Mc 105

User Manual: MC 105

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MANAGEMENT ACCOUNTING: NATURE AND SCOPE

Objective: The present lesson explains the meaning, nature, scope and limitations

of accounting. Further, it discusses the activities covered under

management accounting and its difference with financial accounting.

LESSON STRUCTURE

1.1 Introduction

1.2 Definitions of Management Accounting

1.3 Nature of Management Accounting

1.4 Functions of Management Accounting

1.5 Scope of Management Accounting

1.6 The Management Accountant

1.7 Management Accounting and Financial Accounting

1.8 Cost Accounting and Management Accounting

1.9 Limitations of Management Accounting

1.10 Self-Test Questions

1.11 Suggested Readings

1.1 INTRODUCTION

Management accounting can be viewed as Management-oriented Accounting.

Basically it is the study of managerial aspect of financial accounting,

"accounting in relation to management function". It shows how the accounting

function can be re-oriented so as to fit it within the framework of management

activity. The primary task of management accounting is, therefore, to

redesign the entire accounting system so that it may serve the operational

COURSE: MANAGEMENT ACCOUNTING

COURSE CODE: MC-105 AUTHOR: Dr. N. S. MALIK

LESSON: 01

ETTER: Prof. M S Turan

needs of the firm. If furnishes definite accounting information, past, present or

future, which may be used as a basis for management action. The financial

data are so devised and systematically development that they become a

unique tool for management decision.

1.2 DEFINITIONS OF MANAGEMENT ACCOUNTING

The term “Management Accounting”, observe, Broad and Carmichael, covers

all those services by which the accounting department can assist the top

management and other departments in the formation of policy, control of

execution and appreciation of effectiveness. This definition points out that

management is entrusted with the primary task of planning, execution and

control of the operating activities of an enterprise. It constantly needs

accounting information on which to base its decision. A decision based on

data is usually correct and the risk of erring is minimized. The position of the

management in respect of its functions can be compared to that of an army

general who wants to wage a successful battle. A general can hardly fight

successfully unless he gets full information about the surrounding situation

and the extent of effectiveness of each of his battalions and, to the extend

possible, even the enemy's intentions. Like a general a successful

management too strives to outstrip other competitors in the field by

streamlining its operating efficiency. It needs a thorough knowledge of the

situation and the circumstances in which the firm operates. Such knowledge

can only be gained through the processed financial data rendered by the

accounting department on the basis of which it can take policy decision

regarding execution, control, etc. It is here that the role of management

accounting comes in. It supplies all sorts of accounting information in the

form of such statements as may be needed by the management. Therefore,

management accounting is concerned with the accumulation, classification

and interpretation of information that assists individual executives to fulfill

organizational objectives.

The Report of the Anglo-American Council of Productivity (1950) has also

given a definition of management accounting, which has been widely

accepted. According to it, "Management accounting is the presentation of

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

of policy and the day to day operation of an undertaking". The reasoning

added to this statement was, "the technique of accounting is of extreme

importance because it works in the most nearly universal medium available

for the expression of facts, so that facts of great diversity can be represented

in the same picture. It is not the production of these pictures that is a function

of management but the use of them." An analysis of the above definition

shows that management needs information for better decision-making and

effectiveness. The collection and presentation of such information come

within the area of management accounting. Thus, accounting information

should be recorded and presented in the form of reports at such frequent

intervals, as the management may want. These reports present a systematic

review of past events as well as an analytical survey of current economic

trends. Such reports are mainly suggestive in approach and the data

contained in them are quite up to date. The accounting data so supplied thus

provide the informational basis of action. The quality of information so

supplied depends upon its usefulness to management in decision-making.

The usual approach is that, first of all, a thorough analysis of the whole

managerial process is made, then the information required for each area is

explored, and finally, all the information, after analysis in terms of alternatives,

is taken into consideration before arriving at a management decision. It is to

be understood here that the accounting information has no end in itself; it is a

means to an end. As its basic idea is to serve the management, its form and

frequency are all decided by managerial needs. Therefore, accounting aids

the management by providing quantitative information on the economic well

being of the enterprise. It would be appropriate if we called management

accounting an Enterprise Economics. Its scope extends to the use of certain

modern sophisticated managerial techniques in analyzing and interpreting

operative data and to the establishment of a communication network for

financial reporting at all managerial levels of an organization.

1.3 NATURE OF MANAGEMENT ACCOUNTING

The term management accounting is composed of 'management' and

'accounting'. The word 'management' here does not signify only the top

management but the entire personnel charged with the authority and

responsibility of operating an enterprise. The task of management accounting

involves furnishing accounting information to the management, which may

base its decisions on it. It is through management accounting that the

management gets the tools for an analysis of its administrative action and can

lay suitable stress on the possible alternatives in terms of costs, prices and

profits, etc. but it should be understood that the accounting information

supplied to management is not the sole basis for managerial decisions. Along

with the accounting information, management takes into consideration or

weighs other factors concerning actual execution. For reaching a final

decision, management has to apply its common sense, foresight, knowledge

and experience of operating an enterprise, in addition to the information that is

already has.

The word 'accounting' used in this phrase should not lead us to believe that it

is restricted to a mere record of business transactions i.e., book keeping only.

It has indeed a 'macro-economic approach'. As it draws its raw material from

several other disciplines like costing, statistics, mathematics, financial

accounting, etc., it can be called an interdisciplinary subject, the scope of

which is not clearly demarcated. Other fields of study, which can be covered

by management accounting, are political science, sociology, psychology,

management, economics, statistics, law, etc. A knowledge of political science

helps to understand authority relationship and responsibility identification in an

organization. A study of sociology helps to understand the behaviour of man

in groups. Psychology enables us to know the mental make-up of employers

and employees. A knowledge of these subjects helps to increase motivation,

and to control the actions of the people who are ultimately responsible for

costs. This builds a better employer-employee relationship and a sound

morale. The subject of management reveals the processes involved in the art

of managing, a knowledge of economics assists in the determination of

optimum output in the forecasting of sales and production, etc., and also

makes it possible to analyze management action in terms of cost revenues,

profits, growth, etc. It is with the help of statistics that this information is

presented to the management in a form that can be assimilated. The subject

of management accounting also encompasses the subject of law, knowledge

of which is necessary to find out if the management action is ultra-vires or not.

It is, therefore, a wide and diverse subject.

Management accounting has no set principles such as the double entry

system of bookkeeping. In place of generally accepted accounting principles,

the philosophy of cost benefit analysis is the core guide of this discipline. It

says that no accounting system is good or bad but is can be considered

desirable so long as it brings incremental benefits in excess of its incremental

costs. Applying management accounting principles to financial matters can

arrive at no single perfect solution. It is, therefore, an inexact science, which

uses its own conventions rather than standardized principles. The facts to be

studied here can be interpreted in different ways and the precision of the

inferences depends upon the skill, judgement and common sense of different

management accountants. It occupies a middle position between a fully

matured and an infant subject.

Since management accounting is managerially oriented, its data is selective in

nature. It focuses on potential opportunities rather than opportunities lost.

The data is operative in nature catering to the operational needs of a firm. It

details events, monetary and non-monetary. The nature of data, the form of

presentation and its duration are mainly determined by managerial needs. It

is quite frequently reported as it is meant for internal uses and managerial

control. An accountant should look at his enterprise from the management's

point of view. Whenever he fails to do that he ceases to be a management

accountant.

Management accounting is highly sensitive to management needs. However,

it assists the management and does not replace it. It represents a service

phase of management rather than a service to management from

management accountant. It is rather highly personalized service. Finally, it

can be said that the management accounting serves as a management

information system and so enables the management to manage better.

1.4 FUNCTIONS OF MANAGEMENT ACCOUNTING

The basic function of management accounting is to assist the management in

performing its functions effectively. The functions of the management are

planning, organizing, directing and controlling. Management accounting helps

in the performance of each of these functions in the following ways:

(i) Provides data: Management accounting serves as a vital source of

data for management planning. The accounts and documents are a

repository of a vast quantity of data about the past progress of the

enterprise, which are a must for making forecasts for the future.

(ii) Modifies data: The accounting data required for managerial decisions

is properly compiled and classified. For example, purchase figures for

different months may be classified to know total purchases made

during each period product-wise, supplier-wise and territory-wise.

(iii) Analyses and interprets data: The accounting data is analyzed

meaningfully for effective planning and decision-making. For this

purpose the data is presented in a comparative form. Ratios are

calculated and likely trends are projected.

(iv) Serves as a means of communicating: Management accounting

provides a means of communicating management plans upward,

downward and outward through the organization. Initially, it means

identifying the feasibility and consistency of the various segments of

the plan. At later stages it keeps all parties informed about the plans

that have been agreed upon and their roles in these plans.

(v) Facilitates control: Management accounting helps in translating

given objectives and strategy into specified goals for attainment by a

specified time and secures effective accomplishment of these goals in

an efficient manner. All this is made possible through budgetary

control and standard costing which is an integral part of management

accounting.

(vi) Uses also qualitative information: Management accounting does

not restrict itself to financial data for helping the management in

decision making but also uses such information which may not be

capable of being measured in monetary terms. Such information may

be collected form special surveys, statistical compilations, engineering

records, etc.

1.5 SCOPE OF MANAGEMENT ACCOUNTING

Management accounting is concerned with presentation of accounting

information in the most useful way for the management. Its scope is,

therefore, quite vast and includes within its fold almost all aspects of business

operations. However, the following areas can rightly be identified as falling

within the ambit of management accounting:

(i) Financial Accounting: Management accounting is mainly concerned

with the rearrangement of the information provided by financial

accounting. Hence, management cannot obtain full control and

coordination of operations without a properly designed financial

accounting system.

(ii) Cost Accounting: Standard costing, marginal costing, opportunity

cost analysis, differential costing and other cost techniques play a

useful role in operation and control of the business undertaking.

(iii) Revaluation Accounting: This is concerned with ensuring that capital

is maintained intact in real terms and profit is calculated with this fact in

mind.

(iv) Budgetary Control: This includes framing of budgets, comparison of

actual performance with the budgeted performance, computation of

variances, finding of their causes, etc.

(v) Inventory Control: It includes control over inventory from the time it is

acquired till its final disposal.

(vi) Statistical Methods: Graphs, charts, pictorial presentation, index

numbers and other statistical methods make the information more

impressive and intelligible.

(vii) Interim Reporting: This includes preparation of monthly, quarterly,

half-yearly income statements and the related reports, cash flow and

funds flow statements, scrap reports, etc.

(viii) Taxation: This includes computation of income in accordance with the

tax laws, filing of returns and making tax payments.

(ix) Office Services: This includes maintenance of proper data processing

and other office management services, reporting on best use of

mechanical and electronic devices.

(x) Internal Audit: Development of a suitable internal audit system for

internal control.

(xi)

1.6 THE MANAGEMENT ACCOUNTANT

Management Accounting provides significant economic and financial data to

the management and the Management Accountant is the channel through

which this information efficiently and effectively flows to the management. The

Management Accountant has a very significant role to perform in the

installation, development and functioning of an efficient and effective

management information system. He designs the framework of the financial

and cost control reports that provide each management level with the most

useful data at the most appropriate time. He educates executives in the need

for control information and ways of using it. This is because his position is

unique with respect to information about the organization. Apart from top

management no one in the organization perhaps knows more about the

various functions of the organization than him. He is, therefore, sometimes

described as the Chief Intelligence Officer of the top management. He

gathers information, breaks it down, sifts it out and organizes it into

meaningful categories. He separates relevant and irrelevant information and

then ranks relevant information in an intelligible form to the management and

sometimes also to those who are interested in the information in the

information outside the company. He also compares the actual performance

with the planned one and reports and interprets the results of operations to all

levels of management and to the owners of the business. Thus, in brief,

management accountant or controller is the person who designs the

management information system for the organization, operates it by means of

interlocked budgets, computes variances and exhorts others to institute

corrective measures. Mr. P.L. Tandon has explained beautifully the position

of the management accountant in the following words.

"The management accountant is exactly like the spokes in a wheel,

connecting the rim of the wheel and the hub receiving the information. He

processes the information and then returns the processed information back to

where it came from"1.

Dr. Don barker2 sees a very bright future for the management accountants.

According to him, "Management Accountants will be presented with many

opportunities for innovative actions in the global economic environment. In

addition to their role of providing accurate, timely and relevant information,

management accountants will be expected to participate as business

consultants and partners with management in the strategic planning process".

Thus, there are tremendous possibilities for management accountants to

shine as a professional group in the years to come. To fit in this role, it is

necessary that the management accountants develop effective

communication abilities, adopt a structured approach, a flexible

accommodation and keep themselves aware with the latest evolving

technologies in the profession.

FUNCTIONS OF MANAGEMENT ACCOUNTANT

It is the duty of the management accountant to keep all levels of management

informed of their real position. He has, therefore, varied functions to perform.

His important functions can be summarized as follows:

1 Tandon, P.L.: "The Role of Management Accountants in General Management”. 4th All India

Seminar on Management Accounting, Lucknow, Feb. 1963.

2. President (1991-92), The Institute of Management Accountants, USA.

(i) Planning: He has to establish, coordinate and administer as an

integral part of management, an adequate plan for the control of the

operations. Such a plan would include profit planning, programmes of

capital investment and financing, sales forecasts, expenses budgets

and cost standards.

(ii) Controlling: He has to compare actual performance with operating

plans and standards and to report and interpret the results of

operations to all levels of management and the owners of the business.

This id done through the compilation of appropriate accounting and

statistical records and reports.

(iii) Coordinating: He consults all segments of management responsible

for policy or action. Such consultation might concern any phase of the

operation of the business having to do with attainment of objectives

and the effectiveness of the organizational structures and policies.

(iv) Other functions:

¾ He administers tax policies and procedures.

¾ He supervises and coordinated the preparation of reports to

governmental agencies.

¾ He ensures fiscal protection for the assets of the business through

adequate internal control and proper insurance coverage.

¾ He carries out continuous appraisal economic and social forces and

the government influences, and interprets their effect on the

business.

It should be noted that the functions of a Management Accountant are

more of those of a 'staff official'. He, in addition to processing historical

data, supplies a good deal of information concerning the future

operations in line with the management's needs. Besides serving top

management with information concerning the company as a whole, he

supplies detailed information to the line officers regarding alternative

plans and their profitability, which help them in decision-making. As a

matter of fact the Management Accountant should not bother himself

regarding the decision taken by the line officials after tendering advice

unless he has reasonable grounds to believe that such a decision is

going to affect the interests of corporation adversely. In such an event

also he should report it to the concerned level of management with

tact, firmness combined with politeness.

1.7 MANAGEMENT ACCOUNTING AND FINANCIAL ACCOUNTING

Financial accounting and management accounting are closely interrelated

since management accounting is to a large extent rearrangement of the data

provided by financial accounting. Moreover, all accounting is financial in the

sense that all accounting systems are in monetary terms and management is

responsible for the contents of the financial accounting statements. In spite of

such a close relationship between the two, there are certain fundamental

differences. These differences can be laid down as follows:

(i) Objectives: Financial accounting is designed to supply information in

the form of profit and loss account and balance sheet to external

parties like shareholders, creditors, banks, investors and Government.

Information is supplied periodically and is usually of such type in which

management is not much interested. Management Accounting is

designed principally for providing accounting information for internal

use of the management. Thus, financial accounting is primarily an

external reporting process while management accounting is primarily

an internal reporting process.

(ii) Analyzing performance: Financial accounting portrays the position of

business as a whole. The financial statements like income statement

and balance sheet report on overall performance or statues of the

business. On the other hand, management accounting directs its

attention to the various divisions, departments of the business and

reports about the profitability, performance, etc., of each of them.

Financial accounting deals with the aggregates and, therefore, cannot

reveal what part of the management action is going wrong and why.

Management accounting provides detailed analytical data for these

purposes.

(iii) Data used: Financial accounting is concerned with the monetary

record of past events. It is a post-mortem analysis of past activity and,

therefore, out the date for management action. Management

accounting is accounting for future and, therefore, it supplies data both

for present and future duly analyzed in detail in the 'management

language' so that it becomes a base for management action.

(iv) Monetary measurement: In financial accounting only such economic

events find place, which can be described in money. However, the

management is equally interested in non-monetary economic events,

viz., technical innovations, personnel in the organization, changes in

the value of money, etc. These events affect management's decision

and, therefore, management accounting cannot afford to ignore them.

For example, change in the value of money may not find a place in

financial accounting on account of "going concern concept". But while

affecting an insurance policy on an asset or providing for replacement

of an asset, the management will have to take into account this factor.

