

operations, such as the inauguration of extensive marketing campaigns,

experiments with new products or with new methods of distribution, carry ing put

of special jobs and similar to the operations that are outside the usual business of

buying, fabricating and selling.

This distinction between permanent and variable working capital is of great

significance particularly in arranging the finance for an enterprise. Regular or fixed

working capital should be raised in the same way as fixed capital is procured,

through a permanent investment of the owner or through long-term borrowing. As

business expands, this regular capital will necessarily expand. If the cash returning

136

from sales includes a large enough profit to take care of expanding operations

and growing inventories, the necessary additional working capital may be provided

by the earned surplus of the business. Variable needs can, however, be financed

out of short-term borrowings from the Bank us from public in Cue form of deposits.

The position with regard to the 'fixed working capital' and 'variable working

capital' can be shown with the help of the following figures:

Fig. 10.1 Steady Firm's working capital requirement

From the above figure it should not be presumed that permanent working capital

shall remain fixed throughout the life of the concern. As the size of the business grows, permanent working capital too is bound to grow. The position can be

depicted with the help of the following figure:

Variable working

capital

Fixed working capital

Period O X

Y A

mou

nt

1

Fig. 10.2 Growth Firm's working capital requirement

So unlike a static concern, the fixed working capital of a growing concern will

increase with the growth in its size.

10.3.3 ELEMENTS OF WORKING CAPITAL

(i) Cash: Management of cash is very important from firm's point of view.

There must be balance between the twin objectives of liquidity and cost while

managing cash. There must be adequate cash to meet the requirements of all

segments of the organisation. Excess cash may be costly for the concern as it will

increase the cost in terms of interest. Less cash may also be harmful to the

concern as it will not be able to meet the liabilities as the appropri ate time. Thus

the requirements of the cash must be estimated properly either by preparing cash

flow statements or cash budgets. This will help the management to invest the idle

funds remuneratively and shortages, if any, may be met timely by making different

arrangements. Therefore, it is necessary that every segment of the organisation

must have adequate cash in order to meet the requirements of that segment

without having surplus balances. Cash management is highly centralised whereby

cash inflows and outflows are centrally controlled but in multi-divisional

companies it may be possible to decentralise cash requirements so that every

company may have cash for its requirements,

(ii) Marketable (Temporary) Investments: Firms hold temporary investments

for surplus cash flows arising either during seasonal operations or out of sale of

long term securities. In most cases the securities are held primarily for

precautionary purposes-most firms prefer to rely on bank credit to meet temporary

transactions or speculative needs, but to hold some liquid assets to guard against a

possible shortage of bank credit. The cash forecast may indicate whether excess

cash available is temporary or "hot. If it is found that excess liquidity will be

temporary, the cash should then be invested in marketable but temporary

Variable working

capital

Period O X

Y

Am

ou

nt

investments. It should be remembered that even if a substantial part of idle cash is

invested even though for a short period, the interest earned thereon is significant.

(iii) Receivables: Management of receivables involves a trade off between the

gains due to additional sales on account of liberal credit facilities and additional cost

of recovering those debts. If liberal credit facilities are given to the customers, sales

will definitely increase. But on the other hand bad debts, collection expenses and

interest charge will increase. Similarly if the credit policy is strict, the sales will be

less and customers may go to the competitors where liberal credit facilities are

available. This will result in loss of profit because of less sales but there will be saving

because of less bad debts, collection and interest charges. Management of debtors

also covers analysis of the risks associated with advancing credit to a particular

customer. Follow up of debtors and credit collections are the remaining aspects of

receivables management.

(iv)Inventories: Inventories include all investments in raw materials, work-in-

progress, stores, spare parts and finished goods; they constitute an important part

of the current assets. The purchase of inventory involves investment which must be

properly controlled. There are many issues of inventory management which must

be taken into consideration as fixation of minimum and maximum level, deciding

the issue of pricing policy, setting up the procedures for receipts and inspection,

determining the economic ordering quantity, providing proper storage facilities,

keeping control on obsolescence and setting up an effective information system with

reference to inventories. Inventory management requires the attention of stores

manager, production manager and financial manager. There must be adequate

inventories in order to avoid the disadvantages of both inadequate and excessive

inventories.

(v) Creditors: Management of creditors is very important aspect of working

capital. If the payment of creditors is delayed there is a possibility of saving of some

interest but it can be very costly because it will spoil the goodwill of the concern in

the market, As far as possible, the credit manager should try to get the liberal

credit terms so that payment may be made at the stipulated time.

10.3.4 ASSESSMENT OF WORKING CAPITAL REQUIREMENTS

The following factors are considered for a proper assessment of the quantum of

working capital requirements:

(i) The Production Cycle: There is bound to be time span in raw materials

input in manufacturing process and the resultant output as finished product. To

sustain such production activities the requirement of investment in the form of

working capital is obvious. The lesser the production cycle (or the operating cycle)

the lesser will be the requirements of working capital. There are enterprises due to

their nature of business will have shorter cycle than others. Further, even within

the same group of industries, the more the application of technological advances

in, will result in shortening the operating cycle. In this context the choice of product

requiring shorter or greater operating cycle will have a direct impact on the

working capital requirements. This is a factor of paramount importance irrespective

of whether a new industry is venturing production of the first time or an on-going

business. Hence it can be said that the time span for each stage of the process of

manufacture if geared to improve upon will lead to better efficiency and utilisation

of working capital.

(ii) Work-in-Process: A close attention is to be given to the accumulation of

work-in-progress or work-in-process. Unless the sequences of production process;

leading to conversion into finished product is kept under close observation to

achieve better production and productivity, more and more working capital funds

will be tied up. In this context, proper production planning and control is vital.

(iii) Terms of Credit from Suppliers of Materials and Services: The more

the terms of credit is favourable i.e., the more the time allowed by the creditor's to

pay them, the lesser will be the requirement of working capital. Hence, the

negotiation with the suppliers in respect of price and the credit period is an

important aspect in working capital management. In this process the impact of the

requirement of finance is shared by the creditors for goods and services.

(iv) Realisation from Sundry Debtors: The lesser the time span between

selling the product and the realisation the more will be the quicker inflow of cash.

This, in turn, will reduce the finance required for working capital purposes. A

realistic credit control will reduce locking up of finance in the form of sundry

debtors, The impact of better realisation will not only help in reducing the working

capital fund requirement but also can boost up the finance needed for other

operational needs. The important factors in credit control will be; (a) volume of credit

sales desired; (b) terms of sales and (c) collection policy.

(v) Control on Inventories, The decision to maintain appropriate minimum

inventories either in the form of raw material, stores materials, work-in-process or

finished products is an important factor in controlling finance locked up. The

better the control on inventories the lesser will be the requirements of working

capital. The following vital factors involved in inventory management are to be

considered for an effective inventory control: (a)volume of sales, (b) seasonal

variation in sales, (c)selling- 'off the shelf, (d) stocking to gain from higher price

under inflationary conditions, (e) the operating cycle, i.e., the time interval between

manufacturing, selling and realization and (f) safety or buffer stock. A minimum

policy levels of stock may have to be maintained to seize the opportunity of selling

when there is spark in demand for the product.

(vi) Liquidity- versus Profitability : The management dilemma as to the

optimal balancing between liquidity (or solvency) and the profitability is another

factor of great importance on the determination of the level of working capital

requirement. In other words, the level of liquidity and the profitability to be

maintained according to goals of the financial management.

(vii) Competitive Conditions: The whole question of cash inflow depends as to

the quickness in selling the products and the realization thereof. In this context,

the nature of business and the product will be the two important contributory

factors as to the policy on the quantum of working capital requirements.

(viii) Inflation and the Price Level Changes : In an inflationary trend, the

impact on working capital is that more finance is needed for the same volume of

activity i.e., one has to pay more price for the purchase of same quantity of materials

or services to be obtained; Such raising impact of prices can be fully or partly

compensated by increasing the selling price of the product. All business may not be

in a position to do so due to their nature of product, competitive market or

Government's regulatory price.

(ix) Seasonal Fluctuation and Market Share of Product : There are

products which are mostly in demand in certain periods of the year. In other words,

there may not be any sale or only a fraction of the total sale in off-season due to

seasonal nature of demand for the product. There may be shifting of demand due to

better substitute of the product available. This means the company affected by this

economics, attempts to plan diversification to sustain profit, expansion and growth

of the business. In certain businesses, demands for products are of seasonal in

nature and for certain businesses, the raw materials buying have to be done during

certain seasonal timings. Naturally the working capital requirement will be more in

certain periods than in others.

(x) Management Policy, on Profits, Retained Profit, Tax Planning and

Dividend Policy: The adequacy of profit will lead to strengthen the financial

position of the business through cash generation which will be ploughed back as

internal source of financing. Tax planning is an integral part of working capital

planning. It is not only the question of quantum of cash availability for tax

payment at the appropriate time but also through tax planning the impact of tax

payable can be reduced. Dividend Policy considers the percentage of dividend to be

paid to the shareholders as interin and/or final dividend. There must be cash

available at the appropriate time after the dividend is declared. This way the dividend

payment is connected with working capital management.

(xi) Terms of Agreement: It refers to the terms and conditions of agreement

to repay loans taken from bankers and financial institutions and acceptance of

'fixed deposits' from public. The question of fund arrangement whether for working

capital needs or to long term loans is to be decided after taking into account the

repayment ability. The cash flow projection will have to be made accordingly.

(xii) Cash (Flow) Budget: In order to meet certain cash contingencies it may be

necessary to have liquidity in form of marketable securities as cash reservoir. This

extra cash reserve may remain as an idle. fund. This type of cash reserve is

necessary to meet emergency disbursements.

(xiii) Overall Financial and Operational Efficiency ; A professionally

managed company always applies appropriate tools and techniques to achieve

efficiency and utilization of working capital fund. Adequacy of assessment and control

of business will lead to improve the 'working capital turnover'. Management also will

have-to keep itself abreast of the environmental, technological and other changes

affecting the business so that an effective and efficient financial management can

play a vital role in reducing the problems of working capital management.

(xiv) Urgency of Cash : In order to avoid product becoming obsolete or to

under-cut the competitors to hold the market share or in case of emergency for

cash funds, it may be necessary to sell out products at a cheaper rate or at a

discount or allowing cash rebate for early reali zation from sundry debtors

(customers). This situation may boost up the cash availability. However, this sort

of critical situation should be avoided as this results in reducing profit.

(xv) Importance of Labour Mechanization: Capital intensive industries,

ie., mechanized and automated industries, will require lower working capital, while

labour intensive industries such as small scale and cottage industries will require

larger working capital.

(xvi) Proportion of Raw Material to Total Costs : If the raw materials are

costly, the firm may require larger working capital while if raw materials are

cheaper and constitute a small part of the total cost of production, lower working

capita! is required.

(xvii) Seasonal variation: During the busy season, a business requires larger

working capital while during the slack season a company requires 'lower working

capital. In sugar industry the season is-November to June, while in the woollen

industry the season is during the winter. Usually the seasonal or variable needs of

working capital are financed by temporary borrowing.

(xviii) Banking Connections: If the corporation has good banking connections

and bank credit facilities, it may have minimum margin of regular working capital

over current liabilities. But in the absence of the availability of bank finance, it

should have relatively larger among of net working capital.

(xix) Growth and Expansion: For normal rate of expansion in the volume of

business, one may have greater proportion of retained profits to provide for more

working capital; but fast growing concerns require larger amount of working capital.

A plan of working capital should be formulated with an eye to the future as well as

present needs of a corporation.

10.3.5 PROBLEMS OF INADEQUACY OF WORKING CAPITAL

In case of inadequacy of working capital, a business may have to face the

following problems:

(i) Production Facilities: It may not be possible to have the full utilization of

the production facilities to the optimum level due to the inability of buying sufficient

raw material and/or major renovation of the plant and machinery.

(ii) Raw Material Purchases: Advantage of buying at cash discount or on

favourable terms may not be possible due to paucity of funds..

(iii) Credit Mating: When financial crisis continues, the credit worthiness of

the company may be lost, resulting in poor credit rating.

(iv)Seizing Business Opportunities: In case of boom for the products and for

the business, the company may not be in a position to produce more to earn

'opportunity profit' as there may be inadequacy of finished products availability.

(v) Proper Maintenance of Plant and Machinery : If the business Is on

financial crisis, adequate sums may not be available for regular repair and

maintenance, renovation or modernization of plant to boost up production and to

reduce per unit cost.

(vi). Dividend Policy: In the absence of fund availability it may not be possible

to maintain a steady dividend policy. Under such financial constraint, whatever

surplus is available will be kept in general reserve account to strengthen the

financial soundness of the business.

(vii) Reduced Selling: Due to the constraint in working capital, the company

may not be in a position to increase credit sales to boost up the sales revenue.

(viii) Loan Arrangement: Due to the emergency for working capital the

company may have to pay higher rate of interest for arranging either short-term or

long-term loans.

(ix) Liquidity versus Profitability : The lower liquidity position may also

result in lower profitability.

(x) Liquidation of the Business: If the liquidity position continues to remain

weak, the business may run into liquidation.

To remedy the situation of working capital crisis, the following steps are

required:

(a)An appraisal and review is to be conducted to minimize the operating cycle.

Adequate credit control measures are to be adopted for early and prompt

realization from the debtors.

Proper planning and control of cash management through cash flow

forecasting.

Whether more credit periods can be obtained for buying is to be explored.

10.3.6 REASONS FOR INADEQUACY OF WORKING CAPITAL

Inadequacy or shortage of working capital may arise for various reasons, of

which, the main reasons are the following:

(i) Operating losses: This may arise when the cost of production and other

related costs are more than the sales revenue, reduction in sales, falling prices,

increased depreciation.etc. It is obvious that a company facing losses will not have

any cash generation' to sustain its on-going business.

(ii) Extraordinary Losses: There may be exceptional losses due to fall in price

of finished product stocks, government action, obsolescence or otherwise. The effect

of such a loss will be a reduction in current assets or increase in current liabilities

without any corresponding favourable change in the working capital composition.

(iii) Expansion of Business: The company during the profitable years might

have invested substantially in fixed capital assets, increased production and

increased credit sales to make the sales volume grow rapidly. Against those activities,

the pitfalls of over-trading may show its ugly, face subsequently. That is why a

balancing judgement between investment, liquidity and profitability is to be drawn

and projected to save the business falling into financial crisis. Thus the continuity

and growth of the business may be jeopardised. Along with the increased sales

there may be increase in inventories and higher sundry debtors. Such excessive

build-up of inventories and receivables may amount to alarming figures.

:(iv) Payment of Dividend and Interest : The payment of interest for

borrowings will have to be made as per terms of agreement. Similarly, the payment

of dividend may have to be arranged to keep up the business prestige to the public

and to the shareholders. There may be profit to declare dividend but there may not

be adequate cash to disburse dividend. In case of insufficient funds to meet the

aforesaid, liabilities, the mobilizing of funds will be necessary.

10.3.7 EXCESSIVE WORKING CAPITAL

The following are the major disadvantages of having or holding excessive

working capital.

(i) Overtrading: A time may come when overtrading will engulf the financial

soundness of the business.

(ii) Excessive Inventories: The inventories holding may become excessive

under the influence of excessive funds availability.

(iii) Liquidity versus Profitability: The situation of liquidity and the

profitability may be misbalanced.

(iv) Inefficient Operation: Availability of excessive production facilities may

result in higher production but sales may not be anticipated to match goods

produced.

(v) Lower Return on Capital Employed : There may be reduced profi t in

relation to total capital employed resulting in lower rate of return on capital

employed,

(vi) Increased Fixed Capital Expenditure: As enough fund is available there

may be boost-up in acquiring plant and machinery to enhance production facilities.

In case there is not enough sales potentiality with adequate margin of profit

such fixed investment may not be worthwhile for fund employment.

10.3.8 PRINCIPLES OF WORKING CAPITAL MANAGEMENT

1.Principle of Risk Variation: If working capital is varied relative to sales, the

amount of risk that a firm assumes is also varied and the opportunity for gain or

loss is increased.

This principle implies that a definite relation exists between the degree of risk

that management assumes and the rate of return. That is, the more risk that a firm

assumes, the greater is the opportunity for gain or loss. It should be noted that

while the gain resulting from each decrease in working capital is measurable, the

losses that may occur cannot be measured. It is believed that while the potential

loss, the exactly opposite occurs if management continues to decrease working

capital that is to say., potential losses are small at first for each decrease in

working capital but increase sharply if it continues to be reduced. It should be the

goal of management to find that point of level of Working Capita! at which the

incremental loss associated with a decrease in Working Capital investment becomes

greater than the incremental gain associated with that investment. Since most of

the managers do not know what the future holds, they tend to maintain an

investment in working capital that exceeds the ideal level. It is this excess that

concerns since the size of the investment determines firm's rate of return on

investment. The obvious conclusion is that managers should determine whether

they operate in business that react favourably to changes in working capital levels, if

not, the gains realized may not be adequate in comparison to the risk that must be

assumed when working capital investment is decreased.

2, Principle of Equity Position: Capi tal should be invested in each

components of working capital as long as the equity position of the firm increases.

It follows from the above that the management is faced with the problem of

determining the ideal 'level' of working capital. The concept that each rupee

invested in fixed or variable working capital should contribute to the net worth of

the firm should serve as a basis for such a principle.

3. Principle of Cost of Capital: The type of capital used to finance working

capital directly affects the amount of risk that a firm assumes as well as the

opportunity for gain or loss and cost of capital.

Whereas the first principle dealt with the risk associated with the amount of

working capital employed in relation to sales, the third principle is concerned with

the risk resulting from the type of capital used to finance current assets. It has

been observed that return, to equity capital increases directly with the amount of

risk assumed by management. This is true but only to a certain point. When

excessive risk is assumed, a firm's opportunity for loss will eventually over-

shadow its, opportunity for gain, and at this point return to equity is threatened.

When this occurs, the firm stands to suffer losses. Unlike rate of return, cost of

capital moves inversely with risk; that is, as additional risk capital is employed by

management, cost of capital declines. This relationship prevails until the firm's

optimum capital structure is achieved; thereafter, the cost of capital increases.

4. Principle of Maturity of Payment: A company should make every effort to

relate maturities of payment to its flow of internally generated funds. There should

be the least disparity between the maturities of a firm's short-term debt

instruments and its flow of internally generated funds because a greater risk is

generated with greater disparity. A margin of safety should, however, be provided for

short term debt-payments.

5. Principle of Negotiation: The risk is not only associated with the amount

of debt used relative to equity, it is also related to the nature of the contracts

negotiated by the borrower. Some of the clauses of the contracts such as

restrictive clause and dates of maturity directly affect a firm's operation: Lenders of

short term funds are particularly conscious of this problem and they ask for cash

flow statements. Lenders realize that a firm's ability to repay short-term loan

directly related to cash flow and not to earnings and, therefore, a firm should make

every effort to tie maturities to its flow of internally generated funds. This concept

serves as the basis for the final hypothesis of this presentation. Specifically, it

may be stated as follows: "The greater the disparity between the maturities of

firm's short term debt instrument and its flow of internally generated funds, the

greater the risk and vice-versa". One can see that it is possible for a firm to face

insolvency or embarrassment even though it might be making a profit. It is

extremely difficult to predict accurately a firm's cash flow in an economy such as

ours. Therefore, a margin of safety should be included in every short term debt

contract; that is, adequate time should be allowed between the time the funds are

generated and the date of maturity.

Steps Involved in Efficient Management of working capital

1. Proper financial set up with appropriate authority and responsibility,

2. Coordination between the following functional areas in the organisation:

Production planning and control

Sales Credit control

Materials management

Optimal utiliztion of fixed plant and machinery together with other

facilities. Sale of uneconomical fixed assets

Acquiring plant and machinery to augment production.

Cost reduction programme

3. Financial planning and control for achieving increased profitability to have

adequate 'cash generation' and 'plough back' of profits so that there is adequate

internal source of finance.

4. Proper cash management through projection of cash flow and source and

application of funds flow statement.

Establishing appropriate Information and Reporting System.

10.3.9 SOURCES OF WORKING CAPITAL

1. Permanent working capital: Issue of shares , debentures and transfer

from retained earnings.

2. Term loans from the financial institutions (developments banks) (eg)

IDBI.

3. Cash advance from the customers.

4. Factoring: it involves an outright sale of receivables of affirm to a

financial institutions at discount rate. They will assume the collection

services from the debtors.

5. Discounting the bills with banks and accepting houses.

6. Credit from friends and relatives.

7. Issue commercial paper. It is a form of issuance promissory note

negotiable by endorsement and delivery. It may be issued even at

discount. It has been prescribed by the RBI of India. The investor is

assured of ready liquidity.

8. Certificate deposit is document of title similar to a deposit receipt issued

by a bank. It is a bearer document, hence readily negotiable. The

investor is assured of ready liquidity.

9. Issuing bonds to public for a specific period with fixed interest rate.

10. Attracting deposit from the public.

10.4 REVISION POINTS

Working Capital = Current Assets – Current Liabilities

Net Working Capital, Gross Working Capital

Fixed and variable working capital

Problems of inadequacy of working capital

Dangerous of excess working capital.

10.5 INTEXT QUESTIONS

1. Discuss the importance of working capital for a manufacturing concern.

2. Explain the various determinants of working capital of a concern.

3. What are the advantages of having ample working capital funds?

4. Differentiate between fixed working capital and variable working capital.

5. What are the different principles of working capital management?

6. Summarize the causes for and changes in working capital of a firm.

10.6 SUMMARY

Proper management of working capital is very important, for the success of .an

'enterprise. It aims at protecting the purchasing power of assets and maximi zing

the return on investment. Constant management is required to maintain appropriate

levels in the various working capital components. Sales expansion, dividend

declaration, plant expansion, new product line, increased salaries and wages,

rising price levels etc., put added strain on working capital maintenance.

