1. 1. TEFI Distance Learning Program BUSINESS FINANCE - 1 BUSINESS FINANCE - 1 Prof. R. Balachandran
2. 2. ChapterNo.1 FinancialAccounting&AccountsFunction Contents ObjectivesofFinancialAccountingandAccountsFunction Financial Accounting Process Steps involved till final accounts Differences among proprietorship firm, partnership firm and a limited company in terms of FinancialAccounting Differentfinancialstatementsandtheirpurposesinbusiness Figures What they mean to a business, Understanding financial statements for decision-makinginbusiness Financial Accounting as different from Management Accounting and Cost Accounting Formats of Financial statements for business Profit & Loss statement, Balance Sheet,CashflowstatementandFundsflowstatement Attheendofthechapterthestudentwillbeableto: Understand the Financial Accounting process and prepare simple statements of Profit & Loss & Balance Sheet Map the differences between Accounts and Finance functions in an enterprise Understand numbers contained in financial statements in the context of business&usethemindecisionmakinginbusiness Prepareothertwofinancialstatements,CashflowandFundsflow Map the differences among Financial Accounting, Management Accounting andCostAccounting TEFI Distance Learning ProgramTEFI Distance Learning Program 32 FINANCIAL ACCOUNTING & ACCOUNTS FUNCTION BUSINESS FINANCE - 1
3. 3. TEFI Distance Learning ProgramTEFI Distance Learning Program Introduction Financial Accounting is done on the basis of certain Accounting Principles thatareuniversalinnature It is based on a specific accounting system and has to follow certain basic rules thatareagainuniversalinnature It also involves specific standards called Accounting standards and practices called Generally Accepted Accounting Practices (GAAP), which are different from country to country. Indian Accounting standards are known as AS and Generally Accepted Accounting Practices are known as GAAP, India At present, readily available application software has simplified maintenance of financial accounts and generation of required financial statements Why Financial Accounting Running a business, as we may recall, involves financially, certain amount of money coming in and certain amount of money going out. The money coming in could be from the owners of the business enterprise, loans from banks and others or due to the operations of the business enterprise. Similarly, the money going out could be for purchasing of assets required by the business or for meeting expenses of the business enterprise or for paying off loans earlier taken. Whatever be the purpose of money coming in and money going out, these financial transactions are required to be recorded on a day-to-day basis so that atanygiventime,theownerswillbeinapositiontoknow: How much money has come into the business and what the source of this money is How much money has gone out of business and the purposes for which the moneyhasbeenspent This is called Financial Accounting. In short, Financial Accounting faithfully records all the transactions in a business enterprise that involve money and these transactions are referred to as Financial or Accounting transactions. Let us examine the following examples to understand the purposeofFinancialAccounting. Exampleno.1 IhavepurchasedgoodsforsaleworthRs.20,000/-againstcash I need to record the details to know the value of goods purchased by me and against what like cash or credit and in case it is a credit transaction, from whom as I will be required to pay the supplier later, what is the quantum of goods purchased so that I can know any given time how much unsold items I have on hand (called stocks) Similarly I have taken a loan of Rs. 1,00,000/- from a bank to run my business. I need to record the details to know who has given me money so that I can 54 return the same to the lender as and when required and as stipulated at the time oftakingtheloan. Another example I am selling goods worth Rs.50,000/- on credit. The buyer is going to pay me after some time. I need to record the details to know who my customer to whom I have sold goods on credit is, so that I can follow-up for getting the payment. If we carefully go through the above examples, we will notice that Financial Accounting transactions could involve: Cash or credit (the manner of payment, now or later respectively) Income or Expense (revenue coming in due to sale of goods or services and revenue going out due to purchase of goods or services respectively) Asset (what the business enterprise owns, purchased out of capital, owners' contribution and/or loans from others) and Liability (what the business enterprise owes to an outsider who has given it financial resourcesforpurchaseofassets) ThustheobjectiveofFinancialAccountingis: To know the financial position of the business enterprise in terms of: How much revenue has come in (Income) and how much revenue has gone out (Expense) At the end of a given period, say one year, whether the business is in profit (Income > Expenses and difference between Income & Expenses) or Loss (Expense > Income and difference between Expense & Income) What the sources of money coming into the business enterprise (Liabilities) are and where they have been used (Assets) How much money did the owners bring into the business enterprise at the beginning and what its current value is (owners' funds original investment as enhanced by profits retainedinthebusiness) Relatedtermsinconnectionwiththeaboveobjectiveare: Accountingprinciples These are common for the entire globe. For example, the owner of the business enterprise and the business enterprise are different from each other from Accounting angle. Proof of this principle the owner's contribution called capital to the business enterprise is reflected as Liability in the Accounts of the enterprise, while the owner accounts for it as an Asset as it is an investment. FINANCIAL ACCOUNTING & ACCOUNTS FUNCTION BUSINESS FINANCE - 1
4. 4. TEFI Distance Learning ProgramTEFI Distance Learning Program AccountingRules&Regulations These are again common for the entire globe. These rules and regulations essentially tell us which account is to be credited or which account is to be debited. For example I sell goods against cash Goods account is credited and cash account is debited is an Accounting Transaction. Accounting system Cash system that can be followed by a proprietorship firm or partnership firm this follows cash coming in or going out for accounting for an item of income (that could result cash coming in) or expense (that could result cash going out). This system does not consider credit transactions. Hence accounting is not done of outstanding transactions. There is noreceivableorpayableinthiscase Accountingstandards (AS) Given by the Institute of Chartered Accountants ofIndia (ICAI)alongwithGenerally AcceptedAccounting Practices (GAAP), India.Operating income (coming from the main operationsofthe enterprise like trading, manufacturing or services) and non- operating income (coming from investments made outside the business in some other business could be share capital or debt instrumentslikedebenture,bondetc.) Accountingperiod This would depend upon the country in which the business enterprise operates. For instance in India, the accounting st st period is from 1 April to 31 March this is also called Uniform Accounting Period (as all kinds of business organizations like Proprietorship firm or Partnership firm or Limited company have to follow this uniformly in India) or Financial Year Profit and Loss statement Statement prepared at the end of the Accounting period as above showing the summary of all income items and expense items besides the result of performance, namely Profit or Loss fortheperiod. BalanceSheet Statement of Assets and Liabilities as at the end of the Accounting period as above, i.e., the sources of funds (term indicating money) Liabilities and uses of funds Assets Other Accounting Terms have been explained in the Chapter GlossaryofTerms Fund This represents financial resource taken or given by the business enterprise depending upon whether money comes in or goes out. This is a macro term and includes both cash and credit. For example, a supplier giving goods on credit does not give cash but gives goods that are worth certain specified value. The above information will be useful to the following users of financialstatements: OwnersoftheBusinessEnterprise LenderswhohavegivenmoneytotheBusinessEnterprise Other stakeholders of the Business Enterprise like employees,suppliersetc. Government agencies like Income Tax authorities and others who are interested in investing in the business enterprise in Sharecapitalorloan,likedebentureorbond FunctionsofAccountsDepartmentthatdoesFinancialAccounting 1. Maintenance of Accounts strictly in accordance with the Accounting Principles, following Accounting Rules as per prescribed Accounting system and observing Accounting standards as well GAAP depending upon the country of operations. 2. Control over amounts receivable, amounts payable, bank accounts, cash on hand etc. 3. Preparation of budgets, both revenue and capital, with the objectives of allocation of resources, control and monitoring of expenses 4. Compliance with payment of Advance Tax as per the Rules and Regulations in this behalf 5. Effective Tax planning thorough understanding of Income Tax Rules and Regulations with a view to minimize tax payable by the enterprise 6. Maintenance of Financial Management Information System (popularly known as MIS) that is a review of performance of key financial parameters vis--vis the estimates this is an important tool in taking corrective action in time and hence forms an integral part of decision-makingprocess 7. Being responsible for the process of Audits of various kinds Internal Audit, Statutory Audit, Tax Audit etc. 6 7 FINANCIAL ACCOUNTING & ACCOUNTS FUNCTION BUSINESS FINANCE - 1
