UNDERSTANDING FINANACIAL STATEMENTS

OWNER Shareholders Government

Board of Directors

ENTERPRISE/ FIRM(Department Entity) Management Workers Material

EXTERNAL AGENCIES Clients Creditors Debtors Government

2

ACCOUNTING SYSTEM

ACCOUNTIN G IS

an INFORMATION SYSTEM

which records BUSINESS TRANSACTIONS and reports them in FINANCIAL STATEMENTS and cost and control statements

3

FINANCIAL ACCOUNTING: Financial Accounting is a process and set of procedures for recording, summarizing, classifying analyzing and reporting financial transactions. Financial Accounting is concerned with preparation of Balance Sheet, Profit and Loss Accounts and Cash Flow Statements of the entities indicating the financial position as on a particular date, the operating results over a period of time and wherefrom funds have come and where funds have gone during the period. COST ACCOUNTING: The technique and process of ascertaining the amount of expenditure incurred in or attributable to particular products, processes centres or services. This involves collecting, classifying processing and analyzing costing data for either cost control/ reduction or product costing purposes. MANAGEMENT ACCOUNTING: The application of financial accounting and cost accounting data to generate information to assist managerial decision making in its functions of promoting maximum efficiency and in formulating and co-ordinating future plans and subsequently in measuring their execution.

4

FINANCIAL STATEMENTS RFLECT FINANCIAL POSITIONS OPERATING RESULTS SOURCES & USES OF FUND/CASH

5

ACCOUNTANTS

PREPAREOWNERS For use of Internal Groups

For

MEASURE OF PROFITABILITY ASSETS AND LIABILTIESFor

FINANCIAL STATEMENTS

ENTERPRISE MANAGEMENT For

CORRECTION OF ADVERSE TRENDS ASSURANCE THAT STATEMENTS REPRESENT POSITION FAIRLY

INTERNAL AUDITORS

6

ACCOUNTANTS INVESTORS

For

PROFITABILITY PROFITABILITY PRODUCTIVITY TAX ASSESSMENT PRODUCTIVE USE OF RESOURCES SAFETY AND REPAYMENT OF LOANSASSURANCE THAT STATEMENTS REPRESENT POSITION FAIRLY

For

PREPARE

TRADE UNIONS For

FINANCIAL STATEMENTS

For use of External Groups

TAX AUTHORITIES

For THE PUBLIC

For CREDITORS

EXTERNAL AUDITORS

For

7

BASIC ACCOUNTING CONCEPTS 1) The Business Entity Concept BUSINESS ACCOUNTS DEAL WITH TRANSACTIONS OF A SPCIFIC ENTITY (ENTERPRISE), A LEGAL CORPORATE PERSONALITY. THOUGH IT HAS NO FLESH, NO BONE AND NO BLOOD. ONCE INCORPORATED, IT HAS PERPETUAL SUCCESSION. 2) The Money Measurement Concept ALL BUSINESS TRANSACTION ARE RECORDED (EXPRESSED) IN TERMS OF MONEY 3) The Going Concern Concept ACCOUNTING IS BASED ON ASSUMPTION THAT THE ENTERPRISE WILL OPERATE INDEFINITELY 4) The Cost Concept FIXED ASSETS ARE ACCOUNTED FOR AT ACQUISITION COST RATHER THAN VALUE THEY COULD BE SOLD FOR 5) The Dual Aspect Concept EVERY (EVENT) TRANSACTION RECORDED AFFECTS AT LEAST TWO ITEMS IN A FINANCIAL STATEMENT 6) The Accrual Concept INCOME AND EXPENSES ARISING FROM TRANSACTIONS ARE RECORDED IN THE PERIOD IN WHICH THEY OCCUR RATHER THAN THE PERIOD IN WHICH PAYMENT IS MADE. SEEKS TO MATCH COSTS WITH REVENUES

8

FUNDAMENTAL ACCOUNTING CONVENTIONS THE MOST COMMONLY USED ACCOUNTING COVENTIONS ARE: 7) CONSISTENCY ONCE A METHOD OR POLICY IS ADOPTED, SUBSEQUENT TRANSACTIONS WILL BE TREATED IN THE SAME WAY; OTHERWISE, CHANGES SHOULD BE EXPLAINED 8) COSERVATISM TO AVOID OVERSTATEMENT, WHENEVER THERE IS CHOICE IN VALUING ASSETS OR LIABILITIES THE MORE CONSERVATIVE VALUE WILL BE USED 9) MATERIALITY TRIVIALITIES ARE IGNORED. PERSONAL JUDGEMENT AND COMMON SENSE DETERMINE WHETHER AN ITEM IS TRVIAL OR NOT 10) OBJECTIVITY DATA SHOULD BE SELECTED IN AS OBJECTIVE A MANNER AS POSSIBLE

9

THE ACCOUNTING EQUATIONFINANCIAL POSITION AT ONE POINT IN TIME

EQUITYOWNERS CLAIMS

++

LIABILITIESWHAT THE ENTERPRISE OWES TO CREDITORS

==

ASSETSWHAT THE ENTERPRISE OWNS

Net worth (NW)+Long Term Liabilities (LTL)+Current Liabilities (CL) = Net Fixed Assets (NFA)+Current Assets(CA)+Non Current Assets(NCA)+Intangible Assets (IA) (Based on Test of Time) (Based on Test of Purpose)

NW + LTL + CL (NW IA) + LTL

= =

NFA + CA + NCA + IA NFA + (CA CL) + NCA

10

BALANCE SHEET FROMAT 1 AS OF (date) . LIABILITIES Equity Capital Stock Retained Earnings Total Equity Long-term Liabilities Long-term Debt Current Liabilities Short-term Loans Accounts Payable Total Current Liabilities TOTAL LIABILITIES & EQUIY ASSET Fixed Assets Land, Building & Civil Works Plant & Equipment Less: Accum. Depreciation Capital Work-in-Process Net Fixed Assets Current Assets Cash/ Bank Balance Accounts Receivable Inventories Total Current Assets Other Assets - Investments TOTAL ASSETS