There are two concepts of working capital. Net working capital and Gross

working capital.

There are two types of working capital, they are (i) fixed or Permanent and (ii)

Temporary or variable

10.7 TERMINAL EXERCISES

1. The total of all currents means

(a) Working capital (b) Net working capital (c) Gross working capital.

2. Generally the major portion of working capital constitutes

(a) Cash (b) Receivable (c) Inventories (d) Debtors

10.8 SUPPLEMENTARY MATERIALS

http://kesdee.com/

http://simplestudies.com/

http://repository.um.edu.my/

10.9 ASSIGNMENT

Prepare a report on various techniques used in working capital management.

Prepare an essay on effective management of working capital. How would you

determine the level of working capital.

10.10 SUGGESTED READINGS / REFERENCE BOOKS

Working Capital Management. by Agarwal . N. K. New Delhi, Sterling

Publications (P) Ltd.

Financial Management, by Khan M.Y. and Jain. P.K. New Delhi, Tata McGraw

Hill Co.,

Working Capital Management, by Ramamoorthy V.E. Madras, Institute for

Financial Management and Research.

10.11 LEARNING ACTIVITIES

Special conference may be arranged impart more knowledge about working

capital management to the students. Students may arrange group discussion and

identify new ideas or techniques to determine the optimum level of working capital.

Collect the information regarding the practical applications of working capital

management.

10.12 KEY WORDS

Working capital

Net working capital

Gross working capital

LESSON - 11

WORKING CAPITAL FORECASTING TECHNIQUES AND FINANCING

POLICY

11.1 INTRODUCTION

Working capital requirements can be determined mainly in three ways: Per

cent-of-sales method, Regression analysis method, and the working capital cycle

method

11.2 OBJECTIVES

After reading this lesson you should be able to:

Know the concept of working capital cycle

Identify the working capital gap

Explain the working capital forecasting techniques

11.3 CONTENT

11.3.1 Per cent-of-sales method

11.3.2 Regression analysis method

11.3.3 The working capital cycle method

11.3.4 Financing Policy Meaning

11.3.5 Matching ( Moderate) approach

11.3.6 Aggressive Approach

11.3.7 Conservative Approach

11.3.8 Balanced policy

11.3.1 PER CENT-OF-SALES METHOD

It i s a tradi tional and simple method of determining the volume of working

capital and its components, sales being a dominant factor. In this method, working

capital is determined as a percent of forecasted sales. It is decided on the basis of

past observations. If over the year, relationship between sales and working capital

is found to be stable, then this relationship may be taken as

a standard for the determination of working capital in future also. This

relationship between sales and working capital and its various components may be

expressed in three ways: (i) as number of days' of sales, (ii) as turnover, and (i ii) as

percentage of sales.

The per cent-of-sales method of determining working capital is' simple and easy

to understand and is useful in forecasting of working capital requirements,

particularly in the short-term. However, the greatest drawback of this method is

the assumption of linear relationship between sales and working capital. Therefore,

this method cannot be recommended for universal application. It may be found

suitable by individual companies in specific situations.

11.3.2 REGRESSION ANALYSIS METHOD

As stated earlier the regression analysis method is a very useful statistical

technique of forecasting. In the sphere of working capital management it helps in

making projection after establishing the average relationship in the past years

between sales and working capital (current assets) and its various components. The

analysis can be carried out through the graphic portrayals (scatter diagrams) or

through mathematical formula.

The relationship between sales and working capital or various components may

be simple and direct indicating complete linearity between the two or may be

complex in differing degree involving simple linear regressions or simple

curvil inear regression, and multiple regressions situations.

This method, with a range of techniques suitable for simple as well as complex

situations, is an undisputed refinement on traditional approaches of forecasting

and determining working capital requirements. It is particularly suitable for long-

term forecasting.

11.3.3 WORKING CAPITAL CYCLE METHOD

The working capital cycle refers to the period that a business enterprise takes

in converting cash back into cash. As an example, a manufacturing firm uses cash

to acquire inventory of materials that is converted into semi finished goods and then

into finished goods. When finished goods are disposed of to customers on credit,

accounts receivable are generated. When cash is collected from customers, we again

have cash. At this stage one operating cycle is completed. Thus a circle from cash-

back-to-cash is called the working capital cycle. This concept is also be termed as

"Pipe Line Theory" as popularly known.

Fig. 11.1 Working Capital Cycle

2.Inventory of raw

materials

3.Semi finished goods

4.Inventory of finished

goods

5.Accounts receivable

1.Cash

Thus we see that an working capital cycle, generally, has the following four

distinct stages:

1. The raw materials and stores inventory stage;

2. The semi-finished goods or work-in-progress stage;

3. The finished goods inventory stage; and

4. The accounts receivable or book debts stage.

Each of the above working capital cycle stage is expressed in terms of number of

days of relevant activity and requires a level of investment to support it. The sum

total of these stage-wise investments will be the total amount of working capital of

the firm.

A series of such operating cycle recur one after another and chain continues till

the end of the operating period. In this way the entire operating period has a

number of operating cycles. It is important to note that the velocity or speed of this

cycle should not slacken at any stage; otherwise the normal duration of the cycle will

be lengthened, resulting in an increased need for working fund. The faster the speed

of the operating cycle, shorter will be its duration and larger will be the number of

total operating cycles In a year (operating period) which in turn would be

instrumental in giving the maximum level of turnover with comparatively lower

level of working fund.

The four steps involved in this method are: (i ) computing the duration of the

operating cycle, (ii) calculating the number of operating cycles in the operating period,

(iii) estimating the total amount of annual operating expenses, and (iv) ascertaining

the total working capital requirements. Each step is discussed with some detail in

the following paragraphs.

(i) Duration of Operating Cycle: The duration is computed in days by adding

together the average storage period, of raw materials, works-in-progress, finished

goods and the average collection period and then deducting from the total the

average payment period. The formula to express the framework of the operating

cycle is:

O = (R + W + F + D) - C

where: O = Duration of operating cycle

R = Raw material average storage period

W = Average period of work-in-progress

F = Finished goods average storage period

D = Debtors collection period

C = Creditors payment period

The average inventory, trade creditors, work-in-progress, finished goods and

book debts can be computed by adding the opening and closing balances at the end

of the year in the respective accounts and dividing the same by two. The average

per day figures can be obtained by dividing the concerned annual figures by 365 or

the number of days in the given period.

(ii) Number of Operating Cycle in Operating Period : This is found out by

dividing the total number of days in the operating period by number of days in the

operating cycle as shown below :

N = P / O

where: N = Number of operating cycle in operating period

P = Number of days in the operating period

O = Duration of operating cycle (in days)

Suppose the operating period is one year (365 days) and the duration of

operating cycle is 73 days then the number of operating cycles in the operating

period will be:

𝑁 =365

73= 5 𝐶𝑦𝑐𝑙𝑒𝑠

(i ii ) Total amount of Annual Operating Expenses: These expenses include

purchase of raw materials, direct labour costs and the overhead costs-calculated on

the basis of average storage period of raw materials and the time-lag involved in the

payment of various items of expenses. The aggregate of such separate average

amounts will represent the annual operating expenses.

(iv) Estimating the Working Capital Requirement: This is calculated by

dividing the total annual operating expenses by the number of operating cycles in

the operating period as shown below:

R =E

𝑁

where : R = Requirement of Working Capital (Estimated)

E= Annual Operating Expenses

N = Number of operating cycles in the operating Period

The amount of working capital thus estimated is increased by a fixed percentage

so as to provide for contingencies and the aggregate figure gives the total estimate

of working capital requirements. The operational cycle method of determining

working capital requirements gives only an average figure. The fluctuations in the

intervening period due to seasonal or other factors and their impact on the working

capital requirements cannot be judged in this method. To identify these impacts,

continuous, short-run detailed forecasting and budget exercises are necessary.

Illustration 1

The following data have been extracted from the financial records of Prabhakar Enterprises Limited:

Raw Materials Rs. 8 per unit, Direct Labour, Rs. 4 per unit, and Overheads Rs.

80,000

Additional information

i. The company sells annually 25,000 units @ Rs. 20 per unit. All the goods

produced are sold in the market.

i i . The average storage period for raw materials is 40 days and for finished

goods it is 18 days.

i ii . The suppliers give 60 days credit facility to the firm for purchases. The firm

also sells goods on 60 days credit to i ts customers.

iv. The duration of the production cycle is 15 days and raw material is issued

at the beginning of each production cycle.

v. 25% of the average working capital is kept as cash for contingencies,

On the basis of the above information, estimate the total working capital

requirements of the firm under Operating Cycle Method.

Solution

Duration of Operating Cycle Days

i. Materials storage period 40

ii. Production cycle period 15

iii. Finished goods storage period 18

iv. Average collection period 60

________

133

Less : Average payment period 60

_________

Duration of Operating Cycle 73

Number of Operating Cycles in a year: Total Number of Days in a year divided

by Duration of operating Cycle =365

73= 5 𝑐𝑦𝑐𝑙𝑒𝑠 𝑖𝑛 𝑦𝑒𝑎𝑟.

Total Annual Operating Expenses

Raw Material 25,000×8 = 2,00,000

ii. Direct Labour 25,000×4 = 1,00,000

iii. Overheads 80,000

_________

Total Operating Expenses for the year 3,80,000

_________

Estimating Working Capital Requirements

=Total anual operation expenses

Number of operation cycles in the year=

3,80,000

5= 𝑅𝑠. 76,000

Add. 25% of the above by cash

(for Contingencies) 19,000

__________ Total Working Capital Requirement 95,000

__________

Illustration 2

Messrs Senthil Industries Ltd. are engaged in large scale retailing. From the

following information, you are required to forecast their working capital requirements

of this trading concern.

Projected annual sales 65 Lakhs

Percentage of Net Profit on cost of sales 25 %

Average credit allowed to Debtors 10 Weeks

Average credit allowed by Creditors 4 weeks

Average stock carrying (in terms of sales requirement) 8 weeks

Add 10% to computed figures to allow for contingencies.

Solution

Statement of Working Capital Requirements

Selling Price

Basis (Rs. In lakhs)

Cost Price

Basis (Rs. In lakhs)

Current Assets Stock Rs.1.00 lak x 8 Debtors

At cost equivalent Rs.1.00 lak x 10 = 10 lak

Profit Rs. 13

52× 10 = 2.5 lakhs

Less Current Liabilities Creditors Rs.1.00 x 4 =

Working Capital Computed Add. 10 % contingencies

Net Working Capital

8.00

12.50

8.00

10.00

20.50

4.00

18.00

4.00

16.50

1.65

14.00

1.40

18.15 15.40

Projected annual Sales --- 65 lakhs

Net profit 20 % on sales or 25% on cost of sales ... 13 lakhs

Cost of sales (65 – 13) = Sales – Profit ... 52 lakhs

Cost of sales per week ( 52 weeks in a year) 1 lakh

Note : It has been assumed that the creditors include those for both goods and

expenses and that all such creditors allow one month credit on average.

Interpretation of Results 4 The amount of working capital fund above is to

be interpreted as the amount to be blocked up in inventory, debtors (minus

creditors)at any time during the period(year)in view, in order that the anticipated

activity (sales primarily)can go on smoothly. The amount is not for a period of time

but at any point of time. It represents the maximum(or the highest)quantum of

locking up at any time during the period.

Illustration 3

Ramaraj Brothers private Limited sells goods on a gross

Profit of 25%. Depreciation is taken into account as a part of cost of

production. The following are the annual figures given to you.

Rs.

Sales (two months credit) 18,00,000

Materials consumed (one month’s credit) 4,50,000

Wages paid (one month lag in payment) 3,60,000

Cash manufacturing expenses (one month

Lag in payment) 4,80,000

Administration expenses(one month

Lag in payment) 1,20,000

Sales promotion expenses (paid quarterly in

Advance) 60,000

Income tax payable in 4 instalments of which

One lies in the next year 1,50,000

The company keeps one months’ stock each of raw materials and finished

goods. It also keeps Rs.1,00,000 in each. You are required to estimate the working

capital requirements of the company on cash basis assuming 15% safety margin.

Solution:

Statement of Working

Currents Assets: Rs.

Debtors (cash cost of goods sold i.e, 14,70,00 x2/12) 2,45,000

Prepaid sales expenses 15,000

Inventories 37,500

Raw materials (4,50,000/12) 1,07,500

Finished goods (12,90,000/12) 1,00,000

Current Liabilities:

Sundry creditors (4,50,000/12)

5,05,000

37,500

Outstanding manufacturing expenses (4,80,000/12) 40,000

Outstanding administration expenses (1,20,000/12) 10,000

Provision for taxation (1,50,000/4) 37,500

Outstanding wages (3,60,000/12) 30,000

1,55,000

Working Capital ( CA – CL) 3,50,000

52,500 Add. 15% for contingencies

Total Working Capital required 4,02,500

Working Notes:

1. Total Manufacturing Expenses RS.

Sales 18,00,000

Less : Gross profit 25% on sales 4,50,000

____________

Total cost 13,50,000

Less: Cost of materials Rs.4,50,000

Wages Rs.3,60,000

_________ 8,10,000 __________

Manufacturing Expenses 5,40,000

2.Depreciation:

Total Manufacturing Expenses 5,40,000 Less: Cash Manufacturing Expenses 4,80,000

_________ Depreciation 60,000 _________

1. Total Cash Cost:

Total Manufacturing Cost 13,50,000

Less: Depreciation 60,000

__________

12,90,000

Add. Administrat ion Expenses 1,20,000

Sales promotion Expenses 60,000

__________

Total Cash Cost 14,70,000

11.3.4 FINANCING POLICY

The current assets financing plan may be readily related to the broader issue of

the financing plan for all the firms' assets. The firm has a wide variety of financing

policies it may choose, and the fact that short-term financing usually is less costly

but involves more risk than long-term financing plays an important part in

describing the degree of aggressiveness or conservatism of the firm's financing

policy.

In comparing financing plans we .should distinguish between three different

kinds of financing; (i) permanent source of financing, (ii) temporary source of

financing and (iii) the spontaneous short-term financing. A firm's investment is

namely financed by the some of its spontaneous, temporary and permanent sources

of financing.

(i) A permanent investment in an asset is one that the firm expects to hold for

period longer than one year Permanent investments are made in the firm's

minimum level of current Assets as well in i ts fixed assets. Permanent sources of

financing include intermediate and long-terns debt, preference share and equity

share

(ii) Temporary investments are comprised of the firm's investments in current

assets, which will be liquidated and not replaced within the current year. For

example, a seasonal increase in the level of inventory is a temporary investment as

the holding up in inventories will be eliminated when it is no longer needed.

Temporary source of financing is a current liability. Thus, temporary financing

consists of the various sources of short-term debt including secured and unsecured

bank loans, commercial paper, factoring of accounts receivables, and public

deposits.

iii) Besides permanent and temporary sources of financing, there al so exist

spontaneous sources. Spontaneous sources consist of the trade credit and other

accounts payable- that arise spontaneously in the firm's day-to-day operations.

Examples include wages and salaries payable, accrued interest, and accrued

taxes.

These expenses generally arise in direct conjunction with the firm's ongoing

operations; they are referred to as spontaneous. Popular example of a spontaneous

source of financing involves the use of trade credit. As the firm acquires materials for

its inventories, credit is often made available spontaneously or on demand by the firm's

suppliers. Trade credit appears on the firm's balance sheet as accounts payable.

The size of the accounts payable balance varies directly with the firm's purchases

of inventory items, which in turn are related to the firm's anticipated sales. Thus, a

part of the financing needs by the firm is spontaneously provided by its use of trade

credit.

The long term working capital can be conveniently financed by (a) owners

equity e.g. shares and retained earnings,(b) lenders' equity e.g. debentures,

and(c)fixed assets reduction e.g., sale of assets, depreciation on fixed assets etc.

This capital can be preferably obtained from owners' equity as they do not carry

with them any fixed charges in the form of interest or dividend and so do not throw

any burden on the company. Intermediate working capital funds are ordinarily raised

for a period varying from 3 to 5 years through loans which are repayable in

instalments e.g., working capital term-loans from the commercial banks or from

finance corporations.

11.3.5 MATCHING (OR MODERATE) APPROACH

Matching approach is also called Hedging principle. It involves matching the

cash flow generating characteristics of a firm's assets with the maturity of the

source of financing used. The rationale for matching is that since the purpose of

financing is to pay for assets, when the asset is expected to be relinquished so

should the financing be relinquished. Obtaining the needed funds from a long-term

source (longer than one year) would mean that the firm would still have the funds

after the inventories have been sold. In this case the firm would have "excess"

liquidity, which they either hold in cash or invest in low yielding marketable

securities. This would result in an overall lowering of firm profits. Similarly arranging

finance for shorter periods that the assets require is also costly in that there will be

.extra transaction costs involved in continually arranging new short-term financing.

Also, there is always the risk that new financing cannot be obtained in times of

economic difficulty.

The firm's permanent investment in assets is financed by the use of either

permanent source of financing (intermediate-and long-term debt, preference shares,

and equity shares) or spontaneous source (trade credit and other accounts

payable,), its temporary investment in assets is financed with temporary (short-term

debt) and/or spontaneous sources of financing. Note the matching approach has

been modified to state: Asset needs of the firm, not financed by spontaneous

sources, should be financed in accordance with the rule: permanent asset

investments financed with permanent sources and temporary investments financed

with temporary sources.

Since total assets must always equal to the sum of spontaneous, temporary,

and permanent sources of financing, the hedging approach provides the financial

manager with the basis for determining the sources of financing to use at any point

in time.

11.3.6 AGGRESSIVE APPROACH

The firm's financing plan is said to be aggressive if the firm uses more short-

term negotiated financing than is needed under a matching approach. The firm is

no longer financing all its permanent assets with long-term financing. Such plans

are said to be aggressive because they involve a relatively heavy use of (riskier)

short-term financing. The more short-term financing used relative to long-term

financing, the more aggressive is the financing plan. Some firms are even financing

part of their long-term assets with short-term debt, which would be a highly

aggressive plan.

11.3.7 CONSERVATIVE APPROACH

Conservative financing plans are those plans that use more long-term financing

than is needed under a matching approach. The firm is financing a portion of its

temporary current assets requirements with long-term financing. Also, in periods

when the firm has no temporary current assets the firm has excess (unneeded)

financing available that will be invested in marketable securities. These plans are

called conservative because they involve relatively heavy use of (less risky) long-term

financing.

Comparison of Conservative, Hedging and Aggressive Approaches: These

approaches to working capital financing can be compared on the basis of (a) cost

considerations, (b) profitability considerations, and (c) risk considerations (probability

of technical insolvency). The following statement gives a comparative evaluation.

Comparative Evaluation of Financing Approaches

Financial

Approaches or plan

Cost Risk Return of profitability

Conservative High Low Low Hedging Moderate Moderate Moderate

Aggressive Low High High

11.3.8 BALANCED POLICY

Because of the impracticalities in implementing the matching policy and the

extreme nature of the other two policies, most financial managers opt for a compromise

position. Such a position is the balanced policy. As its name implies, management

adopting this policy balances the trade-off between risk and profitability in a manner

consistent with its attitude toward bearing risk. The long-term financing is used to

support permanent current assets and part of the temporary current assets. Thus

short-term credit is used to cover the remaining working capital needs during

seasonal peaks. This implies that as any seasonal borrowings are repaid, surplus

funds are invested in marketable securities.

This policy has the desirable attribute of providing a margin of safety not found

in the other policies. If temporary needs for current assets exceed management's

expectations, the firm will still be able to use unused short-term lines of credit to

fund them. Similarly, if the contraction of current assets is less than expected,

short-term loan payments can still be met, but less surplus cash will be available

for investment in marketable securities. In contrast to the other working capital

policies, a balanced policy will demand more management time and effort. Under

the policy, the financial manager will not only have to arrange and maintain short-

term sources of financing but must be prepared to manage the investment of excess

funds.

The Appropriate Working Capital Policy

The analysis so far has offered insights into the risk-profitability trade-off

inherent in a variety of different policies. Just as there is no optimal capital

structure that all firms should adopt, there is no one optimal working capital policy

that all firms should employ. Which particular policy is chosen by a firm will

depend on the uncertainty regarding the magnitude and timing of cash flows

associated with sales; the greater this uncertainty, the higher the level of working

capital necessary. In addition, the cash conversion cycle will influence a firm's

working policy; the longer the time required to convert current assets into cash, the

greater the risk of illiquidity. Finally, in practice, the more risk averse management

is the greater will be the net working capital position. The management of working

capital is an ongoing responsibility that involves many interrelated and

simultaneous decisions about the level and financing of current assets. The

considerations and general guidelines offered in this lesson should be useful in

establishing an overall net working capital' policy.

Illustration 1

Following is the summary of Balance Sheets of a firm under the three

approaches:

Policy

Conservative Hedging Aggress ive

Liabilitie s

Current Liabilit ies 5,000 15,000 25,000 Long term loan 25,000 15,000 5,000 Equity 50,000 50,000 50,000

Total 80,000 80,000 80,000 Assets:

Current Assets

(a) Permanent Requirement (b) Seasonal Requirement

20,000 15,000 45,000

20,000 15,000

45,000

20,000 15,000

45,000 Fixed Assets Total 80,000 80,000 80,000

Additional Information

i. The firm earns, on an average, approximately 6% on investments in current assets and 18% on investments in fixed assets,

ii. Average cost of current liabilities is 5% and average cost of long-term funds is 12%.

Compute the costs and returns under any three different approaches, and

comment on the policies.

Solution

i. Computation of Costs under Conservative, Matching & Aggressive

Approaches.

