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UNIT-I
UNIT-II
UNIT-III
UNIT-IV
UNIT-V
Subject Description: This course presents the principles of accounting, preparation of financial
statements, analysis of financial statements, costing techniques, financial management and its functions.
Goals: To enable the students to learn the basic principles of accounting and preparation and analysis
of financial statements and also the various functions of financial management.
UNIT I
Financial Accounting - Definition - Accounting Principles - Concepts and conventions - Trial Balance
– Final Accounts (Problems) - Depreciation Methods-Straight line method, Written down value
method.
UNIT II
UNIT III
Cost Accounting - Meaning - Distinction between Financial Accounting and Cost Accounting - Cost
Terminology: Cost, Cost Centre, Cost Unit - Elements of Cost - Cost Sheet - Problems.
Budget, Budgeting, and Budgeting Control - Types of Budgets - Preparation of Flexible and fixed
Budgets, master budget and Cash Budget - Problems -Zero Base Budgeting.
Marginal Costing - Definition - distinction between marginal costing and absorption costing - Break
even point Analysis - Contribution, p/v Ratio, margin of safety - Decision making under marginal
costing system-key factor analysis, make or buy decisions, export decision, sales mix decision-
Problems
UNIT IV
Objectives and functions of Financial Management - Role of Financial Management in the organisation
- Risk-Return relationship- Time value of money concepts - Indian Financial system - Legal, Regulatory
and tax framework. Sources of Long term finance - Features of Capital market development in India
- Role of SEBI in Capital Issues.
Capital Budgeting - methods of appraisal - Conflict in criteria for evaluation - Capital Rationing -
Problems - Risk analysis in Capital Budgeting.
UNIT V
Cost of Capital - Computation for each source of finance and weighted average cost of capital -EBIT
-EPS Analysis - Operating Leverage - Financial Leverage - problems.
Working Capital Management - Definition and Objectives - Working Capital Policies - Factors affecting
Working Capital requirements - Forecasting Working Capital requirements (problems) - Cash
Management - Receivables Management and - Inventory Management - Working Capital Financing -
Sources of Working Capital and Implications of various Committee Reports.
UNIT-I
LESSON
1
FINANCIAL ACCOUNTING
CONTENTS
1.0 Aims and Objectives
1.1 Introduction
1.2 Process of Accounting
1.2.1 What is Cash System?
1.2.2 What is Accrual System?
1.2.3 Value at Which it is to be Recorded ?
1.3 Utility of the Financial Statements
1.3.1 To Management
1.3.2 To Shareholders, Security Analysts and Investors
1.3.3 To Lenders
1.3.4 To Suppliers
1.3.5 To Customers
1.3.6 To Govt. and Regulatory Authorities
1.3.7 To Promote Research and Development
1.4 Accounting Principles
1.5 Accounting Concepts
1.5.1 Money Measurement Concept
1.5.2 Business Entity Concept
1.5.3 Going Concern Concept
1.5.4 Matching Concept
1.5.5 Accounting Period Concept
1.5.6 Duality or Double Entry Accounting Concept
1.5.7 Cost Concept
1.6 Accounting Conventions
1.6.1 Convention of Consistency
1.6.2 Convention of Conservatism
1.6.3 Convention of Disclosure
1.6.4 Persons of Nature
1.6.5 Persons of Artificial Relationship
1.6.6 Persons of Representations
1.6.7 Receiver of the Benefits
1.6.8 Giver of the Benefits
1.7 Real Accounts
1.8 Nominal Accounts
1.9 Transactions in between the Real A/c
1.9.1 What is Movement-In?
1.9.2 What is Movement-Out?
1.10 Journal entries in between the accounts of two different categories
1.10.1 What is meant by Ledger?
1.10.2 Ledgering
1.11 Case Let
1.12 Let us Sum up
1.13 Lesson-end Activity
1.14 Keywords
1.15 Questions for Discussion
1.16 Suggested Readings
Accounting and Finance
for Managers 1.0 AIMS AND OBJECTIVES
In this less we shall discuss about financial accounting. After going through this lesson
you will be able to:
(i) analyse process of accounting and accounting concepts.
(ii) discuss accounting conventions.
1.1 INTRODUCTION
Accounting is a business language which elucidates the various kinds of transactions
during the given period of time. Accounting is defined as either recording or recounting
the information of the business enterprise, transpired during the specific period in the
summarized form.
What is meant by accounting?
Accounting is broadly classified into three different functions viz
Recording
Classifying and Transactions of Financial Nature
Summarizing
Is accounting an equivalent function to book keeping ?
No, accounting is broader in scope than the book keeping., the earlier cannot be
equated to the later. Accounting is a combination of various functions viz
Accounting
Recording of Transactions
Classification
Sum m arisation
Interpretation
American Institute of Certified Public Accountants Association defines the term accounting
as follows "Accounting is the process of recording, classifying, summarizing in a
significant manner of transactions which are in financial character and finally results
are interpreted."
Qualities of Accounting:
l In accounting, transactions which are non- financial in character can not be recorded.
l Transactions are recorded either individually or collectively according to their groups.
l Users should be able to make use of information.
8
Financial Accounting
1.2 PROCESS OF ACCOUNTING
Step 1
Identification of Transaction
Recording
Step 2
Preparation of Business Transactions
Step 3
Recording of Transactions in Journal
Grouping
Step 4
Posting In Ledgers
Summarizing
Step 5
Preparation of Unadjusted Trial Balance
Step 6
Pass of Adjustment Entries
Step 7
Preparation
Financial Accounting is described as origin for the creation of information and the
continuous utility of information
After the creation of information, the developed information should be appropriately
recorded. Are there any scales/guide available for the recording of information? Yes,
What are they?
They are as follows
l What to record: Financial Transaction is only to be recorded
l When to record: Time relevance of the transaction at the moment of recording
l How to record: Methodology of recording - It contains two different systems of
accounting viz cash system and accrual system
1.3.3 To Lenders
The lenders do study about the business enterprise through the available information of
its financial statements normally before lending. The aim of the study is to analyse the
status of the firm for the worthiness of lending with reference to the payment of interest
periodicals and the repayment of the principal.
1.3.4 To Suppliers
The suppliers are in need of information about the business fleeces before sale of goods
on credit. The Suppliers are very cautious in supplying the goods to the business houses
based on the various capacities of themselves. The most important capacity required as
well as expected from the buyer firms is that prompt repayment of dues of the credit
purchase from the suppliers. This quality of prompt payment could be known through
culling out the information from the balance sheet.
It mainly plays pivotal role in answering the status inquiries about the buyer
1.3.5 To Customers
The legal relationship of the transferability of ownership of the products is obviously
understood through financial information available in the statements. The agreement of
warranty and guarantee is tested through the financial status of the enterprise.
(b) Classifying
(c) Summarising
Accounting Concepts
Accounting Conventions
Accounting Principles
12
1.5.1 Money Measurement Concept Financial Accounting
This is the concept tunes the system of accounting as fruitful in recording the transactions
and events of the enterprise only in terms of money. The money is used as well as
expressed as a denominator of the business events and transactions. The transactions
which are not in the expression of monetary terms cannot be registered in the book of
accounts as transactions.
For e.g. 5 machines, 1 ton of raw materials, 6 fork lift trucks, 10 lorries and so on. The
early mentioned items are not expressed in terms of money instead they are illustrated
only in numbers. The worth of the items are getting differed from one to another. To
record the above enlisted items in the book of accounts, all the assets should be converted
in to money. For e.g. 5 lathe machines worth Rs 1,00,000; 1 ton of raw materials worth
amounted Rs. 15,00,000 and so on.
The transactions which are not in financial in character cannot be entered in the book of
accounts.
Type of Capital
Liabilities Assets
Share capital Plant and Machinery
Preference Share Capital Land and Buildings
Debentures/Long Term Borrowings Fixtures and Tools
Retained Earnings Delivery vehicles
Commercial Paper Furniture – Industry and office
Public Deposits Office administrative devices
Bank Loan Marketable securities
Overdraft Short-term investments
Pre received Income Closing stock
Outstanding Expenses Pre paid expenses
Sundry Creditors Outstanding Income
Bills Payable Sundry debtors
Provision for Taxation Bill Receivable
Cash at Bank
Cash in Hand
15
Accounting and Finance
for Managers Concept of mutual agreement and sharing of benefits
According to this convention, the entire status of the firm should be highlighted / presented
in detail without hiding anything; which has to furnish the required information to various
parties involved in the process of the firm.
Next stage is to classify the accounts into various categories.
Classification of Accounts: The entire process of accounting brought under three major
segments ; which are broadly grouped into two categories.
Accounts
Personal Impersonal
Accounts Accounts
The entire accounts of the enterprise is broadly classified into two categories viz Personal
Accounts and Impersonal Accounts. The Impersonal accounts is further classified into
two categories viz Real accounts and Nominal accounts.
What is personal accounts?
It is an account which deals with a due balance either to or from these individuals on
a particular period. It is an account normally reveals the outstanding balance of the firm
to individuals e.g. suppliers or outstanding balance from individuals e.g. customers. This 17
Accounting and Finance is the only account which emphasizes the future relationship in between the business
for Managers
firm and the individuals.
The personal accounts can be classified into three categories.
are coming into the firm and the assets which are going out of the firm.
Whenever any movement of the assets taking place with reference to any transactions
either coming into the firm or going out of the firm should be recorded in accordance
with the set golden rules of this account.
Journalising the entries are different from one transaction to another The difference is
only due to nature and characteristics of the transactions. To journalise as easy as possible,
the systematic approach to be adopted to post the transactions without any ambiguity.
Journalising can be generally categorized into following various categories.
l Taking place within the same natured accounts
l Taking part in between accounts of two different in categories
First, we will discuss the journalizing of entries of the same natured accounts. This can
be classified into various segments
l Transactions only in between the personal accounts
l Transactions only in between the real accounts
Under the category of transactions which affect only the personal accounts are as follows:
19
l Between the persons of the nature
Accounting and Finance l Between the persons of the artificial relationship
for Managers
l Between the persons of Representations
What are the points to observed at the moment of journalizing ?
l The nature of the accounts to be identified
l The accounts to be correlated to the golden rules
l Once the accounts are finalized, the next stage is to pass the entry through proper
debiting and crediting of the accounts respectively.
The meaning of the transaction should be made explicit for easier understanding through
brief and catchy narration to follow as well as evade the ambiguity in near future.
Mr Sundar is a debtor who has paid Rs 1,500, in the bank A/c
Personal A/cs
Persons of Nature
Giver Receiver
Business Supplier
Enterprise
Rent paid Expense - Office Rent paid Nominal A/c - Debit All expenses and losses
Movement - out Cash – moving out of the firm Real A/c - Credit what goes out
(c) Personal A/c and Personal A/c (d) Real A/c and Real A/c
(3) Identify nature of the transactions: Sundar has purchased goods on credit
from M/s Melvin & Co Rs.15,000. The portion of the goods were found to
damaged which worth of Rs 5,000. Sundar immediately returned the damaged
goods to Melvin & Co.
(a) Identify the various types of accounts involved in the above illustrated
transactions.
(b) Pass the journal entries with regards to the nature of accounts involved.
Illustration 1
Pass the following various journal entries.
(i) Jan 1, 2006 Mr. Sundar has started business with a capital of Rs 50,000
(ii) Jan 2,2006 Goods purchased Rs 10,000
(iii) Jan 5, 2006 Goods sold Rs 5,000
(iv) Jan 10, 2006 Goods purchased from Mittal & Co Rs 10,000
(v) Jan 11, 2006 Goods sold to Ganesh & Co Rs 10,000
(vi) Jan 12,2006 Goods returned to Mittal & Co Rs 1,500
(vii) Jan 20,2006 Goods returned from Ganesh Rs 2,000
(viii) Jan 31,2006 Office Rent paid Rs 500
(ix) Feb 2,2006 Interim Cash Dividend paid Rs 3000
(x) Feb 8, 2006 Cash withdrawn from bank Rs 2,000
(i) Jan 1, 2006 Mr. Sundar has started business with a capital of Rs 50,000
Rs Rs
Jan 1, 2006 Cash A/c Dr 50,000
To Sundar’s capital A/c Cr 50,000
Being capital brought by sundar as cash
(iv) Jan 10, 2006 Goods purchased from Mittal & Co Rs 10,000
Rs Rs
Jan 10, 2006 Purchase A/c Dr 10,000
To Mittal A/c Cr 10,000
Being credit purchase from Mittal
23
Accounting and Finance (v) Jan 11, 2006 Goods sold to Ganesh & Co Rs. 10,000
for Managers
Rs Rs
Jan 11, 2006 Ganesh A/c Dr 10,000
To SaleA/c Cr 10,000
Being credit sale made to Ganesh
(vi) Jan, 12, 2006 Goods returned to Mittal & Co Rs. 1,500
Rs Rs
Jan 12, 2006 Mittal &Co A/c Dr 1,500
To Purchase Return A/c Cr 1,500
(Being the goods returned to supplier Mittal &Co)
(vii) Jan 20, 2006 Goods returned from Ganesh Rs. 2,000
Rs Rs
Jan 20, 2006 Sales ReturnA/c Dr 2,000
To Ganesh&co Cr 2,000
Being sales return made by Ganesh & Co
(viii) Jan 31, 2006 Office Rent paid Rs. 500
Rs Rs
Jan 31, 2006 Office Rent A/c Dr 500
To Cash A/c Cr 500
Being office rent paid
Classification of transactions is being done only on the basis of preparing the ledger
accounts. The accounts are classified on the basis of nature and characteristics.
How the account transactions are classified ?
The accounts are classified through the preparation of ledger.
1.10.1 What is meant by Ledger?
Ledger is nothing but preliminary book of accounting transactions at which, each account
is separately maintained through the allotment of various pages for exclusive recording.
The exclusive allotment of pages for every account to finalize their balances. Finally,
ledger can be understood that is a document of grouping the transactions under one
heading .
It is a fundamental book of accounts which mainly highlights the status of the accounts.
Example: Plant & Machinery’s ledger A/c should reveal the transactions of the sale &
purchase of the plant and machinery.
How the transactions are recorded in the ledger ?
The journal entries which are recorded nothing but posting of the entries in the ledger
book of accounts. Posting / entering the journal entries are routinely carried out
immediately after the transactions.
Prior to discuss the posting of journal entries into the ledger accounts, every body should
24 know the contents of the ledger. The ledger is segmented into two different categories.
Proforma of the Ledger Account Financial Accounting
Credit item of the journal transaction Debit item of the journal transaction
“Krishna capital A/c” to be recorded in “Cash A/c” to be recorded in the
the debit side of the A/c i.e. Cash A/c credit side of the remaining A/c i.e
Krishna capital A/c debited into cash A/c Cash A/c credited into Krishna capital A/c 25
Accounting and Finance Next step is to Balance the individual Ledger A/c:
for Managers
How to balance the ledger A/c?
The individual ledger A/c may have more than two transactions during the specified period.
l The first step is to find out the totals of debit and credit side of the ledger account.
l The second step is to compare the totals of the two different sides
l The third step is to find out the total of which side is greater over the other
l The fourth step is to identify the difference among the two different side balances
i.e., debit and credit side totals.
l The fifth step is most important step which balances the difference on the total of
the side which bears lesser total over the greater.
l If the balance of the debit side of the ledger is more than the credit side of the
ledger is called as Debit balance ledger and vice versa in the case of Credit balance
ledger
l The closing balance of one ledger account will become automatically a opening
balance of the same ledger account for next accounting period.
Post the journal entries into respective ledger accounts. And list out their accounting
balances.
(i) Jan 1, 2006 Mr. Sundar has started business with a capital of Rs. 50,000
Rs Rs
Jan 1, 2006 Cash A/c Dr 50,000
To Sundar’s capital A/c Cr 50,000
Being capital brought by Sundar as cash
(ii) Jan 2, 2006 Goods purchased Rs 10,000
Rs Rs
Jan 2, 2006 Purchase A/c Dr 10,000
To Cash A/c Cr 10,000
Being cash purchase is made
Rs Rs
Jan 20, 2006 Sales ReturnA/c Dr 2,000
To Ganesh& co Cr 2,000
Being sales return made by Ganesh & Co
List out the various accounts which are involved in the enterprise during the year?
I. Cash Account
II. Sundar Capital Account
III. Purchase Account
IV. Sales Account
V. Mittal & Co Account
VI. Ganesh & Co Account
VII. Sales Return Account
VIII. Purchase Return Account
IX. Office Rent Account
X. Interim Dividend Account
XI. Bank Account
Dr Cash Account Cr
Date Particular Rs Date Particulars Rs
Jan 1 To Sundar Capital 50,000 Jan 2 By Purchase 10,000
Jan 5 To Sale 5,000 Jan 31 By Office Rent 500
Feb 2 To Interim Dividend 3,000 By Balance c/d 49,500
Feb 8 To Bank 2,000
60,000 60,000
50,000 50,000
` By Balance B/d 50,000
Note: Sundar capital account is having the greater credit balance over the debit balance
account which led to credit balance account.
Dr Purchase Account Cr
Date Particular Rs Date Particulars Rs
Jan 2 To Cash 10,000 By Balance c/d 20,000
Jan 10 To Mittal & Co 10,000
20,000 20,000
To Balance B/d 20,000
Note: Purchase account is bearing the debit balance account
Dr Sale Account Cr
Date Particulars Rs Date Particulars Rs
To Balance c/d 15,000 Jan 5 By Cash 5,000
Jan 11 By Ganesh 10,000
15,000 15,000
By Balance B/d 15,000
Note: Sale account is bearing the credit balance account
Dr Sales Return Account Cr
Date Particulars Rs Date Particulars Rs
Jan 20 To Ganesh 2000 By Balance c/d 2000
2000 2000
1,500
10,000 10,000
By Balance B/d 8,500
Note: Mittal & Co account is having the greater total in the credit side than the debit
side led to credit balance at the closing
28
Dr Ganesh & Co Account Cr Financial Accounting
10,000 10,000
To Balance B/d 8,000
Note: Ganesh & Co account is bearing a greater debit side total than the credit side total
which led to have debit balance account
Dr Office Rent Account Cr
Date Particulars Rs Date Particulars Rs
Jan 31 To Cash 500 By Balance c/d 500
500 500
To Balance B/d 500
Note: Office rent account is bearing debit balance
Dr Interim Dividend Account Cr
Date Particular Rs Date Particulars Rs
To Balance c/d 3,000 Feb 2 By Cash 3,000
3,000 3,000
2,000 2,000
29
Accounting and Finance Balance sheet as on dated 31st Mar, 2006
for Managers
Liabilities Assets
Capital(A.Pandit) 1,00,000 Building 80,0000
(+) Commission 4,925 Depreciation 2.5% 2,000
1,04,925 78,000
(+)Net profit 11,869 Furniture 23,000
1,16,794 Depreciation 10% 2,050
(-)Drawings 16,000 20,950
1,00,794 Closing stock 1,14,500
Capital( B.Pandit) 1,00,000 Sundry Debtors 25,000
(+)Commission 1,187 Cash in hand 400
1,01,187
(+) Net profit 11,869
1,13,056
(-)Drawings 16,000 97,056
Bank overdraft 29,000
Sundry creditors 12,000
2,38,850 2,38,850
List out the various accounting concepts dealt in the above balance sheet.
Explain the treatment of accounting concepts
1.14 KEYWORDS
Record
Accounting
Revenues
Personal Account
Normal Account
Real Account
Classifying
Summarizing
Business Entity Concept
Money Measurement Concept
Going Concern Concept
Matching Concept
Duality Concept
Ledger
32
LESSON
2
TRIAL BALANCE
CONTENTS
2.0 Aims and Objectives
2.1 Introduction
2.2 Grouping of Various Accounting Transactions
2.3 Preparation of the Trial Balance
2.4 Why the Subsidiary Accounts have to be prepared?
2.4.1 Purchase Book
2.4.2 Purchase Returns Book
2.4.3 Sales Book
2.5 Steps involved in the Sales Book
2.5.1 Sales Return Book
2.6 Steps Involved in the Sales Return Book
2.6.1 Trade Bills Book
2.6.2 Bills Receivable Book
2.7 What is meant by the Cash Transaction?
2.7.1 Double Columnar Cash Book
2.7.2 Three Columnar Cash Book
2.7.3 Multi Columnar Cash Book
2.7.4 Petty Cash Book
2.8 Let us Sum up
2.9 Lesson-end Activity
2.10 Keywords
2.11 Questions for Discussion
2.12 Suggested Readings
2.1 INTRODUCTION
The next most important stage is to prepare the statement (summary) of accounting
balances and their names for the specified accounting period to the tune of principle of
grouping transactions, known as Trial Balance.
Accounting and Finance Trial Balance is a list of accounting balances and their names; of the enterprise during
for Managers
the specified period which includes debit and credit balances of the various balanced
ledger accounts out of the journal entries.
Cash Non-Cash
Transaction Transaction
Subsidiary books are classified on the basis of transactions viz Cash transactions and
Non-cash transactions
First , let us discuss the Non-cash transactions
What is meant by the Non-cash transaction?
The Non-cash transaction is a transaction out of credit terms and conditions of the
enterprise.
The Non cash transactions shall include the following transactions of the enterprise,
which do not involve any cash ; are as follows
l Credit Sales Book
l Credit Purchases Book
l Credit Sales Return Book
l Credit Purchases Return Book
l Bills Payable Book - Out come of Credit transaction
l Bill Receivable Book - Out come of Credit transaction
Date Name of the Supplier Ledger Folio Inward Invoice No. Amount Rs
Out Ward Invoice No- This book registers the invoice number of the goods /
raw materials sold out to the buyers on credit.
Amount (Rs)- It is fundamental document to earmark the value of the
goods/raw materials sold out on credit to the various
buyers. It facilitates the firm to identify the amount of
sales transacted on credit as well as to collect the
amount of dues from the buyers.
The following are the various components dealt in the design of the book
Name of the customer - It includes the most important information about the buyer
who returned the goods /raw materials, non-confirming to specifications of the placed.
Ledger folio - It contains the page number of the journal entry posted.
Credit Note No - It is a number on the original copy of the document sent to
the firm from whom the goods are received i.e., buyer
Sl.No. Date From Acceptor Date Term Date of Where Amt How
whom of the Receivable Rs Disposed
Received the Maturity
bill
The following are the some of the important components normally included in the book:
Name of the drawer - Name of the person or concern , who or which draws the bill
nothing but either seller or manufacturer or supplier of the goods
or raw materials.
Payee - To whom the payment has to be paid
Date of the bill - Normally included to know the date at when the bill was drafted
which is under the possession of the seller or supplier.
Date of Maturity - It is the date at when the payment has to be made as per the
terms of trade.
Where payable - At where the amount of the bills to paid
It is another kind of cash book which is nothing but extension of earlier versioned single
columnar cash book. The double columnar cash book includes the operations of the
enterprise into two different categories viz transactions through Cash and Bank. It
means that the entire receipts and payments of the business routed through cash and
bank. The transaction of the business with the bank either at the moment of cash
withdrawal or cash deposit leads to register the movement of cash from one entity to
another through the contra entries.
The contra entries are posted in two different occasions viz cash withdrawal and cash
deposit.
During the cash withdrawal, the movement of cash is depicted below for easier
understanding, which is nothing but the movement of asset from bank to firm.
Firm Bank
Bank Firm
SAVINGS BANK A/c OPERATIONS
Transaction No 1
Jan 5, 2006, Cash withdrawal Rs.10,000 from the bank is having the following journal entry
Cash A/c Dr Rs.10,000
To Bank A/c Cr Rs.10,000
(Being cash withdrawn from the bank A/c)
From the above entry, it is obviously understood that the bank is the giver of the cash
resources from the savings bank a/c and cash receipts are made only due to withdrawal
of cash from the bank
There are two different angles of cash withdrawal one is in the dimension of firm and
another is bank.
Firm Bank
Cash receipts Cash Payments
40
* Bank overdraft
The above table of double columnar cash book clearly elucidates the contra entry process Trial Balance
taken place in between two entities viz firm and bank .
42
Trial Balance M/s Brown Trial Balance
43
Accounting and Finance Annexure-I
for Managers
Proforma Trial Balance
2.10 KEYWORDS
Trial Balance
Subsidiary Journals 45
Accounting and Finance Purchase books
for Managers
Acceptor
Cash Transaction
Double Columnar Cash book
Petty Cash book
46
LESSON
3
FINAL ACCOUNTS
CONTENTS
3.0 Aims and Objectives
3.1 Introduction
3.2 Trading Account
3.2.1 Balancing Process
3.3 Profit & Loss Account
3.4 Balance Sheet
3.4.1 Cash Method of Accounting
3.4.2 Mercantile Method of Accounting
3.5 Let us Sum up
3.6 Lesson-end Activity
3.7 Keywords
3.8 Questions for Discussion
3.9 Suggested Readings
3.1 INTRODUCTION
The preparation of Final accounts the business firm involves two different stages viz Preparation
of Accounting and Positional Statements of the enterprise. The preparation of Accounting
statements involve two different categories viz Trading account and Profit & Loss account.
The preparation of the positional statement involves only one statement viz Balance
sheet. In this chapter the accounting statements as well as Balance sheet will be elaborately
discussed to the tune of adjustments. First the trading account contents and format are
discussed to determine the Profit and Loss under the trading account of the business
firm, i.e. Gross profit.
Second part of this chapter deals with the preparation of Profit & Loss account in order
to determine the operating profit & loss of the enterprise.
Third part of the chapter involves in the preparation of financial position of the enterprise
in terms of Liabilities and Assets.
** Gross Loss is the outcome of an excess of the debit side total over the total of credit
side. It means that the gross loss is the excess of expenses in the debit side over the
incomes in the credit side.
Gross Loss = [EXPENSES (DEBIT)> INCOMES(CREDIT)]
*Gross profit Rs. 5, 000 is the resultant of excess income over the expenses.
The total of the credit side more than the debit side total of the trading account.
Illustration 2 with Opening stock, various kinds of purchases and sales, Closing
stock
From the following information, prepare the trading account for the year ended 31st
48 Mar, 2006.
Rs. Final Accounts
The balancing process of the profit and loss account leads to two different categories
*Net profit is the resultant of excess of income in the credit side over the expenses in
the debit side of the Profit and Loss account
** Net Loss is an outcome of excess of expenses in the debit side over the incomes in
the credit side
Illustration 4
From the following information, Prepare the Profit and Loss account
Debit Credit
Rs Rs
Gross profit from the trading account 1, 00, 000
Manager Salary 30, 000
Office lighting 5, 000
Office Rent 15, 000
Local Taxes 1, 000
Salary paid to salesmen 20, 000 51
Accounting and Finance Commission charges paid 10, 000
for Managers
Legal charges paid 3, 000
Bad debts 1, 500
Advertising charges 25, 000
Package charges 7, 500
Discount allowed 3, 000
Discount received 4, 000
Dividend received 2, 000
Rent received 1, 000
Depreciation charges 10, 000
Repairs and Maintenance 2, 500
Interest on loans 1, 500 500
Dr Profit and Loss account for the year ended …………………………… Cr
Rs Rs
To Manager Salary 30,000 By Gross profit B/d 1,00,000
To Office lighting 5,000 By Discount received 4,000
To Office Rent 15,000 By Dividend received 2,000
To Salary paid salesman 20,000 By Rent received 1,000
To commission charges 10,000 By Interest received 500
To Legal charges 3,000 By Net Loss c/d* 24,500
To Bad debts 1,500
To Advertising charges 25,000
To Package charges 7,500
To Depreciation charges 10,000
To Repairs and maintenance 2,500
To Interest on loan 1,500
To Local taxes 1000
1,32,000 1,32,000
* Net loss is the excess of the expenses total in the debit side Rs. 24, 500 over the
incomes total in the credit side of the profit and loss account.
52
Final Accounts
Liabilities Rs Assets Rs
Capital XXXX Land & Building XXXX
Less: Drawings XXX Plant & Machinery XXXX
Add: Net profit XXXX Furniture& fittings XXXX
XXXX Fixtures& tools XXXX
Long-term borrowings XXXX Marketable securities XXXX
Sundry creditor XXX Closing stock XXXX
Bills payable XXX Sundry debtors XXXX
Bank overdraft XXX Bills receivable XXXX
Outstanding expenses XXX Pre paid expenses XXXX
Pre received income XXX Cash at Bank XXXX
Cash in hand XXXX
Total liabilities XXXX Total Assets XXXX
Cash in hand XXXX
Total liabilities XXXX Total Assets XXXX
The downward arrow shows the order / arrangement of the assets and liabilities on the
basis of permanence or long lastingness
The upward arrow shows the order /arrangement of the assets and liabilities on the
basis of liquidity.
Methods of determining the accounting income includes:
i. Cash method of accounting
ii. Mercantile method of accounting
1. Why land and building is given greater priority under the order of permanence?
2. Why cash in hand is given greater priority under the order of liquidity?
Adjustment entries
The adjustment entries are classified into three segments viz on expenses, incomes and others. 53
Accounting and Finance On expenses
for Managers
The adjustment entries on expense can be classified into two categories
(i) Outstanding Expenses: These are incurred expenses but not paid in cash
E.g. Rent of the office is Rs. 22, 000 for 11 months only The enterprise has failed
to remit the payment of last month rent amounted Rs. 2, 000. According to mercantile
system of accounting, the rent of the office, whether fully paid or not, it should be
totally considered for the entire duration to determine the income of the enterprise.
Finally, what is to be done ? The amount of actual rental should be added with the
rent which has not been paid by the enterprise i-e (Rs. 22, 000+Rs. 2, 000=Rs. 24,
000)
Treatment of the transaction
Debit the expense account
Credit the liability i-e of the person to whom the amount to be paid
Profit &Loss A/c:- Add the outstanding amount with the total expenses already paid
Balance sheet:-Include it as an item of responsibility under the liabilities side
(ii) Prepaid expenses: Normally, some of the expenses paid for availing the services
are not fully extracted during the term; which left / unused should be normally
carried forward to the next term. It means that the expense which is paid in
advance to make use of the service for forthcoming period to whom is known as
debtor; the person who keeps the money of the enterprise for the definite duration
is nothing but an asset.