(v) Periodicity of reporting: The period of reporting is much longer in

financial accounting as compared to management accounting. The

Income Statement and the Balance Sheet are usually prepared yearly

or in some cases half-yearly. Management requires information at

frequent intervals and, therefore, financial accounting fails to cater to

the needs of the management. In management accounting there is

more emphasis on furnishing information quickly and at comparatively

short intervals as per the requirements of the management.

(vi) Precision: There is less emphasis on precision in case of

management accounting as compared to financial accounting since the

information is meant for internal consumption.

(vii) Nature: Financial accounting is more objective while management

accounting is more subjective. This is because management

accounting is fundamentally based on judgement rather than on

measurement.

(viii) Legal compulsion: Financial accounting has more or less become

compulsory for every business on account of the legal provisions of

one or the other Act. However, a business is free to install or not to

install system of management accounting.

The above points of difference between Financial Accounting and

Management Accounting prove that Management Accounting has flexible

approach as compared to rigid approach in the case of Financial Accounting.

In brief, financial accounting simply shows how the business has moved in the

past while management accounting shows how the business has to move in

the future.

An attempt may now be made to compare and study the two types of

accounting on basis of the characteristics of the data used. It is presented

through the box- 1.1, given below.

Box 1.1

Features of data Provided by Financial Provided by

Accounting Management accounting

1. Period After a stated period At frequent intervals

2. Time Historical data Current and future data

3. Unit of expression Money only Any statistical unit

4. Nature Actual data Projected data

5. Specificity Aggregates Detailed analysis

6. Description Money consequences Events

7. Reality Objective Subjective

8. Precision Pie to Pie accuracy May be guess-work

9. Principles Double entry system Cost benefit analysis

10. Legality Obligatory Optional

11. Purpose Overview of entire Analytical details of such

Business activity activities as call for decisions

1.8 COST ACCOUNTING AND MANAGEMENT ACCOUNTING

Cost accounting is the process of accounting for costs. It embraces the

accounting procedures relating to recording of all income and expenditure and

the preparation of periodical statements and reports with the object of

ascertaining and controlling costs. It is, thus, the formal mechanism by

means of which the costs of products or services are ascertained and

controlled. On the other hand, management accounting involves collecting,

analyzing, interpreting and presenting all accounting information, which is

useful to the management. It is closely associated with management control,

which comprises planning, executing, measuring and evaluating the

performance of an organization. Thus, management accounting draws

heavily on cost data and other information derived from cost accounting.

Today cost accounting is generally indistinguishable from the so-called

management accounting or internal accounting because it serves multiple

purposes. However, management accounting can be distinguished from cost

accounting in one important respect. Management accounting has a wider

scope as compared to cost accounting. Cost accounting deals primarily with

cost data while management accounting involves the considerations of both

cost and revenue. Management accounting is an all inclusive accounting

information system, which covers financial accounting, cost accounting, and

all aspects of financial management. But it is not a substitute for other

accounting functions. It involves a continuous process of reporting cost,

financial and other relevant data in an analytical and informative way to

management. We should not be very much concerned with boundaries of cost

accounting and management accounting since they are complementary in

nature. In the absence of a suitable system of cost accounting, management

accountant will not be in a position to have detailed cost information and his

function is bound to lose significance. On the other hand, the management

accountant cannot effectively use the cost data unless it has been reported to

him in a meaningful and informative form.

1.9 LIMITATIONS OF MANAGEMENT ACCOUNTING

Management accounting, being comparatively a new discipline, suffers from

certain limitations, which limit its effectiveness. These limitations are as

follows:

1. Limitations of basic records: Management accounting derives its

information from financial accounting, cost accounting and other

records. The strength and weakness of the management accounting,

therefore, depends upon the strength and weakness of these basic

records. In other words, their limitations are also the limitations of

management accounting.

2. Persistent efforts. The conclusions draws by the management

accountant are not executed automatically. He has to convince people

at all levels. In other words, he must be an efficient salesman in selling

his ideas.

3. Management accounting is only a tool: Management accounting

cannot replace the management. Management accountant is only an

adviser to the management. The decision regarding implementing his

advice is to be taken by the management. There is always a

temptation to take an easy course of arriving at decision by intuition

rather than going by the advice of the management accountant.

4. Wide scope: Management accounting has a very wide scope

incorporating many disciplines. It considers both monetary as well as

non-monetary factors. This all brings inexactness and subjectivity in

the conclusions obtained through it.

5. Top-heavy structure: The installation of management accounting

system requires heavy costs on account of an elaborate organization

and numerous rules and regulations. It can, therefore, be adopted only

by big concerns.

6. Opposition to change: Management accounting demands a break

away from traditional accounting practices. It calls for a rearrangement

of the personnel and their activities, which is generally not like by the

people involved.

7. Evolutionary stage: Management accounting is still in its initial stage.

It has, therefore, the same impediments as a new discipline will have,

e.g., fluidity of concepts, raw techniques and imperfect analytical tools.

This all creates doubt about the very utility of management accounting.

1.10 SELF-TEST QUESTIONS

1. What do you mean by management accounting? Explain giving examples.

2. What are the functions of a management accountant? Elaborate each one

of them.

3. Explain the benefits of management accounting in the business sector and

service sector.

4. Distinguish management accounting from financial accounting and cost

accounting.

5. Explain the limitations of management accounting.

1.11 SUGGESTED READINGS

1. Ashish K. Bhattacharya, Principles and Practices of Cost Accounting

(3rd.), New Delhi: Prentice Hall of India Private Limited, 2004.

2. Charles T. Horngren, Cost Accounting, A Managerial Emphasis,

Prentice Hall Inc., 1973.

3. D. T. Decoster and E. L. Schafer, Management Accounting, New York:

John Willey and Sons, 1979.

4. John G. Blocker and Wettmer W. Keith, Cost Accounting, New Delhi:

Tata Mc Grw Publishing Co. Ltd., 1976.

5. R. K. Sharma and Shashi K. Gupta, Management Accounting-

Principles and Practice (7th.), New Delhi: Kalyani Publishers, 1996.

FINANCIAL STATEMENT ANALYSIS

Objective: The present lesson explains the discrepancy between accounting

income and economic income; identify the devices used in practice to

exploit the use of the bottom line; the use of a firm's financial

statements to calculate standard financial ratios; decompose the return

on equity into its key determinants; carry out comparative analysis; and

highlights the uses of financial statement analysis for different

purposes.

LESSON STRUCTURE

2.1 Introduction

2.2 Financial Statements

2.3 Financial Statement Analysis

2.4 Methodical Presentation of Financial Statement Analysis

2.5 Techniques /Tools of Financial Statement Analysis

2.6 Self-Test Questions

2.7 Suggested Readings

2.1 INTRODUCTION

Financial statements are an important source of information for evaluating the

performance and prospects of a firm. If properly analyzed and interpreted,

financial statements can provide valuable insights into a firm's performance.

Analysis of financial statements is of interest to lenders (short term as well as

long term), investors, security analysts, managers, and others. Financial

statement analysis may be done for a variety of purposes, which may range

COURSE: MANAGEMENT ACCOUNTING

COURSE CODE: MC-105 AUTHOR: DR. N. S. MALIK

LESSON: 02

ETTER: Dr. Karam Pal

from a simple analysis of the short-term liquidity position of the firm to a

comprehensive assessment of the strengths and weaknesses of the firm in

various areas. It is helpful in assessing corporate excellence, judging

creditworthiness, forecasting bond ratings, evaluating intrinsic value of equity

shares, predicting bankruptcy, and assessing market risk.

2.2 FINANCIAL STATEMENTS

Managers, shareholders, creditors and other interested groups seek answers

to the following questions about a firm: What is the financial position of firm at

a given point of time? How has the firm performed financially over a given

period of time? What have been the sources and uses of cash over a given

period? To answer these questions, the accountant prepares two principal

statements, the balance sheet and the profit and loss account, and an

ancillary statement, the cash flow statement.

2.2.1 BALANCE SHEET

The balance sheet shows the financial condition of a business at a given point

of time. As per the Companies Act, the balance sheet of a company shall be

in either the account (horizontal) form or the report (vertical) form. Exhibit 2.1

shows the balance sheet of Horizon Limited as on March 31, 2005 cast in the

account as well as the report form. While the report form is most commonly

used by companies, it is more convenient to explain the contents of the

balance sheet of Horizon Limited, cast in the account form, as given Exhibit

2.2.

Structure of Balance Sheet as per the Companies Act

Exhibit 2.1 Account Form

Liabilities Assets

Share capital Fixed assets

Reserves and surplus Investments

Unsecured loans Current assets, loans and

advances

Current liabilities and provisions Current assets

Current liabilities Loans and advances

Provisions Miscellaneous expenditure

and losses

Exhibit 2.2 Report Form

I Sources of Funds

(1) Shareholders funds

(a) Share capital

(b) Reserves & surplus

(2) Loan funds

(a) Secured loans

(b) Unsecured loans

II Application of Funds

(1) Fixed assets

(2) Investments

(3) Current assets, loans and advances

Less: Current liabilities and provisions

Net current assets

(4) Miscellaneous expenditure and losses.

Liabilities. Liabilities defined very broadly represent what the business entity

owes others. The Companies Act classifies them as share capital, reserves

and surplus, secured loans, unsecured loans, current liabilities and provisions

Share Capital: This is divided into two types: equity capital and preference

capital. The first represents the contribution of equity shareholders who are

the owners to the firm. Equity capital, being risk capital, carries no fixed rate

of dividend. Preference capital represents the contribution of preference

shareholders and the dividend rate payable on it is fixed.

Reserves and Surplus: Reserves and surplus are profits, which have been

retained in the firm. There are two types of reserves: revenue reserves and

capital reserves. Revenue reserves represent accumulated retained earning

from the profits of normal business operations. These are held in various

forms: general reserve, investment allowance reserve, capital redemption

reserves, dividend equalization reserve, and so on. Capital reserves arise out

gains, which are not related to normal business operations. Examples of such

gains are the premium on issue of shares or gain on revaluation of assets.

Surplus is the balance in the profit and loss account, which has not been

appropriated to any particular reserve account. Note that reserves and

surplus along with equity capital represent owners' equity or net worth.

Secured Loans: These are the borrowings of the firm against which specific

collateral have been provided. The important components of secured loans

are: debentures, loans from financial institutions, and loans from commercial

banks.

Unsecured Loans. These are the borrowing of the firm against which no

specific security has been provided. The major components of unsecured

loans are: fixed deposits, loans and advances from promoters, inter-corporate

borrowings, and unsecured loans from banks.

Current liabilities and Provisions: Current liabilities and provisions, as per

the classification under the companies Act, consist of the amounts due to the

suppliers of goods and services bought on credit, advance payments

received, accrued expenses, unclaimed dividend, provisions for taxes,

dividends, and so on. Current liabilities for managerial purposes (as distinct

from their definition in the Companies Act) are obligations, which are expected

to mature in the next twelve months. So defined, they include current

liabilities and provisions as per the classification under the Companies Act

plus loans (secured and unsecured) which are repayable within one year from

the date of the balance sheet.

Assets: Broadly speaking, assets represent resources, which are of some

value to the firm. They have been acquired at a specific monetary cost by the

firm for the conduct of its operations. Assets are classified under the

Companies Act as fixed assets, investments, current assets, loans and

advances, miscellaneous expenditure and losses.

Fixed Assets: These assets have two characteristics: they are acquired for

use over relatively long periods for carrying on the operations of the firm and

they are ordinarily not meant for resale. Examples of fixed assets are land,

buildings, plant, machinery, patents, and copyrights.

Investments: These are financial securities owned by the firm. Some

investments represent long-term commitment of funds (usually these are the

equity shares of other firms held for income and control purposes). Other

investments are likely to be short term in nature such as holdings of units in

mutual fund schemes and may rightly be classified under current assets for

managerial purposes. (Under the requirements of the Companies Act,

however, short term holding of financial securities also has to be shown under

investments and not under current assets.)

Current Assets, Loans and Advances: This category consists of cash and

other assets, which get converted into cash during the operating cycle of the

fir. Current assets are held for a short period of time as against fixed assets,

which are held for relatively longer periods. The major components of current

assets are: cash, sundry debtors, inventories, loans and advances, and pre-

paid expenses. Cash denotes funds readily disbursable by the firm. The bulk

of it is usually in the form of bank balances and the rest is currency held by

the fir. Sundry debtors (also called accounts receivable) represent the

amounts owned to the firm by its customers who have bought goods and

services on credit. Sundry debtors are shown in the balance sheet at the

amount owed, less an allowance for bad debts. Inventories (also called

stocks) consist of raw materials, work-in-process, finished goods, and stores

and spares. They are usually reported at the lower of the cost or market

value. Loans and advances are the amounts loaned to employees, advances

given to suppliers and contractors, advance tax paid, and deposits made with

governmental and other agencies. They are shown at the actual amount.

Pre-paid expenses are expenditures incurred for services to be rendered in

the future. These are shown at the cost unexpired service.

Miscellaneous Expenditures and Losses: This category consists of two

items: (i) miscellaneous expenditures and (ii) losses. Miscellaneous

expenditures represent certain outlays such as preliminary expenses and

developmental expenses, which have not been written off. From the

accounting point of view, a loss represents a decrease in owners' equity.

Hence, when a loss occurs, the owners' equity should be reduced by that

amount. However, as per company law requirements, the share capital

(representing owners' equity) cannot be reduced when a loss occurs. So the

share capital is kept intact on the left hand side (the liabilities side) of the

balance sheet and the loss is shown on the right hand side (the assets side)

of the balance sheet.

2.2.2 PROFIT AND LOSS ACCOUNT

The Companies Act has prescribed a standard form for the balance sheet, but

none for the profit and loss account. However, the Companies Act does

require that the information provided should be adequate to reflect a true and

fair picture of the operations of the company for the accounting period. The

Companies Act has also specified that the profit and loss account must show

specific information as required by Schedule IV. The profit and loss account,

like the balance sheet, may be presented in the account form or the report

form. Typically, companies employ the report form. The report form

statement may be a single-step statement or a multi-step statement. In a

single step statement, all revenue items are recorded first, then the expense

items are show and finally the net profit is given. While a single step profit and

loss account aggregates all revenues and expenses, a multi-step profit and

loss account provides disaggregated information. Further, instead of showing

only the final profit measure, viz., the profit after tax figure, it presents profit

measures at intermediate stages as well.

¾ Net sales

¾ Cost of goods sold

¾ Gross profit

¾ Operating expenses

¾ Operating profit

¾ Non-operating surplus/deficit

¾ Profit before interest and tax

¾ Interest

¾ Profit before tax

¾ Tax

¾ Profit after tax.

2.3 FINANCIAL STATEMENTS ANALYSIS

Financial Statements Analysis (FSA) refers to the process of the critical

examination of the financial information contained in the financial statements in order

to understand and make decisions regarding the operations of the firm. The FSA is

basically a study of the relationship among various financial facts and figures is given

in a set of financial statements. The basic financial statements i.e. the Balance Sheet

and the Income Statement, already discussed in the preceding lesson contain a whole

lot of historical data. The complex figures as given in these financial statements are

dissected/broken up into simple and valuables elements and significant relationships

are established between the elements of the same statement or different financial

statements. This process of dissection, establishing relationships and interpretation

thereof to understand the working and financial position of a firm is called the FSA.

Thus, FSA is the process of establishing and identifying the financial weaknesses and

strength of the firm. It is indicative of two aspects of a firm i.e. the profitability and the

financial position and it is what is known as the objectives of the FSA.

2.3.1 Objectives of the FSA: Broadly, the objective of the FSA is to

understand the information contained in financial statements with a view to

know the weaknesses and strength of the firm and to make a forecast about

the future prospects of the firm and thereby enabling the financial analyst to

take different decisions regarding the operations of the firm. The objectives of

the FSA can be identified as:

¾ To assess the present profitability and operating efficiency of the firm

as a whole as well as for its different departments and segments.

¾ To find out the relative importance of different components of the

financial position of the firm.

¾ To identify the reasons for change in the profitability/financial position

of the firm, and

¾ To assess the short term as well as the long term liquidity position of

the firm.

2.3.2 Types of Financial Analysis

Financial analysis can be classified into different categories depending upon

(1) the material used, and (2) the modus operandi of analysis.

