management accounting book

MANAGEMENT ACCOUNTING

BABASAB PATIL (BEC DOMS)




LESSON – 1INTRODUCTION

The term “Management Accounting” is of recent origin. It was first coined bythe British Team of Accountants that visited the U.S.A. under the sponsorship ofAnglo-American Productivity Council in 195 with a view of highlighting utility ofAccounting as an “effective management tool”. It is used to describe themodern concept of accounts as a tool of management in contrast to theconventional periodical accounts prepared mainly for information of proprietors.The object is to expand the financial and statistical information so as to throwlight on all phases of the activities of the organisation.

All techniques which aim at appropriate control, such as financial control,budgeted control, efficiency in operations through standard costing,cost-volume-profit theory etc, are combined and brought within the purview ofManagement Accounting.

Management Accounting evolves a scheme of accounting which lays emphasison the planning of future (logical forecasting), simultaneously finding thedeviations between the actual and standards. Another significant feature ofManagement Accounting is reporting to top-management. Finally, accountinginformation should be presented in such a way as to assist the management inthe formulation of policy and in the day-to-day conduct of business. Forexample, the published accounts of business concerns do not furnishmanagement with information in a form that suggest the line on whichmanagement policies and actions should proceed. It requires further analysisclassification and interpretation before the management can draw lessons fromthem for their guidance and action.

DEFINITION OF MANAGEMENT ACCOUNTING

Management Accounting may be defined as “the presentation of accountinginformation in such a way as to assist the management in the creation of the



policy and day-to-day operation of an undertaking” – Management Accountingof the Anglo-American to productivity.

The Institute of Chartered Accountants of England has defined it –

“Any form of accounting which enables a business to be conducted moreefficiently can be regarded as Management Accounting”.

Robert N. Anthony has defined Management Accounting as follows-

“Management Accounting is concerned with accounting information that isuseful to management.”

According to American Accounting Association, “Management Accountingincludes the methods and concepts necessary for effective planning for,choosing among alternative business actions and for control through theevaluation and interpretation of performance”. This definition is fairlyillustrative.

According to Kohler, Forward Accounting includes “Standard costs, budgetedcosts and revenues, estimates of cash requirements, break even charts andprojected financial statements and the various studies required for theirestimation, also the internal controls regulating and safeguarding futureoperating.”

Blending together into a coherent whole financial accounting, cost accountingand all aspects of financial management”. He has used this term to include “theaccounting methods, systems and techniques which, coupled with specialknowledge and ability, assist manageme4nt in its task of maximizing profits orminimizing losses.” – James Batty.



Thus all accounting which directly or indirectly providing effective tools tomanagers in enterprises and government organizations lead to increase inproductivity is “Management Accounting.”

OBJECTIVES OF MANAGEMENT ACCOUNTING:

The basic objective of Management Accounting is to assist the management incarrying out its duties efficiently.

The objectives of Management Accounting are:

1. The compilation of plans and budgets covering all aspects of thebusiness e.g., production, selling, distribution research and finance.

2. The systematic allocation of responsibilities for implementation of plansand budgets.

3. The organization for providing opportunities and facilities for performingresponsibilities.

4. The analysis of all transactions, financial and physical, to enable effectivecomparisons to be made between the forecasts made and actualperformance.

5. The presentations to management, at frequent intervals, of up-to-dateinformation in the form of operating statements.

6. The statistical interpretation of such statements in a manner which will beof utmost assistance to management in planning future policy andoperation.

To achieve the above objectives, Management Accounting employs threeprinciples devices, viz.,-

1. Forward Looking Principle – basis on the past and all other availabledata, forecasting the future and recommending wherever appropriate, thecourse of action for the future.



2. Target Setting Principle – fixation of an optimum target which isvariously known as standard, budget etc., and through continuous reviewensuring that the target is achieved or exceeded.

3. The Principle of Exception – instead of concentrating on voluminousmasses of data, Management Accounting concentrates on deviations fromtargets (which are usually known as variances) and continuous andprompt analysis of the causes of these deviations on which to basemanagement action.

SCOPE OF MANAGEMENT ACCOUNTING:

The scope of Management Accounting is wide and broad based. It encompasseswithin its fold a searching analysis and branches of business operations.However, the following facets of Management Accounting indicate the scope ofthe subject.

1. Financial Accounting.

2. Cost Accounting

3. Budgeting & Forecasting

4. Cost Control Procedure

5. Statistical Methods

6. Legal Provisions

7. Organisation & Methods

1. Financial Accounting: This includes recording of external transactionscovering receipts and payments of cash, recording of inventory and salesand recognition of liabilities and setting up of receivables. It alsopreparation of regular financial statements. Without a properly designedaccounting system, management cannot obtain full control andco-ordination.

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



operation. It plays an important role in assisting the management in thecreation of policy and the operation of undertaking.

3. Budgeting & Forecasting: These are concerned with the preparation offixed and flexible budgets, cash forecast, profit and loss forecasts etc., inco-operation with operating and other departments. Management ishelped by them.

4. Cost Control Procedure: It is concerned with the establishment andoperation of internal report in order to convert the budget in to operatingservice. Management is helped by them by measuring actual resultsbudgetary standards of performance.

5. Statistical Methods : These are concerned with generating statistical andanalytical information in the form of graphs charts etc. of all departmentof the organization. Management need not waste time in understandingthe facts and more time and energy can be utilized in sound plans andconclusions.

6. Legal Provisions: Many management decisions depend upon theprovisions of various laws and statutory requirements. For example, thedecision to make a fresh issue of shares depends upon the permission ofcontroller of capital issues. Similarly, the form of published accounts, theexternal audit the authority to float loans, the computation andverification of income, filing tax returns, making tax payments for excise,sales, payroll income etc., all depend on various rules and regulationspasses from time to time.

7. Organization & Methods: They deal with organization, reducing the costand improving the efficiency of accounting as also of office operations,including the preparation and issuance of accounting and other manuals,where these will prove useful.

It is clear that Management Accounting has a vital relation with all those areasexplained above.

FUNCTIONS OF MANAGEMENT ACCOUNTING:

The functions of management accounting may be said to include all activitiesconnected with collecting, processing, interpreting and presenting informationto management. The Management Accounting satisfies the various needs of



management for arriving at appropriate business decisions. They may bedescribed as follows:

1. Modification of Data:

Accounting data required for decision – making purposes is supplied bymanagement accounting through resort to a process of classification andcombination which enables to retrain similarities of details without eliminatingthe dissimilarities (e.g.) combination of purchases for different months andtheir breakup according to class of product, type of suppliers, days of purchase,territories etc.

2. Analysis & Interpretation of Data:

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

3. Facilitating Management Control

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

4. Formulation of Business Budgets:One of the primary functions of management is planning. It is done byManagement Accounting through the process of budgeting. It involves thesetting up of objectives, and the selection of the most appropriate strategies bycomparing them with reference to some discriminating criteria. Probability,Probability, forecasting, and trends are some of the techniques used for thispurpose.

5. Use of Qualitative Information:



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

6. Satisfaction of Informational Needs of Levels of Management:

It serves management as a whole according to its requirements it serves topmiddle and lower level managerial needs to subserve their respective needs. Forinstance it has a system of processing accounting data in a way that yieldsconcise information covering the entire field of business activities at relativelylong intervals for the top management, technical data for specialized personnelregularly and detailed figures relating to a particular sphere of activity at shortintervals for those at lower rungs of organizational ladder.

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

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

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

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

Thirdly, it brings in the concept of cost-Benefits analysis. The basic approach isto split all costs and benefits into two groups – measurable and non measurable.It is easy to deal with measurable costs which are expressed in terms of money.But there are several ventures such as office canteens where the cost-benefitsmay not be monetarily measurable.



LIMITATIONS OF MANAGEMENT ACCOUNTING

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

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

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

3. It is one thing to record, interpret and evaluate an objectives historicalevent converted into money figures, while it is something quite differentto perform the same function in respect of post possibilities, futureopportunities and unquantifiable situation. Execution of the conclusionsdrawn by the management accountant will not occur automatically.Therefore, a continuous effort to achieve the goal must be made at alllevels of management.

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



LESSON – 2

FINANCIAL ACCOUNTING AND MANAGEMENT ACCOUNTING

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

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

2. Nature – Financial accounting is concerned almost exclusively withhistorical records whereas management accounting is concerned with thefuture plans and policies. Management’s interest in the past is only to theextent that it will be of assistance in influencing company’s future. Thehistorical nature of financial accounting can be easily understood in thecontext of the purposes for which it was designed but managementaccounting does not end with the analysis of what has happened in thepast and extends to the provision of information for use in improvingresults in future.

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

4. Characteristics – Financial accounting places great stress on thosequalities in information which can command universal confidence, likeobjectivity, validity absoluteness, etc. whereas management accountingemphasizes those characteristics which enhance the value of information



in a variety of uses, like flexibility, comparability etc. This difference is soimportant that a serious doubt has been raised as to whether both thetypes of characteristics can be preserved within the same framework.

5. Type of Data Used Financial accounting makes use of data which ishistorical quantitative, monetary and objective, on the other handmanagement accounting used data which is descriptive, statisticalsubjective and relates to future. Therefore management accounting is notrestricted, as financial accounting is, to the presentation of data that canbe certified by independent auditors.

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

7. Outside Dictates – As financial accounting ahs been assigned the role of areference safeguarding the interests of different parties connected withthe operation of a modern business undertaking, outside agencies havelaid down standards for ensuring the integrity of information processedand presented in financial accounting statements. Consequently, financialaccounting statements are standardized and are meant for external use.So, far as management accounting is concerned, there is no need forclamping down such standards for the preparation and presentation ofaccounting statements as management is both the initiator and user ofdata. Naturally, therefore, management accounting can be smoothlyadapted to the changing needs of management.

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



LESSON – 3FUNCTIONS OF FINANCIAL CONTROLLER

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

It is not surprising, therefore, that controllership function has developed paripassu with the development of management accounting so much so that thereis a tendency to record the two as synonymous. In a way, this is true becauseof controller in the United States does all that management accounting isexpected to accomplish, in fact, controller is the pivot round which system ofmanagement accounting revolves.

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

Concept:

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

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



budgets and cost standards, together with the necessary procedure toeffectuate the plan.

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

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

iv. To administer tax policies and procedures.v. To supervise and coordinate the preparation of reports to governmental

agencies.vi. To assure fiscal protection to the assets of the business through

adequate internal control and proper insurance coverage.vii. To continuously appraise economic and social forces and government

influences and interpret their effect on business.

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

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



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

Modern Controller does not do any controlling, as is commonly understood, interms of line authority over other departments, his decision regarding the bestaccounting procedures to be followed by line people are transmitted to theChief Executive who communicates them by a manual of instructions comingdown through line chain of command to all people affected by the procedures.

Limitation:It is also necessary that the limitation of Controller’s role imposed by the verynature of his work, must be borne in mind. Though the Controller helps inbringing together all phases of management, he does not pretend to solve theproblems of production of marketing, he knows their nature and so can discussin detail with all levels of management the financial implications of solutionsthey suggest.



LESSON – 4FINANCIAL STATEMENTS:According to the American Institute of Certified Public Accountants, “Financialstatements reflect a combination of recorded facts accounting conventions andpersonal judgements and the judgements and conventions applied affect themmaterially.” This statement makes clear that the accounting information asdepicted by the financial statements are influenced by three factors viz.recorded facts, accounting conventions and personal judgements.

OBJECTIVES OF FINANCIAL STATEMENTS:1. To provide reliable information about economic resources andobligations of a business and other needed information about changes insuch resources or obligations.

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

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

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

1. Shareholders2. Debenture-holders3. Creditors4. Financial institutions and commercial banks5. Prospective investors6. Employees and trade unions7. Tax authorities8. Govt. departments9. The company law board



10. Economists and investment analysis, etc.

IMPORTANCE OF FINANCIAL STATEMENTS

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

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

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

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

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



Importance of National Economy: The rise & growth of the corporate sector, toa great extent, influences the economic progress of a country. Unscrupulous &fraudulent corporate managements shatters the confidence of the generalpublic in joint stock companies which is essential for economic progress &retard economic growth of the country. Financial Statements come to rescue ofgeneral public by providing information by which they can examine & asses thereal worth of the company & avoid being cheated by unscrupulous persons.

Limitations of Financial Statements:

1. It shows only historical cost.2. It does not take into account the price level changes.3. It considers only monetary aspects but does not consider some vitalnon-monetary factors.

4. It is based on convention and judgement. Hence there is no accuracy.5. Comparison of Financial Statements depends upon the uniformity ofAccounting policies.

6. It is subject to window dressing.



LESSON – 5ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS

Financial Statement are indicators of the two significant factors:

(i) Profitability, and (ii) Financial soundness

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

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

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

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

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

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

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

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



analysis gives the management considerable insight into levels and areas ofstrength and weakness. Since this type of analysis is based on the data fromyear to year rather than on the date, it is also termed as Dynamic Analysis.

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

TECHNIQUES OF FINANCIAL ANALYSIS

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

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

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

Comparative Balance Sheet: Comparative Balance Sheet as on two or moredifferent dates can be used for comparing assets and liabilities and finding out



any increase or decrease in those items. Thus, while in a single Balance Sheetthe emphasis is on persent position, it is on change in the comparative BalanceSheet. Such a Balance sheet is very useful in studying the trends in anenterprise.

The preparation of comparative financial statements can be well understoodwith the help of the following illustration.

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

PROFIT AND LOSS ACCOUNT(In Lakhs of Rs.)

Particular 1987 1988 *Assets 1987 1988Rs. Rs. Rs. Rs.

To Cost of Goods sold 600 750 By NetSales

800 1,000

To operating ExpensesAdministrative Expenses 20 20Selling Expenses 30 40To Net Profit 150 190

800 1,000 800 1,000



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

Liabilities 1987 1988 Assets 1987 1988Rs. Rs. Rs. Rs.

Bills Payable 50 75 Cash 100 140

SundryCreditors

150 200 Debtors 200 300

Tax Payable 6% 100 150 Stock 200 300Debentures 6% 100 150 Land 100 100PreferenceCapital

300 300 Building 300 270

Equity Capital 400 400 Plant 300 270

Reserves 200 245 Furniture 100 1401300 1520 1300 1520



SOLUTION:Swadeshi Polytex Limited

COMPARATIVE INCOME STATEMENTFOR THE YEARS ENDED 31ST DECEMBER AND 1988

(In Lakhs of Rs.)Absoluteincrease ordecrease in1988

Percentageincrease ordecrease in1988

1987 1988Net Sales 800 1000 +200 +25Cost of GoodsSold

600 750 +150 +25

Gross Profit 200 350 +50 +25OperatingExpensesAdministrationExpenses

20 20 - -

SellingExpenses

30 40 +10 +33.33

TotalOperatingExpenses

50 60 10 +20

OperatingProfit

150 190 +40 +26.67



Swadeshi Polytex LimitedCOMPARATIVE BALANCE SHEET

AS ON 31ST DECEMBER, 1987, 1988Figures in lakhs of rupees

Assets 1987 1988 Absoluteincrease ordecreaseduring 1988

Percentageincrease (+)or decrease(-) during1988

Current Assets:Cash 100 140 40 +40Debtors 200 300 100 +50Stock 200 300 100 +50Total CurrentAssets

500 740 240 +50

Fixed Assets:Land 100 100 - -Building 300 270 -30 -10%Plant 300 270 -30 -10%Furniture 100 140 +40 +40%Total Fixed Assets 800 780 -20 -2.5%Total Assets 1300 1520 220 +17%



Liabilities &Capital:Current LiabilitiesBills Payable 50 75 +25 +50%Sundry Creditors 150 200 +50 +33.33%Tax Payable 100 150 +50 +50%Total CurrentLiabilities

300 425 +125 +41.66%

Long-termLiabilities : 6%

100 150 +50 +50%

DebenturesTotal Liabilities 400 575 +175 +43.75%Capital & Reserves6% Pre. Capital 300 300 - -Equity Capital 400 400 - -Reserves 200 245 45 22.5Total Shareholders’ 900 945 45 5%FundsTotal Liabilities andCapital

1300 1520 220 17%

2. Common – size Financial Statements: Common – size FinancialStatements are those in which figures reported are converted intopercentages to some common base. In the Income Statement that salefigure is assumed to be 100 and all figures are expressed as a percentageof this total.