Debit the asset - Advance payment for service
Credit
Profit the expense
&Loss A/c:- Deduct the prepaid amount from the total expenses already paid
Balance sheet:-Include it as an item of application under the assets side
(v) Bad debts: Bad debts is the result of credit sales which only due to the inability of
customers / consumers to settle the overdue. The inability may be due to poor
repaying capacity or insolvent during the moment of the sales. The bad debt due to
the inability cannot be deducted from the sales volume which was already transacted.
The debts cannot be recovered has to be treated as a loss of the firm.
Debit all losses of the firm. The losses due to bad debts should be appropriately
effected as well as adjusted in the individuals' account i-e in the consumers' account
who received the goods on credit
Profit &Loss A/c:- Non recovery of credit sales is deemed to be a losses – should be debited to
Profit & Loss A/c
Balance sheet:-Non recovery of credit sales should be deducted from the volume of credit sales
transacted by the firm under the Assets side in order to determine the original amount of credit
outstanding
Illustration 5
From the following information extracted from the books of Jain & Co, Prepare Trading,
Profit & Loss A/c for the year ended and Balance sheet as on that date.
Particulars Debit Rs Credit Rs
Purchase 90,300
Sales 1,37,200
Return inward 2,200
Stock 1.1.96 40,000
Drawing 5,000
Building 30,000
Machinery 20,000
Furniture 8,000
Debtors 25,000
Wages 3,000
Carriage inwards 2,000
Rent and Rates 1,500
Bad debts 1,000
Cash 3,500
Investment 10,000
Postages 2,500
Insurance 2,000
Return outwards 1,300
Capital 50,000
Creditors 24,000
Interest 500
Commission 3,250
Provision Bad debts 750
Bank O/d 40,000
Salaries 11,000
Total 2,57,000 2,57,000
Additional Information:
1. Value of the stock on 31. 12. 96 Rs. 65, 000
2. Goods worth Rs 800 for his personal use of the proprietor
3. Rs. 400 of insurance paid is nothing but advance payment
4. Salary Rs. 1000 for the month of Dec 1996 has not yet paid outstanding
5. Charge depreciation
a. Building 2% per annum
b. Machinery 10% per annum
c. Furniture 15% per annum
6. Maintain provision for doubtful debts @ 5% on sundry debtors. Prepare Trading
and Profit & Loss Account of Jain & Co for the year ended 1995-96
Dr Rs Rs Rs Rs Cr
To Opening stock 40,000 By Sales 1,37,200
To Purchases 90,300 (-) Return Inward 2,200
(-)Purchase Return 1,300 1,35,000
(-) Goods taken by 800 By Closing Stock 65,000
56 proprietor
Contd...
To Net purchases 88,200 Final Accounts
To Wages 3,000
To Carriageinward 2,000
To Gross Profit c/d 66,800
(Balancing figure)
2,00,000 2,00,000
To Rent & Rates 1,500 By Gross profit B/d 66,800
To Bad Debts 1000 By Commission 3,250
To Postages 2,500 By Interest 500
To Insurance 2,000
(-) Prepaid 400
1,600
To Salaries 11,000
(+)O/s of Salary 1,000
12,000
To New Provision 5% 1,250
on Sundry Debtors-
Rs.25,000
(-)Old Provision 750
500
To Depreciation
Building 2% 600
Machinery 10% 2,000
Furniture15% 1,200 3,800
To Net profit c/d 47,650
(Balancing figure)
70,550 70,550
Illustration 6
From the following information drawn from the books of M/s Sundaran & Co prepare
Trading, Profit & Loss account for the year ended 31st Mar, 2004 and Balance sheet as
on dated
Particulars Debit (Rs.) Credit (Rs.)
Sundaran’s Capital 1,81,000
Sundaran’s Drawings 36,000
Plant and Machinery Balance on 1st April 2003 1,20,000
Plant and machinery additions on 1st Oct,2003 25,000
Stock opening 95,000
Purchases 7,82,000
Return Inwards 12,000 57
Contd...
Accounting and Finance Sundry debtors 20,600
for Managers Furniture & Fixture 15,000
Freight duty 2,000
Rent Rate and Taxes 24,600
Printing stationery 3,800
Trade expenses 5,400
Sundry creditors 40,000
Sales 9,80,000
Return outwards 3,000
Postage & Telegsundaram 800
Provision for bad debts 400
Discounts 1,800
7,200
Rent of the premises sub let for the year upto 30th Sept2004
Insurance charge 2,700
Salaries & wages 31,300
Cash in hand 6,200
Cash at bank 30,500
Carriage outwards 500
Total 12,13,400 12,13,400
Additional Information
1. Stock on 31st Mar, 2004 Rs. 94, 600
2. Write off Rs. 600 as bad debts
3. Provision for doubtful debts 5%on debtors
4. Create a provision on for discount on debtors & Reserve for creditors 2%
5. Provide a depreciation on furniture and fixture at 5% per @
6. Plant machinery depreciation 20%
7. Insurance unexpired Rs. 100
8. A fire occurred on 25th Mar 2004 in God own and the stock of the value of the 5000
destroyed fully insured the insurance admitted claim fully yet to be paid.
Trading account M/s. Sundaran &Co for the year ended 2003-04
Dr Rs Rs Rs Rs Cr
To opening stock 95,000 By sales 9,80,000
To Purchase 7,82,000 (-) Return 12,000 9,68,000
(-)Returns 3000 Closing stock 94,600
To Net purchases 7,79,000 Goods 5,000
destroyed by
fire
Freight Duty 2,000
To Gross Profitc/d 1,91,600
10,67,600 10,67,600
Profit & Loss Account of M/s. Sundaran &Co for the year ended 2003-04
Dr Rs Rs Rs Rs Cr
To Carriage Outwards By Gross profit B/d 1,91,600
500 Transferred from trading
account
To rent, rate and taxes 24,600 By discount 1,800
To painting & 3,800 By Rent of Sublet 7,200
stationery
Trade expenses 5,400 (-) Advance receipt rent of 3,600
sublet for 6 months:7,200/12
monts= Rs.600 P.M
For 6 months
Postage and telegram 800 3,600
Insurance charge 2,700 By 2% reserve on sundry 800
58 creditors
Contd...
(-) unexpired 100 Final Accounts
2,600
Salaries and wages 31,300
ToDepreciation 750
Furniture and Fixture
@5% on Rs.15,000
Plant and machinery 24,000
1st April 2003@20%
on Rs.1,20,000 (12
months)
Plant and machinery 2,500
1st Oct,2003 @20% on
Rs.25,000(6 months)
26,500
To Bad debts write off 600
To New provision 1000
(-)Old provision 400
To provision to be 600
created
To discount on debtors 380
2%
To Net profit c/d 99,970
Transferred to Balance
sheet
1,97,800 1,97,800
Illustration 7
From the following figures extracted from the books of M/s Amal &Vimal 31st Mar, 02
Particulars Debit(Rs) Credit (Rs)
Opening stock 30,000
Purchases 1,10,000
Sales 2,50,000
Building 55,000
Wages 23,000
Carriage inwards 3,000
Bills payable 10,000
Furniture 9000
Salaries 42,000
59
Advertisement 24,000
Contd...
Accounting and Finance Coal and coke 2,000
for Managers Cash at bank 14,000
Pre paid wages 1,000
Depreciation fund investment 25,000
Machinery at cost(Rs.10,000 New) 60,000
Sundry debtors 20,000
Bad debts 3,000
Depreciation fund 25,000
Sundry creditors 24,000
Rent rate and taxes 4,000
Trade expense 4000
Capital Amal 50,000
Vimal 40,000
Petty expenses 4,000
Provision for doubtful debts 1,000
Gas and water 1,200
Cash in hand 800
Outstanding rent 400
Adjustment entries:
a. The partners share profit and losses Amal 2/5 and Vimal 3/5
b. closing stock Rs. 15, 000
c. stock valued at Rs. 10, 000 was destroyed by fire but insurance company admitted
a claim of 8, 500 only and the claim is not yet paid.
d. Wages include Rs. 2, 000 for installation of anew machinery on 1st Dec., 2005
e. Depreciate the machinery at 10% per annum
Trading account of M/sVimal & Amal & Co for the year ended 2001-02
Dr Rs Rs Rs Rs Cr
To opening stock 30,000 By sales 2,50,000
To purchases 1,10,000 By closing stock 15,000
To wages 23,000 By goods destroyed 10,000
(-)Erection 2,000
21,000
To Coal and coke 2,000
To Gas and water 1,200
To Carriage inwards 3,000
To Gross profitc/d 1,07,800
2,75,000 2,75,000
Profit & Loss account of M/s Vimal& Amal &Co for the year ended 2001-02
Dr Rs Rs Rs Rs Cr
To Salaries 42,000 By Gross 1,07,800
profitB/d
To Advertisement 24,000
To Bad debts 3,000
To Trade expenses 4,000
To Rent, rates & Taxes 4,000
To Depreciation(d) 5,400
To Insurance Loss 10,000
Admitted claim 8,500
1,500
To petty expenses 4,000
To Net profit l
Amal 7,960
Vimal 11,940
19,900
60 Total 1,07,800 Total 1,07,800
Balance sheet of M/s Vimal & Amal &Co as on dated 31st Mar, 2002 Final Accounts
Due to the difference in the trial balance, an examination of the goods was conducted
which reveals following errors.
Rs. 25 paid to the conveyance was debited to motor van maintenance account
Rs. 2, 000 drawn from bank towards for establishment charges was omitted to posted in
to ledger.
Cash column in the cash book on the receipt side stands excess total by Rs. 400
Adjustment entries:
a. Establishment of charges have been paid only up to Nov & provision of Rs 2, 000
61
has to be made for Dec.
Accounting and Finance b. Electricity charges are O/s Rs. 25
for Managers
c. (½) commission on total sales is payable to salesmen, towards which Rs. 1000 as
paid in advance.
d. Fixed deposit earns interest at 9% per annum
e. Provide depreciation 20% per annum on motor car
f. Closing stock 31st Dec., 2003
To prepare the trial balance, the following necessary corrections should be made on the
respective accounting heads given.
I. Rs. 25 paid to the conveyance was debited to motor van maintenance account-
The errors to be rectified which is known as error without affecting the trial balance.
Rs. 25 should be deducted from the Motor maintenance account for the wrong
entry debited already but at the same time right entry has to be made under the
conveyance account through the addition of Rs. 25 i.e., Rs. 25 to be debited.
To put it in to nutshell, Rs 25 should be deducted from the total of Motor maintenance
account in order to cancel the wrong debit entry i.e.
Rs. 23, 425-Rs. 25=Rs. 23, 400
To effect the correct entry, Rs. 25 should be to the original conveyance account
i.e.
Rs. 3, 816+Rs. 25= Rs. 3, 841/-
II. Rs. 2, 000 was drawn from the bank omitted in the establishment charges account;
which is meant for the purpose. -
Rs. 2, 000 should be added to the establishment charges account total in order to
identify the total of establishment charges.
Total establishment charges = Rs. 22, 000+ Rs. 2000= Rs. 24, 000
III. Cash column in the cash book on the receipt side excess total Rs. 400 i.e. Rs. 400
excess total should corrected on the given balance of cash in hand in order to
determine the real volume of cash in hand.
Real volume of cash in hand = Rs. 1, 823-Rs. 400 = Rs, 1423
Now we have to illustrate the corrected trial balance by incorporating the above
given changes.
Particulars Trial Balance Debit Rs Credit Rs
Capital 6,00,000
Drawings 12,000
Buildings 2,00,000
Furniture & Fittings 30,000
Depreciation Reserve 13,000
Purchases 4,00,000
Sundry creditors 40,000
Sales 5,00,000
Debtors 1,20,000
Establishment charges Rs.20,000 22,000
Electricity charges 6,575
Postage & telegram 1,284
Traveling& Conveyance 3,841
Advance for salesmen commission 1,000
Insurance 2,500
62 Rent received 12,000
Contd...
Motor van (purchased 1.1.2003 80,000 Final Accounts
Motor van maintenance 23,400
Fixed deposit 1,00,000
Cash in hand 1,423
Cash at bank 1,47,977
Depreciation 13,000
Total 11,65,000 11,65,000
Rs Rs Rs Rs
Profit & Loss account for the year ended 31st Dec, 2003
To Insurance 2,500 By Gross 2,00,000
profitB/d
To motor 23,400 By Rent received 12,000
maintenance
To establishment 22,000 Interest received 3,000
charge
Dec provision 2,000
24,000
To Traveling & 3,841
conveyance
To Postage and 1,284
telegram
To electricity charges 6,575
O/s E.B charges 25
6,600
To depreciation 13,000
To sales commission 1,000
paid
To commission O/s 1,500
2,500
To Depreciation of 16,000
motor van @ 20%
To Net profit c/d 1,21,875
2,15,000 2,15,000
Liablities Rs Rs Assets Rs Rs
Capital 6,00,000 Cash in hand 1,423
(+)Net profit 1,21,875 Cash at bank 1,47,977
7,21,875 Fixed Deposit 1,00,000
(-)Drawings 12,000 Interest 3,000
7,09,875 Motor van 64,000
Sundry creditors 40,000 Sundry debtors 1,20,000
Provision for 2,000 Building 2,00,000
establishment
charges
Electrical charges 25 (-)Reserve 10,000 1,90,000
O/s Commission 1,500 Furniture 30,000
(-) Reserve 3,000 27,000
Closing stock 1,00,000
7,53,400 7,53,400
63
Accounting and Finance Pandit Broths for the year ended 31st Mar, 2006
for Managers
Particulars Debit Rs Credit Rs
Capital A.Pandit 1,00,000
B.Pandit 1,00,000
Drawings A Pandit 16,000
B.Pandit 16,000
Buildings 80,000
Furniture & fittings 20,000
Purchases 2,00,000
Sales 3,00,000
Stock 1.4.2005 50,000
Wages & salaries 44,000
Rates & Taxes 1,600
Office expenses 60,000
Sundry debtors 25,000
Sundry creditors 12,000
Cash in hand 400
Cash at Bank O/D 29,000
Freight inwards 28,000
Total 5,41,000 5,41,000
Adjustment:
a. Closing stock Rs. 1, 14, 500
b. There was fire in the premises on 25th Nov, 2005, which damaged the portion of
the stock the loss was estimated Rs. 17, 500
c. A. Pandit is the in-charge of purchases of stock item & he is to be paid 2. 5% on
such purchases
d. A steel table purchased 1st Feb Rs. 3, 000 debited to purchase account
e. B. Pandit who looks after all aspect other than purchases is entitled to the
commission of 5% on Net profits of after charging commission
f. Depreciation is to be charged at 2. 5% per annum on building & 10% on furniture
fittings profits or losses or share equally for the partners.
Dr Trading account for the year ended 2005-06 Cr
Rs Rs Rs Rs
To Opening Stock 50,000 By Sales 3,00,000
Purchases 2,00,000 By Closing stock 1,14,500
(-)Purchase of table 3,000 By Goods Loss by fire 17,500
1,97,000
(+)Commission to 4,925
A.Pandit
2,01,925
To Carriage inwards 28,000
To Wages & Salary 44,000
To Gross profit 1,08,075
c/ d
Total 4,32,000 Total. 4,32,000
Liabilities Assets
Capital(A.Pandit) 1,00,000 Building 80,0000
(+) Commission 4,925 Depreciation 2.5% 2,000
1,04,925 78,000
(+)Net profit 11,869 Furniture 23,000
1,16,794 Depreciation 10% 2,050
(-)Drawings 16,000 20,950
1,00,794 Closing stock 1,14,500
Capital( B.Pandit) 1,00,000 Sundry Debtors 25,000
(+)Commission 1,187 Cash in hand 400
1,01,187
(+) Net profit 11,869
1,13,056
(-)Drawings 16,000 97,056
Bank overdraft 29,000
Sundry creditors 12,000
2,38,850 2,38,850
3.7 KEYWORDS
Trading account: It is the accounting statement of revenues and expenses 65
Accounting and Finance Balance Sheet: It is nothing but a positional statement of assets and liabilities of the firm
for Managers
on a particular date
G. P- Gross profit: Resultant of excess of trading incomes over the expenses
G. L-Gross Loss: Resultant of excess of trading expenses over the incomes/ revenues
N. P- Net profit: Resultant of excess of Profit & Loss incomes /revenues over the
expenses
N. L-Net Loss: Resultant of excess of Profit & Loss expenses over the incomes
66
CHAPTER
4
DEPRECIATION ACCOUNTING
CONTENTS
4.0 Aims and Objectives
4.1 Introduction
4.6 Dissimilarities in between the Straight Line Method and Written Down Value Method
4.9 Keywords
4.1 INTRODUCTION
The depreciation accounting is mainly based on the concept of income. The concept of
income is matching of revenues with expenses. The goods purchased are frequently
matched through immediate sale or within a year. The crux of the concept of income is
that the expenses are to be matched against the revenues. The ultimate aim of matching
is done in order to determine the volume of profit or loss of the transaction. If the assets
are nothing but long term assets procured by the enterprise should be matched against
Accounting and Finance the revenues of them. The matching of expenditure of the assets incurred by the firm at
for Managers
the time of purchase against the revenues is the hard core task of the firm. Why it is
being considered as a cumbersome task in matching ? The benefits/revenues of the
fixed assets expected to accrue for many number of years but not within a year. The
initial investment on the assets at the time of purchase should be matched against the
revenue pattern of the same year after year in order to find out the profitability of the
long term investment. To have an effective matching against the revenues on every
year, the amount of purchase has to be stretched. The stretching of expenses into many
years is known as depreciation.
l To recover the cost: The depreciation charge is a mean to recover the cost of
operations of the enterprise. More specifically to recover the cost of asset procured
which is in usage.
l To facilitate the induction of new asset: To replace the old one, the new asset has
to be purchased only with the help of depreciation charge
l To find out the correct P&L accounting balance
l To know the original position of the enterprise through proper adjustments on the
fixed assets
(1) Depreciation is
(a) Capital expenditure (b) Revenue expenditure
(c) Expense (d) Non recurring expenditure
(2) Depreciation accounting facilitates to know
(a) Original value of the asset (b) Realisable value of the asset
(c) Book value of the asset (d) Both (a) & (c)
(3) Depreciation is an item to be recorded finally in the
(a) Trading account (b) Profit & Loss account
(c) Balance sheet (d) Profit & Loss A/c and
Balance Sheet
From the above table, Rs. 20, 000 is charged on every year to recover Rs. 1, 00, 000
during its life period i.e. 5 years
Illustration 2
Original value of the investment- Rs. 1, 00, 000
Scrap value – Rs. 10, 000
Life of the asset -5 years
To understand the methodology of straight line depreciation, the following table will illustrate
the process
Value of the asset (Begin) Rs Depreciation Rs Value of the asset End Rs
71
Accounting and Finance l For the accounting entry III year depreciation Rs Rs
for Managers
31st March, 2002 Depreciation A/c Dr 16,000
l The next account involved is the scrap value account which amounted Rs 10, 000
While selling the residual portion of the asset, the firm is able to receive Rs. 10, 000
as receipt as cash. The sale of residual part of the machinery leads to bring cash
resources inside the firm and inturn the plant and machinery is going out of the
firm.
l For the accounting entry of scrap value Rs Rs
31st March, 2004 Cash A/c Dr 10,000
l The next transaction is the final transaction pertaining to the posting of depreciation
accounting balance under the P& L account
l It is nothing but the transfer of Depreciation accounting balance into P&L account
At the end of every year immediately after finalizing the accounting balance of
depreciation is regularly posted under the P&L account.
l The journal entry transfer is carried out as follows
l For the I year depreciation transfer to P&L A/c Rs Rs
31st March, 2000 P&L A/c Dr 16,000
The preparation of Plant & Machinery account : It is very simple to prepare the machinery
Ledger account
Dr Plant & Machinery I Yr Cr
By Balance c/d
transferred to
Second year Plant & Machinery
A/C 74,000
90,000 90,000
74,000 74,000
73
Accounting and Finance Dr Plant & Machinery A/c III Yr Cr
for Managers
Date Particular Rs Date Particulars Rs
58,000 58,000
26,000 26,000
M/s Muruganand &Co is a trader bought furniture costing Rs 2, 20, 000 for his new
branch on 1st April, 2000. As the furniture bought was superior quality material. The
auditors estimated its residual valued at Rs. 20, 000 after a working life of ten years.
Further additions were made into the same category on 1st Oct, 2001 and 1st April, 2002
which costing Rs 16, 800 and Rs. 19, 000 (with a scrap value of Rs 800 and Rs. 1000
respectively). The trader closed his accounts on 31st Mar every year and wanted to
apply straight line method of depreciation. Show the furniture a/c for four years.
First step is to find out the depreciation of the furniture for various number of years i-e 4
years. The depreciation is to be calculated on every year.
The most important point to be borne in our mind while calculating depreciation, the
following points to be taken into consideration
First, is there any % of depreciation charge given. If given, the depreciation to be
calculated on the volume of available balance at the end.
Secondly, if the % of depreciation charge is not given in our problem, How the volume of
depreciation can be calculated ?
The depreciation can be calculated as follows
Original value of the asset - Scrap value
Deprecation =
Life period of the asset
In this problem, due to absence of depreciation %, the above illustrated formula should
have to be applied throughout the problem
Date of Purchase First Second Third Total
Furniture furniture Furniture Depreciation
cost
2000 2001 2002
Particulars
Rs
Rs Rs Rs
75
Accounting and Finance Accounting Entries are as follows:
for Managers
During the year 1st April 2, 000; Rs. 2, 20, 000 worth of furniture was bought
Rs Rs
1 April,2000 Furniture A/c Dr 2,20,000
Being the depreciation charged for the second furniture for 6 months
In the next step, the furniture account to be prepared for every year
Furniture A/c (2000-01)
2,20,000 2,20,000
2,16,800 2,16,800
By Depreciation 1,800
2,15,000 2,15,000
By Depreciation 1,600
By Depreciation 1,800
1,91,600 1,91,600
Merits
l It is simple to calculate only due to fixed depreciation charge on the value of the
asset
l The value of the asset is depleted to either zero or scrap value of the asset
l This method is most suited for patents trade marks and so on
78
Demerits Depreciation Accounting
l The utility of the asset is not considered at the moment of charging constant
depreciation over the asset
l During the later years of the asset, the efficiency will automatically come down
and simultaneously the maintenance cost of the asset will rigger up which is illogical
in charging fixed charge throughout the life period of the asset
= 1-(S/C)1/n
The meaning of the above illustrated formulae is discussed through the explanation of
two different components.
First one is (S/C)1/n , the ration of the scrap value of the asset on the original value of
the asset is appropriately apportioned throughout the life period of the assets. It is nothing
but the percentage of scrap value widened across the life period of the asset. Once the
scrap value percentage is known, the next important step is to determine the depreciable
value of the asset. The depreciable value of the asset can be derived by deducting the
percentage from No 1.
Illustration 5
Life of the asset (n)=3 years
Expected scrap value at the end of 3 years= Rs. 12, 800
Original Investment=Rs. 2, 00, 000
Find out the percentage of depreciation to be charged
Under this method, to charge depreciation as well as to find out the value of the asset as
on a particular date, the depreciation percentage must be given. In this problem,
depreciation % is not given, in order to determine the above illustrated formulae should
be applied
= 1-(S/C)1/n
=1-(Rs. 12, 800/Rs. 2, 00, 000)(1/3)
=1-4/10=6/10=60%
The following workings will obviously facilitate to understand the charge of depreciation
The value of the Asset at the beginning of 1st Year = Rs. 2, 00, 000
(-) Depreciation 60% on Rs. 2, 00, 000 (Original value ) = Rs. 1, 20, 000
Value of the asset at the beginning of 2nd Year = Rs. 80, 000
(-)Depreciation 60% on Rs 1, 20, 000. (Book Value) = Rs. 48, 000
79
Accounting and Finance Value of the asset at the beginning of 3rd Year = Rs. 32, 000
for Managers
(-)Depreciation 60% on Rs 32, 000( Book Value) = Rs. 19, 200
Value of the asset at the end of the year = Rs. 12, 800
Depreciation
Illustration 6
On 1st April, 2000, a firm purchases machinery worth Rs. 3, 00, 000. On 1st Oct, 2002 it
buys additional machinery worth Rs. 60, 000 and spends Rs. 6, 000 on its erection. The
accounts are closed normally on 31 Mar. Assuming the annual depreciation to be 10%
Show the machinery account for 3 years under the written down value method.
After passing the journal entries, the next step is to prepare ledger account of machinery
Machinery A /c (2000-01)
Dr Cr
Date Particulars Amount Date Particulars Amount
Rs Rs
1st To Bank 3,00,000 31st By Depreciation 30,000
April,2000 Mar,2001
By Balance c/d 2,70,000
3,00,000 3,00,000
31st To Balance B/d 2,70,000
Mar,2001 Transfer to
Machinery A/c
(20001-02) 81
Accounting and Finance MachineryA/c (2001-02)
for Managers
Dr Cr
Date Particulars Amount Date Particulars Amount
Rs Rs
1st To Balance B/d 2,70,000 31 st By Depreciation 27,000
April,2000 Mar,2001
By Balance c/d 2,43,000
2,70,000 2,70,000
31st To Balance B/d 2,43,000
Mar,2001 Transfer to
Machinery A/c
(2002-03)
4.9 KEYWORDS
Depreciation: Continuous reduction/ decrease /diminution in the value of the asset
Depreciation accounting: Recording the entries of depreciation through journal, ledger
accounts of Depreciation, Fixed asset and Profit & Loss account.
Original Value of the asset: The value of the asset at the time of purchase or acquisition
Book Value of the asset: The value of the asset after deducting the depreciation from
the value of the asset at the beginning.
Scrap value of the asset: It is the value at the end of the life period of the asset; at
when the asset cannot be put for further usage.
83
UNIT-II
LESSON
5
FINANCIAL STATEMENT ANALYSIS
CONTENTS
5.0 Aims and Objectives
5.1 Introduction
5.2 Definition & Classification of Financial Statement Analysis
5.3 Comparative Financial Statements
5.4 Trend Percentage Analysis
5.5 Let us Sum up
5.6 Lesson-end Activity
5.7 Keywords
5.8 Questions for Discussion
5.9 Suggested Readings
5.1 INTRODUCTION
The financial statements are affording many facts though they are absolute and concrete
in terms; but not in a position to interpret and analyse the stature of the enterprise. To
analyse and interpret, the financial statement analysis is being applied across the financial
statements viz Trading, Profit & Loss Account and Balance sheet.
Under the financial statement analysis, the information available are grouped together in
order to cull out the meaningful relationship which is already available among them; for
interpretation and analysis.
Comparison in between financial statements Comparison in between the financial statements of various
of two or more years firms or industrial average
The first step we have to segregate the available information into two different categories
viz Assets and Liabilities
l The firm has registered 25% increase in sales from the year 2004 to 2005
l Cost of goods sold raised 30% from the year 2004 to 2005
l There is no change in the level of operating expenses
l The firm has got 22. 22% increase in the level of net profits from the year 2004 to
2005
Illustration 3
From the following information, prepare a comparative income statement:
Particulars 2001 Rs 2002 Rs
Sales 10,00,000 8,00,000
Cost of goods sold 6,00,000 4,00,000
Administration Expenses 2,00,000 1,40,000
Other Income 40,000 20,000
Income tax 1,20,000 1,40,000
For this problem, the inferences could be enlisted according to the comparative statement
analysis on Profit & Loss Accounts of two different year viz 2001 and 2002.
The next important tool of financial statement analysis is a common size statement
analysis which known as predominant tool in intra firm analysis in studying the share of
each component.
The components are translated into percentage for analysis and interpretations. For
profit and loss account, Net sales is considered as a base for the computation of a share
of each financial factor available.
For Balance sheet, total volume of assets and liabilities are taken into consideration for
the computation of a share of each financial factor available under the heading of assets
and liabilities.
Illustration 4
Prepare the common size statement analysis for the firm ABC ltd
Liabilities 1990Rs 1991Rs Assets 1990Rs 1991 Rs
Share capital 2,00,000 3,00,000 Fixed assets 2,25,000 4,00,000
Reserves and 1,00,000 2,00,000 Stock 1,29,000 2,00,000
surpluses
Bank overdraft 60,000 2,00,000 Quick assets 46,000 2,00,000
Quick liabilities 40,000 1,00,000
The above illustration highlights the share of every component in the balance sheet out
of the total volume of assets and liabilities.
This will certainly facilitate the firm to easily understand not only the share of every
component but also facilitates to have a meaningful and relevant comparison with various
time horizons.
From the following table, prepare the common size statement analysis:
92
Financial Statement Analysis
Check Your Progress
(c) To undergo financial planning based upon the yester financial performance
Current year
= × 100
Base year
This trend ratio is being computed for every component for many number of years
which not only facilitates comparison but also guides the firm to understand the trend
path of the firm.
5.7 KEYWORDS
Balance Sheet
Financial Statement
Financial data
Assets
Firm
5. 9 SUGGESTED READINGS
R. L. Gupta and Radhaswamy, “Advanced Accountancy”.
V. K. Goyal, “Financial Accounting”, Excel Books, New Delhi.
Khan and Jain, “Management Accounting”.
S. N. Maheswari, “Management Accounting”.
S. Bhat, “Financial Management”, Excel Books, New Delhi.
Prasanna Chandra, “Financial Management – Theory and Practice”, Tata McGraw
Hill, New Delhi (1994).
I. M. Pandey, “Financial Management”, Vikas Publishing, New Delhi.
Nitin Balwani, “Accounting & Finance for Managers”, Excel Books, New Delhi.