11

BALANCE SHEET FORMAT 2 AS OF (date) .ASSETS Fixed Assets Land Building Plant & Equipment Less Accum. Depreciation Capital Work-in-Process Net Fixed Assets Other Assets - Investments Current Assets Cash/ Bank Balance Accounts Receivable Inventories Total Current Assets Current Liabilities Short-term Loans Accounts Payable Total Current Liabilities Net Current Assets Total Assets Long-term Liabilities Long-term Loan Debenture Deposits EQUITY & LIABILITIES Equity Equity Share Capital Preference Share Capital Retained Earning Total Equity TOTAL EQUITY & LIABILITIES12

ASSETS CURRENT13

TYPE CASH

EXAMPLE PETTY CASH MONEY IN BANK

USES (ILLUSTRATIVE) DEBT PAYMENT PAYMENT FOR OPERATING EXPENSES & CONTINGENCIES; PAYMENT FOR OTHER ASSETS MAINTAING PRODUCTION & DELIVERY SCHDULES

INVENTORIES

RAW MATERAIL SPARE PARTS & CONSUMABLES WORK-IN-PROCESS FINISHED PRODUCT (UNSOLD)

ACCOUNT RECEIVABLE SHORT-TERM INVESTMENT PREPAID EXPENSES

GOODS & SERVICES SOLD TO FACILITATE SALES BUT NOT YET PAID FOR BY GIVING CREDIT NOTES & DEPOSITS GAINING INCOME ON DRAWING INTEREST, ETC SURPLUS FUNDS INSURANCE PREMIUMS LICENSE FEES RENT INTEREST ACCRUED BUT NOT DUE FACILITATE THE NORMAL OPERATION OF AN ENTERPRISE TO CAPTURE INCOME FOR THE PERIOD

ACCRUED INCOME

________________________ NOTE: ASSETS ARE CLASSIFIED CURRENT IF THEY ARE USED UP OR CLEARED DURING A RELATIVELY SHORT PERIOD OF TIME USUALLY ONE YEAR ASSET FIXED14

TYPE LAND

EXAMPLE

BUILDING & CIVIL WORKS PLANT AND MACHINARY * BUILDING AND EQUIPMENT INSTALLED FURNITURE AND FIXTURES, VEHICLES PLANT UNDER CONSTRUCTION PLANT AND EQUIPMENT STILL IN NONPRODUCTIVE STAGE

* VALUED AT COST LESS DEPRECIATION NOTE: FIXED ASSETS ARE RESOURCES EXPECTED TO LAST AND NOT TO BE USED UP OR CLEARED WITHIN ONE YEAR. INTANGIBLE ASSETS TYPE EXAMPLE

15

RESEARCH AND DEVELOPMENT (DEFERRED REVENUE EXPENDITURE)

COST OF PROTOTYPE DEVELOPMENT & STUDIES FOR IMPROVED PRODUCTIO, EFFICIENCY & PROCESS DEVELOPMENT (COULD ALSO BE EXPENSED) GOODWILL VALUE PRODUCTION RIGHT

GOODWILL PATENTS, CPOYRIGHTS

PRE-OPERATING EXPENSES SALARIES, TRAINING & OTHER EXPENSES PRIOR TO REGULAR OPERATIONS BUSINESS LOSS OPERATING LOSS IN INTIAL YEARS

*

NONPHYSICAL POOSESSIONS OF AN ENTERPRISE EXPECTED TO YIELD BENEFITS OVER A PERIOD OF YEARS

LIABILITIES CURRENT TYPE EXPANATION & EXAMPLE16

ACCOUNTS PAYABLE BILLS/NOTES PAYABLE

GOODS & SERVICES RECEIVED ON CREDIT PROMISSORY NOTES; BILLS OF EXCHANGE ISSUED BY ENTERPRISE FOR SERVICES OR GOODS RECEIVED PORTION OF SALARIES DUE BUT NOT YET PAID PORTION OF TAXES DUE BUT NOT YET PAID LOANS TO BE REPAID IN LESS THAN ONE YEAR PORTION OF LOAN TERM DEBT DUE FOR PAYMENT WITHIN ONE YEAR

ACCURED EXPENSES ACCRUED TAXES SHORT-TERM LOANS LONG-TERM LOAN (current portion)

DIVIDNENDS PAYABLE

____________ NOTE: LIABILITIES PAYABLE WITHIN THE CURRENT ACCOUNTING PERIOD LIABILITIES LONG TERM

17

TYPE LONG TERM LOANS

EXAMPLE BANK LOANS (TERM LOAN) BONDS/ DEBENTURES SUPPLIERS CREDIT (DEFERRED) DEPOSITS (LONG-TERM)

_________ NOTE: LIABILITIES PAYABLE WITHIN A PERIOD OF MORE THAN ONE ACCOUNTING PERIOD

EQUITIES (OWNERS EQUITY)18

TYPEPROPRIETORS CAPITAL

EXPLANATIONORIGINAL AMOUNT INVESTED IN ENTERPRISE

STOCK-COMMON/ PREFERRED

AMOUNT INVESTED BY SHAREHOLDERS

RETAINED EARNINGS

EARNINGS RETAINED AFTER DISTRIBUTION OF DIVIDENDS

QUASI - EQUITY STATE INVESTMENT SUSIDY SALES TAX LOAN STATE DEVELOPMENT LOAN SUBORDINATED LOAN FROM PROMOTERS BOOK GAP (ACTUAL VIABILITYVALUE FUNDING COST OF MEZZANINE ACQUIRING ASSET) CAPITAL

FIXED ASSETS IN OPERATION

VALUE OF ASSET USED UP IN OPERATION DURING ITS LIFE (FULL DEPRECIATION)