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

SOLUTION:Swadeshi Polytex Limited

COMMON – SIZE INCOME STATEMENT



FOR THE YEARS ENDED 31ST DECEMBER 1987 AND 1988(Figures in Percentage)

1987 1988Net Sales 100 100Cost of Goods Sold 75 75Gross Profit 25 25Opening Expenses:Administration Expenses 2.50 2Selling Expenses 3.75 4Total OperatingExpenses

6.25 6

Operating Profit 18.75 19

Interpretation: The above statement shows that though in absolute terms, thecost of goods sold has gone up, the percentage of its cost to sales remainsconstant at 75%, this is the reason why the Gross Profit continues at 25% ofsales. Similarly, in absolute terms the amount of administration expensesremains the same but as a percentage to sales it has come down by 5%. Sellingexpenses have increased by 25%. This all leads to net increase in net profit by25% (i.e., from 18.75% to 19%)



3. Trend Percentage: Trend Percentages are immensely helpful in making acomparative study of the Financial statements for several years. Themethod of calculating trend percentages involves the calculation ofpercentage relationship that each item bears to the same item in the baseyear. Any year may be taken as base year. It is usually the earliest year.Any intervening year may also be taken as the base year. Each item ofbase year is taken as 100 and on that basis the percentages for each ofthe years are calculated. These percentages can also be taken as IndexNumbers showing relative changes in the financial data resulting with thepassage of time.The method of trend percentages is useful analytical device for themanagement since by substitution percentages for large amounts, thebrevity and readability are achieved. However, trend percentages are notcalculated for all of the items in the financial statements. They are usuallycalculated only for major items since the purpose is to highlightimportant changes.Besides, Fund flow Analysis, Cash Flow Analysis and Ratio Analysis arethe other tools of Financial Analysis which have been discussed in detailas separate chapters.



LESSON – 6RATIO ANALYSIS

Meaning and Nature of ratio analysis

The term “ratio” simply means one number expressed in terms of another. Itdescribes in mathematical terms the quantitative relationship that existsbetween two numbers, the terms “accounting ratio”. J. Batty points out, is usedto describe significant relationships between figures shown on a Balance Sheet,in a Profit and Loss Account, in a Budgetary control System or in any other Partof the accounting organisation. Ratio Analysis, simply defined, refers to theanalysis and interpretation of financial statements through ratios. Nowadays itis used by all business and industrial concerns in their financial analysis. Ratioare considered to be the best guides for the efficient execution of basicmanagerial functions like planning, forecasting, control etc.

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

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

Ratios, by themselves, are meaningless. They derive their status partly from theingenuity and experience of the analyst who uses the available data in a



systematic manner. Besides, in order to reach valid conclusions, ratios have tobe compared with some standards that are established with a view to representthe financial position of the business under review. However, it should be bornein mind that after computing the ratios one cannot categorically say whether aparticular ratio is god or bad as the conclusions may vary from business tobusiness. A single ideal ratio cannot be applied for all types of business. Speedycompiling of ratios and their presentations in the appropriate manner areessential. A complete record of ratios employed in advisable and explanationof each, and actual ratios year by year should be included. This record may betreated as a part of an Accounts Manual or a special Ratio Register may bemaintained.

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

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

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

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

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

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

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



LESSON – 7

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

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

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

Capital employed

The term capital employed has been given different meanings by differentaccountants. Some of the popular meanings are as follows:

i) Sum-total of all assets whether fixed or currentii) Sum-total of fixed assetsiii) Sum-total of long-term funds employed in the business, i.e.,

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

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



The term “Operating profit” means “Profit before Interest & Tax.” The term“Interested” means “Interested on long term borrowing”. Interest on short –term borrowings will be deducted for computing operating profit. Non-termborrowing will be deducted for computing operating profit. Non-tradingincomes such as interested on Government securities or non-trading losses orexpenses such as loss on account of fire, etc., will also be excluded.

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

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

Shareholders’ Funds

The term Net Profit here means “Net Incomes after Interest & Tax” It is differentfrom the “Net Operating Profit” Which is used for computing the “Return onTotal Capital Employed” in the business. This because the shareholders areinterested in Total Income after Tax including Net Non-operating Income (i.e.,Non-operating Income – Non-operating Expenses)

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

Net Profit after Interest & taxFixed dividend cover =

-------------------------------------------------Preference dividend

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

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

Principal Payment Instalment



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

1 – (Tax rate)

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

Net Profit Before Interest & Tax5. Interest Coverage Ratio =

-------------------------------------------------------Interest Charges

Gross Profit6. Gross Profit Ratio =

------------------------------------------------- x 100Net Sales

Net Profit7. Net Profit Ratio =

------------------------------------------------ x 100Net Sales

Operating ProfitOperating Profit Ratio =

-------------------------------------------- x 100Net Sales

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

Operating Cost9. Operating Ratio = --------------------------------- x 100

Net Sales

Amount available to Equity Shareholders



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

Number of Equity Shares

Market Price per Share11. Price – Earnings (P/E) Ratio =

-------------------------------------------Earning Per Share



LESSON – 8

1. Fixed assets turnover ratio : This ratio indicates the extent to which theinvestments in fixed assets contribute towards sales. If compares with aprevious period, it indicates whether the investment in fixed assets hasbeen judicious or not. The ratio is calculated as follows:

Net Sales---------------------------------Fixed Assets (NET)

2. Working Capital Turnover Ratio: This is also known as Working CapitalLeverage Ratio. This ratio indicates whether or net working capital hasbeen utilized in making sales. In case a company can achieve highervolume of sales with relatively small amount of working capital, it is anindication of the operating efficiency of the company. The ratio iscalculated as follows.

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

Working Capital

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

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

The Debtor’s turnover ratio is calculated as under:Credit sales

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

The term Accounts Receivable include “Trade Debtors” and Bill Receivable”.



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

Total Sales---------------------------------------------

Accounts Receivable

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

The ratio helps in Cash Budgeting, since the flow of cash form customers canbe worked out on the basis of sales.

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

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

Debtors’ turnover

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

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

Credit sales for the year

Accounts receivable(c)

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



Average monthly or daily credit sales

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

In a YEAR by the average collection period (e.g., 12/2-6). Similarly Where thenumber of months (or days) in a year are divided by the debtors turnover,average debt collection period is obtained (i.e., 12/6 – 2 months)

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

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

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

(iii) Creditors’ turnover ratio (Creditors’ velocity): It is similar to debtors‘Turnover Ratio. It indicates the speed with which the payment for creditpurchases are made to the creditors. The ratio can be computed as follows:

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

Average accounts payable

The term Accounts payable include “Trade Creditors” and “Bills payable”

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



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

Account Payable

(iv) Debt payment period enjoyed ratio (Average age of payable):

The ratio give the average credit period enjoyed from the creditors. It can becomputed by any one of the following methods:

Month’s or days in a year(a)

---------------------------------------------------Creditors’ turnover

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

Credit purchases in the year

Average accounts payable(c)

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

Average monthly (or daily) credit purchases

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

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



Cost of goods sold during the year------------------------------------------------------Average inventory

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

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

Cost of goods sold1*--------------------------------------------------

Average stock of finished goods

Materials consumed2** ----------------------------------------------

Average stock of raw materials

Cost of completed work3*** ------------------------------------------

Average work in progress

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

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

Average inventory at selling Prices

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



Inventory at the beginning of the accounting period +Inventory at the end of the accounting periodAverage Inventory =--------------------------------------------------------------------------------------

2

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

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

(i) The raw materials should not exceed 2-4 months’ consumption of the year.(ii) The finished goods should not exceed 2-3 months’ sales(iii) Work in progress should not exceed 15-30 days’ cost of sales.

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

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

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



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

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



LESSON – 9

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

Financial ratios can be divided into two broad categories:

(1) Liquidity Ratios & (2) Stability Ratios

(1) LIQUIDITY RATIOS: These ratios are termed as “working capital” or“short-term solvency ratios”. As enterprise must have adequate working-capitalto run its day-to-day operations. Inadequacy of working capital may bring theentire business operation to a grinding halt because of inability of enterprise topay for wages, materials & other regular expenses.

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

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

Current Liabilities

Current assets mean assets that will either be used up or converted into cashwithin a year’s of time or normal operating cycle of the business, whichever islonger. Current liabilities means liabilities payable within a year or operatingcycle, whichever is longer, out of existing current assets or by creation ofcurrent liabilities. A list of items include in current assets & current liabilities



has already been given in the performs analysis balance sheet in the precedingchapter.

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

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

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

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

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

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



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

Current liabilities

Some accountants prefer the term “Liquid Liabilities” for “Current Liabilities” orthe purpose of ascertaining this ratio. Liquid liabilities means liabilities whichare payable within a short period. The bank over-draft (if it becomes apermenant mode of financing) & cash credit faculties will be excluded fromcurrent liabilities in such a case.

The ideal ratio is 1.

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

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

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

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

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

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

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



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

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

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

Long – Term funds

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

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

(a) Capital Gearing Ratio: Capital gearing (or leverage) refers to the proportionbetween fixed interest or dividend bearing funds & non-fixed interest ordividend bearing funds in the total capacity employed in the business. Thefixed interest or dividend bearing funds include the funds provided by thedebenture holders & preference shareholders. Non-fixed interest or dividendbearing funds are the funds provided by the equity shareholders. The amount,therefore, includes the Equity Share Capital & other Reserves. A properproportion between the two funds is necessary in order to keep the cost ofcapital at the minimum.

The capital gearing ratio can be ascertained as follows:

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

-Equity Shareholder’s Funds



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

Total long-term debtDebt – Equity Ratio = ------------------------------------------

Shareholder’s funds

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

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

Shareholder’s funds= --------------------------------

Total tangible assets

Significance: This ratio focuses the attention on the general financial strengthof the business enterprise. The ratio is of particular importance to the creditorswho can find out the proportion of shareholders funds in the total assetsemployed in the business. A high proprietary ratio will indicate a relatively littledanger to the creditor’s etc., in the event of forced reorganization or windingup of the company. A low proprietary ratio indicates greater risk to thecreditors since in the event of losses a part of their money may be lost besidesloss to the properties of the business. The higher the rate, the better it is. Aratio below 50 percent may be alarming for the creditors since they may have tolose heavily in the event of company’s liquidation on account of heavy losses.

ADVANTAGES OF RATIO ANALYSIS

Following are some of the advantages of ratio analysis:



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

2. Facilitates inter-firm comparison: Ratio Analysis provides date forinter-firm comparison. Ratios highlight the factors associated withsuccessful & unsuccessful firms. They also reveal strong firms & weakfirms, over-valued & under valued firms.

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

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

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

LIMITATIONS OF ACCOUNTING RATIOS

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

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

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



Financial statements show only historical cost but not market value.

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

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

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

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

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

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

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

COMPUTATION OF RATIOS



Illustration 1: Following is the Profit and Loss Account and Balance Sheet of JaiHind Ltd., Redraft the for the purpose of analysis and calculate the followingratios:

i. Gross Profit Ratiosii. Overall Profitability Ratioiii. Current Ratioiv. Debt-Equity Ratiov. Stock Turnover Ratiosvi. Liquidity Ratios

PROFIT AND LOSS ACCOUNT

Db. Cr.ParticularsOpening stock of finishedgoods

1,00,000 Sales 10,00,000

Opening stock of rawmaterials

50,000 Closing stock of rawmaterials

1,50,000

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

1,00,000

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

Manufacturing expenses 1,00,000Administration expenses 50,000Selling & Distributionexpenses

50,000

Loss on sale of plant 55,000Interest on Debentures 10,000Net Profit 3,85,000

13,00,000 13,00,000



BALANCE SHEETLiabilities Rs. Assets Rs.Share Capital: Fixed Assets 2,50,000Equity Share Capital 1,00,000 Stock of raw materials 1,50,000Preference share capital 1,00,000Reserves 1,00,000 Stock of finished 1,00,000Debentures 2,00,000 Sundry debtors 1,00,000Sundry Creditors 1,00,000 Bank Balance 50,000Bills Payable 50,000

6,50,000 6,50,000

SOLUTION:INCOME STATEMENT

Sales Rs.10,00,000

Less: Cost of salesRaw material consumed (op. Stock + Purchases– Closing Stock)

2,00,000



Direct Wages 2,00,000Manufacturing expenses 1,00,000Cost of production 5,00,000Add: Opening stock of finished goods 1,00,000

6,00,000Less: Closing stock of finished goods. Cost ofgoods sold

1,00,000 5,00,000

Gross Profit 5,00,000Less: Operating Expenses:Administration expenses 50,000Selling and distribution expenses 50,000 1,00,000Net operating profit 4,00,000Add: Non-trading income: 50,000Profit on sale of shares 4,50,000

Less: Non-trading expenses or losses:Loss on sale of plant 55,000Income before interest & tax 3,95,000Less: Interest on debentures 10,000Net Profit before tax 3,85,000

BALANCE SHEET (OR POSITION STATEMENT)Rs.

Bank balance 50,000Sundry debtors 1,00,000Liquid assets 1,50,000Stock of raw materials 1,50,000



Stock of finished goods 1,00,000Current assets 4,00,000Sundry creditors 1,00,000Bills Payable 50,000Current liabilities 1,50,000Working Capital (Rs. 4,00,000 – Rs. 1,50,000) 2,50,000Add Fixed assets 2,50,000Capital employed 5,00,000Less Debentures 2,00,000Shareholders’ net worth 3,00,000Less Preference share capital 1,00,000Equity shareholders’ net worth 2,00,000Equity shareholders’ net worth is represented by: 1,00,000Equity Share capital 1,00,000Reserves 2,00,000

Ratios:Gross Profit x 100 50,000 x 100

(i) Gross Profit Ratio ------------------------------------------------------ = 50%

Sales 10,00,000

Operating Profit x 100 4,00,000 x 100(ii) Overall Profitability Ratio = ------------------------------- =

--------------------- = 80%Capital employed 5,00,000

Current assets 4,00,000(iii) Current Ratio = ------------------------------- =

-------------------------- = 2.67



Current liabilities 1,50,000

External equities 3,50,000(iv)Debt Equity Ratio: = -------------------------- =

--------------------- = 1.17Internal equities 3,00,000

(or)

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

----------------- = 0.40Total long-term funds 5,00,000

(or)

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

-------------------- = 0.67Shareholders’ funds 3,00,000

(v) Stock turnover ratio:

Cost of goods sold 5,00,000(a) As regards average total inventory = ----------------------------= ----------------- = 2.5

Average inventory* 2,00,000

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

(b) As regards average inventory of finished goods:Cost of goods sold 5,00,000



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

Average inventory of finished goods 1,00,000

(c) As regard average inventory of raw materials:

Materials consumed 2,00,000--------------------------------------------------

= ---------------- = 2Average inventory of materials 1,00,000

Liquid assets 1,50,000(iv) Liquid Ratio: ------------------------- = ----------------- =1

Current liabilities 1,50,000

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

Debtor’s Velocity 3 MonthsStock Velocity 8 MonthsCreditor’s Velocity 2 MonthsGross Profit Ratio 25 percent

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

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

SOLUTION :

(a) Sales:



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

Sales

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

4,00,000Sales = ----------------------------- x 100 = Rs. 16,00,000

25

(b) Sundry Debtors :Debtor’s

Debtor’s Velocity = --------------------- x 12Sales

“Debtor’s Velocity of 3 months” Presumably means that Accounts Receivableequal to 3 months’ Sales or ¼ of the year’s sales.