94
LESSON
6
RATIO ANALYSIS
CONTENTS
6.0 Aims and Objectives
6.1 Introduction
6.2 Definition
6.3 How the Accounting Ratios are Expressed?
6.4 Purpose, Utility & Limitations of Ratio Analysis
6.5 Classification of Ratios
6.6 Short-term Solvency Ratios
6.6.1 Current Assets Ratio
6.7 Standard Norm of the Current Ratio
6.7.1 Implication of High Ratio of Current Assets over the Current Liabilities
6.7.2 Limitation of the Current Ratio
6.7.3 Acid Test Ratio
6.7.4 Super Quick Assets Ratio
6.8 Capital Structure Ratios
6.9 Debt–equity Ratio
6.9.1 Long-Term Debt-equity Ratio
6.9.2 Standard Norm of the Debt-equity Ratio
6.9.3 Total Debt–equity Ratio
6.10 Proprietary Ratio
6.11 Fixed Assets Ratio
6.12 Standard Norm of the Ratio
6.13 Coverage Ratios
6.13.1 Interest Coverage Ratio
6.13.2 Dividend Coverage Ratio
6.14 Return on Capital Employed
6.15 Stock Turnover Ratio
6.16 Debtors Turnover Ratio
6.16.1 Debtors Velocity
6.16.2 Creditors Turnover Ratio
6.17 Dupont Analysis
6.18 Let us Sum up
6.19 Lesson-end Activity
6.20 Keywords
6.21 Questions for Discussion
6.22 Suggested Readings
Accounting and Finance
for Managers 6.0 AIMS AND OBJECTIVES
In this lesson we shall discuss about ratio analysis. After going through this lesson you
will be able to:
(i) understand purpose, utility and limitations of ratio analysis
(ii) analyse classifications of ratios and Du pont analysis
6.1 INTRODUCTION
The ratio analysis is an one of the important tools of financial statement analysis to study
the financial stature of the business fleeces, corporate houses and so on.
How the ratios are able to facilitate to study the financial status of the enterprise ?
What is meant by ratio?
The ratio illustrates the relationship between the two related variables
What is meant by the accounting ratio?
The accounting ratios are computed on the basis available accounting information
extracted from the financial statements which are not in a position to reveal the status of
the enterprise.
The accounting ratios are applied to study the relationship between the quantitative
information available and to take decision on the financial performance of the firm.
6.2 DEFINITION
According to J. Betty, “The term accounting is used to describe relationships
significantly which exist in between figures ratio shown in a balance sheet, Profit
& Loss A/c, Trading A/c, Budgetary control system or in any part of the accounting
organization. ”
According to Myers “Study of relationship among the various financial factors of
the enterprise”
Expression
Current Ratio Net Profit Ratio Stock Turnover Ratio Fixed assets to
/Leverage Ratio capital
i. Easy to understand the financial position of the firm: The ratio analysis facilitates
the parties to read the changes taken place in the financial performance of the firm
from one time period to another.
ii. Measure of expressing the financial performance and position: It acts as a
measure of financial position through Liquidity ratios and Leverage ratios and also
a measure of financial performance through Profitability ratios and Turnover Ratios.
iii. Intra-firm analysis on the financial information over many number of years:
The financial performance and position of the firm can be analysed and interpreted
with in the firm in between the available financial information of many number of
years; which portrays either increase or decrease in the financial performance.
iv. Inter-firm analysis on the financial information within the industry: The
financial performance of the firm is studied and interpreted along with the similar
firms in the industry to identify the presence and status of the respective firm
among others.
v. Possibility for Financial planning and control: It not only guides the firm to earn
in accordance with the financial forecasting but also facilitates the firm to identify the
major source of expense which drastically has greater influence on the earnings.
Limitations of the Ratio Analysis are:
i. It is dependant tool of analysis: The perfection and effectiveness of the analysis
mainly depends upon the preparation of accurate and effectiveness of the financial
statements. It is subject to the availability of fair presentation of data in the financial
statements.
ii. Ambiguity in the handling of terms: If the tool of analysis taken for the study of
inter firm analysis on the profitability of the firms lead to various complications. To
study the profitability among the firms, most required financial information are
profits of the enterprise. The profit of one enterprise is taken for analysis is Profit
After Taxes (PAT) and another is considering Profit Before Interest and Taxes
(PBIT) and third one is taking Net profit for study consideration. The term profit
among the firms for the inter firm analysis is getting complicated due to ambiguity
or poor clarity on the terminology.
iii. Qualitative factors are not considered: Under the ratio analysis, the quantitative
factors only taken into consideration rather than qualitative factors of the enterprise.
The qualitative aspects of the customers and consumers are not considered at the
moment of preparing the financial statements but while granting credit on sales is
normally considered.
iv. Not ideal for the future forecasts: Ratio analysis is an outcome of analysis of
historical transactions known as Postmortem Analysis. The analysis is mainly
based on the yester performance which influences directly on the future planning
and forecasting ; it means that the analysis is mainly constructed on the past
information which will also resemble the same during the future analysis.
v. Time value of money is not considered: It does not give any room for time value
of money for future planning or forecasting of financial performance ; the main
reason is that the fundamental base for forecasting is taken from the yester periods
which never denominate the timing of the benefits.
What is meant by current assets /Current assets are nothing but available in the form of
cash, equivalent to cash or easily convertible in to cash.
What is meant by the current liabilities?
Current liabilities are nothing but short term financial resources or payable in short span
of time within a year.
Current Assets
Current =
Current Liabilities
Current Ratio
C ash at B an k :
C ash in H an d
99
Accounting and Finance
for Managers Liquid Assets
Acid Test Ratio ( Quick Assets Ratio) =
Current Liabilities
Liquid Asset = Current Assets – ( Closing Stock +Pre paid expenses)
Quick
Liquid Assets Ratio
Rs
Cash in hand 4,00,000
100 Sundry Debtors 1,60,000
Stock 2,40,000 Ratio Analysis
Current Liabilities:
Sundry creditors 3,00,000
Bills Payable 1,00,000
Illustration 2
The firm satisfies the standard norm of the current asset ratio and Liquid assets ratio
M/s Shanmuga &Co
Balance sheet as on dated 31st Mar, 2005
Particulars Rs. Particulars Rs.
Share capital 42,000 Fixed Assets Net 34,000
Reserve 3,000 Stock 12,400
Annual Profit 5,000 Debtors 6,400
Bank overdraft 4,000 Cash 13,200
Sundry creditors 12,000
Total 66,000 Total 66,000
Current Assets
Current Ratio =
Current Liabilities
Rs. 32,000
=
Rs.16,000
=2
It satisfies the standard norm of the current asset ratio
Quick assets Current Assets - Closing Stock
Liquid assets ratio = =
Current Liabilities Current Liabilities
Rs. 19,600
= = 1.225
Rs. 16,000
The firm financial position satisfies the standard norm of the Liquid assets ratio.
Illustration 3
Liquid Assets Rs. 65,000; Stock Rs. 20,000; Pre paid expenses Rs. 5,000; Working
capital Rs. 60, 000
Calculate current assets ratio and liquid assets ratio
For the computation of current assets ratio, current assets volume must be known. It is
not available in our problem, instead the liquid assets and prepaid expenses are given
together which will facilitate to find the total volume of current assets.
Current Assets= Liquid Asset + Prepaid expenses + closing stock
= Rs. 65,000 + Rs. 5,000+20,000
= Rs. 90,000
The next step is to find out the current liabilities. The volume of current liabilities could
be found out through the available information of working capital.
Net working capital= Current Assets- Current Liabilities
101
Accounting and Finance Rs. 60,000 = Rs. 70,000 - Current liabilities
for Managers
Current liabilities = Rs. 90,000 - Rs. 60,000= Rs. 30,000
From the above, the current ratio could be found out
Rs. 90,000
Current Ratio = =3> 2
Rs. 30,000
The firm satisfies the more than the norm of the current ratio. It means that the firm
keeps excessive current assets more than that of requirement.
Rs. 65,000
Quick Assets Ratio = = 2.17
Rs. 30, 000
The firm keeps more liquid assets than that of the specified norm means that excessive liquid
assets are held by the firm than the requirement in the form of idle not productive in utility.
Illustration 4
The current ratio of Bicon Ltd. is 4.5 :1 and liquidity ratio is 3:1 stock is Rs. 6,00,000 Find
out the current liabilities.
To find out the volume of current liabilities, initially the share of closing stock should be
found out in the total of current assets.
Share of stock =Current Assets Ratio – Liquid Assets Ratio
=4.5-3. 0=1.5
Share of the stock=1.5
If the share of the stock is 1.5 which amounted Rs. 6,00,000
What is the volume of current liabilities for the ration of 1?
Rs. 6,00,000
Current Liabilities = = 4,00,000
1.5
Capital Structure
It illustrates the firms’ ability in making the payment of preference dividend out of the
earnings available in the hands of the firm after the payment of taxation. If the size of the
Profits after taxation is greater means that greater the cushion for the payment of
preference dividend and vice versa.
The preference dividends are to be paid without fail irrespective of the profits available
in the hands of the firm after the taxation.
Profitability Ratios
The ratios are measuring the profitability of the firms in various angles viz
l On sales
l On investments
l On capital employed and so on
While discussing the measure of profitability of the firm, the profits are normally classified
into various categories
l Gross Profit
l Net Profit
l Earnings before interest and taxes
l Earnings after taxation and so on
All profitability ratios are normally expressed only in terms of (%). The return is normally
expressed only in terms of percentage which warrant the expression of this ratio to be
also in percentage.
GP Ratio: The ratio elucidates the relationship in between the Gross profit and sales
volume.
It facilitates to study the profit earning capacity of the firm out of the manufacturing or
Trading operations.
NP Ratio: The ratio expresses the relationship in between the Net profit and sales
volume. It facilitates to portray the overall operating efficiency of the firm. The net
profit ratio is an indicator of over all earning capacity of the firm in terms of return out
of sales volume.
Operating profit ratio: The operating ratio is establishing the relationship in between
the cost of goods sold and operating expenses with the total sales volume.
Return on Assets: This ratio portrays the relationship in between the earnings and total
assets employed in the business enterprise. It highlights the effective utilization of the
assets of the firm through the determination of return on total assets employed.
Activity turnover ratio: It highlights the relationship in between the sales and various
assets. The ratio indicates that the rate of speed which is taken by the firm for converting
the assets into sales.
Higher the ratio is better the firm in converting the stock into sales and vice versa
The next step is to find out the number of days or weeks or months taken or consumed
by the firm to convert the stock into sales volume.
365days/52weeks/12months
Debtors velocity =
Debtor turnover ratio
107
Accounting and Finance Standard norm of the ratio
for Managers
Greater the duration is better the liquidity management of the firm in availing the credit
period of the creditors and vice versa.
Illustration 5
Sundaram &co sells goods on cash as well as credit basis. The following particulars are
extracted from the books of accounts for the calendar 2005
Particulars Rs
Total Gross sales 2,00,000
Cash sales ( included in above) 40,000
Sales returns 14,000
Total Debtors 18,000
Bills receivable 4,000
Provision for doubtful debts 2,000
Total creditors 20,000
Calculate average collection period
To find out the average collection period, first Debtors turnover ratio has to computed
Rs. 1, 46,000
Debtor turnover ratio =
Rs. 4,000 + Rs.18,000
= 6.64 times
365 days
Creditors velocity =
Creditors turnover ratio
Credit purchases
Creditors turnover ratio =
Bills payable + Sundry creditors
Rs.1,00,000
=
Rs.16,000 + Sundry creditors
The next step is to find out the sundry creditors, the reversal process to be adopted
365 days
73 days =
Creditors turnover ratio
365 days
Creditors turnover ratio = = 5 times
73 days
The next step is to substitute the found value in the equation of creditors turnover ratio
Rs. 1,00,000
Rs. 16,000 + Sundry creditors =
5
Sundry creditors= Rs. 20,000 – Rs. 16, 000= Rs. 4,000
Illustration 7
From the following information, prepare a balance sheet show the workings
1. working capital Rs. 75,000
2. Reserves and surplus 1,00,000
3. Bank overdraft 60,000 109
Accounting and Finance 4. Current ratio 1.75
for Managers
5. Liquid Ratio 1,15
6. Fixed assets to proprietors’ fund .75
7. Long term liabilities Nil
(B.Com. Madras, April 1980)
First step is to find out the current liabilities
Rs. 75,000×1.75
Current assets = = Rs.1,75,000
.75
Working capital = Current assets – current liabilities
Current liabilities = Current assets – working capital
CL= Rs. 1, 75, 000 – Rs. 75, 000=Rs. 1, 00, 000
4,00,000 4,00,000
Gros Profit
GP ratio = × 100
Sales
Rs. 1,60,000
25% = × 100
Sales
Rs.1,60,000
Saels = = Rs. 6,40,000
25%
Now the volume of cost of goods sold has to be found out from the early available
information i.e., sales and gross profit
Cost of goods sold= Sales – Gross profit
= Rs. 6,40,000 – Rs. 1,60,000= Rs. 4,80,000
The next step is to find out the volume of average stock through the earlier formula
Rs. 4,80,000
112
8 times =
Average stock
Average stock = Rs. 60,000 Ratio Analysis
The next step is to apply the conditionality with regards to closing stock
12 months
Debtors Velocity =
Debtors turnover ratio
12 months
Debtors turnover ratio = = 4 times
3 months
Credit sales
4 times =
Bills receivable + Sundry debrors
Rs. 6,40,000
Rs. 10,000 + Sundry debtors =
4
Sundry debtors = Rs. 1, 60, 000–Rs. 10, 000= Rs. 1, 50, 000
The next important stage is to find out the sundry creditors
To find out the sundry creditors, the creditors velocity has to be applied in the formula
In addition to the earlier, one missing information has to be found out i-e Credit purchases
The volume of purchase to be found out through the formula of cost of goods sold
Cost of goods sold= Opening stock +Purchases – Closing stock
Rs. 4,80,000 = Rs. 58,000+Purchases – Rs. 68,000
Purchases = Rs. 4,80,000–Rs. 58,000+Rs. 68,000
= Rs. 4,80,000+Rs. 10,000= Rs. 4,90,000
12 months
Creditors velocity =
Creditors turnover ratio
12 months
Creditors turnover ratio = 6 times
2 months
Rs. 4,90,000
6 times = + Sundry creditors
Rs. 4,000
Sales
Fixed assets turnover ratio = 5 times =
Fixed Assets
Rs. 6,40,000
= = Rs.1, 28, 000
5 times
Proprietors’ fund
Proprietor’s fund = Fixed assets+ Current Assets – Current liabilities
The above equation is coined on the basis of Double accounting concept
Fixed assets + Current assets = Total assets = Total Liabilities
Total Assets – Current liabilities = Total Liabilities – Current liabilities
Current assets volume is not known, In such cases the stock volume should be added
with the Liquid assets to derive the early mentioned.
Current assets= Closing stock + Liquid Assets
= Rs. 68,000+ Rs. 1,94,666 = Rs2,62,666
Proprietor’s fund = Rs. 1,28,000+ Rs. 2,62,666 – Rs. 81,667
= Rs. 3,08,999
Share capital = Proprietor’s fund – Reserves and surpluses
= Rs. 3,08,999 – Rs. 56,000= Rs. 2,52,999
Cash and Bank Balances to be found out in the next stage
From the above found information the detailed balance sheet with as many as information
possible to portray
Balance sheet as on dated ——————————————-
Liabilities Rs Assets Rs
Share capital 2,52,999 Fixed assets 1,28,000
Reserves and surpluses 56.000 Stock 68,000
Bills receivable 4,000 Debtors 1,50,000
Sundry creditors 77,667 Bills receivable 10,000
Cash and Bank Balance 34,666
3,90,666 3,90,666
Illustration 9
From the following particulars, prepare trading, profit and loss account and a balance
sheet
Current ratio -3
Liquid ratio -1.8
114
Bank overdraft –Rs. 20,000
Working capital – Rs. 2,40,000 Ratio Analysis
Current Assets
Current ratio = =3
Current Liabilities
Current Assets- Current Liabilities = Working capital
3 – 1 = 2 = Rs. 2, 40, 000
The volume of working capital Rs 2,40,000 is equated to share 2
What is the volume of current liabilities for the share of 1
Current liabilities = Rs. 2, 40, 000 = Rs. 1,20,000
2
The volume of current assets = Rs. 1,20,000 × 3= Rs. 3,60,000
The next step is to find out the volume of liquid assets
Liquid assetss
Liquid assets ratio = 1.8 =
Liquid Liabilities
When the Bank overdraft is given, the liquid liabilities should be computed.
Liquid liabilities = Current liabilities – Bank overdraft
= Rs. 1,20,000 – Rs. 20,000 = Rs. 1,00,000
Liquid assets is 1.8 times greater than the Liquid liabilities
Liquid assets = 1.8 × Rs. 1,00,000 = Rs. 1,80,000
To find out the volume of the stok
Stock = Current assets – Liquid assets
=Rs. 3,60,000 – Rs. 1,80,000
= Rs. 1,80,000
The next step is to find out the cost of goods sold
To find out the cost of goods sold, the stock turnover ratio has to be found out
Rs.15,00,000
Sales = = Rs.18,75,000
80
Gross profit = Rs. 18, 75, 000 – Rs. 15, 00, 000= Rs. 3,75,000
The next step is to find out the volume of debtors
The debtors could be found out with the help of debtors turnover ratio and collection
period
12 months
Debtors velocity or collection period =
Debtors turnover ratio
12 months
Debtors turnover ratio = = 12 times
1 month
Credit Sales
12 times =
Average debtors
Rs. 18,75,000
Average Debtors = = Rs.1,56,250
12
The next step is to find out the creditors. The volume of creditors ; to find out the volume
of the creditors, the creditors turnover ratio and creditors average payment period should
have to be applied
12 months
Creditors average payment period =
Creditors turnover ratio
12 months
Creditors turnover ratio = = 24times
0.5
credit purchase
Creditors turnover ratio = Average creditors
credit purchase
Average creditors =
24 times
Now the volume of credit purchase to be found out with the help of cost of goods sold
formula
Cost of goods sold= Opening stock+ Purchases- Closing stock
Rs. 15,00,000–Rs. 1,20,000+Rs. 1,80,000= Purchases
Rs. 15,60,000 = Purchases
116 Average creditors = Rs. 65,000
The next step is to find out the proprietary fund ; this could be found out by using the ratio Ratio Analysis
proprietary fund to fixed assets ratio
Total Assets= Total Liabilities
Long term liabilities + Short term liabilities = Fixed assets + Current assets + Investments
Share holders’ fund – Fixed assets = Current assets + Investment – Current liabilities–
Debenture
1– 0.9= Rs. 2,00,000+Rs. 3,60,000–Rs. 1,20,000–Rs. 3,60,000
1– 0.9= Rs. 80,000
0.1=Rs. 80,000
If 0.1 share is the volume of Rs. 80,000 what is the volume of proprietary fund for the
share of 1?
The volume of proprietary fund = Rs. 8,00,000
The volume of fixed assets = Rs. 80,000× 0.9= Rs. 7,20,000
The next step is to find out the volume of the share capital. This could be found out only
with the help of the ratio given Reserves and surpluses to share capital
Reserves and surpluses = 25 % of share capital
It means that % is Share capital.
Share capital + Reserves and surpluses = Shareholders’ fund
100+25=125
To find out the share of share capital from the shareholders’ fund, the following is the
computation
Rs.8,00,000
× 100 = Rs. 6,40,000 = share capital
125
Reserves and surpluses = 25% on the Share capital
= 25% on Rs. 6,40,000 =Rs. 1,60,000
The last step is to find out the Net profit, which could be found out through the Net profit
to share capital
Net profit is 20% on share capital
Net profit = 20% on Rs. 6,40,000= Rs. 1,28,000
Next stage is to prepare the Trading, Profit & Loss A/c for the year ended and Balance
sheet as on dated
Trading Profit & Loss Account for the year ended ——————————————
Dr Cr
Particulars Rs Particulars Rs
To opening stock 1,20,000 By sales 18,75.000
To purchases 15,60,000 By closing stock 1,80,000
To Gross profit c/d 3,75,000
20,55,000 20,55,000
To Debenture Interest 8% 28,800 By Gross profit B/d 3,75,000
Rs.3,60,000
To Balancing figure other 2,18,200
expenses
To Net profit c/d* 1,28,000
3,75,000 3,75,000 117
Accounting and Finance Balance sheet as on dated
for Managers
Liabilities Rs Rs Assets Rs Rs
Share capital 6,40,000 Fixed assets 7,20,000
Reserves and 32,000 Investments 2,00,000
Surpluses
Profit during the 1,28,000 1,60,000
year
8% Debentures 3,60,000
Current liabilities Current Assets
Overdraft 20,000 Stock 1,80,000
Creditors 65,000 Debtors 1,56,250
Others 35,000 1,20,000 Other current asset 23,750 3,60,000
12,80,000 12,80,000
Sales
Expenses
Administrative,
Selling and
Roce distribtution
Return on expense
capital
employed
Capital Current
employed Fixed asset
liabilities
6.20 KEYWORDS
Ratio
Stock term over ratio
Acid Test ratio
Fixed assets ratio
Accounting ratio
GP ratio
Coverage ratio
Stock velocity
Du analysis
7
FUND FLOW STATEMENT ANALYSIS
CONTENTS
7.0 Aims and Objectives
7.1 Introduction
7.2 Meaning & Objectives of Fund Flow Statement Analysis
7.3 Methods of Preparing Fund Flow Statement
7.3.1 Schedule of Changes in Working Capital
7.3.2 Net Profit Method
7.3.3 Sales Method
7.3.4 First Method
7.3.5 Second Method
7.4 Advantages of Preparing Fund Flow Statement
7.4.1 Illustrative Statement of Financing
7.4.2 To fulfil the Primary Objective of the Financial Management
7.4.3 Facilitation through Financial Planning
7.4.4 Guide to Working Capital Management
7.4.5 Indicator of Yester Track Path of the Firm
7.5 Let us Sum up
7.6 Lesson-end Activity
7.7 Keywords
7.8 Questions for Discussion
7.9 Suggested Readings
7.1 INTRODUCTION
Every business establishment usually prepares the balance sheet at the end of the fiscal
year which highlights the financial position of the yester years It is subject to change in
the volume of the business not only illustrates the financial structure but also expresses
the value of the applications in the liabilities side and assets side respectively. Normally,
Balance sheet reveals the status of the firm only at the end of the year, not at the
beginning of the year. It never discloses the changes in between the value position of the
firm at two different time periods/dates.
The method of portraying the changes on the volume of financial position is the statement
fund flow statement. To put them in nutshell, fund between two different time periods. It is
120
further illustrated that the changes in the financial position or the movement or flow of fund.
Fund Flow Statement Analysis
7.2 MEANING & OBJECTIVES OF FUND FLOW
STATEMENT ANALYSIS
A report on the movement of funds or working capital. In a narrow sense the term fund
means cash and the fund flow statement depicts the cash receipts and cash disbursements/
payments. It highlights the changes in the cash receipts and payments as a cash flow
statement in addition to the cash balances i.e., opening cash balance and closing cash
balance. Contrary to the earlier, the fund means working capital i.e., the differences
between the current assets and current liabilities.
The term flow denotes the change. Flow of funds means the change in funds or in
working capital. The change on the working capital leads to the net changes taken place
on the working capital i.e., especially due to either increase or decrease in the working
capital. The change in the volume of the working capital due to numerous transactions.
Some of the transactions may lead to increase or decrease the volume of working
capital. Some other transactions neither registers an increase nor decrease in the volume
of working capital.
According Foulke “A statement of source and application of funds is a technical device designed
to analyse the changes to the financial condition of a business enterprise in between two dates”
Various Facets of Fund flow statement are as follows:
l Statement of sources and application of funds
l Statement changes in financial position
l Analysis of working capital changes and
l Movement of funds statement
Objectives of fund flow statement analysis:
(1) It pinpoints the mobilization of resources and the further utilization of resources
(2) It highlights the financing of the general expansion of the business firms
(3) It exemplifies the utilization of debt finance in the structure of financing
(4) It portrays the relationship between the financing, investment, liquidity and dividend
decision of the firm during the given point of time.
The next important step is to prepare that Adjusted profit and loss account
The first method is widely used method by all in determining the volume of Fund from
Operations (FFS)
Under the Net Profit Method, Fund flow from operations can be computed
7.3.2 Net Profit Method
Under this method, Fund from operations can be determined in two different ways .The
first method is through the statement format
Net Profit from the Profit & Loss A/c xxxxx
Add:
(A) Non Funding Expenses:
Loss on Sale of Fixed Assets xxxx
Loss on Sale of Long Term Investments xxxx
Loss on Redemption Debentures/Preference Shares xxxx
Discount on Debentures /Share xxxx
(B) Non Operating Expenses:
Depreciation of fixed Assets xxxx
(C) Intangible Assets:
Amortization of Goodwill xxxx
Amortization of Patent xxxx
Amortization of Trade Mark xxxx
(D) Fictitious Assets:
Writing off Preliminary expense xxxx
122 Writing off Discount on Shares/Debentures xxxx
(E) Profit Appropriation Fund Flow Statement Analysis
124
The next step is to prepare the fund flow statement. The proforma of the fund flow Fund Flow Statement Analysis
statement
Sources of funds Uses of funds
• Funds from Business Operation • Funds Lost in Operations
• Non trading Incomes • Redemption of Preference Share Capital
• Sale of Non-Current Assets • Repayment of Loans
• Sale of Long Term Investments • Purchase of Long Term Investments
• Issue of shares • Purchase of Fixed Assets
• Acceptance of deposits • Payment of Taxes
• Long Term Borrowings • Payment of Dividends
• Decrease in Working Capital • Drawings
• Loss of Cash
• Increase in Working Capital
Form the following details prepare a statement showing changes in working capital during
1985:
Balance sheet of Pioneer ltd. as on 31st December
Liabilities 1984 Rs 1985 Assets 1984 1985
Rs. Rs. Rs.
Share capital 5,00,000 6,00,000 Fixed assets 10,00,000 11,20,000
Reserves 1,50,000 1,80,000 Less:Depreciation 3,70,000 4,60,000
Profit and Loss A/c 40,000 65,000 6,30,000 6,60,000
Debentures 3,00,000 2,50,000 Stock 2,40,000 3,70,000
Creditors for goods 1,70,000 1,60,000 Book Debts 2,50,000 2,30,000
Provision for tax 60,000 80,000 Cash in hand 80,000 60,000
Preliminary expeneses 20,000 15,000
12,20,000 13,35,000 12,20,000 13,35,000
(B.com., Bharathidasan November, 1986)
The first step is to prepare the schedule of changes in working capital.
Schedule of changes in working capital
1984 1985 Increase Decrease
In working In working
capital capital
Current asset:
Stock 2,40,000 3,70,000 1,30,000 ------------
Book debts 2,50,000 2,30,000 ------- 20,000
Cash in hand 80,000 60,000 20,000
5,70,000 6,60,000 1,30,000 40,000
Current liability
Creditors for goods 1,70,000 1,60,000 10,000 -------
Working capital 4,00,000 5,00,000 1,40,000 40,000
Increase in working capital 1,00,000 ------------ 1,00,000
5,00,000 5,00,000 1,40,000 1,40,000
Illustration 2
From the following two balance sheet as at December 31, 2004 and 2005. Prepare the
statement of sources and uses of funds.
2004 2005 2004 2005
Liabilities Rs. Rs. Rs. Rs.
Share capital 80,000 90,000
Trade creditors 20,000 46,000
Profit & Loss a/c 4,60,000 5,00,000
Assets
Cash 60,000 94,000
Debtors 2,40,000 2,30,000
Stock in trade 1,60,000 1,80,000
Land 1,00,000 1,32,000
5,60,000 6,36,000 5,60,000 6,36,000
The first step is to prepare the schedule of changes in working capital.
Schedule of changes in working capital
2004 2005 Increase Decrease
In working In working
captial capital
Current asset:
Cash 60,000 94,000 34,000
Debtors 2,40,000 2,30,000 10,000
Stock in trade 1,60,000 1,80,000 20,000
4,60,000 5,04,000
Current liability
Trade creditors 20,000 46,000 26,000
Working capital 4,40,000 4,58,000 54,000 36,000
Increase in working capital 18,000 ------------- ---------- 18,000
4,58,000 4,58,000 54,000 54,000 127
Accounting and Finance The next step is to prepare the non current accounts of the firm.
for Managers
Dr Land A/c Cr
Rs. Rs.
To Balance B/d 1,00,000
To Cash(Purchase) balancing fig. 32,000 By Balance c/d 1,32,000
1,32,000 1,32,000
Next non-current account item is the share capital account in the liability side.
The closing balance of the share capital is more than that of the opening balance which
means that the firm has undergone the issue of further more share capital.
During the issue of share capital, the cash resources are raised by the firm through the
sale of shares.
Dr Share capital A/c Cr
Rs. Rs.
To Balance c/d 90,000 By Cash( Issue of shares) 10,000
Balancing fig.
By Balance b/d 80,000
90,000 90,000
Then the next step is to prepare the adjusted profit and loss account to determine the
fund from the operations
Dr Adjusted Profit & Loss A/c Cr
Rs. Rs.
By Balance B/d 4,60,000
To Balance c/d 5,00,000 By Fund from operation 40,000
Balancing fig.
5,00,000 5,00,000
The next step is to prepare the fund flow statement of the firm
Fund flow statement
Sources Rs. Applications Rs.
Issue of Shares 10,000 Purchase of Land 32,000
unds from operation 40,000 Increase in working capital 18,000
50,000 50,000
Illustration 3
From the following relating to Panasonic ltd., prepare funds flow statement.