5. 5. Differences among proprietorship and partnership firms on one hand and limited companies on the other hand in respect of Financial Accounting process/system Parameter Sale proprietorship Parternship Limited Firms Firms Companies TEFI Distance Learning ProgramTEFI Distance Learning Program Accounting Process 8 9 Financial transaction takes place in the Enterprise it could be cash or on credit if it is Cash, it could result in cash inflow or outflow Decide on which Account To be debited or credited In accordance with Accounting principles, the Relevant Rules & Regulations & prescribed Accounting system Transactions are maintained in ledgers Creditors, debtors etc. and Registers Sales, Purchases etc. on individual transaction basis Transactions are consolidated in a control book of accounts named General Ledger this contains a single consolidated account for each item of income, expense, asset and liability example, one account for operating income, one debtors account, one creditors account etc. Verification step whether the sum of all credits is equal to sum of all debits as it should be in case the business enterprise is following double-entry book-keeping system also known as Accrual Accounting System This is done by extracting all the balances of General Ledger in a statement known as Trial Balances. In this statement, the income and liabilities will appear under Credit side while assets and expenses will appear under Debit side. This statement will however disclose errors of some types like wrong head of accounting, error of omission or commission on both the sides to the same extent. Example customer debited for credit sale by Rs.10,000/- more and sales also credited by Rs.10,000/- more. Process of rectification of errors pointed out by the Trial Balance statement. Further where the errors are not shown by the Trial Balance, the process of reconciliation is initiated especially in the case of creditors, debtors and bank accounts. This is done by asking for statements of our accounts with them so that we can go through entry by entry and verify whether the entries are correct or not. If there is a mistake correction is carried out Closing entries are then made depreciation on fixed assets, provision for bad and doubtful debts, provision for outstanding expenses, outstanding income, adjustment for pre-paid expenses and income received in advance etc. are made before preparation of final financial statements for the accounting year, namely Profit & Loss statement & Balance Sheet Profit & Loss statement and Balance sheet are prepared in the case of proprietorship firms and partnership firms, the two statements can be prepared in any format whereas in the case of limited companies, the business enterprise has to prepare in accordance with the formats provided for in Schedule VI of The Companies Act FINANCIAL ACCOUNTING & ACCOUNTS FUNCTION BUSINESS FINANCE - 1 Step no. 1 Accounting transaction analysis and deciding which Account to be debited and which account to be credited Step no. 2 Entering the various transactions in the basic books of Accounts Registers and ledgers excluding General Ledger Stepno.3 Postingtheconsolidatedfigureseachaccount-wiseinthe ControlbookcalledGeneralLedger Stepno.4 Verificationofthedouble-entrybookkeepingprocessthrough TrialBalance Stepno.5 RectificationoferrorspointedoutbyTrialBalance Step no. 6 Closing and adjustment entries at the end of the Accounting period Step no. 7 Preparation of Profit & Loss Statement and Balance Sheet as per prescribed formats in the case of limited companies as per Schedule VI of the Companies' Act No compulsion. The firm can choose either of them but once decided, will have to stick with it If cash system is adopted, credit transactions will be ignored No specific formats Trading and Profit & Loss Accounts Transferred to the capital of the owner thereby increasing the investment of the owner in the firm No compulsion under the partnership Act. The firm can choose either of them but once decided, will have to stick with it If cash system is adopted, credit transaction will be ignored No specific formats Trading and Profit & Loss Accounts Transferred to the capital accounts of the owners thereby increasing their investment in the firm in accordance with the basis of Profit shearing in the partnership Deed Under the provision of The Companies Act. it is compulsory to adopt the Accrual basis of Accounting. No choice The enterprise has to account for both cash and credit transactions Specific formats as per Schedule VI of the Companies Act. Profit & Loss and Profit & loss Appropriation Account Transferred to Reserves & surplus as share capital of the owners cannot be altered by retained profits in business Accounting system Accrual or cash Cash transaction and credit transactions Final audited statements presentation in specific formats Componants of P & L Statement Retained profit in business (Profit after Tax as reduced by profit with drawn from business or distributed in the form of dividend)
6. 6. TEFI Distance Learning ProgramTEFI Distance Learning Program Difference between finance function and accounts function Finance and accounts functions may be integrated in an organisation. This means that one department handles both. In most of the small and medium size units in India, the functions will be integrated. A business enterprise will require a full-fledged finance department only when the functions listed above are predominant functions impacting business in a big way. If the finance functions are not predominant functions, Accounts department looks after Finance also. Constant requirement of funds, surplus for investment etc, could be some of the factors influencing the need for a full-fledged Finance department. Different financial statements in a business enterprise and their purposes understanding the meaning of the figures contained in the financial statements Statement no. 1 Profit&Lossstatement Denotes profit or loss for the enterprise for the year. Usually prepared for a year that is referred to as Financial year. This is also called Uniform Accounting Period. Can be prepared on a monthly basis too. The result will not be accurate as some of the figures like depreciation will be more accurate only on an annual basis. The same thing goes for provision for outstanding income or expenses too. Profit and Loss statement indicates the financial performanceoftheyearjustgoneby. 10 Pointers in Profit & Loss statement: 1. Whether the business earns operating profit? That is operating income (-) operating expenses (operations being trading, manufacturing or services) and this excludes income from investment made in some other enterprise or other activity not connected with the main operations of the enterprise. Example, sale of fixed asset, rent income, sale of scrap generated during the process of manufacturing. 2. Is it that the business is in profit only due to non-operating income as described above? If it is so, it means that the main operations of the enterprise are in loss and the firm is able to keep its head above waters only due to profit coming fromotherthanmainoperations. 3. How do operating expenses behave? Are they increasing in proportion to the increase in revenue or disproportionately to the increase in revenue? If they increase disproportionately, it means that stricter control over expenses is indicated. 4. In case operating expenses have gone up, which group of operating expenses gone up? Is it manufacturing/operations or administrative or selling/marketing or finance expense that is going up disproportionately? What is the level of closing stock in the Profit and Loss statement? Has the level gone up disproportionately to the increase in revenue? This is important, as increase in levels of inventory is going to involve carrying cost like return on investment made in it and this will surely reduce the profits of the enterprise. The above list is only suggestive and not exhaustive Statement no. 2Balance Sheet Denotes position of Assets and Liabilities as on a particular date. It is useful for a business enterprise for knowing the sources of funds for the business enterprise and their uses. Further, any user of this statement will come to know how the original investment in share capital by the owners has grown due to profits retained in business, also known as Reserves & Surplus, especially in the case of a reputed company. In short, capital shareholders' funds = Total assets (-) External funds invested in business, both short-term (not exceeding 12 months duration) and term liabilities (exceeding 12 months duration). This usually indicates the financial performance of the past including the year just gone by. Example no. 2: Suppose the sum total of all assets = Rs. 120 lacs and the external funds invested in business = Rs. 80 lacs. The shareholders' funds are = Rs. 120 lacs 11 Financial Accounting Functions Corresponding Finance Functions Maintenance of Accounts strict compliance with statutory provisions as per ICAI guidelines, Accounting Standards, GAAP (India) provisions, Income Tax Act provisions etc. Financial planning and Resources mobilization. Adequate resources in time and in a cost-effective way. More of market orientation than statute-orientation Responsible for budgets both revenue and capital Cash management stand-by arrangements, both in case of excess and deficit Tax compliance and tax planning besides audit Responsible for treasury management largely, liquidity management, risk management and investment management Management Information System & Reports for Finance Strategic Financial Management initiatives like expansion, diversification etc. FINANCIAL ACCOUNTING & ACCOUNTS FUNCTION BUSINESS FINANCE - 1
7. 7. under review. Pointers in the Cash flow statement 1. Has the month just gone by generated any surplus of cash or has it resulted in deficit? 2. If there is a surplus, how to utilize the same and if there is a deficit, whatisthealternativesourcethatcangivecashtofillthegap? 3. Whether the cash flow statement is useful to the business enterprise as a tool in financial planning? This can happen only if the estimate is realistic and the actual at the end of the month does not differ fromtheestimatebyawidemargin Statementno.4Fundsflowstatement Denotes movement of funds (please refer to fund under terms at the beginning) during a period under review. Generation of funds and its use can be explained in terms of assets and liabilities in simple terms as under: Inliabilitiesor inassets =Sourceoffunds Inliabilitiesor inassets =Use of funds From the above, the reader can understand the linkage between Funds flow statement and the balance sheet of the enterprise. Usually this period is one year. Funds flow statement can be prepared on an Estimation or Actuals basis this entirely depends upon the purpose for which funds flow statement is being prepared. If it is for Financial Planning and Resources Mobilization, it is done on Estimation basis say for the next one to two years; on the other hand, if it is prepared for review purposes, it is done on Actuals basis. Having seen that this statement is closely linked to balance sheet, let us see the difference between the two statements. While funds flow statement tells you about the movement of funds (proposed or actual), balance sheet gives the impact on Assets and Liabilities due to movement of funds during a given period. Funds are divided into Resources (funds coming into business) and Uses (funds going out of business). Resources are presented in three broad heads whileusesarepresentedintwobroadheadsasunder: Resources: Long-term accruals from business = Funds generated from operations Long-term funds (external) = Fresh capital coming into business like share capital or loans + sale of fixed assets + sale of investment etc. Short-term funds (external) = Fresh short-term borrowing from banks for working capital + any increase in other short-term funds like TEFI Distance Learning ProgramTEFI Distance Learning Program12 13 (-) Rs. 80 lacs = Rs. 40 lacs. Suppose the starting point for this business enterprise is Rs. 20 lacs from the owners towards capital, this means that at present the original investment of Rs. 20 lacs has grown to Rs. 40 lacs over a period of time. Pointers in the balance sheet: 1. What is the level of funds employed in business? Is it increasing disproportionately to the level of revenue? 