Rs.1,60,000

Account Receivable = --------------------- x 1 4,00,0004

Less Bills Receivable 25,000-------------------------

Sundry Debtors 3,75,000-------------------------

(c) Closing Stock:Cost of goods sold



Stock Velocity =------------------------------------------

Average stock

Cost of goods sold = Sales – Gross profit= 16,00,000 – 4,00,000 = Rs. 12,00,000

12,00,000Average Stock = ------------------------- x 8 = Rs. 8,00,000

12

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

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

16,00,000 - 10,000Therefore, Opening Stock = ---------------------------------

2= 7,95,000

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

(d) Sundry Creditor’s:

Total Creditor’sCreditor’s Velocity i.e., = ------------------------------ x 12

Purchases

Purchases = Cost of goods sold + Closing Stock – opening Stock= 12,00,000 + 8,05,000 – 7,95,000 = Rs. 12,10,000



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

Hence Account Payable = Rs. 2,01, 667Less : Bills Payable = 10,000

--------------------Sundry Creditor’s Rs. 1,91,667

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



LESSON – 10FUNDS FLOW ANALYSIS

The technique of Funds Flow Analysis is widely used by the financial analyst,credit granting institutions and financial managers in performance of their jobs.It has become a useful tool in their analytical kit. This is because the financialstatements, i.e., “Income Statement” and the “Balance Sheet” have a limited roleto perform. Income statement measures flow restricted to transactions thatpertain to rendering of goods or services to customers. The Balance Sheet ismerely a static statement. It is a statement of assets and liabilities which doesnot focus major financial transactions which have been behind the balancesheet changes. One has to draw inferences after comparing the balance sheetsof two periods. For example, if the fixed assets worth Rs. 2,00,000 arepurchased during the current year by raising share capital of Rs. 2,00,000 thebalance sheet will simply show a higher capital figure and higher fixed assetsfigure. In case, one compares the current year’s balance sheet with the previousyear, then only one can draw an inference that fixed assets were acquired byraising share capital of Rs. 2,00,000. Similarly, certain important transactionwhich might occur during the course of the accounting year might not find anyplace in the balance sheet. For example, if a loan of Rs. 2,00,000 was raisedand paid in the accounting year the Balance sheet will not depict thistransaction. However, a financial analyst must know the purpose for which theloan was utilized and the source from which it was raised. This will help him inmaking a better estimate about the company’s financial position and policies.

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

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

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

The broad categories of current assets, therefore, are



1. Cash including fixed deposits with banks.2. Accounts receivable, i.e., trade debtors and bills receivable,3. Inventory i.e., stocks of raw materials, work-in-progress, finished goods,stores and spare parts.

4. Advances recoverable, i.e., the advances given to supplier of goods andservices or deposit with government or other public authorities, e.g.,customer, port authorities, advance income tax, etc.

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

Current Liabilities: The term ‘Current Liabilities’ is used principally todesignate such obligations whose liquidation is reasonably expected to requirethe use of assets classified as current assets in the same balance sheet or thecreation of other current liabilities or those expected to be satisfied within arelatively short period of time usually one year. However, this concept ofcurrent liabilities has now undergone a change. The more modern versiondesignates current liabilities as all obligations that will require within thecoming year or the operation cycle, whichever is longer. The use of existingcurrent assets or the creation of other current liabilities . in other words, themore fact that an amount is due within a year does not make it current liabilityunless it is payable out of existing current assets or by creation of currentliabilities. For example debentures due for redemption within a year of thebalance sheet date will not be taken as a current liability if they are to be paidout of the proceeds of a fresh issue of shares / debentures or out of theproceeds realized on account of sale of debentures redemption fundinvestments.

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

The broad categories of current liabilities are:

1. Accounts payable e.g., bill payable and trade creditors.2. Outstanding expenses, i.e., expenses for which services have beenreceived by the business but for which the payment has not made.

3. Bank-over drafts.



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

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

6. Current maturities of long-term loans, i.e., long-term debts due within ayear of the balance sheet date or installments due within a year in respectof these loans, provided payable out of existing current assets or bycreation of current liabilities, as discussed earlier. However, installmentsof long-term loans due after a year should be taken as non-currentliabilities.

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

USES OF FUNDS FLOW A STATEMENT

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

1. It explains the financial consequences of business operations. Funds flowstatement provides a ready answer to so many conflicting situations, suchas:

Why the liquid position of the business is becoming more and moreunbalanced inspite of business making more and more profits.How was it possible to distribute dividends in excess of current earningsor in the presence of a new loss for the period?How the business could have good liquid position in spite of businessmaking losses or acquisition of fixed assets?Where have the profits gone?



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

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

What is the overall credit-worthiness of the enterprise?What are the sources of prepayment of the loans taken?How much funds are generated through normal business operations?It what way the management has utilized the funds in the past and whatare going to be likely use of funds?It acts as an instruments for allocation of resources.It is a test as to effective or otherwise use of working capital .

PREPARATION OF FUNDS FLOW STATEMENTIn order to prepare a Funds Flow Statement, it is necessary to find out the“sources” and “applications” of funds.

Sources of funds. The sources of funds can be both internal as well as external.

Internal Sources: Funds from operations is the internal source of funds.However, following adjustments will be required in the figure of Net Profitfor finding out real funds from operations.Add the following items as they do not result in outflow of funds:1. Depreciation on fixed assets2. Preliminary expenses or goodwill, etc., written off.3. Contribution of debenture redemption find, transfer to general reserve,etc, if they have been deducted before arriving at the figure of net profit.

4. Provision for taxation and proposed dividend are usually taken asappropriations of profits only and not current liabilities for the purposesof Funds Flow Statement. This is being discussed in detail later. Tax ordividends actually paid are taken as applications of funds. Similarly,interim dividend paid is shown as an applications of funds. All these



items will be added back to net profit, if already deducted, to find fundsfrom operations.

5. Loss on sale of fixed assets.

Deduct the following items as they do not increase funds;

1. Profit on sale of fixed assets since the full sale proceeds are taken as aseparate source of funds and inclusion here will result in duplications.

2. Profit on revaluation of fixed assets.3. Non-operating incomes such as dividend received or accrued dividend,refund of income tax, rent received or accrued rent. These items increasefunds but they are non-operating incomes. They will be shown underseparate heads as ‘source of funds’ in the Funds Flow Statement.

In case the profit and Loss Account shows “Net Loss”, this should be taken asan item which decreases the funds.

External Sources: These sources includes-

1. Funds from long-term loans2. Sale of fixed assets3. Funds from increase in share capital4. Application of funds5. Purchase of fixed assets6. Payment of dividends7. Payment of fixed liabilities.8. Payment of tax liability.

Technique for preparing a funds flow statement

A funds flow statement depicts change in working capital. it will, therefore, bebetter for the students to prepare first a Schedule of Changes in WorkingCapital before preparing a funds flow statement.



Schedule of changes in working capitalThe schedule of changes in working capital can be prepared by comparing thecurrent assets and the current liabilities of two periods. It may be in thefollowing form.

SCHEDULE OF CHANGE IN WORKING CAPITALItems As As on Change

--- --- Increase Decrease(+) (-)

Current AssetsCash balanceBank balanceMarketable securitiesAccounts receivableStock-in-tradePrepaid expensesCurrent LiabilitiesBank overdraftOutstanding expensesAccounts payable



Capital

Rules for preparing the Schedules:1. Increase in a current asset, result in increase (+) in “working capital”2. Decrease in current asset, results in decrease (-) in “working capital”3. Increase in a current liability, results in decrease (-) in “Working capital”4. Decrease in a current liability, results in increase (+) in “Working capital”

Funds – flow statement

While preparing a funds flow statement, current assets and current liabilitiesare to be ignored. Alternation is to be given to changes in Fixed Assets andFixed Liabilities. The statement may be prepared in the following form.

FUNDS FLOW STATEMENTSources of funds: Rs. Application of Funds Rs.Issue of Shares --- Redemption of Redeemable ---Issue of Debentures --- Preference Shares ---Long-term Borrowing --- Redemption of Debentures ---Sale of Fixed Assets --- Payment of other long-term

loans---

Operating profit* --- Operating Loss* ---Decrease in working capital --- Payment of dividend, tax, etc. ---

Increase in working capital* ----

* Only one figure will be there.



The change in working capital disclosed by the ‘schedule of changes in workingcapital will tally with the change disclosed by the ‘funds flow statement’.

Illustration 1:From the following balance sheet of X Ltd. On 31st December 1985 and 1986,you are required to prepare.

1. A schedule of changes in working capital2. A funds flow statement

Liabilities 1985 1986 Assets 1985 1986Rs. Rs. Rs. Rs.

Share Capital 1,00,000 1,00,000 Goodwill 12,000 12,000General Reserve 14,000 18,000 Building 40,000 36,000Profit & Loss A/c 16,000 13,000 Plant 37,000 36,000Sundry Creditors 8,000 5,400 Investments 10,000 11,000Bills Payable 1,200 800 Stock 30,000 23,400Provision forTaxation

16,000 18,000 Bill Receivable 2,000 3,200

Provision fordoubtful debts

400 600 Debtors 18,000 19,000



Cash at Bank 6,600 15,200

1,55,600 1,55,800 1,55,600 1,55,800

The following additional information has also been given.1. Depreciation charged on Plant was Rs. 4,000 and on Building Rs. 4,0002. Provision for taxation of Rs. 19,000 was made during the year 1986.3. Interim dividend of Rs. 8,000 was paid during the year 1986.

SCHEDULE OF CHANGES IN WORKING CAPITAL1985 1986 Increase Decrease

(+) (-)Current Assets: Rs. Rs. Rs. Rs.Cash at Bank 6600 15200 8600Debtors 18000 19000 1000Bills receivable 2000 3200 1200Stock 30000 23000Current Liabilities 6600



Provision for doubtfuldebts

400 600 200

Bills payable 1200 800 400 ---Sundry Creditors 8000 5400 2600 ---

Total 13800 6800

FUNDS FLOW STATEMENTSources Rs.Funds from operations 36000Total sources 36000Applications: Rs.Purchase of plant 3000Tax paid 17000Investments purchased 1000Interim dividend paidTotal application 29000Net increase in working capital 7000

Working Notes:1. Funds from operations: Rs. Rs.

Profit & Loss account balance on 31st Dec., 1986 13000Add: Items which do not decrease funds fromOperationsTransfer to General Reserve 4000Provision for Tax 19000Depreciation:Plant 4000



Building 4000Interim Dividend paid 8000 39000

52000Less: Profit & Loss balance on 31st Dec., 1988 16000

Funds from operations for the year 36000

2. Purchase of Plant. This has been found out by preparing the PlantAccount.

Plant AccountTo balance b/d 37000 By Depreciation 4000To bank 3000 By balance c/d 36000

(Purchase of plant balancingfigure)

40000 40000

3. Tax paid during the year has been found out by preparing a Provision forTax Account.

Provision For Tax AccountTo blank By balance b/d 16000(being tax paid – balancing figure) 17000 By P & L A/c 19000To balance c/d 18000

35000 35000

4. ‘Investment’ have been taken as a fixed asset presuming that they arelong-term investment.



LESSON – 11

CASH FLOW ANALYSIS

Cash flow analysis is another important technique of financial analysis. Itinvolves preparation of Cash flow statement for identifying sources andapplications of cash. A cash flow statement is a statement depicting change incash position from one period to another. For example, if the cash balance ofbusiness is shown by its Balance sheet on 31st December, 1978 at Rs. 20,000while the cash balance as per its balance sheet on 31st December, 1979 is Rs.30,000. There has been an inflow of cash of Rs. 10,000 in the year 1979 ascompared to the year 1978. The cash flow statement explains the reasons forsuch inflows or outflows of cash, as the case may be. It also helps managementin making plans for the immediate future.

A cash flow statement can be prepared on the same pattern on which a fundsflow statement is prepared. The change in the cash position from one period toanother is computed by taking into account “Sources” and “Application” of cash.

Format of a Cash Flow Statement

A cash flow statement can be prepared in the following form:



Cash Flow StatementFor the year endingon ...

Balance as on 1.1.19...Cash balance ......Bank balance ......Issue of Shares .....Raising of long-term loans ......Sale of fixed assets ......Short-term borrowings ......Cash from operation ......Profit as per Profit and Loss Account ......Add/Less : Adjustment for non-cashitemsAdd: Increase in current liabilitiesDecrease in current assets ......Less: Increase in current assets .....Decrease in current liabilities ......Total cash available (1)Less: Application of Cash:Redemption of redeemable preferenceshares

......

Redemption of long-term loans ......Purchase of fixed assets ......Decrease in deferred payment liabilities ......Cash outflow on account of operation ......Tax paid ......Dividend paid ......Decrease in unsecured loans, depositsetc.,

......



Closing balances*Cash balance ......Bank Balance ......

* There total should tally with the balance as shown by (1) – (2)

DIFFERENCE BETWEEN CASH FLOW ANALYSIS AND FUNDS FLOW ANALYSIS

Following are the points of difference between a Cash Flow Analysis and aFunds analysis.

1. A cash flow statement is concerned only with the change in cash positionwhile a funds flow analysis is concerned with changed in working capitalposition between two balance sheet dates. Cash is only one of theconstituents of working capital besides several other constituents such asinventories, accounts receivable, prepaid expenses.

2. A cash flow statement is merely a record of cash receipts anddisbursements. Of course, it is valuable in its own way but if fails to bringto light many important changes involving he disposition of resources.While studying the short-term solvency of a business one is interestednot only in cash balance but also in the assets which are easilyconvertible into cash.

3. Cash flow analysis is more useful to the management as a tool offinancial analysis in short period as compared to funds flow analysis. Ithas rightly been said that shorter the period covered by the analysis,greater is the importance of cash flow analysis. For example, if it is to befound out whether the business can meet it obligations maturing after 10years from now, a good estimate can be made about firm’s capacity tomeet its long-term obligations if changes in working capital position onaccount of operations are observed. However, if the firm’s capacity tomeet a liability maturing after one months is to be seen, the realisticapproach would be to consider the projected change in the cash positionrather than an expected change in the working capital position.

4. Cash is part of working capital and, therefore, an improvement in cashposition results in improvement in the funds position but the reverse isnot true. In other words, “inflow of cash” results in ‘inflow of funds’ butinflow of funds may not necessarily result in “inflow of cash”. Thus, asound funds position does not necessarily mean a sound position but asound cash position generally means a sound funds position.



5. Another distinction between a cash flow analysis and a funds flowanalysis can be made on the basis of the techniques of their preparation.An increase in a current liability or decrease in a current asset results indecrease in working capital and vice verse. While an increase in a currentliability or decrease in a current asset (other than cash) will result inincrease in cash and vice versa.

Some people, as stated before, use of term “funds” in a very narrow sense of‘cash’ only. In such an event the two terms ‘Funds’ and ‘Cash’ will havesynonymous meaning.

UTILITY OF CASH FLOW ANALYSIS1. Helps in efficient cash management2. Helps in internal financial management3. Discloses the movement of cash4. Discloses success or failure of cash planning

LIMITATIONS OF CASH FLOW ANALYSIS1. Cash flow statement cannot be equated with the Income Statement. Anincome statement takes into account both cash as well as non-cash itemsand, therefore, net cash flow does not necessarily mean net income ofthe business.