1. On the Basis of Material Used: Under this category the financial

analysis can be of two types: a) External Analysis; b) Internal Analysis

a. External Analysis: The outsiders to the business carry out this

kind of analysis, which includes investors, credit agencies,

government agencies and other creditors who have no access

to the internal records of the company. In the recent times this

analysis has gathered momentum towards better corporate

governance and government regulations for more detailed

disclosure of information by the companies in their financial

statements.

b. Internal Analysis: In contrary to the above this analysis is done

by those who have access to the books of accounts and other

information related to the business. The analysis is done

depending upon the objective to be achieved through this

analysis.

2. On the basis of Modus Operandi: In this case too, the financial

analysis can be of two types: a) Horizontal Analysis; b) Vertical

Analysis

a Horizontal Analysis: Under this financial statements for a

number of years are reviewed and analyzed. The current year’s

figures are compared with standard or base year.

b Vertical Analysis: Under this type of analysis a study is made

of the quantitative relationship of the various items in financial

statements on a particular date. For example, the ratios of

different items of costs for a particular period may be calculated

with the sales for that period. These types of financial analysis

are useful in comparing the performance of several companies

in the same group, or divisions or departments in the same

company.

In addition to above, the FSA for a firm can be undertaken in different ways.

There is 'the best' technique of the FSA, which can be applied to all the firms

under all the situations. The type of the FSA undertaken depends upon the

person doing the FSA and the purpose of which the FSA has been

undertaken. Different person/parties may undertake the FSA for different

purposes. The persons/parties, who are usually interested in the FSA, may

be the shareholders, the creditors, the financial institutions, the investors and

the management itself. The FSA can be classified into different categories as

follows: a) Internal and External FSA; b) Dynamic and Static FSA

a) Internal and External FSA: The FSA is said to be internal when it is

done by a person who has access to the books of the account and

other related information of the firm. This type of FSA is conducted for

measuring the operational and managerial efficiency at different

hierarchy levels of the firm. This type of analysis is quite

comprehensive and reliable. In order to undertake internal FSA, either

an employee of the same firm or an outside agency may be entrusted

the responsibility. External FSA, on the other hand, is one, which is

conducted by an outsider without having any access to the basic

accounting record of the firm. These outsiders may be the creditors,

the investors, the shareholders, the credit rating agencies etc. The

external FSA is dependent on the published financial data of the firm

and consequently can serve only limited purpose.

b) Dynamic and Static FSA: The FSA is said to be dynamic if it covers a

period of several years. Financial data/information for different years is

incorporated in the FSA to assess the progress of the firm. This type of

FSA is also called the horizontal analysis. The dynamic FSA is useful

for long-term trend analysis and planning. In dynamic FSA, the

figures/data for a year are placed and compared with the figures/data

for several other years and changes from 1 year to another are

identified. Since, the dynamic analysis covers a period of more than 1

year (may be up to 5 years or 10 years), is given a considerable insight

into areas of financial weaknesses and strength of the firm. On the

other hand, the static FSA covers a period of 1 year only and the

analysis is made on the basis of only one set of financial statements.

So, it is study in terms of information at a particular date only. It is also

called vertical FSA. Impliedly, the static FSA fails to incorporate the

periodic changes and therefore, may not be very conducive to a proper

understanding of the financial position of the firm. It may be noted that

both the dynamic and static FSA should be conducted simultaneously

as both are indispensable for understanding the profitability and

financial position of the firm.

On the basis of the above discussion, it can be said that FSA

investigative and thought provoking process in nature. The basic

objective of FSA is financial planning and forecasting on the basis of

meaningful interpretation of the financial information. It is forward

looking exercise. Since, decisions are going to be taken on the basis

of the FSA, the analyst must be careful, precise, analytical, objective

and intelligent enough to undertake the FSA in a systematic way.

2.4 METHODICAL PRESENTATION TO FSA

The financial statements usually present the financial data in a traditional

form. However, in order to make meaningful and convenient analysis, the

presentation of data may be modified and suitably rearranged. In the

modified form, the items of a statement are presented in a vertical form and in

a particular sequence only. However, it must be noted that this modified form

of the financial statements is only a matter of convenience and not a

compulsory requirement and therefore, there is no standard form of

methodical presentation. The FSA can be undertaken even without such

modification but not so conveniently. In methodical presentation, the financial

information can be presented even side by side for inter-firm comparison or

for dynamic FSA. A set of methodical presentation of the Income Statement

and the B/S are given in the Table 2.1 and 2.2 respectively.

Table 2.1 : Income Statement (Methodical presentation).

INCOME STATEMENT FOR THE YEAR ENDING......

Amount Amount

Sales

Cash sales *****

Credit sales *****

Less: Sales return *****

Net sales (1) *****

Less: Cost of good sold:

Opening stock *****

+ Purchases *****

+Manufacturing expenses *****

+ Direct expenses *****

- Closing stock *****

Total cost of goods sold (2) ***** *****

Gross Profit (3) *****

Less: Operating expenses : (4)

Selling expenses *****

Administrative expenses *****

Depreciation ***** *****

Operating profit (5) *****

Add: Non Operating Income *****

Less: Non Operating Expenses *****

Profit before Interest & Taxes (6) *****

Less : Interest Charges: (7)

Interest on Loans *****

Interest on Debenture ***** *****

Profit before tax (6-7) (8) *****

Less: Provision for tax (9) *****

Net Profit (10) *****

Table 2.2: The balance Sheet (Methodical presentation).

BALANCE SHEET AS ON.........

Amount Amount

Preference Share Capital *****

Equity Share Capital *****

Total Share Capital (1) ***** *****

Add: Capital Reserve *****

General Reserve *****

Share Premium A/c *****

Capital Redemption Reserve A/c *****

Profit & Loss A/c ***** *****

Less: Preliminary Expenses *****

Accumulated Losses ***** *****

Shareholders Fund (2) *****

Add: Long Term Loans *****

Debentures ***** *****

Capital Employed (3) *****

Represented by:

Fixed Assets

Land & Building *****

Plant & Machinery *****

Furniture & Fixture *****

Gross Block *****

Less : Depreciation *****

Fixed Assets (Net) (4) *****

Working Capital

Cash and Bank *****

Receivable *****

Marketable Securities *****

Liquid Assets (5) *****

+ Inventories *****

Total Current Assets (6) *****

Trade Creditors *****

Bills Payable *****

Expenses Outstanding *****

Provision for Tax *****

Quick Liabilities (7) *****

+ Bank Overdraft *****

Total Current Liabilities (8) *****

Net Working Capital (6-8) (9) *****

Total Assets (4+9) (10) *****

2.5 TECHNIQUES/TOOLS OF THE FSA

As already discussed, that the FSA can be undertaken by different persons

and for different purposes, therefore, the methodology adopted for the FSA

may be varying from the one situation to another. However, the following are

some of the common techniques of the FSA: a) Comparative financial

statements. (b) Common-size financial statements, (c) Trend percentages

analysis, and (d) Ration Analysis. The last techniques i.e. the ration analysis

is the most common, comprehensive and powerful tool of the FSA. For the

sake of proper understanding, all these techniques have been discussed in

detail as follows:

2.5.1 COMPARATIVE FINANCIAL STATEMENTS (CFS)

In CFS, two or more BS and/or the IS of a firm are presented simultaneously

in columnar form. The financial data for two or more years are placed and

presented in adjacent columns and thereby the financial data is provided a

times perspective in order to facilitate periodic comparison. In CFS, the BS

and the IS for number of years are presented in condensed form for year-to-

year comparison and to exhibit the magnitude and direction of changes.

The preparation of the CFS is based on the premise that a statement covering

a period of a number of years is more meaningful and significant than for a

single year only, and that the financial statements for one period represent

only 1 phase of the long and continuous history of the firm. Nowadays, most

of the published Annual Reports of the companies provide important statistical

information about the company in condensed from for the last so many years.

The presentation of such data enhances the usefulness of these reports and

brings out more clearly the nature and trends of changes affecting the

profitability and financial position of the firm.

So, the CFS helps a financial analyst in horizontal analysis of the firm and in

establishing operating and positional trend of the firm. The CFS may be

prepared to show the absolute amount of different items in monetary terms,

the amount of periodic changes in monetary terms and the percentages of

periodic changes to reveal the proportionate changes. The CFS can be

prepared for both the BS and IS.

Comparative Income Statement (CIS): A CIS shows the figures of different

items of the ISs of the firm in absolute terms, the absolute changes from one

period to another and if desired, the changes in percentage form. The CIS is

helpful in deriving meaningful conclusions regarding changes in sales volume,

cost of goods sold, different expense items etc. From the CIS a financial

analyst can quickly ascertain whether sales are increasing or decreasing and

by how much amount or by how much percentage. Similarly, analysis can be

made for other items also.

Comparative Balance Sheet (CBS): The CBS shows the different assets

and liabilities of the firm on different dates to make comparisons of absolute

balances and also of changes if any, from one date to another. The CBS may

be helpful in analyzing and evaluating the financial position of the firm over a

period of number of years. The preparation of CFS can be explained with the

help of Example 2.1.

Example 2.1: Following are the IS and BS of ABC & Co. for the year 2003

and 2004, Prepare the CBS and CIS for these two years.

Income Statements for the year 2003 and 2004

(Figures in Rs.)

To Cost of good sold 300000 375000 By Net Sales 400000 500000

To General Expenses 10000 10000

To Selling Expenses 15000 20000

To Net Profit 75000 95000

400000 500000 400000 500000

_________________________________________________________________

Balance Sheets as on December 31

(Figures in Rs.)

__________________________________________________________________

Liabilities 2003 2004 Assets 2003 2004

Capital 350000 350000 Land 50000 50000

Reserves 100000 122500 Building 150000 135000

Secured Loans 50000 75000 Plant 150000 135000

Creditors 100000 137000 Furniture 50000 70000

Outstanding 50000 75000 Cash 50000 70000

Expenses

Debtors 100000 150000

Stores 100000 150000

Particulars 2003 2004 Particulars 2003 2004

650000 760000 650000 760000

Solution:

COMPARATIVE INCOME STATEMENT

FOR THE YEARS ENDING 2003 AND 2004

(Figures in Rs.)

__________________________________________________________________

Liabilities 2003 2004 Change in % change in

2004 2004

Net Sales 400000 500000 100000 + 25

Less cost of goods 300000 375000 75000 + 25

Soled

Gross Profit (1) 100000 125000 25000 + 25

Less General 10000 10000 ---- -----

Selling Expenses 15000 20000 5000 + 33.3

Total Expenses (2) 15000 30000 5000 + 20

Net Profit (1-2) 75000 95000 20000 + 26.7

__________________________________________________________________

COMPARATIVE BALANCE SHEET AS ON DEC. 31

__________________________________________________________________

Liabilities 2003 2004 Change in % change in

2004 2004

Land 50000 50000 ---- ----

Building 150000 135000 - 15000 - 10

Plant 150000 135000 -15000 - 10

Furniture 50000 70000 20000 + 40

Total F. assets (1) 400000 390000 -10000 - 2.5

Cash 50000 70000 20000 40

Debtors 100000 150000 50000 50

Stock 100000 150000 50000 50

Total C. Assets (2) 250000 370000 120000 48

Creditors 100000 137500 37500 37.5

O/s Expenses 50000 75000 25000 50

Total Liabilities (3) 150000 212500 62500 41.7

Net Working 100000 157500 57500 57.5

Capital (2 - 3)

Total Assets (1+2) 650000 760000 110000 16.9

Capital 350000 350000 ------- ------

Reserves 100000 122500 22500 22.5

Proprietor's Fund (4) 450000 472500 22500 5

Secured Loans (5) 50000 75000 25000 50

Capital Employed 500000 547500 47500 9.5

(4+5)

Total Assets (1+2) 650000 760000 110000 16.9

Cap.+ Total

Liabilities (3+4+5) 650000 760000 110000 16.9

Interpretation: On the basis of CIS it can be said that Gross Profit for the

year 2004 has increased by 25% over the profit for the year 2003. The Net

Sales during the same period has increased by 25%, which was coupled with

increase in the cost of goods sold which also increased by same 25%. This

means that Input/Output ratio or the production efficiency level has been

maintained during 2004. the same increase of 25% in Net Sales and the Cost

of goods sold has resulted in increase in Gross Profit by 25%. The increase

in Net Profit is more pronounced i.e. by 26.7%. The reason for a higher

increase in Net Profit is the comparatively less increase in total expenses

(only 20%). The General Expenses during 2003 and 2004 were same but the

increase in Selling Expenses by 33 1/3% has resulted increase of total

expenses by 20%. The CBS also reveals many facts about the composition of

assets and the financial structure of the firm. The Fixed Assets have

decreased over the period by 2.5%, though this decrease has primarily

resulted by the amount of depreciation @ 10% on Buildings and Plant.

However, the Current Assets have increased by 48%, this increase of 48% is

too much in view of increase in Net Sales by 25% only. Moreover, the

Current Liabilities have increased by 41.7%. Since the increase in Current

Assets is more than increase is Current Liabilities, therefore the Net Working

Capital has increased by 57.5%. The clearly indicates that the Working

Capital of the firm is not properly managed. Had the increase in current

assets restricted to 25% or the increase in current liabilities was also achieved

at 48% or so, then the situation would not have been so alarming. However,

the decrease in fixed assets has been offset by increase in Net Working

Capital and consequently the total assets have increased by 16.9%. The firm

has not raised any capital during the period and the increase in proprietor's

funds has resulted because of increase in retained profits by Rs. 22,500. The

Secured Loans have also increased by 50%. The funds provided by the

retained earnings and the secured loans seem to have been utilized in

financing the current assets. This has, on one hand increased the short term

paying capacity of the firm and on the other hand, will affect the earning

capacity of the firm as the current assets are less or non productive. The

increase in total assets by 16.9% is matched with the increase in total

liabilities (proprietor's fund plus the secured loans)) by 16.9%. So, the CFS

explains about the changes in different items of the financial statements.

However, despite this revelation, the CFS fails to highlight the component

changes in relation to total assets or total liabilities. The CFS does not throw

light on the variations in each asset as a percentage of total assets for a

particular period or changes in different liabilities in relation to total liabilities

for that period etc. This drawback of CFS is taken care of by the Common

Size Statement.

2.5.2 COMMON SIZE STATEMENT (CSS)

The CSS represents the relationship of different items of a financial statement

with some Common item by expressing each item as a percentage of the Common

item. In Common size Balance Sheet, each item of the Balance Sheet is stated as a

percentage of the total of the Balance Sheet. Similarly in Common size Income

Statement, each item is stated as percentage of the Net Sales. The percentages for

different items are computed by dividing the absolute amount of that item by the

Common base (i.e. the Balance Sheet Total or the Net Sales as the case may be) and

then multiplying by 100. The percentage so calculated can be easily compared with

the corresponding percentages in some other period. Thus, the CSS is useful not only

in intra-firm comparisons over a series of different year but also in making inter-firm

comparisons for the same year or for several years. The procedure and the technique

of preparation of the CSS can be explained with the help of Example 2.2.

Example 2.2.

With the use of data given in the Example 2.1 prepare the Common Size BS and

Common Size IS for the years 2003 & 2004.

Solution:

COMMON SIZE BALANCE SHEET

Amount (Rs.) Percentages

__________________________________________________________________

Liabilities 2003 2004 2003 2004

Land 50000 50000 7.70 6.59

Building 150000 135000 23.07 17.76

Plant 150000 135000 23.07 17.76

Furniture 50000 70000 7.70 9.21

Total Fixed Assets (1) 400000 390000 61.54 51.32

Cash 50000 70000 7.70 9.20

Debtors 100000 150000 15.38 19.74

Stock 100000 150000 15.38 19.74

Total C. Assets (2) 250000 370000 38.46 48.68

Total Assets (1+2) 650000 760000 100 100

Capital 350000 350000 53.85 46.05

Reserves 100000 122500 15.38 16.12

Proprietor's Fund (3) 450000 472500 69.23 62.17

Secured Loan 50000 75000 7.70 9.87

Creditor 100000 137500 15.37 18.09

O/s Expenses 50000 75000 7.70 9.87

Total Liabilities (4) 200000 287500 30.77 37.83

Total Capital +

Liabilities (3+4) 650000 760000 100 100

_________________________________________________________________

COMMON SIZE INCOME STATEMENT

Amount (Rs.) Percentages

__________________________________________________________________

2003 2004 2003 2004

Net Sales 400000 500000 100.0 100.0

Less : Cost of goods sold 300000 375000 75.0 75.0

Gross Profit (1) 100000 125000 25.0 25.0

Less : General Expenses 10000 10000 2.5 2.0

Selling Expenses 15000 20000 3.75 4.0

Total Op. Expenses(2) 25000 30000 6.25 6.0

Net Profit (1-2) 75000 95000 18.75 19.00

Interpretation: The Common size BS and the Common Size IS reveal that

proportion of fixed assets out of total assets has reduced from 61.54% to

51.32% whereas the proportion of reliance of the firm on the current assets.