2. What is the relationship between owners' contribution and borrowed funds? Is it in line with what the lenders usually accept 1.5:1to2:1(excludingshort-termliabilities) 3. Will the enterprise be able to meet the short-term liabilities from its short-termassets? 4. Whether the Return on Investment (ROI) for the business is coming down or going up? This is a combination of P&L and Balance sheet. Funds employed in business are known from the balance sheet while the earnings are known from the Profit and Loss statement. 5. Whether the capacity of the business enterprise to pay interest and repay loan installments is satisfactory? This is again a combination of Profit & Loss statement for earnings and Balance sheet for the repaymentliability Statementno.3 Cashflowstatement Denotes the position of cash inflow and cash outflow for a particular period. The period is usually one month, but can be more frequently done. This is useful to a business enterprise from the point of view of control and monitoring the amount of cash available in business, also known as liquidity. This information is required both for planning, i.e., arranging for back up, in case the available cash is less than required and control, in case the available cash is more than required. The business enterprise cannot afford to keep more cash than required, as idle cash does not earn any return and it is better to save interest by putting the excess cash back into overdraft etc. The loss incurred by keeping more cash than required is often referred to as opportunitycost. Exampleno.3: My enterprise requires Rs.10lacs on an average by way of cash. Suppose my projected receipts for December 2004 are Rs.250lacs and projected outflows are Rs.260lacs with opening balance of Rs.10lacs. This will result in my closingbalanceofcashofRs.20lacs. This is far in excess of my requirement of Rs.10lacs. What do I do with this excess cash? I put it back into my bank account so that I can save some interest especially if my bank account is overdraft like account in which case, I pay interest on the amount used by me. Once I prepare the cash flow statement, I compare it with the actual position at the end of the month so that I can verify as to how far I have been good in projecting my cash position for the month FINANCIAL ACCOUNTING & ACCOUNTS FUNCTION BUSINESS FINANCE - 1
8. 8. TEFI Distance Learning ProgramTEFI Distance Learning Program14 15 Uses: Long-term uses = Fresh purchase of fixed assets + fresh investment made by the business + repayment of loans or redemption of bonds/debentures etc. Short-term uses = Fresh purchase of inventory + any increase in level of receivables or any other short-term (working capital) asset + any reduction in short-term liabilities like bank overdraft or level of creditors etc. Example no. 4: Long-term sources (Internal) Rs.20lacs Long-term sources (External) Rs.30lacs Short-term sources Rs.20lacs Total funds available Rs.70lacs Long-term use Rs.40lacs Short-term use Rs.30lacs Total uses Rs.70lacs In the above example, we observe that short-term funds are deficient in comparison with short-term use, whereas long-term funds are in excess of long-term use. This should be the feature of any Funds flow statement, as long-term sources that include profit retained in business will be available both for long-term and short-term use. As against this, short-term funds (otherwise known as working capital funds) are not available for long-term purposes. The reason is obvious short-term funds are available for day-to-day operations and hence if they are diverted to long-term use, the efficiency of the business enterprise will be drastically affected. It will affect the income as well as increase the cost by way of interest in case we take additional borrowingtofillthegapcausedbyreductioninworkingcapitalfunds. PointersinFundsflowstatement: 1. Whether long-term sources are in excess of long-term use or isittheotherwayaround? 2. It is desirable to have long-term sources in excess of long term use and this excess is available to short-term purposes Differences among Financial Accounting, Management Accounting and Cost Accounting Financial Accounting Cost Accounting Management Accounting Function is to record all the financial transactions in accordance with certain principles, standards etc. Function is to analyse costs associated with an activity or a product or a division and ascertain whether the activity or a division or a product is profitable or not Function is to make required modifications in the financial accounting, analyse and present it to the management for control and managerial decision-making Provides historical data and is a measure of performance of the business enterprise as a whole Is concerned more with costs associated with a specific product etc. to ascertain the profitability of the product or division provides a tool in the hands of the management to take decision on product or activity. Works with the data provided by Financial accounting Financial accounting data modified by regrouping the items as required for decision-making. Non- financial data like quantitative data also used in management accounting. Further even future data considered as required by management Compulsory for all the business enterprises to follow Not compulsory at least in some industries. Maintained purely for pricing decisions, control of costs and planning for profits Not at all compulsory in any industry. It is purely at the instance of the management for their purpose and not for any external use Useful more for outsiders as a pointer to the financial performance of the business enterprise Useful for managerial decision-making including management. May not be useful for owners in a professional set-up Useful for owners of the business enterprise in any set-up. Not much flexibility more or less standardised Involves detailed study of costs and hence depends upon the nature of enterprise Thoroughly flexible in approach depending upon the requirement of control from the managements point of view. Involves generation of Management Information System Reports FINANCIAL ACCOUNTING & ACCOUNTS FUNCTION BUSINESS FINANCE - 1
9. 9. TEFI Distance Learning ProgramTEFI Distance Learning Program Profit & Loss & Balance Sheet Example no. 5 - A sample of Profit and Loss Account (Rupees in Lacs) Income from operations 100 Operating expenses: Salaries 30 Repairs and maintenance 3 Depreciation 10 Office and general expenses 10 Marketing expenses including Commission, if any 7 Interest and other Charges 10 Total expenses 70 Profit before tax 30 Tax at 35% 10.5 Profit after tax 19.5 Dividend 7.5 Profit retained in Business [Retained Earnings] 12 Learningpoints: ! Interest is charged to income before determining the profit of the organisation. Once the profit of the organisation is determined, tax is paid at the stipulated rate and the dividend is paid only after this. Thus,dividendisprofitallocation. ! This difference between interest and dividend gives opportunity to business enterprises, to have a mix of capital of the owners and loans taken from outside, so that they can save on tax, through the interest charged as expense on the income. The amount of tax so saved is called tax shield on the interest. ! In the case of profit distributed among the partners as well in the case of dividend distributed among the shareholders, these are not taxed againinthehandsoftheowners. Linkagebetweenbalancesheetandprofitandlossaccounts The above statement is known as the Profit and Loss Account. This records the income and expenditure for a given period and is closed as soon as the period is over. The residual profit, as it belongs to the owners, gets transferred to the capital account in another statement, called Balance Sheet. The balance sheet tells us about the following: How much money has the business enterprise raised ? Which are the sources for the money ? What is the use for this money ? 16 17 Example no. 6 The balance sheet is also known as Assets and Liability statement. A sample balance sheet is shown below: (Rupees in lacs) Liabilities Assets Sharecapital: 100 FixedAssets 60 Reserves: 150 Less: Depreciation 30 (Retained profits Net Fixed Assets: 30 over a period of Investments: 80 time) Current Assets: Net worth 250 Bills Receivable 100 Bank overdraft 30 Cash and Bank 35 Creditors for expenses 10 Other current assets 60 Other current liabilities 15 Total current assets 195 Total current liabilities 55 Total Liabilities 305 Total Assets 305 Suppose profit for the year is Rs.30 lacs after paying tax and dividend. This would be transferred to the balance sheet and the reserves at the end of the current year would be Rs.150 lacs + Rs.30 lacs = Rs.180 lacs. Similarly the depreciation claimed on the fixed assets and shown as an operating expense would also get transferred to the balance sheet to reduce the value of the fixed assets. Let us assume that there is no increase in the fixed assets during the year that there are no other changes and the depreciation for the year is Rs.10 lacs. We can construct the balance sheet for the next year without much change, excepting to accommodate these figures of depreciation and increase in reserves. The balance sheet as at the end of the next year would look as under: (Rupees in Lacs) Liabilities Assets Share capital 100 Fixed assets 60 Reserves and surplus 180 Less: depreciation 40 Net worth 280 Net fixed assets 20 Bank overdraft 30 Investments 100 Current Assets : Creditors for expenses 10 Bill Receivable 120 Other current liabilities 15 Cash and Bank 35 Total current liabilities 55 Other current assets 60 Total liabilities 335 Total current assets 215 Total Assets 335 FINANCIAL ACCOUNTING & ACCOUNTS FUNCTION BUSINESS FINANCE - 1
10. 10. TEFI Distance Learning ProgramTEFI Distance Learning Program18 19 Weseethatbetweenthetwobalancesheets,therearetwochanges InvestmenthasgoneupbyRs.20lacsand BillreceivablehasgoneupbyRs.20lacs. The total is Rs.40 lacs. Where have these funds come from? This amount is the total of profit transferred to balance sheet from the profit and loss account and depreciation added back, as it does not involve any cash outlay. The figure is Rs.30 lacs + Rs.10 lacs = Rs.40 lacs. This figure is referred to as internal accruals. This need not be the case all the times. Where we use these funds entirely depends upon the business priority and what we have shown is only a sample. Learning points: ! The business enterprise generates funds from operations, known as internal accruals comprising depreciation (which is added back, beingonlyabook-entry)andprofitaftertaxanddividend; ! Where these funds are used is entirely dependent upon business exigencies; Depreciation claimed in the books as an expense goes to reduce the value of the fixed assets in the books, while profit after tax and dividend is shown as Reserves and increases the net worth of the company. Exampleno.7 Cashflowstatement OpeningBalanceforPeriod (+)Receiptsduringtheperiod (-)Expensesduringtheperiod = Closing Balance for the period (is the same as Opening Balance for the next period) (Rupees in Lacs) Cash Receipts Revenue Receipts Sales Receipts 100 Dividend income on shares 5 Rent income 10 Total 115 Capital Receipts Fresh debenture 50 Fresh term loan 100 Sale of fixed asset 10 Total 160 Non-Revenue Receipt Sale of shares 20 Total 20 Total Receipts 295 Cash Payments Revenue expenditure Payment to creditors 75 Payment of interest 15 Payment of expenses 25 Total 115 Capital expenditure Purchase of fixed assets 150 Repayment of term loan 25 Total 175 Non-Revenue expenditure Purchase of UTI Units 2 Total 2 Total Payments 292 Opening balance of cash 3 Add: Total Receipts 295 Less: Total Payments 292 Closing balance of cash 6 (Opening balance for the next period) Example no. 8 Funds flow statement Financial statements - Funds flow statement - Format Funds inflow sources Long-termfunds 2003-2004 2004-2005 Profitafterfax 240 265 Less: Dividendpaid 80 80 Netprofit 151 176 Add: Depreciationfor theyear 36 40 Amountamortised 15 15 (A) - Long-termfunds (internal) 202 231 FINANCIAL ACCOUNTING & ACCOUNTS FUNCTION BUSINESS FINANCE - 1