A FIXED ASSET (PLANT) HAS USEFULNESS OVER A NUBER OF YEARSESTIMATED ASSET LIFE

SALVAGE VALUE

19 BEGINNING END

FULL DEPRECIATION IS AN EXPENSE. AN ENTERPRISE HAS TO CHARGE COSTS FOR THE USE OF AN ASSET OVER ITS ESTIMATED LIFE STRIGHET LINE DEPRECIATION (A COMMON USED SYSTEM)Book Value

Depreciation in 5th A/C Period 20

$

Book Value at Start of 5th A/C Period

Book Value at End of 5th A/C Period

SALVAGE VALUE

1

2

3

4

5

6

N

Accounting Periods

ASSET LIFE

RULES:Book Value

Book Value Salvage Value DEPRECIATION PER A/C PERIOD = N BOOK VALUE OF ASSET AT END OF PERIOD ACCUM.= BOOK VALUE AT START OF PERIOD DEPR. AT DEPR. AT ACCUM. START OF 5TH A/C - DEPRECIATION IN PERIOD 5TH A/C END OF Depreciation inPERIOD 5th A/C Period PERIOD

ACCUMULATED DEPRECIATION

SALVAGE VALUE

21 1 2 3 4 5 N A/c Periods

ACCUM. DEPR. AT END OF PERIOD = ACCUM. DEPR. AT START OF PERIOD + DEPR. IN PERIOD

_________ NOTE: THS ITEM APPEARS IN THE BALANCE SHEET ONLY

AMORTIZATION OF INTANGIBLE ASSETS INTANGIBALE ASSSETS CAN BE TREATED IN THE SAME WAY AS FIXED ASSETS. THEY ARE NEEDED FOR OPERATION AND ARE ACQUIRED WITH ENTERPRISE FUNDS.22

EXAMPLE: PATENTS CAPITALIZED & MAY BE EXPENSED OVER A PERIOD OF TIME COST OF R & D ARE SOMETIMES CAPITALIZED AND EXPENSED OVER A PERIOD OF TIME EXPENSES CAPITALIZED DURING INTIAL NONPRODUCTIVE PERIOD INTIAL OPERATING LOSS

RESEARCH & DEVELOPMENT

PRE-OPERATIONAL EXPENDITURE BUSINESS LOSS

AN INTANGIBLE ASSET IS ASSUMED TO HAVE A CERTAIN USEFUL LIFE AND ITS ORIGINAL VALUE IS DEPRECIATED OVER THIS PERIOD. DEPRECIATION OF INTANGIBLE ASSETS IS KNOW AS AMORTIZATION.

FUND FLOWS ACCOUNTING PERIOD

BALANCE SHEET

BUSINESS TRANSACTION IN PERIOD23

NEXT BALANCE SHEET

PASSAGE OF TIME

ACCOUNTING PERIOD

EXAMPLE: STARTING BALANCE SHEET

TRANSACTION DURING THE PEIOD

ENDING BALANCE SHEET

NOTE: ACCOUNTING PERIOD IS PERIOD BETWEEN TWO CONSECTIVE FINANCIAL STATEMENTS

FUNDS FLOW ASSETS24

LIABILITES

Sources Application

+

+ -

TOTAL SORUCES TOTAL APPLICATIONS = INCREASE OR DECREASE IN CASH IN PREIOD

NOTE:

+ -

indicates an increase in Assets or Liabilities indicates a decrease in Assets or Liabilities

EXAMPLE

25

FUNDS FLOW STATEMENT (For the period ending (date) ) SOURCES Profit before Taxes Depreciation Increase in A/C Payable Increase in Bank Loan Total Sources APPLICATIONS Expenditures for plant/ equipment Repayment of Long-term Debt Increase in A/C Receivable Increase in Inventories Taxes Dividends Total Applications Increase (decrease) in Cash

PROFIT & LOSS ACCOUNT GROSS SALES/ INCLOME LESS: EXCISE DUTY26

PULS: PLUS/ MINUS: NET SALES LESS: LESS: LESS: LESS: LESS: LESS: LESS: LESS: GROSS PROFIT LESS: LESS: LESS:

OTHER INCOME = OPERATIONAL STOCK VARIATION RAW MATERAIL SPARAES & CONSUMABLES POWER & UTILITIES SALARIES WAGES REPAIRS & MAINTAINANCE ADMINISTRATIVE EXPENSES SELLING COST AMORTISATION OF MIS EXPENSES INTEREST LEASE RENTAL DEPARECIATION

CONVERSION EFFCIENCY

FINANCING EFFCIENCY

OPERATING PROFIT PLUS/MINUS PRIOR PERIOD ADJUSTMENT PLUS/MINUS EXCEPTIONAL ITEMS PLUS OTHER INCOME NON-OPERATIONAL PROFIT BEFORE TAX LESS: TAX SHIELD AVAILABLE PROFIT AFTER TAX (NET PROFIT) PLUS: DEPRECIATION PLUS: AMORTISATIONS GROSS CASH ACCRUAL LESS: DIVIDEND NET CASH ACCRUAL THE PROFIT AND LOSS OR THE INCOME STATEMENT27TAX EFFCIENCY

FLOWS (TRANSACTIONS) WHICH AFFECT EQUITY ARE TABULATED IN A SPECIAL FUNDS FLOW STATEMENT CALLED THE INCOME STATEMENT

IN THIS STATEMENT SALES, COSTS AND EXPENSES ARE MATCHED FOR A SPECIFIC PERIOD OF TIME AND INCOME (PROFIT) IS COMPUTED FOR THE ACCOUNTING PERIOD LIKE THE OTHER STATEMENTS IT REFLECTS ACCRUAL TRANSACTRIONS EVEN THOUGH CASH PAYMENT IS DEFERRED

DEPRECIATION IN FUNDS FLOW STATEMENTS

28

DEPRECIATION APPEARS IN INCOME STATEMENT UNDER EXPENSES (IT IS AN ESTIMATE OF THE PORTION OF THE CAPITAL ASSET USED SURING THE PERIOD) DEPREICIATION INCREASES EXPENSES AND DECREASES EQUITY THIS TRANSACTION DOES NOT INVOLVE A CHANGE IN CASH. AN EQUAL FLOW UNDER SOURCES IS THEREFORE REQUIRED FOR BALANCE. ALTHOUGH DEPRECIATION IS NOT TRULY A SOURCE OF FUNDS SINCE IT EXISTS ONLY TO THE EXTENT THAT REVENUES COVER ALL OTHER EXPENSES AND IS NOTIONALLY AN ALLOCATION OF INCOME FOR EVENTUAL REPLACEMENT OF ASSETS

II.