2. The cash balance as disclosed by the cash flow statement may notrepresent the real liquid position of the business since it can be easilyinfluenced by postponing purchases and other payments.

3. Cash flow statement cannot replace the Income Statement or the Fundsflow statement. Each of them has a separate function to perform.

Illustration 1

From the following balances you are required to calculate cash from operations:

Debtors 1987 1988Rs. Rs.



Bills receivable 50,000 47,000Creditors 10,000 12,000Bills payable 20,000 25,000Outstanding expenses 8,000 6,000Prepaid expenses 1,000 1,200Prepared expenses 800 700Accrued Income 600 750Income received in advance 300 250Profit made during the year .... 1,30,000

CASH FROM OPERATIONSProfit made during the year .... 1,30,000Add:Decrease in Debtors 3000Increase in Creditors 5000Increase in outstanding expenses 100 8300Less:Increase in Bills Receivable 2500Decrease in Bills payable 2000Increase in Accrued Income 150Decrease in Income received in advance 50 4700Cash from operation 133600

Illustration 2:Balance Sheets of A and B on 1.1.1988 and 31.12.1988 were as follows:

BALANCE SHEET

1.1.88 31.12.88 1.1.88 31.12.88Liabilities Rs. Rs. Assets Rs. Rs.



Creditors 40,000 44,000 Cash 10,000 50,000Mrs. A’sLoan

25,000 .... Debtors 30,000 50,000

Loan fromBank

40,000 50,000 Stock 35,000 25,000

Capital 1,25,000 1,53,000 Machinery 80,000 55,000Building 35,000 60,000

2,30,000 2,47,000 2,30,000 2,47,000

During the year of a machine costing Rs. 10,000 (accumulated depreciation Rs.3,000) was sold for Rs. 5,000. The provision for depreciation against Machineryas on 1.1.1988 was Rs. 25,000 and on 31.12.1988 Rs. 40,000. Net profit forthe year 1988 amounted to Rs. 45,000. You are required to prepare Cash FlowStatement.

SolutionCash Flow Statement

Cash balance as on 1.1.1988 Rs. 10,000Add: SourcesCash from Operations Rs. 59,000Loan from Bank 10,000Sale of Machines 5,000 74,000

8,400Less: Applications:Purchase of Land 10,000Purchase of Building 25,000Mrs. A’s Loan repaid 25,000Drawings 17,000 77,000Cash Balance as on December 31, 1988 7,000

Working Notes



CASH FROM OPERATIONS

Profit made during the year Rs. 45,000Add: Depreciation on Machinery 18,000Loss on Sale of Machinery 2,000Decrease in Stock 10,000Increase in Creditors 4,000 34,000

79,000Less: Increase in Debtors 20,000Cash from Operation 59,000

Machinery Account (At Cost)

To Balance b/d 1,05,000 By Bank 5,000By Loss on Sale ofmachinery

2,000

By provision forDepreciation

3,000

By balance c/d 95,000

1,05,000 1,05,000

PROVISION FOR DEPRECIATION

To machinery A/c 3,000 By balance b/d 25,000To balance c/d 40,000 By P & L A/c 18,000



balancing figure)

43,000 43,000



LESSON 12BUDGETS AND BUDGETARY CONTROL

The management is efficient if it is able to accomplish the objective of theenterprise. It is efficient when it accomplishes the objectives with minimumeffort and cost. In order to attain long-range efficiency and effectiveness,management must chart out its course in advance. A systematic approach tofacilitate effective management performances profit-planning and control, orbudgeting. Budgeting is therefore an integral part of management. In a way, abudgetary control system has been described as a historical combination of a“goal – setting machine for increasing an enterprise’s profits, and agoal-achieving machine for facilitating organizational coordination andplanning while achieving the budgeted targets.”

DefinitionsThe Institute of Cost and Management Accountants, London, gives the followingdefinitions:

A budget is “a financial and / or quantitative statement, prepared and approvedprior to a defined period of time, of the policy to be pursued during that periodfor the purpose of attaining a given objective. It may include income,expenditure and the employment of capital.*

Budgetary control. “The establishment of departmental budgets relating theresponsibilities of executive to the requirements of a policy, and the continuouscomparison of actual with budgeted results, either to secure by individualaction the objectives of the policy, or to provide a firm basis for its revision.”

Thus, a budget is a predetermined statement of management policy during agiven period which provides a standard for comparison with the results actuallyachieved. Budgetary control is a system of controlling costs which includes thepreparation of budgets, coordinating the departments and establishingresponsibilities, comparing actual performance with that of budgeted andacting upon results to achieve maximum profitability. Budgeting is essentiallyconcerned with planning, and can be broadly illustrated by comparison with theroutine a ship’s captain follows on each voyage.

Operation of Budgetary Control



The steps involved in a Budgetary Control system can be outlined as follows:1. Establish a plan or target of performance which coordinates all theactivities of the business.

2. Record the actual performance3. Compare the actual performance with that planned.4. Calculate the differences, or variances, and analyze use reasons for them.5. Act immediately, if necessary, to remedy the situation.

Objectives of Budgetary Control

Briefly, the main objectives of budgetary control are:

1. To combine the ideas of all levels of management in the preparation ofthe budget.

2. To coordinate all the activities of the business.3. To centralize control.4. To decentralize responsibility to each manager involved.5. To act as a guide for management decision-making when unforeseeableconditions affect the business.

6. To plan and control income and expenditure so that maximumprofitability is achieved.

7. To direct capital expenditure in the most profitable direction.8. To ensure that sufficient working capital is available for the efficientoperation of the business.

9. To provide a yardstick against which results can be compared.10. To show management where action is needed to remedy a situation.

Basic Conditions for the Successful Operation of Budgetary Control

Realistic Budget: The quality of the budget is very important for the successfuloperation of budgetary control. If should be realistic and operationally feasible.Flexible budget is normally a good budget as it take into consideration thedynamics of the business. It must be based on what is attainable, must suit the



organizational facilities and complexities and must be flexible to accommodatethe changing environment of the business.

Qualitative and Timely Reporting : Variances must be analyzed, interpreted andreported in a manner which is easily understandable. Reporting must be ontime and bring out significant areas/points and be precise, simple andmeaningful. Time is the essence of reporting and maintenance of time scheduleenhances the value of reporting and leads to correction of many adverseevents/trends which otherwise would have taken a heavy toll.

Management’s Attitude: The management must have a positive attitude towardsbudgetary control. Any scheme of control is a discipline and regulation.Management must have faith and confidence in the scheme. Management musttake keen interest in the scheme of budgetary control and renderwhole-hearted support and cooperation in making this a success.

Advantages of Budgetary Control

The following are some of the most significant advantages of budgeting :

1. Budgeting compels management to plan for the future. The budgetingprocess forces management to look ahead and become more effectiveand efficient in administering business operations. It instills intomanagers the habit of evaluating carefully their problems and relatedvariables before making any decisions.

2. Budgeting helps to coordinate, integrate, and balance the efforts ofvarious departments in the light of the overall objectives of the enterprise.This results in goal congruency and harmony among the departments.

3. Budgeting facilitates control by providing definite expectations in theplanning phase that can be used as a frame of reference for judging thesubsequent performance. Undoubtedly, budgeted performance is a morerelevant standard for comparison than past performance is based onhistorical factors which are constantly changing.

4. Budgeting improves the quality of communication. The enterprise’sobjectives, budgets goals, plans, authority and responsibility andprocedures to implement plans are clearly written and communicatedthrough budgets to all individuals in the enterprise. This results in betterunderstanding and harmonious relating among mangers andsubordinates.



5. Budgeting helps to optimize the use of the firm’s resources, both capitaland human. It aids in directing the total efforts of the firm into the mostprofitable channels.

6. Budgeting increase the morale and thereby the productivity of theemployees by seeking their meaningful participation in the formulation ofplans and policies, bringing about a harmony between individual goalsand the enterprise’s objectives, and by providing incentives for betterperformance.

7. Budgeting develops profit-mindedness and cost consciousness.8. Budgeting permits the management to focus attention on significantmatters through budgetary reports. Thus, it facilitates management byexception and thereby saves the management’s time and energy.

9. Budgeting measure efficiency and thereby enables self-evaluation by themanagement, it also indicates the progress made in attaining theenterprise’s objectives.

Problems of the Budgeting System

The major problems in developing a budgeting system are:

1. Getting the support and involvement of all levels of management.2. Developing meaningful forecasts and plans, especially the sales plan.3. Inducing all individuals to get involved in the budgeting process, andgaining their full participation.

4. Establishing realistic objectives, procedures and standards of desiredperformance.

5. Applying the budgeting systems in a flexible manner.6. Maintaining effective follow-up procedures, and adapting the budgetingsystem to changing circumstances.

Limitations of Budgetary Control

Management must consider the following limitations in using the budgetingsystem as a device to solve managerial problems:



1. Budgeting is not an exact science, its success depends upon the precisionof estimates. Estimates are based on facts and managerial judgement.Managerial judgement can suffer from subjectivity and personal biases.The efficacy of budgeting thus depends upon the quality of managerialjudgement.

2. A perfect system of budging cannot be organized in a short period.Business conditions change rapidly. Therefore, the budging systemshould be continuously adapted to changing circumstance. Budgeting hasto be a continuous exercise, it is a dynamic process. Management shouldnot lose patience, it should go on trying various techniques andprocedures in developing and using the budgeting system.

3. A skillfully prepared budget system will not by itself improve themanagement of an enterprise unless it is properly implemented. For thesuccess of the budgetary system, it is essential that it is understood by all,and that the managers and subordinates put in concerted effort foraccomplishing the budget goals. All persons in the enterprise must befully involved in the preparation and execution of budgets, otherwisebudgeting will not be effective.

4. Budgeting is a management tool, a way of managing, not themanagement itself. The presence of a budgetary system should not makemanagement complacent. To get the best results, management shoulduse budgeting with intelligence and foresight, along with othermanagerial techniques. Budgeting assets management, it cannot replacemanagement.

5. Budgeting will be ineffective and expensive if it is unnecessarily detailedand complicated. A budget should be precise in format and simple tounderstand, it should be flexible in application.

6. Budgeting will hide inefficiencies instead of revealing them if there is notevaluation system. There should be continuous evaluation of the actualperformance. The standards should also be re-examined regularly.

Organisation for Budgetary Control

1. Creation of budget centres. Centres of departments should beestablished for each of which budgets can be set with the help of thehead of department concerned. A budget centre is a centre or departmentor a segment of a an organisation for which budgets are prepared.Budgets should be set with the help of the heads of these centres so thatthese may be implemented more effectively.



2. Preparation of an organisatoin chart. This defines the functionalresponsibilities of each member of the management, and ensures that heknows his position in the company and his relationship with othermembers.

3. Establishment of a budgeted committee. In small companies budgetofficer or the accountant may coordinate all the work connected withbudgets, but in large companies a budget committee is often establishedto formulate a general programme for preparing budgets and exercisingoverall control. The Chief Executive of the company may establishguiding principles but usually he delegates the responsibility foroperating the system to the budget officer as secretary of the committee.This committee is composed of the chief executive, budget officer andheads of the main department such as those shown in Fig. 1. Eachmember will prepare his own initial budget or budgets, which will then beconsidered by the committee, and all budgets will be coordinated. Usuallymany changes are necessary before the budgets can be finally integratedand approved.

4. Preparation of budget manual. This ia defined (by the I.C.M.A.) as adocument which sets out the responsibilities of the persons engaged inthe routine of, and the forms and records required for budgetary control.It is usually in loose-leaf form so that alternations can easily be made asand when required, appropriate sections can be issued to executivesrequiring them. An index will be provided so that information can belocated quickly. Such a manual will usually prove invaluable, as it willinclude information such as:

(a) Description of the system and its objectives,(b) Procedure to be adopted in operating system(c) Definitions of responsibilities and duties(d) Reports and statements required for each budget period(e) The accounts code in use.(f) Deadline by which data are to be submitted.

5. Budget Period: There is no “right” period for any budget. Budget periodsmay be short term and long term. If a business experiences seasonalfluctuations, the budget period will probably extend over one seasonalcycle. If this cycle covers, say two or three years, the long-term budgetwould cover the period, while the short-term budgets would perhaps bepreparation on a monthly basis for control purpose. Short-termbudgeting is usually costly to prepare and operate, while long-term



budgeting may be considerably affected by unforeseen conditions.Budget periods frequently used in industry vary between one month andone year, the latter probably being the most commonly used as it fits inwith the normally accepted accounting period. However, forecasts ofmuch longer periods than a year may be used in the case of capitalexpenditure budgets, for example, which must be planned well inadvance. A common practice in industry is to have a series of budgetperiods. Thus, the sales budget may cover the next five years, whileproduction and cost budgets may cover only one year. These yearlybudgets will be broken down into quarterly or even monthly periods.Where long-term budgets are operated it is usual to supplement themwith short-term ones.

6. The key factor. This is the factor whose influence must first be assessedin order to ensure that functional budgets are reasonably capable offulfillment. The key factor-known variously as the “limiting” or“governing” or “principle budget” factor is of vital importance. It may notbe the same for each budget period, as the circumstances may change. Itdetermines priorities in functional budget. Among the many key factorswhich may affect budgeting are the following:a. Management

i. Lack of capital, restricting policyii. Lack of knowhowiii. Inefficient executivesiv. Insufficient research into product design and methods.



LESSON – 13

Classification of BudgetsThough budgets can be classified according to various points of view thefollowing bases of classification are generally in vogue:

(a) Classification according to time factor(b) Functional classification(c) Classification according to flexibility factor.

(A)Classification according to time factor.

(1) Long-term Budgets (2) Short-term Budgets (3) Current Budgets: Theycover a period of a month or so and as shot-term budgets, they getadjusted to prevailing circumstances. Sometimes, within the frameworkof a short-term budget, there are quarterly plans which are prepared byrecasting the budget for a still shorter period on the basis of theperformance of the immediate past. In a way, these quarterly budgets aremeant to be an elaboration of the annual budget.

(B) Functional Classification

(1) Sales Budget, (2) Production Budget, (3) Personnel Budget (4) PurchaseBudget : Correlated with sales forecast and production planning, itdeals with purchases that are required for planned production.purchase would include both direct and indirect materials and goods.(5) Research Budget (6) Cash Budget (7) Capital Budget (8) MasterBudget (9) Plant utilization Budget (10) Office and AdministrationBudget. This budget represents cost of all administrative expenses,such as managing director’s salary, staff salaries and expenses ofoffice management like lighting and cleaning.

(C)Classification According to Flexibility

(1) Fixed Budget: This is budget in which targets are rigidly fixed. Suchbudgets are usually prepared from one to three months in advance of



the fiscal year to which they are applicable. Thus, twelve months ormore may elapse before figures forecast for the December budget Areused to measure actual performance. Many things may happen duringthis intervening period and they mayh make the figures go widely outof the line with the actual figures. Thought it is true that a fixed, orstatic budget as it is sometimes called, can be revised whenever thenecessity arises, it smacks of rigidity and artificially so far as controlover costs and expenses are concerned. Such budgets are preferredonly where sales can be forecast with the greatest of accuracy whichmeans, in turn, that the cost and expenses in relation to sales can bequite accurately ascertained.

(2) Flexible Budget



LESSON – 14

SALES BUDGET

This is a forecast of total sales expressed and incorporated in quantities and /or money. A sales budget may be prepared by expressing turnover under anyone or combination of the following:

1. Product or product group;2. Territories, areas and countries;3. Types of customers, e.g., National, Government, export, home,wholesales, or retails;

4. Salesman, agents or representatives, and5. Period; such as quarters, months, weeks, etc.

A sales budget may be prepared with the help of any one or more of thefollowing methods.