Conservative Hedging (Matching)

Aggressive

Cost of Current

Liabilit ies 5 % on

5,000= 250 15,000 = 750 25,000=1,250

Cost of long term

funds 12 % on

75,000 = 9,000 65,000 = 7,800 55,000 = 6,600

Total Cost 9,250 8.550 7,850 ii. Computation of returns under the three Approaches

Conservative Hedging (Matching)

Aggressive

Return of Current Assets 6 % on

35,000 = 2,100 35,000 = 2,100 35,000 = 2,100

Return of Fixed Assets 18 % on

45,000 = 8,100 45,000 = 8,100 45,000 = 8,100

Total Return

Less: Cost of financing

Net Return

10,200

(9,250)

10,200

(8,550)

10,200

(7,850)

950 1,650 2,350

iii. Measurement of (a) Liquidity (b) Risk of Commercial Insolvency i.e.

illiquidity under the three approaches

Conservative Hedging (Matching)

Aggressive

(a) Net Working

Capital (CA-CL)

35,000 -5,000 = 30,000

35,000 -15,000 = 20,000

35,000 -25,000 = 10,000

(b) Current

Ratio (CA _ CL)

35,000

5,000

= 7 : 1

35,000

15,000

= 2.33 : 1

35,000

25,000

= 1.4 : 1

Comments

(i) Cost of financing is highest being Rs. 9,250 in conservative approach, and

lowest (Rs. 7,850) in aggressive approach (the total funds being the same, i.e., Rs.

80,000).

(ii) Return on investment (net) is lowest in conservative approach being

Rs.950 and highest in aggressive approach being Rs. 2,350.

(iii) Risk is measured by the amount of net working capital. The larger the net

working capital, the lesser will be the degree of technical insolvency or the lesser will

be the inability to meet obligations on maturity dates. In other words, larger net

working capital means less risk. The net working capital is comparatively larger in

conservative approach and therefore, the degree of risk is low. The net working capital

is comparatively lower in aggressive approach, and, therefore, the degree of risk is

high.

Risk is also measured by the degree of liquidity. The larger the degree of

liquidity, the lesser will be the degree of risk. One of the measurements of degree of

liquidity is current ratio; it is also known as 'Working Capital Ratio: This ratio signifies

the firm's ability to meet its current obligations. The larger the ratio, the greater

the liquidity, and the lesser the risk. In conservative approach, current ratio is the

highest being 7 : 1 , and in aggressive approach, this ratio is lowest being 1.4 : 1.

Therefore, there is low risk in conservative approach.

The aforementioned analysis leads to the following conclusions :

(i) In conservative approach, cost is high, risk is low, and return is low.

(ii) In aggressive approach, cost is low, risk is high, and return is high.

Hedging approach has moderate cost, risk and return. It aims at trade-off

between profitability and risk.

11.4 REVISION POINTS

Working capital requirements can be determined mainly in three ways: Per

cent-of-sales method, Regression analysis method, and The working capital cycle

method.

Approach of working capital --- Matching (or) Moderate Approach, Aggressive

Approach, Conservative Approach.

11.5 INTEXT QUESTIONS

1. What are the different methods of forecasting working capital

requirements?

2. Explain:, (a) Core current assets (b) Working Capital Gap (c) Working

capital cycle

3. What are the risk-return trade-offs involved in choosing a mix of

short- and long-term financing?

PRACTICAL PROBLEMS

1.The Board of Directors of Guru Nanak Engineering Company Private Ltd, requests you to prepare a statement showing the Working Capital Requirements

Forecast for a level of activity of 1,56,000 units of production.

The following information is available for your calculation: Raw materials 90 per unit Direct Labour 40 per unit

Overheads 75 per unit ______

205 Profits 60 ______

Selling price per unit 265 ______

B. (i) Raw materials are in stock on average one month. (ii) Materials are in

process, on average two weeks, (iii) Finished goods are in stock, on average one

month (iv) Credit allowed by suppliers one month (v) Time lag in payment from

debtors 2 months (vi) Lag in payment of wages 1 .j weeks.

(vii) Lag in payment of overheads is one month

20% of the output is sold against cash. Cash in hand and at Bank is expected

to be Rs.60,000. It is to be assumed that production is carried on evenly throughout

the year, wages and overheads accure similarly and a time period of 4 weeks is

equivalent to a month. [Ans: Working Capital Required Rs.74,13,000]

Notes(i) Since wage's and overheads accrue evenly on average, half the wages

and overhead would be included in working progress. Alternatively if it is assumed

that the direct labour and overhead are introduced at the beginning. full wages and

overhead would be included.

2. A proforma cost sheet of a company provides the following particulars:

Elements of Cost

Raw Materials 40%

Labour 10%

Overheads 30%

The following further particulars are available:

a. Raw materials are to remain in stores on an average 6 weeks.

b. Processing time is 4 weeks.

c. Finished goods are required to be in stock on average period of 8 weeks

d. Credit period allowed to debtors, on average 10 weeks.

e. Lag in payment of wages 4 weeks

f. Credit period allowed by creditors 4 weeks

g. Selling price is Rs.50 per unit

You are required to prepare an estimate of working capital requirements adding

10% margin for contingencies for a level of activity of 1,30,000 units of production.

[Ans: Working Capital Required=Rs.25,2,5000]

3. From the following information extracted from the books of a manufacturing concern, compute the operating cycle in days -

Period covered : 365 days

Average period of credit allowed by suppliers 16 days. Average total of debtors outstanding 4,80,000 Raw-Material Consumption 44,00,000

Total Production Cost 1,00,00,000 Total cost of Sales l ,05,00,000

Sales for the year 1,60,00,000 Value of average stock maintained -

Raw Materials 3,20,000

Work-in-Progress 3,50,000

Finished goods 2,60,000

[Ans.: Total period of operating cycle 44 days]

4. The management of Jayant Electrical Ltd. is faced with various alternatives

for managing its current assets. The company is producing 1,00,000 units of

electrical heaters. This is its maximum installed capacity. Its selling price per unit is

Rs.50. The entire output is sold in the market. Fixed assets of the company are

valued at Rs. 20 lakhs. '

The company earns 10% on sales before interest and taxes. The management is

faced with three alternatives about the size of investment in current assets. (i) to

operate with current assets of Rs. 20 lakhs, or (ii) to operate with current assets of

Rs, 15 lakhs, or (iii) to operate with current assets of Rs 10 lakhs.

You are required to show the effect of the above three alternative current assets management policies on the degree of profitability of the company. [Ans.: (i)

Conservative Policy (i i ) Moderate Policy ( i i i ) Aggressive Policy.

5. (a) Total investments:

In Fixed Assets 1,20,000

In Current Assets 80,000 ___________ 2,00,000

Earning (EBIT) is 25%. (b) Debt-ratio is 60%. (c) Rs. 80,000 being (40% assets) financed by the equity shareholder,

i.e., long-term sources. (d) Cost of short-term debt and long-term debt is 14% and 16% respectively.

(e) Assume Income-tax @ 50%. As a result of the financing policy, ascertain the return on equity shares.

[Ans.: Return on equity is highest in aggressive policy]

11.6 SUMMARY

Working capital requirements can be determined mainly in three ways: Per cent-of-sales method, Regression analysis method, and The working capital cycle method

Working capital is called cash – back – to – cash. Thus working cycle has four distinct stage, they are raw materials and stores inventory stage, semi finished

goods or Work in progress stage, finished goods inventory stage and finally accounts receivable stage.

There are three approaches in working capital, they are Matching or Moderate

approach, Aggressive approach, Conservative approach.

11.7 TERMINAL EXERCISE

1. Aggressive approach means

(a) using short term finance (c) using equity finance

(b) using long term finance (d) using retained earnings.

2. Matching approach is also called

(a) Aggressive Approach (b) Conservative Approach

(c) Hedging Approach

11.8 SUPPLEMENTARY MATERIALS

http://dosen.narotama.ac.id/

http://www.osbornebooksshop.co.uk/

http://www.fao.org/

11.9 ASSIGNMENT

1.Evaluate the following statement: "A firm can reduce its risk of illiquidity with higher current-asset investments, but the return on capital goes down."

2. There are four different policies that managers must consider in designing their working capital policy. Explain the salient features of each policy. What are

the advantages and disadvantages of each such policy?

11.10 SUGGESTED READINGS

1. Agarwal, F.K : Working Capital Management, New Delhi, Sterling Publications (P) Ltd.

2. Kulshrestha, R.S. : Financial Management, Agra, Sahitya Bhavan.

3. Ramamoorthy, V.E. : Working Capital Management, Madras, Institute for Financial Management and Researc

11.11 LEARNING ACTIVITIES

Make group discussion on working capital management in a manufacturing

industry. And write short note about various working capital forecasting technique adopted by those industry.

11.12 KEY WORDS

Working capital gap

Working capital cycle

Duration of operating cycle

Hedging Approach

Conservative Approach

Aggressive Approach.

LESSON 12

IMPORTANCE OF CAPITAL BUDGETING

12.1 INTRODUCTION

Capital budgeting decisions are of paramount importance in financial

decisions, because efficient allocation of capital resources is one of the most crucial

decisions of financial management. Capital budgeting is budgeting for capital

projects. It is significant because it deals with right kind of evaluation of projects.

The exercise involves ascertaining / estimating cash inflows and outflows, matching

the cash inflows with the outflows appropriately and evaluation of desirability of the

project. It is a managerial technique of meeting capital expenditure with the overall

objectives of the firm. Capital budgeting means planning for capital assets. It is a

complex process as it involves decisions relating to the investment of current funds

for the benefit to be achieved in future. The overall objective of capital budgeting is

to maximize the profitability of the firm / the return on investment.

Capital Budgeting is the process of making investment decision in Fixed

assets or Capital expenditure. Capital Budgeting is also known as Investment

decision making, planning of capital acquisition, planning of capital expenditure,

analysis of capital expenditure.

12.2 OBJECTIVES

After completing this Lesson you should be able to know

Meaning of Capital Budgeting

Need and importance of Capital Budgeting

12.3 CONTENT

12.3.1 Capital Expenditure

12.3.2 Capital Budgeting Definition

12.3.3 Need and Importance of Capital Budgeting

12.3.1 CAPITAL EXPENDITURE

A capital expenditure is an expenditure incurred for acquiring or improving the

fixed assets, the benefits of which are expected to be received over a number of

years in future. The following are some of the examples of capital expenditure.

1. Cost of acquisition of permanent assets such as land & buildings, plant & machinery, goodwill etc.

2. Cost of addition, expansion, improvement or alteration in the fixed assets.

3. Cost of replacement of permanent assets.

4. Research and development project cost etc.

5. Capital expenditure involves non-flexible long term commitment of funds.

12.3.2 CAPITAL BUDGETING – DEFINITION

“Capital budgeting” has been formally defined as follows.

“Capital budgeting is long-term planning for making and financing proposed

capital outlay”. - Charles T. Horngreen

“The capital budgeting generally refers to acquiring inputs with long -term

returns”. - Richards & Greenlaw.

“Capital budgeting is concerned with the allocation of the firms’ source

financial resources among the available opportunities. The consideration of

investment opportunities involves the comparison of the expected future streams of

earnings from a project with the immediate and subsequent streams of earning

from a project, with the immediate and subsequent streams of expenditure” - G.C.

Philippatos,

“Capital budgeting consists in planning development of available capital for the

purpose of maximizing the long-term profitability of the concern” - Lyrich

“Capital budgeting involves the planning of expenditure for assets, the

returns from which will be realized in future time periods”. Milton H. Spencer

It is clearly explained in the above definitions that a firm’s scarce financial

resources are utilizing the available opportunities. The overall objective of the

company from is to maximize the profits and minimize the expenditure of cost.

Further, the long-term activities are those activities that influence firms operation

beyond the one year period. The basic features of capital budgeting decisions are:

There is an investment in long term activities

Current funds are exchanged for future benefits

The future benefits will be available to the firm over series of years.

The Investment of Funds in long term activities which are usually non-

flexible.

Each project involves huge amount of funds

Objective :

1. To find out the profitable capital expenditure.

2. Ensure efficient control over large investment and expenditures.

3. To find out the quantum of finance required for to capital expenditure.

4. To facilitate long – range planning.

5. To evaluate the merits of each proposal to decide which project is best.

12.3.3 NEED AND IMPORTANCE OF CAPITAL BUDGETING

Capital budgeting is the process of evaluating and selecting long-term

investments that are consistent with the goal of the firm. There are many factors

responsible for determining the need for capital investment like Expansion,

Diversification, Obsolescence, Wear and tear of old equipment, Productivity

improvement, Replacement and modernization and so on.

When the investments are profitable the firm’s value will increase and they

add to the shareholders’ wealth. The investment will add to the shareholders’

wealth if it yields benefits, in excess of the minimum benefits as per the opportunity

cost of capital.

The need and importance of capital budgeting has been explained as follows:

1. Long-term Implication

Capital expenditure decision affects the company's future cost structure over a

long time span. The investment in fixed assets increases the fixed cost of the firm

which must be recovered from the benefit of the same project. If the investment

turns out to be unsuccessful in future or give less profi t than expected, the

company will have to bear the extra burden of fixed cost. Such risk can be

minimized through the systematic analysis of projects which is the integral part of

investment decision.

2. Irreversible Decision

Capital investment decision are not easily reversible without much financial

loss to the firm because there may be no market for second-hand plant and

equipment and their conversion to other uses may not be financially viable. Hence,

capital investment decisions are to be carried out and performed carefully and

effectively in order to save the company from such financial loss. The investment

decision which is undertaken carefully and effectively can save the firm from huge

financial loss aroused due to the selection of unfavourable projects.

3. Long-term Commitments of Funds

Capital budgeting decision involves the funds for the long-term. So, it is long-

term investment decision. The long-term commitment of funds leads to the financial

risk. Hence, careful and effective planning is must to reduce the financial risk as

much as possible.

The significance of capital budgeting can also analyzed with the help of

following points.

Capital budgeting involves capital rationing. This is the available funds that

have to be allocated to competing projects in order of project potential.

Normally the individuality of project poses the problem of capital rationing

due to the fact that required funds and available funds may not be the same.

Capital budget becomes a control device when it is employed to control

expenditure. Because manned outlays are limits to actual expenditure, the

concern has to investigate the variation in order to keep expenditure under

control.

A firm contemplating a major capital expenditure programme may need to

arrange funds many years in advance to be sure of having the funds when

required.

Capital budgeting provides useful tool with the help of which the

management can reach prudent investment decision.

Capital budgeting is significant because it deals with right mind of

evaluation of projects. A good project must not be rejected and a bad project

must not be selected. Capital projects need to be thoroughly evaluated as to

costs and benefits.

Capital projects involve investment in physical assets such as land, building

plant, machinery etc. for manufacturing a product as against financial

investments which involve investment in financial assets like shares, bonds

or mutual funds. The benefits from the projects last for few to many years.

Capital projects involve huge outlay and last for years.

Capital budgeting thus involves the making of decisions to earmark funds

for investment in long term assets yielding considerable benefits in future,

based on a careful evaluation of the prospective profitability / utility of such

proposed new investment.

It is clear from the above discussion what capital investment proposals involve

a. Longer gestation period

b. Substantial capital outlay

c. Technological considerations

d. Irreversible decisions

e. Environmental issues

f. Independent proposals

g. Mutually exclusory proposals

4. Permanent Commitments of Funds

The investment made in the project Results in the permanent commitment of

Funds. The greater risk is also involved because of permanent commitment of

Funds.

5. National Importance

The selection of any project results in the employment opportunity,

economic growth and increase per capital income. These are the ordinary positive

impact of any project selection made by any company.

12.4 REVISION POINTS

1.Capital Expenditure A capital expenditure is an expenditure incurred for

acquiring or improving the fixed assets, the .benefits of which are expected to be

received over a number of years in future.

2. Capital Budgeting Capital budgeting involves the planning of expenditure

for assets, the returns from which will be realized in future time periods

3. The need and importance of capital budgeting has been explained as

Long-term Implication Irreversible Decision .Long-term Commitments of Funds,

Permanent Commitments of Funds, National Importance.

12.5 INTEXT QUESTIONS

1. Define capital Budgeting

2. Define Irreversible Decision

3.What do you mean by Long term implication?

12.6 SUMMARY

Capital Budgeting is the process of making investment decision in capital

expenditures. A capital Expenditure is an expenditure incurred for acquiring or

improving the fixed assets, the benefits of which are expected to be received over a

number of years in future. Capital expenditure involves non flexible long term

commitment of funds. Capital Budgeting is also known as long term investment

decision. Capital Budgeting decisions are among the most crucial and critical

business decisions. Special care to be taken in making these decisions on account

of the following reasons; heavy investment, permanent commitment of funds, long

term effect on profitability, irreversible in nature .

12.7 TERMINAL EXERCISE

1. …………………………..is the process of making investment decisions in

capital expenditures.

2. ………………………..is an expenditure incurred for acquiring or

improving the fixed assets, the benefits of which are expected over a number of years in future.

12.8 SUPPLEMENTARY MATERIALS

http://www2.fiu.edu/

http://www.fao.org/

https://msu.edu

http://people.hss.caltech.edu/

http://www.investopedia.com/

http://umanitoba.ca/

http://isites.harvard.edu/

https://www.cfainstitute.org

www.cengage.com

www.hss.caltech.edu

12.9 ASSIGNMENTS

1. Examine the need and importance of Capital Budgeting.

2. Highlight the basic features of capital Budgeting Decisions.

12.10 SUGGESTED READINGS /REFERENCE BOOKS

1. Agrawal, Shah, Mendiratta, Agarwal, Sharma, Tailor — Cost and

Management Accounting ( Malik and Co.)

2. Agrawal, Jain, Sharma, Shah, Mangal — Cost Accounting ( RBD, Jaipur)

3. Agarwal. M.R. — Managerial Accounting (Garima Publications)

4. Agrawal — Management Accounting (RBD. Jaipur)

12.11 LEARNING ACTIVITIES

Identify the importance of capital budgeting and relates with any one of the

organizations which is nearby you and correlate how they are giving importance to capital Budgeting

12.12 KEYWORDS

Capital Budgeting, Capital Expenditure, Long-term Implication, Irreversible

Decision. Long-term Commitments of Funds, Permanent Commitments of Funds, National Importance.

LESSON 13

METHODS OF EVALUATING CAPITAL INVESTMENT PROPOSAL

13.1 INTRODUCTION

The capital Budgeting techniques or evaluation of investment proposals have

considerably gained the importance. This is more true in the modern business

environment. After the introduction of New Economic Policy, the environments in

the industry and service sector have considerably changed. Number of mergers,

acquisition, and joint ventures and continues innovation are being experienced in

the markets. Therefore it is very difficult to arrive at decision for financing the

project. It is absolutely essential for every business entity to make use of this scare

resource on the most profitable lines. Following are some of the important methods

used in practice in evaluating the investment proposals.

13.2 OBJECTIVES

After completing this Lesson you should be able to know

Various techniques of investment Appraisal

Discounted and Non-Discounted Cash Flow Methods

Merits and demerits of Various techniques

13.3 CONTENT

13.3.1 Techniques of Investment Appraisal

13.3.2 Non-Discounted Cash Flow Criteria

13.3.3 Discounted Cash Flow Criteria

13.3.4 Discounted Cash Flow Techniques Merits

13.3.5 Discounted Cash Flow Techniques Demerits

13.3.6 Comparison Between NPV and IRR

13.3.1 TECHNIQUES OF INVESTMENT APPRAISAL

There are many methods for evaluating or ranking the investment proposals.

In all these methods, the basic approach is to compare the investments in the

project to the benefits derived there from. These methods can be categorized as

Follows:

13.3.2 NON-DISCOUNTED CASH FLOW CRITERIA / TRADITIONAL METHODS

Pay-back period

Discounted payback period

Accounting rate of return (ARR)

13.3.3 DISCOUNTED CASH FLOW (DCF) CRITERIA

Net present value (NPV)

Internal rate of return (IRR) / Excess PV Index method/benefit

Profitability index (PI) / Benefit cost ratio

NON-DISCOUNTED CASH FLOW CRITERIA

Payback period Method

This method is popularly known as pay off, pay-out, recoupment period method

also. It gives the number of years in which the total investment in a particular

capital expenditure pays back itself. This method is based on the principle that

every capital expenditure pays itself back over a number of years. It means that it

generates income within a certain period. When the total earnings (or net cash-

inflow] from investment equals the total outlay, that period is the payback period of

the capital investment. An investment project is adopted so long as it pays for itself

within a specified period of time — says 5 years or less. This standard of

recoupment period is settled by the management taking into account a number of

considerations. While there is a comparison between two or more projects, the

lesser the number of payback years, the project will be acceptable.

The formula for the payback period calculation is simple when the cash inflow

is even throughout life of the project/ Machine/ Capital investment. First of all,

net-cash-inflow (Profit after Tax Before Depreciation) is determined. Then we divide

the initial cost (or any value we wish to recover) by the annual cash-inflows and the

resulting quotient is the payback period. As per formula:

If the annual cash-inflows are uneven, then the calculation of payback

period takes a cumulative form. We accumulate the annual cash-inflows till the

recovery of investment and as soon as this amount is recovered, it is the expected

number of payback period years. An asset or capital expenditure outlay that pays

back itself early comparatively is to be preferred.

Payback Method – Merits

The payback period method for choosing among alternative projects is very

popular among corporate managers and according to Quirin even among Soviet

planners who call it as the recoupment period method. In U.S.A and U.K. this

method is widely accepted to discuss the profitability of foreign investment.

Following are some of the advantages of pay back method:

1. It is easy to understand, compute and communicate to others. Its quick

computation makes it a favourite among executive who prefer snap answers.

2. It gives importance to the speedy recovery of investment in capital assets. So

it is useful technique in industries where technical developments are in full

swing necessitating the replacements at an early date.