GUIDELINES FOR CALCULATION OF RATIO CONNOTATIONS OF TERMS USED

29

1.

Debt (Term Liabilities)

a) Long-term loans/deposits (repayable after 12 months) including interest bearing unsecured loans from Government/ Government agencies, promoters, etc. b) Debentures [Convertible debentures to be treated as debt (except that part of debentures which are compulsorily convertible into equity) until they are converted, irrespective of the period of maturity] c) Deferred payments d) Preference shares due for redemption between 1 and 3 years.

30

2.

Equity (Owned funds)

a) Ordinary share capital b) Preference share capital due for redemption after 3 years c) Free reserves and surplus less accumulated losses, arrears of depreciation, goodwill and miscellaneous expenses (i.e. preliminary expenses, etc.) to the extent not written off. Development rebate/investment allowance reserve, debenture redemption reserve, dividend equalization reserve, etc. should also be treated as free reserves. Reserves created out of revaluation of assets should not be taken as free reserves. d) Premium on issue of shares e) Amount of Central/ State subsidy f) Long-term interest-free unsecured loans from State Government agencies (such as sales-tax loans, etc.) and promoters, usually subordinated to institutional loans (if not subordinated, such loans may be treated as debt) g) Non-refundable deposits in the case of cooperatives. a) Stock of raw material b) Stores c) Work-in-progress d) Finished goods e) Book debts including debts on account of bills discounted f) Bills and other receivables g) Loans and advances h) Pre-paid expenses (such as advance payment of tax) i) Cash and deposits with banks. Note: Investments are not to be included in current assets a) Sundry creditors b) Unpaid dividends c) Provision for taxation d) Bank borrowings for working capital including bills discounted e) Unsecured loans/ deposits to the extent not treated as debt or equity31

3.

Current assets

4.

Current Liabilities

f) Preference shares redeemable within one year g) Other current liabilities and provisions. 5. 6. Stock of finished goods Annual sales (net sales) Closing stocks of finished goods. Income from sale of finished goods net of excise duty less discounts and returns. Non-operating income need not be including in net sales; however, such income should be shown separately to form part of the turnover. The amounts of receivables and/ or sundry debtors as given in the balance sheet, including bills discounted. Closing stocks of new materials, chemicals and bought-out components Opening stocks plus purchase made during the year minus closing stock of raw materials, chemicals and bought out components. Net fixed assets (gross fixed assets minus depreciation) plus capital work-in-progress. Arrears of depreciation, if any. To be accounted for in full while preparing the analysis of balance sheets and profit and loss accounts even if not provided for in the accounts and shown as arrears (if necessary, give a suitable foot note.) a) Equity share capital (paid-up value) b) Preference share capital (paid-up value) c) Free reserves (i.e. reserves created out of revenue profits and not set aside specifically to meet depreciation, taxation or any other knownliablity, contingency or commitment); development rebates/ investment allowance reserve, debenture redemption reserves, dividend equalization reserve etc. and Central/ State subsidy should be treated as free reserves. Reserves created by revolution of assets should not be taken as free reserves d) Surplus (if any) in profit and loss account e) Deduct from sum-total of (a to d) intangible assets, goodwill, etc, and deficit (if any) in profit32

7.

Receivable

8. 9.

Stocks of new materials Consumption of raw materials

10.

Net block

11.

Net Worth

and loss account 12. 13. 14. 15. Gross Profit Operating profit Net Profit Profit before interest, depreciation and tax Profit after interest and depreciation but before tax Profit after interest, depreciation and tax but including other income

Capital employed (to be a) Net worth (as given at 11 above) computed as at the beginning of b) Debentures the year) c) Long term loans including interest free unsecured loans from State Government, Government agencies, etc. d) Deferred credits e) Short term loans such as bank borrowings, etc. f) Unsecured loans and deposits. Cost of production a) Cost of raw materials, chemicals, components and stores b) Utilities c) Labour and plant overheads d) Other factory overheads e) Administrative expenses f) Sales expenses g) Reyalty and know-how payable Net sales realisation (net of excise duty and returns) plus value of closing stocks of finished goods and work-in-process minus value of opening stock of finished goods and work-in-process Value of output minus cost of raw materials, fuel, power, water and other direct material inputs like consumables, stores and spare etc. (net value added equals gross value added minus depreciation. a) Raw materials b) Bought-out components, chemicals etc. c) Stores and spares d) Utilities (power, water, fuel etc.) e) Packing materials f) Interest on working capital borrowings g) Direct selling expenses h) Royalty (variable)33

16.

17.

Value of output

18.

Gross value added

19.

Variable cost (for calculating break-even point)

i) Other expenses varying proportionately with output j) Contingencies relating to the above items. 20. Fixed and semi-variable cost (for calculating break-even point) a) Wages and salaries b) Factory and plant overheads c) Repairs and maintenance d) Administrative expenses e) Interest on term liabilities f) Selling expenses (other than variable items) g) Fixed know-how fees/royalty payments h) Depreciation i) Contingency relating to the above items.