(1) Analysis of past sales: Analysis of past sales for a number of years, say 5to 10 years, viz. long-term trend, seasonal trend, cyclical trend, sundryother factors. The long-term trend represents the movement of thefortunes of a business over many years. The seasonal trend may affectmany types of business and hence this factor must be taken into accountwhen studying figures for consecutive months over a number of years.The cyclical trend represents the fluctuations in the business activity dueto the effect of the trade cycle. In order to study the cyclical trend it isdesirable to disregard the effects to the long-term and seasonal trends.Sundry factors include, such as a strike in the industry or a serious fire orflood. From such analysis it will be possible to suggest future trends. Inanalyzing such sales, considerable help can be obtained from statisticalreports produced by the trade units and commercial intelligence units,government publications, etc.

(2) Studying the impact of factors affecting sale: Any change in the companypolicy or method should always be considered. For example, introductionof special discounts special salesmen, a new design of the product, newor additional advertising campaigns, improved deliveries, after-salesservice should have some market effect on a sales budget. Whilepreparing such forecasts, the sales manager must consider the opinion of



divisional managers and other sales staff, the budget officer and theaccountant. It will be observed that the preparation of a sales budgetinvolves many factors and calls for a high degree of knowledge ofconditions, and if ability to deduce fro the known facts and variousestimates the probable course of sales budget is prepared first. Ifproduction is the key factor, the production budget should be built upfirst and the sales budget must be drawn up within up within the limitsimposed by the production budget.

Illustration 1AB Co. Ltd. manufactures two products, A and B, and sells them through twodivisions – North and South. For the purpose of submission of sales budget tothe budget committee, the following information has been made available.

Product North SouthA 4,000 at Rs. 9 6,000 at Rs. 9B 3,000 at Rs. 21 45,000 at Rs. 21

Actual sales of the current year were:Product North SouthA 5,000 at Rs. 9 6,000 at Rs. 9B 2,000 at Rs. 21 4,000 at Rs. 21

Market studies reveal that the product A, is popular but under-period. It isobserved that if the price of A is increased by Re. 1 it will still find a readymarket. On the other hand, B is over-period to customers and the market couldabsorb more if the sales price of B is reduce by Re. 1. The management hasagreed to give effect to the above price changes.

From the information relating to these price changes and reports fromsalesman, the following estimates have been prepared by divisional managers.Percentage increase in sales over current budget is:Product North SouthA +10% +5%B +20% +10%Additional sales above the estimated sales of divisional managers are:



Product North SouthA 600 units 700 units’B 400 units 500 unitsPrepare a Sales Budget

Solution

Sales BudgetA B Co. Ltd.For the Year : 19 x 7

Prepared by ......................Checked by ......................Submitted on ....................

Division Product Budget forFuture PeriodUnit PriceValue

Budget forCurrent PeriodUnit Price Value

Actual salesfor CurrentPeriod UnitPrice Value

Qty Rs. Rs. Qty Rs. Rs. Qty Rs. Rs.

North A 5,000 10 50,000 4,000 9 36,000 5,000 9 45,000

B 4,000 20 80,000 3,000 21 63,000 2,000 21 42,000

Total 9,000 1,30,000 7,000 99,000 7,000 87,000

South A 7,000 10 70,000 6,000 9 54,000 7,000 9 63,000

B 6,000 20 1,20,000 5,000 21 1,05,000 4,000 21 84,000

Total 13,000 1,90,000 11,000 1,59,000 11,000 1,47,000

Total A 12,000 10 1,20,000 10,000 9 90,000 12,000 9 1,08,000

(Summary) B 10,000 20 2,00,000 8,000 21 1,68,000 6,000 21 1,26,000

Total 22,000 3,20,000 18,000 2,58,000 18,000 2,34,000

Production Budget



Like the sales budget, the production budget is built up in terms of quantitiesand money. The quantities are entered at the beginning and, when theremainder of the budget have been built up and the cost of productioncalculated, the costs are entered to compile a production cost budget. Inpreparing the production budget, consideration should be given to thefollowing:

(1) Principal budget factor, e.g., if sales be the budget factor then it shouldbe the sales budget; otherwise other budgets.

(2) Production planning and determination of optimum factory capacity.(3) The opening stocks, and stocks required to be carried at the end of theperiod.

(4) The policy of the management regarding manufacture or purchase ofcomponents.

The production budget may be classified under the following heads:

(a) Products(b) Manufacturing department(c) Months, quarters, etc.

ABC Col. Ltd.(Production Budget (in units)Items A B For the year.....

RemarksSales during the period 12,000 10,000Required stock on 31st Dec. 1,000 2,000Total 13,000 12,000Less Estimated Opening stock 1,000 1,000Estimated production 12,000 11,000

Purchase Budget



A purchase Budget gives the details of the purchase which must be made tomeet the needs of the business. It includes all items of purchase. Such as rawmaterials, indirect materials and other equipments. The purchase budget forraw materials is the most important and the following factors are required tobe considered in preparing this budget.

(1) Opening and closing stocks.(2) Unfulfilled orders at the beginning of the budget period.(3) Storage space, economic buying quantity, and financial resources.(4) The prices to be paid.

Illustration 5The following information regarding the stocks of materials required for theproduction programme of Ramesh Limited is available.

Materials EstimatedConsumptionduring 1983-84(in kg)

Estimated Stocks(in kg)

In 1st July 1983 On 30th June 1984AB 9,03,000 20,000 17,000GH 6,90,000 10,000 20,000XY 5,47,000 30,000 33,000

Collating the details given above with the information contained in the MaterialsBudget, prepare the Purchase Budget of Ramesh Limited.

Solution

Ramesh LimitedPurchase Budget(1983-84)

Particulars AB GH XY



kg. kg kgEstimate Consumption 9,03,000 6,90,000 5,47,000Add: Stock required on 30-06-84 17,000 20,000 33,000Total requirements 9,20,000 7,10,000 5,80,000Less: Estimated stock on1st July 1983 20,000 10,000 30,000Quantity to be purchased 9,00,000 7,00,000 5,50,000Price per kg (Estimate Re. 1 50 p 40 pEstimated cost of purchaseof materials (Rs) 9,00,000 3,50,000 2,20,000

Preparation of Cash Budget

A complete system of budgetary control makes the construction of cash budgeteasy. It is one of the functional budgets which is prepared along with otherbudgets. There are three recognized methods of preparing a cash budget.

(a) The Receipts and Payment Method;(b) The Adjusted Profit and Loss Method; and(c) The Balance Sheet Method.

Steps to be Adopted

Cash Receipts Forecast; Cash receipts from sales, debtors, income from sales ofassets and investments and probable borrowings should be forecast andbrought into cash budget. Any lag in payment by debtors or by others shall beconsidered for ascertaining further cash inflows.

Cash requirements forecast: Total cash outflows are taken out from operatingbudgets for the elements of cost, and from capital expenditure budget for thepurchase of fixed assets. Adjustments are to be made for any lag in payments.



Care must be taken to ensure that outstanding or accruals are excluded fromthe cash budget since this method is based on the concept of actual cash flows.

Illustration 6

A newly started company Quick Co. Ltd., wishes to prepare cash budget fromJanuary. Prepare a cash budget for the first six months from the followingestimated revenue and expenditure.

Month Total Sales Material Wages ProductionOverheads

Selling anddistributionOverheads

Rs. Rs. Rs. Rs. Rs.,Jan. 20,000 20,000 4,000 3,200 800Feb. 22,000 14,000 4,400 3,300 900Mar. 24,000 14,000 4,600 3,300 800Apr. 26,000 12,000 4,600 3,400 900May. 28,000 12,000 4,800 3,500 900June 30,000 16,000 4,800 3,600 1,000

Cash balance on 1st January was Rs. 10,000. A new machine is to be installed atRs. 30,000 on credit, to be repaid by two equal installments in March and April.

Sales commission @ 5% on total sales is to be paid within the month followingactual sales. Rs. 10,000 being the amount of 2nd call may be received in March.Share premium amounting to Rs. 2,000 is also obtainable with 2nd call.



Period of credit allowed to suppliers 2 monthsPeriod of credit allowed to customers 1 monthDelay in payment of overheads 1 monthDelay in payment of wages ½ month

Assume cash sales to be 50% of total sales.

Quick Co. Limited

Cash BudgetFor the period January to June 1984

Details Jan. Feb. Mar. Apr. May. June

Rs. Rs. Rs, Rs, Rs, Rs.

A Balance b/d 10,000 18,000 29,000 20,000 6,100 8,800

B Receipts:

Cash Sales (50%)

10,000 11,000 12,000 13,000 14,000 15,000

Debtors - 10,000 11,000 12,000 13,000 14,000

Capital - - 10,000 - - -

Share premium - - 2,000 - - -

(A + B) Total 20,000 39,000 64,800 45,000 33,100 37,800

C Payments Material - - 20,000 14,000 14,000 12,000

Wages 2,000 4,200 4,500 4,600 4,700 4,800

Production Overheads - 800 900 800 900 900

Commission - 1,000 1,100 1,200 1,300 1,400

Machinery - - 15,000 15,000 - -



(C) Total 2,000 9,200 44,800 38,900 24,300 22,600

Balance

(A+B+C) 18,000 29,800 20,000 6,100 8,800 15,200

Flexible Budgets

In those industries where the pattern of demand is stable, a fixed budget maybe adequate, especially where the budget period is comparatively short. In suchbusinesses it is possible to forecast sales with a considerable degree ofaccuracy. There are many undertakings where stable conditions are absent. Insuch concerns fluctuations in output might lead to violent deviations fromd thebudget. In such concerns it is usual to adopt the flexible budgetary technique.A flexible budget is a budget which is designed to change in accordance withthe level of activity actually attained. If flexible.

The owner of a car knows that the more he uses it per year the more it costshim to operate it. He also knows that the more he uses his car the less its costsper running metres. The reason for this lies in the nature of the expenses, someof which are fixed while others are variable or semivariable. Insurance, taxes,registration, and garaging are fixed costs; they remain the same whether thecar is operated 1,000 or 2,000 kilometers. The costs of tyres, petrol oil, andrepair are variable costs and depend largely upon the kilometers driven.Obsolescence and depreciation result in a combined type of cost that, althoughfluctuating to some degree upon the usage of the car, is semi-variable for itdoes not vary directly with the usage. The cost of operating the car perkilometer depends on the number of kilometers the car is used. The mileageconstitutes the basis for judging the activity of the automobile. If the ownersprepares an estimate of total cross and compares his actual expanses with thebudget in keeping his expenses within the allowed limits, unless he takes themileage factor into account.

Originally, the flexible budget idea was applied principally to the control ofdepartmental factory overhead. In recent years, however, the idea has beenapplied to the entire budget so that production budgets as well as selling andadministrative budgets are prepared on a flexible basis. The construction of aflexible budget is identical with that of a fixed budget, except that a budget iscalculated for each volume ranging from a possible 60 per cent to 100 per centof capacity. When actual figures are available estimate previously determinedfor the level attained are compared with actual results, and the differences arenoted. This end-of period comparison is used to measure the performance ofeach department head. It is this readymade method of comparison that makes



the flexible budget a valuable instrument for cost control. The flexible budgetassists in evaluating the effects of varying volumes of activity on profits and oncash position.

Illustration 9

The following data are available in a manufacturing company for the half-yearperiod ending 30th June, 1984.

Fixed expenses: Rs. (Lakhs)Wages and salaries 8.4Rent, rates, and taxes 5.6Depreciation 7.0Sundry administrative expenses 8.9

29.9

Semi-variable expenses @ 50% ofcapacity -Maintenance and repairs 2.5Indirect labour 9.9Sales department salaries etc., 2.9Sundry administrative expenses 2.6

17.9

Variable expenses: @ 50% of capacity -Material 24.0Labour 25.6Other expenses 3.8

53.4

It is assumed that fixed expenses remain constant for all levels of production’semi-variable expenses remain constant between 45% and 65% of capacity,



increasing by 10% between 65% and 80% of capacity and 20% between 89% and100% of capacity.

Sales at the various levels are:60% capacity Rs. 100.00 lakhs75% Capacity 120.00 Lakhs90% Capacity 150.00 Lakhs100% Capacity 170.00 Lakhs

Prepare a flexible budget for the half-year and forecast the profits at 60%, 75%,90% of capacity.

Solution

Flexible Budget for the Half-Year Ending 30th June 1984(showing the forecast of profit of different levels)

Operating capacity

Elements of cost 50% 60% 75% 90%



StandardA Fixed expenses:Wages and salaries 8.4 8.4 8.4 8.4 8.4Rent, rates and taxes 5.6 5.6 5.6 5.6 5.6Depreciation 7.0 7.0 7.0 7.0 7.0Sundry expenses 8.9 8.9 8.9 8.9 8.9

29.9 29.9 29.9 29.9 29.9

B. Semi-variable exp:Maintenance and repairs 2.5 2.5 2.75 3.00 3.00Indirect labour 9.9 9.9 10.89 11.88 11.88Sales Dept. salaries 2.9 2.9 3.19 3.48 3.48Sundry Adm. expenses 2.6 2.6 2.86 3.12 3.12

17.9 17.9 19.69 21.48 21.48

C. Variable expenses:Material 24.0 28.80 36.00 43.20 48.0Labour 25.6 30.72 30.47 46.08 51.2Other expenses 3.8 4.56 5.70 6.84 7.6

53.4 64.08 80.17 96.12 106.8

Total cost of Production 101.2 111.88 129.76 147.50 158.18(i.e. Total of A, B and C)Profit (+) of Loss (-)

-11.88 -9.76 +2.50 +11.82

Sales 100.00 120.00 150.00 170.00

Less: Bills Payable = 10,000



Sundry Creditors = Rs. 1,91,667



LESSON – 15

CAPITAL BUDGETING

Concept of Capital Expenditure

Every business concern has to face the problem on capital expendituredecisions some time or the other. Hence, planning for capital expenditure hasbecome an integral part of policy making, management and budgetary control.Capital expenditure is one which is intended to benefit future periods andnormally includes investment in fixed assets and other development projects. Itis essentially a long-term function, and such for a decision to buy land,buildings or plant and machinery etc., would influence the activity of thebusiness for a considerable period of time. Hence, it is essential to keep a closewatch on capital expenditure at all times. Further, the advent of mechanizationand automation has resulted in management being confronted with ever morefrequent and difficult problems. Despite the fact that various techniques havebeen developed to assist management in its task of decision-making moreeffectively, the ultimate decision depends on the availability of relevantinformation which can be generated only by well-established capitalexpenditure budgeting system. The other commonly used nomenclatures forcapital expenditure decision are “Capital Budgeting”, or “Capital investmentDecision”, or simply “Investment Decisions”.

Concept of capital Budgeting

Capital budgeting normally refers to long-term planning for proposed capitaloutlays and their financing. It is the decision-making process by which firmsevaluate the acquisition of major fixed assets whose benefits would be spreadover several time periods. Succinctly, it involves current investment in which thebenefits are expected to be received beyond one year in the future. The use ofone year as a line of demarcation is, however, somewhat arbitrary. The mainexercise in capital budgeting is to judge whether or not an investmentproposals provides a reasonable return to investors which would be consistentwith the investment objective of the business. Hence, capital budgeting involvesgeneration of investment proposals, estimating costs and benefits (cash flows)for the investment proposals and evaluation of net benefits and selection ofprojects based upon an acceptance criterion.