Balance sheet of Pioneer ltd. as on 31st December
Liabilities 1994 1995 Assets 1994 1995
Rs Rs Rs Rs
Share capital 6,00,000 8,00,000 Fixed assets 3,80,000 4,20,000
Reserves 2,00,000 1,00,000 Accounts 2,10,000 3,00,000
receivable
Retained earnings 60,000 1,20,000 Stock 3,00,000 3,90,000
Accounts payable 90,000 2,70,000 Cash 60,000 1,80,000
9,50,000 12,90,000 9,50,000 12,90,000
Additional information:
l The company issued bonus shares for Rs.1,00,000 and for cash Rs.1,00,000
l Depreciation written off during the year Rs.30,000
The first step is prepare the statement of changes in working capital
Schedule of changes in working capital
1994 1995 Increase Decrease
In working in working
captial capital
Current asset:
Cash 60,000 1,80,000 1,20,000 ----------
128 Contd...
Stock in trade 3,00,000 3,90,000 90,000 ---------- Fund Flow Statement Analysis
Accounts receivable 2,10,000 3,00,000 90,000 ----------
5,70,000 8,70,000
Current liability
Accounts payable 90,000 2,70,000 1,80,000
Working capital 4,80,000 6,00,000 3,00,000 1,80,000
Increase in working capital 1,20,000 1,20,000
6,00,000 6,00,000 3,00,000 3,00,000
The ultimate aim is to find out the original cost of the machinery for the preparation of
the machinery account:
Before preparing the Machinery account, the worth of the sale transaction of the
machinery should be found out .
Original cost of the Machinery Rs.10,000
(-)Depreciation Rs.3,000
Machinery worth for sale Rs.7,000
(-)Machinery sold Rs.5,000
Loss on sale of the portion of the machinery sold Rs.2,000
Dr Machinery A/c Cr
Rs Rs
To Balance B/d 1,05,000 By Cash (Sales) 5,000
By Provision for machinery 3,000
By loss on sale(Adjusted profit 2,000
and loss account)
By Balance c/d 95,000
1,05,000 1,05,000
The next one is the provision for depreciation account or Accumulated depreciation
account.
130
Dr Provision for Depreciation A/c Cr Fund Flow Statement Analysis
Rs Rs
To Machinery A/c 3,000 By Balance B/d 25,000
To Balance c/d 40,000 By depreciation provided during 18,000
the current year
43,000 43,000
Dr Capital A/c Cr
Rs Rs
To Drawings (Balancing fig) 17,000 By Balance B/d 1,25,000
To Balance c/d 1,53,000 By Net profit 45,000
1,70,000 1,70,000
(1) Purchase of plant & machinery Rs.10 lakh through the issue of 1 Lakh
shares at Rs.10 per share ; affect the following accounts
(a) Non current asset and Non current liability accounts
(b) Non current asset and Current liability accounts
(c) Current asset account and Non current liability accounts
(d) Current asset and current liability accounts
(2) XYZ Ltd. has made a credit purchase of Rs.1 lakh worth of goods led to
Rs.1 lakh worth of additional stock of tradable goods for the enterprise,
leads to
(a) Increase in the working capital - Applications
(b) No change in the working capital position -Neither an application nor resource
(c) Decrease in the working capital-Resource
(d) None of the above
(3) The meaning of the "To cash ( Tax paid)" entry posted in the Provision for
taxation account is
(a) Last year taxation is paid through the current year provision
(b) Current year taxation is paid through the current year provision
(c) Last year tax is paid through the last year taxation
(d) Current year taxation is paid through the last year provision
(4) Profit on sale of the fixed assets are considered to be
(a) Resource to the enterprise
(b) Non operating income
(c) Application of the enterprise
(d) None of the above
(5) The treatment of current year depreciation with the closing balance of profit
in determining the fund from operations
(a) To be added
(b) To be multiplied
(c) To be deducted
(d) To be divided Contd... 133
Accounting and Finance (6) The redemption bank term loan leads to change in the
for Managers
(a) Non current liability account and current asset account
(b) Current asset account and current liability account
(c) Non current asset account and current liability account
(d) Non current asset account and current liability account
7.7 KEYWORDS
Fund: Fund means working capital
Flow: Flow means changes occurred in between two different time periods
Statement of changes in working capital: Enlisting the changes taken place in between
the Current assets and current liabilities of two different time horizons
Current assets: Assets which are in the form of cash, equivalent to cash or easily
convertible into cash .
Current liabilities: Short term financial resources of the firm
Non-current assets: Long term assets
Non current liabilities: Long term financial resources
Increase in working capital: Increase in Net working capital i.e. Excess of current
assets over the current liabilities- Applications side of the fund flow
Decrease in working capital: Decrease in Net working capital i.e. Excess of current
liabilities over the current assets - Resources side of the fund flow
Fund from operations: Income generated from only operations
Fund lost in operations: Loss incurred in the operations
135
Accounting and Finance
for Managers LESSON
8
CASH FLOW STATEMENT ANALYSIS
CONTENTS
8.0 Aims and Objectives
8.1 Introduction
8.2 Meaning & Motives of Cash Flow Statement
8.3 Utility of Cash Flow Statement
8.4 Steps in the Preparation of Cash Flow Statements
8.4.1 Preparation of Adjusted Profit and Loss Account
8.4.2 Comparison of Current Items to determine the Inflow of Cash or Outflow of Cash
8.4.3 Preparation of Cash Flow Statement
8.5 Let us Sum up
8.6 Lesson-end Activity
8.7 Keywords
8.8 Questions for Discussion
8.9 Suggested Readings
8.1 INTRODUCTION
Cash is considered one of the vital sources of the firm to meet day to day financial
commitments. The cash is considered to be as most important source of life blood of the
business. The day to day financial commitments are met out only out of the available
resources. The cash resources are availed through two different type of receipts viz.
sales, dividends, interests known as regular receipts and sale of assets, investments
known as irregular receipts of the business enterprise. To have smooth flow of business
enterprise, it should have ample cash resources for its operations. The availability of
cash resources is mainly depending on the cash inflows of the enterprises. The smoothness
in operations of the enterprise is obtained through an appropriate matching of cash inflows
and cash outflows.
To have smoothness in the operations of the enterprise, the firm should have an appropriate
volume of cash resources at speedier rate as well as more than the financial commitments
of the firm. This smoothness could be attained by way of an appropriate planning analysis
on the cash resources of the firm. The meaningful analysis is only possible through cash
flow statement analysis which facilitates the firm to identify the possible sources of cash
136 as well as the expenses and expenditures of the firm.
Cash Flow Statement Analysis
8.2 MEANING & MOTIVES OF CASH FLOW STATEMENT
The cash flow statement is being prepared on the basis of an extracted information of
historical records of the enterprise. Cash flow statements can be prepared for a year, for
six months , for quarterly and even for monthly. The cash includes not only means that
cash in hand but also cash at bank.
Motives of preparing the cash flow statement:
l To identify the causes for the cash balance changes in between two different time
periods, with the help of corresponding two different balance sheets.
l To enlist the factors of influence on the reduction of cash balance as well as to
indicate the reasons though the profit is earned during the year and vice versa.
137
Accounting and Finance
for Managers 8.4 STEPS IN THE PREPARATION OF CASH FLOW
STATEMENTS
Balancing Figure
138
Cash Flow Statement Analysis
Alternate method:
Decrease in current assets &
Increase in current liabilities
Net Profit
( +)
(-)
Sales Method
Cash Sales
139
Accounting and Finance
for Managers Check Your Progress
Illustration 1
From the following balances you are required to calculate cash from operations:
Particulars December 31
1992 Rs 1993 Rs
Debtors 1,00,000 94,000
Bills receivable 20,000 25,000
Creditors 40,000 50,000
Bills payable 16,000 12,000
Outstanding expenses 2,000 2,400
Prepaid expenses 1,600 1,400
Accrued Income 1,200 1,500
Income received in advance 600 500
Profit made during the year - 2,60,000
According to net profit method , the cash from operation has to be found out
Cash from operations
= Net profit (+) Decrease in current assets (-) Increase in current assets
& &
Increase in current liabilities Decrease in current liabilities
The next step is to quantify the decrease in current assets and increase in current liabilities,
in order to add with the closing net profit of the given statements and then the added
volume should be deducted from the increase in current assets and decrease in current
liabilities.
140
Cash from operations Rs Rs Cash Flow Statement Analysis
Profit made during the year s
Add
Decrease in debtors 6,000
Increase in creditors 10,000
Outstanding expenses 400
Prepaid expenses 200
16,600
Less
Increase in Bills receivable 5,000
Decrease in Bills payable 4,000
Increase in accrued income 300
Income received in advance 100
9,4000
Cash from operations 2,67,200
Illustration 2
From the following profit and loss account you are required to compute cash from
operations
Profit and loss account for the year ending 31st Dec, 1983
Rs Rs
To salaries 10,000 By Gross profit 50,000
To Rent 2,000 By profit on sale of land 10,000
To Depreciation 4,000 By income tax refund 6,000
To loss on sale of plant 2,000
To Good will written off 8,000
To proposed dividend 10,000
To provision for taxation 10,000
To Net profit 20,000
66,000 66,000
Cash from operations Rs Rs
Net profit made during the year 20,000
Add:
Non cash expenses
Depreciation 4,000
Loss on sale of plant 2,000
Good will return off 8,000
Non operating expenses
Proposed dividend 10,000
Provision for taxation 10,000 34,000
Less
Non cash income
Profit on sale of land 10,000
Non operating income
Income tax refund 6,000 16,000
38,000
Illustration 3
The comparative balance sheets of M/s Ram Brothers for the two years were as follows
Liabilities Mar,31 Assets Mar,31
1984 1985 1984 1985
Capital 3,00,000 3,50,000 Land &Building 2,20,000 3,00,000
Loan from Bank 3,20,000 2,00,000 Machinery 4,00,000 2,80,000
Creditors 1,80,000 2,00,000 Stock 1,00,000 90.000
Bills payable 1,00,000 80,000 Debtors 1,40,000 1,60,000
Loan from SBI 50,000 Cash 40,000 50,000
9,00,000 8,80,000 9,00,000 8,80,000
141
Accounting and Finance Additional Information
for Managers
i. Net profit for the year 1985 amounted to Rs. 1,20,000
ii. During the year a machine costing Rs.50,000 ( accumulated depreciation Rs. 20,000)
was sold for Rs. 26,000. The provision for depreciation against machinery as on 31
Mar, 1984 was Rs.1,00,000 and 31st Mar, 1985 Rs.1,70,000
You are required to prepare a cash flow statement
First step is to prepare non current accounts
Non current account includes both non current liability and asset
First start with non current liability
Dr Capital A/c Cr
Rs Rs
To Drawings. Balancing Fig. 70,000 By Balance B/d (Opening) 3,00,000
To Balance c/d(Closing ) 3,50,000 By Net profit 1,20,000
4,20,000 4,20,000
The next step is to find out the depreciation provided during the year, which affects non
current asset account of the firm is Machinery account.
Before discussing the accounting transactions, the journal entry for provision for
depreciation should be known.
Provision for depreciation Account
Dr Cr
Rs Rs
To Machinery 20,000 By Balance B/d 1,00,000
To Balance C/d 1,70,000 By Adjusted profit and loss 90,000
account ( Depreciation provided
during the year)
1,90,000 1,90,000
Once the loss of the transaction is found out, the amount of the loss should be appropriately
recorded
Machinery Account
Dr Cr
Rs Rs
To Balance B/d (Opening) 5,00,000 By cash sale 26,000
By Profit and loss a/c Loss 4,000
Balancing Fig
By Depreciation Provision 20,000
By Balance c/d(Closing ) 4,50,000
2,80,000+1,70,000
5,00,000 5,00,000
142
Dr Land and Building Cr Cash Flow Statement Analysis
Rs Rs
To Balance B/d(Opening) 2,20,000
To Purchase 80,000 By Balance c/d(Closing ) 3,00,000
3,00,000 3,00,000
The next step is to prepare adjusted profit and loss account
Dr Adjusted profit and loss account Cr
To Machinery A/c(Loss on sale ) Rs. By Balance B/d Rs.
4,000
To Depreciation provided during 90,000 By cash from operations 2,14,000
the year
To Balance c/d 1,20,000
2,14,000 2,14,000
Additional information
i. Dividends amounting to Rs 7,000 were paid during the year 1996
ii. Land was purchased for Rs. 20,000
iii. Rs.10,000 were written off on good will during the year
iv. Bonds of Rs.12,000 were paid during the course of the year
v. You are required to prepare a cash flow statement
The first step is to prepare non current accounts
The first step is to prepare non current assets and liabilities account
As far as non current asset account - Land account has to be prepared
Dr Land Cr
Rs Rs
To Balance B/d(Opening) 40,000
To Purchase (Given) 20,000 By Balance c/d(Closing ) 60,000
60,000 60,000 143
Accounting and Finance The non current liability account to be prepared
for Managers
The first non current liability account got affected is Share capital account
Dr Share capital account Cr
Rs Rs
By Balance B/d(Opening ) 1,40,000
To Balance c/d (Closing ) 1,48,000 By cash Balancing figure 8,000
1,48,000 1,48,000
The next non current liability account is that Bonds account
Dr Bond account Cr
Rs Rs
To cash redemption (Given) 12,000 By Balance B/d(Opening ) 24,000
To Balance c/d(Closing ) 12,000
24,000 24,000
The next step is to prepare the Adjusted profit and loss account
Dr Adjusted profit and loss account Cr
To provision for doubtful 200 By Balance B/d 20,080
debts
To Good will written off 10,000 By cash from operations 18,240
To dividends paid 7000
To Balance c/d 21,120
38,320 38,320
The next most important step is to compare the current assets during the two years
Increase in Accounts payable - Rs. 2,960 - Cash inflow
Decrease in Inventories -Rs. 7,000 - Cash inflow
Increase in Bank Balance - Rs. 2,400 -Cash outflow
Increase in accounts receivable -Rs. 5,600 - Cash outflow
The next step is to draft the Cash flow statement
Cash flow statement
Inflow Rs Out flow Rs
Opening cash balance 18,000 Increase in Bills receivable 5,600
Issue of shares 8,000 Purchases of land 20,000
Increase in Bills payable 2,960 Dividends paid 7,000
Decrease in stock 13,000 Bonds repaid 12,000
Cash from operations 18,240 Closing cash balance 15,600
60,200 60,200
(1) Cash flow statement analysis is an analysis of short span of analysis due to
(a) Current assets position is only considered
(b) Super quick assets position only considered
(c) Working capital position is considered
(d) None of the above
(2) How cash flows are denominated in terms of both current assets and current
liabilities?
(a) Increase in current assets & Decrease in current liabilities
(b) Decrease in current assets & Increase in current liabilities
(c) Increase in current assets & Increase in current liabilities
144
Contd...
(d) Both (a) & (b) Cash Flow Statement Analysis
8.7 KEYWORDS
Cash
Cash Flow Statement
Fund Flow Statement
146
UNIT-III
LESSON
9
COST ACCOUNTING & PREPARATION OF COST
STATEMENT
CONTENTS
9.0 Aims and Objectives
9.1 Introduction
9.2 Meaning of Cost Accounting
9.2.1 What is a Cost of a Product?
9.3 Cost Classification
9.3.1 By Nature or Element or Analytical Segmentation
9.3.2 By Functions
9.3.3 Direct and Indirect Cost
9.3.4 By Variability
9.3.5 By Controllability
9.3.6 By Normality
9.3.7 By Time
9.3.8 For Planning and Control
9.3.9 For Managerial Decisions
9.4 Distinction between Financial Accounting & Cost Accounting
9.5 Unit Costing
9.5.1 Cost Sheet - Definition
9.5.2 Direct Material
9.5.3 Direct Labour
9.5.4 Direct Expenses
9.5.5 Indirect Material
9.5.6 Indirect Labour
9.5.7 Indirect Expenses
9.6 Direct Cost Classification
9.7 Indirect Cost Classification
9.8 Stock of Raw Materials
9.9 Stock of Semi Finished Goods
9.10 Stock of Finished Goods
9.11 Let us Sum up
9.12 Lesson-end Activity
9.13 Keywords
9.14 Questions for Discussion
9.15 Suggested Readings
Accounting and Finance
for Managers 9.0 AIMS AND OBJECTIVES
In this lesson we shall discuss about cost accounting and preparation of cost statement.
After going through this lesson you will be able to:
(i) discuss meaning of cost accounting and distinction between financial accounting
and cost accounting.
(ii) analyse unit costing and direct, indirect and classification
9.1 INTRODUCTION
Cost accounting is that branch of the accounting information system, which records,
measures and reports information about costs. The primary purpose of cost accounting
is cost ascertainment and its use in decision-making and performance evaluation. It is
also useful in planning and controlling.
Cost Centre
Cost Ascertainment
Service centre is the centre or division which normally incurs direct or indirect costs but
does not work directly on products. Normally, Maintenance dept. and general factory
office are very good examples of the service centre.
Apart from the above classification, one more important centre is profit centre.
What is meant by profit centre?
It is a centre not only responsible for both revenue as well as expenses but also for the
profit of an activity.
9.3.2 By Functions
Under this methodology, the costs are classified into various divisions or functions of the
enterprise. viz Production cost, Administration cost, Selling & Distribution cost and so on.
The detailed classification is that total of production cost sub classified into cost of
manufacture, fabrication or construction.
And another classification of cost is commercial cost of operations; which is other than
the cost of manufacturing and production.
The major components of commercial costs are known as administrative cost of operations
and selling and distribution cost of operations.
9.3.4 By Variability
The costs are grouped according to the changes taken place in the level of production or
activity.
It may be classified into three categories:
Fixed cost: It is cost which do not vary irrespective level of an activity or production
Rent of the factory, salary to the manager and so on.
Variable cost: It is a cost which varies in along with the level of an activity or production.
e.g. Material consumption and so on.
Semi variable cost: It is a cost which is fixed upto certain level of an activity, then later
it fluctuates or varies in line with the level of production. It is known in other words as
step cost. e.g. Electricity charges.
9.3.5 By Controllability
The cost are classified into two categories in accordance with controllability, as follows:
Controllable costs: Cost which can be controlled through some measures known as
controllable costs. All variable cost are considered to be controllable in segment to some
extent.
Uncontrollable costs: Costs which cannot be controlled are known as uncontrollable
costs. All fixed costs are very difficult to control or bring down; they rigid or fixed
irrespective to the level of production.
9.3.6 By Normality
Under this methodology, the costs which are normally incurred at a given level of output
in the conditions in which that level of activity normally attained.
Normal cost: It is the cost which is normally incurred at a given level of output in the
conditions in which that level of output is normally achieved.
Abnormal cost: It is the cost which is not normally incurred at a given level of output in
the conditions in which that level of output is normally attained.
9.3.7 By time
According to this classification, the costs are classified into Historical costs and
Predetermined costs:
152
Historical costs: The costs are accumulated or ascertained only after the incurrence Cost Accounting &
Preparation of Cost Statement
known as Past cost or Historical costs.
The following are the two major classifications viz standard cost and budgetary control:
The prepared standards are compared with the actual performance of the firm in studying
the variances in between them. The variances are studied and analysed through an
exclusive analysis.
Budget: A budget is detailed plan of operation for some specific future period. It is an
estimate prepared in advance of the period to which it applies. It acts as a business
barometer as it is complete programme of activities of the business for the period covered.
The control is exercised through continuous comparison of actual results with the budgets.
The ultimate aim of comparing with each other is to either to secure individuals' action
towards the objective or to provide a basis for revision.
Marginal cost is the amount at any given volume of output by which aggregate costs are
changed if the volume of output is decreased or increased by one unit.
Cost
O V E R H E A D S
The cost of the product or service should have to come across many stages. The
determination of the unit cost involves two different major stages viz Direct and Indirect
154 costs.
What is meant by direct cost ? Cost Accounting &
Preparation of Cost Statement
Direct cost is the cost incurred by the firm which can be ascertained and measured for
a product.
Direct cost of the product can be classified into three major categories.
9.5.2 Direct Material
Direct material which is especially used as a major ingredient for the production of a
product. For Example: The wood is a basic raw material for the wooden furniture. The
cost of the wood procured for the furniture is known direct material cost.
The cotton is a basic raw material for the production of yarn. The cost of procuring the
cotton is known as direct material for the manufacturing of yarn.
9.5.3 Direct Labour
Direct labour is the cost of the labour which is directly involved in the production of
either a product or service. For e.g. The cost of an employee who is mainly working for
the production of a product /service at the centre, known as direct labour cost.
9.5.4 Direct Expenses
Direct expenses which are incurred by the firm with the production of either a product
or service. The excise duty, octroi duty are known as direct expenses in connection with
the production of articles and so on.
Indirect cost is the cost whatever incurred by the firm can be ascertained but not measured
more specifically for a product.
9.5.5 Indirect Material
The material which is spent cannot be measured for a product is known as indirect
material. For e.g. the thread which is used for tailoring the shirt cannot be measured or
quantified in specific length as well as ascertained the cost.
9.5.6 Indirect Labour
Indirect labour is the cost of the labour incurred by the firm other than the direct labour
cannot be apportioned. For e.g: Cost of supervisor, cost of the inspectors and so on.
9.5.7 Indirect Expenses
Indirect expenses are the expenses other than that of the direct expenses in the production
of a product. The expenses which are not directly part of the production process of a
product or service known as indirect expenses. For e.g.: Rent of the factory, salesmen
salary and so on.
Advantages of preparing the cost sheet:
1. It is a only statement reveals the cost of the output as well as unit cost of the
output
2. It facilitates the manufacturer to access the control on the costs through breakups
in the cost
3. It extends room for the management to study the variations of the cost with the
help of an effective comparison of standard costs
4. The businessman is able to get an insight on the various components of cost as well
as able to exercise the control on the excessive costs incurred
5. It poses the firm to supply the goods against the orders with reasonable accuracy
in submitting the orders.
1. Cost is
(a) An expense incurred (b) An expenditure incurred
(c) An income received (d) None of the above 155
Contd...
Accounting and Finance 2. Cost is
for Managers
(a) Direct cost only (b) Indirect cost only
(c) Both (a) & (b) (d) None of the above
3. Direct cost is
(a) Direct Materials (b) Direct labour
(c) Direct Expenses (d) Prime cost
To find out the unit cost of the product, the statement of cost plays pivotal role in
determining the cost of production, cost of goods sold, cost of sales and selling price of
the product at every stage.
During the preliminary stage of preparing the cost statement of the product, there are
two things to be borne in our mind at the moment of classification.
1. Direct cost classification
2. Indirect cost classification
Prime cost
Direct Material
Direct Labour
Direct Expenses
The next stage in the unit costing to find out the factory cost. The factory cost could be
computed by the combination of the indirect cost classification.
Factory overheads are nothing but the indirect expenses incurred during the industrial
156
process.
Cost Accounting &
Preparation of Cost Statement
Factory cost
Electric power
Storekeeper’s wages
Factory rent
Depreciation
1. Direct materials is
(a) Opening stock + Purchases
(b) Purchases + Closing stock
(c) Opening stock + Purchases – closing stock
(d) Purchases – Closing stock
2. Salary paid to Supervisor
(a) Manufacturing overheads
(b) Administrative overheads
(c) Direct labour
(d) Selling & Distribution overheads
The next stage in the process of the unit costing is to find out the cost of the production
The cost of production is the combination of both the factory cost and administrative
overheads.
Administrative overheads is the indirect expenses incurred during the office administration
for the smooth flow production of finished goods.
Cost of Production
Administrative Overheads Factory Overheads
Office Rent
Repairs – Office
Office lighting
Depreciation-office
Manager salary
Telephone charges
Stationery
157
Accounting and Finance Immediate next stage to determine in the process of unit costing is the component of
for Managers
cost of sales. The cost of sales is the blend of both viz. Selling overheads and cost of
production.
What ever the cost involved in the production process in the factory as well in the
administrative proceedings are clubbed with the selling overheads to determine the cost
of sales.
Selling overheads are nothing but the indirect expenses incurred by the firm at the moment
of selling products. In brief, whatever the expenses in relevance with the selling and
distribution are known as Selling overheads.
Cost of sales
Salesman salary
Carriage outward
Salesmen commission
Travelling expenses
Advertising
Free samples
Ware housing
Delivery charges
The last but most important stage in the unit costing is determining the selling price of the
commodities. The selling price of the commodities is fixed by way of adding both the
cost of sales and profit margin out of the product sales.
Under the unit costing, the selling price of the product can be determined through the
statement form.
The cost sheet or cost statement is as follows in the determination of the selling price of
the product.
1. Overheads is
(a) Manufacturing expenses (b) Administrative expenses
(c) Selling & Distribution expenses (d) a,b, & c
2. Cost of the Cloth incurred at the moment of purchase made by the Ready
garments manufacturer is
(a) Direct materials (b) Indirect materials
(c) Direct expenses (d) Indirect expenses
158
Contd...
3. Salesman salary given by the firm to promote the sales is Cost Accounting &
Preparation of Cost Statement
(a) Direct labour (b) Indirect expenses
(c) Direct expenses (d) Indirect labour
4. Selling price is
(a) Cost of sales (b) Cost of production
(c) Profit margin + Cost of goods sold (d) Profit margin + Cost of sales
Illustration 1
Calculate the prime cost, factory cost, cost of production cost of sales and Profit form
the following particulars:
Rs. Rs.
Direct Materials 2,00,000 Office stationery 1000
Direct wages 50,000 Telephone charges 250
Direct expenses 10,000 Postage and telegrams 500
Wages of foreman 5,000 Salesmens’ salaries 2500
Electric power 1,000 Travelling expenses 1,000
Lighting :Factory 3,000 Repairs and renewal Plant 7,000
Office 1,000 Office premises 1,000
Storekeeper’s wages 2,000 Carriage outward 750
Oil and water 10,00 Transfer to reserves 1,000
Rent: Factory 10,000 Discount on shares written 1000
off
:Office 5,000 Advertising 2,500
Depreciation Plant 1000 Warehouse charges 1000
office 2,500 Sales 3,79,000
Consumable store 5,000 Income tax 20,000
Managers’ salary 10,000 Dividend 4,000
Directors’ fees 2,500
Cost statement /Cost Sheet
Particulars Rs Rs
Direct Materials 2,00,000
Direct wages 50,000
Direct expenses 10,000
PRIME COST 2,60,000
Factory Overheads:
Wages of foreman 5,000
Electric power 1,000
Lighting :Factory 3,000
Storekeeper’s wages 2,000
Oil and water 1000
Rent:Factory 10,000
Depreciation Plant 1000
Consumable store 5,000
Repairs and renewal Plant 7,000
35,000
Factory cost 2,95,000
Administration overheads
Rent Office 5,000
Depreciation office 2,500
Contd... 159
Accounting and Finance Managers’ salary 10,000
for Managers
Directors’ fees 2,500
Office stationery 1000
Telephone charges 250
Postage and telegrams 500
Office premises 1,000
Lighting Office 1,000
23,750
Cost of production 3,18,750
Selling and distribution overheads
Carriage outward 750
Sales mens’ salaries 2500
Travelling expenses 1,000
Advertising 2500
Warehouse charges 1000
7,750
Cost of sales 3,26,500
Profit 52,500
Sales 3,79,000
The Next stage in the preparation of the cost statement is to induct the stock of raw
materials, work in progress and finished goods.
Particulars Rs
Prime cost XXXXXX
(+)Factory overheads incurred XXXXXX
(+)Opening work in progress XXXXXX
(-)Closing work in progress XXXXXX
Factory cost XXXXXX
160
Cost Accounting &
9.10 STOCK OF FINISHED GOODS Preparation of Cost Statement
The treatment of the stock of finished goods should carried over in between the opening
stock and closing stock and adjusted among them before the finding the cost of goods
sold.
Particulars Rs
Cost of production XXXXX
(+)Opening stock of finished goods XXXXX
(-)Closing stock of finished goods XXXXX
Cost of goods sold XXXXX
Illustration 2
The following data has been from the records of Centre corporation for the period from
June 1 to June 30, 2005
2005 2005
1st Jan 31st Jan
Cost of raw materials 60,000 50,000
Cost of work in progress 24,000 30,000
Cost of finished good 1,20,000 1,10,000
Transaction during the month
Purchase of raw materials 9,00,000
Wages paid 4,60,000
Factory overheads 1,84,000
Administration overheads 60,000
Selling overheads 40,000
Sales 18,00,000
161
Accounting and Finance
for Managers Check Your Progress
Illustration 3
From the following information extracted from the records of the M/s sundaram &co
Stock position of the firm
Particulars Rs 1-4-1994 Rs 31-3-1995
Stock of raw materials 80,000 1,00,000
Stock of finished goods 2,00,000 3,00,000
Stock of work in progress 20,000 28,000
Particulars Rs Particulars Rs
Indirect labour 1,00,000 Administrative expenses 2,00,000
Oil 20,000 Electricity 60,000
Insurance on fixtures 6,000 Direct labour 6,00,000
Purchase of raw materials 8,00,000 Depreciation on Machinery 1,00,000
Sale commission 1,20,000 Factory rent 1,20,000
Salaries of salesmen 2,00,000 Property tax on building 22,000
Carriage outward 40,000 Sales 24,00,000
162 Contd...
Cost of Production 20,00,000 Cost Accounting &
Preparation of Cost Statement
(+)Opening stock of finished goods 2,00,000
(-)Closing stock of finished goods 3,00,000
Cost of goods sold 19,00,000
Selling overheads:
Sales commission 1,20,000
Salaries of salesmen 2,00,000
Carriage outward 40,000
Cost of sales 22,60,000
Profit margin 1,40,000
Sales 24,00,000
Note: Property tax on the plant is to included under the factory overheads. The tax is
paid by the firm on the plant which is engaging in the production process.
Illustration 4
Prepare the cost sheet to show the total cost of production and cost per unit of goods
manufactured by a company for the month of Jan, 2005. Also find the cost of sale and
profit.
