Management Accounting Mba Bk

8/2/2019 Management Accounting Mba Bk

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MANAGEMENT ACCOUNTING


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LESSON 1INTRODUCTION

The term Management Accounting is of recent origin. It was first coined bythe British Team of Accountants that visited the U.S.A. under the sponsorship of

Anglo-American Productivity Council in 195 with a view of highlighting utility of

Accounting as an effective management tool. It is used to describe the

modern concept of accounts as a tool of management in contrast to the

conventional periodical accounts prepared mainly for information of proprietors.

The object is to expand the financial and statistical information so as to throw

light on all phases of the activities of the organisation.

All techniques which aim at appropriate control, such as financial control,

budgeted control, efficiency in operations through standard costing,

cost-volume-profit theory etc, are combined and brought within the purview of

Management Accounting.

Management Accounting evolves a scheme of accounting which lays emphasis

on the planning of future (logical forecasting), simultaneously finding the

deviations between the actual and standards. Another significant feature of

Management Accounting is reporting to top-management. Finally, accountinginformation should be presented in such a way as to assist the management in

the formulation of policy and in the day-to-day conduct of business. For

example, the published accounts of business concerns do not furnish

management with information in a form that suggest the line on which

management policies and actions should proceed. It requires further analysis

classification and interpretation before the management can draw lessons from

them for their guidance and action.

DEFINITION OF MANAGEMENT ACCOUNTINGManagement Accounting may be defined as the presentation of accounting

information in such a way as to assist the management in the creation of the

policy and day-to-day operation of an undertaking Management Accounting

of the Anglo-American to productivity.


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The Institute of Chartered Accountants of England has defined it

Any form of accounting which enables a business to be conducted more

efficiently can be regarded as Management Accounting.

Robert N. Anthony has defined Management Accounting as follows-

Management Accounting is concerned with accounting information that is

useful to management.

According to American Accounting Association, Management Accounting

includes the methods and concepts necessary for effective planning for,

choosing among alternative business actions and for control through the

evaluation and interpretation of performance. This definition is fairly

illustrative.

According to Kohler, Forward Accounting includes Standard costs, budgeted

costs and revenues, estimates of cash requirements, break even charts and

projected financial statements and the various studies required for their

estimation, also the internal controls regulating and safeguarding future

operating.

Blending together into a coherent whole financial accounting, cost accounting

and all aspects of financial management. He has used this term to include the

accounting methods, systems and techniques which, coupled with special

knowledge and ability, assist manageme4nt in its task of maximizing profits or

minimizing losses. James Batty.

Thus all accounting which directly or indirectly providing effective tools to

managers in enterprises and government organizations lead to increase in

productivity is Management Accounting.

OBJECTIVES OF MANAGEMENT ACCOUNTING:


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The basic objective of Management Accounting is to assist the management in

carrying out its duties efficiently.

The objectives of Management Accounting are:

1. The compilation of plans and budgets covering all aspects of the

business e.g., production, selling, distribution research and finance.

2. The systematic allocation of responsibilities for implementation of plans

and budgets.

3. The organization for providing opportunities and facilities for performing

responsibilities.

4. The analysis of all transactions, financial and physical, to enable effective

comparisons to be made between the forecasts made and actual

performance.

5. The presentations to management, at frequent intervals, of up-to-date

information in the form of operating statements.

6. The statistical interpretation of such statements in a manner which will be

of utmost assistance to management in planning future policy and

operation.

To achieve the above objectives, Management Accounting employs three

principles devices, viz.,-

1. Forward Looking Principle basis on the past and all other availabledata, forecasting the future and recommending wherever appropriate, the

course of action for the future.

2. Target Setting Principle fixation of an optimum target which isvariously known as standard, budget etc., and through continuous review

ensuring that the target is achieved or exceeded.

3. The Principle of Exception instead of concentrating on voluminousmasses of data, Management Accounting concentrates on deviations from

targets (which are usually known as variances) and continuous and

prompt analysis of the causes of these deviations on which to base

management action.


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SCOPE OF MANAGEMENT ACCOUNTING:

The scope of Management Accounting is wide and broad based. It encompasses

within its fold a searching analysis and branches of business operations.

However, the following facets of Management Accounting indicate the scope of

the subject.

1. Financial Accounting.

2. Cost Accounting

3. Budgeting & Forecasting

4. Cost Control Procedure

5. Statistical Methods

6. Legal Provisions

7. Organisation & Methods

1. Financial Accounting: This includes recording of external transactionscovering receipts and payments of cash, recording of inventory and salesand recognition of liabilities and setting up of receivables. It also

preparation of regular financial statements. Without a properly designed

accounting system, management cannot obtain full control and

co-ordination.

2. Cost Accounting : It acts as a supplement to financial accounting. It isconcerned with the application of cost to job, product, process and

operation. It plays an important role in assisting the management in the

creation of policy and the operation of undertaking.

3. Budgeting & Forecasting: These are concerned with the preparation offixed and flexible budgets, cash forecast, profit and loss forecasts etc., in

co-operation with operating and other departments. Management is

helped by them.

4. Cost Control Procedure: It is concerned with the establishment andoperation of internal report in order to convert the budget in to operating


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service. Management is helped by them by measuring actual results

budgetary standards of performance.

5. Statistical Methods : These are concerned with generating statistical andanalytical information in the form of graphs charts etc. of all department

of the organization. Management need not waste time in understandingthe facts and more time and energy can be utilized in sound plans and

conclusions.

6. Legal Provisions: Many management decisions depend upon theprovisions of various laws and statutory requirements. For example, the

decision to make a fresh issue of shares depends upon the permission of

controller of capital issues. Similarly, the form of published accounts, the

external audit the authority to float loans, the computation and

verification of income, filing tax returns, making tax payments for excise,

sales, payroll income etc., all depend on various rules and regulationspasses from time to time.

7. Organization & Methods: They deal with organization, reducing the costand improving the efficiency of accounting as also of office operations,

including the preparation and issuance of accounting and other manuals,

where these will prove useful.

It is clear that Management Accounting has a vital relation with all those areas

explained above.

FUNCTIONS OF MANAGEMENT ACCOUNTING:The functions of management accounting may be said to include all activities

connected with collecting, processing, interpreting and presenting information

to management. The Management Accounting satisfies the various needs of

management for arriving at appropriate business decisions. They may be

described as follows:

1. Modification of Data:

Accounting data required for decision making purposes is supplied bymanagement accounting through resort to a process of classification andcombination which enables to retrain similarities of details without eliminatingthe dissimilarities (e.g.) combination of purchases for different months and


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their breakup according to class of product, type of suppliers, days of purchase,territories etc.

2. Analysis & Interpretation of Data:The data becomes more meaningful with the analysis and interpretation. Forexample, when Profit and Loss account and Balance Sheet data are analyzed bymeans of comparative statements, ratios and percentages,cash-flow-statements, it will open up new directions for its use bymanagement.

3. Facilitating Management Control

Management Accounting enables all accounting efforts to be directed towardscontrol of destiny of an enterprise. The essential features in any system ofcontrol are the standards for performance and measure of deviation therefrom.This is made possible through budgetary control and standards costing whichare an integral part of Management Accounting.

4. Formulation of Business Budgets:One of the primary functions of management is planning. It is done byManagement Accounting through the process of budgeting. It involves thesetting up of objectives, and the selection of the most appropriate strategies by

comparing them with reference to some discriminating criteria. Probability,Probability, forecasting, and trends are some of the techniques used for thispurpose.

5. Use of Qualitative Information:Management Accounting draws upon sources, other than accounting, for suchinformation as is not capable of being readily convertible into monetary terms.Statistical compilations, engineering records and minutes of meeting are a fewsuch sources of information.

6. Satisfaction of Informational Needs of Levels of Management:

It serves management as a whole according to its requirements it serves topmiddle and lower level managerial needs to subserve their respective needs. Forinstance it has a system of processing accounting data in a way that yieldsconcise information covering the entire field of business activities at relatively


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long intervals for the top management, technical data for specialized personnelregularly and detailed figures relating to a particular sphere of activity at shortintervals for those at lower rungs of organizational ladder.

The gist of Management Accounting can be expressed thus, it is a part of overall managerial activity not something grafted on to it from outside guidingand servicing management as a body, to derive the best return form itsresources, both the itself and for the super system within which it functions.