3. It is an adequate measure for firms with very profitable internal investment

opportunities, whose sources of funds are limited by internal low availability

and external high costs.

4. It is useful for approximating the value of risky investments whose rate of

capital wastage (economic depreciation and obsolescence rate) is hard to

predict. Since the payback period method weights only return heavily and

ignores distant returns it contains a built-in hedge against the possibility of

limited economic life.

5. When the payback period is set at a large “number of years and incomes

streams are uniform each year, the payback criterion is a good

approximation to the reciprocal of the internal rate of discount.

Payback Method – Demerits

This method has its own limitations and disadvantages despite its simplicity

and rapidity. Here are a number of demerits and disadvantages claimed by its

opponents:-

1. It treats each asset individually in isolation with the other assets, while

assets in practice cannot be treated in isolation.

2. The method is delicate and rigid. A slight change in the division of labour

and cost of maintenance will affect the earnings and such may also affect

the payback period.

3. It overplays the importance of liquidity as a goal of the capital expenditure

decisions. While no firm can ignore its liquidity requirements but there are

more direct and less costly means of safeguarding liquidity levels. The

overlooking of profitability and over stressing the liquidity of funds can in

no way be justified.

4. It ignores capital wastage and economic life by restricting consideration to

the projects’ gross earnings.

5. It ignores the earning beyond the payback period while in many cases

these earnings are substantial. This is true particularly in respect of

research and welfare projects.

6. It overlooks the cost of capital which is the main basis of sound investment

decisions.

In perspective, the universality of the payback criterion as a reliable index of

profitability is questionable. It violates the first principle of rational investor

behaviour-namely that large returns are preferred to smaller ones. However, it can

be applied in assessing the profitability of short and medium term capital

expenditure projects.

Accounting Rate of Return Method

It is also known as Accounting Rate of Return Method / Financial Statement

Method/ Unadjusted Rate of Return Method also. According to this method, capital

projects are ranked in order of earnings. Projects which yield the highest earnings

are selected and others are ruled out. The return on investment method can be

expressed in several ways a follows:

(i) Average Rate of Return Method

Under this method we calculate the average annual profit and then we divide it

by the total outlay of capital project. Thus, this method establishes the ratio

between the average annual profits and total outlay of the projects.

As per formula,

Thus, the average rate of return method considers whole earnings over the

entire economic life of an asset. Higher the percentage of return, the project will be

acceptable.

(ii) Earnings per unit of Money Invested

As per this method, we find out the total net earnings and then divide it by the

total investment. This gives us the average rate of return per unit of amount (i.e.

per rupee) invested in the project. As per formula:

The higher the earnings per unit, the project deserves to be selected.

(iii) Return on Average Amount of Investment Method

Under this method the percentage return on average amount of investment is

calculated. To calculate the average investment the outlay of the projects is divided

by two. As per formula:

Here:

Average Annual Net Income does not mean average Annual Cash-inflow

Average Investment may be of the following:

OR

OR

Thus, we see that the rate of return approach can be applied in various

ways. But, however, in our opinion the third approach is more reasonable and

consistent.

Accounting Rate of Return Method – Merits

This approach has the following merits of its own:

1. Like payback method it is also simple and easy to understand.

2. It takes into consideration the total earnings from the project during its

entire economic life.

3. This approach gives due weight to the profitability of the project.

4. In investment with extremely long lives, the simple rate of return will be

fairly close to the true rate of return. It is often used by financial

analysis to measure current performance of a firm.

Accounting Rate of Return Method – Demerits

1. One apparent disadvantage of this approach is that its results by

different methods are inconsistent.

2. It is simply an averaging technique which does not take into account the

various impacts of external factors on over-all profits of the firm.

3. This method also ignores the time factor which is very crucial in

business decision.

4. This method does not determine the fair rate of return on investments. It

is left to the discretion of the management.

Discounted Cash flows (DCF) Techniques (or) Time Ad jested Method

Another method of computing expected rates of return is the present value

method. This method involves calculating the present value of the cash benefits

discounted at a rate equal to the firm’s cost of capital. The method is popularly

known as Discounted Cash flow Method. The concept of DCF valuation is based on

the principle that the value of a business or asset is inherently based on its ability

to generate cash flows for the providers of capital. To that extent, the DCF relies

more on the fundamental expectations of the business than on public market

factors or historical precedents, and it is a more theoretical approach relying on

numerous assumptions. A DCF analysis yields the overall value of a business (i.e.

enterprise value), including both debt and equity. In simple the “presen t value of

an investment is the maximum amount a firm could pay for the opportunity of

making the investment without being financially worse off.”

Key Components of a DCF:

Free Cash flow (FCF): Cash generated by the assets of all the business (both

tangible and intangible) available for distribution to all providers of capital. FCF is

often referred to as unlevered free cash flow, as it represents cash flow available to

all providers of capital and is not affected by the capital structure of the business.

Terminal value (TV): Value at the end of the FCF projection period (Horizon

Period).

Discount rate or Present Value factor (PV) – The rate used to discount the

projected FCFs and terminal value to their present values.

The financial executive compares the present values with the cost of the

proposal. If the present value is greater than the net investment, the proposal

should be accepted. Conversely, if the present value is smaller than the net

investment, the return is less than the cost of financing. Making the investment in

this case will cause a financial loss to the firm. There are four methods to judge the

profitability of different proposals on the basis of this technique

(i) Net Present Value Method

This method is also known as Excess Present Value or Net Gain Method. To

implement this approach, we simply find the present value of the expected net cash

inflows of an investment discounted at the cost of capital and subtract from it the

initial cost outlay of the project. If the net present value is positive, the project

should be accepted: if negative, it should be rejected.

NPV = Total Present value of cash inflows – Net Investment

If the two projects are mutually exclusive the one with higher net present value

should be chosen. The following example will illustrate the process:

Assume, the cost of capital after taxes of a firm is 6%. Assume further, that the

net cash-inflow (after taxes) on a Rs. 5,000 investment is forecasted as being

2,800 per annum for 2 years. The present value of this stream of net cash-inflow

discounted at 6% comes to 5,272 (1,813 x 2800).

Therefore, the present value of the cash inflow = 5,272

Less present value of net investment = 5,000

Net Present value = 272

(ii) Internal Rate of Return Method

This method is popularly known as time adjusted rate of return

method/discounted rate of return method also. The internal rate of return is

defined as the interest rate that equates the present value of expected future

receipts to the cost of the investment outlay. This internal rate of return is found by

trial and error. First we compute the present value of the cash-flows from an

investment, using an arbitrarily elected interest rate. Then we compare the present

value so obtained with the investment cost. If the present value is higher than the

cost figure, we try a higher rate of interest and go through the procedure again.

Conversely, if the present value is lower than the cost, lower the interest rate and

repeat the process. The interest rate that brings about this equality is defined as

the internal rate of return. This rate of return is compared to the cost of capital and

the project having higher difference, if they are mutually exclusive, is adopted and

other one is rejected. As the determination of internal rate of return involves a

number of attempts to make the present value of earnings equal to the investment,

this approach is also called the Trial and Error Method,

(iii) Profitability Index (PI) Method

This method is otherwise called benefit cost ratio method or Desirability

Factor. One major disadvantage of the present value method is that it is not easy to

rank projects on the basis of net present value particularly when the cost of

projects differs significantly. To compare such projects the present value

profitability index is prepared. The index establishes relationship between cash-

inflows and the amount of investment as per formula given below:

NPV GPV PI = --------------- x 100 OR -------------------- x 100

Investment Investment

For example, the profitability index of the Rs. 5,000 investment discussed in

Net Present Value Method above would be:

OR

The higher profitability index, the more desirable is the investment. Thus, this

index provides a ready compatibility of investment having various magnitudes. By

computing profitability indices for various projects, the financial manager can rank

them in order of their respective rates of profitability.

(iv) Terminal Value Method

This approach separates the timing of the cash-inflows and outflows more

distinctly. Behind this approach is the assumption that each cash-inflow is re-

invested in other assets at the certain rate of return from the moment, it is received

until the termination of the project. Then the present value of the total compounded

sum is calculated and it is compared with the initial cash-outflow. The decision rule

is that if the present value of the sum total of the compounded re-invested cash-

inflows is greater than the present value of cash-outflows, the proposed project is

accepted otherwise not. The firm would be different if both the values are equal.

This method has a number of advantages. It incorporates the advantage of re -

investment of cash-inflows by compounding and then discounting it. Further, it is

best suited to cash budgeting requirements. The major practical problem of this

method lies in projecting the future rates of interest at which the intermediate cash

inflows received will be re-invested.

13.3.4 DISCOUNTED CASH FLOW TECHNIQUES – MERITS

1. This method takes into account the entire economic life of an investment

and income there from. It gives the rate of return offered by a new

project.

2. It gives due weight to time factor of financing. In the words of Charles

Horngreen “Because the discounted cash-flow method explicitly and

routinely weights the time value of money, it is the best method to use

for long-range decisions.

3. It permits direct comparison of the projected returns on investments

with the cost of borrowing money which is not possible in other

methods.

4. It makes allowance for differences in the time at which investment

generate their income.

5. This approach by recognizing the time factor makes sufficient provision

for uncertainty and risk. It offers a good measure of relative profitability

of capital expenditure by reducing the earnings to the present values.

13.3.5 DISCOUNTED CASH FLOW TECHNIQUES – DEMERITS

This method is criticized on the following grounds:

1. It involves a good amount of calculations. Hence it is difficult and

complicated one. But this criticism has no force.

2. It is very difficult to forecast the economic life of any investment exactly.

3. The selection of cash-inflow is based on sales forecasts which are in

itself an indeterminable element.

4. The selection of an appropriate rate of interest is also difficult.

13.3.6 COMPARISON BETWEEN NPV AND IRR (NPV VS. IRR)

The Net Present value method and the Internal Rate of Return Method are

similar in the sense that both are modern techniques of capital budgeting and both

take into account the time value of money. In fact, both these methods are

discounted cash flow techniques. However, there are certain basic differences

between these two methods of capital budgeting:

1. In the net present value method the present value is determined by

discounting the future cash flows of a project at a predetermined or specified

rate called the cut off rate based on cost of capital. But under the internal

rate of return method, the cash flows are discounted at a suitable rate by hit

and trial method which equates the present value so calculated to the

amount of the investment. Under IRR method, discount rate is not

predetermined.

2. The NPV method recognizes the importance of market rate of interest or cost

of capital. It arrives at the amount to be invested in a given project so that

its anticipated earnings would recover the amount invested in the project at

market rate. Contrary to this, the IRR method does not consider the market

rate of interest and seeks to determine the maximum rate of interest at

which funds invested

3. in any project could be repaid with the earnings generated by the project.

4. The basic presumption of NPV method is that intermediate cash inflows are

reinvested at the cut off rate, whereas, in the case of IRR method,

intermediate cash flows are presumed to be reinvested at the internal rate of

return.’

5. The results shown by NPV method are similar to that of IRR method under

certain situations, whereas, the two give contradictory results under some

other circumstances. However, it must be remembered that NPV method

using a predetermined cut-off rate is more reliable than the IRR method for

ranking two or more capital investment proposals.

(a) Similarities of Results under NPV and IRR

Both NPV and IRR methods would show similar results in terms of accept or

reject decisions in the following cases:

1. Independent investment proposals which do not compete with one

another and which may be either accepted or-rejected on the basis of a

minimum required rate of return.

2. Conventional investment proposals which involve cash outflows or

outlays in the initial period followed by a series of cash inflows.

The reason for similarity of results in the above cases lies on the basis of

decision-making in the two methods. Under NPV method, a proposal is accepted if

its net present value is positive, whereas, under IRR method it is accepted if the

internal rate of return is higher than the cut off rate. The projects which have

positive net present value, obviously, also have an internal rate of return higher

than the required rate of return.

(b) Conflict between NPV and IRR Results

In case of mutually exclusive investment proposals, which compete with one

another in such a manner that acceptance of one automatically excludes the

acceptance of the other, the NPV method and IRR method may give contradic tory

results. The net present value may suggest acceptance of one proposal whereas, the

internal rate of return may favour another proposal. Such conflict in rankings may

be caused by any one or more of the following problems:

1. Significant difference in the size (amount) of cash outlays of various

proposals under consideration.

2. Problem of difference in the cash flow patterns or timings of the various

proposals and

3. Difference in service life or unequal expected lives of the projects.

Exercise:

1) Equipment A has a cost of 75,000 and net cash flow of `20,000 per year for

six years. A substitute equipment B would cost ` 50,000 and generate net cash flow

of ` 14,000 per year for six years. The required rate of return of both equipments is

11 per cent. Calculate the IRR and NPV for the equipments. Which equipment

should be accepted and why?

Solution:

Equipment A

NPV = 20,000 x PVAF6, 0.11 - 75,000

= 20,000 x 4.231 - 75,000

= 84,620 - 75,000 = ` 9,620

IRR = 20,000 x PVAF6, r = 75,000

PVAF6, r = 75,000 / 20,000 = 3.75

From the present value of an annuity table, we find:

PVAF6,0.15 = 3.784

PVAF6,0.16 = 3.685

Therefore,

3.784 – 3.75 IRR = r = 0.15 + 0.01

3.784 – 3.685 = 0.15 + 0.0034 = 0.1534 or IRR = 15.34%

Equipment B:

NPV = 14,000 x PVAF6,0.11 - 50,000

= 14,000 x 4.231 - 50,000

= 59,234 - 50,000 = Rs 9,234

IRR = 14,000 x PVAF6,r = 50,000

PVAF6, r = 50,000 / 14,000 = 3.571

From the present value of an annuity table, we find:

PVAF6,0.17 = 3.589

PVAF6,0.18 = 3.498

Therefore,

Equipment A has a higher NPV but lower IRR as compared with equipment B.

Therefore equipment A should be preferred since the wealth of the shareholders will

be maximized.

5) For each of the following projects compute (i) pay-back period, (ii) post pay-

back profitability and (iii) post-back profitability index

a) Initial outlay ` 50,000

Annual cash inflow

(after tax but before depreciation) ` 10,000

Estimated life 8 Years

b) Initial outlay ` 50,000

Annual cash inflow (after tax but before depreciation)

First three years ` 15,000

Next five years ` 5,000

Estimated life 8 Years

Salvage ` 8,000

Solution:

a) i) Pay-back period = Investment / Annual Cash Flow = 50,000 / 10,000 = 5 Years

ii) Post pay back profitability

= Annual cash inflow (Estimated life–payback period)

= 10,000 (8 – 5) = 30,000 iii) Post back profitability index

= 30,000 / 50,000 x 100 = 60%

b) i) As the case inflows are the equal during the life of the investment payback

period can be calculated as:

1st year’s cash inflow 15,000

2nd year’s cash inflow 15,000

3rd year’s cash inflow 15,000

4th year’s cash inflow 5,000

50,000

Hence, the pay-back period is 4 years. ii) Post pay back profitability

= Annual cash inflow x remaining life after pay –back period) = 5,000 x 4

= 20,000 iii) Post back profitability index

= 20,000 / 50,000 x 100

= 40% 6. X Ltd. is considering the purchase of a machine. Two machines are available

E and F. the cost of each machine is 60,000. Each machine has expected life of 5

years. Net profits before tax (50%) and after depreciation (20% WDV) during

expected life of Five years of the machines are given below:

Year E (Machine) F (Machine)

1 15,000 5,000

2 20,000 15,000

3 25,000 20,000

4 15,000 30,000

5 10,000 20,000

Total 85,000 90,000

Solution:

Statement of Profitability

Year Machine E Machine F

PBTAD Tax 50% PATD PBTAD Tax 50% PATD

1 15,000 7,500 7,500 5,000 2,500 2,500

2 20,000 10,000 10,000 15,000 7,500 7,500

3 25,000 12,500 12,500 20,000 10,000 10,000

4 15,000 7,500 7,500 30,000 15,000 15,000

5 10,000 5,000 5,000 20,000 10,000 10,000

Total 85,000 42,500 42,500 90,000 45,000 45,000

Machine E Machine F

Average profit after tax 42,500 x 1/5 = 8,500 45,000 x 1/5 = 9,000

Average investment 60,000 x ½ = 30,000 60,000 x ½ = ` 30,000

Average return on average 8,500/30,000 x 100

= 28.33%

9,000/30,000 x 100

= 30%

Thus, machine F is more profitable.

Capital Rationing – Meaning Capital rationing refers to a situation where a firm is not in a position to invest

in all profitable projects due to the constraints on availability of funds. We know

that the resources are always limited and the demand for them far exceeds their

availability, it is for this reason that the firm cannot take up all the projects though

profitable, and has to select the combination of proposals that will yield the greatest

profitability.

Capital rationing is a situation where a firm has more investment proposals

than it can finance. It may be defined as “a situation where a constraint is placed

on the total size of capital investment during a particular period”. In such an event

the firm has to select combination of investment proposals that provide the highest

net present value subject to the budget constraint for the period. Selecting of

projects for this purpose will require the taking of the following steps:

Ranking of projects according to profitability index or internal’-rate of return.

Selecting projects in descending order of profitability until the budget figures

are exhausted keeping in view the objective of maximizing the value of the firm.

PRACTICAL PROBLEMS

1. Project cost is Rs. 30,000 and the cash inflows are Rs. 10,000, the life of

the project is 5 years. Calculate the pay-back period. (Ans:3 years).

2. A project costs Rs. 20,00,000 and yields annually a profit of Rs.

3,00,000 after depreciation @ 12½% but before tax at 50%. Calculate

the pay-back period. (Ans: 5 years )

3. Certain projects require an initial cash outflow of Rs. 25,000. The cash

inflows for 6years are Rs. 5,000, Rs. 8,000, Rs. 10,000, Rs. 12,000, Rs.

7,000 and Rs. 3,000.Calculate payback period. (Ans: 3 yrs 2month )

4. F ltd is considering two projects. each requires an investment of

Rs.10,000.the firm cost of capital is 10%,the net cash inflows from

investment in the two projects X and Y are as follows :

Year X Y

1 5000 1000

2 4000 2000

3 3000 3000

4 1000 4000

5 - 5000

6 - 6000 The company has fixed 3 years pay-back period as the cut-off point, state

which project should be accepted .

Ans: Traditional pay-back period for:

Project X= 2 years &4 Months (2.33 years) Project Y=4 years.

Discounted pay-back period @ 10%Project:

X=2.95 years & project Y=4.79 years

5. Seshu Ltd has two projects under consideration which are mutually

exclusive. the projects have to be depreciated on straight line basis and the tax rate

may be taken as 50%.

Year Profit before Depreciation

A(Rs.) B(Rs)

1 80,000 20,000

2 60,000 40,000

3 40,000 60,000

4 20,000 80,000

5 10,000 1,00,000

Calculate payback period.

[Ans project A=2 Years ,4 months ;B = 3 years 2 months ]

6. A company is considering the purchase of the following machines:

Automatic machine Ordinary machine

Cost (Rs)

Life (Years )

Sales (Rs)

Cost :

Materials

Labour

Variable OH

2,24,000

5 ½

1,50,000

50,000

12,000

24,000

60,000

8

1,50,000

50,000

60,000

20,000

Compute the payback period and profitability beyond the payback period.

[Ans:payback period Automatic = 3.5 yrs , Ordinary = 3 yrs ; profitability beyond PB

period: automatic =Rs 1,28,000, Ordinary = Rs 1,00,000 ]

7. MM Ltd is considering the purchase of new machine which will carry out

operations performed by labour. A and B are alternative models. From the following

information, you are required to prepare a profitability statement and workout the

pay-back period in respect of each machine:

Particulars Machine A Machine B

Estimated life of machines years

Cost of machine

Cost of indirect materials

Estimated savings in scrap

Additional cost of maintenance

Estimated savings in direct wages:

Number of Employee not required

Wages per employee

5

1,50,000

6,000

10,000

19,000

150

600

6

2,50,000

8,000

15,000

27,000

200

600

Taxation is to be regarded as 50% of profit (ignore depreciation for calculation

of tax).which model would you recommend? State your reasons.

(Ans: payback period in case of machine A is 4 years and in case of machine

B,it is 5 years. Hence, Machine A is preferred)

8. No project is acceptable unless the yield is 10% Cash inflows of certain

project along with cash outflow are given below:

Year Outflow Rs. Inflow Rs.

0 1,50,000

1 30,000 20,000

2 30,000

3 60,000

4 80,000

5 30,000 The salvage value at the end of 5th year is Rs.40,000. Calculate the NPV.

[Ans:8,860]

9. A Ltd. has under consideration the following two projects. their details are as

under:

Project X Project Y

Investment in machinery

Working capital

Life of machinery

Scrap value of machinery

Tax rate

Income before depreciation and tax

at the end of year

1

2

3

4

5

6

Rs.10,00,000

5,00,000

4 yrs

10 %

50 %

8,00,000

8,00,000

8,00,000

8,00,000

-

-

15,00,000

5,00,000

6 yrs

10 %

50 %

15,00,000

9,00,000

15,00,000

8,00,000

6,00,000

3,00,000

You are required to calculate the accounting rate of return and suggest which project is to be preferred.

(Ans: ARR Project X Rs =19.1%,Project Y Rs = 17.75%)

10. A new capital project costing Rs.140 Lakhs will yield on an average a profit

before tax and depreciation of Rs.50 lakhs .depreciation will be Rs.20 lakhs per

annum and the tax rate is 50%. Work out the pay_back period and return on

investment.