Importance of Capital Budgeting

1. Involves commitment of huge financial resourcesThe capital investment involved is usually very large. It will have severalfar-reaching implications on the activities of business and may even seriouslyaffect the very financial or flexibility of the business. It is these implicationswhich make capital budgeting so important.

2. Wrong sale forecast may lead to over-or under-investment of resourcesIt shows the possibility of expanding the production facilities to coveradditional sales shown in the sales forecast. In fact the economic life of theasset acquired represents an indirect sales forecast for the duration of itseconomic life. Any error in this regord may result in over-or under-investmentin fixed assets, i.e., excess production capacity or inadequate capacity. It alsoenables the cash forecast to be completed.

3. Leads to better timing of assetsCapital budgeting may allow altimative forms of assets to be considered asreplacement for assets which are wearing out or are in danger of becomingobsolete in other words, it would lead to better timing of asset purchases andimprovement in quality of assets purchased. It helps to match efficiently theneed for capital goods with their availability. It also assists in formulating asound depreciation and asset replacement policy.

4. It ensures the selection of the right source of finance at the right time.Capital expenditure decisions involve substantial funds which may not beimmediately, and automatically available. A well – established capital budgetwould enable the management to decide in advance the source of finance andensure their availability at the right time.

Objective of capital Budgeting

1. Selection of the right mix of profitable projects.It may be said that the overall objectives of capital budgeting is to allocate theavailable investible funds among the competing capital projects in order tomaximize the total profitability. This is made possible by employing the various



evaluation techniques for the selection of investment projects which contributethe maximum towards the overall investment objective. In the case of publicenterprises, capital budgeting may also assure fulfillment of other objectivesuch as promotion of employment, development of backward regions, etc.

2. Capital Expenditure control.

Control of capital expenditure is the next important objective of capitalbudgeting. This is achieved by forecasting the long-term financial requirementsand thereby enabling the management to plan in advance to raise funds at theright time. The objective of preparing capital budget is to plan and thencompare the actual capital expenditure with the budgeted figure for controllingcosts.

3. Determining the required quantum and the right source of funds forinvestment.

The next important objective of capital budgeting is to determine the fundsrequired for long-term project and to see that such estimates fall in line withthe company’s financial policies. It also aims to compromise between theavailability of funds and needs of the capital projects.

Types of capital investment projectsInvestment projects may be classified in a number of ways. The following kindsof investment projects are commonly used by both private and public sectorbusiness units in their capital expenditure forecasts:

(a) Expansion of existing product lines.(b) Expansion into new product lines.(c) Replacement and modernization schemes(d) Projects for the utilization of scraps, and also of surplus installed capacity(e) Cost reduction projects.

The projects listed above are generally profit-oriented and therefore they maybe evaluated on the basis of their costs and benefits. But there are investmentswhich are undertaken by all business units and on which it would be difficult tomeasure returns, such as the following:



(1) Safty precautions provision of safety devices and equipment may bedemanded by various legal requirements.

(2) Welfare projects: provision of sports facilities for employees may boostemployees morale. This cannot be evaluated financially.

(3) Service projects: provision of buildings and equipment for nonmanufacturing departments may be essential, but the return frominvestment on them cannot be evaluated.

(4) Research and development: This may be initiated to improve the companymethods or products. It would be very difficult to measure the return onR&D for a considerable period of time.

(5) Educational projects: Provision of company training course may beinstrumental in improving the efficiency of employment but the returnsfrom investment on such programmes may be difficult to evaluate.

Relevant cost for capital expenditure decisionGenerally, costs and benefits in the form of cash flows are more relevant forcapital budgeting then the conventional accounting cost and benefits becausesuch costs and benefits normally encounter a number of measurementproblems owing the factors such as method of depreciation, valuation ofinventories, write-off etc., Different types of investment decisions call fordifferent kinds of costs. not all costs which are used in conventional accountingsystem are relevant for investment decision making. A few items of relevantcosts are:

Future costs: Future costs are the projected or estimated costs. they arerelevant for all types of investment decision past cost, though not relevant fordecision-making, are useful to the extent that they furnish a starting point forfuture cost projections. While calculating these costs, factors such as marketconditions, economic conditions, political situation, general trend in the pricelevels, probabilities relating to future production and sales, economic life of theproject, etc. are to be taken into account.

Opportunity costs: In simple terms, opportunity cost refers to the benefits ofthe best alternative foregone. As the investment in a project involvescommitment of the firm’s investible funds it becomes relevant to consider theopportunity of getting some benefits by employing the resources on someother alternative. For example, in an expansion scheme the economic value ofthe space required rather than its book value is relevant. In a replacementdecision, the realizable value rather then the book value of the old may berelevant as a reduction of the cost of replacement. This type of cost is relevant



for all types of investment decision. Imputed cost is a kind of opportunity cost.It is the cost which is not actually incurred, but would be incurred in theabsence of self-owned factors, e.g. cost of retained earnings, rent on companyowned facilities, etc.

Incremental or differential cost: It is the additional cost due to a change in thevolume of business or nature of business activity. Hence it is useful fordecisions such as adding new machinery, new – product, changing adistribution channel etc. sometimes this cost is considered synonymous withmarginal cost. But marginal cost has much limited meaning as it refers to thecost of an added unit of output.

Interest cost : Accounting reports normally ignore the imputed interest oncapital which is relevant for decision-making purposes. Interest cost constitutesthe minimum acceptance criterion for capital investment projects undertakenfor profit. A firm must at least recover its money before it can realize a profit onits own investment.

Depreciation and Income-tax: Depreciation is normally excluded whilecalculating cash flows for investment, appraisal and evaluation. But it isincluded for calculating the accounting rate of the project. Payment of taxesresults in cash flows and therefore, is an important element in capitalinvestment decisions. Income-tax has a number of effects on capitalinvestment decisions. Hence, tax laws and applicable legal decisions emphasisethe need for special skill in this area.

Secondary costs and benefits: These costs and benefits are particularly relevantfor the capital expenditure decision in public enterprises. They are external tothe project implementing body and there for called external cost and benefits,or simply “externalities”. These are the costs and benefits, which are imposedon other sectors- government, society or the economy as a whole – during theconstruction and operation of the project and for which nothing is paid orreceived. There are two types of externalities, viz., technological and pecuniary.The smoke and dust pollution and noise etc., are examples of technologicalexternalities pecuniary externalities are such as increasing rates of hire forfactors of production, reduction in prices of substitute projects, etc. secondarybenefits are the increase in profits that can be attributed to the increasedactivity of processors, merchants and others who handle the project’s output orinput. The major problems associated with these costs and benefits are theiridentification and measurement. However, for easy identification they should be



related to the socioeconomic objectives assigned to the project. To measurethese costs and benefits, shadow prices or imputed prices should be used.

Capital Expenditure Control

The control over capital expenditure is growing in importance as mechanizationand automation are introduced and extended. However, formal capitalbudgeting is still undeveloped as it is of comparatively recent origin. Anysystem of capital expenditure control should have the following feature.

Planned development: Capital expenditure should be carefully planned toinclude developments in each site or department to ensure that each unit in thegroup or company is developing in step with the overall plan preparation ofcapital budget will be essential, even when companies to not operate acomplete system of budgetary control. Capital appropriations and paymentmust be planned well in advance.

Control of progress: A progress record is necessary to show the progress ofeach capital project. The budget and actual expenditure will be compared foranalysis and control. These reports are also useful to ensure that the overallprogramme remains within the limits set by the policy of the company.

Post-completion Audits: This is an important step of capital expenditurecontrol. Post – completion audits of projects determine. Where their actualvalue is in accordance with the one determined at the time of authorization.This review can be very important because it may reveal inefficiencies in thesystem, and it would provide experience which would help in avoidingrepetition of mistakes.

Forms and procedures: There should be a routine for controlling capitalexpenditure. A procedure should be adopted for the various stages requestingfor capital expenditures, authorization, reporting the progress of such projectsand audit. A well designed from should be used for the above purposes forbetter control.



LESSON – 16

Methods of Ranking Investment Proposals

The final step in a the capital budgeting system involves evaluating theprofitability of the alternative project and selecting the best one. A firm mayface a situation where more investment proposals may be available thaninvestible funds. Some proposals may be good, some moderate, and many poor.Hence, a ranking procedure has to be evolved so that the available funds can beallocated among different proposals in a profitable manner. Essentially, theranking procedure envisages relating of a stream of future benefits to the costof investments. Among the various methods, the following are commonly usedby many business concerns:

Traditional or non-time value techniquesi. Payback periodii. Average rate of returniii. Modern or time value techniquesiv. Discounted cash flow methodsv. Net present valuevi. Benefit / cost radiovii. Internal rate of return

Payback period

Business units, while selecting investment projects, would consider the recoverof cost as the first and foremost concern, even though earning maximum profitis then ultimate goal. Payback period normally refers to the time required forrecouping the initial investment in full with the help of the stream of annualcash flows generated by the project. It is also called ‘pay-out or pay off period”,expressed, as:

CPayback period (PB) = ------------

1



Where C = original coast of investment, and I = annual cash inflows.

In the case of uneven cash inflows it may be expressed asPB = P =

Where X represents cash flows during periods 0,1,2,.....P represents paybackperiod. The cash flows for the purpose of PB calculation, would be savings orearnings after payment of taxes but before depreciation. To illustrate, if a cashoutlay of Rs. 30,000 is expected to yield a constant net cash flow (cashearnings minus cash expenses) of Rs. 12,000 P a for a period of 5 years, the PBis 2 ½ years (Rs. 30,000 + Rs. 12,000).

Selection criteria: Among the mutually exclusive or alternative projects whosePBs are lower than the cut-off period, the project with the shorter PB would beselected. In case there are budget constraints, the procedure would be to rankthe projects in the ascending order of PBs and select the first ‘X’ number ofprojects which the budget provision permit. However, with a views to makingthe selection process more realistic, a cut-off period or minimum payback ratiocould be set up and all investment proposals for which the PB is greater thanthis cut-off period be rejected. Payback ratio is the inverse of the paybackperiod. For a payback period of 4 years, the payback ratio is 1/4. Thus largerthe payback ratio, better the project.

Illustration 1

From the following advise the management as to which project is preferablebased on payback period. The standard cut off period for the company is 5years.

Project ARs.

Project BRs.

Capital cost 15,000 15,000Cash flows (savings before depreciation, but aftertaxes)

Ist year 5,000 4,000IInd year 5,000 4,000



IIIrd year 5,000 4,000IVth year 2,000 3,000Vth year 2,000 7,000VIth year 2,000 9,000

21,000 31,000

Solution Project A Project BPayback period = 3 years 4 years

(5,000 + 5,000 + 5,000 = 15,000) (Rs. 4,000 + 4,000 +4,000 + 3,000 = 15,000)

The PBs of A and B are 3 years and 4 years respectively and thus project. A isadjudged superior to project B in terms of PB criterion since it is also shorterthan the cut-off period.

Merits of payback period:

1. It is easy to operate and simple to understand2. This method is preferred on the ground that returns beyond three or fouryears are so uncertain that it is better to disregard them altogether in aplanning decision.

3. It is appropriate for industries with a high rate of technologicalobsolescence in which the receipts beyond PB are regarded as totallyuncertain.

4. This method is also useful to a concern which is short of cash and iseager to get back the cash invested in a capital expenditure project.

5. As the method considers the cash flows during the payback period of theproject, the estimates would be reliable and the results may becomparatively more accurate.

Despite the simplicity and ease of operation, this method suffers from severaldrawbacks.

Demerits



1. The PB is more a liquidity than a profitability concept, for it places accentonly on the recovery of cash outlay and stresses the importance ofliquidity, that is recovery at the cost of profitability.

2. It does not consider the earnings beyond the payback period. This maylead to wrong selection of investment projects. Profitable projects withlong gestation periods or projects which generate high returns only aftera certain period of time may be rejected under this method.

3. The most serious limitation of this method is that it ignores the timevalue of money.

Average Rate of return Method (ARR)

ARR is considered to be an improvement over the PB method for it considersthe earnings of a project during its entire economic life. It is also known as‘Return on investment method’.

Average earnings or returnARR =

-------------------------------------------------- x 100Average investment

The average return is computed by adding all the earnings after depreciation,and dividing them by the project’s economic life. Average investment is thesimple average of the values of assets at the beginning and end of the usefullife of the asset which in most cases, Would be zero. Though sometimes initialinvestment is used, average investment is more logical.

Selection Criteria: The decision rule is that a project with the highest rate ofreturn on investment is selected on condition that such rate is above thestandard rate set, or the cut-off rate.

Illustration 2

Calculate the average rate of return for project ‘A’ and ‘B’ from the followinginformation.

Project A Project BInvested (Rs) 25,000 37,500

Expected life (in years) 4 5



Net earnings (after depreciation and taxes)Years1 2,500 3,7502 1,875 3,7503 1,875 2,5004 1,250 1,2505 -- 1,250

7,500 12,500

If the desired rate of return is 12%, which project should be selected?

SolutionProject A Project B

Average return Rs. 7,500 Rs. 12,500

4 5-Rs. 1,875 Rs. 2,500

Averageinvestment

Rs. 25,000 + 0 Rs. 37,500+0

2 2-Rs. 12,500 Rs. 18,750

Average rate of Rs. 1,875x100 Rs. 2,500x100Rs. 12,500 Rs. 18,750

return -15% 13.33%

Both the projects satisfy the minimum required rate of return. However, if theprojects are mutually exclusive or alternative i.e. only one project is to beselected, project A will be selected as its ARR is higher than project B. if theyare not mutually exclusive, and there are no budget constraints, both theprojects will be selected.



Merits:

1. This method is also easy to understand and simple to operate2. The ARR method takes into account earnings over the entire economiclife of the project.

3. This is really a profitability concept since it considers net earnings afterdepreciation, i.e., excess of earnings over original cost of investment.

4. Projects which differ widely in characted could be compared under thissystem.

Demerits1. The most severe criticism of this method is that it ignores the time valueof money.

2. Normally, a host of variants are to be resolved relating to its componentsviz., earnings and investment cost. For example, it may be the gross, netor average investment which is to be considered for computation. Thismay produce different rates of any one proposal.

3. Another problem in connection with the method is regarding areasonable rate of return on investments. Some stipulate a minimum rateso that if projects do not satisfy this rate, they are summarily excludedfrom consideration.



LESSON – 17

Discounted Cash Flow (DCF) Method or Time Adjusted Technique

The discounted cash flow technique is an improvement on the pay-back periodmethod. It takes into account both the interest factor as well as the return afterthe pay-back period. The method involves three stages.

i. Calculation of cash flows, i.e., both inflows and outflows (preferably aftertax) over the full life of the asset.

ii. Discounting the cash flows so calculated by a discount factoriii. Aggregating of discounted cash inflows and comparing the total with the

discounted cash outflows.iv. Discounted cash flow technique thus recognizes that Re 1 of today (the

cash outflow) is worth more than Re. 1 received at a future date (cashinflow)

Discounted cash floe methods for evaluating capital investment proposals areof three types:

(a) Net Present Value (NPV) Method(b) Excess Present value Index (or) Benefit Cost Ratio(c) Internal Rate of Return

NPV MethodThis is generally considered to be the best method for evaluating the capitalinvestment proposals. In case of this method cash inflows and cash outflowsassociated with each project are first worked out. The present values of thesecash inflows and outflows are then calculated at the rate of return acceptable tothe management. This rate of return is considered as the cut-off rate and isgenerally determined on the basis of cost of capital suitably adjusted to allowfor the risk element involved in the project. Cash outflows represent theinvestment and commitments of cash in the project at various points of time.The working capital is taken as a cash outflow in the year the project startscommercial production. profit after tax but before depreciation represents cash



inflow. The Net present value (NPV) is the difference between the total presentvalue of future cash inflows and the total present value of future cash outflows.