From the above discussions, one may come to the following conclusions aboutthe fundamental approach in Management Accounting.

Firstly, the Management Accounting functions is a managerial activity and itputs its finger in very pie without itself making them it guides and aids settingof objectives, planning coordinating, controlling etc. But it does not itselfperform these functions.

Secondly it serves management as a whole top middle and lower level according to its requirements. But in doing so it never fails in keeping in focusthe macro-approach to the business as a whole.

Thirdly, it brings in the concept of cost-Benefits analysis. The basic approach isto split all costs and benefits into two groups measurable and non measurable.

It is easy to deal with measurable costs which are expressed in terms of money.But there are several ventures such as office canteens where the cost-benefitsmay not be monetarily measurable.

LIMITATIONS OF MANAGEMENT ACCOUNTING

Comparatively, Management Accounting is a new discipline and is still verymuch in a state of evolution. There fore it comes across the same impedimentsas a relatively new discipline has to face-sharpening of analytical tools and

improvement of techniques creating uncertainty about their applications.

1. There is always a temptation to make an easy course of arriving atdecision to intuition rather than taking the difficulty of scientificdecision-making.


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2. It derives its information from financial accounting, cost accounting andother records. Therefore, strength and weakness of ManagementAccounting depends upon the strength and weakness of basic records.

3. It is one thing to record, interpret and evaluate an objectives historicalevent converted into money figures, while it is something quite different

to perform the same function in respect of post possibilities, futureopportunities and unquantifiable situation. Execution of the conclusionsdrawn by the management accountant will not occur automatically.Therefore, a continuous effort to achieve the goal must be made at alllevels of management.

4. Management Accounting will not replace the management andadministration. It is only a toll of management. Of course, it will save themanagement from being immersed in accounting routine and process thedata and put before the management the facts deviating from thestandard in order to enable the management to take decisions by the rule

of exception.


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LESSON 2FINANCIAL ACCOUNTING AND MANAGEMENT ACCOUNTING

The terms financial accounting, and management accounting, are not pricesdescription of the activities they comprise. All accounting is financial in thesense that all accounting systems are in monetary terms and management, ofcourse, is responsible for the content of financial accounting reports. Despitethis close interrelation, there are some fundamental differences between thetwo and they are:

1. Subject Matter : Managements need to focus attention on internal detailsis the origin of the basic differences between financial accounting andmanagement accounting. In financial accounting, the enterprise as awhole is dealt with while, in management accounting, attention isdirected towards various parts of the enterprise which is regarded mainlyas a combination of these segments. Thus financial statements, likebalance-sheets and income statements, report on the overall status andperformance of the enterprise but most management accounting reportsare concerned with departments products, type of inventories, sales orother sub-division of business entity.

2. Nature Financial accounting is concerned almost exclusively withhistorical records whereas management accounting is concerned with thefuture plans and policies. Managements interest in the past is only to the

extent that it will be of assistance in influencing companys future. Thehistorical nature of financial accounting can be easily understood in thecontext of the purposes for which it was designed but managementaccounting does not end with the analysis of what has happened in thepast and extends to the provision of information for use in improvingresults in future.

3. Dispatch In Management Accounting, there is more emphasis onfurnishing information quickly then is the case with financial accounting.This is so because up-to-date information is absolutely essential as abasis for management action and management accounting would losemuch of its utility if information required the time lag between the end ofaccounting period and the preparation of accounting records for thesame, it has not been, and cannot be, totally eliminated.

4. Characteristics Financial accounting places great stress on thosequalities in information which can command universal confidence, likeobjectivity, validity absoluteness, etc. whereas management accountingemphasizes those characteristics which enhance the value of informationin a variety of uses, like flexibility, comparability etc. This difference is so


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important that a serious doubt has been raised as to whether both thetypes of characteristics can be preserved within the same framework.

5. Type of Data Used Financial accounting makes use of data which ishistorical quantitative, monetary and objective, on the other handmanagement accounting used data which is descriptive, statistical

subjective and relates to future. Therefore management accounting is notrestricted, as financial accounting is, to the presentation of data that canbe certified by independent auditors.

6. Precision There is less emphasis in precision in management accountingbecause approximations are often as useful as figures worked outaccurately.

7. Outside Dictates As financial accounting ahs been assigned the role of areference safeguarding the interests of different parties connected withthe operation of a modern business undertaking, outside agencies havelaid down standards for ensuring the integrity of information processed

and presented in financial accounting statements. Consequently, financialaccounting statements are standardized and are meant for external use.So, far as management accounting is concerned, there is no need forclamping down such standards for the preparation and presentation ofaccounting statements as management is both the initiator and user ofdata. Naturally, therefore, management accounting can be smoothlyadapted to the changing needs of management.

8. Element of compulsion These days, for every business, financialaccounting has become more or less compulsory indirectly if not directly,due to a number of factors but a business is free to install, or not to

install, a system of management accounting.


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LESSON 3FUNCTIONS OF FINANCIAL CONTROLLER

The gradual growth of management accounting has brought with it arecognition of the desirability of segregating the accounting function fromother activities of a secretarial and financial nature in order to make possible amore accurate accounting control over multifarious, complex and sprawlingbusiness operations. As a natural corollary, controller has come into being byway of a skilled business analyst who, due to his training and experience, is thebest qualified to keep the financial records of the business and to interpretthese for the guidance of the management.

It is not surprising, therefore, that controllership function has developed pari

passu with the development of management accounting so much so that thereis a tendency to record the two as synonymous. In a way, this is true becauseof controller in the United States does all that management accounting isexpected to accomplish, in fact, controller is the pivot round which system ofmanagement accounting revolves.

Generally speaking, controllership function embraces within its broad sweepand wide curves, all accounting functions including advice to management oncourse of action to be taken in a given set of circumstances with the object ofcompletely eliminating the role of intuition in business affairs.

Concept:

There is no precise concept of controllership as it is still in an evolutionary state.Even if the concept was possible of being described, it cannot be said that,wherever a controller is in existence, he exercises all the functions that atheoretical controller is expected to do because the real meaning of the term isdependent upon the agreement between him and the undertaking the seeks toserve. However, the controllers Institute of America has drafted a seven-pointconcept of modern controllership. The hallmarks of the concept are:

i. To establish, coordinate and administer, as an integral part ofmanagement, an adequate plan for the control of operations. Such a planwould provide, to the extent required in the business, for profit planning,programs for capital investing and financing, sales forecast, expensebudgets and cost standards, together with the necessary procedure toeffectuate the plan.


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ii. To compare performance with operating plans and standards and toreport and interpret the results of operations to all levels of managementand to the owners of business. This function includes the formulation andadministration of accounting policy and the compilation of statisticalrecords and special reports as required.

iii. To consult with all segments of management responsible for policy oraction concerning any phase of the operations of business as it relates tothe attainment of objectives and the effectiveness of policies,organization structure and procedures.

iv. To administer tax policies and procedures.

v. To supervise and coordinate the preparation of reports to governmentalagencies.

vi. To assure fiscal protection to the assets of the business throughadequate internal control and proper insurance coverage.

vii. To continuously appraise economic and social forces and governmentinfluences and interpret their effect on business.

The controllers Institute, as well as the National Industrial conference Board ofthe United States, have spelt out the functions of the controller in still greaterdetail but the seven-point concept of modern controllership is board enough toleave no phase of policy or organization beyond the controllers jurisdiction.Through the concept has been laid down mainly from the functional point ofview, it lifts the notion of controllership from pedestrian paper-shuffling to atop-management attitude that aids decision making, it broadens controllers

outlook and provides him with specific goals.

Status of Controller:

There is no fixed place for the controller in the hierarchy of management. It issometimes said that the status of controller is not ensured simply by virtue ofhis holding the office but depends, in no small measure, upon hi personality,mental equipment, industrial background and his capacity to convince others ofhis ability as well as integrity. Moreover, it would depend upon the terms of hisappointment and, therefore, it is bound to vary with every individualundertaking. The terms of appointment may be fixed by the Board of Directors

or may be included in the Articles of Association of the Company.

As a matter of general principle, all accounting functions, even though remotelyconnected with finance, are included in the responsibilities of the controller. Asthe chief accounting authority, the controller normally has his place in thetop-level management along with the Treasurer who looks after bank accountsand the safe custody of liquid assets. Usually, the elevation of Controller to the


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post of Vice-President Finance in taken for granted and is considered only aroutine matter.