Particulars Rs Partiuclars Rs
Stock of raw materials1.1.2005 6,000 Factory rent and rates 6,000
Raw materials procured 56,000 Office rent 1,000
Stock of raw material31.1.2005 9,000 General expenses 4,000
Direct wages 14,000 Discount on sales 600
Plant depreciation 3,000 Advertisement expenses 1,200
Loss on the sale of plant 600 Income tax paid 2000
Sales Rs.,1,50,000
Illustration 5
XYION Co Ltd., is an export oriented company manufacturing internal -communication
equipment of a standard size. The company is to send quotations to foreign buyers of
your product. As the cost accounts chief you are required to help the management in the
matter of submission of the quotation of a cost estimate based on the following figures
relating to the year 1984
Total output (in units ) 20,000
Rs. Rs.
Local Raw materials 20,00,000 Excise duty 4,00,000
Imports of raw materials 2,00,000 Administrative office expenses 4,00,000
Direct labour in works 20,00,000 Salary of the managing director 1,20,000
Indirect labour in works 4,00,000 Salary of the joint managing 80,000
director
Storage of raw materials and 1,00,000 Fees of directors 40,000
spares
Fuel 3,00,000 Expenses on advertising 3,20,000
Tools consumed 40,000 Selling expenses 3,60,000
Depreciation on plant 2,00,000 Sales depots 2,40,000
Salaries of works personnel 2,00,000 Packaging and distribution 2,40,000
Note:
i. Local raw materials now cost 10% more
ii. A profits margin of 20% on sales is kept
iii. The government grants subsidy of Rs. 200 per unit of exports
Prepare the cost statement in columnar form
Cost Statement of XYION Ltd.
Rs Rs
Particulars Cost Rs Rs Unit/Price
Cost20,000
Local raw materials 20,00,000
(+) Increase in local raw materials 2,00,000
22,00,000
(+)Imports of raw materials 2,00,000
Direct Materials 24,00,000
Direct labour 20,00,000
Prime cost 44,00,000
Factory overheads:
Indirect labour in works 4,00,000
Storage of raw materials and spares 1,00,000
Fuel 3,00,000
Tools consumed 40,000
164 Contd...
Depreciation on plant 2,00,000 Cost Accounting &
Preparation of Cost Statement
Salaries of works personnel 2,00,000
Excise duty 4,00,000 16,40,000
Works cost 60,40,000
Administrative & office Expenses 4,00,000
Salaries of Managing director 1,20,000
Salaries of Joint Managing Director 80,000
Fees of directors 40,000 6,40,000
Cost of Production 66,,80,000
Selling & Distribution expenses
Expenses of Advertising 3,20,000
Selling expenses 3,60,000
Sales depots 2,40,000
Packaging and distribution 2,40,000 11,60,000
Cost of sales 80% 78,40,000
Profit Margin 20% 19,60,000
Sales 100% 98,00,000/20,000units 98,00,000 490
Export subsidy per unit 40,00,000 200(–)
Selling price for local market 58,00,000/20,000units 58,00,000 290
sales
9.13 KEYWORDS
Cost: Expense incurred at the either cost centre or service centre.
Cost sheet: It is a statement prepared for the computation of cost of a product/service.
165
Accounting and Finance Direct cost: cost incurred which can be easily ascertained and measured for a product.
for Managers
Indirect cost: cost incurred cannot be easily ascertained and measured for a product.
Cost centre: The location at where the cost of the activity is ascertained.
Product centre: It is the location at where the cost is ascertained through which the
product is passed through.
Service centre: The location at where the cost is incurred either directly or indirectly
but not directly on the products.
Profit centre: It is responsibility centre not only for the cost and revenues but also for
profits for the activity.
Prime cost: combination of all direct costs viz Direct materials, Direct labour and Direct
expenses.
Factory cost: It is the total cost incurred both direct and indirect at the work spot during
the production of an article.
Cost of production: It is the combination of cost of manufacturing an article or a product
and administrative cost.
Cost of sales: It is the entire cost of a product.
Selling price or Sales: The summation of cost of sales and profit margin.
166
LESSON
10
BUDGETARY CONTROL
CONTENTS
10.0 Aims and Objectives
10.1 Introduction
10.2 Types of Budget
10.3 Cash Budget
10.4 Fixed & Flexible Budget
10.4.1 Fixed Budget
10.4.2 Flexible Budget
10.5 Master Budget
10.6 Zero Base Budgeting (ZBB)
10.6.1 Traditional Budgeting vs Zero Base Budgeting
10.6.2 Steps involved Zero Base Budgeting
10.6.3 Benefits of Zero Base Budgeting
10.6.4 Criticism
10.7 Let us Sum up
10.8 Lesson-end Activity
10.9 Keywords
10.10 Questions for Discussion
10.11 Suggested Readings
10.1 INTRODUCTION
Budget is an estimate prepared for definite future period either in terms of financial or
non financial terms. Budget is prepared for any course of action or business or state or
Nation, as a whole. The budget is usually expressed in terms of total volume.
According to ICMA, England, a budget is as follows "a financial and or quantitative
statements prepared and approved prior to a defined period of time, of the policy to be
pursed during the period for the purpose of attaining a given objective".
It is in other words as " detailed plan of action of the business for a definite period of time".
What is meant by Budget?
It is a statement of financial affairs/quantitative terms of an activity for a defined period,
to achieve the enlisted objectives.
Accounting and Finance for What is budgeting?
Managers
Budgeting is the course involved in the preparation of budget of an activity.
What is Budgetary Control?
Budgetary control contains two different processes one is the preparation of the budget
and another one is the control of the prepared budget.
According to ICMA, England, a budgetary control is " the establishment of budgets
relating to the responsibilities of executives to the requirements of a policy and the
continuous comparison of actual with budgeted results, either to secure by individual
action the objectives of that policy or to provide a basis for its revision".
According to J.Batty "Budgetary control is a system which uses budgets as a mans of
planning and controlling all aspects of producing and/or selling commodities and services".
168
Budgetary Control
10.2 TYPES OF BUDGET
The budgets can be classified into three categories:
Budgets
Material Budget
Short Term
Labour Budget
Cash budget
Other Incomes
169
Accounting and Finance for Cash payments are as follows:
Managers
Cash payments
Illustration 1
From the following information prepare a cash budget for the months of June and July
Month Credit sales Credit purchase Manufacturing Selling
Rs Rs Overheads Rs overheads Rs
April 80,000 60,000 2,000 3,000
May 84,000 64,000 2,400 2,800
June 90,000 66,000 2,600 2,800
July 84,000 64,000 2,000 2,600
Additional Information:
1. Advance tax of Rs 4,000 payable in June and in December 1994
2. Credit period allowed to debtors is two months
3. Credit period allowed by the vendors or suppliers
4. Delay in the payment of other expenses one month
5. Opening balance of cash on 1st June is estimated as Rs. 20,000/-
Solution:
First step is in the preparation of a cash budget is to open the statement with the opening
cash balance available.
Secondly, if any cash receipts are available that should be added one after another. In
this problem, Sales can be bifurcated into two classifications, the first one is cash sales.
If the cash sales is given, the amount of cash receipt due to cash sales should have to be
immediately brought under the respective period i-e during the same month or week.
The next is the credit sales of the firm, the volume of sales should only be effected only
at the amount of realization of sales or collection of credit sales from the consumers and
customers. If cash sales is not given instead credit sales only the component given, that
should be added in the list of cash receipts ; by registering the credit period involved for
the customers and consumers. Being as credit sales, the amount of sales realization
should only relevantly be considered during the specified period.
Third step is to list out the various items of cash expenses expected to incur during the
specified period. The text of the problem deals with the delay of making the payment of
expenses is one month in all cases; It means the expenses like Manufacturing overheads,
selling overheads are expected to pay one month later i-e these expenses will be paid
one month after. It means that the May month of other expenses are paid only in the
month of June and during the month of June month expenses are met out.
The purchases requires same kind of treatment in the case of sales. Normally, the
purchases are classified into two divisions viz cash purchases and credit purchases.
The cash purchases should be given effect only at the moment of cash payment is paid
170
on the volume of purchase, but, if the credit purchases are made by the firm, the credit
allowed by the vendor/supplier to make the payments should be relatively considered for Budgetary Control
the expected outflow of cash i-e payment of purchase one month later or two months
later.
The expected time period occurrence of a either cash receipt or cash payment should be
considered for the preparation of the cash budget.
The cash budget should be prepared separately in the statement to derive the closing
balance of the specified year/month. The closing balance of the yester period or previous
period has to be carried forward to the next period as opening balance of the preparation
of a budget. The closing balance of the month June will be the opening balance of the
month July. Once the statement has been completed in the preparation of budget of
respective periods should be consolidated for the specified periods.
Cash Budget for the Months of June and July 1998
Particulars June Rs July Rs
Opening balance 20,000 26,800
Receipts: 80,000 84,000
Sales
Total Cash Receipts I 1,00,000 1,10,800
Payments: 64,000 66,000
Purchases
Manufacturing Overheads 2,400 2,600
Selling Overheads 2,800 2,800
Tax payable 4,000 -------------
Total Payments II 73,200 71,400
Balance I-II 26,800 39,400
Illustration 2
From the estimates of income and expenditure, prepare cash budget for the months from
April to June.
Month Sales Rs Purchases Rs Wages Rs Office Exp. Selling Exp. Rs
Rs
Feb 1,20,000 80,000 8,000 5,000 3,600
Mar 1,24,000 76,000 8,400 5,600 4,000
Apr 1,30,000 78,000 8,800 5,400 4,400
May 1,22,000 72,000 9,000 5,600 4,200
June 1,20,000 76,000 9,000 5,200 3,800
i. Plant worth Rs. 20,000 purchase in June 25% payable immediately and the remaining
in two equal installments in the subsequent months
ii. Advance payment of tax payable in Jan and April Rs 6,000
iii. Period of credit allowed
a. By suppliers 2 months
b. To customers 1 month
iv. Dividend payable Rs.10,000 in the month of June
v. Delay in payment of wages and office expenses 1 month and selling expenses
½ month. Expected cash balance on 1st April is Rs. 40,000.
Solution:
a. Plant worth Rs 20,000/ purchased, payable immediately is 25% i-e Rs.5,000 should
be paid in the month of June. The remaining cost of the machine has to be paid in
the subsequent months, after June. The payments whatever are expected to make
after June is not relevant as far as the budget preparation concerned.
171
Accounting and Finance for b. Delay in the payment of wages and office expenses is only one month. It means
Managers
wages and office expenses of Feb month are paid in the next month, March.
Selling expense From the above coloured boxes, it is obviously understood that
during the months of April, May and June ; the following will be stream of payment
of selling expenses.
April= Rs. 2,000 of Mar (Previous Month) and Rs. 2,200 of April (Current month)=
Rs.4,200/
May= Rs. 2,200 of April (Previous Month) and Rs.2,100 of May (Current month)=Rs.
4,300/
June= Rs. 2,100 of May (Previous Month) and Rs.1,900 of June (Current
month)=Rs. 4,000/
c. Selling expenses is having the delay of ½ month, which means 50% of the selling
expenses is paid only in the current month and the remaining 50% is paid in the next
Particulars Feb Mar April May June
Selling 3,600 4,000 4,400 4,200 3,800
Expenses
Payment 50% 1,800 2,000 2,200 2,100 1,900
in the current
month
Delay 50%- 1,800 2,000 2,200 2,100 1,900
will be paid in
the subsequent
month
Every month 50% of the selling expenses of the current month and 50% of the previous
month selling expenses are paid together ; the above coloured boxes depict the payment
of 50% of the current selling expenses along with 50% expenses of previous month.
Cash Budget for the Periods ( April and June)
Flexible budget is prepared for any level of production as an estimate of statement of all
expenses i-e the expenses are classified into three categories viz variable, semi-variable
and fixed expenses. The structure of the budget for any output is only to the tune of the
actual performance achieved. This is the budget facilitates not only to have comparison in
between various levels of production but also to identify the level of lowest production cost.
Utilities of the flexible budget:
l This budget is most useful tool of analysis in studying the sales at when the
circumstances are not warranting to predict
l It is mostly suited to the seasonal business, where the sales volume is getting differed
from one period to another due to changes taken place in the taste and preferences
of the buyers
l The production is being done on the basis of demand of the products in the market.
The demand of the products is studied only through demand forecasting. The flexible
budget is more applicable in the case of products, which are greatly finding difficult
to forecast the demand
l The budget is prepared only during the time of acute shortage of resources of
production viz Men, Material and so on
Illustration 3
Draft a flexible budget for overhead expenses on the basis of following information and
determine the overhead rates at 70% 80% and 90% plant capacity.
Particulars 70% capacity 80% capacity Rs 90% capacity
Variable Overheads
Indirect Labour ----------------- 24,000 ----------------
Stores including spares ----------------- 8,000 ----------------
Semi-variable overheads ----------------- 40,000 ----------------
Power( 30% fixed ,70%)
Repairs and maintenance ----------------- 4,000 ----------------
80% fixed and 20% variable
Fixed Overheads ----------------- 22,000 -----------------
Depreciation
Insurance ----------------- 6,000 -----------------
Salaries ----------------- 20,000 -----------------
Total overheads ----------------- 1,24,000 -----------------
Solution:
Flexible Budget for the various capacities
Illustration 5
From the following information relating to 1963 and conditions expected to prevail in
1964, prepare a budget for 1964:
State the assumption you have made, 1963 actuals
Sales 1,00,000 (40,000 units)
Raw materials 53,000
Wages 11,000
Variable overheads 16,000
Fixed overheads 10,000
174
1964 prospects Budgetary Control
10.6.4 Criticism
1. Non financial matters cannot be considered for the cost & benefit analysis
2. Difficulties involved in the process of ranking of the decision packages
3. It needs more time span for preparation and cost of operations is more and more
10.9 KEYWORDS
Budget: A financial statement prepared for specified activity for future periods
Budgeting: Activity of preparing the budget is known as budgeting
Budget control: Quantitative controlling technique to assess the performance of the
organization
Cash Budget: It is a statement prepared by the organization to identify the future needs
and receipts of cash from the yester activities
Flexible Budget: It is a financial statement prepared on the basis of principle of flexibility
to identify the cost of the unknown level of production from the existing level of operational
176 capacity.
Budgetary Control
10.10 QUESTIONS FOR DISCUSSION
1. Define budget.
2. Define budgetary control.
3. Highlight the various types of budget.
4. Elucidate the process of production budget.
5. Illustrate the methodology of purchase budget.
6. Draw the process of preparing the cash budget.
177
Accounting and Finance for
Managers LESSON
11
MARGINAL COSTING
CONTENTS
11.0 Aims and Objectives
11.1 Introduction
11.2 Meaning & Definition of Marginal Costing
11.3 Why Marginal Cost is called as Incremental Cost?
11.4 Why Marginal Cost is called in other words as Variable Cost?
11.4.1 Fixed Cost
11.4.2 Variable Cost
11.4.3 Semi-variable Cost
11.4.4 Method of Difference
11.4.5 Method of Coverages
11.5 Break Even Point Analysis
11.5.1 Break Even Point in Units
11.6 Verification
11.6.1 Selling Price Method
11.6.2 PV Ratio Method
11.6.3 Graph Method
11.7 Margin of Safety
11.8 Determination of Sales Volume in Rupees at Desired Level of Profit
11.9 Applications of Marginal Costing
11.9.1 Make or Buy Decision
11.9.2 Worth of Production
11.9.3 Worth of Purchase
11.10 Accepting the Export Offer
11.11 Key Factor
11.12 Selecting the Suitable Product Mix
11.13 Determining Optimum Level of Operations
11.14 Alternative Method of Production
11.15 Let us Sum up
11.16 Lesson-end Activity
11.17 Keywords
11.18 Questions for Discussion
11.19 Suggested Readings
178
Marginal Costing
11.0 AIMS AND OBJECTIVES
In this lesson we shall discuss about marginal costing. After going through this lesson
you will be able to:
(i) understand meaning and definition of marginal costing
(ii) analyse break even point analysis
(iii) discuss applications of marginal costing and selecting the suitable product mix.
11.1 INTRODUCTION
It is one of the premier tools of management not only to take decisions but also to fix an
appropriate price and to assess the level of profitability of the products/services. This is
a only costing tool demarcates the fixed cost from the variable cost of the product/
service in order to guide the firm to know the minimal point of sales to equate the cost of
production. It is a tool of analysis highlighting the relationship in between the cost, volume
of sales and profitability of the firm.
179
Accounting and Finance for
Managers 11.3 WHY MARGINAL COST IS CALLED AS
INCREMENTAL COST?
From the above example, it is obviously understood that marginal cost is nothing but a
cost which incorporates the incremental changes in the cost of production due to either
an increase or decrease in the level of production by one unit, meant as incremental cost.
Y’
X’
X'- Units
Y'- Cost in Rupees
Variable Cost
180
X'- Units Marginal Costing
Contribution
Marginal Costing(MC)
Break Divide
Even Equal
Break Even Point is the point at which the Total Cost is equivalent to Total Revenue. At
the break even point the business neither earns profit nor incurs a loss. It means that the
182 firm's cost is recovered at the minimum level of production.
Marginal Costing
No Profit / No Loss
If Sales > BEP Sales æÆ earn profit i.e. Total Sales> Total Cost which leads to earn
profit.
If Sales< BEP Sales æÆ incur loss i.e. Total Sales< Total Cost which registers incurrence
of loss.
This Break even point analysis can be interpreted into two classifications. The first
classification is narrow sense of BEP, which mainly emphasizes on BE Point.
The second segment is the broader sense which elucidates the role of BEP towards
managerial decisions
l Fixation of Selling price
l Acceptance of Special / Foreign order
l Incremental Analysis- On cost as well as revenue
l Make or Buy Decision
l Key factor analysis
l Selection of production mix
l Maintaining the specified level of profit and so on
The enlisted decisions will be discussed immediately after the preliminary aspects of
marginal costing i.e. Break even analysis.
The Break even point in accordance with narrow sense can be classified into two
categories
l Break Even Point in Units
l Break Even Point in Sales
Fixed Cost
"X" units =
Contribution Margin Per Unit
The total number of units "X" which equate the contribution volume of "X" units with the
total fixed cost is the Break Even Point (Units).
Fixed Cost
Break Even Point (Units) =
Contribution Margin Per Unit
Rs.1000/-
= = 100 Units
Rs.10/-
The above illustration reveals that how many number of times the contribution margin
per unit should be equivalent to the total fixed cost volume. Hence the number of times
is nothing but the units required to have equivalent volume of contribution to the tune of
184 fixed cost.
Marginal Costing
11.6 VERIFICATION
At the level of 100 units
Sales 100×Rs.20 Rs.2,000/
Variable Cost 100×Rs.10 Rs.1,000/
Contribution 100×Rs.10 Rs.1,000/
Fixed Cost Rs.1,000/
Profit/Loss 0 d
Break Even Point ( Sales Volume Rs):
Break even point in sales can be found out in two methods.
1. Selling Price Method
2. PV Ratio Method.
Fixed Cost
BEP(Rs) =
PV ratio
What is PV ratio?
PV ratio is Profit Volume ratio which establishes the relationship in between the profit
and volume of sales. It is a ratio normally expressed in terms of contribution towards
volume of sales. It is expressed in terms of percentage.
Utility of PV ratio:
l To find out the Break Even Point in sales volume
l To identify the desired level of profit at any sales volume
l To determine the sales volume to earn required level of profit
l To identify better product mix among the alternatives available etc.
Rs.1000/-
PV ratio = ×100 = 50%
Rs. 2000/-
PV ratio at the level of one unit
Rs.10/-
PV ratio = × 100 = 50%
Rs. 20/-
From the above workings, it obviously understood that every unit of sale contributes
50% towards in covering the fixed cost and profit. 185
Accounting and Finance for
Managers Fixed Cost
Break Even Sales:
PV ratio
At the level of 100 units In Percentage
Sales 100×Rs.20 Rs. 2,000/ 100%
Variable Cost 100×Rs.10 Rs.1,000/ 50%
Contribution 100×Rs.10 Rs.1,000/ 50%
Fixed Cost Rs.1,000/
Profit/Loss 0 f
PV Ratio = Rs.1000/Rs.2000 = 50%
50 % of what ?
If Rs.100 is Sales ; Rs.50 is Contribution and the remaining Rs.50 variable cost.
Contribution
At Break even sales, Fixed Cost = Contribution; × Sales = Sales
Contribution
is the volume which neither earns nor incurs loss.
Illustration 2:
Calculate Break Even Point from the following particulars
Fixed Cost Rs.3,00,000
Variable Cost Per Unit Rs.20/-
Selling Price Per Unit Rs.30/-
Fixed Cost
Break Even Point (Units) =
Contribution Margin Per Unit
First Step to find out Contribution margin per unit
Contribution Margin Per Unit = Selling Price Per Unit – Variable Cost Per Unit
= Rs.30 – Rs.20 = Rs. 10
Rs.3,00,000
= = 30,000 units
Rs.10
Break Even (Rupees) can be found out in two ways
Method I:
= B.E.P (Units) × Selling Price
= 30,000 units × Rs.30= Rs.9,00,000/-
(Or)
Method II:
Under this method PV ratio component has to be found out
Contribution
PV ratio = × 100
186 Sales
Marginal Costing
Rs 10
= × 100 = 33.33%
Rs.30
Illustration 3:
Calculate Break even point Rs.
Sales 6,00,000/-
Fixed Cost 1,50,000/-
Variable Expenses
Direct Material 2,00,000/-
Direct Labour 1,20,000/-
Overhead Expenses 80,000/-
First step to find out the total volume of Variable expenses
Variable Expenses = Direct Material + Direct Labour + Overhead Expenses
= Rs.2,00,000 + 1,20,000 + 80,000 = Rs.4,00,000/-
Second Step to find out the contribution
Contribution = Sales- Variable Expenses
= Rs.6,00,000- 4,00,000= Rs. 2,00,000/-
Third step to find out PV ratio
PV ratio= Contribution/ Sales= Rs,2,00,000/Rs.6,00,00= 1/3
Final Step to find out Break even sales
Fixed Cost
BEP (Units) =
Contribution Margin per unit
Rs.27,000
= = 1080 units
Rs.25
If break even point is reduced to the level of 900 units; what is the new selling price?
First step to find out the contribution margin per unit; contribution margin per unit will be
computed from the BEP (units) formula.
Rs.27,000
BEP (Units) = 900 =
Contribution Margin per unit
Cost/ Volume
Rs 3000 TS
2000
1500 TC
BEP
1000 Margin
of Sa fety
500 FC
10
50 100 150
Units
(Or)
Profit
=
PV ratio
The greater the margin of safety leads to soundness of the firm's business.
Fixed Cost
Break Even Sales (Rupees) =
PV ratio
The above formula is in accordance with the method of coverage i-e covering the fixed
cost and profit.
Contribution = Fixed Cost + Profit
To earn desired level of profit, which the firm intends to earn should have to be combined
with the fixed cost, are the two different components to be covered only in order to find
out the contribution level to the tune of unchanged selling price and variable cost per unit.
Illustration 5:
From the following information relating to quick standards ltd., you are required to find
out i) PV ratio ii) break even point iii) margin of safety iv) calculate the volume of sales
to earn profit of Rs.6,000/
Total Fixed Costs Rs.4,500/
Total Variable Cost Rs.7,500/
Total Sales Rs.15,000/-
First step to find out the Contribution volume
Sales Rs 15,000/
Variable Cost Rs. 7,500/
Contribution Rs.7,500/
Fixed Cost Rs.4,500/-
Profit Rs.3,000
(i) Second step to determine the PV ratio
Contribution 7,500
PV ratio = × 100 = × 100 = 50%
Sales 15,000
Profit Rs.3,000
(b) Margin of Safety = = = Rs.6,000/-
PVratio 50%
(iv) Sales required to earn profit = Rs.6,000/
To determine the sales volume to earn desired level of profit
Rs.4,500 + Rs.6,000
= = Rs.21,000/-
50%
Illustration 6:
Break even sales Rs.1,60,000
Sales for the year 1987 Rs.2,00,000
Profit for the year 1987 Rs.12,000
Calculate
(a) Profit or loss on a sale value of Rs.3,00,000
(b) During 1988, it is expected that selling price will be reduced by 10%. What should
be the sale if the company desires to earn the same amount of profit as in 1987 ?
The major aim to compute fixed expenses.
In this problem, the profit volume is given which amounted Rs.12,000
Profit = contribution- Fixed expenses
From the above equation, the volume of contribution only to be found out
To find out the volume of contribution, the PV ratio has to be found out
Before finding out the PV ratio, the margin of safety should be found out
Margin of safety = Actual sales - Break even sales
= Rs.2,00,000-Rs.1,60,000 = Rs.40,000
Another formula for to find out the Margin of safety is as follows
Profit
Margin of safety =
PV ratio
Profit Rs.12,000
PV ratio = = = 30%
Margin of safety Rs.40,000
What is PV ratio ?
Contribution
PV ratio = × 100
Sales
Contribution
30% =
Rs.2,00,000
190
Contribution = Rs.2,00,000 × 30% = Rs.60,000 Marginal Costing
Now with the help of the available information, the fixed expenses to be found out from
the illustrated formula
Fixed expenses = Contribution- Profit = Rs.60,000 – Rs,12,000 = Rs.48,000
The next one is to find out the corresponding variable cost. The variable cost could be
found out with the help of the following formula
Sales- Variable cost = Contribution
Rs.2,00,000- Rs.60,000= Variable cost= Rs.1,40,000
(a) Profit or loss on the sale value of Rs 3,00,000
For a sale value of Rs.3,00,000 what is the contribution ?
Contribution for Rs.3,00,000 sale= Rs.3,00,000 × 30%= Rs.90,000
Profit or Loss= Contribution – Fixed expenses= Rs.90,000–Rs,48,000=
Rs 42,000 (Profit)
(b) Sales to be found out to earn same level of profit
Sale value reduced 10% from the actual
Rs. 2,00,000–Rs.20,000 Rs.1,80,000
Variable cost Rs.1,40,000
Contribution Rs.40,000
For the new level of sale volume in rupees, the new PV ratio has to be found out
Contribution Rs.40,000
PV ratio = × 100 = × 100 = 2/9 times
Sales Rs.1,80,000
The next important step is to determine the volume of the sales to earn the desired
level of profit
Rs.48,000 + Rs.12,000
= = Rs.2,70,000
2/9
Illustration 7:
SV ltd a multi product company, furnishes you the following data relating to the year
1979
Particulars First half of the year Second half of the year
Sales Rs.45,000 Rs.50,000
Total cost Rs40,000 Rs.43,000
Assuming that there is no change in prices and variable costs that the fixed expenses are
incurred equally in the two half year periods calculate for the year 1979
Calculate
(a) PV ratio
(b) Fixed expenses
(c) Break even sales
(d) Margin of safety
(C.A. Inter May, 1980) 191
Accounting and Finance for (a) The first step is to find out the PV ratio
Managers
Change in Profit
Formula for PV ratio = × 100
Change in Sales
To identify the change in profit, the profits of the two different periods should be
known
Profit= Sales-Total cost
Profit of the first half of the year = Rs.45,000–Rs.40,000 = Rs.5,000
Profit of the second half of the year= Rs.50,000–Rs.43,000 = Rs.7,000
Change in profit= Rs.7,000–Rs.5,000= Rs.2,000
Change in sales= Rs.50,000–Rs.45,000=Rs.5,000
Rs.2,000
PV ratio = × 100 = 40%
Rs.5,000
(b) Fixed expenses, to find out the contribution should be initially found out
Contribution = Sales × PV ratio
= Rs.50,000 × 40% = Rs.20,000
The fixed expenses to be found out through the following equation
Contribution-Fixed expenses= Profit
Rs.20,000–Rs.7,000= Rs.13,000= Fixed expenses
The fixed expenses found only for six months ; for the entire year
= Rs.13,000 × 2=Rs. 26,000
(c) BE Sales
Fixed expenses Rs. 26,000
= = = Rs.65,000
PV ratio 40%
(d) Margin of safety
= Total sales- BE sales
The next component to be found out is total sales
Total sales = Sale of the first half of the year + Sale of the second half of the year
= Rs.45,000 + Rs.50,000 = Rs.95,000
Margin of safety= Rs.95,000 – Rs.65,000= Rs.30,000
Rs. 30,000
Margin of safety in percentage of sales = × 100= 31.578%
Rs. 95,000
Rs.20,000
= = 2,000 units
Rs.50–Rs.40
At 2,000 units, the firm considers both alternatives are incurring equivalent volume of
Cost in manufacturing.
Cost of buying for 2,000 units
=2,000 units × Rs.50 per unit= Rs. 1,00,000
Cost of Buying Break even in Rupees
= Rs.20,000 + 2,000 units × Rs.40 = Rs.1,00,000
From the above, it obviously understood that both are bearing equivalent amount of
costs. It means both are neither profitable nor non- profitable.
Which one is better for the firm?
No of Units Manufacturing cost Buying cost Decision
@ 2,001 units Rs.20,000+ Rs.80,0040 2001 × Rs.50 Manufacturing
=Rs.1,00,040 = Rs.1,00,050 cost < Buying cost
Advisable to
manufacture
@1,999 units Rs.20,000+Rs.79,960 1,999 × Rs.50 Manufacturing
=Rs.99,960 Rs.99,950 cost > Buying cost
194 Advisable to Buy
The next step is to identify the worth of either manufacturing the units or buying the units Marginal Costing
at 5,000
If the manufacturer buys from the outsider= 5,000 × Rs.50= Rs.2,50,000
If the same manufacturer produces the component instead of buying
=Rs.20,000+ Rs.2,00,000= Rs.2,20,000
From the above, the company is finally advised to manufacture the component due to
low cost of manufacture.
The acceptance of the order will generate marginal profit of Rs.30,000 which should be
accepted. The fixed portion of the factory and selling overheads were already met out 195
Accounting and Finance for which should not be included again in the computation of the marginal or additional cost
Managers
of the foreign order placed by the business enterprise.