11. 11. TEFI Distance Learning Program Decreaseinoverdraft/cashcredit 0 0 Decreaseintradecreditors 85 0 Decreaseinprovisionsandother Short-termliabilities 0 0 Decreaseinshort-termloans 0 0 (E)-Short-termuses 270 336 Total uses = D + E 750 854 SummaryofFundsflowstatement Long-termfunds 467 568 Long-termuse 480 518 Surplusor(deficit) (13) 50 Short-termfunds 283 286 Short-termuse 270 336 Surplusor(deficit) 13 (50) Questions and numerical exercises for practice and reinforcement of learning 1. What kind of business organization is suitable to begin with foranentrepreneurandwhy? 2. What is the objective of financial accounting from the point of view of the owner of an enterprise? 3. Suppose you want to know the financial performance of your business for the current year, which statement gives you the relevant figures? Which statement gives you the financial position of the enterprise? 4. Trace the advantages of a cash flow statement to a business enterprise. Can you use this statement for planning for resources? If no, which statement is available to you for this purpose ? 5. For you as the owner of a business enterprise, is it necessary to know in depth the process of financial accounting? In case your answer is no how can you run the enterprise withafullcontrolovertheamountinvestedinbusiness? 6. What is the significance of operating income from business point of view? Suppose you have operating loss of Rs. 5 lacs and overall profit of Rs. 2 lacs, what does it mean?WhatisthesourceoftheoverallprofitofRs.2lacs? 21 FINANCIAL ACCOUNTING & ACCOUNTS FUNCTION TEFI Distance Learning Program20 BUSINESS FINANCE - 1 Increase in share capital 0 0 Increase in term loans 150 0 Increase in debentures/bonds 0 250 Increase in fixed deposits/acceptances and other medium and long-term liabilities 75 50 Decrease in investments 25 15 Sale proceeds of fixed assets 15 22 (B) - Long-term funds (external) 265 337 Total Long-term funds (A+B) 467 568 Increase in short-term bank borrowing overdraft/cash credit 133 132 Increaseintradecreditors 0 67 Increaseinshort-termloans 65 22 Increaseinprovisions andother 33 45 Short-termliabilities 0 0 Decreaseincashandbank Decreaseininventory 0 0 Decreaseinreceivables 52 0 Decreaseinothercurrentassetq 0 0 (C) -Short-termfunds 283 286 Totalfunds generatedduring theyear 750 854 Funds outflow - uses Long-term use 2003-2004 2004-2005 Increaseinfixedassets 175 268 Increaseininvestment 75 50 Decreaseintermloans,redemptionof bondsanddebenturesanddecreasein othermediumandlong-termliabilities 230 200 (D) Long-termuses 480 518 Short-term use Increaseininventory 122 160 Increaseinreceivables 0 147 Increaseincashandbank 32 14 Increaseinothercurrentassets 31 15
12. 12. TEFI Distance Learning ProgramTEFI Distance Learning Program ChapterNo.2 CostsinBusiness&RoleofCosting Contents Whatiscost? Differencebetweencostandexpenseinbusiness Whatiscosting? RoleofCostinginabusinessenterprise Marginalcostinganditsuseindeterminingbreak-evenanalysis Possible activities where costs could be high and measures of containing them Attheendofthechapterthestudentwillbeableto: Prepareacostsheetforajob Determinethebreak-evenpointforagivenbusiness Planforscaleofbusinessandprofits Examine possible areas of high cost in one's own business and evolve suitable measures of controlling them Introduction In Chapter no. 1, we had seen the role of Accounts and the process of Accounting. We had also familiarized ourselves with the four financial statements, namely Profit & Loss statement, Balance Sheet, Cash flow statement & Funds flow statement and their use in one's business. In this chapter, we turn our attention to costs in a business enterprise. All of us have heard expense as well as cost and mostly would have taken these terms to mean the same. They are not the same. In a new business in the absence of expense before revenues start flowing into business from the activity of the enterprise, the costs associated with an activity are determined based on estimates. For an existing business, however, cost is derived from business expenses. This is done by segregating the business expenses into distinct levels like in the case of a manufacturing unit: Production/manufacturing Office administration Marketing/selling & Cost of borrowing Finance cost Further expense is a part of Profit & Loss statement while cost is a part of Cost Accounting. The purpose of Cost Accounting is to keep record of all the costs associated with various products individually, or a group of products or a business unit or a business division (in case an enterprise has more than one division), or a branch (in case an enterprise has more than one branch) etc 22 23 At the very basic level, we can say that it is used for the following purposes in a business: ! Determine the price at which a business enterprise should sellitsproductorservice ! Ascertain the correct profitability of a product at the end of the year. Suppose a business enterprise has more than one product, it could be that overall the business may be in profit while in one product it could be losing. The loss in one product could be more than made up by gainsinanotherproductandhenceoveralltheresultisProfit. ! Take suitable business decisions on increasing the production/sale of a product or reducing its production/sale depending upon the analysis as perthesecondstep ! Review the costs on actual basis at the end of the period and compare the actual profit earned with the estimated one to know the areas responsible for higher costs if any so as to evolve suitable corrective measurestocontrolthehighercosts Etc. Roleofcostinginbusiness Suppose we manufacture a single product. Then we know all the costs associated with this single product. Hence it is easy for us to analyze the costs from the Profit and Loss Account at the end of the Accounting period or even more frequently. The bifurcation of costs should be into major heads as describedaboveforamanufacturingunit. However, the bifurcation of costs into the major 4 heads is not going to be easy for each product in the case of a multi-product enterprise. The Profit & Loss statement as seen in Chapter no. 1 represents the total cost of the organization for all the products and activities of the enterprise without any bifurcation. CostAccountingjustdoesthatbasedonfollowingconsiderations. 1. Whether the cost is incurred directly in producing the product? Known as direct cost. The direct cost gets absorbed into the total cost of the product and the Entrepreneur or his /her Accountant need not employ any specific tool for allocating the costs over various activities. Example material or wages. Most of the times, the direct costs vary with the level of production or sales as the case may be in proportion. 2. If not a direct cost, then it ist an indirect cost like for example, the salary of factory supervisor. Unlike direct cost, the indirect cost gets allocated over various products or activities of the organization. For this the Entrepreneur or his/her Accountant needs some basis for bifurcation. For example rent paid for the building that houses all the plant and machinery. The rent cost can be bifurcated on more than one basis among the various products coming from the plant and machinery. At stage 1, the rent is allocated among the plant and machinery based on the area occupied by each machine to the total area. At stage 2, the rent allocated to a particular machine gets allocated among its various products based on the numbers if they are homogenous in value or based COSTS IN BUSINESS & ROLE OF COSTING BUSINESS FINANCE - 1
13. 13. TEFI Distance Learning ProgramTEFI Distance Learning Program on different values and units if their production values are different. Most of the times, the indirect costs do not vary with the level of production or sales as the case may be in proportion; they may vary less thanproportionately.Hencetheyarecalledfixedcostsalso. Note: There could be notable exceptions of direct costs being fixed and not variable with the level of production or sales as the case may be. Take for example, wages. We can see that wages are direct cost in terms of contribution to production and hence get absorbed. However the reader will appreciate that a major portion of the wages is fixed and a very small portion of it is variable in the form of production incentive. It is in fact on this very issue, in the past, there used to be big tussle between the management of enterprises and the workers' unions. The trade unions would want the entire portion of wages to be fixed while the management would like to maximize the portion of variable wages so that they can easily link the variable portion to theproductionoutputgivenbytheworker/workers. Thus Cost Accounting is complementary to Financial Accounting. It exactly tells us as to whether we are in profit in all the products that we are manufacturing. It could so happen that while in some products we are in profit, in some others we could be in loss. For taking a decision by the Entrepreneur, the costs need to be accounted for properly and absorbed (in the case of direct costs) or allocated properly (in the case of indirect costs). In the absence of Cost Accounting, we continue to sell huge volume of a product in which we are losing and at the end of the Accounting period, we are in big loss. Had we checked it up earlier, we could have taken corrective action of either reducing the production of the product in which we are losing or if the market can absorb a higher value, increase its selling price. Concept of cost and bifurcation of cost into fixed and variable Marginal costing As mentioned earlier, usually all direct costs are variable costs as they vary with the level of activity and indirect costs are also fixed costs as they do not vary with the level of activity and are necessarily incurred irrespective of level of activity. Here, the reader will be well advised to keep in mind that considering inflation every year, all costs vary and hence the basis of bifurcation of costs into fixed and variable requires relooking at. What we mean by the term variable costs is that the costs vary with the level of activity, be it production or sales, in proportion to the increase in that activity of production or sales. Similarly, fixed costs are those that do not vary in proportion to the level of activity and most of the times, they vary less than proportionately to the increase in the level of activity, be it production or sales. While it is true that all costs vary if we consider inflation, for a while let us forget and discuss marginal costing. This principle is based on incidence of fixed costs in a business those are independent of production means that they are incurred even before producing the first unit. This is based on the premises that for a given business, for a given period, the 24 25 fixed costs do not increase while the variable costs increase directly with each unitproducedmore.Thisisexplainedthroughanexampleasunder: Exampleno.1 Suppose for a manufacturing unit, the fixed costs are Rs.1lac and the variable costis65%ofthesalepriceofRs.25/-perunit.Whatdoesthismean? At the very beginning, the business recovers variable costs from the customer. The fixed costs are not fully recovered. The difference between selling price and variable cost is called contribution. At first the contribution is less than fixed costs and hence the total costs > total revenue. This results in alosssituation. At stage no. 2, the contribution = fixed costs; this is the stage of break-even pointwhenthereisneitherprofitnorloss. Beyond this stage, the contribution = fixed costs + profits. Thus theoretically, wecanseethreestagesinanybusinessasunder: Stage1,wherecontribution