34

III. INTERPRETATION OF RATIOS

A.

APPRAISAL RATIOS

Break Even Point (BEP)BEP = Fixed costs and Semi-fixed costs Contribution

Where Contribution = Net Sales Less Variable Costs. It is called contribution as it contributes to the recovery of fixed cost and thereafter profit. Fixed and semi fixed costs include (i) Salaries and wages, (ii) Repairs and maintenance, (iii) Administrative and miscellaneous expenses, (iv) Fixed portion of selling expenses, (v) Fixed royalty and Know-how payments, (vi) Interest on term debt, (vii) Depreciation on straight line basis (not to be included for cash break-even calculation), Variable costs include (i) Raw material, (ii) Outside purchases, (iii) Purchase of goods for resale, (iv) Consumable stores and spares, (v) Packing materials, (vi) Power, fuel and water, (vii) Royalty payments linked to sales, (viii) Variable selling expenses, (ix) Interest on working capital and (x) other variable expenses varying directly in proportion to output. Since in the short-run, the semi-fixed costs may not vary materially with the level of output, the entire semi-fixed costs are added to the fixed costs for BEP calculation. Capacity utilization is to be worked out on the basis of installed capacity (not optimum/ licenced capacity). BEP is to be calculated on the basis of cost structure related to capacity utilization for the year of normal operations. Cash BEP is to be worked out on the basis of same formula without taking depreciation as part of fixed cost. Cash Flow BEP is to be computed on the basis of cash BEP after adding installment of principal to fixed cost. Rationale: Break-even is the point at which a product or service stops costing money to produce and sell and starts generating a profit for the business. This means sells have reached sufficient volume to cover the variable and fixed costs of producing and distributing the product. At any particular level of capacity utilization, BEP is calculated to ascertain the cushion or margin of safety available for the industrial unit to withstand an unforeseen adversity. This is particularly important in times of depression when sales are falling and management must know at which level profit will change into loss. The ultimate goal of any business is to make money, but break-even analysis can also provide valuable information for profitable businesses in terms of setting price levels, targeting optional variable/ fixed price combinations and determining the financial attractiveness of various strategies for a business. During business downswing BEP enables budgeting the level of activity and decision making whether to continue or close down the business operations. Break-even analysis is particularly useful in comparing/ evaluating alternative scenarios.35

For examples, what happens when you increase selling prices by 25%? What happens when unit sales fall by 20%? Example Ordinary Ballpoint Pen Selling Price per unit Variable Cost per unit Contribution per unit Fixed cost (includes Depreciation of Rs. 100) Capacity utilization Sales Volumes Installment of Principal Volume of Production (Units) Sales Value (Rs) Variable Cost (Rs) Contribution Fixed Cost 250 500 250 250 500 (250) 400 800 400 400 400 @ _____0 Cash BEP Rs. 2 Rs. 1 Rs. 1 Rs. 500 80% 750 Rs. 50 450 900 450 450 450 @ @ _______0 500 1000 500 500 500 __0 750 1500 750 750 500 250 1000 2000 1000 1000 500 500

Cash Flow Operation BEP BEP

@ Excluding depreciation of Rs. 100 @ @ Excluding depreciation of Rs.100 and including installment of Principal of Rs. 50. Operating BEP Cash BEP = Cash Flow BEP Fixed Cost = Contribution per unit Foxed Cost Less Depreciation Contribution per unit Rs.500 = Rs. 1 Rs. 400 = 400 Units = Rs. Rs.450 = 450 Units = Rs.1 = 500 Units

Fixed Cost Less Depreciation Plus Installment Principal = Contribution per unit

Operating BEP Capacity = 500 * 80 % = 53 1 % 750 3 Cash BEP Capacity = 400 * 80 % = 42 2 %36

750

3

Cash Flow BEP Capacity = 450 * 80 % = 48 % 750 Fixed Assets Coverage Ratio (FACR) (times) Net Fixed Assets + Capital Work-in-progress = Deferred Credits + Term loans + Debentures Secured by first charges over fixed assets + External Commercial Borrowings + Foreign Suppliers Credit + Working Capital term Loan + Deferred Interest + Other Loans. FACR indicates overall coverage/ security cover available for the borrowings. For existing companies, numerator is to be calculated as : Net Fixed Assets Add: Capital work-in-progress Less: Revaluation Amount Less: Net value of fixed assets hypothecated on specific/ first charge basis. For projects under implementation, assets would be equal to the entire capital cost incurred less preliminary expenditure which will not be capitalized. Example: Net Fixed Assets Term Loan = Rs. 150 Rs. 100 Rs. 150 Rs. 100 = 1.5 times

FACR (Security Cover) Security Margin

= Net Fixed Asset Term Loan % Net Fixed Assets = 150 100 % 150

= 33 1 % 3

Note: Net fixed assets which form part of security for institutional loans only to be included in this ratio and to be calculated from the date of project completion. Debt Services Coverage Ration (DSCR) Gross Cash Accruals + Interest on Term Debt + Lease Rentals DSCR = Repayment of installment Term Debt and Deferred Credits + Interest on Term Debt + Lease Rentals Average DSCR to be computed by taking the total of all values of the numerator and denominator for the entire period of the proposed term loans commencing from the year in which commercial production starts, and not by taking an average of the DSCRs for each37