Instead, If the firm accepts the local order at the rate of Rs.20 which automatically will
spoil the relationship with the very good customers who regularly purchase at the rate of
Rs.24. This will lead to cannibalization of the existing pricing strategy.
(I.C.W.A.Inter)
The product is being chosen by the manufacturer based on the ability of generating
higher contribution. The higher the contribution leads to a better the position for the firm
The worth of the product is being selected on the basis of
Particulars Per unit of Product A Rs Per unit of Product B Rs
Selling price 100 110
Less :Direct Material 24 14
Direct Labor @ Re 1per hr 2 3
Variable overhead Rs.2 per hr 4 30 6 23
Contribution 70 87
Standard time to produce 2 Hours 3 Hours
Contribution per hour per product Rs.70/2 Hrs= Rs.35 Rs.87/3 Hrs= Rs 29
From the above calculation, it is obviously understood that the firm is having higher
contribution margin per hour in the case of product A over the other one, portrays the
product A is better than B.
Illustration 12
The following particulars are obtained from costing records of a factory:
Particulars Per unit of Product A Rs Per unit of Product B Rs
Direct Material Rs.20 per Kg 80 320
Direct Labor @ Re 10per hr 100 200
196
Contd...
Variable overhead 40 80 Marginal Costing
Now the contribution per unit has found out with the help of above given information the
next step is to study the contribution margin per unit to the tune of given constraints of
the firm.
(a) The first constraint is in adequate supply of the raw material: The raw materials
are considered to be precious due to insufficient supply to the requirement of the
firm. Having considered the scarcity of the raw material, the constraint in availing
the raw material is denominated in terms of ability of contribution generation.
Particulars Per unit of Product A Rs Per unit of Product B Rs
Contribution margin per unit 180 400
Consumption of raw material
per unit
Cost of raw material per unit Rs 80 = 4 Kgs Rs.320 = 16 Kgs
Cost of material per Kg Rs.20 Rs20
Contribution per Kg Rs. 180 = Rs.45 Rs.400 = Rs.25
4 Kgs 16 Kgs
It obviously understood that the firm enjoys greater contribution margin per k.g in
the case of Product A during the scarcity of raw material than the product B.
(b) Then the production capacity of the firm is subject to the availability of the labour and
the hours normally consumed by them for the production of a single product. Due to
shortage of the labour, the firm should identify the product which requires lesser
labour hours as well as able to generate more contribution margin per labour hour.
In the next step, Contribution margin per hour should be calculated.
Particulars Per unit of Product A Rs Per unit of Product B Rs
Contribution margin per unit 180 400
Consumption of Labor Hrs
Cost of Labor per unit
Cost of Labor per Hour Rs100 = 10 Hrs Rs.200 = 20 Hrs
Rs.10 Rs10
Contribution per Hr of the Rs. 180 = Rs.18 Rs.400 = Rs. 20
product 10 Hrs 20 Hrs
197
Accounting and Finance for The contribution per hour is greater in the case of the product B, considered to be
Managers
as a better product among the given. It means that the firm has better opportunity
to earn greater contribution in the case of product B than A.
(c) The next one is that sale of the quantities is the major limiting factor. It means that
the vendor finds some what difficulties in selling the articles. While considering the
difficulties in selling the quantities, the firm should identify the product which is able
to generate greater contribution.
From the earlier calculation, it is clearly understood that, the product B is bearing
greater value of contribution margin per unit than the product.
(d) If the sales value is considered to be a limiting factor, to choose one among the
given products PV ratio is being applied as a measure. It means that the sales
value of the products are ignored for comparison in between them. To identify the
better product, irrespective of the price, PV ratio should be applied. The PV ratio
of the Product A & B are calculated as follows
Contribution
Profit volume ratio = × 100
Sales
For A = 45%
For B = 40%
The PV ratio is greater in the case of product A than B. The product A has to be
chosen
1. Which is the following factor equated to the Contribution at the level of Break Even
Point ?
(a) Fixed cost (b) Sales
(c) Variable cost (d) Semi-Variable cost
2. What is the change to be made on the BEP formula to find out the volume of sales at
the desired level of profit ?
(a) Desired profit (b) Fixed cost
(c) Desired profit with Fixed cost (d) Desired cost + Fixed profit
1. If the supply of the material is considered to be scared in the market for two different
units of production of ABC ltd. How the worth of the units of production could be
studied through Key factor analysis?
198
Contd...
(a) Contribution per unit (b) Contribution per labour Marginal Costing
Illustration 13
From the following information has been extracted of EXCEL rubber products ltd
Direct materials A Rs 16
Direct materials B Rs12
Direct wages A 24 Hrs at 50 paise per hour
Direct wages B 16 Hrs at 50 paise per hour
Variable overheads 150% of wages
Fixed overheads Rs. 1,500
Selling price A Rs.50
Selling price B Rs.40
The directors want to be acquainted with the desirability of adopting any one of the
following alternative sales mixes in the budget for the next period.
(a) 250 units of A and 250 units of B
(b) 400 units of B only
(c) 400 units of A and 100 units of B
(d) 150 units of A and 350 units of B
State which of the alternative sales mixes you would recommend to the management?
The first step is to determine the contribution margin per unit of A and B.
The determination of the contribution of product A and B are through the preparation of
Marginal costing statement.
Particulars Product A Rs Product B Rs
Selling price 50 40
Less: Direct Materials 16 12
Direct wages 12 8
Variable overheads 18 12
Variable cost 46 32
Contribution 4 8
The profit level among the given various mixes, the mix (d) is able to generate
highest volume of profit over the others
10,000
For 50% = units × 50 = 12,500 units
40
10,000 units
For 90 % = × 90 = 22,500 units
40
The important information is that the changes taken place in the selling price of the
product.
Selling price = Rs.20 @ 40% i.e., 10,000 units
Selling price @ 50% i.e. 12,500 units = Rs.20–3% on Rs.20 = Rs.19.40
Selling price @90% i.e. 22,500 units=Rs.20–5% on Rs.20 = Rs.19
While preparing the marginal costing statement, the fixed cost portion should not be
included for the computation of the contribution.
The next step is to prepare the marginal costing statement.
Particulars 50 % capacity(12,500 Units) 90% capacity Rs(22,500 units
Per unit Rs Total Rs Per unitRs TotalRs
Selling price 19.40 2,42,500 19.00 4,27,500
Less: Direct Materials 10 1,25,000 9.50 2,13,750
Direct wages 3 37,500 3 67,500
Variable overheads 2 25,000 2 45,000
Variable cost 15 14.50
Contribution 4.40 55,000 4.50 1,01,250
Fixed costs 30,000 30,000
Profit 25,000 71,250
11.17 KEYWORDS
Marginal cost: Change occurred in the cost of operations due to change in the level of
production.
B E P (Units): It is the level of units at which the firm neither incurs a loss nor earns
profit.
BEP (Volume): It is the level of sales in Rupees at which the firm neither incurs a loss
nor earns profit.
Fixed cost: It is a cost which is fixed or remains the same for irrespective level of
production.
Variable cost: It varies along with the level of production.
Contribution: It is an amount of balance available after the deduction of variable cost
from the sales.
Key factor: Factor of influence on the component of contribution.
PV ratio: Profit volume ration which is nothing but the ratio in between the contribution
and sales.
Desired profit: It is a profit level desired by the firm to earn at the given level of sales
volume.
203
UNIT-IV
LESSON
12
FINANCIAL MANAGEMENT
CONTENTS
12.0 Aims and Objectives
12.1 Introduction
12.2 Finance and Related Disciplines
12.2.1 Finance and Economics
12.2.2 Finance and Accounting
12.3 Profit Maximization
12.3.1 Criticism
12.4 Wealth Maximization
12.5 Objectives & Functions of Financial Management
12.6 Let us Sum up
12.7 Lesson-end Activity
12.8 Keywords
12.9 Questions for Discussion
12.10 Suggested Readings
12.1 INTRODUCTION
The financial management was initially perceived that the study with reference to only
procurement of funds but later it was extended to one more additional feature that efficient
utilization of funds.
It is imperative to understand the meaning of the term “Finance”
l Money with objective
l Money with purpose
l Money with direction
l Money with target
l Money with achievement
l Money with aim
The above explanation is able to understand the real meaning of the term finance which is
nothing but effective utilization raised money with some purpose to achieve in desired direction.
Accounting and Finance
for Managers 12.2 FINANCE AND RELATED DISCIPLINES
The study of role of finance in the organization is with reference to financial management.
The financial management is the course which has drawn major focus points from the
many more disciplines. To study them, the inter relationship in between the financial
management and other related disciplines.
The following are the related disciplines viz
l Finance and Economics
l Finance and Accounting
l Finance and Marketing
l Finance and production
l Finance and Quantitative Methods
Financial management is the course which has drawn major focus points
from the many more disciplines. Discuss.
12.3.1 Criticism
There is misapprehension about the workability of the private enterprise which normally
strives for the profit maximization but not by considering the welfare of the society
The next most important criticism is that in ability to fit into the practical considerations
The second set of criticism is that the set of technical flaws or set backs associated with
the financial management.
The technical flaws of the profit maximization is studied under three different headings viz:
Ambiguity
Timing of benefits
Quality of benefits
Ambiguity: Profit is to be maximized; which profit has to be maximized? Either Net profit
or Gross profit is to be maximized? Whether the short term or long term profit is to be
maximized? Whether total profit or rate of profit is to be maximized? Whether the return
on the total assets employed or the return on the total capital employed is to be maximized?
The maximization of profit is vague due unclear definition of the term profit.
Timing of Benefits
Project Alternative A Alternative B
Rs Lakh Rs Lakh
Period 1 50 -------
Period 2 100 100
Period 3 50 100
Total 200 200
From the above table, the two alternative projects A and B are found to be identical with
reference to profit maximization due to equivalent volume of profits of them.
Really speaking, these two projects are not identical, why?
209
Accounting and Finance One missing phenomenon is that timing of benefits.
for Managers
The timing of benefits should be relatively given greater importance for weighing the
project at the moment of consideration.
Project alternative A is better than the project alternative B, why?
Project alternative A is able to generate the benefits during the period 1 which is known
as earlier benefits, facilitating the A alternative to go for reinvestment, but in the case of
reinvestment opportunity is denied due to non availability of profits during the early season
i.e. period 1
Quality of Benefits
Project Alternative A Rs Alternative B Rs
Lakh Lakh
Recession 9 0
Normal 10 10
Boom 11 20
Total 30 30
Under the profit maximization, the quality of benefits are not considered what is meant
by the quality of benefits?
It means the certainty of benefits. The more certain the benefits is better the quality of
benefits and vice versa. The profit maximization failed in its attempt to consider the
quality of benefits. It has considered the both project are identical but really they are not.
Alternative B project is more volatile returns in other words they are more uncertain
unlike the project A. The project A is having only least volatility in the earning pattern
during the three seasons. A is the better project which has greater certainty in accruing
benefits over the others, are normally preferred by the risk averters.
210
Lower the discount Rate portrays that Lower Risk and Lower uncertainty
The Decision Criterion is based on the comparison in between the Value and Cost Financial Management
The Creation of Value takes place only at when the economic benefits are more than
Cost
The Reduction of wealth just contrary to the earlier which normally produces lesser
Economic Benefits than Cost
The decision of either acceptance or rejection is subject to the net present value
It is imperative to refer the words of Ezra's Solomon to illustrate the importance of the
wealth maximization
"The gross present worth of a course of action is equal to the capitalised value of the
flow future expected benefit, discounted at a rate which reflects their
certainty/uncertainty. Wealth or net present worth is the difference between gross present
worth and the amount of capital investment required to achieve the benefits being
discussed. Any financial action which rates wealth or which has a net present worth
above zero is a desirable one and should be undertaken. Any financial action which does
not meet this test should be rejected. If two or more desirable courses of action are
mutually exclusive, then the decision should be to do that which creates most wealth or
shows the greatest amount of net present worth"
l W = V-C
l W = Net present worth
l V = Gross present worth
l C = Investment required to acquire the asset/purchase the course of action
l V = E/K
l E = Size of the benefits available to the suppliers of capital
l K = capitalization rate reflecting quality and
Timing of benefits attached to E
l E = G–(M+I+T)
l G = Average future flow of gross earnings expected from the course of action,
before the maintenance charges, taxation, expected flow of interest, preference
dividend
l M = Average annual required investment to maintain G
l I =Expected flow of annual payments of Interest, Preference Dividend and other
prior charges
l T=Expected annual outflow of taxes
Alternate method:
A1 A2 A3 An
l 1
+ 2
+ 3
....... + -C
(1 + K) (1 + K) (1 + K) (1 + K) n
A1, A2, A3--------depicts the flow of cash resources from a course of action over the
period of time
K=is an appropriate discount rate
C=Initial outlay to acquire the asset
If the out come is positive means that net present worth is positive i.e., more than the
initial investment, considered to be fruitful for the investment and vice versa
Wealth of the investors= market value of the shareholding of the investors
If net worth is positive then the wealth of the investors will go up ; it means that the
market value of the share holding of the investors will pile up.
It is called in other words as Maximization of market value of the shares.
211
Accounting and Finance
for Managers 12.5 OBJECTIVES & FUNCTIONS OF FINANCIAL
MANAGEMENT
The next aspect is that organization of finance function.
The finance function is classified into two categories viz routine functions and functions
of special importance.
The routine functions are normally Accounting aspects of transactions of the business
enterprise which mainly given controller of the finance department.
The functions of special importance are normally involved in the process of preparing
the policies of the organization with reference to finance administration ; which is mainly
earmarked to the Treasurer of the finance department of the organization
The following are the important functions of the Treasurer which normally have special
importance in characteristics:
l Obtaining finance
l Banking relationship
l Investor relationship
l Short-term financing
l Cash management
l Credit administration
l Investments
l Insurance
The following are the vital functions of the Controller which regularly include:
l Financial accounting
l Internal audit
l Taxation
l Management accounting and control
l Budgeting, planning and control
l Economic appraisal and so on
1. Finance is the
(a) Money with motive (b) Money with purpose
(c) Money with objective (d) (a), (b) and (c)
2. Wealth is defined as
(a) Gross cash flow (b) Net cash flows
(c) Initial investment (d) None of the above
3. Why profit maximization is sidelined ?
(a) Ambiguous (b) Lack of quality of benefits
(c) Timing of benefits (d) (a), (b) and (c)
4. Which of the following function is the treasurer of the organisation?
(a) Obtaining finance (b) Financial accounting
(c) Internal audit (d) None of the above
212
Financial Management
12.6 LET US SUM UP
The major part of the financial management is to raise the financial resource to the
requirements. While raising the financial resources, the availability is subject to the macro
economic influences. Accounting is mainly vested with the collection and presentation of
data. But the finance is closely connected with the decision-making of the organization.
The objectives of the financial management are classified into two categories viz
l Profit maximization
l Wealth maximization
Profit is defined in two different angles viz. Owner's and Operational perspective.
Owners' perspective definition of profit is the share of national income paid to the owners.
Operational perspective defines the term profit as when the output exceeds the inputs of
the process. "The gross present worth of a course of action is equal to the capitalised
value of the flow future expected benefit, discounted at a rate which reflects their
certainty/uncertainty. Wealth or net present worth is the difference between gross present
worth and the amount of capital investment required to achieve the benefits.
12.8 KEYWORDS
Finance: A study of money with objective and desired direction
Profit: In terms of operations - Input < Output
Treasurer: Who carries out the financial management operation with special importance
Controller: Who carries out the routine functions of finance
Wealth maximization: Net present worth maximization; maximization of the market
value of the shares
13
TIME VALUE OF MONEY
CONTENTS
13.0 Aims and Objectives
13.1 Introduction
13.2 Foundations of The Time Value of Money
13.3 Classifications of The Time Value of Money
13.3.1 Rule of 72
13.3.2 Rule of 69
13.4 Frequency of Compounding
13.5 Effective Rate of Interest
13.6 Future Value of an Annuity
13.6.1 Future Value of Annuity Due
13.6.2 Sinking Fund Factor Method
13.7 Present Value of Single Cash Flow
13.8 Present Value of Annuity
13.9 Capital Recovery Factor Method
13.10 Let us Sum up
13.11 Lesson-end Activity
13.12 Keywords
13.13 Questions for Discussion
13.14 Suggested Readings
13.1 INTRODUCTION
The time value of money has gained greater importance in studying the viability of the
project by comparing the initial investment with the anticipated future benefits. If the
anticipated future benefits are more than the initial investment then the investment is
214 found to be viable in generating the economic benefits.
Why the time value of money principle is warranted to study under the financial Time Value of Money
management ?
The following are the many reasons involved:
To determine the real rate of return
l With reference to Money employment on productive assets
l In an inflationary period, a rupee today has greater purchasing power than rupee in
the future
l The future is uncertain- Individuals prefer current consumption rather than future
consumption
13.3.1 Rule of 72
The initial amount of investment gets Doubled within which 72/I
I = Interest Rate of the investment
Illustration 2
The amount of the investment is Rs.1,000. The annual rate of interest is 12%. When this
amount of Rs.1,000 will get doubled ?
= 72/12 = 6 years
13.3.2 Rule of 69
The amount method is found to crude method in determining the doubling period which
has its own limitations. The Rule of 69 was developed only in order to remove the
bottlenecks associated with the early model of doubling period.
The rule of 69 is found to be a scientific method as well as rational method in determining
the doubling period of the investment
=.35+ 69/I
Illustration 3
The amount of the investment is Rs.1,000. The annual rate of interest is 11% When this
amount of Rs 1,000 will get doubled?
=.35+ 69/11= 6.6227 yrs
1. State Bank of India announces that your money is getting doubled in 99 months.
What is the rate of interest payable ?
2. The next aspect in the Future value of money is interest frequency of
compounding.
How much does a deposit of Rs. 5,000 grow to at the end of 6 years. If the nominal rate
of interest is 12% and frequency is 4 times a year?
The future value of Rs. 5,000 will be
= Rs.5,000(1+.12/4)4×6
= Rs.5,000(2.033)= Rs.10,165
FVAn = =
[
A (1 + K) n − 1 ]
Future Value Interest Factor Annuity (FVIFA)
k
Illustration 6
Suppose you deposit Rs.1,000 annually in a bank for 5 years and your deposits earn a
compound interest rate of 10% What will be value of the deposit at the end of 5 years?
Assuming the each deposit occurs at the end of the year, the future value of this annuity?
FVAn = Rs.1,000(FVIFA) for 10% and 5 years
FVAn = =
[
A (1 + K) n − 1 ]
× (1+k) 217
k
Accounting and Finance for Illustration 7
Managers
If you invest Rs 1,000 at the beginning of every year, for four years. What will be the
value of the investment finally.
FVAn = Rs.1,000
[(1 + .10) − 1] × (1+.10)
5
.10
= Rs.1,000 × 6.7155= Rs.6,715.5
1. Four annual equal payments of Rs.2,000 are made into a deposit account
that pays 8% interest per year. What is the future value of this annuity at the
end of 4 years ?
2. You can save Rs.2,000 a year for 5 years, and Rs.3,000 a year for 3 years
thereafter. What will these savings cumulate to at the end of 8 years. If the
rate of interest is 10?
1. How much you should save annually to accumulate Rs.20,000 by the end of
10 years. If the saving earns an interest of 12%?
2. Mr vinay plans to send his son for higher studies abroad after 10 years. He
expects the cost of these studies to be Rs.1,00,000. How much should he
save annually to have a sum of Rs 1,00,000 at the end of 10 years. If the
interest rate is 12%?
l The discounting may be frequent in times like intra year compounding, intra month
compounding and so on.
l Subject to
v Number of periods in the analysis- increases
v Discount rate applicable per period decreases
m xn
Ê 1 ˆ
v PV= FV Á
Ë 1 + k /m ˜¯
To get Rs.20,000, how much should be invested per year (at the end). The important
information of the banking investment reveals the following are the rate of interest
is 10% and the normal compounding process is once in 6 months.
Ê (1 + K) n -1 ˆ
l PVAn,k = Á æÆ Present value factor annuity
Ë K(1 + k)n ˜¯
Illustration 11
If you expect to receive Rs.1,000 annually for 3 years, each receipt is expected to be at
the end of the years. What would be the present value of future cash inflows @ discount
rate of 10% ?
PVA n,k = Rs.1,000 × (2.487)= Rs.2,487
Ê K(1 + k) ˆ
A = PVA Á æÆ Reciprocal to Present value of an annuity
Ë (1 + K) n -1 ˜¯ 219
Accounting and Finance for Illustration 12
Managers
If your father deposits Rs.1,00,000 on retirement in a bank which pays 10% annual
interest. How much can be withdrawn annually for a period of 10 years?
A = PVA(1/PVIFA)
A = Rs.1,00,000 (1/6.145)= Rs.16,273
13.12 KEYWORDS
Time value of money: Money value in terms of time, money value in between the
present and future
Future value of money: Present value of money in terms of future through compounding
process
Present value of money: Future value of money is reckoned to "0" time period horizon
FVIF: Future value interest factor component for compounding
FVIFA: Future value interest factor component for compounding the series of cash
payments or receipts
PVIF: Present value interest factor of single cash flow
PVIFA: Present value of interest factor of multiple cash flows
Regular annuity: Series which normally happen at the end of the specified horizon
Annuity Due: Series which normally happen at the beginning
Doubling period: During which the amount of the investment gets doubled within the
given compounding factor component
Effective rate of interest: It is the rate of interest which the investment grows
14
SOURCES OF LONG TERM FINANCE
CONTENTS
14.0 Aims and Objectives
14.1 Introduction
14.2 Equity Shares
14.2.1 Sweat Security
14.2.2 Non Voting Shares
14.2.3 Bonus Issue
14.3 Preference Shares
14.3.1 Cumulative Preference Shares
14.3.2 Non Cumulative Preference Shares
14.4 Debentures
14.5 Bonds
14.6 Warrants
14.7 Let us Sum up
14.8 Lesson-end Activity
14.9 Keywords
14.10 Questions for Discussion
14.11 Suggested Readings
14.1 INTRODUCTION
The sources of long-term finance could be classified into the following categories:
l Equity shares
l Preference shares
l Debentures
l Bonds
l Warrants
222
The combination of the sources of long-term finance is known as capital structure. From Sources of Long Term Finance
the above classification, we will discuss one after the another.
14.4 DEBENTURES
Sec 2(12) of the Companies Act defines "Debenture includes debenture stock, bonds
and any other securities of a company whether constituting a charge on the assets of the
company". Debenture is an evidencing document i.e., long-term promissory note.
14.5 BONDS
It is a long-term debt instrument issued by the company to raise the financial resources
from the market, for specific period and it carries fixed rate of interest which has its own
salient features
l Issued at face value i.e Par value and Par or Discount.
l Rate of interest is fixed or flexible i.e. variable / floating rate of bond - coupon rate
of bond.
l Maturity date is specified but not in the case of perpetual bonds.
l Redemption value - in the bond certificate - may be par or premium - terms of the
issue.
l Bonds are traded in the market.
Type of Bonds
l Secured Bond: Issued on the assets of the issuer.
l Unsecured Bond: Issued by the issuer on the basis of name and fame.
l Perpetual bond: Bonds do not have maturity.
l Redeemable bond: Redemption or Repayment of the principal is specified by the
issuer.
l Fixed rate bonds: Rate of Interest is fixed at.
l Flexible/Floating rate bonds: Rate of interest is subject to prefixed norms.
The further more classification of bonds are available. They are following:
Zero Coupon bonds: These bonds are sold at discounted value and will be given at the
face value after the maturity period.
226
Deep discount bonds: It is another kind of zero coupon bond. Large discount is made Sources of Long Term Finance
on their nominal value. Interest is paid only at the time of maturity - 3-25 years.
Pay in kind bonds: This another kind of long-term instrument of raising funds. During
the First three years, these bonds need not pay any interest to the holders of the bonds,
in stead the interest bonds are issued which are known as additional bonds. These additional
bonds are called as baby bonds or kid bonds which are derived out of the parent bond. It
is identified by the many of the companies as wonderful instrument to raise the capital
from the market at the early stage of commencement of business.
The next type long-term instrument is that Warrants.
14.6 WARRANTS
These are nothing but Bearer documents which are title to buy the specified number of
equity shares at specified price during the future period. The life period of the warrants
are normally too long.
The warrants are normally issued by the company only in order to attract the issue of
fixed bearing securities viz preference shares and debentures.
The following are the various type of warrants:
l Detachable warrants: Warrants which are issued along with the host securities;
detachable
l Puttable warrants: The warrants issued are sold back to company before expiry
date
l Naked warrants: Warrants issued without any host securities
Advantages of the warrants
l Making other host securities more attractive
l It facilitates the companies to stand on its own leg and reduces the rate to depend
on the intermediaries
l The exercise of the warrants only during the future period which fosters better
planning for the company
l Lower cost of debt due to greater attraction towards warrants - denominated in
terms of equity shares - which are at later date
l Warrants are highly liquid which means they are traded in the Stock Exchanges
provided the warrants should not be exercised.
14.9 KEYWORDS
Share: smaller unit of the share capital of the company
Preference share: Preferential rights are pegged with this type of a share to share
228 anything from the company prior to the equity shareholders
Bond: Long-term debt instrument Sources of Long Term Finance
Debenture: Long-term debt instrument floated by the company with or without charge
on the assets of the company.
Security: The amount of lending is secured through the charge on the assets
Redemption: Time period of repayment and payment of the principal and interest
respectively are known
Warrants: Title to buy equity shares at the specified price in the future date
Host securities: These are the securities which are normally issued by the company
along with the warrants viz preference share and debenture
Naked warrants: Without any host securities, if any warrants are issued
229
Accounting and Finance
for Managers LESSON
15
CAPITAL MARKET DEVELOPMENTS IN INDIA
CONTENTS
15.0 Aims and Objectives
15.1 Introduction
15.2 Capital Market Reforms - In General
15.3 Reforms in Primary Market
15.3.1 Reforms in the Primary Market: 1996-97
15.3.2 Reforms in 1997-98
15.3.3 Reforms in 1998-2001
15.4 Reforms in the Secondary Market
15.4.1 Capital Market Reforms: 1996-97
15.4.2 Capital Market Reforms: 1997-98
15.4.3 Capital Market Reforms: 1998-2001
15.4.4 Capital Market Reforms: 2005-2007
15.5 Let us Sum up
15.6 Lesson-end Activity
15.7 Keywords
15.8 Questions for Discussion
15.9 Suggested Readings
15.1 INTRODUCTION
The capital market is one of the important constituents of the economy to groom and
develop to attain the required growth rate through the attraction of corpus from not only
in domestic market but also from international markets. In India, the capital market is
more vibrant in the modern days due to many more developments routed through the
structured mechanism of the market. The structured market facilitates to bring forth
many developments in the capital market only in order to facilitate the companies to
230 attract more investors to contribute financial resources to the requirement.
The participation of the investors is subject to the market environment conditions. To Capital Market
Developments in India
attract more investors from the various corners of the market, the developments are
inevitable. The development of the capital market in India are many fold and multi
structured. The series of development could be studied one after the another.
15.7 KEYWORDS
IPO: Initial Public offering
BSE: Bombay Stock Exchange
NSE: National Stock Exchange
OTCEI: Over the Counter Exchange of India
SEBI: Securities Exchange Board of India
SCRA: Securities Contract Regulation Act
Grading: Rating from the credit rating agencies
Dematerialisation: Transforming the physical securities into electronic transformation
sheets through the maintenance of Demat A/c
Book building: It is a process for identifying the right price of the process
CCI: Controller of Capital Issues Act
ESOP: Employees Stock Option Scheme
16
INDIAN FINANCIAL SYSTEM
CONTENTS
16.0 Aims and Objectives
16.1 Introduction
16.2 Organised Capital Market
16.3 Un-organized Capital Market
16.4 Organized Money Market
16.4.1 Market for Banking Financial Institutions
16.4.2 Market for Non Banking Financial Institutions
16.5 Un-organized Money Market
16.6 Let us Sum up
16.7 Lesson-end Activity
16.8 Keywords
16.9 Questions for Discussion
16.10 Suggested Readings
16.1 INTRODUCTION
The Indian financial system coined more particularly immediately after the independence
1947. Since 1947, the role of the financial system is more vibrant in meeting the needs
and demands of not only the country but also the corporate sectors. It outperformed in
the economy for the development of the nation through the collection of saving from the
households for development of the nation as well as the corporate sectors. The Indian
financial system could be bifurcated into two different segments viz.
Secondary
16.8 KEYWORDS
Organised Capital Market
238 Primary market
Initial Public offering Indian Financial System
Public issue
Secondary market
Mutualised Stock exchanges
Demutualised Stock exchanges
Unorganized Capital market
Bill market
Discounting market
Acceptance market
Govt Securities market
Bonds market
Un-organized money market
239
Accounting and Finance
for Managers LESSON
17
SEBI IN CAPITAL MARKET ISSUES
CONTENTS
17.0 Aims and Objectives
17.1 Introduction
17.2 Objectives of the SEBI
17.3 Entity of SEBI
17.4 Organisational Grid of the SEBI
17.5 Powers and Functions of SEBI
17.6 Role of SEBI
17.6.1 Promoter’s Contribution
17.6.2 Disclosures
17.6.3 Book Building
17.6.4 Allocation of Shares
17.6.5 Market Intermediaries
17.6.6 Debt Market Segment
17.6.7 Brokers
17.6.8 Suspension of a Broker
17.6.9 Recent Developments
17.7 Critical Review of SEBI
17.8 Let us Sum up
17.9 Lesson-end Activity
17.10 Keywords
17.11 Questions for Discussion
17.12 Suggested Readings
17.1 INTRODUCTION
During the late 80, the GOI decided to replace the Controller of Capital Issues Act, by
way of inducting the Securities Exchange Board of India, in order to introduce the
regulatory environment in the Indian capital market, to pave way for the promotion of
240 congenial and conducive climatic condition for the investing public. Hence the Government
of India has instituted the supreme authority SEBI to monitor and control the proceedings SEBI in Capital Market Issues
of the capital market in the country.