Modern Controller does not do any controlling, as is commonly understood, in

terms of line authority over other departments, his decision regarding the bestaccounting procedures to be followed by line people are transmitted to theChief Executive who communicates them by a manual of instructions comingdown through line chain of command to all people affected by the procedures.

Limitation:

It is also necessary that the limitation of Controllers role imposed by the verynature of his work, must be borne in mind. Though the Controller helps inbringing together all phases of management, he does not pretend to solve theproblems of production of marketing, he knows their nature and so can discuss

in detail with all levels of management the financial implications of solutionsthey suggest.


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LESSON 4FINANCIAL STATEMENTS:According to the American Institute of Certified Public Accountants, Financialstatements reflect a combination of recorded facts accounting conventions and

personal judgements and the judgements and conventions applied affect themmaterially. This statement makes clear that the accounting information asdepicted by the financial statements are influenced by three factors viz.recorded facts, accounting conventions and personal judgements.

OBJECTIVES OF FINANCIAL STATEMENTS:1. To provide reliable information about economic resources and

obligations of a business and other needed information about changes insuch resources or obligations.

2. To provide reliable information about changes in net resource [resourcesless obligations] arising out of business activities and financialinformation that assits in estimating the earning potentials of business.

3. To disclose to the extent possible, other information related to thefinancial statements that is relevant to the needs of the users of thesestatements.

USES AND USERS OF FINANCIAL STATEMENTS:Different classes of people are interested in the financial statement analysiswith a view to assessing the economic and financial position of any business orindustrial concern in terms of profitability, liquidity or solvency. Such personsand bodies include:

1. Shareholders

2. Debenture-holders

3. Creditors

4. Financial institutions and commercial banks

5. Prospective investors

6. Employees and trade unions

7. Tax authorities

8. Govt. departments

9. The company law board

10. Economists and investment analysis, etc.


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IMPORTANCE OF FINANCIAL STATEMENTS

IMPORTANCE TO MANAGEMENT:Financial statements help the management to understand the position,progress and prospects of business results. By providing the management withthe causes of business results, they enable them to formulate appropriatepolicies and courses of actions for the future. The management communicateonly through these financial statements their performance to various partiesand justify their activities and thereby their existence.

IMPORTANCE TO THE SHAREHOLDERSThese statements enable the shareholders to know about the efficiency andeffectiveness of the management and also the earning capacity and thefinancial strength of the company.

IMPORTANCE TO LENDERS/CREDITORS:The financial statements serve as a useful guide for the present suppliers andprobable lenders of a company. It is through a critical examination of thefinancial statements that these groups can come to know about the liquidityprofitability and long-term solvency position of a company. This would help

them to decide about their future course of action.

IMPORTANCE TO LABOUR:Workers are entitled to bonus depending upon the size of profit as disclosed byaudited profit and loss account. Thus, P & L a/c becomes greatly important tothe workers in wage negotiations also the size of profits and profitabilityachieved are greatly relevant.

IMPORTANCE TO PUBLIC:Business is a social entity. Various groups of the society, though not directlyconnected with business, are interested in knowing the position, progress andprospects of a business enterprise. They are financial analysts, lawyers, tradeassociations, trade unions, financial press research scholars, and teachers, etc.

Importance of National Economy: The rise & growth of the corporate sector, toa great extent, influences the economic progress of a country. Unscrupulous &


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fraudulent corporate managements shatters the confidence of the generalpublic in joint stock companies which is essential for economic progress &retard economic growth of the country. Financial Statements come to rescue ofgeneral public by providing information by which they can examine & asses thereal worth of the company & avoid being cheated by unscrupulous persons.

Limitations of Financial Statements:

1. It shows only historical cost.

2. It does not take into account the price level changes.

3. It considers only monetary aspects but does not consider some vitalnon-monetary factors.

4. It is based on convention and judgement. Hence there is no accuracy.

5. Comparison of Financial Statements depends upon the uniformity ofAccounting policies.

6. It is subject to window dressing.


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LESSON 5ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS

Financial Statement are indicators of the two significant factors:

(i) Profitability, and (ii) Financial soundness

Analysis and interpretation of financial statements, therefore, refer to such atreatment of the information contained in the income statement and theBalance Sheet so as to afford full diagnosis of the profitability and financialsoundless of the business.

TYPES OF FINANCIAL ANALYSISFinancial Analysis can be classified into different categories depending upon

(i) The materials used and (ii) The modus operandi of analysis

ON THE BASIS OF MATERIAL USED: According to this basis financial analysiscan be of two types.

(i) External Analysis: This analysis is done by those who are outsiders for thebusiness. The term outsiders includes investors, credit agencies, governmentand other creditors who have no access to the internal records of the company.

(ii) Internal Analysis: This analysis is done by persons who have access to thebooks of account and other information related to the business.

On the basis of modus operandi. According to this, financial analysis can alsobe two types.

(i) Horizontal analysis: In case of this type of analysis, financial statements fora number of years are reviewed and analyzed. The current years figures arecompared with the standard or base year. The analysis statement usuallycontains figures for two or more years and the changes are shown recordingeach item from the base year usually in the from of percentage. Such ananalysis gives the management considerable insight into levels and areas of


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strength and weakness. Since this type of analysis is based on the data fromyear to year rather than on the date, it is also termed as Dynamic Analysis.

(ii) Vertical analysis: In case of this type of analysis a study is made of thequantitative relationship of the various terms in the financial statements on aparticular date. For example, the ratios of different items of costs for aparticular period may be calculated with the sales for that period such ananalysis is useful in comparing the performance of several companies in thesame group, or divisions or departments in the same company.

TECHNIQUES OF FINANCIAL ANALYSIS

A financial analyst can adopt one or more of the following techniques/tools offinancial analysis.

1. Comparative Financial Statements: Comparative financial statements arethose statements which have been designed in a way so as to providetime perspective to the consideration of various elements of financialposition embodied in such statements. In these statements figures fortwo or more periods are placed side by side to facilitate comparison.

Both the income statement and Balance Sheet can be prepared in theform of Comparative Financial Statements.

Comparative Income Statement: The Income statement discloses net profit orNet Loss on account of operations. A comparative Income Statement will showthe absolute figures for two or more periods, the absolute change from oneperiod to another and if desired the change in terms of percentages. Since, thefigures for two or more period are shown side by side, the reader can quicklyascertain whether sales have increased or decreased, whether cost of sales hasincreased or decreased etc. Thus, only a reading of data included in

Comparative Income Statements will be helpful in deriving meaningfulconclusions.

Comparative Balance Sheet: Comparative Balance Sheet as on two or moredifferent dates can be used for comparing assets and liabilities and finding outany increase or decrease in those items. Thus, while in a single Balance Sheetthe emphasis is on persent position, it is on change in the comparative Balance


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Sheet. Such a Balance sheet is very useful in studying the trends in anenterprise.

The preparation of comparative financial statements can be well understood

with the help of the following illustration.

ILLUSTRATION : From the following Profit and Loss Accounts and the BalanceSheet of Swadeshi polytex Ltd. For the year ended 31st December, 1987 and1988, you are required to prepare a comparative Income Statement andComparative Balance Sheet.

PROFIT AND LOSS ACCOUNT(In Lakhs of Rs.)

Particular 1987 1988 *Assets 1987 1988

Rs. Rs. Rs. Rs.

To Cost of Goods sold 600 750 By NetSales

800 1,000

To operating Expenses

Administrative Expenses 20 20

Selling Expenses 30 40

To Net Profit 150 190

800 1,000 800 1,000


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BALANCE SHEET AS ON 31ST DECEMBER(In Lakhs of Rs.)

Liabilities 1987 1988 Assets 1987 1988

Rs. Rs. Rs. Rs.

Bills Payable 50 75 Cash 100 140

SundryCreditors

150 200 Debtors 200 300

Tax Payable 6% 100 150 Stock 200 300

Debentures 6% 100 150 Land 100 100

PreferenceCapital

300 300 Building 300 270

Equity Capital 400 400 Plant 300 270

Reserves 200 245 Furniture 100 140

1300 1520 1300 1520


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SOLUTION:Swadeshi Polytex Limited

COMPARATIVE INCOME STATEMENT

FOR THE YEARS ENDED 31ST DECEMBER AND 1988

(In Lakhs of Rs.)