Similarly, out the total liabilities the proportion of the proprietor's funds has

reduced from 69.23% to 62.17% and the proportion of external liabilities has

increased from 30.77% to 37.83%. Since, no new capital has been issued

and the other liabilities have increased, the proportion of capital in the total

financing of the firm has gone down from 53.85% to 46.05%.

Further, the Cost of goods sold as well as the Gross Profit has remained

pegged at 75% and 25% of Net Sales. However, the Net Profit has increased

from 18.75% to 19% of Net Sales. This is due to decrease in operating

expenses from 6.25% to 6% of the Net Sales.

It can be observed that the CSS can be used for analyzing and comparing the

financial position of a firm for two different periods or between two firms for

the same year. This comparability was not available in the CFS because of

difference in firms’ sizes or in different years. Of course, in order to make the

CSS more meaningful, the analyst should ensure that accounting policies of

different firms being compared or for different year are unchanged or not

significantly different.

The CSS can be easily used for analyzing and for some real insight into

operational and financial position of the firm over a period of different years.

However, it may become difficult and cumbersome if the period to be covered

is more than two years. The CSS does not show the variations in different

items from one period to another. In horizontal analysis, the CSS may not

provide sufficient information about the changing pattern or trend of different

items over years. In such a situation, the Trend Percentage Analysis can be

of immense help.

2.5.3 TREND PERCENTAGE ANALYSIS (TPA)

The TPA is a technique of studying several financial statements over a series

of years. In TPA, the trend percentages are calculated for each item by taking

the figure of that item for some base year as 100. So, the trend percentage is

the percentage relationship, which each item of different years bears to the

same item in the base year. Any year may be taken as the base year. Any

year may be taken as the base year, but generally the starting/initial year is

taken s the base year. So, each item for base year is taken as 100 and then

the same item for other years is expressed as a percentage of the base year.

The TPA which can be used both for the BS as well as the IS has been

explained with the help of the Example 3.3.

Example 2.3: From the following data relating to the ABC & Co. for the year

2001 to 2004, calculate the trend percentages (taking 2001 as base year).

(Figure in Rs.)

__________________________________________________________________

2001 2002 2003 2004

Net Sales 200000 190000 240000 260000

Less: Cost of goods sold 120000 117800 139200 145600

Gross Profit 80000 72200 100800 114400

Less: Expenses 20000 19400 22000 24000

Net Profit 60000 52800 78800 90400

__________________________________________________________________

Trend percentages

__________________________________________________________________

2001 2002 2003 2004

Net Sales 100 95.0 120.0 130.0

Less: Cost of goods sold 100 9.2 115.8 121.3

Gross GXX Profit 100 90.3 126.0 143.0

Less: Expenses 100 97.0 110.0 120.0

Net Profit 100 88.0 131.3 150.6

__________________________________________________________________

Interpretation: On the whole, the 2002 was a bad year but the recovery was

made during 2003 with increase in volume as well as profits. The figures of

2002 when compared with 2001 reveal that the Sales have reduced by 5%,

but the cost of goods sold and the Expenses have decreased only by 1.8%

and 3% respectively. This resulted in decrease in Net Profit by 12%. The

position was recovered in 2003 and not only the decline was arrested but the

positive growth was also visible both in 2003 and 2004. Again, the increase in

Net Profit by 31.3% (2003) and 50.6% (2004) is much more than the

increased in sales by 20% and 30% respectively. This again testifies that a

substantial portion of the cost of goods sold and expenses is of fixed nature.

So, the TPA is an important tool of historical analysis. It can be of immense

help in making a comparative analysis over a series of years. The TPA

provides brevity and easy readability to several financial statements as the

percentages figures disclose more than the absolute figures. However, some

precautions must be taken while using the TPA as a technique of the AFS as

follows:

There should not be a significant and material change in accounting policies

over the years. This consistency is necessary to ensure meaningful

comparability.

i. Proper care must be taken while selecting the base year. It must be a

normal and a representative year. Generally the initial year is taken as

base year, but intervening year can also be taken as the base year, if the

initial year is not found to be normal year.

ii. The trend percentages should be analyzed vis-à-vis the absolute figure to

avoid any misleading conclusions.

iii. If possible, the figures for different year should be adjusted for variations in

price level also. For example, increase in Net Sales by 30% (from 100 in

2001 to 130 in 2004) over 3 years might have resulted primarily because

of increase in selling price and not because of increase in volume.

Quite often, it may be difficult to interpret the increase or decrease in any item

(in absolute terms or in percentages terms) as a desirable change or an

undesirable change. For example, decrease in cash may be discouraging if it

is going to affect the liquidity but may be encouraging if it has resulted out of

better cash management. Similarly, increase in inventory may result because

of decrease in sales or because of necessity to maintain a minimum level of

stock. In such cases, therefore, the techniques of CFS, CSS and the TPA

may not be of much help. Financial analysts have developed another

technique called the Ratio Analysis, which is presumably the most common

and widely used technique of the FSA.

2.5.4 RATIO ANALYSIS (RA)

The RA has emerged as the principal technique of the FSA. A ratio is a

relationship expressed in mathematical terms between two individual or groups of

figures connected with each other in some logical manner. The RA is based on the

premise that a single accounting figure by itself may not communicate any meaningful

information but when expressed as a relative to some other figure, it may definitely

give some significant information. The relationship between two or more accounting

figures/groups is called a financial ratio. A financial ratio helps to summarize a large

mass of financial data into a concise form and to make meaningful interpretations and

conclusions about the performance and positions of a firm. For example, a firm having

Net Sales of Rs.5, 00,000 is making a gross profit of Rs.1, 00,000. It means that the

ratio of the Gross Profit to Net Sales is 20% i.e.

(Rs.1, 00,000/Rs.5, 00,000) x 100.

Steps in Ratio Analysis: The RA requires two steps as follows:

i. Calculation of a ratio (as discussed later), and

ii. Comparing the ratio with some predetermined standard. The standard

ratio may be the past ratio of the same firm or industry's average ratio or

a projected ratio or the ratio of the most successful firm in the industry.

In interpreting the ratio is compared with some predetermined standard.

The importance of a correct standard is obvious as the conclusion is

going to be based on the standard itself.

Types of comparisons: As already stated that the RA comprised of two

steps i.e. the calculation and thereafter the comparison with some standard.

The calculation part (as discussed later) of a ratio merely involves the

application of a formula to the given financial data to establish the

mathematical relationship. The comparison is the next steps. The ratio can

be compared in three different ways.

Cross-Section Analysis: One way of comparing the ratio or ratios of a firm

is to compare them with the ratio or ratios of some other selected firm in the

same industry at the same point of time. So, it involves the comparison of two

or more firm's financial ratios at the same point of time. The Cross-Section

Analysis helps the analyst to find out as to how a particular firm has

performed in relation to it competitors. The firm’s performance may be

compared with the performance of the leader in the industry in order to

uncover the major operational inefficiencies. In this type of an analysis, the

comparison with a standard helps to find out the quantum as well as direction

of deviation from the standard. It is necessary to look for the large deviations

on either side of the standard could mean a major concern for attention. The

Cross-Section Analysis is easy to be undertaken as most of the data required

for this may be available in financial statements of the firm.

2.5.5 Time-Series Analysis

The analysis is called Time-Series Analysis when the performance of a firm is

evaluated over a period of time. By comparing the present performance of a

firm with the performance of the same firm over last few years, an

assessment can be made about the trend in progress of the firm, about the

direction of progress of the fir. The information generated by the Time-Series

Analysis can also help the firm to assess whether the firm is approaching long

term goals or not. The Time-Series Analysis can be extended to cover

projected financial statements. In particular, the Time Series Analysis looks

for (i) Important trends in financial performance, (ii) Shift in trend over the

years, and (iii) Significant deviations if any, from the other set of data.

Combined Analysis: If the Cross-Section and Time Series Analyses, both

are combined together to study the behavior and pattern of ratios, then

meaningful and comprehensive evaluation of the performance of the firm can

definitely be made. A trend of ratios of a firm compared with the trends of the

ratios of the standard firm can give good results. For example, the ratio of

Operating expenses to Net Sales for a firm, may be higher than the industry

average, however, over the years it has been declining for the firm, whereas

the industry average has not shown any significant changes. (This topic is

covered in detail in the chapters to follow)

2.6 SELF-TEST QUESTIONS

6. What do you mean by financial statements? Explain their different types .

7. What is financial statement analysis? Explain its objectives.

8. What are the types of financial statement analysis? How an accountant in

a firm can arrange them?

9. Explain the benefits of financial statement analysis to a business operating

in the manufacturing sector and service sector.

10. Explain the various techniques applied for carrying out the financial

statement analysis.

2.7 SUGGESTED READINGS:

1. Ashish K. Bhattacharya, Principles and Practices of Cost Accounting (3rd.),

New Delhi: Prentice Hall of India Private Limited, 2004.

2. Charles T. Horngren, Cost Accounting, A Managerial Emphasis, Prentice

Hall Inc., 1973.

3. D. T. Decoster and E. L. Schafer, Management Accounting, New York:

John Willey and Sons, 1979.

4. John G. Blocker and Wettmer W. Keith, Cost Accounting, New Delhi: Tata

Mc Grw Publishing Co. Ltd., 1976.

5. R. K. Sharma and Shashi K. Gupta, Management Accounting-Principles

and Practice (7th.), New Delhi: Kalyani Publishers, 1996.

COURSE: MANAGEMENT ACCOUNTING

Author: Dr. B.S. Bodla

Course code: MC-105 Vetter: Dr. Karam Pal

Lesson: 3

RATIO ANALYSIS

Objective: To make appropriate decisions in keeping with the objectives of the

firm, the financial manager must have analytical tools. The financial

ratio analysis which is the subject matter of this chapter is such a tool.

After going through this chapter, the students must be capable of

analysing the financial data using ratio analysis.

Lesson Structure

3.1. Introduction to financial analysis

3.2. Use of financial ratios

3.3. Precaution in using ratio analysis

3.4. Types of ratios

3.4.1. Liquidity ratios

3.4.2. Debt (or leverage) ratios

3.4.3. Coverage ratios

3.4.4. Profitability ratios

3.4.5. Market-value ratios

3.5. Illustrative problems

3.6. Summary

3.7. Review questions

3.8. Suggested readings

3.1. Introduction to Ratio Analysis

To evaluate the financial performance of a company, the financial ratios are used as a

very sophisticate tool. But, the type of analysis varies according to the specific

interests of the party involved. Trade creditors are interested primarily in the liquidity

of a firm. Their claims are short term, and the ability of a firm to pay these claims is

best judged by means of a thorough analysis of its liquidity. The claims of

bondholders, on the other hand, are long term. Accordingly, they are more interested

in the cash-flow ability of the company to service debt over the long run. The

bondholder may evaluate this ability by analyzing the capital structure of the firm, the

major sources and uses of funds, its profitability over time, and projections of future

profitability.

Investors in a company’s common stock are concerned principally with present and

expected future earnings and the stability of these earnings about a trend, as well as

their covariance with the earnings of other companies. As a result, investors might

concentrate their analysis on a company’s profitability. They would be concerned

with its financial condition insofar as it affects the ability of the company to pay

dividends and to avoid bankruptcy. In order to bargain more effectively for outside

funds, the management of a firm should be interested in all aspects of financial

analysis that outside suppliers of capital use in evaluating the firm. Management also

employs financial analysis for purposes of internal control. In particular, it is

concerned with profitability on investment in the various assets of the company and in

the efficiency of asset management.

3.2. Use of Financial Ratios

For analysing the financial condition and performance of a company, the financial

analyst needs certain yardsticks. The yardstick frequently used is a ratio, or index,

relating two pieces of financial data to each other. Analysis and interpretation of

various ratios should give experienced, skilled analysts a better understanding of the

financial condition and performance of the firm than they would obtain from analysis

of the financial data alone.

The analysis of financial ratios involves two types of comparison. First, the analyst

can compare a present ratio with past and expected future ratios for the same

company. The current ratio (the ratio of current assets to current liabilities) for the

present year end could be compared with the current ratio for the preceding year end.

When financial ratios are arrayed on a spreadsheet over a period of years, the analyst

can study the composition of change and determine whether there has been an

improvement or deterioration in the financial condition and performance over time.

The above is termed as trend analysis. Financial ratios also can be computed for

projected, or pro forma, statements and compared with present and past ratios. In the

comparison over time, it is best to compare not only financial ratios but also the few

figures.

The second method of comparison involves comparing the ratios of one firm with

those of similar firms or with industry averages at the same point in time. Such a

comparison gives insight into the relative financial condition and performance of the

firm. Sometimes a company will not fit neatly into an industry category. In such

situations, one should try to develop a set, albeit usually small, of peer firms for

comparison purposes.

3.3. Precaution in using Ratio Analysis

The analyst should avoid using rules of thumb indiscriminately for all industries. For

example, the criterion that all companies should have at least a 2-to-1 current ratio is

inappropriate. The analysis must be in relation to the type of business in which the

firm is engaged and to the firm itself. The true test of liquidity is whether a company

has the ability to pay its bills on time. Many sound companies, including electric

utilities, have this ability despite current ratios substantially below 2 to 1. It depends

on the nature of the business. Only by comparing the financial ratios of one firm with

those of similar firms can one make a realistic judgement.

Similarly, analysis of the deviation from the norm should be based on some

knowledge of the distribution of ratios for the companies involved. If the company

being studied has a current ratio of 1.4 and the industry norm is 1.8, one would like to

know the proportion of companies whose ratios are below 1.4. If it is only 2 per cent,

we are likely to be much more concerned than if it is 25 per cent. Therefore, we need

information on the dispersion of the distribution to judge the significance of the

deviation of a financial ratio for a particular company from the industry norm.

Comparisons with the industry must be approached with caution. It may be that the

financial condition and performance of the entire industry is less than satisfactory, and

a company’s being above average may not be sufficient. The company may have a

number of problems on an absolute basis and should not take refuge in a favourable

comparison with the industry. The industry ratios should not be treated as target asset

and performance norms. Rather, they provide general guidelines. For benchmark

purposes, a set of firms displaying ‘best practices’ should be developed.

In addition, the analyst should realize that the various companies within an industry

grouping may not be homogeneous. Companies with multiple product lines often defy

precise industry categorization. They may be placed in the most ‘appropriate’ industry

grouping, but comparison with other companies in that industry may not be

consistent. Also, companies in an industry may differ substantially in size.

Because reported financial data and the ratios computed from these data are

numerical, there is a tendency to regard them as precise portrayals of a firm’s true

financial status. Accounting data such as depreciation, reserve for bad debts, and other

reserves are estimates at best and may not reflect economic depreciation, bad debts,

and other losses. To the extent possible, accounting data from different companies

should be standardized.

3.4. Types of Ratios

Financial ratios can be grouped into five types: liquidity, debt, profitability, coverage,

and market-value ratios. No one ratio gives us sufficient information by which to judge

the financial condition and performance of the firm. Only when we analyze a group of

ratios we are able to make reasonable judgements. We must be sure to take into account

any seasonal character of a business. Underlying trends may be assessed only through a

comparison of raw figures and ratios at the same time of year. We would not compare a

December 31 balance sheet with a May 31 balance sheet, but we would compare

December 31 with December 31.

Although the number of financial ratios that might be computed increases geometrically

with the amount of financial data, we concentrate only on the more important ratios in

this lesson. Computing unneeded ratios adds both complexity and confusion to the

problem. To illustrate the ratios discussed in this lesson, we use the balance sheet and

income statements of a Hypothetical Manufacturing Company shown in Tables 1 and 2.

Table 3.1: Hypothetical Manufacturing Company Balance Sheet

March 31, 2005

(Rs.) March 31, 2004

(Rs.)

Assets

Cash and short-term investments 177689 175042

Accounts receivable 678279 740705

Inventories 1328963 1234725

Prepaid expenses 20756 17197

Deferred income taxes 35203 29165

Current assets 2240890 2196834

Property, plant, and equipment 159686 1538495

Less: Accumulated depreciation 856829 791205

740057 747290

Investment, long term 65376 -

Other assets 205157 205624

Total assets 3251480 3149748

Liabilities and shareholders’ equity

Bank loans and notes payable 448508 356511

Accounts payable 148427 136793

Income taxes payable 36203 127455

Accruals 190938 164285

Current liabilities 824076 785044

Long-term debt 630783 626460

Shareholders’ equity

Common stock (Rs. 5 par value) 420828 420824

Additional paid-in capital 361158 361059

Retained earnings 1014635 956361

Total shareholders’ equity 1796621 1738244

Total liabilities and equity 3251480 3149748

3.4.1. Liquidity ratios

Liquidity ratios are used to judge a firm’s ability to meet short-term obligations. From them,

much insight can be obtained into the present cash solvency of a company and its ability to

remain solvent in the event of adversities. Essentially, we wish to compare short-term

obligations with the short-term resources available to meet these obligations.