Ans. pay back period = 4 years, ARR(on original investment)=10.71%;

ARR(on average investment)= 21.43 %

11. A project requires initial investment of Rs 85,000 and is expected to give

cash flows of Rs 18,000, Rs25,000,Rs 10,000,Rs.25,000 and Rs. 30,000 for 5 years

respectively. the project has a salvage value of Rs.10,000. The company ’s target

rate of return is 10%.calculate the profitability of the projects by using profitability

index method. (Ans: P.I = 1.017)

12. A project costs Rs.16,000 and is expected to generate cash inflows of

Rs.4,000 each for 5 years .calculate internal rate of return . (Ans.8%)

13. MM Limited considering a project with an Initial investment of Rs1,80,000,

the life of the project is four years and estimated net annual cash flows are as

follows

Year Rs

1

2 3

4

45,000

60,000 90,000

60,000 Calculate internal rate of return [Ans:14.49 %]

14. Easwar limited company is considering an investment in a project with a

capital outlay of Rs.2,00,000. The estimated annual income after depreciation but

before tax is Rs. 1,00,000; each in the first and second year 80,000; each in the

third and fourth year and Rs.40,000 in the fifth year. Depreciation may be taken

at 20% on original cost and taxation at 50% of net income you are required to

evaluate the project according to each of the following method:

a) Payback period method

b) Rate of return on original investment method

c) Rate of return on average investment method

d) Net present value method discounting in flow at 10%

YEAR 1 2 3 4 5

P.V.F 0.909 0.826 0.751 0.683 0.621

Ans : a)2.25 years b)20 % c) 40 % d) 1,08,130

15. The expected cash flows of a project are as follows :

Year 0 1 2 3 4 5

Cash flow 1,00,000 20,000 30,000 40,000 50,000 30,000

The cost of capital is 12% calculate:

a) NPV (b) IRR (c) Payback period and (d) Discounted payback period

Ans: a ) 19,060 b) 20.56% c) 3 years 2 months d) 3 yrs 11 months

Capital rationing

16. A ltd. has an investment budget of Rs.25 Lakh for next year.it has under

consideration three projects A,B and C(B and C are mutually exclusive )and all of

them can be completed within a year. Further details are given below :

Project Investment required Net present value

A

B

C

14

12

10

5.6

7.2

5.0

Recommend the best policy to utilize budget, supported by proper reasoning

[Ans: A&B is not possible as investment required exceeds Rs.25 lakh.

B&C is not possible as they are mutually exclusive projects:

A&C is only possible option thought NPV is lowest(i.e.,10.6lakh]

17. In capital rationing situation (investment limit Rs.25 Lakh ),suggest the

most desirable feasible combination on the basis of the following data (indicate

justification)

Project Initial outlay NPV

A

B

C

D

15

10

7.5

6

6

4.5

3.6

3

Project B and C are mutually exclusive.

[Ans: Projects A and B combination give highest NPV of Rs. 10.50 lakh. by

undertaking these projects wealth maximization is possible]

18. APJ Ltd. has the following proposals

Project Cost Net present value

A

B

C

D

E

1,00,000

3,00,000

50,000

2,00,000

1,00,000

20,000

35,000

16,000

25,000

30,000

Total funds available are Rs.3, 00,000 determine the optimal combination of

projects assuming that (i) the projects are divisible and (ii) if the projects are not

divisible

[Ans :(i) The company can get a NPV OF Rs.72,125 by selecting projects

C+E+A+ ¼ of D;

(ii)Combination of A+C+E(Total outlay Rs 2,50,000) is the best it gives a

maximum NPV of Rs.66,000]

19. Ram Ltd is considering the following six proposals

Project Cost NPV

1 2

3 4 5

6

1,000 6,000

5,000 2,000 2,500

500

210 1,560

850 260 500

95 You are required to calculate the profitability index for each projects and rank

them which projects would you choose if the total funds are Rs.8000.

[Ans: P.I:P1:1.21; P2:1.26; P3:1.17; P4:1.13; P5:1.20; P6:1.19;1,2 and 6 is the

best combination as it gives the highest NPV of Rs.1,865]

OTHER PROBLEMS FOR BEST PRACTICE

1. Evaluation of Cash Flows. Below are the cash flows for two mutually

exclusive projects.

year CFX CFY

0 (5,000) (5,000)

1 2,085 0

2 2,085 0

3 2,085 0

4 2,085 9,677

a. Calculate the payback for both projects.

b. Initially, the cost of capital is uncertain, so construct NPV profiles for the two

projects (on the same graph) to assist in the analysis. The profiles cross at what

cost of capital? What is the significance of that?

c. It is now determined that the cost of capital for both projects is 14%. Which

project should be selected? Why?

d. Calculate the MIRR for both projects, using the 14% cost of capital.

Answers: a. 2.4 yrs, 4 yrs; b. 10%; c. X; d. MIRRX = 19.69%

2. More practice with Cash Flow Evaluation. Cash flows for two mutually exclusive projects are shown below:

year CFM CFN 0 (100) (100)

1 10 70 2 60 50

3 80 20 Both projects have a cost of capital of 10%.

a. Calculate the payback for both projects.

b. Calculate the NPV for both projects.

c. Calculate the IRR for both projects.

d. Calculate the MIRR for both projects.

Answers: a. 2.4 yrs, 1.6 yrs; b. Rs.18.78, Rs.19.98; c. 18.1%, 23.56%; d. 16.5%,

16.9%;

3. Expansion Project. A machine has a cost of Rs.180. It will have a life of 3

years, and will be depreciated straight line to zero salvage value. It will result in

sales revenue of Rs.200 per year and cash operating costs of Rs.110 per year. Use

of the machine will require an increase in working capital of Rs.70 for the 3 years,

beginning at year 0. The appropriate discount rate is 8% and the firm’s tax rate is

40%.

a. Calculate the initial cash flow at time 0.

b. Calculate the annual operating cash flows (they are identical each year).

c. Calculate the relevant terminal cash flows at the end of year 3.

d. What is the NPV for the machine?

Answers: a. -250; b. 78; c. 70; d. Rs.6.58

4. Inflation adjustment: A project requires an initial investment of Rs.8,000,

has a 4-year life and provides expected cash flows as follows, based on year 1 prices

and costs:

Annual revenue = Rs.5,000

Annual cash operating costs = Rs.2,000

Annual depreciation = Rs.2,000

Terminal cash flow = 0

Cost of capital = 14% and Tax = 30%

a. Calculate the annual operating cash flows without adjusting for inflation.

(Are these cash flows real or nominal?) Calculate the associated NPV.

b. Adjust the cash flows to reflect the effects of inflation, which is expected to

affect sales revenue and cash operating expenses at the rate of 4% annually. (Are

these cash flows real or nominal?) Calculate the associated NPV.

c. Which NPV is the correct one for evaluating the project?

Ans: a. -Rs.133; b. Rs.202

5. Mutually Exclusive Projects with Unequal Lives. Murray’s Coffee House

is trying to choose between two new coffee bean roasters. The required rate of

return for either machine is 10%. Shown below are the after-tax cash flows

associated with each machine:

year CFX CFY

0 (50,000) (30,000)

1 20,000 20,000

2 20,000 20,000

3 20,000

4 20,000

a. Calculate the replacement chain NPV for each project.

b. Calculate the equivalent annual annuity for each project.

c. Which project should be selected? Why?

Answers: a. RCNPVX = Rs.13,397, RCNPVY = Rs.8,604; b. EAAX = Rs.4,226,

EAAY = Rs.2,714

6. Risk Adjustment and Project Selection. Acme Mfg is considering two

projects, A & B, with cash flows as shown below:

Period CFA CFB

0 -50,000 -100,000

1 20,000 60,000

2 20,000 25,000

3 20,000 25,000

4 20,000 25,000

The opportunity cost of capital for A is 14 percent. The opportunity cost of

capital for B is 10 percent.

a. Calculate the NPV for each project.

b. Calculate the IRR for each project.

c. Which project(s) should be accepted in each of the following situati ons?

(1) The projects are mutually exclusive and there is no capital constraint.

(2) The projects are independent and there is no capital constraint.

(3) The projects are independent and there is a total of Rs.100,000 of

financing for capital outlays in the coming period.

d. Explain why the cost of capital for A might be higher than for B.

Answers: a. NPVA = Rs.8,274, NPVB = Rs.11,065; b. IRRA = 21.86%, IRRB = 16.08%

7. Replacement project: Existing machine was purchased 2 years ago at a

cost of Rs.3,200. It is being depreciated straight line over its 8 year life. It can be

sold now for Rs.3,000 or used for 6 more years at which time it will be sold for an

estimated Rs.500. It provides revenue of Rs.5,000 annually and cash operating

costs of Rs.2,000 annually.

A replacement machine can be purchased now for Rs.7,800. It would be used

for 6 years, and depreciated straight line. It will result in additional sales revenue

of Rs.1,500 annually, but because of its increased efficiency it would reduce cash

operating costs by Rs.600 per year. The new machine would require additional

inventories of Rs.700, and accounts receivable would increase by Rs.300. Its

expected salvage value in 6 years is Rs.2,000.

The tax rate is 40% and the required rate of return is 13%. Should the old

machine be replaced?

a. Calculate the incremental cash flow at time 0.

b. Calculate the incremental annual operating cash flows that result from the

new machine.

c. Calculate the incremental terminal cash flow.

d. Show the incremental CFs in the table below.

Year Cash Flow

0 ________

1 ________

2 ________

3 ________

4 ________

e. Calculate the NPV for this project.

Answers: a. –Rs.6,040; b. Rs.1,620; c. 1,900; e. 1,349

Pay back period

(A) When Cash inflows are uniform

Initial investment Rs.2,00,000

Annual cash inflow Rs.50,000

Pay back period = Original Investment

Annual cash inflow

= 2,00,000 50,000 = 4 Years

(B) When cash inflows are not uniform

It investment in a project Rs.8,00,000 and net cash inflows after tax but before

depreciation are estimated for the next 6 years as Rs.20,000, Rs.25,000,

Rs,20,000, Rs.30,000, Rs.35,000 and Rs.15,000 Respectively, pay back period is

calculated as follows.

Solution

Year Cash Inflow Cumulative cash inflows

1 Rs.20,000 Rs.20,000

2 Rs.25,000 Rs.45,000

3 Rs.20,000 Rs.65,000

4. Rs.30,000 Rs.95,000

At end of 4th year the cumulative cash inflow exceeds the investment of Rs.80,000

Pay back period = 3 Years + 15000 30000

= 3 Years + ½ year = 3.5 Year

ARR on original investment method

Annual average net earnings ARR = ------------------------------------------- x 100 Original investment – scrap value

ARR on average investment method

Annual average net earnings ARR = ------------------------------------x 100

Average investment

Average investment = Original investment

2

Average investment = Original investment – Scrap value of asset

2

Original invest – scarp value

Average investment = + Additional working

2 + scrap capital value

Discount Factor

1 where

(1+r)n

r – Discount rate

n – No of years

For example

Discounting factor at 10% rate for a period of 5 year

P.V. Factor for 1st year = 1 = 1 = 0.909

(1 + 1)1 1. 1

P.V. Factor for 2nd year = 1 = 1 = 0.826

(1 + 1)2 1. 21

P.V. Factor for 3rd year = 1 = 1 = 0.751

(1 + 1)3 1. 33

ARR

The following data relating to two machines x and y

Mac x Mar y

Original cost Rs.2,00,000 Rs.2,00,000

Estimated life in year 5 5 Expected salvage value Rs.20,000 Rs.40,000 Additional working capital

Needed on average Rs.40,000 Rs.30,000 Income tax rate 40% 40%

Estimated incomes before depreciation and tax

X y

1st year 60,000 1,00,000 2nd year 80,000 80,000

3rd year 1,00,000 1,60,000 4th year 1,20,000 40,000 5th year 1,40,000 1,80,000

Depreciation is to be charges under SLM. you are required to calculate the

accounting rate of return on the average investment for both the machines.

Solution

ARR on average investment

= average annual net earnings x 100

Average investment

Aug Invest = org. invest – scrap values + Add net + scrap value working

2 capital

Mac X = 2,00,000 – 20,000 + 40,000 + 20,000

2

= Rs.1,50,000

Mac Y = 2,00,000 – 40,000 + 30,000 + 40,000

2

= Rs.1,50,000

38,400

ARR of Mac X = ------------ x 100 = 25.6% 1,50,000 Working notes

Calculation of average annual net earnings

Mac X

Ave annual earnings before dep and tax

60,000 + 80,000 + 1,00,000 + 1,20,000 + 1,40,000 = 1,00,000

5

(-) Dep. 2,00,000 – 20,000 = 36,000

5 64,000

(-) Tax at 40% = 64000 x 40% = 25600

Average annual net earnings, after = 38400

Dep. and tax

Mac Y

Avg annual earnings before depreciation and tax

= 1,00,000 + 80,000 + 1,60,000 + 40,000 + 1,80,000 = 1,12,000

5

(-) Dep. 2,00,000 – 40,000 = 32,000

5 = 80,000

(-) Tax 40% = 80,000 x 40% = 32,000

Ave annual net earnings after dep and tax = 48,000

Profitability Index and NPV method

Two projects a and b which mutually exclusive are being under consideration.

Both of them require an investment of Rs.1,00,000 each. The net cash inflows are

estimated as under.

Year A B

1 10,000 30,000

2 40,000 50,000

3 30,000 80,000

4 60,000 40,000

5. 90,000 60,000

The company’s targeted rate of return on investment is 12% you are required to

access the projects on the basis of the present values, using, 1)NPV Method 2)

Profitability Index Method.

Present values of Re 1 at 12% interest for five years are given below.

1st year : 0.893 : 2nd Yr : 0.797 ; 3rd year

0.712 ; 4th year 0.636 ; 5th year 0.567

Statement showing present values of projects

Year PV lf Re 1 at 12%

pa

Project

cash inflows

A Project B

Present value of

cash in flow

Cash

inflow

P.V.of cash

inflow

(1) (2) (3) (4) (5) (6)

1. 0.893 10,000 8930 30,000 26790

2. 0.797 40,000 31880 50,000 39850

3. 0.712 30,000 21360 80,000 56,960

4. 0.636 60,000 38160 40,000 25,440

5. 0.567 90,000 51,030 60,000 34,020

1,51,360 1,83,060

1) NPV Project A B

Present value of cash inflow 1,51,360 1,83,060

(-) Initial invest 1,00,000 1,00,000

51,360 83,060

Project B is accepted because higher NPV

2) Profitability Index (PI)

PI = PV of cash inflow

PV of cash outflow

Project A Project B

PV of cash inflows 1,51,360 1,83,060

PV of cash outflow 1,00,000 1,00,000

(Initial invest)

PI = 1,51,360 1,83,060

1,00,000 1,00,000

= 1.5136 1.8306

Project B is accepted because higher P.I

13.4 REVISION POINTS

1. Pay Back Method It gives the number of years in which the total investment

in a particular capital expenditure pays back itself.

2. Accounting Rate of Return method, capital projects are ranked in order

of earnings. Projects which yield the highest earnings are selected and others are

ruled out.

3. Average Rate of Return method establishes the ratio between the average

annual profits and total outlay of the projects.

4. Earnings per unit of money gives us the average rate of return per unit of

amount (i.e. per rupee) invested in the project.

5. Return on Average amount of Investment method under this method the

percentage return on average amount of investment is calculated.

6. Net Present Value Method we simply find the present value of the expected

net cash inflows of an investment discounted at the cost of capital and subtract

from it the initial cost outlay of the project. If the net present value is positive, the

project should be accepted: if negative, it should be rejected.

7. Internal Rate of Return Method The internal rate of return is defined as

the interest rate that equates the present value of expected future receipts to the

cost of the investment outlay.

8. Profitability Index Method The present value profitability index establishes

relationship between cash-inflows and the amount of investment.

9. Terminal Value Method approach is the assumption that each cash-inflow

is re-invested in other assets at the certain rate of return from the moment; it is

received until the termination of the project.

and subtract from it the initial cost outlay of the project. If the net present

value is positive, the project should be accepted: if negative, it should be rejected.

Internal Rate of Return Method The internal rate of return is defined as the interest

rate that equates the present value of expected future receipts to the cost of the

investment outlay. Profitability Index Method The present value profitability index

establishes relationship between cash-inflows and the amount of investment.

Terminal Value Method approach is the assumption that each cash-inflow is re-

invested in other assets at the certain rate of return from the moment; it is received

until the termination of the project.

13.5 INTEXT QUESTIONS

1. Define Internal Rate of Return.

2. What do you mean by Pay Back period ?

3. What do you mean by terminal value method?

4. What do you mean by profitability Index Method?

13.6 SUMMARY

There are number method are used for evaluating capital investment proposals.

Different firms may use different methods for evaluating the project proposals.

While evaluating two basic principles are kept in view namely, the bigger benefits

are always preferable to small ones and that early benefits are always better than

the deferred ones. While evaluating, the following methods are usually followed. Pay

Back Method It gives the number of years in which the total investment in a

particular capital expenditure pays back itself. Accounting Rate of Return method,

capital projects are ranked in order of earnings. Projects which yield the highest

earnings are selected and others are ruled out. Average Rate of Return method

establishes the ratio between the average annual profits and total outlay of the

projects. Earnings per unit of money gives us the average rate of return per unit of

amount (i.e. per rupee) invested in the project. Return on Average amount of

Investment method under this method the percentage return on average amount of

investment is calculated.Net Present Value Method we simply find the present value

of the expected net cash inflows of an investment discounted at the cost of capital

13.7 TERMINAL EXERCISE

1. The technique of long term planning for proposed capital outlays and

their financing termed as ………………………………………. .

2. The minimum rate of return expected on a capital investment project is

termed as…………………….. .

3. The rate of interest at which the present value of expected cash inflows

from a project equals the present value of expected cash outflows of the

same project is termed as…………………………. .

4. ………………………………….is the annual average yield on a project.

5. The period needed to recoup, in the form of cash inflows from

operations, the initial money invested is termed as………………………..

13.8 SUPPLEMENTARY MATERIALS

http://www2.fiu.edu/

http://www.fao.org/

https://msu.edu

http://people.hss.caltech.edu/

http://www.investopedia.com/

http://umanitoba.ca/

http://isites.harvard.edu/

wps.prenhall.com/wps

https://www.cfainstitute.org

www.cengage.com

www.hss.caltech.edu

13.9 ASSIGNMENTS

1. Critically evaluate the net present value criterion.

2. Evaluate internal rate of return as a investment criterion.

3. Describe and evaluate the average rate of return method.

4. Critically evaluate the payback period as method of investment

appraisal.

13.10 SUGGESTED READINGS / REFERENCE BOOKS

Agrawal & Agrawal — Management Accounting (RBD. Jaipur)

Jain, Khandelwal, Pareek — Cost Accounting (Ajmera Book depot, Jaipur)

Khan, Jain — Management Accounting (S. Chand & Sons.)

Oswal, Maheshwari, Modi — Cost accounting. Cost Accounting ( RBD, Jaipur)

Pandey. I. M. — Management Accounting (S. Chand & Sons.)

13.11 LEARNING ACTIVITIES

Go to an organization and observe in what ways investment appraisal are

evaluated. Find the positive and negative things in the appraisal

13.12 KEYWORDS

Pay Back Period, accounting rate of return, Net present value, Internal rate of

return, Profitability index method, Terminal value method, Average Investment,

original Investment, Annual cash inflow, Average annual profits after tax, total

earnings, scrap value.

LESSON – 14

MARGINAL COSTING AND BREAK – EVEN ANALYSIS

14.1 INTRODUCTION

Marginal costing is a new area in the field of Accounting. It refers to the

production of additional increments of output. It also discusses its relationship

with Break-even analysis.

Marginal Costing, also known as Direct Costing or Variable Costing or by such

other names, is a comparatively new area in the field of accounting and is one that

is gradually gaining more and more acceptance. Described by different names on

the two sides of the Atlantic. The term ‘Marginal Costing’ is common in U.K. and

other countries of the Continent while the expression ‘Direct Costing’ or ‘Variable

Costing’ is preferred in United States the technique signified by the use of the

meddle of these words has been able to generate strong views both for an against

itself with the result that it has become a subject of lively raging controversy during

recent times

14.2 OBJECTIVES

To understand the concept of Marginal Cost and Cost-volume- profit

Relationship .After reading this lesson you should be able to know the meaning of

Marginal Costing, Break Even point. Understand the concept of marginal costing

and uses of marginal costing.

14.3 CONTENT

14.3.1 Concept of Marginal Cost

14.3.2 Break-up of Semi-Variable Expenses

14.3.3 Practical Application of Marginal Costing

14.3.4 Advantages of Marginal Costing

14.3.5 Limitations of Marginal Costing

14.3.6 Cost-Volume – Profit Relationship Break-Even-Analysis

14.3.7 Marginal Costs are used primarily in guiding decision

14.3.1 CONCEPT OF MARGINAL COST

‘Marginal Cost’ derived from the word ‘Margin’ is well-known concept of

economic theory. Thus, quite in tune with the economic connotation of te term, it

is described in simple words as the cost which arises from the production of

additional increments of output and it does not arise in case the additional

increments are not produced.

It has been derived by the Institute of Cost and Works Accountants, London, in

its publication ‘A Report of Marginal Costing’ as “the amount at any given volume of

output by which aggregate costs are changed if the volume of output is increased or

decreased by one unit”.

From this point of view, marginal costs will be synonymous with variable costs,

i.e., prime costs and variable overheads, in the short run but, in a way, also include

fixed costs in planning production activities over a long period of time involving an

increase in the productive capacity of the business. Thus, marginal costs are

related to change in output under particular circumstances of a case.

However, where an increase in fixed costs is envisaged in the walk of an

accretion to the production capacity and consequently to the level of activity, fixed

costs are dealt with as a part of what are called ‘Different Costs’ so that the usage of

the term ‘Marginal Cost’ is restricted in actual practice only to cases involving a

more effective illustration of the existing installed capacity intended for a better

recovery of fixed costs per unit of output.

According to the Institute of Cost and Works Accountants, London, “Marginal

Costing is the ascertainment, by differentiating between fixed costs and variable

costs, of marginal costs and of the effect on profit or changes in the volume and

type of output.