14. 14. TEFI Distance Learning ProgramTEFI Distance Learning Program26 27 Yes,asunder: Exampleno.3 HowmuchshouldyouselltoregisteraprofitofRs.1lac.? We know that if we record profits in the enterprise, the contribution = FC + profit In this case, the contribution to record Rs. 1 lac profit = 1 lac fixed costs + 1 lac profit = Rs. 2 lacs Hence sales for recording Rs. 2 lacs contribution = 2,00,000/contribution per unit = 22,858 units and the sales volume will be 22,858 x Rs. 25/- per unit = Rs. 5,71,450/- The question perhaps uppermost in the minds of readers now will be, whether the BEP can be found out in the case of multi-product unit. Definitely more complex but not impossible provided the costing system in the business unit is quite efficient. We will have to apportion all the fixed costs of the enterprise among the various products that the unit is manufacturing and determine the break-even point for each of this product. This will enable the management to decide on optimal product mix that will give maximum profits with the least possiblevolumeofbusiness Cost sheet for a job based on bifurcation of costs into direct and indirect costs Now let us see an example as to how we will quote for a job, based on material, labour and manufacturing expenses, both direct and indirect. This is done through a cost sheet Example no. 4 Direct materials 1,00,000 Direct wages: Machineshop: 10,000 hours 80,000 Paintshop: 4,000hours 60,000 1,40,000 Otherdirectmanufacturingexp. 35,000 Indirectmanufacturingexp. Machineshop: 25,000 Paintshop: 12,000 37,000 Administrative overheads 75,000 Selling & distribution overheads 66,000 Total cost 4,53,000 Add: gross margin 25% 1,13,250 Quotation value to the customer 5,66,250 Cost estimation for a job is done on the following lines: Prime cost: Material cost Wages Direct manufacturing expenses (+) Factory overheads = Factory cost (+) Administrative overheads = Office cost (+) Selling overheads = Sales cost (+) Distribution overheads = Total cost, on which gross margin is loaded to get the proper quotation for the customer. Having seen the costs in totality, it is time now for us to go into details of eachofthesemajorheadsofcostsinabusiness Costofproduction Materialsconsumed:Rawmaterialsandpackingmaterials Consumptionofstoresandsparesincludingmachineryspares Wagesforlabour Utilityexpenses:Power,waterandfuel Repairsandmaintenance Depreciationonfactoryassets Manufacturingexpenses Production over-heads including factory administration, time office expenses,insuranceonfactoryassetsetc Administrativeandgeneralexpenses Officesalaries Depreciationonofficeassets Repairstoofficeassets Communicationexpenses Travellingandconveyance Printingandstationary Auditexpenses Legalexpenses Consultancycharges Charityanddonation Rentratesandtaxesetc. Sellinganddistributionexpenses Freight,octroiandinsuranceoutward Advertisement Salescommission Branchofficeexpenses Secondarypackingmaterial Salesincentivesetc. Particulars Rupees Rupees COSTS IN BUSINESS & ROLE OF COSTING BUSINESS FINANCE - 1
15. 15. Break Even Point Analysis Picture TEFI Distance Learning ProgramTEFI Distance Learning Program28 29 Finance and other bank charges Interest on loans Interest on working capital limits given by banks Commission on bills collected through banks, guarantees issued, letters of credit opened by the banks on our behalf etc. Remittance charges for remittance from one place to another place etc. Behaviour of Costs While we do have all the above expenses, a close examination would tell us that all of them do not behave in the same manner. For example, we have an administrative office and pay salaries to the employees in the administrative office. We continue to pay them the salaries, irrespective of whether the level of sales has come down or increased. Like this, we have a lot of business expenditure, which is independent of the level of activity undertaken by the business enterprise. Simultaneously, we do have certain expenses, like communication expenses and hiring costs that entirely depend on the level of activity, like, the scale of a project or the number of projects executed in a given time and man-hours or machine- hours spent on development of a product etc. Note: In the above discussion, the effect of inflation on costs in general has been ignored. This means that due to inflation, all costs in general, be they fixed or variable, increase constantly. In that sense, no cost is fixed and all costs are variable. However, the concept of cost bifurcation into fixed or variable is based on the assumption that in the short run, fixed expenses are constant and short-termcouldmeanupto24monthsinthecaseofamanufacturingit. Relationshipbetweenfixedexpensesandprofits The difference between the selling price and the variable costs is known as contribution. Contribution per unit = Selling price per unit (-) variableexpensesperunit. Itisveryclearthatthisshouldnotonlybe sufficienttomeetthefixedcostsbutalsogiveprofits. Sales amount = S and variable expenses for this sales amount = V, then contribution would be S (-) V. Let us say this is C and the fixed costs are F. Then at the point where the contribution is just enough to meet the fixed expenses, C = F. It is only beyond this point that the sales would give us profit. This point is called break-even point, thereby meaning at this point there would be neither loss nor profit. Once we know our level of fixed expenses and the amount of variable expenses going into every unit of production, we can plan for profits more accurately. Variable Costs Sales Amount Fixed Costs Total Costs Break Even point Units Amount in Rupees COSTS IN BUSINESS & ROLE OF COSTING BUSINESS FINANCE - 1
16. 16. TEFI Distance Learning ProgramTEFI Distance Learning Program LearningPoints: ! Costs associated with any business are bifurcated into direct and indirect, depending upon their relationship with the level of activity in an organisation. ! Costs are also bifurcated into variable and fixed costs depending upon whether they vary with the level of activity of production or sales as the case may be or they remain fixed irrespective of the level of activity. Mostlydirectcostsarevariableandindirectcostsarefixed. ! Contribution is the difference between selling price and variable cost. In the initial stage of sales, contribution goes for meeting the fixed costs and at the point of break even, the contribution = fixed costs. It is only beyond this point that the business enterprise starts earning profit. ! This means that beyond this point, the contribution is sufficient not only for meeting fixed expenses but also gives profit. ! The point of break even helps management in determining the level of operation and the volume of profits that they would like to target in a given year. ! The phenomenon of break even is based on this assumption that in the short run fixed costs do not increase and this short run could be 6 months at the most in the case of a software unit. Visibility of costs across various levels in an organisation The purpose of cost bifurcation into fixed and variable is to have a control over the costs of the enterprise and to achieve the objective of maximising profits for the enterprise. This objective is achievable only when all the employees are aware right from the commencement of their association with the company, that for any operation of the company, we incur costs; be it production, administration or sales. For example, production personnel in charge of production may not appreciate the cost associated with carrying large inventory or cost of consumption of materials during the process or production of the cost of material wasted during transfer or carrying it from one department to another department. Similarly, marketing personnel may not appreciate the cost associated with inventory cost of finished goods or receivable carrying costs etc. The administrative or finance people may not appreciate the cost of delay in getting the finance in terms of market opportunity lost for the business enterprise. Thus there are always visible and invisible costs associated with any operation. We, as managers and owners would appreciate the fact that even when costs are incurred by us directly, we take them for granted; we do not make any conscious efforts to reduce them. Hence it would be unrealistic to expect that we would be cost conscious in the case of those costs, which are not visible to us immediately, while at work, as explained above. Thus from the management's point of view, it is as much important, if not more, to make all the employees aware of invisible costs associated with their area of operation, as it is to have a proper bifurcation of costs intofixed and variable for the purpose of control over them. This alone would enable the employees to develop a holistic view of the company and its operations, instead of being compartmentalized or segmented in their approach. Suggestedcostreductionmeasuresforsomeofthetypicalproblemsfaced inamanufacturingunit Problem Suggested solution 3130 Better material handling facilities even by incurring capital expenditure, if needed. Better quality suppliers by increasing the quantum of indent at a time. Promoting skills of workers by periodic feedback and training inputs. Linkage and long-term contracts with quality suppliers to ensure consistency in supply. A close examination about product- wise consumption and whether we are producing certain varieties wherein the consumption is very high, just to keep certain customers happy as we have all along been producing them, even though the contribution from such product/s is less. Is it because of high consumption of machinery spares? Is high consumption of machinery spares because of old machinery? A study should be made about the recurring cost of spares and the advisability of replacing the machinery one after another in a phased manner the replacement programme is different from modernization programme. Do we have a regular maintenance programme of machinery, depending upon their usage? Is it possible for us to develop indigenous spares in the place of imported spares, in case the spares are imported just now so that lead- time can be less and over all cost will also reduce over a period of time? Material consumption high Repairs and maintenance high COSTS IN BUSINESS & ROLE OF COSTING BUSINESS FINANCE - 1