17.6.2 Disclosures
l Acc.Bhave committee- Financial results i.e., unaudited and audited financial results
should be published.
l Risk factors and positions of the company should be highlighted in detail in the
prospectus .
l Allotment should be done within 30 days from the date of closure of the issue.
During the non allotment of the shares, the company should refund the amount of
the application money.
17.6.7 Brokers
l Registration is given - Member of any stock exchange - key factors of
registration - office space, previous experience, man power, selling or buying in securities
l Code of conduct-execution of orders, fairness of deals with the investors, issue of
contract note
l Financial statements - should be submitted within 6 months of the accounting period
l Book of accounts - A minimum of 5 years to be preserved
l Regional offices - Establishment only with reference to attend the complaints of
the small investors at speedy rate - Kolkata, Chennai and Delhi
l SEBI's final controlling measure is suspension and cancellation of the registration
subject to certain conditions
NRIs/OCB -30% of the equity of the company in accordance with the union budget -
1997-98. It was hiked by the union finance minister during the budget 2000.
17.10 KEYWORDS
Broker: member of the stock exchange, facilitates the client to buy and sell on behalf in
the stock market
Sub-broker: who assists the broker and does the buying and selling transactions for the
client through the broker in the stock exchange
Arbitrage: Buying the security at lesser price at one stock exchange and disposing them
off at higher price at another stock exchange during the same moment
Lead manager: Who takes active role in the process of issue management.
245
Accounting and Finance for
Managers LESSON
18
CAPITAL BUDGETING
CONTENTS
18.0 Aims and Objectives
18.1 Introduction
18.2 Aim of Capital Budgeting
18.3 Methods of Capital Budgeting
18.3.1 Pay Back Period Method
18.3.2 Accounting or Average Rate of Return
18.3.3 Discounted Cash Flows Method
18.4 Present Value Method
18.5 Capital Rationing
18.6 Divisible Project
18.7 Indivisible Project
18.8 Risk Analysis in Capital Budgeting
18.9 Let us Sum up
18.10 Lesson-end Activity
18.11 Keywords
18.12 Questions for Discussion
18.13 Suggested Readings
18.1 INTRODUCTION
The capital budgeting is one of the important decisions of the financial management of the
enterprise. The decisions pertaining to the financial management of the firm are following:
The capital budgeting is the decision of long term investments, which mainly focuses the
acquisition or improvement on fixed assets. The importance of the capital budgeting is
only due to the benefits of the long term assets stretched to many number of years in the
future. It is a tool of analysis which mainly focuses on the quality of earning pattern of
the fixed assets.
The capital budgeting decision is a decision of capital expenditure or long term investment
or long term commitment of funds on the fixed assets.
Charles T. Horngreen “A long-term planning for making and financing proposed capital
outlays”.
Initial Investment
Pay back period =
Average Annual Earnings
Rs. 1,00,000
248 = = 5 Years
Rs. 20,000
It is obviously understood that, Rs.20,000 of annual earnings (cash inflows) requires 5 Capital Budgeting
years time period to get back the original volume of the investment.
If the cash flows are not equivalent, How the pay back period is to be calculated ?
The cost of the project is Rs.1,00,000. The annual earnings of the project are as follows
The ultimate aim of determining the cumulative cash inflows to find out how many
number of years taken by the firm to recover the initial investment.
The next step under this method is to determine the cumulative cash flows
The uncollected portion of the investment is Rs,10,000. This Rs.10,000 is collected from
the 4th year Net income / cash inflows of the enterprise. During the 4th year the total
earnings amounted Rs.20,000 but the amount required to recover is only Rs.10,000. For
earning Rs.20,000 one full year is required but the amount required to collect it back is
amounted Rs.10,000. How many months the firm may require to collect Rs.10,000 out
of the entire earnings Rs.20,000?
Pay back period consists of two different components
l Pay back period for the major portion of the investment collection in full course -
E.g.: 3 years
l Pay back period for the left /uncollected portion of the investment
Rs.10,000
For the second category = = 0.5 years
Rs. 20,000
Illustration 1: A project costs Rs.2,00,000 and yields and an annual cash inflow of
Rs.40,000 for 7 years. Calculate pay back period
First step is identify the nature of the annual cash inflows
249
Accounting and Finance for In this problem, the annual cash inflows are equivalent throughout life period of the
Managers
project
Illustration 2: Calculate the pay back period for a project which requires a cash outlay
of Rs.20,000 and generates cash inflows of Rs 4,000 Rs.8,000 Rs. 6,000 and Rs. 4,000
in the first, second, third, and fourth year respectively
First step is to identify the nature of the cash inflows
The cash inflows are not equivalent/constant
Rs. 2,000
= 0.5 × 12 months = 6 months
Rs. 4,000
Initial Investment
Pay Back Period =
Annual Cash inflow
Compute the comparative profitability of the proposals under the pay back period method.
Ignore Income Tax (I.C.W.A.Final)
The first step is to find out the Annual profits of the two different machines
The next step is to find out the pay back period of the two different machines respectively
Profitability Statement
Post pay back profit of the Automatic machine is higher than the Ordinary machine ;
which amounted Rs.1,28,000.. It means that the profit of the automatic machine after
the recovery of the initial investment is greater than that of the ordinary machine.
Illustration 5: A company has to choose one of the following two mutually exclusive
projects. Investment required for each project is Rs 30,000. Both the projects have to be
depreciated on straight line basis The tax rate is 50%.
For Project B
252
Project A Capital Budgeting
Depreciation
Cash inflows
Depreciation
Cumulative
Profit Before
Depreciation
Profit after
Less Tax
in flows
Years
Cash
Profit
Less
50%
Add
tax
1. 8,400 6,000 2,400 1,200 1,200 6,000 7,200 7,200
2. 9,600 6,000 3,600 1,800 1,800 6,000 7,800 15,000
3. 14,000 6,000 8,000 4,000 4,000 6,000 10,000 25,000
4. 14,000 6,000 8,000 4,000 4,000 6,000 10,000 35,000
5. 4,000 6,000 -(2000) 0 -(2000) 6,000 4,000 39,000
Pay back period = Pay back period of a major portion + Pay back period for remaining
Pay back period of the major portion= the firm has recovered a major portion of the
initial investment of Rs.25,000 within 3 full years out of Rs.30,000
The second half of the equation is that pay back period for the remaining i.e., Rs.5000 of
initial investment which is to be recovered during the fourth year out of Rs.10,000
If Rs.10,000 earned throughout the year /12 months, how many months taken by the
firm in recovering Rs.5,000 out of Rs10,000
Rs. 5,000
= = .5 × 12 months = 6 months
Rs.10,000
Cash inflows
Depreciation
Cumulative
Profit Before
Depreciation
Profit after
Less Tax
in flows
Years
Cash
Profit
Less
50%
Add
tax
Rs. 300
Pay back period of the project B= 4 years +
Rs. 13,000
253
Accounting and Finance for Merits
Managers
l It is a simple method to calculate and understand
l It is a method in terms of years for easier appraisal
Demerits:
l It is a method rigid
l It has completely discarded the principle of time value of money
l It has not given any due weight age to cash inflows after the pay back period
l It has sidelined the profitability of the project.
18.3.2 Accounting or Average Rate of Return:
Under this method, the profits are extracted from the book of accounts to denominate
the rate of return. The profits which are extracted are nothing but after depreciation and
taxation and not cash inflows.
Selection criterion of the projects:
Highest rate of return of the project only is given appropriate weightage.
Annual Return
Accounting Rate of Return (ARR)= × 100
Original Investment
Average annual return= Average profit after depreciation and taxation of the entire life
of project i.e. for many number of years
Illustration 6
Calculate the average rate of return for Projects X and Y from the following
Project X Project Y
Investments Rs.40,000 Rs.60,000
Expected Life 4 years 5 years
Rs.12,000
Average Annual Income( Project X) = = Rs. 3,000
4 years
Rs. 20,000
Average Annual Income ( Project Y) = = Rs. 4,000
5 years
The next step is to find out the Average rate of return :
Rs. 3,000
Average rate of return ( Project X) = × 100 = 7.5%
Rs.40,000
Rs.5,000
Average rate of return ( Project Y) = × 100 = 8.33%
Rs. 60,000
Both the projects are lesser than the given required rate of return. These two projects
are not advisable to invest only due to lesser accounting rate of return.
Illustration 7
The alpha limited is considering the purchase of a machine to replace a machine which
has been in operation in the factory for the last 5 years.
Ignoring interest pay but considering tax at 50% of net earnings suggest which on the
two alternatives should be preferred. The following are the details
First step is to consider that few assumptions to proceed the problem without any technical
difficulties.
First assumption is that there is no closing stock i.e. what ever goods produced are sold
out in the market.
Second assumption is that the volume of the sales is expected to be remain throughout
the life of the period.
Third assumption is that the depreciation charged by the firm is on the basis of straight
line method. 255
Accounting and Finance for Steps involved in the computation of the accounting rate of return
Managers
The first is to compute the total number of units expected to produce
Total number of units of production = Total machine hours per annum × Units per hour
For old machine = 2,000 Hrs × 24= 48,000 units
For new machine = 2,000 Hrs × 36= 72,000 units
The second step is to determine the volume of annual sale of units:
Total volume of sales = Total number of units × Selling price per unit
For old machine = 48,000 units × Rs 1.25= Rs.60,000
For new machine = 72,000 units × Rs.1.25= Rs.90,000
According to the second assumption, the volume of sales is known as unaffected
throughout the life period of the projects.
The next step is to find out the volume of the wages
Total wages = wages per hour × Machine running hours
For old machine = Rs.3 × 2000 Hrs= Rs.6,000
For new machine = Rs5.25 × 2000 Hrs=Rs.10,500
The next step is to find out the total material cost
Total material cost per unit = Total number of units × Material cost per unit
For old machine = 48,000 × .5= Rs.24,000
For new machine = 72,000 × .5=Rs.36,000
The last step is to find out the depreciation
Initial investment
Depreciation under straight line method = Economic life period of the asset
Merits
l It is simple method to compute the rate of return
l Average return is calculated from the total earnings of the enterprise through out
the life of the firm
l The entire rate of return is being computed on the basis of the available accounting
data
Demerits
l Under this method, the rate of return is calculated on the basis of profits extracted
from the books but not on the basis of cash inflows
l The time value of money is not considered
l It does not consider the life period of the project
l The accounting profits are different from one concept to another which leads to
greater confusion in determining the accounting rate of return of the projects
The discounted cash flows method is the only method nullifies the drawbacks associated
with the traditional methods viz Pay back period method and Accounting rate of return
method. The underlying principle of the method is time value of money. The value of 1
Re which is going to be received on today bears greater value than that of 1 Re expected
to receive on one month or one year later. The main reason is that "Earlier the benefits
better the principle". It means that the benefits whatever are going to be accrued during
the present will be immediately reinvested again to maximize the earnings, so that the
earlier benefits are weighed greater than the later benefits. The later benefits are expected
to receive only during the future which is connected with the future i.e., future is uncertain.
It means that there is greater uncertainty involved in the receipt of the benefits connected
with the future.
Why the time value of money concept is inserted on the capital budgeting tools?
The main reason is that the capital expenditure is expected to extend the benefits for
many number of years. The 1 Re is expected to receive one year later cannot be treated
at par with the 1 Re of 2 years later. This is the only method considers the profitability as
well as the timing of benefits. This method gives an appropriate qualitative consideration
to the benefits of various time periods.
257
Accounting and Finance for The time value of money principle is used for an analysis to study about the quality of the
Managers
investments in receiving the future benefits.
There are general classifications which are as follows
l Net present value method
l Present value index method
l Internal rate of return method
Selection criterion
If the present value index is greater than one, accept the proposal; otherwise vice versa
Present value index>1:- Accept the investment proposal
Illustration 8
Project ABC Ltd. costs Rs 1,00,000. It produces the following cash flows
Year 1 2 3 4 5
Cash Inflows Rs 40,000 30,000 10,000 20,000 30,000
Present value of .909 .826 .751 .683 .621
Re1 at 10%
In the above problem, among the given machines, the firm is required to chose only one
machinery. To chose the ideal machinery among the given two, the net present value
should be ranked.
The Machine B has been considered as preferable over the machine A due to higher net
present value. The ranking of the machines do not indulge any difficulties. Why it so ?
The main reason is that both machines are having equivalent volume of investment
outlay. Out of the same initial outlays, we can rank that both machines one after the
another based upon the net present value.
Illustration 10
The initial cost of an equipment is Rs. 50,000. Cash inflows for 5 years are estimated to
be Rs.20,000 per year. The management's desired minimum rate of return is 15%.
Calculate Net present value and Excess present value index.
At the end of every year, the firm expects to earn Rs.20,000. The amount expects to
earn Rs.20,000 on every year is nothing but future value of money. The future value of
money should be converted into the present value for having comparison with the initial
investment.
On every Rs.20,000 expected to receive forms a series of future cash inflows which
should be converted into present value.
This conversion process i.e the process of converting the future value into present value
is known as discounting process. For discounting, the rate which is used for the process
pronounced as discount rate or minimum rate of return. The conversion process can be
done in two different ways.
Discounting process :- PV= FV/ (1+r)n
For first year cash inflow Rs.20,000:-
PV=20,000/(1.15)=20,000×.870 =Rs.17,400
For second year cash inflow Rs.20,000;-
PV=20,000/(1.15)2 =20,000×.756 =Rs.15,120
260
For third year cash inflow Rs.20,000:- Capital Budgeting
PV=20,000/(1.15)3=20,000×.658 =Rs.13,160
For fourth year cash inflow Rs.20,000:-
PV=20,000/(1.15)4=20,000×.572 =Rs.11,440
For fifth year cash inflow Rs.20,000:-
PV=20,000/(1.15)5=20,000×.497 =Rs.9,940
Rs.67,060
OR
Alternately, the discounting can be done as follows
Being Rs.20,000 is nothing but as common cash inflow throughout 5 years of the
project, considered to be a series of cash inflows
Rs.20,000(.870+.756+.658+.572+.497) =Rs.67,060
Net present value = Present value of cash inflows - Present value of cash outlay
=Rs.67,060- Rs.50,000= Rs.17,060
The net present value of the project is +ve. Hence, the project can be accepted.
Illustration 11
A project costs Rs.36,000 and is expected to generate cash inflows of Rs.11,200 annually
for 5 years. Calculate the IRR of the project.
First step is to find out the fake pay back quotient
The next step is to locate the pay back quotient in the table M-4. The present value of 1
Re should be computed for 5 number of years.
The location of the pay back quotient is in between the values of table M-4
The value 3.214 which lies in between 3.274 of 16% and 3.199 of 17%
The next step in the IRR calculation is that locating the maximum rate of return which
equates the initial outlay with the cash inflows of various time periods.
While equating the initial outlay with discounted cash inflows at certain percentage will
derive the original rate of return. The process may be started from two different angles
viz
l Low discount rate
l High discount rate
The computation of IRR can be had through either low discount rate or high discount
rate. This is further extended to different methods of calculation., which are as follows
l On the basis of values extracted from the table
l On the basis of volume
261
Accounting and Finance for Calculation on the basis of discount rate table value
Managers
Lower discount Rate Origin value i.e., unknown Higher discount rate
3.274 IRR -3.214 3.199
Alternately, on the basis of volume, the methodology to be adopted for the determination
of IRR
The cash inflows of Rs.11,200 for 5 years are discounted @ 16% which amounted
Rs.36,668.8. Like wise the cash inflows of the same should be discounted at the rate of
17% which amounted Rs.35,828.8
The next step is to find out the IRR. The IRR can be found out either on the basis of
lower discounted cash inflows or higher discounted cash inflows.
=16%+.796=16.796%
On the basis of discounted cash inflows at higher rate @ 10%
== 17% -.204=16.796%
Merits of DCF methods
l It is only the best method incorporates the timing of benefits - time value of money
l It considers the economic life of the project
l It is a best method for both even and uneven cash inflows
Demerits of DCF methods
l It involves with tedious method of computation
l It is very difficult to locate or identify the exact discounting factor
l It never performs functions of discounting to the tune of accounting concepts.
262
Illustration 12 Capital Budgeting
The depreciation has to be deducted initially from the cash flows before taxation, after
the deduction of taxation, the earnings after taxation should be added with the depreciation
which was already deducted in order to find out the total cash flows after taxation. The
purpose of deducting the depreciation is nothing but an amount to be charged under the
Profit & Loss account against the total revenue. Being as a non-recurring expenditure
not created any outflow cash resources. When there is no cash outflow, the amount of
depreciation should be added finally to derive CFAT(Col 7)
Table
Year CFBT Depreciation Profits Taxes Earnings Cash flows after
Col 1 Rs Rs Before Tax (.35) After tax tax Rs
Col 2 Col 3 Rs Col 5 Rs Col7= Col6+Col3
Col 4=Col2- Col6=Col4
Col3 -Col5
1. 20,000 20,000 Nil Nil Nil 20,000
2. 21,384 20,000 1,384 484 900 20,900
3. 25,538 20,000 5,538 1,938 3,600 23,600
4. 26,924 20,000 6,924 2,423 4,500 24,500
5. 40,770 20,000 20,770 7,270 13,500 33,500
22,500 1,22,500
1. Pay back period method: Under this, method most important step is to identify
the nature of the cash flows after taxation. Are they uniform ? No, they are not
even cash flows. Hence, the cumulative cash flows after taxation has to be found
in order to find out the pay back period of the investment.
263
Accounting and Finance for
Year Cash flows After Tax Rs Cumulative CFAT Rs
Managers
1. 20,000 20,000
2. 20,900 40,900
3. 23,600 64,500
4. 24,500 89,000
5. 33,500 1,22,500
Pay back period= Pay back period for the major portion of the investment
+
Pay back period for the remaining portion unrecovered
Rs.11,000
= 4 year + = 4 year + .328 year
Rs. 33,500
= 4.328 years
2. Average rate of return (ARR):
Average Income
ARR = × 100
Average Investment
Average Income is the average of earnings after taxation of the entire duration.
Why earnings after taxation has to be taken into consideration ? Why not the cash
flows after taxation to be taken for consideration ?
The main purpose of considering the earnings after taxation is that the amount
extracted from the book of accounts and taken for the computation of ARR, and
immediately after the payment of taxation.
Average investment is the average of opening and closing investment. If the
depreciation charge given is nothing but straight line method, automatically final
value of the asset will become equivalent to zero. The closing balance of the asset
/investment is zero.
How the closing balance of the investment could be adjudged as equivalent to
zero?
Table of Depreciation
At the end of the year, the closing balance amounted Rs.0 after charging the
depreciation year after year constantly in volume
264
3. Net present value method: Capital Budgeting
Under this method, the future cash flow after taxation should be discounted at the
rate 10%
Year Cash flows after tax Present value factor @ 10% Total Present Value Rs
1. 20,000 .909 18,180
2. 20,900 .826 17,263
3. 23,600 .751 17,724
4. 24,500 .683 16,734
5. 33,500 .621 20,803
Total Present value 90,704
Less Initial outlay 1,00,000
Net present value ( 9,296)
The net present value is negative due to excessive investment more that of the
present value of future earnings of the enterprise. Under this method, the investment
is not advisable to procure for the firm's requirements.
4. Profitability Index
The profitability index method is more useful in the case of more number of
investments, having uneven investment outlays, but this problem comes with only
one investment proposal It is much easier to assess even in the case of Net
present value method.
(1) Why the depreciation is added at the end of computation to derive the cash
flow ?
(a) Being as recurring charge
(b) Being considered as tax shield
(c) Being as non recurring charge
(d) None of the above
(2) Why "0" value is taken as closing balance of the investment for the computation
of Average investment ?
(a) No value for the closing balance
(b) No value due to the application of straight line method of depreciation
(c) No scrap value at the end of the life of the asset
(d) None of the above
The D, E and B are the project for making an investment which jointly amounted Rs 64
Cr and the remaining the Rs 6 cr to be invested into the project.
18.11 KEYWORDS
Capital budgeting: A study on Long term investment decision in terms of quality of
benefits
Pay back period: It is a time period during which the initial investment is recovered
ARR: Accounting rate of return - It is being calculated in accordance with the financial
statements
PV: Present value
IO: Initial outlay which is nothing but initial investment
NPV: Net present value which is the difference in between the Initial investment and
Present value of future cash inflows
IRR: Internal rate of return which is nothing but highest rate of return expected to earn 267
Accounting and Finance for PI: Profitability Index is the ratio in between the present value of future cash inflows
Managers
and present value of initial
268
LESSON
19
RISK AND RETURN
CONTENTS
19.0 Aims and Objectives
19.1 Introduction
19.2 Meaning of Return & Rate of Return
19.3 Concept and Types of Risk
19.3.1 Interest Rate Risk
19.3.2 Market Risk
19.3.3 Inflation Risk
19.3.4 Business Risk
19.3.5 Financial Risk
19.3.6 Liquidity Risk
19.3.7 Measurement of Risk
19.4 Risk and Return of the Portfolio
19.4.1 Diversification of the Risk of Portfolio
19.5 Relationship between the Risk and Return
19.6 Let us Sum up
19.7 Lesson-end Activity
19.8 Keywords
19.9 Questions for Discussion
19.10 Suggested Readings
19.1 INTRODUCTION
Risk and Return of the investments are interrelated covenants in the selection any
investments, which should be studied through the meaning and definition of risk and
return and their classification of themselves in the first part of this chapter and the
relationship in between them is illustrated in the second half of the chapter.
Price Change
** Capital gains yield =
Market price per share***
l It is risk – variability in a security's return resulting from the changes in the level of
interest rates.
l Security prices - inverse relationship with
v Recent announcement of the monetary policy by RBI- Hike in CRR 5. 50
points to 6 points; change in the rate of interest - change in the prime lending
rate of the banks - Due to Rs. 14,000 cr. amount to be deposited in the
Reserve Bank of India by the Banks - to curtail the Inflation
Behavioural Statistical
The risk is nothing but the difference in between the optimistic and pessimistic returns,
in other words range of the returns. The range of the returns is nothing but the difference
in between highest and lowest returns which normally arise during the periods of boom
and recession. The greater the range refers to the greater the amount of risk and vice
versa. From this table we identify that Asset B is found to be more risky than the asset
A, the reason is higher rang in the case of Asset B unlike Asset A; which highlights the
difference in between the returns of optimistic and pessimistic. This method is found to
be a crude method in studying the risk of the securities.
To nullify the bottlenecks associated with the sensitivity analysis, probability distribution
is considered for the discussion of risk to study more in detail than the earlier sensitivity
analysis. The probabilities are assigned to reveal the possibilities of occurrence of the
event which ranges in between 1-100% of occurring.
If it is certain to occur means that P= 1
If is not certain to occur means that Q = 1
Based on the probabilities, the expected return of the investment could be found out
through the multiplication of the respective returns of the horizon which in relevance
with possibility of occurrences.
l Expected rate of return of the security is as follows :- it is weighted average of all
possible returns multiplied by the respective probabilities.
l Probabilities of various Outcomes during the various seasons are known as weights
272 K×P
The risk can be determined through the statistical measure of dispersion of returns of an Risk and Return
expected value of return of the security.
l Risk is the Standard deviation of returns from the mean/expected value of return
l Square root of squared deviations of the individual expected returns
(å (K–K)2 × P)1/2
Standard Deviation:
l Greater the standard deviation - Greater the risk
l Does not consider the variability of return to the expected value
l This may be misleading - if they differ in the size of expected values
In order to replace the bottlenecks associated with the standard deviation in studying the
risk of the security, the co-variation is suggested to study the risk of the security
l It is a measure of dispersion/ measure of risk per unit of expected return
l It converts the standard deviation of expected values into relative values to enable
comparison of risks with assets having different expected values.
S.D
Coefficient of variation =
Mean
The above table reveals that Portfolio AB is the better one to diversify the risk as minimum
as possible, the reason is that the returns of the respective securities are having negative
correlation among A&B unlike A &C. The negative correlation of the returns between
the A&B only facilitated to reduce the risk to the levels of minimum.
The risk of the portfolio cannot be simply reduced by way adopting the principle of
correlation of returns among the securities in the portfolio. To reduce the risk of the
portfolio, the another classification of the risk has to be studied, which are as follows:
The risk can be further classified into two categories viz Systematic and Unsystematic
risk of the securities
Systematic Risk - which cannot be controlled due to market influences which is known
as Uncontrollable risk, cannot be avoided
Unsystematic Risk-Which can be minimized or reduced this type of risk through
diversification of the securities in the portfolio
l Systematic Risk- Unavoidable, Uncontrollable risk - finally Market risk War, inflation,
political developments
l Unsystematic Risk- Avoidable, Controllable risk. Strike, Lock out, Regulation
Systematic Risk: Which only requires the investors to expect additional return/
compensation to bear the
Unsystematic Risk: The investors are not given any such additional compensation to
bear unlike the earlier.
The relationship could be obviously understood through the study of Capital Asset Pricing
Model (CAPM).
l Developed by William F. Sharpe
l Explains the relationship in between the risk and expected / required return
l Behaviour of the security prices
l Extends the mechanism to assess the dominance of a security on the total risk and
return of a portfolio
l Highlights the importance of bearing risk through some premium
l Efficiency of the markets
v Investors are well informed
274 v No transaction costs - No intermediation cost during the transaction
v No single investor is to influence the market Risk and Return
l Investor preferences
v Highest return for given level of risk Or
v Lowest risk for a given level of return
v Risk - Expected value, standard deviation
1. Return means
(a) Regular income only (b) Capital appreciation income
(c) (a) & (b) (d) None of the above
2. Risk means
(a) Variability of returns (b) Non variability of returns
(c) Mean of the returns (d) None of the above
3. Interest rate risk means
(a) Affects the price of the existing securities due to change in the rate of interest
(b) Affects the price of the new securities due to change in the rate of interest
(c) Affects the price of the existing and new securities due to change in the rate of
interest
(d) None of the above
4. Systematic risk is
(a) Controllable (b) Uncontrollable
(c) Neither controllable nor uncontrollable (d) None of the above
5. Beta is
(a) Diversifiable risk
(b) Undiversifiable risk
(c) Neither diversifiable nor undiversifiable
(d) None of the above
6. Return is
(a) Risk free return
(b) Risk premium 275
Contd...
Accounting and Finance (c) Risk premium pegged with Beta
for Managers
(d) Risk free return and Risk premium pegged with Beta
19.8 KEYWORDS
Risk: Deviation in between the actual return and expected return
Return: It is the combination of regular income and capital appreciation income
Yield: Total earnings in terms of market price
Income yield: Earnings in terms of market price
Interest risk: Deviation of return of the security due to fluctuations of interest
Inflation risk: Deviation of return of the security due fluctuations in the purchasing
power with reference to money supply
Operation risk: Risk which is due to fixed cost of operations
Finance risk: Risk due to the application fixed charge of funds
Beta: Co efficient of market responsiveness of the security
Systematic risk: Risk which cannot be diversified
Unsystematic risk: Risk which can be diversified
Risk free return: Return on risk less investments
Risk premium: Return for the undiversifiable risk to bear
CAPM: Capital Asset Pricing Model for the relationship in between Risk and Return
277
UNIT-V
LESSON
20
COST OF CAPITAL
CONTENTS
20.0 Aims and Objectives
20.1 Introduction
20.1 INTRODUCTION
It is imperative to study the importance of cost of capital to the tune of financing decision
of the firm. The financing decision of the firm normally facilitates the firm to raise the
financial resources to the requirements of the firm. The raising of the financial resources
should be carried out not only to the tune of financial requirements but also it should
mind about the cost of availing the resource; which means that the cost of raising and
applying the resources in and of the organization. The cost is the most limiting factor of
influence for the success of the firm, the reason is that the cost of capital is the major
determinant of success of the business firm. The firm must be facilitated to raise the
financial resources at cheaper cost in order to earn more and more.
Accounting and Finance for The cost of capital is used as a phenomenon for the decision criterion in the case of
Managers
studying the worth of long-term assets, which have got greater importance in the success
of the firm. The cost of capital is instrumented in the Net present value method and
Internal rate of return method of studying the worth of long-term assets under the capital
budgeting decisions of the enterprise.
Assumptions
l It is on the basis of Operating Risk i.e., Business Risk of the firm which is nothing
but determinant of influence is Fixed Cost of Operations. The cost of capital is
subject to the volume of fixed cost of operations of the firm.
l On the basis of Financial Risk i.e., with reference to Financial Commitments of
the firm which in other words as financial Risk. The Interest on debenture,
Preference Dividend on Preference share capital should be paid without fail
irrespective of the firms' earnings according to the terms and conditions of the
issue. The greater the fixed financial commitments require the firm to earn more
and more in order to retain the interest of the shareholders of the firm.
l Operational Terms - capital structure remain unchanged; unless the cost of capital
of the firm would change.
l For new projects, funds are raised only at same proportion.
How the cost of capital is to be denominated in terms ?
Whether the cost of capital is to be denominated in terms of after tax or before tax. Why
it has to be expressed in terms of after tax ? Why not the before tax cost should be taken
into consideration?
For appraising the projects, the return of the investments are considered for comparison
which are nothing but the resultant of earnings of the firm immediately after the payment
of tax. To study the quality of the projects, both factors must be at common at parlance
for comparison.
While computing the cost of capital, the cost of specific sources should be to the tune of
after tax only in order to have an effective comparison.
v Then, the cost of capital is further bifurcated into two categories viz Explicit
cost of capital and Implicit cost of capital.
v Explicit cost of capital: The discount rate that equates the present value of
the cash inflows that are incremental to the taking of the financing opportunity
with the present value of its incremental cash outflows.