In this context, marginal costing is not a system of costing in the sense in

which other systems of costing, like process or job costing, has been designed

simply as an approach to the presentation of accounting information meaningful to

management from the viewpoint of adjusting the profitability to management from

the viewpoint of adjusting the profitability of an enterprise by carefully studying the

impact of the entire range of costs according to their respective nature.

The concept of marginal costing is a formal recognition of ideas underlying

flexible budgets, break-even analysis and cost-volume profit relationship. It is

application of these relationships which involves a change in the conventional

treatment of fixed overheads in relation to income determination.

(A) BASIC CHARACTERISTIC OF MARGINAL COSTING

The concept of marginal costing is based on the important manufacturing

between product costs and period costs, the former being related to the volume of

output and the latter to the period of time rather than the volume of production.

Marginal costing regards as product costs only these manufacturing cost

which have a tendency to vary directly with the volume of output. This is in

complete contrast to the conventional system of costing under which all

manufacturing costs-fixed as well as variable are treated as product costs.

Variability with volume is the criterion for the classification of costs into product

and period categories.

Thus, marginal costing necessities analysis of costs into fixed and variable.

Even the semi-variable costs have to be closely and critically, analysed in order to

resolve themselves into their fixed and variable components depending upon

whether they tend to remain fixed or vary. In this way, marginal costing highlights

the effect of costs on the level of output planned.

(B) WORKING OF MARGINAL COSTING-INCOME DETERMINATION UNDER ABSORPTION AND MARGINAL COSTING

According to traditional costing system, fixed costs of production are

assigned to products to be subsequently released by way of expenses as part of cost

of goods sold or are carried forward as part of the cost of inventory depending upon

whether a period’s production was sole or not during the same period. Such an

approach to the treatment of fixed costs has brought into vogue various methods of

allocation of overheads to different departments on an equitable basis and their

proper apportionments to units produced. However, the various methods devised

fail to give precise results and sometimes even leads to absure situations. Marginal

results costing removes all the difficult involved in the allocation apportionment

and recovery of fixed costs. It is able to accomplish this by excluding fixed costs

from product costs and by writing them of entirely against operations of the period.

Consequently, when the volume of output differs from the volume of sales

the net income reported under marginal costing will differ from that reported under

absorption costing.

(C) ROLE OF CONTRIBUTION

Contribution is of vital important for the system of marginal costing. The

rationale of contribution lies in the fact that, where a business manufactures more

than one product, the profit realized on individuals products cannot possibly be

calculated due to the problem of apportionment of fixed costs to different products

which is done away with under marginal costing. Therefore, some method is

required for the treatment of fixed costs and marginal costing answer to the

challenge is ‘Contribution’.

Contribution is the difference between sales and the variable cost of sales and

is therefore, sometimes referred to as “gross margin”. It is visualized as some sort

of ‘fund’ or ‘pool’ out of which all fixed costs, irrespective of their nature, are to be

met and to which each product has to contribute either profit or loss as the case

may be.

The concept of contribution is useful in the fixation of selling prices,

determination of break-even-point, selection of product mix for profit maximization

and ascertainment of the profitability of produces, departments, etc.

14.3.2 BREAK-UP OF SEMI-VARIABLE EXPENSES

In view of the fact that marginal costing classifies all costs broadly into fixed

and variable only, it becomes necessary to insolate the two components of semi -

variable costs. In fact, the exercise of segregating the fixed and variable costs. In

fact, the semi-variable expenses constitutes by the most challenging problem of

marginal costing.

(a) The method is based on the analysis of historical data relating to periods of

high and low business activity which represent condition at two different levels of

business operations. In selection these periods and in dealing with costs incurred

during such periods, care should be taken to see that figures are not distorted and

by any abnormal factors.

(b) Statistical Scatter graph Method

This is widely used diagrammatic or graphic technique for insolating the fixed and variable portions of semi-variable costs.

According to this methods, costs and relevant figures relating to the level of

activity are plotted on along the vertical or Y-axis and horizontal or X axis

respectively thereby resulting in a scatter graph with each dot on the graph

representing the expense for a particular period at a certain level of activity. A line

is then drawn by visual inspection in such a manner that there are ideally as many

dots above the line as there are below it in order to make it typical of the majority of

dots on the graph. From the point of contact of this line with the vertical axis,

another line across the face of the graph is drawn parallel to the base so that it

represents the fixed component of a particular item of semi-variable expense while

the portion of the diagram lying between the two lines shows variability of an

expense as volume of production increase.

In spite of the fact that dots in the diagram are never to be found in a perfect

linear pattern, the line of total expenditure is drawn as a straight line and, in most

cases, the straight line would for all intents and purpose be a fair representation of

the single line would conform to all observations.

(c) Method of Least Squares

A mathematical techniques of ‘least squares’ is also used for computing a

more exact line, called ‘regression line’ representing total cost of an item of semi-

variable expense than what is possible according to the scatter graph method.

The method of least squares is based on the basic regression equation

y = a + bx where ‘a’ is the fixed portion and ‘b’ is the degree of variability.

Steps involved in putting the method to use are as follows:

i. The simple means of two concerned variables scales of operations and

total expense are calculated.

ii. The deviations of actual figures in the two variables from their respective

average calculated under step (i) above are found out with proper

algebraic signs.

iii. The deviations relating to the variable to relating variables from their

respective means are multiplied together and products obtained.

iv. Deviations of the actual figures of the two variables from their respective

means are multiplied together and products obtained.

v. Products under point (iv) are added.

vi. Squared deviations under point (iii) are totalled.

vii. To total of point (v) is divided by the total of point (vi) to arrive at the

variable rate of an expense.

viii. The fixed portion of the total expense can be calculated by deducting the

products of variable rate and the average cost of the item of expense.

14.3.3 PRACTICAL APPLICATION OF MARGINAL COSTING

(A) Level of Activity Planning

One of the very common problems confronting a business is regarding the

level of activity for which it should have plans in hands, such plans may envisage

an expansion or contraction of productive activities depending upon the qualitative

conditions in the market. The expansion or contraction has to be arranged before

the events overtake the business. In this context, management like to have an idea

of the contribution at different levels of activities and marginal costing proves very

useful from this point of view.

(B) Maximization of Sales

Usually, business enterprises have a variety or product lines, each making

its own contribution to fixed expenses. Changing in the operating profit can result

from shifts in the mixture of products sold in spite of the fact that sales expressed

in terms of money remains the same. Such a situation may also be brought about

by changes in distribution channels, or sales to different classes of customers, if

such an arrangement affects the quantum of contribution over variable costs. It is

in this context that marginal costing is called upon to inform management

regarding the most profitable mix of sales from the entire range of selected

alternatives.

(C) Marginal Costing and Pricing

The determination of prices of products manufactured or services rendered,

by business is often considered to be a difficult problem generally faced by

management of an expertise. However, the basic problem involved in pricing is the

matching of demand and supply.

To illustrate, of a person travels from Delhi to London by a leading

international airline, he may be able to arrange to trip of a country of the Middle

East, he may be able to arrange diametrically by paying only half of the normal

face. These two diametrically opposite position can be reconciled by pointing out

that while normal fares are so determined by leading airlines companies as to

normal overall costs of operation including fixed costs which are bound to be

considerable, smaller companies may fix fares at a level as to cover only marginal

costs and yield some contribution towards profit owing to their inability or

reluctance to do away with their business due to huge funds being sunk in capital

investments.

By placing emphasis on contribution margin, the technique of marginal

costing offers a simple as well as clear portrayal of the relationship between specific

product costs and the different possible selling prices considered. This is due to

the fact that contribution margin is unaffected by the allocation of indirect costs.

(D) Profit Planning

Marginal costing, through the calculation of contribution ratio, enables the

planning of future operations in such a way as to attain either maximum profit or

to maintain a specified level of profit. Thus, it is helpful in profit planning.

14.3.4 ADVANTAGES OF MARGINAL COSTING

(i) Constant in Nature

Marginal costs remain the same per unit of output irrespective of the volume of

production.

(ii) Realistic Valuation

Elimination of fixed overheads from the cost of production means that finished

goods and work-in-progress are valued at their marginal cost and therefore, the

valuation is more realistic and uniform as compared to the one when they are

valued at their total cost.

(iii) Simplification of Overhead Treatment

Marginal costing does away with the need for allocation, apportionment and

absorption of fixed overheads thereby removing an important source of accounting

complications by way of under absorbed over-absorbed overheads.

(iv) facilitating Cost Control

The clear-cut division of costs into their fixed and variable components paves

the way for a better cost control through flexible budget which is based on this

important distinction.

(v) Meaningful Managerial Reporting

As reports to management are based on figures of sales rather than of

production, marginal costing constitutes a better approach in as much a stocks do

not affect the comparisons of efficiency which are made on the basis of sales.

(vi)Basis for Pricing and Tendering

Marginal costing furnishes a better and more logical basis for the fixation of

sales prices as well as in tendering for contracts when business is at a low ebb.

(vii) Aid to Profit Planning

The technique of marginal costing enables data to be presented to

management in a manner as to show cost-volume-profit relationships. In this

connection use is made of break-even charts.

14.3.5 LIMITATIONS OF MARGINAL COSTING

(i) Difficulty in analysis

Considerable difficulty is always experienced in analysis overheads into their

fixed and variable components.

(ii) Lop-sided Emphasis

Marginal costing has a tendency to attach more importance to the selling

function which has the effect of relegating production function to a comparatively

unimportant position. However, the efficiency of a business is to be judged by

taking together its selling as well as production functions into account.

(iii) Difficulty in Application

The technique of marginal costing cannot be adequately applied in the case

of industries in which, according to the nature of business, large stocks have to be

carried by way of work-in-progress.

(iv) Limited Scope

‘As marginal costing distinguishes between the treatment of fixed and

variable components as parts of fixed costs, it is difficult to adopt the technique in

capital-intensive industries where fixed costs are very large.

(v) Inappropriate Basis for Pricing

Selling price cannot reasonably be fixed on the basis of contribution alone

because then there is the danger of too many sales being affected at marginal cost

resulting either in loss to the business of inadequate profits.

In the light of these advantages and disadvantages, marginal costing may be

considered to be a very useful technique from the point of view of management, but

it must be applied with a full awareness of its limitations as well as of the

circumstances in which it can be fruitfully used.

14.3.6 COST-VOLUME-PROFIT RELATIONSHIP – BREAK-EVEN-ANALYSIS

These days, in management accounting a great deal if importance is being

attached to cost-volume-profit relationship which, as its name implies, is an

analysis of three different factor-costs, volume and profit. In this case, an analysis

is made to find out.

What would be the cost of production under different circumstances?

What has to be the volume of production?

What profit can be earned?

What is the difference between the selling price and cost of production?

The answers to these queries underline the important fact that the three

factors of cost, volume and profit are interconnected and dependent on one

another.

14.3.7 MARGINAL COSTS ARE USED PRIMARILY IN GUIDING DECISIONS

The most useful contribution of marginal costing is the assistance if renders to

the management in vital decision-making. The presentation of information under

marginal costing is of use in making policy decisions in cases where the

information obtained from total cost method would be incomplete. Sometimes the

information revealed by total cost method may be even misleading.

The following are a few of the managerial problems which are simplified by the

use of marginal costing techniques:

(1) Pricing of products, (2) Make or buy decisions, (3) Selection of a suitable

product mix, (4) Alternative methods of production and (5) Closing down of

business.

(A) Pricing of Products

Although prices are regulated more by market conditions and other

economic factors than by decision by management, the management while fixing

prices has to keep in view the level of profits expected. In normal times the price

fixed must cover full costs as otherwise profits cannot be earned. But under

certain circumstances, products may have to be priced at a level below total cost, if

sucha course is necessary to meet the situation arising due to trade depression.

This is so because fixed costs will have to be incurred irrespective of whether

production continues or not. Any contribution towards the recovery to fixed costs

will reduce the losses which will be incurred if production is stopped. As a word of

caution fixation of prices below total cost should be made only on a short-term

basis. Marginal costing presents information regarding the rate of contribution at

various levels of prices and capacity, so as to enable the management to know the

price limits within which it can operate.

(B) Make or But Decisions

Decision to make of buy has to be taken when the product begin

manufactured has a component part that can either be made within the factory or

purchased from an outside firm. This decision can be arrived at only by comparing

the supplier’s price with the marginal cost. For example, the total cost of making a

component part comes to Rs.11, consisting of Rs.8 as variable cost and Rs.3 as

fixed cost. Suppose an outside firm is willing to supply the same component part

at Rs.10. The prima facie conclusion is that it is cheaper to buy the component.

But a study of cost analysis above shows that each unit of component contributes

Rs.3 towards the recovery of fixed cost. This fixed cost has to be incurred whether

to make or buy. The real cost in making one unit of component is only Rs.8, which

is its variable cost. The offer should, therefore, be rejected because the acceptance

will mean that the total cost of the purchased part will come to Rs.13 i.e. Rs.10

(Purchase Price) plus Rs.3 (Fixed cost, which cannot be saved if production is

suspended).

However, in arriving at a final decision, other factors may have to be

considered. Thus, the production facilities related by stoppage of production may

be put to some alternative use in which the above argument may not hold good. It,

however, remains true that cost analysis on the marginal cost technique

illuminates an important aspect of decision-making.

(C) SELECTION OF A SUITABLE PRODUCT MIX

When a concern manufactures more that one product, a problem often

arises as to which product mix will yield the highest profits. The cost-profit relation

to different products would vary depending upon the structure and composition of

cost elements and sales price. The products which give the maximum profits are to

be retained and their production pushed up. The production of comparatively

disadvantageous products should be reduced or closed down altogether. Marginal

costing helps management tin taking a decision to continue, increase, reduce or

suspend production of a product or to change the product mix. The best product

mix is one which yields the maximum contribution margin.

(D) ALTERNATIVE METHODS OF PRODUCTION

If the management has to choose from among alternative methods of

manufacturing a product, the changes in the marginal contribution under each of

the proposed methods has to be worked out. Thus for example, a new product may

have been development and the management is faced with the problem of

employing a machine or to manufacture entirely by manual labour. The method of

manufacture which yields the greatest contribution is to be selected keeping of

course, the various key factors in view.

(E) CLOSING DOWN OF BUSINESS

If a sufficient volume of business cannot be secured, the management may be

faced with the problem of deciding whether production should be stopped or not.

This business may take the shape of either temporary suspension of production or

permanent closing down of business.

If the production is temporarily suspended, the object is to close down

operations until trade recession has passed. If the products are making a

contribution towards fixed costs, then generally speaking, production should not be

stopped. This is so because if prices exceed marginal costs, losses will tend to be

minimized by continuing the operations.

Permanent closing down of business is a very drastic decision and will be

carried out only in extreme cases. In the long run selling price must exceed the

total cost so as to give a net margin, otherwise it will not b economical to continue

the production. If the business is not earning sufficient return for the risk involved,

then the production may be closed down permanently.

PRACTICAL PROBLEMS:

COST-VOLUME PROFIT LINKAGE

To understand break-even analysis, it is necessary to understand the

relationship between sales, variable costs and profit. The division of costs into

“Variable” and “Fixed” entails the establishment of a constant linkage between

selling price and variable costs. This leaves behind a surplusous of the sales

revenue. The surplus is called contribution which bears a constant relationship

with sales.

The linkage between revenue and cost data are presented as follows:

Rs.

Sales --------

LESS Variable cost --------

Contribution --------

LESS Fixed Cost --------

Net Profit --------

The relation of the contribution to sales is known as P/V ratio (Profit-Volume

ratio). This ratio is the vital instrument in the hands of the management

accountant while shifting operational data. The P/V ratio has the following special

feature:

1. It is the result of linking contribution to the relevant sales which provides

the contribution.

2. It remains constant so long as the selling price and variable costs per unit

remain constant or fluctuate proportionately.

3. It is unaffected by an change in the level of activity. Hence the ratio would

be constant whether studied on 10,000 units basis, 1000 units basis or a

single unit basis.

4. The ratio is unaffected by any fluctuation in the fixed cost, because the

latter does not enter into the computation of contribution at all.

A substitute for P/V ratio is “Contribution per unit”. This is also an equally

effective instrument of the management accountant in analyzing data. The utility

of P/V ratio or contribution per unit is varied. The following illustration will show

how the instrument is used.

ILLUSTRATION 1

A factory produces 300 units of a product per month. The selling price is

Rs.120 and variable cost Rs.80 per unit. The fixed expenses of the factory amount

to Rs.8,000 per month. Calculate:

(i) The estimated profit in a month wherein 240 units are produced.

(ii) The sales to be made to earn a profit of Rs.7,0000 per month.

SOLUTION

Rs.

Selling Price per unit 120

LESS Variable cost per unit 80

Contribution per unit 40

P/V ratio = PriceSelling

onContributi x 100

= 120

40x 100 = 33 1/3 %

(i) Profit on Sale of 240 Units

Sales of 240 units at Rs.240 each = Rs. 28,800

Contribution from the above at 33 1/3% = Rs. 9,600

LESS: Fixed cost of the month = Rs. 8,000

Profit Rs. 1,600

The result can also arrive at as follows:

Number of units to be sold = 240

Contribution per unit = Rs.40

Contribution from 240 units = 240 x 40 = Rs.9,600

LESS: Fixed Cost = Rs.8,000

Profit = Rs.1,600

(ii) Sales required to earn a profit of Rs.7,000/-

Profit required to earn a profit of Rs.7,000/-

Profit required to be earned = Rs. 7,000

ADD: Fixed Cost = Rs. 8,000

Total Contribution to be earned = Rs.15,000

Since P/V ratio = 33 1/3%

Sales required to earn Rs.15,000

31 33

15,000 x 100 = Rs.45,000

This result can also be arrived as follows:

Contribution per unit Rs.40

Number of units to be sold to earn Rs.15,000

= 40

15,000 = 375 Units

Selling Price per unit = Rs.120

Total Sales = 375 x 120 = Rs.45,000

DETERMINATION OF BREAK-EVEN POINT (BEP)

A break-even point is that level of activity where cost equals total revenue so

that the firm neither earns profit nor suffers any loss. At this stage the firm is said

to break even. This is the point at which the total contribution is just equal to the

fixed costs, hence, no profit or loss is earned. No first would be content to reach

only this point. But this represents a point which one must reach before one goes

further to earn a profit. If one does not reach this point, one has suffered a loss.

By determining this point, the firm can very well assess for itself how far away it

actually is from that point. If the firm is actually at a level higher than the BEP, it

means that it is very profitable. If difficulties develop, it has a cushion or margin of

safety on which to fall back upon.

Out of the contribution after meeting fixed expenses, the net profit is to be

ascertained. But at the BEP there is no profit or loss, hence at the BEP,

contribution equals total fixed expenses. This idea can be stated as follows:

Sale(S) – Variable cost (V) = Fixed Cost (F) + Profit (P)

S – V = F + P

S = V + F + P

P = S – V + F

Therefore, the number of units at the break even point can be worked out

as:

unit per onContributi

Expenses Fixed =

C

F

If the sales have crossed the BEP, it means that the contribution obtained by

the extra sales over the BEP is completely profit because all fixed expenses have

already been met at the BEP stage itself.

ILLUSTRATION 2

The sales of company are at (Rs.200 per unit) Rs. 20,00,000

Variable cost Rs. 12,00,000

Fixed cost Rs. 6,00,000

The capacity of the factory 15,000 units

Determine the BEP. How much profit is the company making?

SOLUTION

Rs.

Selling Price per unit 200

Variable cost per unit 120

Contribution per unit 80

Fixed expenses . . . . . . . Rs.6,00,000

Break-even point = 80

6,00,000 = 7,500 units

Profit Being Earned

Annual Sales (Units) 10,000

BEP (Units) 7,5000

Sales above BEP (Margin of Safety) 2,500

Contribution at Rs.80 per unit

80 x 2500 = 2,00,000

PROOF

S = V + F + P

= 12,00,000 + 6,00,000 + 2,00,000

Sales = 20,00,000

At break even point the contribution is just equal to fixed costs. Any sale

above the BEP also provides the contribution. But as fixed costs are all met already

such contributions become completely profit. The Sales above BEP are known as

margin of safety. The contribution from margin of safety sales is profit as P/V ratio

Sales

onContributi x 100 and as profit is the contribution from these sales above BEP

(ie. margin of safety), the following formula is also true.

Safety of Margin

Profitx 100 = P/V ratio

ILLUSTRATION 3

From the following particulars, Calculate a break-even point for (a) unit, and

(b) sales value.

Total variable costs Rs. 10,000

Total fixed costs Rs. 20,000

Total sales Rs. 50,000

Selling price per unit Rs. 5

Output 10,000 units

Variable cost per unit Rs. 1.00

SOLUTION

Brea-Even point for unit

= Cost Variable Unit - PriceSelling Unit

Cost Fixed

= 1 - 5 Rs.

20,000 Rs. =

4

20,000 = 5,000

= Profit Net - Cost Fixed

Cost Fixed x 100

= 20,000 Rs. 20,000 Rs.

20,000

.sR x 50,000

= Rs.25,000

ILLUSTRATION 4

From the following particulars calculate the break-eve point. Find out the

net profit if sales are 10% and 15% above the break even volume.

Rs.

Selling price per unit 10

Trade Discount 5%

Direct material cost per unit 3

Direct labour cost per unit 2

Fixed overheads 10,000

Variable overheads 100% on Direct labour cost.

SOLUTION

Variable cost per unit (Rs.3 + Rs.2 + Rs.2) = Rs.7

Selling price Rs. 10.00

LESS: 5% Discount Rs. 0.50

9.50

Contribution per unit Rs.9.50 – Rs.7.00 = Rs.2.50

B.E.P. = onContributi

F = Rs.