year. DSCR relates available funds from operation to debt obligation by way of periodic interest and installment repayment. This ratio indicates the ability of the unit to meet its debt obligations and forms the basis for fixation of the repayment schedule. DSCR is to be computed for each year of the loan life and as an average for the total loan amount covering the whole repayment period after commencement of production. Hence, the values in the nominator and the numerator of the ratio may be taken as the sum total of the values for the entire period of the proposed term loans commencing from the year in which commercial production starts. It DSCR for a particular year is less than 1, time relief by way of deferment of interest/ installment is considered . However, if average DSCR for the entire loan is less than 1 the debt component is reduced to sustainable level and promoter is required to infuse additional equity/ subordinated debt to improve DSCR. Internal Rate of Return (IRR): (i) The methodology for computation of post-tax IRR is given below: Cash Outflows each year to include Capital Expenditure on the project (net of interest during construction) and Increase in Gross Working Capital (since interest is a part of return on funds employed, interest during construction period not be included in the outflows). Any expenditure which is essential for maintaining the life and productivity of the project should be charged to repairs and maintenance. Normal capital expenditure provided generally by way of balancing and not for maintaining the physical life of the project, not be treated as an outflow for calculation of IRR. (ii) Cash Inflows each year to include inflows from the operations of the project each year, recovery of 100% working capital, land 100% and other capital assets 5% in the terminal year of operations Cash inflow from operations is defined as: Profit before interest, lease rentals and depreciation Less: Tax, and may be calculated as: Profit before tax, interest, lease rentals and depreciation. Less: interest and lease rentals Less: Depreciation (WDV) Taxable profit/ adjusted tax profits* Less: Tax = Profit after tax Add: Depreciation Add: Interest and lease rentals* = Cash flow from operations. * adjustment to be made for tax incentive available.

38

(iii)

Tax Shield: Tax shield arising out of losses in the initial years of the project can be added back to the cash flows only if the existing operations of the company are liable for tax of that amount. In case of new companies, tax shield cannot be added back to the cash flows. Project Implementation Period: In case the implementation period of a project exceeds one year, the first year of implementation is to be treated as year, the second as 1st year and so on. The first year of operations may therefore become the 3rd or 4th year depending on the implementation schedule.(v) Project Life (for calculation of IRR) is to be 12 years (in no case beyond 12 years).

(iv)

However, in certain industries such as Chemical, Petrochemical and Electronics where the rate of technological obsolescence is faster, appraisal officers may take the project giving adequate justification. Infrastructure Projects like road, port, power, telecommunication, urban infrastructure, etc have longer project life. Rationale Internal rate of return (IRR) otherwise known as DCF yield, Break Even yield or Marginal Efficiency of Capital, is the rate of discount which gives Zero Net Present Value(NPV). It is another analytical tool based on time value of money principle. It is regarded as the companion to Net Present value. Technically, the internal rate of return makes the present value of an investments projected cash flow equal to the cost of the project. Practically speaking the rate that indicates whether or not an investment is worth pursuing. It is the minimum desirable return expected from the project. The calculation of IRR is used to appraise the prospective viability of investments and capital projects. Essentially IRR allows investors to find the interest rate that is equivalent to the monetary returns expected from the project. Once that rate is determined, it can be compared to the rates that could be earned by investing the money elsewhere or to the weighted cost of capital. Typically management require an IRR equal to or higher than the cost of capital depending on relative risk and other factors. Post-tax IRR as an overall return on all resources can be an interesting measure of a projects fundamental soundness since it is not affected by specific financing considerations. Example: Three Projects A, B and C with cash flow profiles are as under A B C Requiring similar Year 0 -24000 -24000 -24000 investment and Year 1 +16000 12000 8000 having 3 years life Year 2 +12000 12000 12000 Year 3 +8000 12000 16000 On Time value of money projectA will be selected. Direct Factor Present Value39

Year

Cash Flow

Discount Factor

Present Value

10% Year 0 Year 1 Year 2 Year 3 -24000 +16000 +12000 +8000-950 NPV = 0

1.00 0.909 0.826 0.751

-24000 14545 9917 6011 647330 % IRR = 27.44

1.00 0.769 0.592 0.455

-24000 12308 7101 3641 -9.50

} 950

7423

{} }6473

20 %

+ 6473 NPV IRR = 10% + 6473 -------- *(30% -10%) 7423 OR 30% 950 7423 = 27.44%

10% Discount Factor

(30% -10%)

Cost of Capital The cost of capital is to be calculated as post-tax weighted average cost of the mix of funds employed for the project (total investment in the project i.e. Capital cost of the project plus Gross Working Capital in the year of normal operations). The costs for different sources of funds are to be taken as follows: a) Equity share capital : 15% b) Cash accruals/ retained Earrings : 15% c) Preference share capital : Preference dividend rate d) Subsidy/ Incentive loans : To be treated free of cost e) Debt : The cost of long-term loans from institutions/banks, non-convertible debentures, deferred credits, bank borrowings for working capital, unsecured loans from public to be taken at the post-tax rate of interest i.e. at their respective effective cost to be calculated as [interest rate * (1 - tax rate)]. The average applicable tax rate is to be taken for this purpose (not the notional prevailing tax rate). The prevailing notional tax rate may be40

50% at a point of time but because of various tax benefits available (due to losses and incentives) the companys actual tax liability is generally lower than the prevailing tax rate. Therefore, the actual tax shield available to the company is the Total tax liability during the life of the project . Total operating profit over the life of the project f) Cost of convertible debentures: The cost of non-convertible portion is to be calculated on the lines indicated for the term loans. Cost of convertible portion is same as cost of equity (15%). h) Cost of Working Capital: the gross working capital requirements in the year of normal operations may be met either by bank borrowings, equity/cash accruals and term loans depending on the cash flows. The costs of bank borrowings, equity/cash accruals and term loans are to be calculated as accordingly. B. PROFITABILTIY RATIOS