Table 2. Hypothetical Manufacturing Company Statement of Earnings

Year ended March

31, 2005 (Rs.)

Year ended march

31, 2004 (Rs.)

Net sales 3992758 3721241

Cost of goods sold 2680298 2499965

Selling, general, and administrative expenses 801395 726959

Depreciation 111509 113989

Interest expense 85274 69764

Earnings before taxes 314282 310564

Provision for taxes 113040 112356

Earnings after taxes 201242 198208

Cash dividends 142968 130455

Retained earnings 58274 67753

Current ratio

One of the most general and most frequently used liquidity ratios is the current ratio:

Current assets

Current liabilities (1)

For Hypothetical Manufacturing Co., the ratio for the 2005 year end is

Rs. 2240890

Rs. 824076 = 2.72

The higher the current ratio, supposedly, the greater the ability of the firm to pay its bills. The

ratio must be regarded as a crude measure of liquidity, however, because it does not take into

account the liquidity of the individual components of the current assets. A firm having

current assets composed principally of cash and current receivables is generally regarded as

more liquid than a firm whose current assets consist primarily of inventories. Consequently,

we must turn to ‘finer’ tools of analysis if we are to evaluate critically the liquidity of the

firm. It is noteworthy that liquidity has been defined as the ability to realize value in money,

the most liquid of assets. Liquidity has two dimensions: (1) the time required converting the

asset into money and (2) the certainty of the price realized. To the extent that the price

realized on receivables is as predictable as that realized on inventories, receivables would be

a more liquid asset than inventories, owing to the shorter time required to convert the asset

into money. If the price realized on receivables is more certain than is that on inventories,

receivables would be regarded as being even more liquid.

Quick ratio

A somewhat more accurate guide to liquidity is the quick, or acid-test, ratio:

Current assets less inventories

Current liabilities (2)

For Hypothetical Co., this ratio is

Rs. 2240890 – Rs. 1328963

Rs. 824076 = 1.11

This ratio is the same as the current ratio, except that it excludes inventories– presumably the

least liquid portion of current assets– from the numerator. The ratio concentrates on cash,

marketable securities, and receivables in relation to current obligations and thus provides a

more penetrating measure of liquidity than does the current ratio.

Liquidity of receivables

Sometimes there are suspected imbalances or problems in various components of the current

assets. In these situations, the financial analyst will want to examine these components

separately in assessing liquidity. Receivables, for example, may be far from current.

Regarding all receivables as liquid when in fact a sizable portion may be past due, overstates

the liquidity of the firm being analyzed. Receivables are liquid assets only insofar as they can

be collected in a reasonable amount of time. For our analysis of receivables, we have two

basic ratios, the first of which is the average collection period:

Receivables × Days in year

Annual credit sales (3)

If we assume for Hypothetical that all sales are credit sales, this ratio is

Rs. 678279 × 365

Rs. 3992758 = 62 days

The average collection period tells us the average number of days receivables is outstanding,

that is, the average time it takes to convert them into cash.

The second ratio is the receivable turnover ratio:

Annual credit sales

Receivables (4)

For Hypothetical Co., this ratio is Rs. 3992758

Rs. 678279 = 5.89

These two ratios are reciprocals of each other. The number of days in the year, 365, divided

by the average collection period, 62 days, gives the receivable turnover ratio, 5.89. The

number of days in the year divided by the turnover ratio gives the average collection period.

Thus, either of these two ratios can be employed.

Year-end versus average receivables- The receivable figure used in the calculation

ordinarily represents year-end receivables. When sales are seasonal or have grown

considerably over the year, using the year-end receivable balance may not be appropriate.

With seasonality, an average of the monthly closing balances may be the most appropriate

figure to use. With growth, the receivable balance at the end of the year will be deceptively

high in relation to sales. The result is that the collection period calculated is a biased and high

estimate of the time it will take for the receivable balance at year end to be collected. In this

case, an average of receivables at the beginning and at the end of the year might be

appropriate if the growth in sales were steady throughout the year. The idea is to relate the

relevant receivable position to the relevant credit sales.

Interpreting the information- The average collection period ratio or the receivable turnover

ratio indicates the slowness of receivables. Either ratio must be analyzed in relation to the

billing terms given on the sales. If the average collection period is 45 days and the terms are

2/10, net 301 the comparison would indicate that a sizable proportion of the receivables is

past due beyond the final due date of 30 days. On the other hand, if the terms are 2/10, net 60,

the typical receivable is being collected before the final due date. Too low an average

collection period may suggest an excessively restrictive credit policy. The receivables on the

books may be of prime quality, yet sales may be curtailed unduly- and profits less than they

might be- because of this policy. In this situation, credit standards for an acceptable account

should be relaxed somewhat. On the other hand, too high an average collection period may

indicate too liberal a credit policy. As a result, a large number of receivables may be past

due- some uncollectible. Here, too, profits may be less than those possible, because of bad-

debt losses and the need to finance a large investment in receivables. In this case, credit

standards should be raised.

Aging of accounts- Another means by which we can obtain insight into the liquidity of

receivables is through an aging of accounts. With this method, we categorize the receivables

at a moment in time according to the proportions billed in previous months. We might have

the following hypothetical aging of accounts receivable at December 31.

Month December November October September August and Total

before

Proportion of

Receivables billed 67% 19% 7% 2% 5% 100%

If the billing terms are 2/10, net 30, this aging tells us that 67 per cent of the receivables at

December 31 are current, 19 per cent are up to 1 month past due, 7 per cent are 1 to 2 months

past due, and so on. Depending on the conclusions drawn from our analysis of the aging, we

may want to examine more closely the credit and collection policies of the company. In the

example, we might be prompted to investigate the individual receivables that were billed in

August and before, in order to determine if any should be charged off. The receivables shown

on the books are only as good as the likelihood that they will be collected. An aging of

accounts receivables gives us considerably more information than the calculation of the

average collection period because it pinpoints the trouble spots more specifically.

Duration of payables

From a creditor’s standpoint, it would be desirable to obtain an aging of accounts payable.

However, few customers are willing to provide such information, and many will resent being

asked. Nonetheless, we often are able to compute the average age of a company’s accounts

payable. The average payable period is

Accounts payable × 365

Purchases (5)

where accounts payable is the average balance outstanding for the year and the denominator

is external purchases during the year.

1 The notation means that the supplier gives a 2 per cent discount if the receivable invoice is paid within 10 days

and that payment is due within 30 days if the discount is not taken.

When information on purchases is not available, one can occasionally use the cost of goods

sold in the denominator. A department store chain, for example, typically does no

manufacturing. As a result, the cost of goods sold consists primarily of purchases. However,

in situations where there is sizable value added, such as with a manufacturer, the use of the

cost of goods sold is inappropriate. One must have the amount of purchases if the ratio is to

be used. Another caveat has to do with growth. As with receivables, the use of a year-end

payable balance will result in a biased and high estimate of the time it will take a company to

make payment on its payables if there is strong underlying growth. In this situation, it may be

better to use an average of payables at the beginning of the year and at the end.

The average payable period is valuable in evaluating the probability that a credit applicant

will pay on time. If the average age of payables is 48 days, and the terms in the industry are

net 30, we know that a portion of the applicant’s payables are not being paid on time. A credit

check of other suppliers will give insight into the severity of the problem.

Liquidity of inventories

We may compute the inventory turnover ratio as an indicator of the liquidity of inventory

Cost of goods sold

Average inventory (6)

For Hypothetical, the ratio is Rs. 2680298

(Rs. 1328963 + Rs. 1234725)/2 = 2.09

The figure for cost of goods sold used in the numerator is for the period being studied-

usually 1 year; the average inventory figure used in the denominator typically is an average

of beginning and ending inventories for the period. The inventory turnover ratio tells us the

rapidity with which the inventory is turned over into receivables through sales. This ratio, like

other ratios, must be judged in relation to past and expected future ratios of the firm and in

relation to ratios of similar firms, the industry average, or both.

Generally, the higher the inventory turnover, the more efficient the inventory management of

a firm. Sometimes a relatively high inventory turnover ratio may be the result of too low a

level o inventory and frequent stockouts. It might also be the result of too many small orders

for inventory replacement. Either of these situations may be more costly to the firm than

carrying a larger investment in inventory and having a lower turnover ratio. Again, caution is

necessary in interpreting the ratio. When the inventory turnover ratio is relatively low, it

indicates slow-moving inventory or obsolescence of some of the stock. Obsolescence may

necessitate substantial write-downs, which, in turn, would negate the treatment of inventory

as a liquid asset. Because the turnover ratio is a somewhat crude measure, we would want to

investigate any perceived inefficiency in inventory management. In this regard, it is helpful to

compute the turnover of the major categories of inventory to see if there are imbalances,

which may indicate excessive investment in specific components of the inventory. Once we

have a hint of a problem, we must investigate it more specifically to determine its cause.

3.4.2. Debt (or leverage) ratios

Extending our analysis to the long-term liquidity of the firm (that is, its ability to meet long-

term obligations), we may use several debt ratios. The debt-to-equity ratio is computed by

simply dividing the total debt of the firm (including current liabilities) by its shareholders’

equity:

Total debt

Shareholders' equity (7)

For Hypothetical, the ratio is

Rs. 1454859

Rs. 1796621 = 0.81

When intangible assets are significant, they frequently are deducted from shareholders’

equity.

The ratio of debt to equity varies according to the nature of the business and the volatility of

cash flows. An electric utility, with very stable cash flows, usually will have a higher debt

ratio than will a machine tool company, whose cash flows are far less stable. A comparison of

the debt ratio for a given company with those of similar firms gives us a general indication of

the creditworthiness and financial risk of the firm.

In addition to the ratio of total debt to equity, we may compute the following ratio, which

deals with only the long-term capitalization of the firm:

Long-term debt

Total capitalization (8)

where total capitalization represents all long-term debt, preferred stock, and share-holders’

equity. For Hypothetical, the ratio is Rs. 630783

Rs. 2427404 = 0.26

This measure tells us the relative importance of long-term debt in the capital structure. The

ratios computed here have been based on book-value figures; it is sometimes useful to

calculate these ratios using market values. In summary, debt ratios tell us the relative

proportions of capital contribution by creditors and by owners.

Cash flow to debt and capitalization

A measure of the ability of a company to service its debt is the relationship of annual cash

flow to the amount of debt outstanding. The cash flow of a company often is defined as the

cash generated from the operation of the company. This is defined as earnings before interest,

taxes and depreciation (EBITD). The cash-flow-to-total-liabilities ratio is simply

Cash flow (EBITD)

Total liabilities (9)

For Hypothetical Co., the ratio is Rs. 511065

Rs. 1454859 = 0.35

The cash flow is composed of earnings before taxes, Rs. 314282, plus interest, Rs. 85274,

and depreciation, Rs. 111509. This ratio is useful in assessing the creditworthiness of a

company seeking debt funds.

Another ratio is the cash-flow-to-long-term-debt ratio-

Cash flow (EBITD)

Long-term debt (10)

Here we have the following for Hypothetical Co. Ltd.:

Rs. 511065

Rs. 630783 = 0.81

This ratio is used to evaluate the bonds of a company. The two cash-flow ratios just described

have proven useful in predicting the deteriorating financial health of a company.

This is particularly helpful in corporate restructuring, where heavily levered transactions

occur. Another ratio often used in this regard is total interest-bearing debt plus equity in

relation to operating cash flows. Known as the enterprise value-to-EBITD ratio, it can be

expressed as

Total borrowings + Equity

Cash flow (EBITD) (11)

For Hypothetical Co., this ratio is

Rs. 2875912

Rs. 511065 = 5.63

where bank loans, notes payable, and long-term debt represent total borrowings. The higher

this ratio, the greater the value that is being placed on the securities. Lenders in highly

levered transactions become concerned when the ratio exceeds 8, as the possibility of default

has been found to be significant at this point.

3.4.3. Coverage ratios

Coverage ratios are designed to relate the financial charges of a firm to its ability to service

them. Bond-rating services, such as CRISIL, ICRA, Moody and Standard and Poor’s, make

extensive use of these ratios. Interest coverage ratio

Interest coverage ratio is one of the most traditional of the coverage ratios. The ratio of

earnings before interest and taxes for a particular reporting period to the amount of interest

charges for the period is known as interest coverage ratio. We must differentiate which

interest charges should be used in the denominator. The overall coverage method stresses a

company’s meeting all fixed interest, regardless of the seniority of the claim. We have the

following financial data for a hypothetical company:

Average earnings before interest and taxes Rs. 2,000,000

Interest on senior 7% bonds - 400,000

Rs. 1,600,000

Interest on junior 8% bonds 160,000

The overall interest coverage would be Rs. 2,000,000/Rs. 560,000, or 3.57. This method

implies that the creditworthiness of the senior bonds is only as good as the firm’s ability to

cover all interest charges.

Of the various coverage ratios, the most objectionable is the prior deductions method. Using

this method, we deduct interest on the senior bonds from average earnings and then divide the

residual by the interest on the junior bonds. We find that the coverage on the junior bonds in

our example is 10 times (Rs. 1600000/Rs. 160000). Thus, the junior bonds give the illusion

of being more secure than the senior obligations. Clearly, this method is inappropriate. The

cumulative deduction method, perhaps, is the most widely used method of computing interest

coverage. Under this method, coverage for the senior bonds would be 5 times. Coverage for

the junior bonds is determined by adding the interest charges on both bonds and relating the

total to average earnings. Thus, the coverage for the junior bonds would be Rs. 2000000/Rs.

560000 = 3.57 times. Cash-flow coverage ratios

This ratio involves the relation of earnings before interest, taxes, and depreciation (EBITD) to

interest and to interest plus principal payments. For the cash-flow coverage of interest we

have

EBITD

Annual interest payments (12)

Cash flow is very useful in determining whether a borrower is going to be able to service

interest payments on a loan. Even for highly levered transactions, lenders want a coverage

ratio comfortably above 2.0. The EBITD interest coverage ratio is highly correlated with

bond ratings and the market’s assessment of risk. To be investment grade, that is, AAA, AA,

A, or BBB, the ratio for an industrial corporation usually must be above 4.0.

The limitations of an interest coverage ratio are that a firm’s ability to service debt is related

to both interest and principal payments. Moreover, these payments are not met out of

earnings per se, but out of cash. Hence, a more appropriate coverage ratio relates the cash

flow of the firm to the sum of interest and principal payments. The cash-flow coverage of

interest and principal ratio may be expressed as-

EBITD

Interest + Principal payments [1/(1 - t)]

where t is the income tax rate and principal payments are annual. Because principal payments

are made after taxes, it is necessary to gross them up so that they correspond to interest

payments, which are made before taxes. If the tax rate were 40 per cent and annual principal

payments Rs. 120,000, before-tax earnings of Rs. 200,000 would be needed to cover these

payments. If the company has preferred stock outstanding, the stated dividend on this stock,

grossed up by 1 minus the tax rate, should appear in the denominator of Equation 13.

For measuring the financial risk of a firm, the financial analyst should first compute the debt

ratios as a rough measure of financial risk. Depending on the payment schedule of the debt

and the average interest rate, debt ratios may or may not give an accurate picture of the ability

of the firm to meet its financial obligations. Therefore, it is necessary to analyze additionally

the cash-flow ability of the company to service debt. This is done by relating cash flow not

only to the amount of debt outstanding but also to the amount of financial charges. Neither

debt ratios nor coverage ratios are sufficient by themselves.

3.4.4. Profitability ratios

There are two types of profitability ratios: (i) those showing profitability in relation to sales,

and (ii) those showing profitability in relation to investment. Together these ratios indicate

the firm’s efficiency of operation.

Profitability in relation to sales

Gross profit margin = Sales less cost of goods sold

Sales (14)

For Hypothetical, the gross profit margin is

Rs. 1312460

Rs. 3992758 = 32.9%

Gross profit margin ratio tells us the profit of the firm relative to sales after we deduct the

cost of producing the goods sold. It indicates the efficiency of operations as well as how

products are priced. A more specific ratio of profitability is the net profit margin:

Net profits after taxes

Sales (15)

For Hypothetical, this ratio is

Rs. 201242

Rs. 3992758 = 5.04%

This ratio tells us the relative efficiency of the firm after taking into account all expenses and

income taxes, but not extraordinary charges.