Absoluteincrease ordecrease in1988

Percentageincrease ordecrease in1988

1987 1988

Net Sales 800 1000 +200 +25

Cost of GoodsSold

600 750 +150 +25

Gross Profit 200 350 +50 +25

OperatingExpensesAdministrationExpenses

20 20 - -

SellingExpenses

30 40 +10 +33.33

TotalOperatingExpenses

50 60 10 +20

OperatingProfit

150 190 +40 +26.67


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Swadeshi Polytex Limited

COMPARATIVE BALANCE SHEET

AS ON 31ST DECEMBER, 1987, 1988

Figures in lakhs of rupees

Assets 1987 1988 Absoluteincrease ordecreaseduring 1988

Percentageincrease (+)or decrease(-) during1988

Current Assets:

Cash 100 140 40 +40

Debtors 200 300 100 +50

Stock 200 300 100 +50Total CurrentAssets

500 740 240 +50

Fixed Assets:

Land 100 100 - -

Building 300 270 -30 -10%

Plant 300 270 -30 -10%

Furniture 100 140 +40 +40%

Total Fixed Assets 800 780 -20 -2.5%

Total Assets 1300 1520 220 +17%

Liabilities &

Capital:

Current Liabilities


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Bills Payable 50 75 +25 +50%

Sundry Creditors 150 200 +50 +33.33%

Tax Payable 100 150 +50 +50%

Total Current

Liabilities

300 425 +125 +41.66%

Long-termLiabilities : 6%

100 150 +50 +50%

Debentures

Total Liabilities 400 575 +175 +43.75%

Capital & Reserves

6% Pre. Capital 300 300 - -

Equity Capital 400 400 - -

Reserves 200 245 45 22.5

Total Shareholders 900 945 45 5%

Funds

Total Liabilities andCapital

1300 1520 220 17%

2. Common size Financial Statements: Common size FinancialStatements are those in which figures reported are converted into

percentages to some common base. In the Income Statement that salefigure is assumed to be 100 and all figures are expressed as a percentageof this total.

Illustration: Prepare a Common size Income Statement & Common-sizeBalance Sheet of Swadeshi Polytex Ltd., for the years ended 31st December,1987 & 1988

SOLUTION:Swadeshi Polytex Limited

COMMON SIZE INCOME STATEMENT

FOR THE YEARS ENDED 31ST DECEMBER 1987 AND 1988

(Figures in Percentage)

1987 1988


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Net Sales 100 100

Cost of Goods Sold 75 75

Gross Profit 25 25

Opening Expenses:

Administration Expenses 2.50 2

Selling Expenses 3.75 4

Total OperatingExpenses

6.25 6

Operating Profit 18.75 19

Interpretation: The above statement shows that though in absolute terms, thecost of goods sold has gone up, the percentage of its cost to sales remains

constant at 75%, this is the reason why the Gross Profit continues at 25% ofsales. Similarly, in absolute terms the amount of administration expensesremains the same but as a percentage to sales it has come down by 5%. Sellingexpenses have increased by 25%. This all leads to net increase in net profit by25% (i.e., from 18.75% to 19%)


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3. Trend Percentage: Trend Percentages are immensely helpful in making acomparative study of the Financial statements for several years. Themethod of calculating trend percentages involves the calculation ofpercentage relationship that each item bears to the same item in the baseyear. Any year may be taken as base year. It is usually the earliest year.

Any intervening year may also be taken as the base year. Each item ofbase year is taken as 100 and on that basis the percentages for each ofthe years are calculated. These percentages can also be taken as IndexNumbers showing relative changes in the financial data resulting with thepassage of time.

The method of trend percentages is useful analytical device for themanagement since by substitution percentages for large amounts, thebrevity and readability are achieved. However, trend percentages are notcalculated for all of the items in the financial statements. They are usuallycalculated only for major items since the purpose is to highlightimportant changes.

Besides, Fund flow Analysis, Cash Flow Analysis and Ratio Analysis arethe other tools of Financial Analysis which have been discussed in detailas separate chapters.


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LESSON 6RATIO ANALYSIS

Meaning and Nature of ratio analysisThe term ratio simply means one number expressed in terms of another. Itdescribes in mathematical terms the quantitative relationship that existsbetween two numbers, the terms accounting ratio. J. Batty points out, is usedto describe significant relationships between figures shown on a Balance Sheet,in a Profit and Loss Account, in a Budgetary control System or in any other Partof the accounting organisation. Ratio Analysis, simply defined, refers to theanalysis and interpretation of financial statements through ratios. Nowadays itis used by all business and industrial concerns in their financial analysis. Ratio

are considered to be the best guides for the efficient execution of basicmanagerial functions like planning, forecasting, control etc.

Ratios are designed to show how one number is related to another. It is workedout by dividing one number by another. Ratios are customarily presented eitherin the form of a coefficient or a percentage or as a proportion. For example, thecurrent Assets and current Liabilities of a business on a particular date are Rs.2.5 Lakhs and Rs. 1.25 lakhs respectively. The resulting ratio of current Assetsand current Liabilities could be expressed as (i.e. Rs. 2,00,000/1,25,000) or as200 per cent. Alternatively in the form of a proportion the same ratio may be

expressed as 2:1, i.e. the current assets are two times the current liabilities.

Ratios are invaluable aids to management and others who are interested in theanalysis and interpretation of financial statements. Absolute figures may bemisleading unless compared, one with another. Ratios provide the means ofshowing the relationship which exists between figures. Though there is nospecial magic in ratio analysis, many prefer to base conclusions on ratios asthey find them highly useful for making judgments more easily. However, thenumerical relationships of the kind expressed by ratio analysis are not an endin themselves, but are a means for understanding the financial position of abusiness. Generally, simple ratios or ratios compiled from a single year financialstatements of a business concern may not serve the real purpose. Hence, ratiosare to be worked out from the financial statements of a number of years.

Ratios, by themselves, are meaningless. They derive their status partly from theingenuity and experience of the analyst who uses the available data in asystematic manner. Besides, in order to reach valid conclusions, ratios have to


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be compared with some standards that are established with a view to representthe financial position of the business under review. However, it should be bornein mind that after computing the ratios one cannot categorically say whether aparticular ratio is god or bad as the conclusions may vary from business tobusiness. A single ideal ratio cannot be applied for all types of business. Speedy

compiling of ratios and their presentations in the appropriate manner areessential. A complete record of ratios employed in advisable and explanationof each, and actual ratios year by year should be included. This record may betreated as a part of an Accounts Manual or a special Ratio Register may bemaintained.

CLASSIFICATION OF RATIOS:Ratios can be classified into different categories depending upon the basis ofclassification.

The traditional classification has been on the basis of the financial statement towhich the determinants of a ratio belong. On this basis of ratios could beclassified as:

1. Profit and loss Accounts Ratios, i.e. ratios calculated on the basis of theitems of the Profit and Loss account only e.g. Gross Profit ratio, stockturnover ratio, etc.

2. Balance sheet ratios, i.e., ratio calculated on the basis of figures ofBalance sheet only, e.g., current ratio, debt-equity etc.

3. Composite ratios or inter-statements ratios, i.e., ratio on figures of profitand loss account as well as the balance sheet, e.g. fixed assets turnoverratio, overall profitability ratio etc.

However, the above basis of classification has been found to be guide andunsuitable because analysis of Balance sheet and Balance sheet and incomestatement can not be done in insalaion. The have to be studied together inorder to determine the profitability and solvency of the business. In order thatratios serve as a toll for financial analysis, they are now classified as:

(1) Profitability Ratios, (2) Coverage Ratios, (3) Turn-over Ratios, (4) Financialratios, (a) Liquidity Ratios (b) Stability Ratios.


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LESSON 7PROFITABILITY RATIOS:Profitability is an indication of the efficiency with which the operations of thebusiness are carried on. Poor operational performance may indicate poor salesand hence poor profits. A lower profitability may arise due to the lack of controlover the expenses. Bankers, financial institutions and other creditors look at theprofitability ratios indicator whether or not the firm earns substantially morethan it pays interest for the use of borrowed funds and whether the ultimaterepayment of their debt appears reasonably certain. Owners are interested toknow the profitability as it indicates the return which they can on theirinvestments. The following are the important profitability ratios:

1. OVERALL PROFITABILITY RATIOS:It is also called Return on investment (ROI) or Return On Capital Employed(ROCE) it indicates the percentage of return on the total capital employed in thebusiness. It is calculated on the basis of the following formula.