17. 17. TEFI Distance Learning ProgramTEFI Distance Learning Program Bifurcationofoperatingexpensesintofixedandvariableexpenses: 32 33 By having an effective means of communication and promoting awareness among all concerned regarding cost associated with communication. Printing and stationary wherever possible, to specify the quality of stationary for taking out draft printouts and final printouts, so that first class stationary need not beusedfortakingdraftprintouts. How does it compare with other units in the same industry? Can we promote consciousness among the production employees regarding power conservation? Can we also promote cost consciousness among administrative staff? Simple measures of switching off lights and fans and air-coolers when not needed will save 10/15%electricitycharges. How do we compare with others in this area? Try and introduce a part of the pay package as incentive based on performance, attendance etc. rather than by way of monthly emoluments. Wherever possible, try and introduce superannuation and personal accident insurance schemes and reduce pro-rata, the increase in emoluments with its incidental increase in terminal and annual benefits. The organisation should have a need based and effective incentive scheme for most of the categories of employees so that reward is not in the form of increments only, that in turn, increases the cost to the organisation by way ofterminalandannualbenefits To make the branch office/development centre/strategic business unit, a profit centre and making the unit-in-charge responsible for the performance of the unit. Control through budgets, excluding specific inputs, which are considered on merits, i.e., on request being justifiedetc. Toning up receivable management by having a systematic follow-up. Try and obtain bill finance by making the customers accept the bills drawn on them. Try and get advance whereverpossible,evenagainstbankguarantee Preferable to enter into annual maintenance contracts with the vendors so as to avoid last minute hitch in the operations due to break down, unless the company has its own machine maintenancedepartment. Communication & Printing and stationary costs alarming Power bill is high/ consumption of electricity is also high. Employee costs Branch office/Development centre/Strategic Business Units etc. High receivable carrying cost because of delay in realisation Maintenance cost being very high Nature of expense Variable Fixed Materials Yes ------ Power/electricity Major portion Minor portion Consumables Yes ------ Stores Major portion Minor portion Wages to labour Minor portion Major portion Repairs & maintenance Major portion Minor portion in view of annual maintenance contract. Factory administration Expenses Minor in the form of incentives Major portion fixed by way of salaries, security contract charges, insurance on factory assets etc. Depreciation on all assets ------- By and large fixed Processing charges or vendor charges paid to outside contractors to whom a part of the job is given for execution By and large variable -------- Staff welfare expense -------- Fixed Insurance charges for all assets -------- Fixed Rent rates and taxes for the business premises -------- Fixed General and Administrative expenses (All) -------- Fixed Selling expenses: Incentives to marketing personnel Variable -------- Advertisement expenses Variable if for specific product/s Fixed for a major portion. Product launch exp. Variable if for specific product/s -------- Branch office exp. -------- By and large fixed FINANCIAL CHARGES: Interest on working capital Variable -------- Interest on term loans -------- Fixed Interest on debenture -------- Fixed Interest on fixed dep. -------- Fixed Interest on unsecured loans -------- Fixed Interest on bonds -------- Fixed COSTS IN BUSINESS & ROLE OF COSTING BUSINESS FINANCE - 1
18. 18. TEFI Distance Learning ProgramTEFI Distance Learning Program34 35 Questionsforrevisionandreinforcementoflearning 1. What is the difference between financial accounting and cost accounting from an entrepreneur's point of view? Describe with an example. 2. What are the major groups of costs in a manufacturing unit and whatarethesub-headsofcostsunderthesemajorgroupsofcosts? 3. Can you plan for profits of your organization based on marginal costing? Illustrate with an example. You may assume suitable figures of variable cost, selling price per unit and fixed costs for the enterprise. 4. What is the concept of cost sheet for a job? Assume suitably costs under all the major heads and prepare a cost sheet for a job manufacturing 1200 unitsofAluminumtanks. 5. Suppose you are always cost conscious as an Entrepreneur. You do not allow costs to increase. Are you practising cost reduction or cost control? Chapter No. 3 Introduction to Financial Management Contents Details of Finance Function listed in Chapter no. 1 Sensitizing to FinancialAccounting ObjectivesofFinancialManagementShort-termandLong-term Financial system and markets in India : Government of India, Ministry of Finance at the helm, statutes, statutory authorities, financial intermediaries, other financial institutions, agents who operate in the markets etc. Brief introduction to Financial Instruments At the end of the chapter the student will be able to: Link the short-term and long-term objectives of Financial Management to profitability and wealth maximization respectively Map the role of Financial markets in India and how they work Evaluate the merits of different financial instruments & Take decision on how much Capital and how much Debt for one's business Introduction Financial Management is an integral part of Business Management. Finance is one of the key functions in an organisation. The other key functions in an organisation are: Production Human Resources Marketing Each of the above function has got sub-divisions for example Production has maintenance, Administration has purchases etc. Finance deals with financial resources. Financial management as a corollary would deal with management of financial resources and related areas. Some of the key finance functions as seen in Chapter no. 1 are: Financial planning and estimation of finance required for the organisation Mobilization of financial resources required as above Ensuring that the funds are available in adequate quantity at appropriate time BUSINESS FINANCE - 1 INTRODUCTION TO FINANCIAL MANAGEMENT
19. 19. TEFI Distance Learning ProgramTEFI Distance Learning Program36 37 andatanaffordablecost Managementofcashintheorganisationthroughcashflowstatement Management of investment outside the business enterprise in other organizations Management of risk in dealing with foreign exchange for imports and exports Let us examine briefly the above functions with some examples. Financial planning and estimation of finance required for the organisation Any activity in a business enterprise requires planning for proper execution in time. Finance is required for any activity at least in the beginning and hence financial planning is the prime function of Finance. This involves detailed study of any activity from understanding the total funds requirement for that activity, when the funds will be required and how much funds will be required at different stages. For a new enterprise the entire resources have to come from outside (externally); for an existing enterprise, a part of the resources at least will be available from the profits made in the past and retained in business after declaring dividend. Example No. 1: We require Rs.10lacs for an activity. Let us see how it affects an existing enterprise. Let us assume the profits available to be Rs.5lacs. Then we require further resources of Rs.5lacs only. This is the difference between an existing enterprise and a new one. Financial planning will take this into account. Mobilization of financial resources Having ascertained in the above example that we require Rs.10lacs for a set activity, for a new enterprise we require the entire amount to be mobilized. For an existing enterprise with available profits of Rs.5lacs, we require only Rs.5lacs. The Financial manager will then assess all the alternative resources available to him (for details please refer to Chapter 7 Financial Planning and Analysis)keepinginmindthefollowingrequisites: Adequacy(availabilityinadequatequantity) Timeliness(availabilityintime)and Cost(atanaffordablecost) Adequate supply in time etc. This has been explained in the above point. For reinforcement the student's attention is drawn to one of the objectives of financial management at least in the short run, the objective of maximizing profits of the organisation. The profits so maximized in turn enhance the Earning Per Share (Please refer to Chapter7 FinancialPlanningandAnalysis) Management of cash in the organisation Thisinvolvesthefollowingsteps: Ascertainingtheaveragecashrequirementbylookingatthepast figuresandforanewenterprise,estimatingthisfigure. Preparing the cash flow statement for a given period, taking all the cash inflows and cash outflows during the period to determine whether there is a surplus or deficit at the end of the period (For format of cash flow statement please refer to Chapter 1 Sensitizing to FinancialAccounting) Arranging for funds from outside especially through a bank with whom the enterprise has loan facilities in case of deficit in the cash flow statement; if on the contrary, the cash flow statement reveals a surplus, dealing with this surplus in a suitable manner (For further details, please refer to chapter 8 - Working Capital Management) Management of investment outside the organisation Over a period of time the enterprise reinvests a part of the profits for future growth of the organisation in business. The Finance manager can invest such funds outside the business in other enterprises also provided the parent enterprise does not require them immediately. Short-term surplus as revealed by the Cash flow statement is also invested for short duration. Thus investment outside one's own business becomes the responsibility of the Finance Manager Management of risk in foreign exchange etc. A business enterprise may require imports and do exports also. Whenever this is done the invoice is in foreign currency imports, the business enterprise. For requires foreign exchange while in exports, it gets foreign exchange. There is a risk involved while doing imports or exports. The risk is that the exchange rate of the foreign currency in terms of Indian Rupees can keep changing. We will explain this through an example. Example no. 2 We have exported goods worth US Dollars 1000. The money is to be received in a month's time. Presently the exchange rate is 1 US Dollar = Rs.44/-. By the time the money is received after a month, in case the rate is less than Rs. 44/-, we will lose money. On the contrary if the exchange rate is more than Rs. 44/-, we will gain. Exactly opposite will be the effect in the case of imports. The importer will pay less if the exchange rate decreases and more if the exchange rate increases. There are ways and means of minimizing the risk of foreign exchange.Financemanagerisexpectedtotakecareofsuchrisks. Short-term and long-term objectives of Financial Management Short-term objective The short-term objective of Financial Management is to procure financial resources at an affordable cost thereby increasing the return to the owners of the business in the form of Profit After Tax (PAT). This objective is often times referred to as profit maximization. This is known as the short-term BUSINESS FINANCE - 1 INTRODUCTION TO FINANCIAL MANAGEMENT