Profitability in relation to investment

The group of profitability ratios relates profits to investments. One of these measures is the

rate of return on equity, or the ROE:

Net profits after taxes – Preferred stock dividend

Shareholders' equity

For Hypothetical Co., the rate of return is

Rs. 201242

Rs. 1796621 = 11.2%

The rate of return on equity tells us the earning power on shareholders’ book investment and

is frequently used in comparing two or more firms in an industry. The figure for share-

holders’ equity used in the ratio may be expressed in terms of market value instead of book

value. When we use market value, we obtain the earnings/price ratio of the stock.

A more general ratio used in the analysis of profitability is the return on assets, or the ROA:

Net profits after taxes

Total assets (16)

For Hypothetical Co., the ratio is

Rs. 201242

Rs. 3251480 = 6.19%

ROA ratio is somewhat inappropriate, inasmuch as profits are taken after interest is paid to

creditors. Because these creditors provide means by which part of the total assets are

supported, there is a fallacy of omission. When financial charges are significant, it is

preferable, for comparative purposes, to compute a net operating profit rate of return instead

of a return on assets ratio. The net operating profit rate of return may be expressed as

Earnings before interest and taxes

Total assets (17)

Using this ratio, we are able to abstract from differing financial charges (interest and

preferred stock dividends). Thus, the relationship studied is independent of the way the firm

is financed. Assets turnover ratio

Generally, the financial analyst relates total assets to sales to obtain the asset turnover ratio:

Sales

Total assets (18)

Hypothetical Co. turnover for the 2005 fiscal year was

Rs. 3992758

Rs. 3251480 = 1.23

Assets turnover ratio tells us the relative efficiency with which the firm utilizes its resources

in order to generate output. It varies according to the type of company being studied. A food

chain has a considerably higher turnover, for example, than does an electric utility. The

turnover ratio is a function of the efficiency with which the various asset components are

managed: receivables as depicted by the average collection period, inventories as portrayed

by the inventory turnover ratio, and fixed assets as indicated by the plant or the sales to net

fixed asset ratio. Earning power

When we multiply the asset turnover of the firm by the net profit margin, we obtain the return

on assets ratio, or earning power on total assets:

Earning power = Sales

Total assets × Net profits after taxes

Sales (19)

Net profits after taxes

Total assets

For Hypothetical Co., we have

Rs. 3992758

Rs. 3251480 × Rs. 201242

Rs. 3992758 = 6.19%

None of these two ratios (the net profit margin and the turnover ratio) by itself provides an

adequate measure of operating efficiency. The net profit margin ignores the utilization of

assets, whereas the turnover ratio ignores profitability on sales. The return on assets ratio, or

earning power, resolves these shortcomings. An improvement in the earning power of the

firm will result if there is an increase in turnover, an increase in the net profit margin, or both.

Two companies with different asset turnovers and net profit margins may have the same

earning power. Firm A, with an asset turnover of 4 to 1 and a net profit margin of 3 per cent,

has the same earning power – 12 per cent- as firm B, with an asset turnover of 11

2 to 1 and a

net profit margin of 8 per cent.

Another way to look at the return on equity (ROE) is

ROE = Earning power × ⎟

⎟

⎠

⎞

⎜

⎝

⎛+Equity

Debt

1 (20)

In this equation, earning power is grossed up by the equity multiplier associated with the use

of debt. For Hypothetical Co.

ROE = 6.19% × 1.81 = 11.20%.

With all the profitability ratios, comparing one company with similar companies is valuable.

Only by comparison are we able to judge whether the profitability of a particular company is

good or bad, and why. Absolute figures provide insight, but relative performance is most

revealing. 3.4.5. Market-value ratios

We do find several widely used ratios that relate the market value of a company’s stock to

profitability, to dividends, and to book equity.

Price/earnings ratio

The price/earnings ratio of a company is simply

P/E ratio =

Share price

Earnings per share (21)

Here, earnings per share (EPS) usually are the trailing 12 months of earnings. However,

security analysts sometimes use estimated EPS for the next 12 months. Suppose Hypothetical

Manufacturing Company has a share price of Rs. 38. With a par value of Rs. 5 per share at

2005 fiscal year end in Table 1, there are 84165600 shares outstanding. Therefore, earnings

per share are earnings after taxes divided by number of shares outstanding, or Rs.

201242000/84165600 = Rs. 2.39. The P/E ratio for Hypothetical Co. is

Rs. 38.00

Rs. 2.39 = 15.9 times

In fact, the P/E ratio is considered as one measure of relative value. The higher this ratio, the

more the value of the stock that is being ascribed to future earnings as opposed to present

earnings. That is to say, likely future growth is what is being valued. During the last 20 years,

the P/E ratio for Standard and Poor’s 500 stock indexes has ranged from 8 to 28. The ratio

reflects a number of things including interest rates, growth expectations for stocks in general.

Dividend Yield

The dividend yield for a stock relates the annual dividend to share price. Therefore,

Dividend yield =

Dividends per share

Share price (22)

Going to Tables 1 and 2, we determine that dividends per share for the 2005 fiscal year are

Rs. 1.70. Therefore, the dividend yield for Hypothetical is

Rs. 1.70

Rs. 38.00 = 4.47%

Noteworthy it is that companies with good growth potential retain a high proportion of

earnings and have a low dividend yield, whereas companies in more mature industries pay

out a high portion of their earnings and have a relatively high dividend yield. Hypothetical

Co. falls in the latter category. Market-to-Book Ratio

The final market-value ratio we consider relates market value per share to book value

M/B ratio =

Share price

Book value per share (23)

where M/B ratio is the market-to-book value ratio. Going again to Table 1, we divide

shareholders’ equity by the number of shares outstanding to get a book value per share of Rs.

21.35. Therefore, for Hypothetical Co., we have

M/B ratio =

Rs. 38.00

Rs. 21.35 = 1.78

The market-to-book value ratio is a relative measure of how the growth option for a company

is being valued vis-à-vis its physical assets. The greater the expected growth and value placed

on such, the higher this ratio. M/B ratios for established companies range from as little as 0.5

to as high as 8.0. The former often is associated with a company that earns less than what the

financial markets require, a harvest situation, and the latter with a company that earns

substantially more through industry attractiveness and/or competitive advantage.

3.5. Illustrative problems

Problem 1. X Co. has made plans for the next year. It is estimated that the company will

employ total assets of Rs. 8, 00,000; 50 per cent of the assets being financed by borrowed

capital at an interest cost of 8 per cent per year. The direct costs for the year are estimated at

Rs. 4, 80,000 and all other operating expenses are estimated at Rs. 80,000. The goods will be

sold to customers at 150 per cent of the direct costs. Tax rate is assumed to be 50 per cent.

You are required to calculate: (i) net profit margin; (ii) return on assets; (iii) assets turnover

and (iv) return on owners’ equity.

Solution.

The net profit is calculated as follows:

Rs. Rs.

Sales (150% of Rs. 4, 80,000) 7, 20,000

Direct costs 4, 80,000

Gross profit 240000

Operating expenses 80,000

Interest charges (8% of Rs. 4, 00,000) 32,000 1, 12,000

Profit before taxes 1, 28,000

Taxes (@ 50%) 64,000

Net profit after taxes 64,000

(i) Net profit margin = Profit after taxes

Sales = Rs. 64000

Rs. 720000 = 0.089 or 8.9%

(ii) Return on assets = EBIT (1 - T)

Assets = 160000 (1 - 0.5)

800000 = 0.10 or 10%

(iii) Assets turnover = Sales

Assets = Rs. 720000

Rs. 800000 = 0.9 times

(iv) Return on equity = Net profit after taxes

Owners' equity = Rs. 64000

50% of Rs. 800000

Rs. 64000

Rs. 400000 = 0.16 or 16%

Problem 2. The total sales (all credit) of a firm are Rs. 6, 40,000. It has a gross profit margin

of 15 per cent and a current ratio of 2.5. The firm’s current liabilities are Rs. 96,000;

inventories Rs. 48,000 and cash Rs. 16,000. (a) Determine the average inventory to be carried

by the firm, if an inventory turnover of 5 times is expected? (Assume a 360-day year), (b)

Determine the average collection period if the opening balance of debtors is intended to be of

Rs. 80,000? (Assume a 360-day year).

Solution.

(a) Inventory turnover = Cost of goods sold

Average inventory

Since gross profit margin is 15 per cent, the cost of goods sold should be 85 per cent of the

sales.

Thus, Cost of goods sold = 0.85 × Rs. 640000 = Rs. 544000.

Rs. 544000

Av. inventory = 5

Average inventory =

Rs. 544000

5 = Rs. 1, 08,800

(b) Average collection period: Average debtors

Credit sales × 360

Average debtors = (op. debtors + cl. Debtors)/2

Closing balance of debtors is found as follows:

Current assets (2.5 of current liabilities) Rs. 2, 40,000

Less: Inventories Rs. 48,000

Cash 16,000 64,000

∴ Debtors Rs. 1, 76,000

Average debtors = (Rs. 1, 76,000 + Rs. 80,000)/2 = Rs. 1, 28,000

Average collection period = Rs. 128000

Rs. 640000 × 360 = 72 days

Problem 3. The following figures relate to the trading activities of Hind Traders Limited for

the year ended 30th June, 2004:

Table 3. Hind Traders Limited _________________________

Rs. Rs.

Sales 15,00,000 Administrative expenses

Purchases 9,66,750 Salaries 81,000

Opening stock 2,28,750 Rent 8,100

Closing stock 2,95,500 Stationery, postage, etc. 7,500

Sales returns 60,000 Depreciation 27,900

Selling and distribution expenses Other charges 49,500

Salaries 45,900 Provision for taxation 1,20,000

Advertising 14,100 Non-operating income

Travelling 6,000 Dividend on shares 27,000

Non-operating expenses Profit on sale of shares 9,000

Loss on sale of assets 12,000

You are required to (1) rearrange the above figures in a form suitable for analysis, and (2)

show separately the following ratios: (i) gross profit ratio; (ii) operating ratio; (iii) stock

turnover ratio.

Solution.

Table 4. Hind Traders Ltd. _______________________________

Profit and Loss Statement

Rs.

Sales (less returns) 15, 00,000

Less: Cost of goods sold:

Opening stock 2, 28750

Purchases 9, 66,750

11, 95,500

Less: Closing stock 2, 95,500 9, 00,000

Gross profit 6, 00,000

Operating expenses

Selling and distribution expenses 66,000

Administrative expenses 1, 74,000 2, 40,000

Operating net profit 3, 60,000

Non-operating income 36,000

Non-operating expenses 12,000 24,000

Profit before tax 3, 84,000

Provision for taxes 1, 20,000

2, 64,000

(a) Gross profit ratio = Rs. 600000

Rs. 1500000 = 0.40 or 40%

(b) Operating ratio =

Cost of goods+Operating expenses

Sales = Rs. 1140000

Rs.1500000 = 0.76 or 76%

Average stock = Rs. 900000

Rs. 262125 = 3.43 times

Problem 4. Towards the end of 2004 the directors of Wholesale Merchants Ltd. decided to

expand their business. The annual accounts of the company for 2004 and 2005 may be

summarised as follows:

Table. Wholesale Merchants Ltd _______________________________

Financial statements (Rs.)

Year 2004 Year

2005

Sales:

Cash 42,000 44,800

Credit 3,78,000 4,78,800

4,20,000 5,23,600

Cost of sales 3,30,400 4,17,200

Gross margin 89,600 1,06,400

Expenses:

Warehousing 18,200 19,600

Transport 8,400 14,000

Administration 26,600 26,600

Selling 15,400 19,600

Debenture interest - 2,800

68,600 82,600

Net profit 21,000 23,800

Fixed assets (Less: depreciation) 42,000 56,000

Current assets

Stock 84,000 1,31,600

Debtors 70,000 1,14,800

Cash 14,000 1,68,000 9,800 2,56,200

Less: Current liabilities 70,000 1,06,400

Net current assets 98,000 1,49,800

Net assets 1,40,000 2,05,800

Share capital 1,05,000 1,05,000

Reserves and undistributed profit 35,000 58,000

Debenture loan - 42,000

Capital employed 1,40,000 2,05,800

You are informed that: (a) All sales were from stocks in the company’s warehouse. (b) The

range of merchandise was not changed and buying prices remained steady throughout the two

years. (c) Budgeted total sales for 2002 were Rs. 3, 90,000. (d) The debenture loan was

received on 1st January 2002, and additional fixed assets were purchased on that date.

You are required to state the internal accounting ratios that you would use in this type of

business to assist the management of the company in measuring the efficiency of its

operation, including its use of capital.

Your answer should name the ratios and give the figures (calculated to one decimal place) for

2004 and 2005, together with possible reasons for changes in the ratios for the two years.

Ratios relating to capital employed should be based on the capital at the end. Ignore taxation.

Solution. The following ratios are calculated for Wholesale Merchants Ltd.:

Table. Ratios for wholesale merchant ltd. _____________________

Ratios (Rs. ‘000) Year

2004

(Rs’ 000) Year 2005

1. Net margin: EBIT/Sales 21,000/4,20,000 5.0% 26,600/5,23,600 5.1%

2. Sales to capital employed 4,20,000/1,40,000 3.0 times 5,23,600/2,05,800 2.5 times

3. Return on capital employed:

EBIT/CE

21,000/1,40,000 15.0% 26,600/2,05,800 12.9%

4. Gross margin: gross profit/sales 89,600/4,20,000 21.3% 1,06,400/5,23,600 20.3%

5. Expenses (excluding interest) to

sales

68,600/4,20,000 16.3% 79,800/5,23,600 15.2%

6. Stock turnover: CGS/Stock 3,30,400/84,000 3.9 times 4,17,200/1,31,600 3.2 times

7. Debtors turnover: credit 3,78,000/70,000 5.4 times 4,78,800/1,14,800 4.2 times

sales/debtors

8. Current ratio: CA/CL 1,68,000/70,000 2.4 times 2,56,200/1,06,400 2.4 times

9. Quick ratio: CA-Stock/CL 84,000/70,000 1.2 times 1,24,600/1,06,400 1.2 times

10. Long-term debt-equity 0 42,000/1,63,800 0.3

Note: EBIT for 2004 and 2005 respectively is: Rs. 21,000 + 0 = Rs. 21,000 and Rs. 23,800 + 2,800 = Rs. 26,600.

Comments. The return on capital employed has fallen from 15% in 2004 to 12.9% in 2005.

The reason lies in the sales to capital ratio which has also fallen in 2005. The increase in

capital employed has not been profitably utilised. The increased capital seems to have been

blocked in stock and debtors.

It will be noticed that the gross margin ratio decreased from 21.3% in 2004 to 20.3% in 2005.

This may be attributed to reduced selling price or granting of trade discounts on bulk orders.

The operating ratio (expense to sales ratio) has fallen in 2004 by 1% and this had a slight

impact on net profit ratio which has increased by 0.1%.

The short-term solvency of the company, reflected by current ratio and quick ratio, is more or

less constant. However, there has been deterioration in the stock turnover and debtors

turnover ratios. This implies the company is holding stocks for longer periods and allowing

longer credit periods to customers.

There is no threat to the long-term solvency of the company. It did not use any long-term debt

in 2004. A debenture loan of Rs. 42,000 is taken in 2005 and is about 0.26 of the equity

funds. By a normal criterion, the company could have a debt equity ratio of 2: 1.

3.6. Summary

Financial ratios can be derived from the balance sheet and the income statement. They are

categorized into five types: liquidity, debt, coverage, profitability, and market value. Each

type has a special use for the financial or security analyst. The usefulness of the ratios

depends on the ingenuity and experience of the financial analyst who employs them. By

themselves, financial ratios are fairly meaningless; they must be analyzed on a comparative

basis.

A comparison of ratios of the same firm over time uncovers leading clues in evaluating

changes and trends in the firm’s financial condition and profitability. The comparison may be

historical and predictive. It may include an analysis of the future based on projected financial

statements. Ratios may also be judged in comparison with those of similar firms in the same

line of business and, when appropriate, with an industry average. From empirical testing in

recent years, it appears that financial ratios can be used successfully to predict certain events,

bankruptcy in particular. With this testing, financial ratio analysis has become more scientific

and objective than ever before, and we can look to further progress in this regard.

3.7. Review questions

1. Explain the need for the financial analysis. How does the use of ratios help in

financial analysis?