Operation Profit x 100-------------------------------

Capital employed

The term capital employed has been given different meanings by different

accountants. Some of the popular meanings are as follows:

i) Sum-total of all assets whether fixed or current

ii) Sum-total of fixed assets

iii) Sum-total of long-term funds employed in the business, i.e.,

Share capital + Reserves & Surplus + Long Term loans + Non business assets +Fictitious assets.

In Management accounting, the term capital employed is generally used in themeaning given in the third point above.

The term Operating profit means Profit before Interest & Tax. The termInterested means Interested on long term borrowing. Interest on short


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term borrowings will be deducted for computing operating profit. Non-termborrowing will be deducted for computing operating profit. Non-tradingincomes such as interested on Government securities or non-trading losses orexpenses such as loss on account of fire, etc., will also be excluded.

2. Return on Shareholders Funds: In case it is desired to work out theprofitability of the company from the shareholders point of view, itshould be computed as follows:

Net Profit after interest & tax---------------------------------------- x 100

Shareholders Funds

The term Net Profit here means Net Incomes after Interest & Tax It is different

from the Net Operating Profit Which is used for computing the Return onTotal Capital Employed in the business. This because the shareholders areinterested in Total Income after Tax including Net Non-operating Income (i.e.,Non-operating Income Non-operating Expenses)

3. Fixed dividend Cover: This ratio is important for preference shareholdersentitled to get dividend at a fixed rate in priority to other shareholders.The ratio is calculated as follows:

Net Profit after Interest & taxFixed dividend cover =

-------------------------------------------------

Preference dividend

4. Debt service coverage ratio: The interest coverage ratio, as explainedabove, does not tell us anything about the ability of a company to makepayment of principle amounts also on time. For this purpose debt servicecoverage ratio is calculated as follows:

Net Profit before interest & taxDebt service coverage ratio =---------------------------------------------------

Principal Payment Instalment

Interest +-----------------------------------------


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1 (Tax rate)

The principle payment instalment is adjusted for tax effects since such paymentis not deductible from net profit for tax purposes.

Net Profit Before Interest & Tax

5. Interest Coverage Ratio =-------------------------------------------------------

Interest Charges

Gross Profit

6. Gross Profit Ratio =------------------------------------------------- x 100

Net Sales

Net Profit

7. Net Profit Ratio =------------------------------------------------ x 100

Net Sales

Operating Profit

Operating Profit Ratio =-------------------------------------------- x 100

Net Sales

Operating Profit = Net Profit + Non-Operating expenses Non operatingincome

Operating Cost

9. Operating Ratio = --------------------------------- x 100

Net Sales

Amount available to Equity Shareholders

10. Earnings Per Share (EPS) =------------------------------------------------------------


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Number of Equity Shares

Market Price per Share

11. Price Earnings (P/E) Ratio =

-------------------------------------------

Earning Per Share


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LESSON 81. Fixed assets turnover ratio : This ratio indicates the extent to which the

investments in fixed assets contribute towards sales. If compares with a

previous period, it indicates whether the investment in fixed assets hasbeen judicious or not. The ratio is calculated as follows:

Net Sales---------------------------------

Fixed Assets (NET)

2. Working Capital Turnover Ratio: This is also known as Working CapitalLeverage Ratio. This ratio indicates whether or net working capital hasbeen utilized in making sales. In case a company can achieve higher

volume of sales with relatively small amount of working capital, it is anindication of the operating efficiency of the company. The ratio iscalculated as follows.

Net Sales----------------------------------

Working Capital

Working capital turnover ratio may take different forms for different purposes.Some of them are being explained below:

(i) Debtors turnover ratio (Debtors, Velocity): Debtors constitute animportant constituent of current assets and therefore the quality of debtors to agreat extent determines a firms liquidity. Two ratios are used by financialanalysis to judge the liquidity of a firm. They are (i) Debtors turnover ratio, and(ii) Debt collection period ratio.

The Debtors turnover ratio is calculated as under:Credit sales

---------------------------------------------Average accounts receivable

The term Accounts Receivable include Trade Debtors and Bill Receivable.


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In case details regarding and closing receivable and credit sales are notavailable the ratio may be calculated as follows:

Total Sales

---------------------------------------------Accounts Receivable

Significance: Sales to Accounts Receivable Ratio indicates the efficiency of thestaff entrusted with collection of book debts. The higher the ratio, the better itis, Since it Would indicate that debts are being collected more promptly. Formeasuring the efficiency, it is necessary to set up a standard figure, a ratiolower then the standard will indicate inefficiency.

The ratio helps in Cash Budgeting, since the flow of cash form customers can

be worked out on the basis of sales.

(ii) Debt collection Period ratio: The ratio indicates the extent to which thedebts have been collected in time. It gives the average debt collection period.The ratio is very helpful to the lenders because it explains to them whethertheir borrowers are collecting money within a reasonable time. An increase inthe period will result in greater blockage of funds in debtors. The ratio may becalculated by any of the following methods.

Months (or days) in a year(a)----------------------------------------------------

Debtors turnover

Average Accounts Receivable x Months (or days) in a year

(b)--------------------------------------------------------------------------------------

Credit sales for the year

Accounts receivable

(c)-------------------------------------------------------------------

Average monthly or daily credit sales


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In fact, the two ratios are interrelated Debtors turnover ratio can be obtainedby dividing the months (or days)

In a YEAR by the average collection period (e.g., 12/2-6). Similarly Where the

number of months (or days) in a year are divided by the debtors turnover,average debt collection period is obtained (i.e., 12/6 2 months)

Significance: Debtors collection period measures the quality of debtors since itmeasures the rapidity or slowness with which money is collected from them. Ashort collection period implied prompt payment by debtors. It reduces thechances of bad debts.

A longer collection period implies too liberal and inefficient credit collectionperformance. However, in order to measure a firms credit and collectionefficiency its average collection period should be compared with the average ofthe industry. It should be neither too liberal nor too restrictive. A restrictivepolicy will result in lower sales which will reduce profits.

It is difficult to provide a standard collection period of debtors. It depends uponthe nature of the industry, seasonable character of the business and creditpolicies of the firm. In general, the amount of receivables should not exceed a3-4 months credit sales.

(ii i) Creditors turnover ratio (Creditors velocity): It is similar to debtorsTurnover Ratio. It indicates the speed with which the payment for creditpurchases are made to the creditors. The ratio can be computed as follows:

Credit Purchases-------------------------------------------

Average accounts payable

The term Accounts payable include Trade Creditors and Bills payable

In case the details regarding credit purchases, opening closing accountspayable have not been given, the ratio may be calculated as follows:

Total Purchases----------------------------------

Account Payable


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(iv) Debt payment period enjoyed ratio (Average age of payable):The ratio give the average credit period enjoyed from the creditors. It can be

computed by any one of the following methods:

Months or days in a year

(a)---------------------------------------------------

Creditors turnover

Average accounts payable x Months (or days) in a year

(b)

----------------------------------------------------------------------------------------

Credit purchases in the year

Average accounts payable

(c)--------------------------------------------------------------

-----------

Average monthly (or daily) credit purchases

Significance: Both the creditors turnover ratio and the debt payment periodenjoyed ratio indicate about the promptness or otherwise in making payment ofcredit purchases. A higher creditors turnover ratio or a lower credit periodenjoyed ratio. Signifies that the creditors are being paid promptly, thusenhancing the credit worthiness of company. However, a very favourable ratioto this effects also shows that the business is not taking full advantage of creditfacilities which can be allowed by the creditors.

Stock Turnover Ratio: This ratio indicate whether investments in inventory isefficiently used or not. It therefore, explains whether investment in inventoriesis within proper limits or not. The ratio is calculated as follows:

Cost of goods sold during the year

------------------------------------------------------


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Average inventory

Average inventory is calculated by taking stock levels of raw materials work in process, finished goods at the end of each months, adding them up and

dividing by twelve.

Inventory ratio can be calculated regarding each constituent of inventory. It maythus be calculated regarding raw materials, Work in progress & finished goods.