Profit before Interest, Lease rentals and Depreciation (PBILD / Total Income (%) Profit before Interest, Lease Rentals and Depreciation * 100 = Net Sales + Operational Income Operating Profit/ Total Income (%) Operating Profit * 100 = Net Sales + Operational Income Net Profit/ Total Income (Y) ______ Net Profit ____ * 100 = Net Sales + Operational Income Net Cash Accruals/Income (%) Net Profit/(Loss) + Depreciation Dividend + Cash Adjustments * 100 = Net Sales + Operational Income + Non-Operational Income Gross profit margin indicates how efficiently a company uses its resources, materials and labour in the production process by showing the percentage of net sales remaining after subtracting the cost of making and selling a product or services. It depicts what part of the income contributes to the cash resources: trend may help predict impending liquidity strains and potential sickness. A high gross profit margin ratio indicates that a business can make a reasonable profit on sales, as long as overheads do not increase. Investors pay attention to the gross profit margin ratio because it tells them how efficient your business is compared to competitors. It is sensible to track gross profit margin ratios over a number of years to see if companys earnings are consistent, growing or declining. For businesses, knowing your gross profit margin ratios is important because if tells you whether your business is pricing goods and services effectively. A low margin compared to your competitors would suggest you are under-pricing while high margin might indicate over pricing. Low profit margin ratios can also suggest the business is unable to control production costs or that low amount of earnings are generated from41

revenues. Profit margin ratios are a popular way to benchmark against competitors. Industries will generally have standard gross profit margin ratios, which are easily discovered. Gross profit margin tends to remain stable over time. Significant irregularities or sudden variations might be a potential sign of financial fraud and accounting irregularities or problem in the business. Return on Capital Employed (ROCE) (%) Operating Profit + Non-operational Income + Interest + Lease Rentals * 100 = Net Fixed Assets + Lease Rentals Payable + Investments + Current Assets Provisions Creditors (The ratio reflects the earning capacity of the assets deployed. Capital work-in-progress and advances against capital expenditure are not included in capital employed as these assets do not start generating returns. Future lease rentals payable is taken as part of capital as it adds to the asset base. The non-interest bearing current liabilities i.e. Provisions and creditors are excluded). Earning Per Share (EPS) in Rs. = Net Profit Preference Dividend Other Dividend No. of equity shares at end of the year

(indicator of capacity to service equity share capital). Dividend Payout Ratio (%) Equity Dividend . = Net Profit Preference Dividend Other Dividend * 100 (indicator of the profit retained within business for reinvestment) Interest Cover (times) PBILDT Tax . = Interest + Lease Rentals This ratio measures the amount of earnings available to make interest payments after all operating and non-operating income and expenses except interest and income taxes are accounted for. Interest coverage is regarded as a measure of a companys creditworthiness because it shows how much income there is to cover interest payments on outstanding debt. Banks and financial analysis also rely on this to gauge the fundamental strength of a business.

C.

LIQUIDITY RATIOS42

Current Ratio =

Current assets as per Balance Sheet Spread (B20) . Current liabilities as per Balance Sheet Spread (B65)

This ratio is an indicator of a company's short-term solvency or liquidity position and ability to meet current obligations. Currents assets basically provide a cover for current liabilities. Though internationally, ideal current ratio is 2:1, in India Banks accept current ratio at 1.33:1. Excess of currents assets over for current liabilities provide buffer or cushion for shrinkage in value of inventories and debtors due to lapse of time in realizing the assets. Note : Current ratio should not be expressed in terms of percentage but as a ratio showing current liabilities as 1 and calculating current assets up to one decimal point. Defensive Interval Ratio (months) = Stock of Finished Goods + Receivables + Cash and Bank Balances. . (Operating Costs + Interest + Lease Rentals) / 12

(period for which the company will be able to carry on its operations with its existing liquid/ quick assets : trend in this ratio may help predication of sickness). D. CAPTALISATION RATIOS (Preference Share Capital Redeemable Within three years + Sales Tax Loan repayable Within three years + Other Incentive Loans repayable within three years + Debentures + Term Loans + Future Lease Rentals Payable Working Capital Term Loan + External Commercial Borrowings + Deferred Interest + Other Loans + Deferred Credits + Foreign Suppliers Credit + unsecured Loans and Deposits repayable after one year) (Installments of all the above dues during the next financial year + portion of Debentures to be compulsorily converted into equity shares) Equity Shares Capital + Preference Share = Capital redeemable after 3 years + other type of share capital + Reserves and Surplus + Subsidy + Sales Tax Loan repayable after three years + Other Incentive Loans repayable after three43

Debt (Long-term)/ Equity Ratio

years + Subordinated Loans from promoters + Portion of debentures to be compulsorily converted into equity shares (Intangibles/ losses). This ratio denotes the relationship between long tem debt and owned funds of a company and helps in assessing the capital gearing. This ratio indicates the Long-term solvency of the company and reflects the soundness of financial health of the company. Debt equity mix in the capital structure depicts risk in financing the company. The risk stems from the fact that debt is repayable, carries fixed charge and is a contractual obligation whereas equity has ownership interest, is of permanent nature and does not carry any dividend obligation. Dividend is payable out of profit after tax at the discretion of the management. As per Government of India Power Policy DER can be 4:1. However, institutions accept DER for infrastructure projects in the range of 65:35 to 80:20. For normal projects DER is upto 1.5:1 maximum. This following points may be noted while working out debt equity ratio:a)

b)

c) d)

In this case of existing companies having investments in other companies the extent to which such investments are considered to be non realizable, may be deducted from the amount of equity. Whether an investment is non realisable or not should be decided taking into account various relevant factors. Free reserves would mean reserves created out of revenue profits and not those set aside specifically to meet depreciation, taxation or ay known liability, contingency or commitment. Reserves created by revaluation of assets should not be treated as free reserves. Debt equity should not be expressed in terms of percentage but as a ratio showing equity as 1 and calculating debt up to one decimal point. Also expression of the ratio in the reverse order may be avoided. Deb-equity ratio may be worked out as on the date of completion of the Project both for new as well expansion cases. (Preference Share capital redeemable within three years + Sales Tax Loan repayable within three years + Other Intensive Loans repayable within three years + Debentures + Term Loans + Further Lease Rentals payable + Working Capital Term Loan + External Commercial Borrowings + Deferred Interest + Other Loans + Deferred Credits + Foreign Suppliers Credit + Bank Borrowings for working capital + Unsecured Loans and Deposits) 44

Overall Debt/ equity ratio

(Portion of debentures to be compulsorily converted into equity shares) Equity Share Capital + Preference Share = Capital redeemable after 3 Years + other type of share Capital + Reserves and Surplus + Subsidy + Sales Tax Loan repayable after three years + Other incentive loans repayable after three years + Subordinated Loans from promoters + portion of debentures to be compulsorily converted into equity shares intangibles/ losses.