2.50

10,000 = 4,000 units

B.E.P. Units 4,000

ADD: 10% 400

4,400 @ Rs.2.50 = 11,000 – 10,000

Profit = Rs.1,000

B.E.P. Units 4,000

ADD: 15% 600

4,600 @ Rs.2.50 = 11,500 – 10,000

Profit = Rs.1,500

PROFIT PLANNING-DESIRED PROFIT

All business want to do something better than the just break-even. Cost-

Volume-Profit analysis is incorporated into break-even analysis by applying the

following formula for x

Xn =

Sales necessary to reach desired profit:

=

Sales

costs Variable -1

profit Desired cost Fixed

Desired Profit unit sales volume:

Margin onContributi Unit

profit Desired cost Fixed

V -P

F

If the selling prices increase, the formula would be,

B.E.P. =

PriceSelling New

costs Variable -1

cost Fixed

If the change in the variable cost takes place, the B.E.P would be

B.E.P. =

ILLUSTRATION 5

Given the following information:

Units of output 5,00,000

Fixed costs Rs.7,50,000

Variable cost per unit Rs.2

Selling price per unit Rs.5

You are required to determine:

i) the break-even point

ii) the sales needed for a profit of Rs.6,00,000 and

iii) the profit if 4,00,000 units are sold at Rs.6 per unit

SOLUTION

(i) Break-even point =

= = c

= 7,50,000 x = Rs.12,50,000

ii) Sales needed for profit of Rs.6,00,000

= =

5

3

00Rs.13,50,0

= Rs.13,50,000 x = Rs.22,50,000

Sales

Cost VariableNew -1

cost Fixed

unit per Sales

unit per cost Variable -1

cost Fixed

5

2 -1

0Rs.7,50,00

3

5

5

2 -1

0Rs.6,00,00 0Rs.7,50,00

3

5

= = 5

22,50,000 = 4,50,000 Units

OR

= V P

F

=

3

0Rs.6,00,00 0Rs.7,50,00 = 5,40,000 Units

iii) Profit on sale of 4,00,000 units at Rs.6 per unit

Sales = 4,00,000 units x Rs.6 = Rs.24,00,000

1

24,00,000=

1

24,00,000 =

6

2-1

Profit 0Rs.7,50,00

1

24,00,000 x

3

2 = 7,50,000 + Profit

Profit = 16,00,000 – 7,50,000 = 8,50,000

Profit = 8,50,000

ILLUSTRATION 6

You are given the income statement of A company Limited

Rs. Rs.

Net Sales 5,00,000

LESS: Expenses:

Variable 3,50,000

Fixed 2,50,000 6,00,000

1,00,000

Assuming that variable expenses will always remain the same percentage of sales.

Compute

(a) What amount of sales will cause the firm to break-even, if fixed expenses

are increased by Rs.1,00,000?

(b) What amount of sales will yield a net profit of Rs.50,000 with the proposed

increase in fixed expenses?

SOLUTION

(a) Break-Even Point =

unit per Sale

00Rs.22,50,0

unit per Sales

cost Variable -1

Profit Desired cost Fixed

Sales

Expenses Variable -1

Profit Desired Expenses Fixed

OR

=

=

or = 0.30

0Rs.3,50,00 B.E.P. = Rs.11,66,667

(b) Required Sales (R.S.) =

= = Rs.13,33,333

MARGIN OF SAFETY

Margin of safety is an important concept in the context o, marginal costing

and cost-volume-profit analysis. The margin of safety refers to the amount by

which sales revenue can fall before a loss is incurred. In other words, it is the

difference between the actual sales and sales at the break-even point or spread

between anticipated sales and break-even sales. Margin of safety can be expressed

in absolute sales amount or in percentage. For example, if a company can break-

even at 50 percent of expected sales, then it has margin of safety of 50 percent. If

the present sales level is Rs.1,000 or 1,000 units the break-even volume may be

sales Rs.500 or 500 units, so the margin of safety is Rs.500 or 500 units. The

margin of safety is given by the formula:

Margin of Safety =

= x 100 = 50 percent

or Rs.1,000 – 500 = Rs.500

Margin of safety =

OR

Margin of Safety (M/S) = x 100

Actual Sales – Sales at BEP

ILLUSTRATION 7

Ratio Margin onContributi

Profit Desired Expenses Fixed

0Rs.5,00,00

0Rs.3,50,00 -1

0Rs.1,00,00 0Rs.2,50,00

Ratio Margin onContributi

Profit Desired Expenses Fixed

0.30

0Rs.4,00,00

Sales Actual

Sales EvenBreak - Sales Actual

Rs.1,500

Rs.500 -Rs.1,000

Sales Budget

Point Even -Break above Sales

RatioP/V

Profit

From the following calculate the break-even point and the turnover required

to earn a profit of Rs.36,000.

Fixed Overheads Rs. 1,80,000

Variable cost per unit Rs. 2

Selling Price Rs. 20

If the company is earning a profit of Rs.36,000, express the ‘margin of safety’

available of it.

SOLUTION

Break-Even Point (in units)

=

= 2 - 20

1,80,000 = 10,000 units

Break-even point (in amount) = 10,000 units @ Rs.20 per unit

= Rs.2,00,000

Turnover required to earn a profit of Rs.36,000:

Turnover units = unit per cost Marginal - unit per PriceSelling

Profit - Expenses Fixed

= = 12,000 units

Turnover is Rs.12,000 units @ Rs.20 per unit

= Rs.2,40,000

MARGIN OF SAFETY

Units Amount

Rs.

Sales to earn a profit of Rs.36,000 12,000 2,40,000

LESS: Sales at Break-Even Point 10,000 2,00,000

Margin of safety 2,000 40,000

Margin of safety can also be calculated by the other formula

Margin of safety = =

= Rs.36,000 x = Rs.40,000

unit per cost Marginal - unit per PriceSelling

Expenses Fixed

Rs.2 - Rs.20

Rs.36,000 -0Rs.1,80,00

RatioP/V

Profit

20

18

36,000 Rs.

18

20

P/V Ratio = = Sales

Cost Marginal - Sales

Rs.20

Rs.2 - Rs.20 =

20

18x 100 = 90%

ILLUSTRATION 8

From the following profit and loss statement, prepare a break-even chart

and determine:

(a) The break-even point

(b) The margin of safety

(c) The sales necessary to obtain a profit of Rs.10,000

Rs. Rs.

Sales 84,000

Costs: Variable 56,000

Fixed 24,000 80,000

Profit 4,000

SOLUTION

Break-even point by algebraic formula:

(a) Break-even point for sale = Profit Cost Fixed

Sales x Cost Fixed

= 4,000 24,000

84,000 x 24,000

= Rs.72,000

Sales

onContributi

(b) Margin of safety = Actual Sales – Break-even sales

= Rs.84,000 – Rs.72,000 = Rs.12,000

(c) Sales at desired profit =

Sales

cost Variable - 1

Profit Desired Cost Fixed

=

84,000

56,000 - 1

10,000 24,000

= 28,000

34,000x 84,000

= Rs.1,02,000

From the break-even chart shown above it will be seen that:

(a) The break-even point is at sales of Rs.72,000

(b) The margin of safety is Rs.84,000 – Rs.72,000 = Rs.12,000 = 14%

(c) The gap between the sales and total cost curves, (i.e., the profit) reaches

Rs.10,000 when the sales are Rs.1,02,000

ILLUSTRATION 9

A radio manufacturing company finds that while it costs Rs.6.25 each to

make component x 273 Q, the same is available in the market at Rs.5.75 each, with

an assurance of continued supply.

Materials Rs.2.75 each

Labour Rs.1.75 ”

Other variables Rs.0.50 ”

Depreciation and other fixed cost Rs.1.25 ”

Rs.6.25

(i) Should you make or buy?

(ii) What would be your decision if the supplier offered the component at

Rs.4.85?

SOLUTION

(i) The variable cost of producing the component is Rs.5 made up as follows:

Rs.

Materials 2.75

Labour 1.75

Other variables 0.50

Variable 5.00

Since the depreciation and other fixed costs are sunk costs, the cost that

can be saved if it is decided to buy the component instead of making it Rs.5 per

unit which is the variable cost. Hence, there will be no saving. Secondly, the cost

of buying will be more Rs.5.75 unless the capacity released, by the decision to buy,

can be utilized in making some other profitable product. So the decision to make or

buy will be influenced by the fact whether the capacity to be released by the

stoppage of production of the component can be utilized profitably or not. If yes,

then buying is preferable, if not, making is preferable.

(ii) If the price offered by the supplier is reduced to Rs.4.85 each then there

will be a saving of 15 paise per unit even if the capac ity released cannot be

profitably employed. In such a case it would be advantageous to buy the

component and efforts may be made to utilize the spare capacity in producing other

profitable products.

Foreign Market

ILLUSTRATION 10

A manufacturer of a certain product has been selling exclusively in the

Indian Market up to now. He has just received his first export enquiry and wants

to quote as competitively as the circumstances will allow. This latest Indian Cost

Sheet is:

Rs.

Raw materials 34 per unit

Direct labour 13

Services 6

Works overhead 7

Office overhead 2

Profit earned in India 62

Indian Selling Price 6

68

Management is thinking of quoting a selling price somewhere between Rs.62

and Rs.68 per unit for this export order. One of the Directors suggests quoting an

even lower price based on the principles of marginal costing. As the firm’s

Accountant you are requested to compute the lowest the management could quote

on these principles. State clearly any assumptions that you may make on the

above facts and also on any other costs or facts.

Statement showing the lowest price for the Export Enquiry:

Rs.

Raw materials 34 per unit

Direct labour 13

Services 4

Marginal Cost 51 per unit

The cost sheet depend on the assumption made. The above is one

illustrative cost sheet based on the principles of marginal costing using the figures

given in the latest “total” cost sheet. The assumptions are given below:

1. It is assumed that sufficient manufacturing capacity exists not to disrupt

the supplies now being made to the Indian mark while fulfilling this export order. If

any such disruption takes place the negative costs of this disruption will be another

direct or opportunity cost of fulfilling this export order.

2. It is assumed in the above calculation that service costs to the extent of

Rs.4 per unit are directly variable with the production put through the shops, and

that the balance of Rs.2 is a fixed expense.

3. Similarly, it is assumed that works overhead is entirely fixed and should,

therefore, be excluded in marginal costing. It is possible that on occasion a part of

the works overhead may actually be variable. Similarly, it is assumed that office

overhead is totally fixed.

4. Certain direct costs of this export order like insurance, special packing,

import duties in the foreign country, special commissions, etc., would have to be

separately calculated and added on to the above marginal cost of Rs.51 before the

selling price is finally fixed. We would have to carefully determine whether the

quoted price should be on FOB or CIF basis. In the same way, the benefit available

from exports, such as cash subsidy that may be available, should be added to the

available price.

On the above basis, any price above Rs.51 (plus the items mentioned in Notes

1 and 4 above) will be the lowest possible price which can be quoted by the

company.

Exercise:

1. From the following information calculate contribution, p/v Ratio, BEP and

Margin of safety.

Total sales Rs. 6,00,000

Selling price per unit Rs. 100

Variable cost per unit Rs. 60

Fixed cost Rs.2,00,000

2. From the following data you are required to calculate break-even point

and net sales value at this point:

Rs.

Direct Material cost per unit 8

Direct Labour cost per unit 5

Fixed overhead 24,000

Variable overheads @ 60% on direct labour

Selling unit 25

Trade Discount 4%

If sales are 15% and 20% above the break-even volumes determine the net

profits.

3. An Analysis of Seshu co. Ltd, led to the following information

Variable cost (% on

sales)

Fixed cost (Rs.)

Direct material

Direct labour

Factory overheads

Distribution overheads

Administration

overheads

32.8

28.4

12.6

4.1

1.1

1.89,000

58,400

66,700

Budgets sales for the year Rs.18,50,000. You are required to calculate .(i)

The break – Even sales. (ii) The profit at the budgets sales, (iii) The profit if

actual sales

(a) Drop by 10%

(b) Increase by 5% from budgeted sales.

4. Assuming that the cost structure and selling price are remain in periods I

and II. Find out

1. P/V Ratio

2. BEP in amount

3. Profit when sales are Rs. 1,00,000

4. Margin of safety in II period

5. Sales required to earn a profit of Rs. 20,000

6. Variable cost for both periods.

Period Sales(Rs.) Profit (Rs.)

I 1,20,000 9,000

II 1,40,000 13,000

Decision Making Problems:

5. Following information has been made available from the cost records of

United Automobiles Ltd, manufacturing spare parts:

Direct Materials Per Unit

X Rs.8

Y 6

Direct Wages

X 24 hours @ 25 paise per hour

Y 16 hours @ 25 paise per hour

Variable overhead 150% of direct wages

Fixed Overheads (total) Rs.750

Selling Price

X Rs.25

Y Rs.20

The directors want to be acquainted with the desirability of adopting any one

the following alternatives sales mixes in the budget for the next period.

(a) 250 units of X and 250 units of Y

(b) 400 units of Y only

(c) 400 units of X and 100 units of Y

(d) 150 units of X and 350 units of Y

6. The cost sheet of a product is given below

Rs.

Direct material 5.00

Direct wages 3.00

Factory Overheads:

Fixed Re. 0.50

Variable Re. 0.50 1.00

---------

Administrative expenses 0.75

Selling or distribution overhead:

Fixed Re. 0.25

Variable Re. 0.50

--------- 0.75

______

Total cost per unit 10.50

______

Selling price per unit is Rs. 12.00

The above figures are for an out put of 50,000 units. The capacity for the firm

is 65,000 units. A foreign customer is desirous of buying 15,000 units at a price of

Rs.10 per unit.

Advise the manufacturer whether the order should be accepted what will be

you advise if the order were from a local merchant?

14.4 REVISION POINTS

Basic characteristic of marginal costing- working of marginal costing, Role of

contribution- Practical Application of Marginal costing – limitations of marginal

costing.

14.5 INTEXT QUESTIONS

1. Define the term ‘Marginal Costing’?

2. Distinguish between absorption costing and marginal costing?

3. Explain the advantages of classifying the cost into fixed and variable

elements?

4. What do you mean by Semi-Variable expenses?

5. Explain the various methods of separating semi-variable expenses into fixed

and variable components?

6. Explain the following terms: Contribution, P/V Ratio, BEP, Margin of

safety.

7. Explain the advantages and disadvantages of marginal costing.

8. What are the limitations of marginal costing?

14.6 SUMMARY

Marginal costs are useful for pricing of products, make or buy decision and

selection of a suitable product mix. Besides the marginal costing help the

organisation in implication of overhead treatment on the other hand the limitations

of marginal costing is difficulty to analysis the overhead in short for marginal cost

some experiences is need.

14.7 TERMINAL EXERCISE

1. Marginal cost is known as

(a)Cost per unit (b) fixed cost (c) variable cost (d) Total cost.

14.8 SUPPLEMENTARY MATERIALS

Emerald / Journal of Accounting Research – emerald insinght.Com

Journal of Management Accounting Research Amercican/

aaahq.org/mad/JMAR/contents,ctm.

14.9 ASSIGNMENTS

1. How can the cost be classified on the basis of variability?

2. Discuss the applications of the marginal costing technique?

14.10 SUGGESTED READINGS / REFERENCE BOOKS

1. De paule. F C ---- Management Accounting in Practice.

2. P.N. Reddy & H.R. Appaniah--- ‘Essential of Management

Accounting

14.11 LEARNING ACTIVITIES

Students are requested to draw a Break Even chart with imagery figures.

14.12 KEYWORD

Marginal Cost, Break Even analysis, Cost volume.

LESSON – 15

MERGERS AND ACQUISITIONS, AND SWOT ANALYSIS

15.1 INTRODUCTION

A company may grow internally, or it may go externally through acquisitions.

The objective of the firm in either case is to maximise existing shareholders wealth.

Another company can be acquired through merger, take-over, consolidation etc. A

merger is a combination of two companies where only one survives. The merged

company goes out of (corporate) existence, leaving its assets and liabilities to the

acquiring corporation. Consider the merger of Tata Fertilisers Ltd. (TFL) with Tata

Chemical Limited (TCL), the promoting company. Under the scheme of merger, TFL

shareholders are offered 17 shares of TCL (market value per share was Rs. 114), for

every 100 shares of TFL held by them. Further, TFL's cumulative convertible

preference (CCP) shareholders who may not want to accept shares in exchange were

given the option of cash payment of Rs. 15 for every share they held. In this merger,

TCL is an acquiring company, which survives where as TFL is being the acquired

company, which ceases to exist,

15.2 OBJECTIVES

After reading this lesson you should be able to:

Understand the meaning of merger, take-over, etc,

Know the different kinds of mergers.

Identify the circumstances which influence merger of companies.

Specify the regulations/guidelines for take-over and merger.

List out recent mergers and acquisitions in India.

15.3 CONTENT

15.3.1 Concept of Merger and Acquisition.

15.3.2 Classification of Mergers-Operating Mergers Versus Financial Mergers

15.3.3 Circumstances which influence merger of Companies Financial and Non

financial factors

15.3.4 Major Mergers in Indian Corporate Sector

15.3.5 Merger process in India

15.3.6 Regulations of Mergers and Take-over.

15.3.7 Tender Offer -

15.3.8 Defensive Strategies

15.3.9 Issues to be considered in Mergers and Acquisitions.

15.3.10 Meaning of SWOT Analysis

15.3.1 CONCEPT OF MERGER AND ACQUISITION

A merger is different from a 'consolidation', or amalgamation which involves the

combination of two or more companies whereby entirely new company is formed.

All the old companies cease to exists, and their equity shares (common stock) are

exchanged for shares in the new company. For example, Hindustan Computer Ltd

(HCL), Hindustan Instruments Ltd., Indian Software Company Ltd. (ISCL) and

Indian Reprographics Ltd (REL) were amalgamated in April 1986 as a new company

called HCL Ltd. In this amalgamation, all the four amalgamated companies lost their

identify and formed a new company known as HCL Ltd. When two companies of

about same size combine, they usually consolidate; on the other hand, when the

two companies differ significantly in size, usually a merger is involved. Though it is

important to understand the distinction, the terms 'merger' and 'consolidation'

tend to be used interchangeably to describe the combination of two companies.

The term 'take-over' means the acquisition by one person or group of persons

or by a company of sufficient shares in another company to give the purchaser

control of that other company. A 'take-over' in this sense differs from merger as the

company which is taken over by the purchaser remains in existence while in merger

one of the two companies goes out of existence. Thus, the take-over tends to denote

the situation where one business offers to buy out of the owners of another, often

against the wishes of the board of directors or groups of shareholders. The dividing

line between the two is indistinct. A number of situations which are presented as

mergers are effectively take-over bids. The directors of the taken over company,

being unable to control effectively the course of events in their business, are glad

of the opportunity to come to an arrangement with another business which

preserves their self-esteem by presenting the operation as merger.

The primary motivation for mergers is to increase the value of combined

enterprise. If companies A and B merge to form company C, and if C’ s value

exceeds that of A and B taken separately, then synergy is said to exist. Synergistic

effects can arise from three sources (i) operating economies resulting from

economies of scale in production or distribution, (ii)financial economies, including a

higher Price-Earnings ratio or a lower cost of debt, or both, and (iii)increased

market power due to reduced competition. Operating and financial economies are

socially desirable, but mergers that reduce competition are both undesirable and

illegal.

15.3.2 CLASSIFICATION OF MERGERS

Economists classify mergers into three groups (a) horizontal, (b) vertical, and (c)

conglomerate.

a. Horizontal Merger: When two or more companies producing the same goods

or offering the same services decide to merge, it becomes a horizontal merger. The

horizontal merger will involve reduction in the number of competition companies in

the effected markets; for example, the emergence of Associated Cement Companies

(ACC) Limited when small cement plants all over the country decided to merge into

one company. The National Textile Corporation (NTC) resulting from the merger of

several sick units manufacturing textile products into one corporation. Merger

of Sundaram Clayton Limited's (SCL) moped division with TVS Suzuki Limited (TSL),

and take-over of Universal Luggage Company by Blowplast Company are other

examples for horizontal merger,

b. Vertical Merger: A vertical merger or integration on the other hand is a

merger between two companies manufacturing different products but having

customer supplier relationship wherein the product of one company is used as raw

materials by the other company. The merger between Tata Iron and Steel Company

Ltd. and. Indian Tube Company Limited is in the nature of a vertical merger

c. Conglomerate, Mergers: Pure Conglomerate merger occurs where-

one company takes over another company in a completely different industry, with

no important common factors between them in production, marketing, research

and development or technology. Such mergers result in no reduction in competition

in the industries concerned, the example of this is the merger between Mahindra

and Mahindra Limited and Indian Aluminium Company Limited,

In any type of merger parties such as the shareholders of the company, the

creditors, the employees, the government through monopoly commissions, the

lending financial institutions, the stock exchange, high courts etc., get involved. In a

decision to allow merger of public limited companies the interest of minority

shareholders and the public interest in general should always be considered before

the necessary permission to merge is granted by the authorities concerned. These

parties should evaluate the proposal of merger in proper perspective considering

carefully the following factors affecting the mergers:

(i) The capacity to influence its market share, (ii)efficiency of the merged

enterprise, (iii)the regional imbalance and the employment, (iv)the effects on

balance of payment, and (v)the public interest.

Operating Mergers Versus Financial Mergers

From the standpoint of financial analysis, there are two basic types of mergers:

1. Operating mergers, in which the operations of two companies are

integrated with the expectation of operating economies for obtaining

synergistic effects.

2. Pure financial mergers, in which the merged companies will not be

operated as a single unit and from which no operating economies are

expected.