Cost of goods sold

1*--------------------------------------------------

Average stock of finished goods

Materials consumed

2** ----------------------------------------------

Average stock of raw materials

Cost of completed work

3*** ------------------------------------------

Average work in progress

The method discussed above is as a matter of fact the best basis for computingthe stock Turnover Ratio. However, in the absence of complete information, theinventory Turnover Ratio may also be computed on the following basis.

Net sales-------------------------------------------------

Average inventory at selling Prices

The average inventory may also be calculated on the basis of the average ofinventory at the beginning and at the end of the accounting period.

Inventory at the beginning of the accounting period +Inventory at the end of the accounting period


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Average Inventory =--------------------------------------------------------------------------------------

2

Significance: As already stated, the inventory turnover ratio signifies theliquidity of the inventory. A high inventory turnover ratio indicates brisk sales.The ratio is, therefore, a measure to discover the possible trouble in the form ofoverstocking or overvaluation. The stock position is known as the graveyard ofthe balance sheet. If the sales are quick such as a position would not ariseunless the stocks consists of unsalable items. A low inventory turnover ratioresults in blocking of funds in inventory becoming obsolete or deteriorating inquality.

It is difficult to establish a standard ratio of inventory because it will differ fromindustry. However, the following general guidelines can be given.

(i) The raw materials should not exceed 2-4 months consumption of the year.

(ii) The finished goods should not exceed 2-3 months sales

(iii) Work in progress should not exceed 15-30 days cost of sales.

PRECAUTIONS: While using the Inventory Ratio, care must be taken regardingthe following factors:

(i) Seasonable conditions: If the balance sheet is prepared at the time of slackseason, the average inventory will be much less (if calculated on the basis ofinventory at the beginning of the accounting period & inventory at close of theaccounting period). This may give a very high turnover ratio.

(ii) Supply conditions: In case of conditions of security inventory may have tobe kept in high quality for meeting the future requirements.

(iii) Price trends: In case of possibility of a rise in prices, a large inventory maybe kept by business. Reverse will be the case if there is a possibility of fall inprices.


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(iv) Trend of volume of business: In case there is a trend of sales beingsufficiently higher than sales in the past, a higher amount of inventory may bekept.


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LESSON 9FINANCIAL RATIOSFinancial Ratios indicate about the financial position of the company.Accompany is deemed to be financially sound if it is in a position to carry on itsbusiness smoothly and meetits obligions, both short term as well as longterm,without strain. It is a sound principle of finance that the short-termrequirements of funds should be met out of short term funds and long-termrequirements should be met out of long-term funds. For example if thepayment for raw materials purchases are made through the issue debentures itwill create a permanent interest burden on the enterprise. Similarly, if fixedassets are purchased out of funds provide by bank overdraft, the firm will cometo grief because such assets cannot be sold away when payment will bedemanded by the bank.

Financial ratios can be divided into two broad categories:

(1) Liquidity Ratios & (2) Stability Ratios

(1) LIQUIDITY RATIOS: These ratios are termed as working capital orshort-term solvency ratios. As enterprise must have adequate working-capitalto run its day-to-day operations. Inadequacy of working capital may bring theentire business operation to a grinding halt because of inability of enterprise to

pay for wages, materials & other regular expenses.

CURRENT RATIOS: This ratio is an indicator of the firms commitment to meetits short-term liabilities. It is expressed as follows:

Current assets-----------------------------

Current Liabilities

Current assets mean assets that will either be used up or converted into cashwithin a years of time or normal operating cycle of the business, whichever islonger. Current liabilities means liabilities payable within a year or operatingcycle, whichever is longer, out of existing current assets or by creation ofcurrent liabilities. A list of items include in current assets & current liabilitieshas already been given in the performs analysis balance sheet in the precedingchapter.


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Book debts outstanding for more than six months & loose tools should not beincluded in current assets. Prepaid expenses should be taken as current assets.

An ideal current ratio is 2. The ratio of 2 is considered as a safe margin ofsolvency due to the fact that if the current assets are reduced to half, i.e., 1instead of 2, then also the creditors will be able to get their payments in full.However a business having seasonal trading activity may show a lower currentratio at a creation period of the year. A very high current ratio is also notdesirable since it means less efficient use of funds. This is because a highcurrent ratio means excessive dependence on long-term sources of raisingfunds. Long-term liabilities are costlier than current liabilities & therefore, thiswill result in considerably lowering down the profitability of the concern.

It is to be noted that the mere fact current ratio is quite high does not meanthat the company will be in position to meet adequately its short-term liabilities.In fact, the current ratio should be seen in relation to the component of currentassets & liquidity. If a large portion of the current assets comprise obsoletestocks or debtors outstanding for a long term, time, the company may fail evenif the current ratio is higher then 2.

The current ratio can also be manipulated very easily. This may be done eitherby either postponing certain pressing payments or postponing purchase ofinventories or making payment of certain current liabilities.

Significance: The current ratio is an index of the concerns Financial stabilitysince it shows the extent of working capital which is the amount by which thecurrent assets exceed the current liabilities. As stated earlier, a higher currentratio would indicate inadequate employment of funds while a poor current ratiois a danger signal to the management. It shows that business is trading beyondits resources.

(II) QUICK RATIO: This ratio is also termed as acid test ratio or liquidity ratio.This ratio is ascertained by comparing the liquid assets (i.e., assets which areimmediately convertible into cash without much loss) to current liabilitiesprepaid expenses and stock are not taken as liquid assets. The ratio may beexpressed as:

Liquid assets---------------------------


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Current liabilities

Some accountants prefer the term Liquid Liabilities for Current Liabilities orthe purpose of ascertaining this ratio. Liquid liabilities means liabilities whichare payable within a short period. The bank over-draft (if it becomes a

permenant mode of financing) & cash credit faculties will be excluded fromcurrent liabilities in such a case.

The ideal ratio is 1.

This ratio is also an indicator of short-term solvency of the company.

A comparison of the current ratio to quick ratio shall indicate the inventory

hold-ups. For example if two units have the same current ratio but differentliquidity ratio, it indicates over-stocking by the concern having low liquidityratio as compared to the concern which has a higher liquidity ratio.

Thus, debtors are excluded from liquid assets for the purpose of comparingsuper quick ratio. Current liabilities & liquid liabilities have the same meaningas explained above. The ratio is the more measure of firms liquidity position.However, it is not widely used in practice.

STABILITY RATIO: These ratios help in ascertaining long term solvency of a firmwhich depends basically on three factors:

(i) Whether the firm has adequate resources to meet its long term fundsrequirements.

(ii) Whether the firm has used an appropriate debt-equity mix to raiselong-term funds.

(iii) Whether the firm earns enough to pay interest & instalment of long-termloans in time.

The capacity of the firm to meet the last requirement can be ascertained bycomputing the various coverage ratios, already explained in the precedingpages. For the other two requirements, the following ratios can be calculated.


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(1) FIXED ASSETS RATIO: This ratio explains whether the firm has raisedadequate long-term funds to meet its fixed assets requirements. It is expressedas follows:

Fixed assets---------------------------

Long Term funds

The ratio should not be more than 1. If it is less than 1, it shows that a part ofthe working capital has been financed through long-term funds. This isdesiarable to some extent because a part of working capital termed as CoreWorking Capital is more or less is a fixed nature. The ideal ratio is 67.

(ii) CAPITAL STRUCTURE RATIOS: These ratios explains how the capitalstructure of firm is made up or the debt-equity mix adopted by the firm. Thefollowing ratios fall in the category.

(a) Capital Gearing Ratio: Capital gearing (or leverage) refers to the proportionbetween fixed interest or dividend bearing funds & non-fixed interest ordividend bearing funds in the total capacity employed in the business. Thefixed interest or dividend bearing funds include the funds provided by thedebenture holders & preference shareholders. Non-fixed interest or dividendbearing funds are the funds provided by the equity shareholders. The amount,

therefore, includes the Equity Share Capital & other Reserves. A properproportion between the two funds is necessary in order to keep the cost ofcapital at the minimum.

The capital gearing ratio can be ascertained as follows:

Funds bearing fixed interest or fixed dividend-------------------------------------------------------------------

-

Equity Shareholders Funds

(b) DEBT-EQUITY RATIO: The debt-equity ratio is determined to ascertain thesoundness of the long-term financial position of the company. It is also knownas External Internal equity ratio.