The equation for calculation NPV is case of conventional cash flows can be putas follows:

R1 R2 R3 RnNPV = ------ + ------- + -------- + ---------

(1 + k) (1 + k)2 (1 + k)3 (1 + k)n

Incase of non-convential cash inflow (i.e. where there are a series of cashinflows as well cash outflows ) the equation for calculating NPV is as follows:

R1 R2 R3 RnNPV = ------ + ------- + -------- + ---------

(1 + k) (1 + k)2 (1 + k)3 (1 + k)n

11 12 13 1n10 ------ + ------- + -------- + ---------

(1 + k) (1 + k)2 (1 + k)3 (1 + k)n

Where NPV = Net present value, R = Cash Inflows at different time periods, KCost of Capital or Cut-off Rate, 1 = Cash outflows at different time periods.

Accept or reject criterion. The net present value can be used as an accept orreject’ criterion. In cash the NPV is positive (i.e., present value of the cashinflows is more than present value of cash outflows) the project should beaccepted.

Illustration

The Alpha Co. Ltd. is concidering the purchase of a new machine. Thealternative machines (A and B) have been suggested, each having an initial cost



of Rs. 4,00,000 and requiring Rs. 20,000 as additional working capital at theend of 1st year. Earning after taxation are expected to be as follows:

Cash InflowsYear Machine A Machine B1 40,000 1,20,0002 1,20,000 1,60,0003 1,60,000 2,00,0004 2,40,000 1,20,0005 1,60,000 80,000

The company has a target of return of 10% and on this basis, you are requiredto compare the profitability of the machines and state which alternative youconsider financially preferable.

Note: The following table gives the present value of Re.1 due in ‘n’ number ofyears.

Year Present value at10%

1 0.912 0.833 0.754 0.685 0.62



SolutionThe Alpha Company

STATEMENT SHOWING THE PROFITABILITY OF THE TWO MACHINES

Year Discount Machine A Machine BCash Inflow Present

ValueCash Inflow Present

valueRs. Rs. Rs. Rs.

1 0.91 40,000 36,000 1,20,000 1,09,2002 0.83 1,20,000 99,600 1,60,000 1,32,8003 0.75 1,60,000 1,20,000 2,00,000 1,50,0004 0.68 2,40,000 1,63,000 1,20,000 81,6005 0.62 1,60,000 9,200 80,000 49,600

Total present value of cash inflow 5,18,400 5,23,200

Total present value of cash outflow 4,18,200 4,18,200(Rs. 4,00,000 + 20,000 x 91)

Net present Value 1,00,200 1,05,000

Excess Present value Index : This is a refinement of the net present valuemethod. Instead of working out the net present value, a present value index isfound out by comparing the total of present value of future cash inflows andthe total of the present value of future cash outflows. This can be put in theform of following formula.



Excess Present Value Index.

Present value of future cash inflows(Or) Benefits Cost (B/C) Ratio =---------------------------------------------------------------- x100

Present value of future cash outflows

Excess present value Index provides ready comparison between investmentproposals of different magnitudes. For example, ‘A’ requiring an investment ofRs. 1,00,000 shows excess present value of Rs. 20,000 while another project ‘B’requiring an investment of Rs. 10,000 shows an excess on present value of Rs.5,000. If absolute figures of present values are compared, Project ‘A’ may to beprofitable.

However, if excess present value index method is followed project ‘B’ wouldprov e to be profitable.

1,20,000Present Value Index for project A = ------------------------ x 100

= 120%1,00,000

15,000Present Value Index for Project B = ------------------------- x 100 =

150%10,000



LESSON – 18

INTERNAL RATE OF RETURN

Internal Rate of Return is that rate at which the sum of discounted cash inflowsequals the sum of discounted cash outflows. In other words, it is the rate whichdiscounts the cash flows to zero. It can be stated in the form of a ratio asfollows:

Cash Inflows------------------- = 1Cash outflows

Thus, in case of this method the discount rate is not known but the cashoutflows and cash inflows are known. For example, if a sum of Rs. 800 investedin a project becomes Rs. 1,000 at the end of a year, the rate of return comes to25% calculated as follows:

R1 = -------------

1 + r

WhereI = Cash Outflow, i.e., initial InvestmentR = Cash Inflowr = Rate of return yoclded by the Investment (or IRR)

Thus:

1000800 = ----------

1 + r



Or 800r + 800 = 1,000Or 800r = 200

200Or r = ------------------ 25 or 25%

800

IllustrationCost of project Rs. 11,000Cash inflow:

Year 1 6,000Year 2 2,000Year 3 1,000Year 4 5,000

Find out Internal Rate of Return

Solution:I

F = --------------------C

F = Factor to be locatedI = Original investmentC = Average cash inflow per year

The ‘factor’ would be

11,000F = -------------------- = 3.14

3,500



The factor thus calculated will be located in. Table II on the line representingnumber of years corresponding to estimated useful life of the asset. This wouldgive the estimate date of return to be applied for discounting the cash inflowsfor the internal rate of return. The rate comes to 10%.

Year Cash inflow DiscountingFactor at 10%

Present value

1 6,000 0.909 5,4542 2,000 0.826 1,6523 1,000 0.751 7514 5,000 0.683 3,415

Total presentvalue

11,272

The present value at 10% comes to Rs. 272. The initial investment is Rs. 11,000.Internal rate of Return may be taken approximately at 10%

In case more exactness is required another trial rate which is slightly higherthan 10% (since at this rate the present value is more than initial investment)may be taken. Taking a rate of 12%, the following results would emerge.

Year Cash inflow DiscountingFactor at 10%

Present value

1 6,000 0.893 5,3582 2,000 0.797 1,5943 1,000 0.712 7124 5,000 0.636 3,180

Total presentvalue

10844

The internal rate of return is this more than 10% but less than 12%. The exactrate may be calculated as follows:



Difference in calculatedPresent value and required

net cash onlyInternal Rate of Return =------------------------------------------- x Difference in rate

Difference in calculatedpresent values

11,272 - 11,000= 10% + -------------------------------- x 2

11,272 – 10,844

272= 10% + ------------- x 2 = 11.3%

428

The exact internal rate of return can be also calculated as follows:

At 10% the present value is + 272At 12% the present value is – 156.

The internal rate would, therefore, the between 10% and 12% calculated asfollows:

272= 10 + --------------------- x 2

272 + 156



= 10 + 1.3 = 11.3%

Merits: The merits of discount cash flow method are as follows:

(i) Discounted cash flow technique take into account the time value ofmoney conceptually it is better than other techniques such aspay-back or accounting rate of return.

(ii) The method takes into account directly the amount of expenses andrevenues over the project’s life. In case of other methods simply theiraverages are taken.

(iii) The method automatically gives more weight to those money valuewhich are nearer to the present period than those which are fatherfrom it. While in case of other methods, all money units are given thesame weight which seems to be unrealistic.

(iv)The method makes possible comparison of projects requiring differentcapital outlays, having different lives and different timings of cashflows, at a particular moment of time because of discounting of allcash flows.

Demerits: The following are the demerits of discounted cash flow method.

(1) The method is difficult to understand and work out as compared to othermethod of ranking capital investment proposals.

(2) The method takes into account only the cash inflows on account of acapital investment decision. As a matter of fact, the profitability or otherwise of a capital proposal can be judged. Only when the net income (andnot the cash inflow) on account of operations is considered.

(3) The method is based on the presumption that cash inflow can be investedat the discounting rate in the new projects. However, this presumptiondoes not always hold goods because it all depends upon the availableinvestment opportunities.



LESSON – 19

MARGINAL COSTING AND COST VOLUME PROFIT ANALYSIS

Marginal costing is a technique of ascertaining marginal costs or variable costs.it is not a system for cost ascertainment, but is mainly a technique to deal withthe effect on profits of changes in volume or type of output. This techniquemay be used in conjunction with other methods of costing. Marginal costing isalso known as ‘direct costing’ or ‘variable costing’. The latter expressions aremainly used in the United States.

Concept of Marginal Cost and Marginal Costing

The concept of ‘marginal cost’ has been borrowed from economic theory. Tothe economist, marginal cost is an incremental cost: he considers it as theaddition to total cost which results from the production of one more unit ofoutput. That is, it does not arise if the additional unit is not produced.

The Institute of Costs and Management Accountants, London, defines marginalcost as:

“The amount at any given volume of output by which aggregate cost arechanged if the volume of output is increased or decreased by one unit.” Asreferred to here, a unit may indicate a single article, a batch of articles, an ordera stage of production capacity, a processor a department, i.e., it relates to thechange in output in the particular circumstances under consideration.

Under marginal costing, costs are mainly classified into fixed costs and variablecosts. the essential feature of marginal costing is that the product or marginalcosts (i.e., those costs which are dependent on the volume of activity, areseparated from the period or fixed costs, i.e., costs which remain unchangedwith a change in the volume of activity. Variability with the volume of output isthe main criterion for the classification of costs into product and periodcategories. Even the semi-variable costs have to be bifurcated into their fixedand variable components based on the variability criterion. In this regard, theabsorption or conventional costing system differs from marginal costing. Underabsorption costing system all manufacturing costs, whether of fixed or variablenature are treated as product costs. all companies which use marginal costing



as an aid to managerial decision-making mainly use the absorption costingsystem.

PROFORMA MARGINAL COST STATEMENT

Product X Product Y TotalSales ................ ................ ...................Less: Variable cost ................ ................ ...................

Contribution ................ ................ ...................Less fixed cost ...................

profit --------------

From the marginal cost statement, the following equations may be derived:

Contribution = Sales – Variable costContribution = Fixed cost + profitFixed cost = Contribution – profitFixed cost = Contribution + LossContribution = fixed Cost + LossSales = Variable cost + ContributionVariable cost = Sales – contributionProfit = Contribution – fixed costLoss = fixed cost – contribution

These equations may be used for solving problems of different types involvingcost-volume – profit relationship.

The Concept of Contribution and its Significance



Contribution is the difference net sales and marginal costs, and it is used torecover fixed costs first. Any excess over fixed costs would be profits. When abusiness manufacturers more than one product, the computation of profitsrealized on individual products may be difficult due to the problem ofapportionment of fixed costs to different products., the rationale ofcontribution lies in the fact that fixed costs are done away with under marginalcosting. The concept of contribution helps to determine the breakeven points,profitability of products, departments, etc., to select product-mix for profitmaximization, and to fix selling prices under different circumstances such astrade depression, expert sales prices discrimination etc. contribution is thedefinite test to ascertain whether a product or process is worthwhile to continueamong different products or processes.

Problem of Key Factor, or Measurement of Profitability

The contribution could be used as a measure to solve the problem of key factor.A key factor, otherwise called ‘limiting factor’, or ‘principal budget factor’, or‘scarce factor’, may be defined as the factor which, over a period, will limite thevolume of output, or which puts a limit on the efforts of the management toproduce as many units of the selected products as it would like to whenmanufacture and sale of a product are confronted by the problem of key factor,the profitability of that particular product is then ascertained by relating the keyfactor used for the manufacture of the product, and its resulting contribution.Generally, sales would be the limiting factor but sometimes, materials, labour,plant capacity, etc., may be the inhibiting, factor when the key factor andcontribution are given, the relative profitability may be calculated by employingthe formula given below:

ContributionProfitability = ------------------------

Key factor

For example, when material is in short supply, profitability is determined bydividing the contribution per unit by the quantity of materials used per unitywhen sales is the key factor, profitability is measured by contribution sales ratio,and so on.

Advantages of Marginal Costing



(a) Marginal costing is easy to understand. It can be combined with standardcosting and budgetary control and thereby make the control mechanismmore effective.

(b) Elimination of fixed overhead from the cost of production prevents theeffect of varying charges per unit, and also prevents the carrying forwardof a portion of the fixed overheads of the current period to thesubsequent period. As such cost and profit are not initiated and costcomparisons becomes more meaningful.

(c) The problem of over or under absorption of overheads is avoided.(d) A clear-cut division of costs into fixed and variable elements makes theflexible budgetary control system more easy and effective and therebyfacilitated greater particle cost control.

(e) If helps profit planning through break – even charts and profit graphscomparative profitability can easily be assessed and brought to the noticeof the management for decision-making.

(f) It is an effective tool for determining efficient sales or production policies,or for taking pricing and tendering decisions, particularly when thebusiness is at a low ebb.

Managerial Uses of Managerial Costing:

From the advantages stated above, the following may be listed as specificmanagerial uses:

(a) Cost Ascertainment: Marginal costing technique facilitates not only therecording of costs but their reporting also. The classification of costs intofixed and variable components makes the top of cost ascertainment moreeasy. The main problem in this regard is only segregation of thesemi-variable cost into fixed and variable elements. However, this may beovercome by adopting any of the methods already explained for thepurpose.

(b) Cost control: Marginal cost statements can be understood more easily bythe management than those presented under absorption costingbifurcation of costs into fixed and variable enables management toexercise control over production cost and thereby effect efficiency. In fact,while variable costs are controllable at the lower levels of management,fixed costs can be controlled at the top level. Under this techniquemanagement can study the behaviour of costs at varying conditions ofoutput and sales and thereby exercise better control over costs.



Limitations of Marginal costing

Despite its superiority over absorption costing, the marginal costing techniquehas its own limitations.

(a) Segregation of all costs into fixed and variable costs is very difficult. Inpractice, a major technical difficulty arises in drawing a sharp line ofdemarcation between fixed and variable costs. the distinction betweenthem holds good only in the short run. In the long-run, however, all costsare variable.

(b) In marginal costing, greater importance is attached to the sales functionthereby relegating the production function largely to a secondary position.But, the real efficiency of a business is to be assessed only by consideringthe selling and production functions together.

(c) The elimination of fixed costs from the valuation of inventories is illogicalsince fixed costs are also incurred in the manufacture of goods. Further,it results in the understatement of the value of stock, which is neither thecost nor the market price.

(d) Pricing decision cannot be based on contribution alone. Sometimes, thecontribution will be unrealistic when increased production and sale areeffected, either through extensive use of existing machinery or byreplacing manuallabour by machines. Another possibility is that there isdanger of too many sales being effected at marginal cost, resulting indenial to the business of inadequate profits.

(e) Although the problem of over or under absorption of fixed overheads canby overcome to a certain extent, the same problem still persist withregard to variable overheads.

(f) The application of this technique is limited in the case of industries inwhich according to the nature of business, large stocks have to be carriedby way of work-in-progress (e.g. contracting firms)

Practical Applications of Marginal Costing

(a) Profit Planning: A business concern exists with the objective of makingprofits, and profits are the yardstick of its success profit planning istherefore a part of operations planning. It is the basis of planning cash,capital expenditure, and pricing. If growth and survival of a business areto be ensured, profit planning becomes an absolute necessary. Marginal



costing assists profit planning through computation of contribution ratio.It enables planning of future operation in such a way as to eithermaximize profits pre maintain specified levels of profit. Normally, profitsare affected by several factors, such as the volume of sales, marginal costper unit, total fixed costs, selling price and sales mix etc., Hencemanagement can achieve their profit goals by varying one or more of theabove variables. Basic marginal costing equations which are useful inprofit planning are as follows.