It is further explained that rate of return of cash flow of the financing opportunity. It
normally takes place only at the moment of raising of financial resources.
l Implicit cost of capital: It is nothing but the Opportunity cost of capital of the
firm to earn through investing elsewhere by the shareholders themselves or by the
company itself. It is rate of return which is associated with the best investment
opportunity for the firm and its shareholders that would have to be forgone, which
were presently considered by the firm.
l Specific cost of specific source of capital: Each source of capital has its own
cost at the moment of raising which form part of the computation of total cost of
282 capital of the firm.
Cost of Capital
20.3 MEASUREMENT OF COST OF DEBT
The cost of the perpetual debt is nothing but the cost of raising the debt financial resource,
in which the time period of repayment of the principal is not known.
This particular specific source has two different classifications viz cost of interest and
cost of debt.
Interest
Cost of interest (Ki) =
Sale value
The next method of computing the cost of debt is only for the debt finance which knows
the repayment period of the principal and the payment of the interest periodicals.
This process of computation could be divided into two categories
First one is the periodical repayment of the principal along with the periodical payment
of interest periodicals.
COIt + COPn
CIo =
(1 + kd) t
The second one is the lump sum repayment of the principally only at the end of the term
of the debenture. 283
Accounting and Finance for
Managers COIt COPn
CIo = +
(1+kd)t (1+Kd)n
Kp=Dividend prefernce(1+Dt)
Kp =
P0 (1–f)
ABC company issues 11 percent irredeemable preference shares of the face value of
Rs. 100 each. Flotation costs are estimated at 5 per cent of the expected sale price a) par
value b) 10% premium c) 5% discount and also compute the Dividend tax at 13.125%
At par
Cost of Preference share capital Cost of preference share with dividend tax
Kp= Rs11./Rs 95.=11.57% Kp = Rs.11(1+.13125) = 13.09%
Rs.95
At Discount
Cost of Preference share capital Cost of preference share with dividend tax
Kp=Rs.11/ Rs.110(.95).= 10.5% Kp = Rs.11(1+.13125) = 13.81%
Rs 110(.95)
At Premium
Cost of Preference share capital Cost of preference share capital with dividend tax
Ki= Rs.11/Rs.95(.95)=12.2% Kd = Rs.11(1+.13125) = 13.78%
Rs 95(.95)
The next methodology under the preference share capital is the cost computation for
redeemable preference share capital. Under this the period of payment of capital is
known along with the payment periodical preference dividends.
285
Accounting and Finance for
Managers Dp Pn
l Po (1-f) = t
+
(1+kp) (1+kp)n
The value of the Kp is lying in between the two rates of discounts viz 11% and 12%
Determination of present value in between 11% and 12%
99.93 94.35
Dividend per share Re 1 Growth rate = 6% Assuming the market price is Rs. 25
What would be market price of a share after 1 year and 2 year
Ke= Re.1/25+ 6%= 4%+ 6%= 10%
The market price at the end of 1 year
Rs.1.06
P1 = = Rs.26.5
10%-6%
The market price at the end of 2nd year
Rs.1.12
P2 = = Rs.28
10%-6%
l Capital Asset Pricing Model approach: The cost of equity share capital is
computed by registering the Beta with reference to the non diversifiable risk in
addition to the diversifiable risk of the equity share with reference to market
responsiveness.
The basic assumptions of the CAPM approach
(i) The efficiency of the security markets
(ii) Investor preferences
The efficiency of the security markets is embedded with the following assumptions:
(a) All investors are common expectations about the expected returns, variances and
correlation of the expected returns among the various securities in the market
(b) All investors have equivalent amount of information
(c) All investors are rational
(d) No transaction costs
(e) No single investor influence the market
The investors' preference with reference to two different types of returns
(i) Highest level return at minimum level risk or
(ii) Lowest level of risk for given level of return
The above alternatives are subject to two different type of risk viz Systematic and
Unsystematic risk.
Systematic risk which cannot be reduced i.e., undiversifiable risk for which allowances
are given to the investors.
Unsystematic risk which can be reduced to the level of minimum for which no other
allowances are given to the investors.
The allowances are given to the investors only subject to the market responsiveness
Beta coefficient
Ke= Rf+ b(Km–Rf)
Problem
l The hypothetical ltd wishes to calculate the cost of equity capital using the CAPM
approach. From the information that the risk free rate of return equals 10% ; the
firms beta equals 1.50 and the return on the market portfolio equals 12.5% Compute
the cost of equity capital
Ke= 10% + 1.5×(12.5%-10%)=13.75% 287
Accounting and Finance for
Managers 20.5 COST OF RETAINED EARNINGS
The next important cost of specific source of capital is cost of retained earnings.
The cost of retained earnings is to be computed on the basis of opportunity cost. It does
not have any direct cost, instead, the amount of retained earnings loses the opportunity
of the investors to earn in the form of dividends due to retained earnings; which are
foregone by them one side and on the other side the earnings which are retained are
invested in some other investments, would be in a position to yield the return, is the cost
of retained earnings.
It could be defined as "cost of retained earnings is the opportunity cost in terms of
dividends foregone by with held from the equity shareholders." The cost of retained
earnings is nothing but the external criterion which is equal to the Ke. Practically speaking,
Ke is more than the Kr due to the floatation cost involved in the process of issue of
shares.
Rs.1,44,000
Ko = × 100 = 11.1%
Rs.13,00,000
Rs.2,01,000
Ko = × 100=11.9%
Rs.13,00,000
20.9 KEYWORDS
Cost of capital: It is the minimum rate of return to be earned at which the capital is
raised
Implicit cost of capital: It is the minimum rate of return to be earned by the firm, at the
moment of retaining the earnings, towards the investment decision 289
Accounting and Finance for Explicit cost of capital: It is the cost incurred by the firm at the moment of raising
Managers
Specific cost of capita: It is the cost incurred at every moment for raising the specific
resource of capital
Book value weights: Weights assigned to the tune of the book value of the capital
Weighted average cost of capital: The aggregate of the weighted specific resources
cost of capital is weighted average cost of capital
290
LESSON
21
LEVERAGE ANALYSIS
CONTENTS
21.0 Aims and Objectives
21.1 Introduction
21.2 Operating Leverage
21.3 Financial Leverage
21.4 EBIT-EPS Analysis
21.5 Combined Leverage
21.6 Let us Sum up
21.7 Lesson-end Activity
21.8 Keywords
21.9 Questions for Discussion
21.10 Suggested Readings
21.1 INTRODUCTION
Leverage means the fixed commitment of the organization. The fixed commitment of
the organization can be classified into two different categories viz fixed cost of operations
and fixed cost of servicing. The fixed cost of operations are pertaining to the investment
decisions and the fixed cost of servicing with reference to the financing decision.
Fixed cost of operations – Investment decisions.
Fixed cost of servicing – Financing decisions.
If Revenues are more than the Variable Cost and Fixed Cost, that is called favorable
or otherwise unfavorable.
From the above illustration, it is obviously understood that from the two different cases.
Case A illustrates that 50% increase in the volume of sales led to 100% increase in the
volume of profit.
Case B highlights that 50% reduction in the volume of sales led to 100% decrease in the
volume of profit.
It is clearly evidenced that % change in the volume of sales is less than the % change in
the volume of profit.
The next step is to define the Degree of Operating Leverage (DOL)
l DOL is the measure reveals the extent or degree of operating leverage.
l When Operating leverage exists ?
Proportionate change in EBIT of a given change in sales is greater than the Proportionate
in sales
292
By algebraically proven and the following formula has derived to determine the DOL Leverage Analysis
through the alternate methodology
To determine the degree of the operating leverage, from the above illustration which is
applied
DOL= Rs.1,00,000/Rs.50,000= +2
The answer of the DOL has been checked in both directions to the direct methodology.
If there is no fixed operating cost in the manufacturing enterprise ? What would be the
Degree of Operating leverage ?
Particulars Base Level New Level
Units sold 1,000 1,100
Sales price per unit Rs.10 Rs.10
Variable cost per unit 6 6
Fixed operating cost Nil Nil
Calculate the Degree of operating leverage
Total contribution
DOL =
EBIT
To find out the EBIT = Sales -VC=Contribution i.e. EBIT
R400
DOL = = +1
Rs.400
In the alternate methodology, the DOL is as follows:
When there is no fixed cost in the cost of operations means that the firm does not have
operating leverage in its operations.
The operating leverage is related to the operating risk of the investments, which means
that fixed cost of operations of the enterprise. It highlights that greater the fixed cost of
operations means that higher the operating risk; which means that greater will be break
even point and vice versa. The greater volume of fixed cost of operations are found to
be more favorable only during the occasion of greater volume of earnings, unless otherwise
the dominance of fixed cost of operations are found to be undesirable to magnify the
volume of EBIT.
From the above illustration, 40% increase in the level of EBIT posed 81.25% increase in
the EPS and vice versa.
Financial leverage can be quantified through the Degree of Financial Leverage (DFL)
The degree of financial leverage is defined as the ratio of % change in the EPS and %
change in the EBIT. Which always greater than 1. The degree of financial leverage is
more than one due to presence of fixed charge of financial resources. This profound
relationship is algebraically proven and illustrated that
EBIT
DFL (Base) =
EBIT–I–Dp/1–t
DFL of the above firm is as follows:
Rs. 10,000
DFL =
Rs10,000 – Rs.2,000–Rs.2,000/.65
= 2.03125
The same example drawn for our better understanding by excluding the fixed charge of
financial resources
294
Leverage Analysis
Case B Case A
Level of Change – 40% + 40%
% change in EPS
Degree of financial leverage =
% Change in EBIT
+ 40%
Case A = =+1
+40%
− 40%
Case B = =+1
− 40%
Alternately, the DFL could be found out as follows:
Rs.10,000
= = +1
Rs.10,000–0–0
It means that the higher Degree of financial leverage means that greater the financial
risk of the firm and vice versa. The greater degree of financial leverage is favorable
only during the greater volume of EBIT to meet the fixed charges unless otherwise, the
firm is required to undergo for liquidation. The interest of the firm may be brought under
the control of the debenture holders and preference shareholders.
% change in EPS
DCL =
% change in Sales
The combined leverage is nothing but % change in the sales volume of the firm leads to
certain % change in the EPS.
DCL = Contribution/EBIT–I
during the occasion of greater volume of earnings, unless otherwise the dominance of
fixed cost of operations are found to be undesirable to magnify the volume of EBIT. The
other name of the financial leverage is Trading on Equity, which illustrates the relationship
in between the application of the fixed charge of funds in the capital structure and
Earning per share. It is the leverage analysis highlights the relationship in between the
financing decision and investment decision. EBIT-EPS analysis is an analysis to study
the impact /effect of the leverage.
21.8 KEYWORDS
Leverage: Fixed commitments of the firm
Operating leverage: It is a measure in the expression of business risk through
quantification of fixed cost
Financial leverage: It is an expression of financial risk due to the presence of fixed
financial commitment of the firm
Combined leverage: Combination of both leverages i.e. Product of Operating and
Financial leverages
Financial break even point: It is a level of EBIT to cover the fixed financial commitment
of the firm
Indifference point: It is the point at which the EBIT and EPS level of the two different
financing plans are nothing but the same.
22
CAPITAL STRUCTURE THEORIES
CONTENTS
21.0 Aims and Objectives
22.1 Introduction
22.2 Assumption of the Capital Structure Theories
22.3 Net Income Approach
22.4 Net Operating Income Approach
22.5 Modigliani–Miller Approach
22.6 Traditional Approach
22.7 Types of Dividend Policies
22.7.1 Cash Dividend Policy
22.7.2 Bond Dividend Policy
22.7.3 Property Dividend Policy
22.7.4 Stock Dividend Policy
22.8 Let us Sum up
22.9 Lesson-end Activity
22.10 Keywords
22.11 Questions for Discussion
22.12 Suggested Readings
22.1 INTRODUCTION
The capital structure theories are facilitating the business fleeces to identify the optimum
capital structure. The optimum capital structure of the organization differs from one
approach to another due the assumption which are underlying with reference to many
factors of influence. The success of the firm is normally depending upon the rate at
which the financial resources are raised, differs from one organisation to another depends
298
upon the needs. The cost of capital is having greater influence on the EBIT level of the
firm; which directs affects the amount of earnings available to the investors, that finally Capital Structure Theories
reflects on the value of the firm. The more earnings available at the end will lead to
greater return on investment holdings of the investors, would enhance the value of shares
due to greater demand. There are two set of approaches with reference to capital
structure; which normally influences the Value of the firm through the cost of overall
capital(Ko) is one approach called relevance approach capital structure theories and
other do not have any influence on the value of the firm is known as irrelevance approach.
The debt finance in the capital structure facilitates the firm to enhance the value of EPS
on one side on the another side it is subject to the financial leverage with reference to
trading on equity. The application of leverage in the capital structure enhances the value
of the firm through the cost of capital.
22.10 KEYWORDS
Arbitrage process
Dividend Policies
Cash dividend policy
303
Accounting and Finance for
Managers
LESSON
23
WORKING CAPITAL MANAGEMENT
CONTENTS
23.0 Aims and Objectives
23.1 Introduction
23.2 Objectives of the Working Capital Management
23.3 Approaches of the Working Capital
23.4 Determinants of Working Capital
23.5 Working Capital Policies
23.6 Estimation of Working Capital Requirement
23.7 Cash Management
23.7.1 Motives of Holding Cash
23.7.2 Objectives of Cash Management
23.7.3 Basic Problems of Cash Management
23.8 Management of Inventories
23.8.1 Meaning of Inventory
23.8.2 Why Inventory is to be Controlled?
23.8.3 Major Benefits of Inventory Control
23.8.4 Centralised Stores
23.8.5 Decentralised Stores
23.8.6 Central Stores and Sub Stores
23.8.7 Recording Level
23.8.8 Minimum Level/Safety Level
23.8.9 Maximum Level
23.8.10 Danger Level
23.8.11 Average Stock Level
23.8.12 Economic Ordering Quantity
23.8.13 ABC Analysis
23.8.14 VED Analysis
23.9 Receivables Management
23.9.1 Concept of Receivables Management
23.9.2 Objectives of Accounts Receivables
23.9.3 Cost of Maintaining the Accounts Receivables
23.9.4 Factors Affecting the Accounts Receivables
23.9.5 Management of Accounts Payable/Financing the Resources
23.10 Various Committee Reports on Working Capital
23.10.1 Dheja Committee Report 1969
304
Contd...
23.10.2 Tandon Committee Working Capital Management
23.1 INTRODUCTION
The working capital is the amount revolving capital to meet the day today requirements
of the firm. The other facets of the working capital is circulating capital, floating capital
and moving capital which are required to meet the immediate requirements of the firm.
The "working capital" means the funds available for day today operations of the enterprise.
It also represents the excess of current assets over the current liabilities which include
the short-term loans.
Accounting standards Board, The institute of Chartered Accountant of India note the
ASB has used the term “working capital” and not “Net working capital”.
1. The recent release of the finance minister during the budget session on the
special excise duty on the cement industry.
2. How the construction industry is affected ? In what way? Which factor of
influence affects the firm?
Inventory
Purchase
Department
Finance
Department
Production Sales
Department Department
Inventory control: Inventory control means that maintenance of desired level of inventory
by way of taking into the economic interest of the firm.
The economic interest of the firm differs from one functional dept. to another due to the
heterogeneous objectives. The economic desired benefits of the dept. are illustrated to
the tune of the preceding illustrated diagrams.
Production department: Benefits towards less production cost through mass production.
Purchase department: Benefits towards discounts, carrying cost and so on.
Sales department: Timely supply of the goods to the requirements, facilitates the firm
to earn greater volume of earning. To reduce the operating cycle in duration in order to
realize the economic benefits as early as possible.
Finance department: Benefits towards the carrying cost, storage cost of the entire
312 inventory.
Working Capital Management
23.8.3 Major Benefits of Inventory Control
l It leads to effective utilization of funds only through an appropriate investment on
inventory
l It facilitates to obtain the economic supply of raw materials
l It possess the firm comfortably to meet the needs and wants of the consumers in
time
l It neither allows the firm to undergo the practices of overstocking nor understocking.
l It leads to effectiveness in the material handing which reduces the wastage, pilferage
and so on.
Before discussing the methods of inventory control, every one must obviously understand
the organization of the stores department. The stores department is the only department
which applies all the techniques of inventory control.
The organization of the inventory control are various in dimensions . The organization of
differs from one industry to another industry, one firm to another within the same industry,
from one nature to another, from volume to another. They are as follows:
a) Centralised stores
b) Decentralised stores
c) Central and Sub stores
This type of organization of stores control has its own advantages and disadvantages in
application
The major advantages are following:
l It requires less space
l It facilitates to minimize the stock investment
l The centralization leads to lower administrative and maintenance cost of stores
313
Accounting and Finance for In addition to the advantages, the present organization suffers with its own limitation
Managers
while in applications; which are following:
l The centralization of stores leads to enhance the cost of transportation as well as
handling cost of materials.
l The centralized system leads to lot of inconvenience and delay to other department
due to distance
l There is a greater risk of calamity loss of materials which are stored under one
roof
l The success is subject to the effectiveness of the transportation
C e n t r a l S t o r e
S u b Sto re S u b Sto re
W e ld ing D ep t P la n nin g D e pt
P ro d u ction D e p t
The role of the store keeper is most inevitable in controlling the stores. While controlling
the stores, the store keeper should neither disturb the production process nor undergo
the practices of overstocking. By earmarking the above enlisted objectives, every store
keeper is led by the various methods of inventory valuation in addition to various methods
314 of requisitioning of material.
First we will discuss, the various methods of requisitioning of materials. Working Capital Management
Reordering Level
Graph of EOQ:
Total cost
Rupees
Cost of carrying
Ordering cost
2AQ
Economic Ordering Quantity (EOQ) =
I
2 × 20,000 × Rs.100
=
0.16% on Rs.4
= 2,500 units
317
Accounting and Finance for The following Table 23.1 illustrates the justification of the EOQ at the 2,500 units level
Managers
Annual requirement of 20,000 units
Particulars 1 2 3 4 5
Size of the Orders 20,000 10,000 5000 2,500 500
Number of order to placed 1 2 4 8 40
= Total Annual Need
Size of the order
2AO
Economic Ordering Quantity (EOQ)=
1
2 × 1600 × Rs.50
EOQ = = 200 units
10% on Rs.40
Illustration 3
Consumption during the year -600 units
Ordering cost Rs. 12 per order
Carrying cost 20%
Price per unit Rs. 20 B.Com. (Punjab)
2AO
Economic Ordering Quantity (EOQ)=
1
2 × 600 × Rs.12
EOQ =
20% on Rs.20
= 60 units
Illustration 4
A manufacturer purchases certain machinery from outside suppliers Rs.60 per unit.
Total annual needs are 800 units. The following are the additional information
Annual return on investments 10%
318
Rent, insurance, taxes per unit per year Rs 2 Working Capital Management
2AO
Economic Order Quantity (EOQ) =
1
2 × 800 × Rs.200
=
10% on Rs.60 +Rs.2
= 200 units
Illustration 5
Given the annual consumption of material is 1,800 units , ordering costs are Rs.2 per
order, price per order price per unit of material is 32 paise and storage costs are 25% per
annum of stock value , find the economic order quantity.
(B.Com. Calicut)
2 AO
Economic Order Quantity (EOQ) =
1
2 × 1,800 × Rs.2
=
25% on 32 paise
= 300 units
Illustration 6
Find out the Re ordering level from the following information
a) Minimum stock 1000 units b) Maximum stock 2000 units c) Time required for
receiving the material 20 days d) Daily consumption of material 100 units
Reordering level = Minimum level + Lead time stock level
The first step is to find out the Lead time stock level
Lead time stock level is nothing but the amount of stock level required by the firm, till the
next fresh receipt of goods, subject to the time normally taken by the supplier to supply.
Lead time stock level= Time required for receiving the material × Daily consumption
Lead time stock level= 20 days × 100 units per day= 2000 units
Reordering level= 1,000 + 2,000 units= 3,000 units
Illustration 7
Calculate maximum level , minimum level and reordering level from the following data
Reorder quantity 2,000 units
Reorder period 8 to 12 weeks
Maximum consumption 800 units per week 319
Accounting and Finance for Normal consumption 600 units per week
Managers
Minimum consumption 500 units per week
Reordering level = Minimum level + Lead time stock level
Or
= Maximum consumption × Maximum lead time
Minimum level= Reordering level – (Average consumption × Average lead time )
Maximum level= Reorder level + Reorder quantity – (Mini consumption × Mini Lead
time)
First step is to find out the Re ordering level
Reordering level = 800 units per week × 12 weeks= 9,600 units
The next step is to find out the Maximum level
Maximum level = 9,600 units + 2,000 units - (500 units × 8 weeks)
= 11,600 units- 4,000 units =7,600 units
The next step is to find out the minimum level . For that Average consumption has to be
found out. The average consumption is nothing but normal consumption. The normal
lead time period is the average of minimum and maximum re order period of the firm in
getting the supply of the materials from the suppliers
Minimum level = 9,600 units – (600 units × 20/2)
= 9,600 units – 6,000 units= 3,600 units
Illustration 8
Two components A and B are used as follows
Normal usage 50 units per week each
Minimum usage 25 units per week each
Maximum usage 75 units per week each
Re order quantity A: 300 units
B: 500 units
Re order period A: 4 to 6 weeks
B: 2 to 4 weeks
Calculate for each component
(B.Com., Madras)
(a) Re order level (b) Minimum level (c) Maximum level and (d) Average stock level
First step is to find out the Reorder level for both A and B components
The maximum usage is common for both A and B components but the reorder period are
different from each other
Reorder level = Maximum consumption /usage × Maximum Reorder period
(A)= 75 units × 6 weeks= 450 units
(B)=75 units × 4 weeks= 300 units
The next step is to determine the Maximum level of both Components A and B
Maximum level = Reordering level + Reordering quantity – (Mini Consumption × Mini
Lead time)
320
(A)= 450 units + 300 units – ( 25 units × 4 weeks) = 650 units Working Capital Management
(4 + 6))
= 450 unit – (50 unit ×
2
(A) = 450 units – 250 units = 200 units
(2 + 4))
(B) = 300 unit – (50 unit ×
2
=300 units – ( 150 units )=150 units
Average stock level = Minimum stock level + ½ Re order quantity
(A)= 2 00 units + ½ 300 units = 350 units
(B)=150 units+ ½ 500 units = 400 unit
Illustration 9
The following information is available in respect of components of R × 100
Maximum stock level 10,000 units
Budgeted consumption Maximum 3,000 units per month
Minimum 1,600 units per month
Estimated delivery period Maximum 4 months
Minimum 2 months
You are required to calculate
(i) Re-order level
(ii) Re-order quantity
Re order level = Maximum consumption × maximum lead time
= 3,000 units × 4 months=1,200 Units
The Reordering quantity could be found out with the help of Maximum level equation
Let us assume Re ordering quantity =X
Maximum level = Re-ordering level + Re-ordering quantity - (Minimum
consumption × Mini Re order period)
= 1,200 units+ (X)-(1,600 units × 2 months)
(-X) = 1,200 units-3,200 Units
= –2000 units
X = 2,000 units
In the stores control , there are two important documents viz Bin card system and stores ledger.
Bin Card: Bin card is a record prepared by the store keeper at the moment of issuing
and receiving the materials. It is maintained by the store keeper for physical verification
with accuracy and effectiveness. The inventory control can be accessed through physical
verification then and there, whenever the situation warrants.
The bin card system is adopted by many firms for their inventory control either in the
form of bin tag or stock card hanging outside the rack in order to portray the information 321
Accounting and Finance for immediately to facilitate the store keeper to understand the stock position of the store
Managers
room.
The bin card system is available in two major categories viz:
Two Bin card system: Under this system two different bins are used. As soon as the
goods or materials received by the store keeper, that should be recorded in terms of
quantities. One among the two should be maintained for Re order level and minimum
level another for Maximum stock level.
To alarm the firm neither to store more than the maximum level nor to issue less than the
minimum level of the stock. If the firm once reaches the maximum level, it should
immediately caution the implications due to the overstocking. The same firm, if reaches
the minimum level of stock, it should not go for further issue of materials to functional
department or otherwise, the firm's production may be disturbed due to the poor stocking.
Bin card for Mini and Reorder Bin card for Maximum Level
level
Maximum Level
Reorder Level
Maximum Level
Three Bin Card system: It is an extension of the early method, which incorporates the
lead time stock level in addition to the other level viz Maximum, Reorder and Minimum
level of the stock. Among the three , two cards are exclusively used by the firm in order
to maintain the appropriate stock level, i.e., for maximum stock level and minimum stock
level. The firm should neither to store beyond the maximum level nor to issue less than
the Minimum level. In between, a separate bin card is used only for the Reorder level
and Lead time stock level at which the firm should go for the placement of an order to
get fresh delivery of materials and facilitate the firm to undergo production without any
interruption by considering the time taken by the supplier to supply the ordered materials.
Reorder level
322 Minimum stock level Lead time stock level Maximum stock level
Some other methods of the inventory control Working Capital Management
There are few models exercise the inventory control , which facilitates the firm to avoid
either under or over stocking.
l ABC Analysis
l VED Analysis
The
C importance of 2,680
the analysis is exercising
67% the control on the inventory.
1,00,000 5%
From the above table, it is obviously understood that the items which have greater %
(75%) in the total value requires rigid control than any other quantity of materials. The
Group C items are bearing 67% of total consumption amounted which 5% of total value
of the items procured by the enterprise.
323
Accounting and Finance for The Unique features of the ABC analysis:
Managers
Nature A Group of Items B Group of Items C Group of Items
Safety stock level Due to greater value- Due to moderate Due to lower value-
least volume safety value-lesser safety High safety stock is
stock to be stock is required required
maintained
System of Purchase Higher value demands Moderate value Lower value needs
centralized system of requires centralized decentralized system
procurement and decentralized of purchase
system of purchase
Advantages
(1) It guides the management to exercise the control based on the value of goods to
the total composition.
(2) Systematic inventory control can be exercised through this analysis on the basis of
value of the materials. The high value materials of Group A are rigidly controlled
which finally led to lesser investments.
(3) Scientific system facilitates to lessen the storage cost of the inventory.
1) Inventory means
a) Stock of Cash b) Stock of Raw materials, work in
progress and Finished goods
c) Stock of spares d) Both b) & c) only
324 Contd...
2) Inventory control is for the maintenance of Working Capital Management
Findings
i) General tendency was found among the firms to avail the bank credit more than
their requirements
ii) Another tendency was among them that the short term credit was generally made
use of by thee for the acquisition of the long term assets
iii) The lending through cash credit should be done on the basis of security in order to
assess the financial position of the firm
326
Recommendations Working Capital Management
i) Appraisal should be done by the bankers on the present and future performance of
the firms
ii) The total dealings are segmented into two categories viz core and short-term needs
iii) The committee suggested the firms to maintain only one account with the one
banker For huge amount of borrowing, consortium was suggested among the
bankers to lend the corporate borrowers
Recommendations
i) Reasonability of the projection statements are to be studied by the banks more
carefully
ii) Current assets and liabilities are to be classified in accordance with the norms
issued by the Reserve bank of India
iii) Maintenance of the current assets ratio 1.33:1
iv) Timely supply the information stipulated by the bankers
v) Apt supply of annual accounting information
Illustration
ABC Ltd. decides to liberalise credit to increase its sales . The liberalized credit policy
will bring additional sales of Rs. 3,00,000. The variable costs will be 60% of sales and
there will be 10% risk for non-payment and 5% collection cost .Will the company benefit
from the new credit policy ?
Particulars Rs
Additional sales volume 3,00,000
(-) Variable cost 1,80,000
Additional revenue 1,20,000
(-)Non payment risk 10% on additional sales volume 30,000
(-) 5% on collection 15,000
Additional revenue from increased sales due to liberal credit policy 75,000
The new credit policy pave way for the firm to earn Rs.75,000 as an additional revenue
through the volume of incremental sales.
Reordering Level is the level at which the firm should go for fresh purchase requisition
of material through the store keeper to meet the requirements. There are few models
exercise the inventory control, which facilitates the firm to avoid either under or over
stocking
l ABC Analysis
l VED Analysis
23.13 KEYWORDS
Working capital: The short term asset meant for day today or immediate financial
commitments
Net working capital: Current assets - current liabilities
Temporary working capital: Which are of immediate importance
Permanent working capital: Which are regular in feature
Cash: coins, notes, currencies and near cash i.e., marketable securities
Cash management: maintain the adequate cash resource and excessive resources
should be invested in the marketable securities
Inventory: Stock of Raw materials, Stock of Work in Progress, Stock of Finished Goods
and Stock of Spares but not Stock of Loose tools.
EOQ: Economic Order Quantity of materials to be ordered/procured
Carrying cost: Cost is incurred for carrying the materials from the place of purchase to
place of production centre/profit centre
Ordering Cost: Cost incurred at the moment of placing the order of goods or materials
e.g. Administration costs, cost of communication and so on.
Maximum level: The stock level of the firm should not be more than the determined
level
Minimum level: The further issues should not be done below the level of the stock of
the firms
Reorder level: At this level, the firm should place an order for the materials to the
requirement
Lead time stock level: This is level required by all the firms to maintain the stock till the
next delivery from the supplier
ABC Analysis: Analysis of exercising the control on the inventory on the basis of value.
Always Better Control Analysis; A- High control for high value goods; B-Moderate
control for lesser value goods and C- Little control on the least value goods
VED Analysis: Vital, Essential and Desirable Analysis – Designed for Spares and
accessories
Bin card: Card or Tag used to illustrate the level of the stock position of the certain
materials at the stores
Stores ledger: It is a official record of receipt and issuance of materials or goods in
329
terms of quantities with value of them
Accounting and Finance for Receivables: It is an asset arises at the moment of credit sales, owed to the firm
Managers
Collection cost: Cost of collection incurred by the firm due to collection of receivables
Agency charges, brokerage charges for collection
Default cost: Cost due to bad debts
330