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Total long-term debt

Debt Equity Ratio = ------------------------------------------

Shareholders funds

Significance: The ratio indicates the preparation of owners stake in thebusiness. Excessive liabilities tend to cause insolvency. The ratio indicates theextent to which the firm depends upon outsiders for its existence. The ratioprovides a margin of safety to the creditors. It tells the owners the extent towhich they can gain the benefits or maintain control with a limited investment.

(c) Proprietary ratio : It is a variant of debt-equity ratio. It establishesrelationship between the proprietors funds & the total tangible assets. It maybe expressed as:

Shareholders funds= --------------------------------

Total tangible assets

Significance: This ratio focuses the attention on the general financial strengthof the business enterprise. The ratio is of particular importance to the creditorswho can find out the proportion of shareholders funds in the total assetsemployed in the business. A high proprietary ratio will indicate a relatively littledanger to the creditors etc., in the event of forced reorganization or winding

up of the company. A low proprietary ratio indicates greater risk to thecreditors since in the event of losses a part of their money may be lost besidesloss to the properties of the business. The higher the rate, the better it is. Aratio below 50 percent may be alarming for the creditors since they may have tolose heavily in the event of companys liquidation on account of heavy losses.

ADVANTAGES OF RATIO ANALYSIS

Following are some of the advantages of ratio analysis:

1. Simplifies financial statements: Ratio Analysis simplified thecomprehension of financial statements. Ratios tell the whole story ofchanges the financial condition of the business.

2. Facilitates inter-firm comparison: Ratio Analysis provides date forinter-firm comparison. Ratios highlight the factors associated with


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successful & unsuccessful firms. They also reveal strong firms & weakfirms, over-valued & under valued firms.

3. Makes intra-firm comparision possible: Ratio Analysis also makespossible comparision of the performance of the different divisions of thefirm. The ratios are helpful in deciding about their efficiency or otherwise

in the past & likely performance in the future.

4. Helps in planning: Ratio Analysis helps in planning & forecasting. Over aperiod of time a firm or industry develops certain norms that mayindicate future success or failure. If relationship changes in firms dataover different time periods, the ratios may provide clues on trends andfuture problems.

Thus Ratio can assist management in its basic functions of forecastingplanning coordination, control and communication.

LIMITATIONS OF ACCOUNTING RATIOS

1. Comparative study required: Ratios are useful in judging the efficiencyof the business only when they are compared with the past results of thebusiness or with the results of a similar business. However, such acomparision only provides a glimpse of the past performance andforecasts for future may not be correct since several other factors likemarket conditions, management policies, etc. may affect the futureoperations.

2. Limitations of financial statements: Ratios are based only on theinformation which has been recorded in the financial statements whichsuffer from a number of limitations.

For example non-financial charges though important for the business are notrevealed by the financial statements. If the management of the companychanges, it may have adverse effect on the future profitability of the companybut this cannot be judged by having a glance at the financial statements of thecompany.

Financial statements show only historical cost but not market value.

The comparision of one firm with another on the basis of ratio analysis withouttaking into account the fact of companies having different accounting policieswill be misleading and meaningless.


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3. Ratios alone are not adequate : Ratios are only indicators they cannot betaken as final regarding good or bad financial position of the businessOther things have also to be seen.

4. Window dressing: The term window dressing means manipulations ofaccounts in a way so as to conceal vital facts and present the financialstatements in a way to show a better position than what it actually is. Onaccount of such a situation presence of a particular ratio may not be adefinite indicator of good or bad management.

5. Problem of price level changes: Financial analysis based on accountingratios will give misleading results if the effects of changes in price levelare not taken into account.

6. No fixed standards: No fixed standards can be laid down for ideal ratios.For example, current ratio is generally considered to be ideal if currentassets are twice the current liabilities. However, in case of these concernswhich have adequate arrangements with their bankers for providingfunds when they require, it may be perfectly ideal if current assets areequal to slightly more than current liabilities.

7. Ratios area composite of many figures: Ratios are a composite of manydifferent figures. Some cover a time period, others are at an instant oftime while still others are only averages. A balance sheet figures showsthe balance of the account at one moment of one day. It certainly may notbe representative of typical balance during the year. It may, therefore, beconducted that ratio analysis, if done mechanically, is not only misleadingbut also dangerous.

The computation of different accounting ratios & the analysis of the financialstatements on their basis can be very well understood with the help of theillustrations given in the following pages:

COMPUTATION OF RATIOS

Illustration 1: Following is the Profit and Loss Account and Balance Sheet of Jai

Hind Ltd., Redraft the for the purpose of analysis and calculate the followingratios:

i. Gross Profit Ratios

ii. Overall Profitability Ratio

iii. Current Ratio


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iv. Debt-Equity Ratio

v. Stock Turnover Ratios

vi. Liquidity Ratios

PROFIT AND LOSS ACCOUNT

Db. Cr.Particulars

Opening stock of finishedgoods

1,00,000 Sales 10,00,000

Opening stock of raw

materials

50,000 Closing stock of raw

materials

1,50,000

Purchase of raw materials 3,00,000 Closing stock of finishedgoods

1,00,000

Direct wages 2,00,000 Profit on sale of shares 50,000

Manufacturing expenses 1,00,000

Administration expenses 50,000

Selling & Distribution

expenses

50,000

Loss on sale of plant 55,000

Interest on Debentures 10,000

Net Profit 3,85,000

13,00,000 13,00,000

BALANCE SHEETLiabilities Rs. Assets Rs.Share Capital: Fixed Assets 2,50,000

Equity Share Capital 1,00,000 Stock of raw materials 1,50,000

Preference share capital 1,00,000

Reserves 1,00,000 Stock of finished 1,00,000


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Debentures 2,00,000 Sundry debtors 1,00,000

Sundry Creditors 1,00,000 Bank Balance 50,000

Bills Payable 50,000

6,50,000 6,50,000

SOLUTION:INCOME STATEMENT

Sales Rs.10,00,000

Less: Cost of sales

Raw material consumed (op. Stock + Purchases Closing Stock)

2,00,000

Direct Wages 2,00,000

Manufacturing expenses 1,00,000

Cost of production 5,00,000

Add: Opening stock of finished goods 1,00,000

6,00,000

Less: Closing stock of finished goods. Cost ofgoods sold

1,00,000 5,00,000


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Gross Profit 5,00,000

Less: Operating Expenses:

Administration expenses 50,000

Selling and distribution expenses 50,000 1,00,000

Net operating profit 4,00,000

Add: Non-trading income: 50,000

Profit on sale of shares 4,50,000

Less: Non-trading expenses or losses:

Loss on sale of plant 55,000

Income before interest & tax 3,95,000

Less: Interest on debentures 10,000Net Profit before tax 3,85,000

BALANCE SHEET (OR POSITION STATEMENT)Rs.

Bank balance 50,000

Sundry debtors 1,00,000

Liquid assets 1,50,000

Stock of raw materials 1,50,000

Stock of finished goods 1,00,000

Current assets 4,00,000

Sundry creditors 1,00,000Bills Payable 50,000

Current liabilities 1,50,000

Working Capital (Rs. 4,00,000 Rs. 1,50,000) 2,50,000

Add Fixed assets 2,50,000

Capital employed 5,00,000


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Less Debentures 2,00,000

Shareholders net worth 3,00,000

Less Preference share capital 1,00,000

Equity shareholders net worth 2,00,000

Equity shareholders net worth is represented by: 1,00,000

Equity Share capital 1,00,000

Reserves 2,00,000

Ratios:

Gross Profit x 100 50,000 x 100(i) Gross Profit Ratio ----------------------------

-------------------------- = 50%

Sales 10,00,000

Operating Profit x 100 4,00,000 x 100

(ii) Overall Profitability Ratio = ------------------------------- =--------------------- = 80%

Capital employed 5,00,000

Current assets 4,00,000

(iii) Current Ratio = ------------------------------- =-------------------------- = 2.67


External equities 3,50,000

(iv) Debt Equity Ratio: = -------------------------- =--------------------- = 1.17

Internal equities 3,00,000

(or)


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Total long- term debt 2,00,000

------------------------------ =----------------- = 0.40

Total long-term funds 5,00,000

(or)

Total long-term debt 2,0,00,000

----------------------------- =-------------------- = 0.67

Shareholders funds 3,00,000

(v) Stock turnover ratio:

Cost of goods sold 5,00,000

(a) As regards average total inventory = ----------------------------= ----------------- = 2.5

Average inventory* 2,00,000

(*) of raw materials as well as finished goods)

(b) As regards average inventory of finished goods:

Cost of goods sold 5,00,000

--------------------------------------------------= ---------------- = 5

Average inventory of finished goods 1,00,000

(c) As regard average inventory of raw materials:

Materials consumed 2,00,000

--------------------------------------------------= ---------------- = 2

Average inventory of materials 1,00,000


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Liquid assets 1,50,000

(iv) Liquid Ratio: ------------------------- = ----------------- =1


ILLUSTRATION 2 : Following are the ratios to the trading activities of NationalTraders Ltd.