20. 20. TEFI Distance Learning ProgramTEFI Distance Learning Program38 39 objective as it is done on a continuous, year-to-year basis. One or more of the followingmeasurescanachievethis: Monitoringofcostsonacontinuousbasisthroughbudgets Suitable cost reduction techniques wherever the costs are high, especially in the case of direct costs like material cost for a manufacturing unit Minimization of cost of borrowed capital from outside by observing financialdiscipline Proper mix of Capital and debt (known as financial leverage for further details please refer to Chapter no. 6 Risk associated with business) Control over liquidity available in the organisation so as to minimize the cost of carrying too much cash etc. Long-term objective The long-term objective of Financial Management is to increase the wealth of the owners of the business. The term wealth refers to various business assets of the enterprise that are free of debt. This means that this wealth belongs to the business owners. This is reflected in the balance sheet as = Total Assets of the business (-) Funds borrowed from outside, both short-term and long-term This can be explained through an example. Example no. 3 Capital in business of the owners = Rs.10lacs Profit retained in business = Rs.20lacs Owners' capital in business = Rs.30lacs Addition to wealth of the enterprise = Rs.20lacs This means that at the starting point the wealth of the enterprise was Rs.10lacs and this has gone up to Rs. 30lacs due to the prudent policy of the management of retaining profits within the organisation. Thus the short-term objective of earning profits is also a contributory factor to realizing the long-term objectiveofwealthmaximization Someofthemeasuresthroughwhichweachievethelong-termobjectiveare: Strategic financial management decisions relating to expansion or diversification, joint venture etc. Thus while profitability reflects the Operating Efficiency, Wealth Maximization reflects the managerial/entrepreneurialcompetency. To sum up, both short-term objective and long-term objective need to be put in place for sustained growth of a business enterprise. To an extent at least, the long-term objective is dependent upon the short-term objective of profit maximization. FinancialsysteminIndia In order to understand financial management better, we need to understand the Financial System that exists in India. Any country needs a system to regulate, supervise, monitor and control the players, intermediaries, the investors etc. who take part in the financial markets in the system. Further an efficient system alone can ensure that the national objective on Economy of the country is met by aligning the developments in the system with the national priorities. An example of the national priority deciding the development in the financial markets is infrastructure development and need for longer duration financial resources and development of deep discounted 1 bonds to meet this requirement. (For further details, please refer to Chapter 5 FinancialResources) The Financial System is one of the most important inventions of the modern society. It is well known that certain sectors in any society have surplus funds, which are available for investment, while certain other sectors demand funds or have use for these funds in their activity. This fundamental forms the basis forthefinancialsystemanywhereintheworld. For example, there are always in any economy, seekers of funds, mainly, businessfirmsandgovernmentandsuppliers offunds,mainlyhouseholds. TheFinancial System TheFinancialMarkets: A Financial Market can be defined as the market in which financial assets are created or transferred. Financial assets represent claims to payment of a sum of money sometime in the future and/or periodic payment in the form of dividendorinterest. Financial markets can be classified as primary and secondary markets. More often, they are also classified as money markets and capital markets. In fact, primary and secondary markets are integral part of capital markets, as money marketshaveaverylimitedsecondarymarket. Primary market: The market for raising funds through share capital, debenture, bonds etc. wherein the funds directly flow from the households and other saving units in the economy to the users of these funds, namely, GovernmentandBusinessEnterprisesintheformofLimitedCompanies. Secondary market: The market for disposing of the claims in the forms of shares, debentures of the investors to other investors without surrendering the Seekers of Funds (Mainly Business, Firms and Government) Suppliers of Funds (Mainly Households) BUSINESS FINANCE - 1 INTRODUCTION TO FINANCIAL MANAGEMENT
21. 21. TEFI Distance Learning ProgramTEFI Distance Learning Program40 41 claim directly to the principal users of these funds, namely, business enterprises or Government. This market enables selling off investment in business enterprises by public at large either through stock exchanges or directlytootherinvestors. ConstituentsoftheIndianFinancialSystem The Government of India, Ministry of Finance, heads the Indian financial system. The ministry in turn is bifurcated into various departments like the Department of Economic Affairs, the Department of Company Affairs etc. The Indian financial system consists of: The financial markets The statutes governing the various segments of the financial markets The statutory authorities responsible for regulating, supervising, monitoring and controlling the markets and its components The financial intermediaries Special organizations Agents operating in different segments of the financial markets and Financial instruments/securities issued in the markets to raise resources The financial markets The financial markets consist of: Money markets maximum duration of 12 months Capital markets Minimum duration 12 months and maximum durationcouldbeeven20-25years Foreignexchangemarkets FinancialServicesmarket: Insuranceservices Banking Non-BankingFinancialCompanies Mutualfunds VentureCapital ETC. The money markets and capital markets in turn do have Primary market and Secondary market. Primary market means issue of financial instruments by companies and others that want to raise financial resources from the market. Secondary market refers to that market wherein the financial instruments issued in the Primary market change hands from one investor to another for financial consideration. SEGMENTS OF MONEY MARKETS: Call money market Exclusively for banks to be borrowers inter-bank operations for a very short period. One day to fourteen days. Fourteen day borrowing is in the notice money market that is also a part of the Call Money Market. Only scheduled commercial banks are permitted to be borrowers in this market. While some banks will be borrowers, some others will be lenders. There is no specific market place. Deals are done over the phone. Commercial paper Issued by companies and Public Sector Undertakings as part of working capital requirement. This is a promissory note issued by companies requiring short-term funds (say from 15 days to 180 days or six months). Maximum period is twelve months. The six- month commercial paper can be extended for a further period of six months, making a total of 12 months. Commercial bills Discounted by banks and Non-banking Financial Institutions. These are short-term bills usually not exceeding 90-120 days covering commercial transactions in the private sector. Treasury bills Issued by Government of India through the RBI for meeting budgetary deficits. These are for fixed maturity periods of 91 days and 364 days. The Reserve Bank of India controls the money markets in India. It is known as money market regulator, but without any supporting statute unlike the capital marketsegmentthathasspecificstatutes. Primarymarket Primary market in the money market is the market in which RBI requiring funds for Government of India issue securities like treasury bills and get finance and there is no specific market place excepting in the case of treasury bills. RBI conducts auction of treasury bills after due notice in national dailies and hence this can be construed as the market place. Secondary market The secondary market is provided by Discount and Finance House of India Limited (DFHI) a subsidiary of RBI. It provides a two-way quotation, one for purchasing money market instruments and another for selling money market instruments. For example, a holder of Treasury bill of Government of India can sell it to DFHI and anyone wants to purchase treasury bills, he can approach DFHI who can sell it to him. There is no secondary market for call money or notice money market. BUSINESS FINANCE - 1 INTRODUCTION TO FINANCIAL MANAGEMENT