The primary benefit from an operating merger is high expected profits. For

example, the combined company may be able to reduce overheads and thereby

raise profits. The expected benefits of financial mergers are more varied. In one

case, the target company may have no financial leverage, so the acquiring firm may

plan to buy the company, pay for it by issuing debt, and gain market value from

the capital structure change. In another instance, one of the firms may be so small

that its stock is illiquid, and its Price-Earning ratio is low. In such a case the stock

will have a low value, and it may represent .a bargain purchase for the acquirer

value. In other instances, one firm may have excessive liquidity, large annual cash

flows, and unused debt capacity, while another firm may need financial resources to

take advantage of growth opportunities.

Financial and Managerial Considerations

Amalgamation is the blending of two or more existing undertakings, the

shareholders of each company becoming substantially shareholders in the company

which is to carry on the blended undertakings. The term amalgamation has not

been defined in the Companies Act. It is an arrangement whereby the assets of two or

more companies become vested in or under the control of one company.

Amalgamation comes into play when two companies are joined to form a third

company or one is absorbed into or blended with another. Amalgamation generally

takes place between companies which are associated with one another in some form

or other e.g. common shareholders, unity of management, common line of business,

location of activities etc. But amalgamation between two companies which have

nothing in common can also take place and this has become equally popular in

the present emphasis on diversification and insulation against economic, socio-

political vicissitudes besides uncertainties of nature. The overall considerations of

business and the needs of socio-economic changes including of scale, industrial

and trade policies of the state may also influence the merger of companies with a

view to achieving long term, economic and financial benefi t, both for the

companies concerned and the

15.3.3 CIRCUMSTANCES WHICH INFLUENCE MERGER OF COMPANIES

(a) Gap between corporate objectives and achievements: Despite reasonable

internal growth, management might find a clear gap between expectations and

realizations ei ther due to time constraint, want of special managerial skills,

productive capacity, technology, research and development etc. Merger of companies

may facilitate companies to grow from a higher take off point and record incremental

sales volume, marshal effectively the available resources and ensure optimum

returns.

(b) The need for diversification: With a view to ensuring greater stability in

the earnings and working capi tal management and to get over the limi tation of

managerial know-how, product and production technology, marketing skills and

other key factors, amalgamation may provide the answer for exchange of all the

readymade skills of the companies concerned so that the new emerging

management may adopt them to advantage. With the transplanting of new skills,

the new management will also be revitalized and the company poised for further

accelerated growth.

(c) Spreading the risk : A small company is exposed to relatively more risk

in embarking upon a new product line. Initial and potential losses may be too

high when compared to capital base. Combination with a larger company would

spread the risk.

(d) Elimination of unhealthy competition : Two companies running identical

business can merge together to avoid competition and save huge money on

competitive advertisements.

(e) Related lines of business: Where activities of companies are complimentary

to one another, merger can help reduce cost of products. Different companies

dealing with product at different stages of production, all of which ultimately

result in the production of one or more major items or products can also merge

together under a common ownership.

(f) Long gestation period : A capital intensive company with a long gestation

period can advantageously increase i ts 'debt, capaci ty' by merging wi th

another noncapital intensive company, especially when the latter company is a

cash rich company and the idle cash can be profitably invested.

(g) Shareholders Net worth: Shareholders of a closely held company can

reasonably expect a better return upon the company merging with a widely held

company besides ensuring enough liquidity and feasibility of altering their

investment portfolio. Further the earning per share of the amalgamating company

is bound to improve and future earnings ensured.

(h) Tax Benefits: The various fax benefits that accrue from amalgamation form

additional incentives.

(i ) Non financial factors : Apart from the financial factors the following

nonfinancial factors have also to play a part in merger proposals: (i ) Role and

compensation of the earlier management over the new or amalgamated company,

(ii)Continuation and promotion of the existing products, (iii) Opportunity to enter new

markets, (iv) Bargaining capacity after merger, (v) Safeguards for future growth,

(vi)Does the amalgamating company gain by the merger? and (vii) Does the

amalgamated company gain by the merger?

(j) In a merger proposal the amalgamated company not only takes over the

physical assets and liabilities of the amalgamating company but its experience,

organisation, proven performance, skilled staff apart from goodwill and these

factors have to be qualitatively assessed end taken note of.

(k) Seasonal or cyclical companies can merge with either non seasonal or other

companies for various reasons like funds management etc. For sick companies,

perhaps, amalgamation with a successful company is a practical proposition. For

successful companies, amalgamation would help securing certain potential tax

incentives apart from providing for external expansion. Small companies can merge

with other small companies if they have necessary managerial talent and

competence in addition to ensuring funds flow, Closely held companies may merge

with widely held companies in order to take advantage of the tax benefits. Even

foreign companies can merge and make the amalgamated company an Indian

company to ensure the tax benefits, by first converting the foreign branch into an

Indian company even as a subsidiary of the foreign company which in turn can be

merged with an Indian company, subject of course to the restriction imposed by other

legislations like MRTP., FERA, etc.

15.3.4 MAJOR MERGERS IN INDIA

Merging Companies Merged Company Remarks David Brown Greaves Cotton

Ruston & Homsby Greaves Semi – conductors VST

industries

ITC Vertical amalgamation increase market share and

enter agri - business Renusagar Power supply Hindalco Industries To generate additional funds

& diversity into extensive

product (merged) Tomcod Hinsustan Lever To become leader in

detergent & soap market Ucal components Pentafour products To increase turnover and

profits

Quest Internal India Ponds India - Wardhaman Auto Electrical Kirloskar Electrical Revival of the Company

Orisa Synthetics Straw Products Rehabilitation

Sources: Economic Times

15.3.5 MERGER PROCESS IN INDIA

The process of amalgamation is legislated by the Companies Act, 1956. The

following procedure for the amalgamation s normally followed:

Examination of object clause

Intimation to Stock Exchange

Approval of Amalgamation Draft

Making Application in the High Court

Drafting of notice and explanatory statements, and its despatch

Filing an affidavit in the court.

Holding of meeting of shareholders and creditors

Petition to the court for confirmation

Passing of orders by High Court

Transfer of the assets and liabilities

Issue of shares and debentures.

Historical Perspective: In India, the whole business of mergers and takeovers

till the 1970's was at a low key, though profitable affair: discussions were generally

conducted across the board and negotiated settlements reached amongst the

parties concerned. In the negotiated settlement, shareholders other than the

controlling interests had no real say, though in the case of mergers they were

required to vote for or against the merger resolution. The enormous clout wielded

by the financial institutions came to light when the famous raid of DCM Ltd. and

Escorts Ltd. was launched by Swaraj Paul in the early 1980's. Given the enormous

amount of floating short term funds held by institutions, industrialists realised that

an institutional vote could make or mar their future. Consequently, a demand was

made to curtail their power.

Though the role of financial institutions in takeover battles is rightly interpreted

as a connivance between political powers and industrialists, it must be borne in

mind that financial institutions are vested with the responsibility of moderating the

stock exchanges. Therefore, it is a matter for them to deal in large quantities of

shares and own large proportions of the share capital.

Financing the Acquisition (Method used in India): The three widely adopted

methods are (i ) using asset based financial to finance acquisition of a divirion,

(ii) buying of shares from the promoters by paying cash or Paying through own shares,

and'(iii) paying own shares in exchange for the company.

15.3.6 REGULATION OF TAKEOVERS

Basically the framework for regulating takeovers must seek to (i) impart

transparency to the process, (ii) protect the interest of the shareholders, and (iii)

facilitate the realisation of economic gains.

Transparency of the Process: A takeover affects the interests of many parties

and constituents, such as the contending acquirers, shareholders, employees,

customers, suppliers, and others. Hence, it-should be conducted in an open manner.

If the process is transparent, take-overs will be viewed favourably by all concerned

and regard a< a legitimate device in the market for corporate control.

Interest of Shareholders: In a take-over, the 'controlling block', which often

tends to be between 10 per cent and 40 per cent, is usually acquired from a single

seller, (Occasionally it may be acquired from many sellers through market

purchases.) Typically the 'controlling block' is bought at a 'negotiated' price which is

higher than the prevailing market price. The Securities and Exchange Board of

India (SEBI) has come out with some guidelines on Corporate Takeovers. The

essential thrust of these guidelines are to make takeovers as transparent as

possible in order to protect target companies and individual shareholders. As per

the guidelines, if a person who holds shares in a company has agreed to acquire

further shares through negotiations, which when taken together with the shares

already held by him, would carry more than 10% of the voting capital, he has to make

a public announcement of an offer to the remaining shareholders of the company,

before he acquires those additional shares.

Realisation of Economic Gains : The primary economic rationale for take-

overs should be to improve the efficiency of operations and promote better

utilisation of resources. In order to facilitate the realisation of these economic gains,

the acquirer must enjoy a reasonable degree of latitude for infusion of funds,

restructuring of operations, liquidation of non-viable division, widening of product

range, redeployment of resources, etc.

Role of Financial Insti tutions : Financial institutions, thanks to their

substantial equity holding in a large number of companies, often hold the balance

of power. Without their support, the acquirer may not be able to enjoy control.

Hence, they have a crucial role to play. Ideally, they should serve as guardians of

larger public interest and ensure that: (a) the process of take-over is open and

transparent", (b)potential acquirers operate on level ground, (c) the takeover is

likely to produce economic gains, (d) the interest of shareholders and other

constituents is reasonably protected, and (e) to undue concentration of market

power arises as a sequel of take-over.

Major Acquisitions in India

Acquired Acquirer Remarks

Polyester Libredivn. of Indian

Organic Chem

Reliance-Industries Cost saving

Sewa Paper and Chewdar Unit

of Titaghur Paper

Ballarpur Industries Acquired

Poysha Industries Tinplate Co. For diversifying to

package business

Andhra Pradesh Steel Balaji Group For revival and

expansion

Andhra Cement India Cement —

Gemini Breweries (P) Ltd. Kishor Chhabria Group Acquired

Kumardhubi Fire Clay Electro Fuel Mfg. Co. For revival

Source: Economic Times,.

15.3.7 TENDER OFFER

A tender offer is a formal offer to purchase a given number of a company's

shares at a specific price. In a tender offer, a company wants to acquire another

company and asks the shareholders' of the target company to "tender" their shares

in exchange for a specific price. The price is generally quoted at a premium i.e.,

above the market price, in order to induce the shareholders to tender their

shares. Tender offer is one of the ways of acquiring control of another company.

Tender offer can be used in two circumstances. First, it can be negotiated directly

through the management. The acquiring company requests the management of

target company to gel i ts approval. When the management of the target

company does not oblige, then the acquiring company can request directly the

shareholders by means of the tender offer. Second, the acquiring company can

directly request the shareholders of the target company to "tender" their shares at

a specific price. The shareholders are informed of the offer through announcement in

the financial press or through direct communication

individually. In USA, the tender offers have been used for a number of years,

but the pace has been intensified rapidly since 1955 whereas in India, there has

been no such tender offers till recently. In September 1989, Tata Tea Ltd. (TTL),

the largest integrated tea company in India, has made an open offer for controlling

interest to the shareholders of the Consolidated Coffee Ltd. (CCL). TTL's Chairman,

Darbari Seth, offered one share in TTL and Rs.1OO in cash (which is equivalent of

Rs. 140) for a CCL share which was then quoting at Rs. 88 on Madras Stock

Exchange. TTL's decision is not only novel in the Indian corporate sector but also a

trend setter. TTL had notified in the financial press about its intention to buyout

some tea estates and solicited offers from the shareholders concerned.

The exchange price for "tender" shares may be either purely cash or purely

shares of the acquiring company. Sometimes, the exchange consideration for tender

shares would be partly by cash and partly by shares of the acquiring company. In a

number of cases, the management of target company resists such tender offers.

There are many reasons for this resistance: (i) the acquiring firm may fail to

understand the culture and problems of the target company, (ii) future plans may not

be in the interests of target company's shareholders, (iii) tender offer or exchange

ratio is too low to accept, and (iv) acquiring company may replace the present

management with a new management.

15.3.8 DEFENCE STRATEGIES

There are a number of tactics and devices to defend the tender offer and avoid

being taken over by another company. The important defensive tactics are

divestitures or spin off, poison pill, green mail, white knight, crown jewels, blank

check, pac-man, shark repellent, gray knight, etc.

Divestiture (spin off): The target company disposes some of its operations or

part of the business in the form of a newly created company.

Crown Jewels: Disposal of profitable divisions / asset coveted by the acquirer,

thus making the target unattractive.

Blank Check: Authorising issuance of new shares, usually preferred at the

discretion of the Board of Directors. Its purpose is to vote down a hostile take -over

attempt.

Poison Pill: Taking on a large debt, usually at exorbitant terms, making the

acquisition less attractive. Scorched earth is an extreme form of this tactics.

Pac-man: This is similar to the popular video game - each company tries to

gobble up the other. The target seeks to acquire the predator, adding to accounting

and legal confusion.

Shark Repellent: Amending the Memorandum or Articles to make a takeover

complex and costly, thereby discouraging it.

Green Mail: Threatening fight for over control of the firm, but with the ultimate

objective of raising the market price of shares and sell ing them at a premium.

White Knight; Inducing a cash rich ally to out-bid the predator and avert a

takeover.

Gray Knight: Enlisting the services of friendly company to purchase the shares

of the predator, keeping him busy with defending his own company.

15.3.9 ISSUES TO BE CONSIDERED IN MERGERS AND ACQUISITIONS

From the above discussion, it is clear that the management of the company,

which is taking over another company, should carefully examine the following aspects

before a final decision is made :

1. How does the merger help the parent company? Does it add to the existing

strengths? Does it provide an assured source of raw materials? Does it

provide forward integration? Does it help in optimal utilisation of the

existing resources?

2. Why should they take over this particular unit, and not some other unit?

What are its unique features? How do they mesh-in with the existing

features of the parent company?

3. Why is the present management selling out? Is the unit inherently alright?

Are there any basic problems, which are not open to easy solution?

4. What kind of post-merger problems are likely to arise? Is the parent company

fully prepared to tackle them?

5. How would the financial insti tutions react to the proposal? What new

conditions are they likely to impose?

6. What would be the impact on the share prices of the parent company?

7. What would be the impact on sales turnover, and profitability of the parent

company after the take-over and merger?

8. What is the right price for the unit? How should it be paid? What should be

the exchange ratio between the shares of the parent company and the merger

company?

Many merchant bankers have impressive shopping lists of companies available

for sale. Some of these bankers are extremely persuasive and sophisticated in their

match-making practices. Even when you are paying through your nose, you may be

under the illusion that it is a steal. Be careful and be on the alert when you are

dealing with she merchant bankers, specialising in take-over deals. It is possible

that your company may be raided by a hostile take-over specialist. In the West,

merchant bankers have devised schemes which help the existing managements to

acquire another company.

Management Buy-outs and Leveraged Buy-outs: During the 1980s, a new

scheme' of corporate restructuring become extremely popular in the USA and the

Western Europe. This new scheme came to be known as leveraged buy out (LBO). As

the name implies, an LBO has two major aspects:

(i ) Using the LBO, the management buys out the entire shareholding of the

company from the public and gets it delisted.

( i i ) For buying shares on such a massive scale, the management takes a loan

and thus leverages the transaction.

The LBO package is usually designed and structured by investment or

merchant bankers. LBOs are a mixed bag with some advantages and

disadvantages, as indicated below

Advantages

1. If the public shareholders get a value higher than the market price

(close to the break-up value) they are benefited, at least, in the short run,

2. The owner-managers and/or the professional managers can run the

companies without any fear of losing control from a hostile take-over.

3. LBOs help to restructure the companies, basically weeding out inefficient

and incompetent managements.

Disadvantages

1. As an LBO usually results in a very high proportion of debt, servicing of the

debt becomes a great financial strain for the company in the post-LBO period.

2. Since the management resorts to asset-stripping and jettisoning of the

subsidiaries to reduce the debt burden after an LBO, it might weaken the company

in the long ran.

3. Continuity and stability will be adversely affected when bankers and stock

market experts start running manufacturing enterprises. The management focus

tends to shift to short term.

Some Policy Issues : LBOs give rise to some major policy issues as listed below:

1.Joint-stock companies which go public and get listed on the stock exchanges

promote a wide dispersal of share ownership. LBOs tend to result in the reverse

namely concentration of share ownership and economic power.

2.LBOs involve considerable debt-financing which- works both ways, When the

operational profits are high, a high debt equity ratio results in high earnings per

share. When the operational profits are stagnating or low, a high debt-equity ratio

is not in the interest of the equity owners.

3.Financing an LBO transaction by way of so-called junk bonds (i.e. high-yield

bonds) may lead to reckless financing affecting the long-term stability of interest

rate structures. Default rates in junk bonds are quite-high.

4. LBOs andxjunk bonds help managements as well as raiders. Thus they tend

to disturb the equilibrium by rocking the boat rather too often.

15.3.10 SWOT ANALYSIS

The overall evaluation of a company’s strength, weakness, opportunities, and

threats is called SWOT analysis. It is a way of monitoring the external and internal

marketing environment.

SWOT (strengths, weakness, opportunities and threats) is one of the technique

that appraise the organisational strengths and weakness and matches them with

environmental opportunities and threats. For example, if a firm has strength in

financial area. It can improve its market share through expanding production

facilities or technological capabilities.

Strengths refers to the competitive advantage and core. Competence (in relation

to the competitor) that a company can exert in the market place. This may lie in

superior technical knowhow, wide distribution channel, motivated employees. Etc.

Weakness are the limitations, constraints or obstacles in resources and

capacities. These weakness may be due to financial resources or technical

knowledge, etc.

Opportunities are the external factors and forces in the business environment

that provide scope for the company to grow and enhance its market share and

profitability Government’s decision to reduce excise or sales tax, increase in GDP,

deli censing, etc are opportunities for business to grow.

Threats are the external factors and forces in the business environment that

pose challenge or check the growth, market share or profitability of the business.

Slow market growth, entry of MNC, etc. Are threats for Indian business houses?

SWOT is basically on exercise in identification and analysis of internal and

external environment. SWOT analysis itself provides no formal set of rules for

strategic success. However there are certain guidelines like objective and open

assessment of strength, weakness, opportunities and threats, that can bring the

company on route of success. Secondly, for successful choice and implementation

of strategies, firm should exploit its competitiveness and strengths and avoid

competing on work areas as W. Stewert Home remarks. “The application of SWOT

analysis to competitors as well as one self should indicate to a business its relative

position in the market and again direct the firm towards appropriate strategies”.

15.4 REVISION POINTS

Merger and Acquisitions- merger means a combination of two companies where only one survives. The term ‘take over’ means the acquisition by one person or

group of persons or by a company of sufficient shares in another company to give the purchaser control of that other company.

Classification of Mergers – in to three groups – they are

(i) Horizontal Merger (ii) Vertical Merger (iii) conglonmerate.

15.5 INTEXT QUESTIONS

1. Define 'Merger' and state the primary motives for mergers.

2. Distinguish between operating mergers and pure financial mergers.

3. Examine several recent mergers and point out the principal motives for

merging in each case

4. Examine a recent merger in which at least part of the payment made to the

seller was in the form of stock. Use stock market prices to obtain an

estimate of the gain from the merger and the cost of the merger.

5. Explain the distinction between a tax free and a taxable merger. State the

circumstances in which you would expect buyer and seller to agree to a

taxable merger.

6. Do you have any rational explanation for the great fluctuations in

aggregate merger activity and the apparent relationship between merger activity and stock prices?

7. What is a tender offer? State the defensive strategies adopted to defend the tender offer,

8. What is meant by Leveraged Buy-out? State its advantages and

disadvantages in the present Indian context.

15.6 SUMMARY

A company may grow internally, or it may go externally through acquisitions.

The objective of the firm in either case is to maximise existing shareholders wealth.

Another company can be acquired through merger, take-over, consolidation etc. A

merger is a combination of two companies where only one survives. The merged

company goes out of (corporate) existence, leaving its assets and liabilities to the

acquiring corporation.

A merger is different from a 'consolidation', or amalgamation which involves the

combination of two or more companies whereby entirely new company is formed.

All the old companies cease to exists, and their equity shares (common stock) are

exchanged for shares in the new company.

Economists classify mergers into three groups (a) horizontal, (b) vertical, and (c)

conglomerate.

From the standpoint of financial analysis, there are two basic types of mergers:

Operating mergers, in which the operations of two companies are integrated

with the expectation of operating economies for obtaining synergistic effects.

Pure financial mergers, in which the merged companies will not be operated as

a single unit and from which no operating economies are expected.

SWOT ANALYSIS:

The overall evaluation of a comapany’s strength, weakness, opportunities, and

threats is called SWOT analysis. It is a way of monitoring the external and internal

marketing environment.

15.7 TERMINAL EXERCISES

1. When two or more companies producing the same goods or offering the same

services decide to merge is known as

(a) Vertical Merger (b) Horizontal Merger (c) Conglomerate Merger

2. One company takes over another company in a completely different industry is

known as

(a) Vertical Merger (b) Horizontal Merger (c) Conglomerate Merger

15.8 SUPPLEMENTARY MATERIALS

http://dosen.narotama.ac.id/

http://www.osbornebooksshop.co.uk/

http://www.fao.org/

15.9 ASSIGNMENTS

Explain the various issues to be considered in Mergers and Acquisitions

decisions.

Give brief summary of SEBI guidelines on merger of companies in India,

15.10 SUGGESTED READINGS /REFERENCE BOOKS

1. Brealey, R. and Myers, S.

Principles of Corporate Finance, New York, McGraw Hill Co.

Acquisitions, Mergers, Sales &

Takevoers : A Hand Book,

15.11 LEARNING ACTIVITIES

Group discussion during PCP dates.

15.12 KEY WORDS

Merger

Horizontal Merger

Vertical Merger

Conglomerate Merger

Acquisition

Take over

Tender offer

SWOT.

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ANNAMALAI UNIVERSITY PRESS 2016 – 2017