2. Is it possible for a firm to have a high current ratio and still find difficulties in paying

its current debt? Explain with illustration.

3. What are the leverage, or capital-structure, ratios? Explain the significance and

limitations of the debt-equity ratio as a measure of the firm’s solvency?

4. Why is it necessary to calculate the profitability ratios in relation to sales? Illustrate

your answer.

5. Explain the calculation and significance of the various measures of rate of return on

investment.

6. Explain the ratios which you, as an analyst, will focus your attention to in the

following cases:

(i) A bank is approached by a company for a loan of Rs. 50 lakh for working-

capital purposes.

(ii) A company requests a financial institution to grant a 10-year loan of Rs. 5

crore.

7. Which of the financial ratios of a company would you most likely refer to in each of

the following situations? Give reasons.

(i) The company asks you to sell material on credit.

(ii) You are thinking of investing Rs. 25,000 in the company’s debentures.

(iii) You are thinking of investing Rs. 25,000 in the company’s shares.

8. “A higher rate of return on capital employed implies that the firm is managed

efficiently.” Is this true in every situation? What or why not?

9. Ratios are generally calculated from historical data. Of what use are they in assessing

the firm’s future financial condition?

10. A firm’s sales are Rs. 4, 50,000, cost of goods sold is Rs. 2, 40,000 and inventory is

Rs. 90,000. What is its turnover? Also, calculate the firm’s gross margin.

11. The only current assets possessed by a firm are: cash Rs. 1, 05,000, inventories Rs. 5,

60,000 and debtors Rs. 4, 20,000. If the current ratio for the firm is 2-to-1, determine

its current liabilities. Also, calculate the firm’s quick ratio.

12. High-Low Plumbing Company sells plumbing fixtures on terms of 2/10 net 30. Its

financial statements over the last 3 years follow:

Amount (Rs.)

2003 2004 2005

Cash 30,000 20,000 5,000

Accounts receivable 200,000 260,000 290,000

Inventory 400,000 480,000 600,000

Net fixed assets 800,000 800,000 800,000

1,430,000 1,560,000 1,695,000

Accounts payable 230,000 300,000 380,000

Accruals 200,000 210,000 225,000

Bank loan, short term 100,000 100,000 140,000

Long-term debt 300,000 300,000 300,000

Common stock 100,000 100,000 100,000

Retained earnings 500,000 550,000 550,000

1,430,000 1,560,000 1,695,500

Sales 4,000,000 4,300,000 3,800,000

Cost of goods sold 3,200,000 3,600,000 3,300,000

Net profit 300,000 200,000 100,000

Using the ratios taken up in the chapter, analyze the company’s financial condition and

performance over the last 3 years. Are there any problems?

13. Assume that a firm has owners’ equity of Rs. 1, 00,000. The ratios for the firm are:

Current debt to total debt 0.40

Total debt to owners’ equity 0.60

Fixed assets to owners’ equity 0.60

Total assets turnover 2 times

Inventory turnover 8 times

Complete the following balance sheet, given the information above.

Liabilities Rs. Assets Rs.

Current debt …….. Cash ……..

Long-term debt …….. Inventory ……..

Total debt …….. Total current assets ……..

Owners’ equity …….. Fixed assets ……..

Total capital …….. Total assets ……..

3.8. Suggested readings

1. Jain and Khan: Management Accounting, TMH, Delhi.

2. Pandey, I.M.: Financial Management, Vikas Publishing House, Delhi.

3. Periasamy, P.: Financial, Cost and Management Accounting, HPH, Delhi.

4. Maheshwari, S.N.: Accounting for Management and Control, Sultan Chand and Sons,

Delhi.

5. Van Horne: Financial Management and Analysis, Pearson Publication, Delhi.

Objectives: After readings this chapter you will be able to: prepare a

statement of changes in working capital; make out a statement of

sources and application of funds; and understand that why non-cash

transactions do not affect funds.

Lesson Structure:

4.1 Introduction

4.2 Meaning & Definitions

4.3 Objectives

4.4 Limitations

4.5 Procedure of Preparing Funds Flow Statement

4.5.1 Statement of Changes in Working Capital

4.5.2 Funds Flow Statement

4.6 Parties Interested in Funds Flow Statement

4.7 Typical Items Which Require Particular Care

4.8 Self Assessment Questions

4.9 Suggested Readings

4.1 INTRODUCTION

The balance sheet and income statement are the traditional basic financial statements

of a business enterprise. Balance sheet gives the summary of the firm’s resources and

obligations at a point of time; profit & loss account reflects the results of the business

Subject: Management Accounting

Subject Code: 105 Author: Ashish Garg

Lesson No: 4

Vetter: Dr B S Bodla

FUNDS FLOW STATEMENT

operations by summarizing revenue and expenses during a period of time. While they

do furnish useful financial data regarding operations, a serious limitation of these

statements is that they do not provide information regarding changes in the firm’s

financial position during particular period of time. They fail to provide the information

regarding causes of changes or the movements of finances between two-time period or

determine the various causes that lead changes in financial position of a concern.

Therefore, an additional statement should be prepared to show the

changes in assets, liabilities and owner’s equity between dates of two

balance sheets. Such a statement referred to as the statement of

changes in financial positions. The statement of changes in financial

position overcomes these limitations of basic financial statements. The

most commonly used forms of the statement of changes in financial

position are called the Funds Flow Statement and the Cash Flow

Statement. Present chapter is oriented on the concept of Funds Flow

Statement

4.2 MEANING & DEFINITIONS

The Funds Flow Statement is combination of three words Funds, Flow and

Statement.

Funds mean working capital. There are mainly two concepts regarding the meaning

of the working capital. First, the broad concept according to which working capital

refers to the gross working capital and represents the amount of funds invested in

current assets. Thus, the gross working capital is the capital investment in total current

assets of the enterprise. Current assets are those assets, which in the ordinary course

of business can be converted onto cash within a short period of time normally one

accounting year. Second, the narrow sense, which termed working capital as the

excess of current asset over current liabilities or that part of the current asset, which is

financed by the long-term source of finance. In case of the Funds Flow Statement we

will use the narrow concept of the working capital.

Flow means movement. It we take the flow of funds it means changes in the position

of the funds due to any transaction. As a result of the transaction the funds may

increase or decrease. The increase in funds is called funds inflow and if funds

decrease, it is called funds outflow. The one important point to be noted here is that

the flow of funds only occurs when a transaction affects on the one hand a non current

account and on the other a current account and vice-versa. If a transaction only two

current account or only two non-current accounts then flow of funds does not take

place because here funds means the difference of the current assets and current

liabilities.

Statement means the written description about some thing or a detail note, which

provide the informations. The Funds Flow Statement means a summary of the sources

and uses of the working capital.

Definitions:

“A statement of sources and application of funds is a technical device designed to

analyze the changes in the financial condition of a business enterprise between two

dates.” Foulke

According to I.C.W.A. “Funds Flow Statement is a statement either

prospective or retrospective, setting out the sources and applications

of the fund of an enterprise. The purpose of the statement is to

indicate clearly the requirement of funds and how they are proposed

to be raised and the efficient utilization and application of the same.”

Anthony defines the Funds Flow Statement as

the sources from which additional funds were derived and the use to

which these sources were put.

Thus, Funds Flow Statement is a statement, which indicates various means by which

the funds have been obtained during a certain period and the ways to which these

funds have been used during that period.

4.3 OBJECTIVES OF FUNDS FLOW STATEMENT

As it is clear form the above discussion the main objective of the Funds Flow

Statement is to know the sources and applications of the funds within a specific time

period. Some other questions are also there which can be sorted out by the help of

Funds Flow Statement. These questions are:

• What happened to the net profit? Where did they go?

• How the higher dividend can be paid in case of shortage of funds?

• What are causes of the shortage of fund in spite of higher profit?

• How the fixed assets have been financed?

• How the obligations are fulfilled?

• How was the increase in working capital financed and how it will be

financed in future?

Importance of funds flow statement is as follows:

1. Provide the information regarding changes in funds position

Funds Flow Statement provides the infomations regarding the funds, from

where they have procured and where they have invested meanwhile two

specific dates.

2. It helps in the formation of future dividend policy

Sometimes a firm has sufficient profit available for distribution as dividend

but yet it may not be advisable to distribute dividend for lack of liquid or cash

resources. In such cases, funds flow statement helps in the formation of a

realistic dividend policy.

3. It helps in proper allocation of resources

The resources of a concern are always limited and it wants to make the best

use of these resources. A projected funds flow statement constructed for the

future helps in making managerial decisions. The firm can plan the

deployment of its resources and allocate them among various applications.

4. It act as future guide

A projected funds flow statement also acts as a guide for future to the

management. The management can come to know the various problems it is

going to face in near future for want of funds. The firm’s future needs of funds

can be projected well in advance and also the timing of these needs. The form

can arrange to finance these needs more effectively and avoid future problems.

5. It helps in appraising the use of working capital

It helps to appraise the performance of a financial manager in utilization of the

working capital and also suggested the right way to use the working capital

efficiently.

6. It helps to the overall credit worthiness of a firm

The financial institutions and banks such as SFI, IDBI, IFCI etc. all ask for

funds flow statement constructed for a number of years before granting loans

to know the creditworthiness and paying capacity of the firm. Hence, a firm

seeking financial assistance firm these institutions has no alternative but to

prepare funds flow statements.

7. It helps to know about the utilization of the sources

It also provides the information to the managers and the

another interested parties that the sources they have collected

or provided where they have allocated.

4.4 LIMITATIONS

The funds flow statement also suffers from some of the limitations, which are as

follows:

1. Prepared from the final statements: The funds flow statement is prepared

with the help of final statements. So all the limitations of the final

statements are inherent in it.

2. Only rearrangement: The funds flow statement is only the rearrangement

of the data provided by the final statements so this is not providing the

actual figure and facts.

3. Past oriented: The funds flow statements provides only the historical

information. They are not guiding about the future.

4. Working capital oriented: It concentrates on the concept of the working

capital and show the position of the working capital in the concern while

changes in cash are more important and relevant for financial

management than the working capital.

5. Periodic in nature: It only reveals the changes in the working capital

position in the concern between to specific dates. It cannot reveal

continuous changes.

6. Not a substitute: It is not a substitute of an income statement or a balance sheet, it

provide only some additional information as regards changes in working capital.

4.5 PROCEDURE FOR PREPARING FUNDS FLOW STATEMENT

Funds flow statement can be prepared by comparing two balance sheets and other information

derived from various accounts as may be needed. While preparing the funds flow statement mainly

two statements are prepared:

1) Schedule of Changes in Working Capital

2) Funds Flow Statement

4.5.1 SCHEDULE OF CHANGING IN WORKING CAPITAL

As earlier stated, here we are using the narrow concept of the working capital it means

working capital means the surplus of current assets over current liabilities. This

statement is made to recognize the changes in the amount of working capital among

the dates of two balance sheets. This statement is prepared by deriving the values of

current assets and current liabilities from the balance sheet. Current assets are those

assets, which can be converted into cash into a short time period in the ordinary

course of the business. Similarly current liability means those obligations, which are

to be fulfilled in a short time period, generally a financial year.

The schedule of changes in working capital can be prepared by comparing the balance

sheets of two dates. Firstly we have to recognize the current assets and current

liabilities of the concern and then compare them between two dates if the current

assets of current year are more than the previous year that is recognized as an increase

in working capital or vice-versa. On the other hand if current liabilities of current year

is more than the previous year it will recognize as decrease in working capital or vice-

versa because Working Capital = Current Assets – Current Liabilities.

Figure 4.1 shows that if two current accounts increases and decreases simultaneously

it puts no effect on the working capital but if any transaction affects a current account

or a non-current account it affects the position of the working capital of concern.

The Performa of the Schedule of Changes in Working Capital is as follows.

Schedule of Changes in Working Capital

Changes in Working Capital

Particulars Previous Year Current Year Increase Decrease

Current Assets:

Cash in Hand

DECREASE INCREASE CURRENT

ACCOUNTS NON-CURRENT

ACCOUNTS

NO IMPACT IMPACT

IMPACT NO IMPACT

CURRENT ACCOUNTS

NON-CURRENT ACCOUNTS

FIG 4.1: EFFECT OF CHANGES IN ACCOUNTS ON WORKING CAPITAL

Cash at Bank

Sundry Debtors

Temporary Investment

Stock/Inventories

Prepaid Expenses

Accrued Income

Total Current Assets

Current Liabilities:

Bills Payable

Sundry Creditors

Outstanding Expenses

Bank Overdraft

Short-term Advances

Dividend Payable

Proposed Dividend*

Provision for Taxation*

Total Current Liabilities

Working Capital (CA-CL)

Net Increase/Decrease

Working Capital

* Proposed dividend and Provision for taxation may be considered as

current liabilities or long-term liabilities. If they are considered as current

liabilities then these will be shown in Schedule of changing in working

capital.

Illustration 4.1: Prepare a Statement of change in working capital from the

following Balance Sheet of Rohan Steel Co.

Balance Sheet of Rohan Steel Ltd. as on 31st Dec.

Liabilities 2003 2004 Assets 003 2004

Creditors 15,000 18,000 Cash 11,200 8,500

Bills Payable 10,000 7,500 Debtors 21,300 23,500

Loan on Mortgage 40,000 40,000 Stock 35,000 30,600

Capital 50,000 45,000 Sinking Find Investment 16,000 12,000

Sinking Fund 16,000 12,000 Land 10,000 10,000

Profit & Loss a/c 13,950 16,275 Building 60,000 60,000

Provision for Doubtful Debts 1,350 1,425 Furniture & Fixture 8,000 7,000

Depreciation Fund 15200 11400

1,61,500 1,51,600 1,61,500 1,51,600

Solution:

Schedule in Changes in Working Capital

2003 2004 Changes in Working

Increase Decrease

Current Assets:

Cash 11,200 8,500 2,700

Debtors less provision 19,950 22,075 2,125

Stock 35,000 30,600 4,400

Total 66,150 61,175

Current Liabilities

Creditors 15,000 18,000 3,000

Bills Payable 10,000 7,500 2,500

Total 25,000 25,500 10,100 4,625

Working Capital (CA-CL) 41,150 35,675

Increase in Working Capital 5,475 5,475

41,150 41,150 10,100 10,100

4.5.2 FUNDS FLOW STATEMENT

Funds flow statement is a statement, which shows the sources and application of the funds during

a particular time period. This statement shows that during that period from where the funds

have been procured and where have been invested. This statement can be prepared in two forms:

1) Report Form

2) T Form or Account Form

Specimens of the both of the form are as follows:

Specimen of T Form of Funds Flow Statement (for the year ended ……..)

Sources of Funds

Amount

Applications of Funds

Amo

unt

Funds from operations Funds Lost in Operations

Issue of Share Capital Redemption of Preference Share

Raising of Long term Loans Redemption of Debentures

Receipts from partly paid shares Repayment of Long-term loan

Sales of non-current assets Purchase of non-current assets

Non-trading receipts Non-trading payments

Sale of Investment Payment of Dividend*

Decrease in working capital Payment of Tax*

Increase in working capital

*Note Payment of dividend and tax will appear as an application of the funds only when

these items are considered as non-current item. If no thing is specified in question then that

depends on the discretion of the student how to treat these items.

Specimen of Report Form of Funds Flow Statement

Sources of Funds Amount

Funds from operations

Issue of Share Capital

Raising of Long term Loans

Receipts from partly paid shares

Sales of non-current assets

Non-trading receipts

Sale of Investment

Decrease in working capital

Total

Applications of Funds

Funds Lost in Operations

Redemption of Preference Share

Redemption of Debentures

Repayment of Long-term loan

Purchase of non-current assets

Non-trading payments

Payment of Dividend

Payment of Tax

Increase in working capital

Total

Let us put a light on the items of the Funds Flow Statement.

Sources of the Funds

Under this heading we will show all the sources of the funds from where the funds are

procured. These sources can be classified in two categories.

1) Internal Source

2) External Source

1.Internal Source: Funds from Operations is only single internal source of funds. Funds

from operations means the funds obtained by the general business of the organization. It is

equal to the difference of revenue obtained by the sale of goods and the total cost of

manufacturing them. As example if a businessman is selling 1000 units of a good @ Rs. 7 per

unit and the direct and indirect expenses incurred on the production of a unit is Rs. 5 per unit.

Then funds from operations will be 1000 X 7 – 1000 X 5 = Rs. 2000. During the calculation

of funds from operations following things should be considered.