Debtors Velocity 3 Months

Stock Velocity 8 Months

Creditors Velocity 2 Months

Gross Profit Ratio 25 percent

Gross profit for the year ended 31st December, 1988 amount to Rs. 4,00,000/-closing stock of the year is Rs. 10,000 above the opening stock. Bills receivableamount to Rs. 25,000 and Bills payable to Rs. 10,000.

Find out: (a) Sales, (b) Sundry Debtors; (c) Closing Stock & (d) Sundry Creditors

SOLUTION :

(a) Sales:

Gross profit

Gross Profit Ratio = ------------------------- x 100

Sales

Gross profit = Rs. 4,00,000/-

4,00,000

Sales = ----------------------------- x 100 = Rs. 16,00,000

25


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(b) Sundry Debtors :

Debtors

Debtors Velocity = --------------------- x 12

Sales

Debtors Velocity of 3 months Presumably means that Accounts Receivableequal to 3 months Sales or of the years sales.

Rs.

1,60,000

Account Receivable = --------------------- x 1 4,00,000

4

Less Bills Receivable 25,000

-------------------------

Sundry Debtors 3,75,000

-------------------------

(c) Closing Stock:

Cost of goods soldStock Velocity =

------------------------------------------

Average stock

Cost of goods sold = Sales Gross profit

= 16,00,000 4,00,000 = Rs. 12,00,000

12,00,000

Average Stock = ------------------------- x 8 = Rs. 8,00,000

12

Total of Opening and Closing stock = 8,00,000 x 2 = 16,00,000


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Closing Stock is higher than Opening Stock by Rs. 10,000

16,00,000 - 10,000

Therefore, Opening Stock = ---------------------------------

2

= 7,95,000

Hence, Closing Stock = 7,95,000 + 10,000 or Rs. 8,05,000

(d) Sundry Creditors:

Total Creditors

Creditors Velocity i.e., = ------------------------------ x 12

Purchases

Purchases = Cost of goods sold + Closing Stock opening Stock

= 12,00,000 + 8,05,000 7,95,000 = Rs. 12,10,000

Creditors Velocity is 2 months, it means that Account Payable are 1/6th of thePurchases for the year

Hence Account Payable = Rs. 2,01, 667

Less : Bills Payable = 10,000

--------------------

Sundry Creditors Rs. 1,91,667

--------------------


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LESSON 10FUNDS FLOW ANALYSIS

The technique of Funds Flow Analysis is widely used by the financial analyst,credit granting institutions and financial managers in performance of their jobs.It has become a useful tool in their analytical kit. This is because the financialstatements, i.e., Income Statement and the Balance Sheet have a limited roleto perform. Income statement measures flow restricted to transactions thatpertain to rendering of goods or services to customers. The Balance Sheet ismerely a static statement. It is a statement of assets and liabilities which doesnot focus major financial transactions which have been behind the balancesheet changes. One has to draw inferences after comparing the balance sheetsof two periods. For example, if the fixed assets worth Rs. 2,00,000 arepurchased during the current year by raising share capital of Rs. 2,00,000 the

balance sheet will simply show a higher capital figure and higher fixed assetsfigure. In case, one compares the current years balance sheet with the previousyear, then only one can draw an inference that fixed assets were acquired byraising share capital of Rs. 2,00,000. Similarly, certain important transactionwhich might occur during the course of the accounting year might not find anyplace in the balance sheet. For example, if a loan of Rs. 2,00,000 was raisedand paid in the accounting year the Balance sheet will not depict thistransaction. However, a financial analyst must know the purpose for which theloan was utilized and the source from which it was raised. This will help him inmaking a better estimate about the companys financial position and policies.

The term fund generally refers to cash, to cash and cash equivalents, or toworking capital. Of these the last definition of the term is by far the mostcommon definition of fund.

There are also two concepts of working capital gross and net concept. Grossworking capital refers to the firms investment in current asset while the termnet working capital means excess of current assets over current liabilities. It isin the latter sense in which the term funds is generally used.

Current Assets: The term Current Assets includes assets which are acquiredwith the intention of converting them into cash during the normal businessoperations of the company.

The broad categories of current assets, therefore, are

1. Cash including fixed deposits with banks.


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2. Accounts receivable, i.e., trade debtors and bills receivable,

3. Inventory i.e., stocks of raw materials, work-in-progress, finished goods,stores and spare parts.

4. Advances recoverable, i.e., the advances given to supplier of goods and

services or deposit with government or other public authorities, e.g.,customer, port authorities, advance income tax, etc.

5. Pre-paid expenses, i.e. cost of unexpired services e.g., insurancepremium paid in advance, etc.

Current Liabilities: The term Current Liabilities is used principally todesignate such obligations whose liquidation is reasonably expected to requirethe use of assets classified as current assets in the same balance sheet or thecreation of other current liabilities or those expected to be satisfied within arelatively short period of time usually one year. However, this concept of

current liabilities has now undergone a change. The more modern versiondesignates current liabilities as all obligations that will require within thecoming year or the operation cycle, whichever is longer. The use of existingcurrent assets or the creation of other current liabilities . in other words, themore fact that an amount is due within a year does not make it current liabilityunless it is payable out of existing current assets or by creation of currentliabilities. For example debentures due for redemption within a year of thebalance sheet date will not be taken as a current liability if they are to be paidout of the proceeds of a fresh issue of shares / debentures or out of theproceeds realized on account of sale of debentures redemption fundinvestments.

The term current liabilities also includes amounts set apart or provided for anyknown liability of which the amount cannot be determined with substantialaccuracy e.g., provision for taxation, pension etc., These liabilities aretechnically called provisions rather than liabilities.

The broad categories of current liabilities are:

1. Accounts payable e.g., bill payable and trade creditors.2. Outstanding expenses, i.e., expenses for which services have been

received by the business but for which the payment has not made.

3. Bank-over drafts.

4. Short-term loans, i.e., loans from banks, etc., which are payable withinone year from the date of balance sheet.


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5. Advance payments received by the business for the services to berendered or goods to be supplied in future.

6. Current maturities of long-term loans, i.e., long-term debts due within ayear of the balance sheet date or installments due within a year in respectof these loans, provided payable out of existing current assets or by

creation of current liabilities, as discussed earlier. However, installmentsof long-term loans due after a year should be taken as non-currentliabilities.

Meaning of Flow of Funds The term Flow means change and therefore, theterm Flow of Funds means Change in Funds or Change in working capital.In other words, any increase or decrease in working capital means Flow ofFunds.

USES OF FUNDS FLOW A STATEMENTFunds flow statement helps the financial analyst in having a more detailedanalysis and understanding of changes in the distribution of resources betweentwo balance sheet dates. In case such study is required regarding the futureworking capital position of the company, a projected funds flow statement canbe prepared. The uses of funds flow statement can be put as follows.

1. It explains the financial consequences of business operations. Funds flow

statement provides a ready answer to so many conflicting situations, suchas:

Why the liquid position of the business is becoming more and moreunbalanced inspite of business making more and more profits.

How was it possible to distribute dividends in excess of current earningsor in the presence of a new loss for the period?

How the business could have good liquid position in spite of businessmaking losses or acquisition of fixed assets?

Where have the profits gone?

Definite answers to these questions will help the financial analyst in advisinghis employer / client regarding directing of funds to those channels which willbe most profitable for the business.


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2. It answers intricate queries. The financial analyst can find out answers toa number of intricate questions.

What is the overall credit-worthiness of the enterprise?

What are the sources of prepayment of the loans taken?

How much funds are generated through normal business operations?

It what way the management has utilized the funds in the past and whatare going to be like

Management Accounting Mba Bk

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