Profit volume ratio (p/w ratio). This is the ratio of contribution to sales.Symbolically it is expressed as:

ContributionC/S ratio or P/V ratio = --------------------------------- x 100

(1)(as a percentage) Sales (S)

Contribution = Sales x P/V ratio (2)

ContributionSales = -------------------------- (3)

P/V ratio

Brake Even point (BEP). This may be defined as that point of sales volume atwhich total revenue is equal to total costs. it is a no-profit no-less point. It maybe derived from the equation (3). We may get

Contribution at BEPBEP (in Rs.) -----------------------------

P/V ratio

At BEP, the contribution will be equal to fixed cost and therefore, the formulamay be restructured as follow:

Fixed CostBEP (in Rs.) = ---------------------------

P/V ratio

Fixed Cost (F)BEP (in units) = -----------------------------

Contribution per unit



Margin of Safety (MS) : This represents the difference between salew orproduction at the selected activity, and the break-even sales or production.

MS = Sales at the selected activity --- BEP

CSales at the selected activity = ----------------------

P-V ratio

FBEP = ----------------------

P/V ratio

C F profit (p)MS =------------------------- ------------ ------------------- =---------------------------

P/V ratio P/V ratio P/V ratio

Where C-F = PMargin of safety is also presented in percentages as follows:

MS (Sales) x 100-----------------------------------------Sales at selected activity

Illustration 2From the following information, calculate BEP and determine the net profit ifsales are 25% above BEP

Selling price per unit Rs. 50Direct material cost per unit Rs. 20Direct wages per unit : Rs. 10Variable overheads per unit : Rs. 7.5Fixed overheads (total) Rs. 50,000



Solution

Marginal Cost Statement

Rs.Selling price per unit 50.00Less: marginal cost perunit

Rs.

Materials 20.00Wages: 10.00Variable overheads: 7.50 37.50Contribution: 12.50

C 12.50P/V ratio = ------------- x 100 = ---------------- x 100 = 25%

S 50

F Rs. 50,000BEP = ---------------- = ----------------------- x 100 =

2,00,000P/V ratio 25

BEP = Rs. 2,00,00025% of BEP = Rs. 50,000

-----------------------Total sales Rs. 2,50,000

Contribution = Sales x P/V ratio



Contribution at Rs. 2,50,000 sales = Rs. 2,50,000 x 25%

Contribution = Rs. 62,500

Less: Fixed cost = Rs. 50,000--------------------

Net profit = Rs. 12,500--------------------

(b) Level of Activity Planning

Business concern may have plans either to expland or contract the level ofactivities depending upon the conditions prevailing in the market. Suchplanning is to be considered before events overtake the business. Marginalcosting is very useful for taking such decisions by enabling management tocompare the contribution at different levels of activities.

Illustration 5

Following is the Cost Structure of JB limited

Levels of Activity

Output (in puts) 60% 70% 80%2,400 2,800 3,200

Costs (Rs.)



Materials 48,000 56,000 64,000Wages 14,400 16,800 19,200Factory overheads 25,600 27,200 28,800

Factory cost 88,000 1,00,000 1,12,000

The factory is considering an increase of production to 90% level of activity. Noincrease in fixed overheads is expected at this level. The management requiresa statement showing all details of factory costs at 90% level of activity.

Solution

Marginal Cost StatementLevel of activity = 90%Output = 3.600 unitsTotal cost Per unit

Rs. Rs.



Material 72,000 20.00Wages 21,600 6.00Variable overheads 14,400 4.00

1,08,000 30.00Fixed overheads 16,000Total factory cost 1,24,000

Note: Factory overheads increase by Rs. 1,600 at each level of activity.Therefore, variable overheads must be

Rs. 1,600----------------- = Rs. 4 per unit. At 80% level of activity, Factory

overheads400 units

are Rs. 28,800 of which variable cost are Rs. 12,800 (Rs. 4 x 3,200), resulting infixed overheads of Rs. 16,000 (Rs. 28,800 – Rs. 12,800).

(D)Profitable Mix of Sales

A company which has a variety of product lines can employ marginal costing inorder to determine the most profitable sales mix from a number of selectedalternatives.

Illustration 6The directors of AB Ltd. are considering the sales budget for the next budgetperiod. The following information has been made available form the costrecords.

Product Z(per unit)

Product Y(per unit)



Directed materials Rs. 40 Rs. 50Selling price Rs. 120 Rs. 200Direct wages (a)Rs. 2 per hour 10 hours 15 hours

Variable overheads : 100% of direct wages

Fixed overheads : Rs. 20,000 p.a.

You are required to present to the management a statement showing themarginal cost of each product, and to recommend which of the following salesmix should be adopted.

(a) 450 units of Z and 300 units of Y(b) 900 units of Z only(c) 600 units of Y only(d) 600 units of Z and 200 units of Y

Solution

Marginal cost statement



Per unitProduct Z Product Y

Rs. Rs. Rs. Rs.Selling price 120 200Less:Materials costDirectmaterials

40 50

Direct wages 20 30Variableoverheads

20 80 30 110

40 90

Selection of AlternativesProducts

Z Y TotalRs. Rs. Rs.

450 – 300 – Y 18,000 27,000 45,000Contribution(450 x Rs. 40)+ (300 x Rs.90)Less: Fixedover-heads

20,000

Profit 25,000900 – ZContribution 36,000 36,000(900 x Rs. 40)Less fixedcost

20,000

Profit 16,000



(c) 600 – YContribution(600 x Rs. 90)

54,000 54,000

Less: fixedcost

20,000

Profit 34,000

600 – Z, 200 –YContribution

24,000 18,000 42,000

(600 x Rs. 40)+ (200 x Rs.90) Less:Fixed cost

20,000

Profit 22,000

Thus, alternative (c) is the one recommended.

(d) Marginal Costing and Pricing

Determining the price of products manufactured by a company is oftenconsidered to be a difficult problem. However, the basic problem involved inpricing is the matching of demand and supply. Marginal costing is somethingused to determine prices, a simple and familiar example being the railway ticket.The normal fare will usually be more than the charge collected for excursionfare (concessional fare) for, the normal fare is calculated to cover all the railwaycosts, including fixed overheads which are a considerable item, whereas theexcursion fare will probably cover only the marginal cost (which is relativelysmall) and some contribution towards profit. The marginal costing techniquecan help management in fixing price in such special circumstances as:

(a) A trade depression in the industry.(b) Spare capacity in the factory(c) A seasonal fluctuation in demand.



(d) When it is desired to obtain a special contract.

Cost – volume – profit AnalysisCost – volume – profit (CVP) analysis is an analytical tool for studying therelationship between volume cost, price and profits. It is an integral part of theprofit planning process of the firm. However, formal profit planning and controlinvolves the use of budgets and other forecasts, and the CVP analysis providesonly an overview of the profit planning process. Besides, it helps to evaluate thepurpose and reasonableness of such budgets and forecasts. Generally, CVPanalysis provides answers to questions such as:

(a) What will be the effect of changes in prices / costs and volume on profit?(b) What minimum sales volume need be effected to avoid losses?(c) What should be the level of activity to earn a target profit?(d) Which product is the most profitable and which product or operation of aplant should be discontinued? Etc

Break – Even Analysis

The break-even analysis is the most widely known from of the CVPanalysis. The study of CVP relationship is frequently referred to as break-evenanalysis. However, some state that up to the point of activity where totalrevenue equals total expenses, the study can be called as break-even analysisand beyond that point, it is the application of CVP relationship.

Thus, a narrow in depredation of break-even analysis refers to a system ofdetermining that level of activity where total revenue equals total cost i.e. thepoint of zero loss. The broader interpretation denotes a system of analysis thatcan be used to determine the probable profit at any level of activity.

Practical Utility of Break-even Analysis

Break-even Analysis can be used to show the effect of a change in any of thefollowing profit factors:

(1) Change in selling price



(2) Change in volume of sales(3) Change in variable costs(4) Change in fixed costs



LESSON 20

MANAGEMENT REPORTING

Information is the basis for decision making in an organisation. The efficiencyof management depends, to a larger extent, upon the availability of regular andrelevant information to those exercise the managerial functions. No planningand control procedure is complete without prompt and accurate feedback ofoperation results and availability of other information. For example,management must know how the actual profit performance collates with that ofbudgeted or standard or with past performances and to what extant thevariation have been caused by various influencing factors. A regular system ofreporting is considered as a better guarantee of efficiency and operation thanreliance on personal qualities. Hence, it is essential that an effective andefficient reporting system is developed as part of accounting methods.

Meaning

The term ‘reporting’ connotes different meanings as under:

(A)Narrating some facts(B) Reviewing certain matter with its merits and demerits and offeringcomments.

(C) Furnishing data at regular intervals in standards form.(D)Submitting specific information for particular purpose upon specificrequest instruction.

Management reporting refers to the formal system whereby relevant requiredinformation is furnished to management by means of reports constantly. Thus,‘report’ is the essence of any management reporting system.

The term ‘Report’ normally refers to a formal communication which movesupward, i.e., for factual communication by a lower to a higher level of authorityin response to order received from higher level. Reports provide means ofchecking the performance. A person, who is issued with orders or instructions



to do certain things should report back what he has done in compliance thereof.Reports may be oral or written and also routine or special.

Objects of ReportingThe primary object of management reporting is to obtain the requiredinformation about the operating results of the organisation regularly in order touse them for future planning and control. Another object is to secureunderstanding and approval of the judgment by the people engaged in variousaspects of the work of enterprise. The second object is closely related to thefirst one and is important in terms of efficiency, morale and motivation.

Essentials of a Good Reporting System

Reporting system enables management at all levels to keep itself abreast ofpast performance as well as developments and it facilitates a check onindividual operating levels. Based on reports, management takes crucialdecisions. Hence, the essentials of good reporting system are as follows:

1. Proper form: In order to facilitate decision-making the informationshould be supplied in form.

2. Proper time: Promptness is very important because information delayed isinformation denied Reports are meant for action and whenadversetendencise or events are noticed, action should follow forthwith.The sooner the report is made the quicker can be the corrective actiontaken.

3. Proper flow of information: The information should flow from the rightlevel of authority to the level of authority where the decision are to bemade. Further a complete and consistent information should flow in asystematic manner.

4. Flexibility: The system should be capable of being adjusted according tothe requirement of the user.

5. Facilitation of evaluation: The system should distinctively reportdeviations from standards or estimates. Controllable factors should bedistinguished from non-controllable factors and reported separately.

6. Economy: There is a cost for rendering information and such cost shouldbe compared with benefits derived from the report or loss sustained by



not having the report. Economy is an information aspect to be consideredwhile developing reporting system.

Models of Reporting

Reports may be presented in the form of written statements, graphs, abd ororal.

1. Written statementsa. Formal financial statements: These statements may deal with anyone or more of the following:

i. Actual against the budgeted figures.ii. Comparative statements over a period of time

b. Tabulated statistics: This statement may deal with statisticalanalysis of a particular type of expenditure over a period of time orsales of a product over a period in different regions, etc.

c. Accounting ratios: The ratios may either form part of the formalfinancial statement or be given in the form separate statement.

2. Graphic reportsThe information may be presented by means of graphic reports whichgive a better visual view of the data than the long array of figures giveninstatements. Charts, diagrams and pictures are the usual form ofgraphic reports. They have the advantage of facilitating quick grasp ofsignificant trends by receivers of information.

3. Oral reportsOral reports are mostly presented at group meetings and conferenceswith individuals.

Basic Requisites of a Good Report

A report is a vehicle carrying information to different levels of administration.Quality of decision-making depends to a large extent on the quality ofinformation supplied and on the promptness and consistency of reporting.Good reporting is necessary for effective communication. hence a good reportshould possess the following basic requisites.



1. Promptness: It means that report must be prepared and presented ontime.

2. From and content: A good report should have a suggestive title, headings,sub-headings, paragraph divisions, statistical figures, facts, dated etc.

3. Comparability: Reports are also meant for comparison.4. Consistency: consistency envisages the presentation of the same type ofinformation as between different reporting periods. Uniform procedureshould be followed over period of time.

5. Simplicity: The report should be in a simple unambiguous and conciseform

6. Controllability: It is necessary that every report should be addressed to aresponsibility centre and present controllable and uncontrollable factorsseparately.

7. Appropriateness: Reports are sent to different levels of management andthe form should be designed to suit the respective levels.

8. Cost considerations: The cost of maintaining the reporting system shouldcommensurate with the benefits derived there form.

9. Accuracy: The report should be reasonably accurate.

Types of reports

Routine Reports

Reports which are submitted at periodical intervals on a regular basis coveringroutine matters e.g., variance analysis, financial statements, budgetary controlstatements are routine reports.

Special Reports

Reports which are submitted on particular occasions on specific request orinstruction are special reports.

Operating Reports



These reports may be classified into control report information – cum-venturemeasurement report.

Control ReportIt is an important ingredient of control process and helps in controllingdifferent activities of an enterprise. It provides information properly collectedand analyzed to different levels of management.

Information ReportThese reports provide information which are very much useful for futureplanning and policy formulation.

Financial ReportsThese report contain information about the financial position of the business.They may be classified into Static Reports and Dynamic Reports. Static reportsreveals the financial position on a particular data e.g., balance sheet of acompany. On the other hand, the dynamic report reveals the movement offunds during a specified period e.g. Fund flow statement, Cash flow statement.




MODEL QUESTION PAPERTime: 3 Hours Max. marks: 100

PART – A (6 x 5 = 30)Answer any SIX questions

All questions carry Equal marksEach answer to a theory question need not exceed One page

1. State the significance of management accounting.2. What are the limitations of financial statements?3. What is debt service coverage ratio?4. State the significance of capital budgeting?5. What is common size financial statements?6. Determine which company is more profitable.

A Ltd. B LtdNet profit ratio 5% 8%Turnover ratio 6 times 3 times

7. Calculate the funds from operations from the following profit and lossaccount:

P & L A/cTo Salaries 5,000 By Gross profit 50,000To Rent 3,000 By Profit on sale of

buildings5,000

To depreciation on plant 5,000To Printing & Stationary 3,000To Goodwill written off 3,000To Preliminary expenseswritten off

2,000

To Provision for tax 10,000To Net Profit 24,000

55,000 55,000



8. Calculate from the following information the break-even point and thenet profit if the sales volume is Rs. 8,00,000, P/V ratio is 40% and marginof safety is 25%.

9. Prepare a production budget for three months ending March-31, 1999for a factory producing four products, on the basis of the followinginformation:

Types ofproduct

Estimated stockon 1 – 1 – 1999

(units)

Estimated salesduring Jan –March 1999(units)

Desired closingStock on

31-3-99 (units)

A 2000 10000 3000B 3000 15000 5000C 4000 13000 3000D 3000 12000 2000

PART – B (5 x 14 =70)

Answer any FIVE questionsAll questions carry EQUAL marks

Each answer to a theory need not exceed Three pages.

10. What is budgetary control? What are the objectives and advantagesof budgetary control?

11. Discuss the different methods of ranking investment proposals.12. What are the functions of management accounting?13. X Ltd., furnishes you the following information:

Year 1998I Half II Half

Sales Rs. 8,10,000 10,26,000



Profit 21,600 64,800

From the above you are required to compute the following assuming that thefixed cost remains the same in both the periods:

i) P/V ratioii) Fixed costiii) The amount of profit or loss where sales are Rs. 6,48,000iv) The amount of sales required to earn a profit of Rs. 1,08,000v) From the balance sheets of A Ltd.; make out i) a statement of changes in

the working capital and ii) Fund Flow statement.

1995 1996 1995 1996Share Capital 4,50,000 5,00,000 Goodwill 1,15,000 90,000General reserve 40,000 70,000 Plant 80,000 2,00,000Profit & LossA/c

30,000 48,000 Buildings 2,00,000 1,70,000

Creditors 97,000 1,33,000 Debtors 1,60,000 2,00,000Bills payable 20,000 16,000 Stock 97,000 1,39,000Provision forTax

40,000 50,000 Bank 25,000 18,000

6,77,000 8,17,000 6,77,000 8,17,000

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