22. 22. TEFI Distance Learning ProgramTEFI Distance Learning Program42 43 InsuranceInsuranceRegulatoryandDevelopmentAct(IRDA)controlled by the Insurance Regulatory and Development Authority coming under GOI, Ministry of Finance Banking Banking Regulations Act controlled by RBI Non-banking Financial Companies (NBFCs example Kotak Mahindra Finance Company Limited) Non-Banking Financial Companies Act of RBI Functioning of limited companies registered in India The Companies' Act controlled by the Company Law Board (CLB) coming under GOI, Ministry of Finance. The principal officer is known as The Registrar of Companies (ROC). Company Law Board is primarily responsible for conduct of the affairs of limited companies registered in India under the Companies' Act. The difference in roles of CLB and SEBI is that the latter is mainly concerned with issue of securities in the capital market protecting the interest of the invests who invest in Foreign Exchange market seametries SEBI is not the companies Act while CLB is not the SCRA. They play complementary roles. Foreign Exchange Management Act and Exchange Control Regulations Act both coming under the RBI Note : Indian companies accessing international markets come directly under the GOI, Ministry of Finance The financial intermediaries A financial intermediary means an institution like a bank mobilising resources from saving units in the economy and deploying these resources by giving loans to or by investment in users of these financial resources for creating economicwealth. Bankingcompanies FinancialInstitutions(FIs) Mutual Funds (MFs) in a limited sense, whenever they invest in securities in the primary market Non-banking Financial Companies (NBFCs) & Venture Capital Funding Agencies Special organisations/Boards These come under one of the financial market regulators or directly under GOI Ministry of Finance All-India Financial Institutions GOI - MOF National Bank for Agriculture and Rural Development NABARD) Export Import Bank of India (EXIM Bank)ETC. Central Board of Direct Taxes - CBDT - GOI - MOF Stock Exchanges - SEBI BUSINESS FINANCE - 1 SEGMENTS OF CAPITALMARKETS: GOI bonds Various state government bonds Bonds issued by Public Sector undertakings likeBHELetc. Bonds issued by private sector companies, banks and financial institutions Debentures issued by private sector companies Share Capital issued by private sector companies Preference share capital issued by private sectorcompanies In the case of public issues by private sector companies, banks, financial institutions and mutual funds, Securities Exchange Board of India (SEBI) is the controlling authority. It is referred to as the capital market regulator. However SEBI does not control Government bonds or securities issued by Public Sector Undertakings. GOI bonds and state government bonds are handled and controlled by RBI. Public sector undertaking like Bharat Heavy ElectricalsLimited(BHEL)comedirectlyunderGOIMOF. Primarymarket There is no specific market place for this. This again, like in the case of money market, facilitates issue of securities by those who require funds in the medium to long-term. The public issue process is supervised and controlled by the lead merchant banker/bankers in the case of all public issues. Primary market ends with the listing of securities on stock exchanges by the Registrar to the Issue. Details of operators in the primary market have been given under Agentsoperatinginfinancialmarkets. Secondarymarket The secondary market begins with the listing of securities on the stock exchanges by the Registrar to the issue. It has a market place in the form of stock exchanges. Its operations are through share brokers who are registered with respective stock exchanges. The stock exchanges in turn are controlled and regulated by SEBI. Details of operators in the secondary market have also beengivenunderAgentsoperatinginthefinancialmarkets. Statutes governing the various segments of the financial markets and the statutoryauthorities StatutemeansanActpassedeitherbytheParliamentorStatelegislature. MoneymarketNospecificstatutecontrolledbyRBI Capital market Securities Contracts Regulations Act and Rules as well as SEBI regulations for the various operators in the Capital market controlled bySEBI.MutualFundsalsocomeundertheRegulationsofSEBI. INTRODUCTION TO FINANCIAL MANAGEMENT
23. 23. TEFI Distance Learning ProgramTEFI Distance Learning Program44 45 Depositories National level special organisations coming under the national stock exchanges and assume responsibility for collating details of ownership of shares issued by a limited company controlled by SEBI Depository participants Retail level operators who maintain Electronic Share Accounts of various owners of securities Financial instruments Already referred to under financial markets above. For further details, please refer to chapter 5 - Financial Resources Questions for reinforcement of learning 1. What do you think is the primary objective of this chapter from the point of view of an Entrepreneur? 2. What are the instruments in the money market and capital market? 3. What is wealth of a business enterprise? Are profit and wealth linked to each other? Illustrate with an example. 4. What do you understand by the term strategic financial management from the point of view of the owner of the business enterprise? When willyouthinkofsuchastrategy? 5. For a new business enterprise, which financial instruments in your opinionareavailabletoyou? BUSINESS FINANCE - 1 InstituteofCharteredAccountantsofIndia(ICAI)-GOI-MOF InstituteofCostandWorksAccountantsofIndia(ICWAI)- GOI-MOF InstituteofCompanySecretariesofIndia(ICSI)-GOI-MOF InstituteofCharteredFinancialAnalystsofIndia(ICFAI) GOI-MOF ForeignInvestmentPromotionBoard(FIPB)GOI-MOF ETC. Agentsoperatingindifferentsegmentsofthefinancialmarkets The agents operating in the capital market are more. Hence we examine them briefly here. In respect of other segments of the financial markets from a study of the above it will be clear to the students as to who the operators are in the respectivesegments. PrimarymarketcontrolledandmonitoredbySEBI Merchantbanker(theprincipaloperator) Merchant banker controls the Primary market and is fully responsible for the issue of public securities like Capital, debentures, bonds etc. the capital market instruments. He is the principal operator and controls and monitors all the other operators in the capital market. He is fully accountable to SEBI for the smooth conduct of the operations in the capital markets. He has to ensure 100% conformity with SCRA rules and regulations as well as SEBI rules and regulations. Sharebrokerswhounderwritebesidesmarketingtheissue Underwriting in the capital market means giving an undertaking to invest money in securities issued to public should the issue fail to collect the required amounts as per SEBI rules and regulations. Underwriting as such does not involve any funds and hence is referred to as fee based activity. However once the issue fails to collect the required amount, the underwriter is expected to make good the deficit amount to the extent undertaken by him. Bankers to the issue who collect the share application money along with the share application forms Advertisement companies and publicity companies Printers for printing the stationery required for the issue Registrars to the Issue who take the responsibility of issuing the securities to successful investors (in case the issue collects more money than the issue size), refund excess money together with interest and getting the securities listedonaStockExchange Secondary market controlled and monitored by SEBI Stock Exchanges controlled and regulated by SEBI Share brokers controlled by respective stock exchanges as well as SEBI INTRODUCTION TO FINANCIAL MANAGEMENT
24. 24. TEFI Distance Learning ProgramTEFI Distance Learning Program46 47 Wholesale price and not the retail price The prices of the selected commodities for determining the rate of inflation over a period of one year could be on the wholesale or retail. The latter one is mostly referred to as consumer price. Thus we have a wholesale price index and consumer price index for expressing rates of inflation. Conventionally in India the rate of inflation has always been expressed in wholesale price index basis rather than consumer price index basis although the consumer price index increase is also published regularly. At present the wholesale price index inflation is around 6%. We will explain this concept through an example. Example no. 1 I had spent Rs. 100/- in getting a basket of commodities one year ago. If the rate of inflation is say 7%, now I will be required to spend Rs. 107/- to get the same basket of commodities. How do we get Rs.107/-? Rs. 100/- x 1.07 = Rs. 107/-. This means that due to inflation, the purchasing power of the local currency decreases with the passage of time. This is exactly the concept of time value of money. In simple words, time value of money means that with the passage of time, money loses its value. Is there a situation in which the prices decrease over a period of time and opposite of inflation takes place? Usually in a developing country, such a situation does not arise, as the demand is always greater than supply. However currently Japan was fill recently experiencing deflation in which current prices would be less than the past prices. This is harmful to a developing economy, as units that save money would get very low interest or no interest. Hence there will be no incentive for the units to invest money in bonds, fixed deposits etc. Concept of Interest as compensation for loss of purchasing power due to inflation: You keep money in a deposit with a bank. It could be a Savings Bank or a Fixed Deposit. What does the bank pay to you? Interest. This is the return on your investment. Why should the bank pay interest to you? Let us enumeratethepossiblereasonsforthebank'saction. ! The bank does the business of lending. For this, it requires funds through deposits. It earns interest on loans and pays interestondeposits; ! With the passage of time, the purchasing power of money reduces. The same thing will happen to your deposit with the bank. The bank gives compensation to you for this loss in value ofmoney; ! In case the bank does not pay interest, it will not get funds for lending. You will not keep deposits with it. You will choose other willing banks or avenues of investment. While all of them are correct, we are more interested in the second reason. Value of money erodes due to inflation as we have seen in the earlier paragraph. The rates of inflation would be different for different countries. Further, it could be different for the same country at different times. Sometimes it could be high while at some other times, it could be low. BUSINESS FINANCE - 1 Chapter No. 4 - Time Value of Money Contents ! Introduction to the concept of inflation Wholesale PriceIndexandConsumerPriceIndex ! Moneylosingvalueduetoreductioninpurchasingpower ! Concept of interest as compensation in purchasing power of money ! Fourtierstructureforratesofinterestinanyeconomy ! Compoundinganddiscountingprocesses ! Applicationoftimevalueofmoneytobusinessdecisions ! Numericalexercisesforpractice Attheendofthechapterthestudentwillbeableto: ! Determine-Futurevalueofapresentsumbycompounding ! Determine-Presentvalueofafuturesumby discounting ! Determine-Presentvalueofabondinvestment ! Explain - the different tiers of interest structure in an economy ` ! Choose thebestprojectbasedonitsNetPresentValue Concept of Inflation Wholesale Price Index and Consumer Price Index Inflation means to increase. In this context, it means increase in prices of commodities. The price increase is due to the difference between supply and demand for a given commodity. If the supply is more than demand, prices decline and if the demand is more, prices increase. In a developing country like India, the demand for most of the commodities will always be more than the supply. Hence inflation will always be experienced in developingmarkets. The increase is constantly measured in all the countries. The items included for determining the prices would be different from country to country. For example, in India, essential commodi