Break-up value of Equity Share (Rs.)

Equity Share Capital + reserves and Surplus intangibles/Losses preference Dividend Arrears Revaluation Amount . = No. of Equity Shares at the end of the year.

(Indicators of possible erosion in the equity capital base). Price Earning (P/E) multiple Market price of Equity Share (Current) (times) = Earning per Share Indicators of under/ over pricing of shares in the market P/E multiple indicates investors confidence in the management of the company. E. GROWTH RATIOS % increase in PBILDPBILD of Current Year PBILD of previous Year = PBILD of Previous Year *100

(Indicators of improvement/ deterioration in the earning capacity: figure to be annualized if the particular accounting year is not 12 months). % increase in Net Manufacturing Sales Net Manufacturing Sales of current Year *100 Net Manufacturing Sales of previous year = Net Manufacturing sales of previous year (figures to be annualized if the relevant P/L account period is not 12 months).

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% increase in Gross Fixed Assets

(Gross Fixed Assets + Capital Work in Progress + Future Lease rentals payable (all at the end of current year) Gross Fixed Assets + Capital Work in progress + Future Lease Rentals payable (as at the end of previous year) Gross Fixed Assets + Capital Work in = Progress + Future Lease Rentals payable as at the end of previous year.

*100 F. TURNOVER

RATIOS (To be suitably adjusted if accounting period in not 12 months). Current assets holding ratio (months) Stocks of Raw Material + Finished Goods + Work-in-Progress + Stores, Spares and Packing materials + Receivables = Gross Sales /12

(Indicators of adequacy of the current assets and the extent to which the gross working capital is turned around in a year).

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Raw Materials Holding Ratio (months)

Stock of Raw Materials = Raw Materials consumed / 12

The ratio, revealing the cost structure is an indicator of stocks of raw materials to annual consumption and indicates the efficiency in inventory management. Stores Holding Ratio (months) Stock of Stores = Consumable stores/12 WIP Holding Ratio (Months) Stock of Work-in-process (WIP) = (Total Operating Cost + Depreciation Market and Selling Expenses + Opening WIP Closing WIP) / 12 (WIP = Work-in-process) Finished Goods Holding ratio (months)

Stock of Finished Goods = (Total Operating Cost + Depreciation + Interest + lease Rentals + Opening Stock of Finished Goods & WIP Closing Stock of Finished Goods and WIP) /12

This ratio reflects the funds blocked in finished goods in relation to sales. Quick turnover of stocks (or a low ratio of finished goods to sales) is an indicator of good management of production sales and stocks of finished goods. Collection Ratio (monthly) Receivables (including contingent liability for bills discounted). = (Gross Sales + Operational Income + NoOperational income) /12 The ratio points to the average period of conversation of sundry debtors to cash i.e. the number of day's credit enjoyed by sundry debtors or the credit period allowed and thus the money blocked with sundry debtors.

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The above indicate production and business efficiency in terms holding of inventories, receivables and the ability to covert them into cash. Total income/ Net Fixed Assets (times)

Net Sales + Other Income (operational) = Net Fixed Assets + Future Lease Rentals Payable. Net Sales + Other Income (Operational) + Other Income (Non-operational) Net Fixed Assets + Future Lease Rentals = payable + investments + Current Assets Provision - Creditors

Capital Turnover Ratio (times)

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(Indicators of efficiency with which capital assets have been used : useful for inter-firm comparison).

G.

OPERATION RATIOS

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All major items of cost are to be related to total cost to indicate the cost structure of the company. Total cost (TC) is defined as Total Operating Costs (excluding purchase of goods for resale and expenditure capitalized + Interest + Lease Rentals + Depreciation. Raw Materials/ TC (%) = Outside purchases /TC (%) = Consumable Stores / TC (%) = Power, fuel, Water/ TC (%) = Salaries and wages / TC (%) = Marketing and Selling expenses/ TC (%) = Other specified costs/ TC (%) = Interest and Lease Rentals/TC (% = Depreciation/ TC (%) = Other residuary costs/ TC % = Raw Materials Consumed TC Outside Purchases TC Consumable Stores TC Power, Fuel, Water TC Salaries and wages TC Advertising and Promotional expenses + Commission and other Selling Expenses + Packing Expenses + Royalty TC Specified cost TC *100 Interest + Lease Rentals TC Depreciation TC Repairs and Maintenance + Admn. And Miscellaneous expenses + R & D Expenditure amount capitalized TC *100 *100 *100 *100

*100 *100

*100

*100

*100

(Expenditure capitalized has been disregarded in operating ratios.)

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H. Other ratios Export sales --------------------------------------------------------------Net manufacturing Sales (Indicator of the companys eligibility for interest concessions) Imported Raw Materials and stores --------------------------------------------------------Total raw Materials and Stores Gross Value Added/ Capital Employed (Net Manufacturing Sales + Closing tock of Finished goods (FG ) and work- in- process (WIP) (Opening Stock of FG and WIP + Cost of Raw Materials + Outside Purchases + Consumable Stores + Packaging Expenses + Power, Fuel and water) Net Fixed Assets + Lease rentals Payable + Investments + Current Assets Provisions creditors Gross value added per worker (Productivity per worker) Investment per worker = = Gross value added Number of workers and salaried employees Capital employed Number of workers and salaried employees These ratios reflect the capital intensity and labour productivity of the project.

*100

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