The profit or loss shown by the Profit & Loss a/c is not always equal to the funds from

operations because in the some non-cash items are included in the Profit & Loss a/c, which

does not affect the working capital such as Depreciation and amortization or written off

Preliminary Expenses, Discount on Debentures, goodwill, Patent Rights, Advertisement

Expenses, Underwriting Commission etc. All the expenses, which do not affect the position

of the funds, should be added back in the profit.

With the non cash expenses some exceptional items are also there which are not concerning

with the operations of the business such as profit or loss arise from the sale of fixed assets

and investment and non business incomes such as dividend received, interest received, rent

received, refund of income tax and appreciation in the value of fixed assets etc. These items

should be deducted from the profit to calculate the funds from operations. There are two

methods to prepare the funds from operations, which are as follows:

A) The First method is to proceed from the figure of net profit or net loss as arrived at

from the profit and loss account already prepared. Funds from operations by this

method can be calculated as below.

Calculations if Funds from Operations

Closing balance of P &L A/c or Retained Earning

Add: Non fund and Non operating items which have been already debited

in P &L A/c

1) Depreciation and Depletion

2) Amortization of fictitious or intangible assets such as:

i) Goodwill

ii) Patents

iii) Trade Mark

iv) Preliminary Exp.

v) Discount in Issue of Shares Etc.

3) Appropriation of Retained Earning such as:

i) Transfer to General Reserve

ii) Dividend Equalization Fund

iii) Transfer to Sinking Fund

iv) Contingency Reserve etc.

4) Loss on Sale of any Non Current assets such as:

i) Loss of sale of Land and Building

)

Loss of sale of Machinery

B) The second method is to prepare the Profit & Loss account afresh by taking into

consideration only funds and operational items, which involves funds and are related to

the normal operations of the business. The balancing figure in this case will be either

funds from operation or funds lost in operations depending upon whether income or credit

side of profit and loss a/c exceeds the expenses or debit side of the profit and loss a/c or

vice-versa.

Funds from operations can also be calculated by preparing Adjusted Profit & Loss A/c

Adjusted Profit and Loss Account

Particulars Amount Particulars Amount

To Depreciation & Depletion By Opening Balance of P & L A/c

To Appropriation of retained earnings By Transfer from excess provisions

To Loss on sale of fixed assets By Appreciation in the value of fixed assets

To Dividend By Dividend received

To Proposed Dividend By Profit on the sale of fixed assets

To Provision for Taxation By Funds from Operations

To Closing Balance of P & L A/c

To Funds lost in Operations (B/F)

Let us take an example of the funds from operations.

Illustration 4.2: Following are Balance Sheet of a Limited Co. as on 31st Dec.2003 and

2004. Balance Sheet

Liabilities 2003 2004 Assets 2003 2004

Share Capital 61,000 74,000 Plant 45,000 43,000

Reserves 13,000 15,500 Building 50,950 48,000

Creditors 28,000 24,000 Stock 20,500 18,800

Bank Overdraft 18,000 Debtors 20,000 16,200

Provision for Taxation 8,000 8,500 Cash 150 180

Profit & Loss A/c 8,600 8,800 Cash at Bank 2,100

Goodwill 2,520

1,36,600 1,30,800 1,36,600 1,30,800

Taking into account the following information, calculate funds from operations: -

1) Interim Dividend was paid Rs.2,000.

2) Dividend proposed for Rs. 4,000.

3) Provision of Rs.9,000 was made for Income Tax.

4) Rs. 2000 was written off as depreciation on Plant and Rs.2,950 on Building.

5) Profit on Sale of Fixed Investment Rs. 1,500.

Solution:

Calculation of net profit for 2003

Rs. Rs.

Credit balance of P & L A/c on 31Dec. 2003 8,800

Less: Credit Balance of P& LA/c on 31Dec.2002 8,600

200

Add:

Interim Dividend 2,000

Proposed Dividend 4,000

Provision made for Income Tax 9,000

Provision Made for Reserve 2,500 17,500

Net Profit During the Year 17,700

Calculation of Funds From Operations

Net Profit During the Year 17,700

Add:

Depreciation on Building 2,950

Depreciation on Plant 2,000 4,950

22,650

Less:

Profit on sale of Fixed Investment 1,500

Profit from Business Operations 21,150

The alternative method for calculation of Funds from operations is as follows:

Adjusted Profit and Loss A/c

To Interim Dividend 2,000 By Opening Balance 8,600

To Dividend Proposed 4,000 By Profit on Sale of Investment 1,500

To Provision for Income Tax 9,000 By Profit From Business Operations 21,150

To Provision for Reserve 2,500 (Balancing Figure)

To Plant A/c(Depreciation) 2,000

To Building A/c (Depreciation) 2,950

To Closing Balance 8,800

31,250 31,250

2. External Source: These sources include:

i) Issue of Share Capital: One of the source of collection of the funds is issuance

of the new share that may be preference share issue or equity share issue. Not only

the new issue but also the call made on the partly paid share is also considered as

the source of the funds because it generates inflow of funds. The premium charged

on the time of issue is also considered, as inflow of funds and similarly the

adjustment for the discount provided on the time of issue should be made. If the

shares are issued in respect of another consideration rather than cash then it will

not be considered as a source of funds.

ii) Issue of Debenture and Raising of Loans: Just like the shares issue of debenture

and raising of loans are also a source of funds and the same adjustment regarding

the premium and discount should be made as in case of the issuance of the share.

iii) Sale of the Fixed Assets and Long-term Investments: One can increase the

funds in the concern by selling their investment they have made in different

alternatives and in fixed assets just like plant, machinery, building etc. but one

thing that should be remembered that if the assets are exchanged with rather than

cash that will not a source of funds.

iv) Non-Trading Receipts: Any non-trading receipts just as rent received, interest

received, dividend received and refund of tax or any another non-operating

income generates the inflow of cash will be treated as source of funds.

v) Decrease in Working Capital: If the working capital decreases in comparison of

previous year in the release of funds from the working capital so that will be

termed as source of funds.

Application or Uses of Funds

The other side of the funds flow statement is application of funds that side shows how the

funds procured from different sources are allocated or used. There may be following uses

or applications of the funds:

1) Funds lost in Operations: Sometimes the result of trading in a certain year is a loss

and some funds are lost during that trading period. Such loss of funds means outflow

of funds so that item if treated as an application of funds.

2) Redemption of the Preference Share Capital: A company can’t redeem its equity

share within its life time but can redeem their preference share as the result of

redemption of preference share an outflow of funds takes place. So the redemption of

the shares is written in the application side of the funds flow statement. One thing

should be remembered is that the premium provided on the redemption will also

considered as an application.

3) Repayment of Loans & Redemption of Debentures: As share the repayment of

loans and redemption of debenture also leads a outflow of cash so these items are also

treated as application of the funds.

4) Purchase of any Non-current or Fixed Asset: If the businessman purchases any

fixed asset or making investment for the long time period that will also generate a

outflow of funds and treated as an application of funds. But if the fixed asset is

purchased in exchange of any other consideration rather than cash that will not treated

as application of funds.

5) Payment of Dividend & Tax: Payment of dividend and tax are also applications if

funds. It is the actual payment of dividend and tax, which should be taken as an

outflow of funds and not the mere declaration of the dividend or creation of a

provision for taxation.

6) Any other Non-trading Payment: Any payment or expenses not related to the

trading operations of the business amounts to outflow and is taken as an application of

funds. The examples could be drawing in case of sole trader or partnership firm, loss

of cash.

4.6 PARTIES INTERESTED IN FUND FLOW STATEMENT

Funds flow statement is useful for different parties interested in the

business. They include owner or shareholder, financial institutions,

employees etc.

1. Owners or Shareholders: Owners and Shareholders are interested in ascertaining the

financial position of the concern. Funds flow statement helps them to find out:

i) Whether the business has enough funds to pay dividend at reasonable rates?

ii) Whether the business is in a position to meet its present liabilities in time?

iii) Whether the management is making effective use of funds at their disposal?

2. Financial Institutions: The financial institutions are interested in the

safety of their funds. A careful analysis of the fund flow statement will

help them in ascertaining:

i) Overall creditworthiness of the enterprise.

ii) The resources from which the enterprise will be in a position to

make repayments of the loans taken.

3. Employees: The employees have also a stake in the business. Their

growth and security of job depends upon the profitability of the firm

which is directly related to effective utilisation of the funds by the

enterprise. The employees can ascertain firm the funds flow statement

regarding effective use of funds by the management during a particular

period. The funds should be managed in a manner that the business is in

a position to make payment of salaries to the employees in the time

beside meeting other business costs.

It is a useful practice in business firms to prepare projected funds flow

statement for a number of years to predict the future availability of the

funds and their utilization. All this will help the firm in better planning of

its resources and their utilizations.

4.7 SOME TYPICAL ITEMS WHICH REQUIRE PARTICULAR CARE

The following items require particular care while preparing a funds flow

statement.

1. Digging out the hidden information: While preparing a funds flow

statement one has to analyze the given balance sheet. Items relating

to current account to be shown in the schedule of change in working

capital. But the non-current items have to be further analyzed to fund

out the hidden information in regard to sale or purchased of non

current assets, issue or redemption of share capital, raising or

repayment of long-term loans, transfer to reserves and provisions etc.

the hidden information can be digged out either by preparing working

notes in the statement form or preparing concerned accounts of non-

current assets and non-current liabilities. Both of these methods have

been clarified by following illustration:

Illustration 4.3 The following is the Balance Sheet of Anil Corporations Ltd.

as on 31st Dec. 2003 and 2004. You are required to prepare a Schedule of

Changes in Working Capital and a Funds Flow Statement.

Balance Sheet of Anil Corporation Ltd.

Liabilities 2003 2004 Assets 2003 2004

Share Capital (Paid up): Land & Buildings 60,000 50,000

11% Cumulative Preference Share 30,000 Plant and Machinery 30,000 50,000

Equity Shares 1,10,000 1,20,000Sundry Debtors 40,000 48,000

General Reserve 4,000 4,000 Stock 60,000 70,000

Profit & Loss A/c 2,000 2,400 Bank 2,400 7,000

9% Debentures 12,000 14,000 Cash 600 1,000

Provision for Taxation 6,000 8,400

Proposed Dividend 10,000 11,600

Current Liabilities 49,000 35,600

1,93,000 2,26,000 1,93,000 2,26,000

Solution:

Schedule of Changes in Working Capital

Particulars 2003 2004 Increase Decrease

Current Assets:

Sundry Debtors 40,000 48,000 8,000

Stock 60,000 70,000 10,000

Bank 2,400 7,000 4,600

Cash 600 1,000 400

1,03,000 1,26,000

Current Liabilities:

Current Liabilities 49,000 35,600 13,400

49,000 35,600

Working Capital (CA-CL) 54,000 90,400

Net increase in Working Capital 36,400 36,400

90,400 90,400 36,400 36,400

Funds Flow Statement

Sources Rs. Applications Rs.

Issue of the Preference Shares 30,000 Purchase of Plant and Machinery 20,000

Issue of the Equity Shares 10,000 Provision for Taxation* 6,000

Issue of the Debentures 2,000 Proposed Dividend** 10,000

Sale of the Land and Buildings 10,000 Net Increase in Working Capital 36,400

Funds from Operations 20,400

72,400 72,400

* For 2003 assumed to be paid

** For 2003 assumed to be paid

Working Notes:

1. As current Liabilities are separately given, provision for taxation and proposed

dividend has not been taken as current liabilities.

2. Calculations of Issue of Preference Shares:

Preference share in beginning of 2004 --------

Preference share raised during the year 2004 30,000

Preference share at the end of 2004 30,000

3. Calculation of Issue of Equity Share:

Equity Share Capital In the beginning of 2004 1,10,000

Equity Share Capital at the end of 2004 1,20,000

Equity Share Capital issued during the year 2004 10,000

4. Issue of Debenture:

9% Debenture in the beginning of 2004 12,000

9% Debenture at the end of the year 2004 14,000

9% Debenture issued during the year 2004 2,000

5.Provision for taxation and proposed dividend for 2003 have been presumed

to be paid in 2004.

6.Calculations of Sale of Land and Buildings:

Opening Balance of Land & Building in 2004 60,000

Closing Balance of Land & Building in 2004 50,000

Land and Building purchased during the year 2004 10,000

7.Purchase of Plant & Machinery:

Opening Balance in 2004 30,000

Closing Balance in 2004 50,000

Purchased during the year 20,000

8.Calculation of Funds from Operations:

Closing Balance of P & L A/c in 2004 2,400

Add: Non-fund and Non-operating items

Debited to P & L A/c:

Provision for taxation 8,400

Proposed Dividend 11,600

22,400

Less: Opening Balance of P & L A/c 2,000

Funds from Operations 20,400

2. Investments: The treatment of the investment depends on the nature of the

investment. If the investment is made in short term investment instrument then it is

considered as current assets and shown in the schedule of changing in working

capital. Or if the investment is made in long term instrument then the difference

between opening and closing balance is treated as purchase or sale of investment and

will be shown in the funds flow statement and appropriate adjustment regarding the

profit or loss on sale of investment is made during the calculation of funds from

operations.

3. Provision for Taxation: If the provision for taxation is treated as current liability

then it should be shown in the schedule of changing in working capital. If it treated, as

non-current liability then opening balance will be shown in the funds flow statement

by assuming it as paid for last year and closing balance will be added back in the

profit if it is debited earlier in P & L A/c for calculation of Funds from Operations.

4. Proposed Dividend: Proposed dividend also can be treated in two ways as same as

provision for taxation. And adjustment will be same as in the case of provision for

taxation.

5. Interim Dividend: The expression interim dividend denotes a dividend paid to the

members of the company during a financial year, before the finalization of annual

accounts. The dividend paid or declared in between the two annual general meeting

should be added back while calculating funds from operations. However, if the figure

of profit is taken prior to the debit of interim dividend this adjustment is nor required.

The interim dividend is also an application of funds and has to appear on the

applications side of funds flow statement.

6. Provision against Current Assets: The provision against the current assets either

deducted from their respective opening and closing balances before entering in the

schedule of changes in working capital or the difference between the opening and

closing balance if excess provision has been created may be treated as appropriation

of profit and should be added back while calculating the funds from operations. The

amount of excess provision will not be shown in the schedule of changes in working

capital.

7. Depreciation: depreciation means decrease in the value of an asset due to wear and

tear, lapse of time, obsolesce and accident. Depreciation is taken as an operating

expense while calculating operating profit. When we make the entry of depreciation

profit and loss account is debited while fixed asset account is credited with the

amount of depreciation. Since, both the accounts are non-current accounts so

depreciation is treated as a non-fund item. It is neither a source nor a application of

funds so it is added back to operating profit to find out funds from operations.

Illustration 4.4: The following schedule shows the balance sheets in

condensed form of Bharat Carbons Limited at the beginning and end

of the year:

Particulars 1/1/2002 31-12-2002

Cash 50,409 40,535

Sundry Debtors 77,180 73,150

Temporary Investment 1,10,500 84,000

Prepaid Expenses 1,210 1,155

Inventories 92,154 1,05,538

Surrender Value of Life Policies 4,607 5,353

Land 25,000 25,000

Other Fixed Assets(Including Machinery) 1,47,778 1,82,782

Debenture Discount 4,305 2,867

5,13,143 5,20,380

Sundry Creditors 1,03,087 95,656

Outstanding Expenses 12,707 21,663

4% Mortgage Debentures 82,000 68,500

Accumulated Depreciation 96,618 81,633

Allowance for Inventory Loss 2,000 8,500

Reserve for Contingency 1,06,731 1,34,178

Surplus in P/L A/c 10,000 10,250

Equity Share Capital 1,00,000 1,00,000

5,13,143 5,20,380

Additional Information:

1. Net profit for the year 2002 as P/L A/c is Rs. 49,097.

2. 10% cash dividend was paid during the year.

3. The premium on life policies Rs. 2,773 was paid during the year, which Rs. 1,627 has

been written off from P/L A/c.

4. New machinery was purchased for Rs. 31,365 and machinery costing Rs. 32,625 was

sold during the year. Depreciation on machinery sold had accumulated to Rs. 29,105

at the date of the sale. It was sold as scrap for Rs. 1,500.

5. The Mortgage debentures mature at the rate of Rs. 5,000 per year. In addition to the

above The Company purchased and retired Rs. 8,500 of the debentures at Rs. 103.

Both the premium on retirement and the applicable discount were charged to P/L A/c.

6. The allowance for inventory loss was credited by a charge to expenses in each year to

provide for obsolete items.

7. A debit to reserve for contingencies of Rs. 11,400 was made during the year. This

was in respect of settlement of past tax liability.

You are required to prepare a statement showing the sources and applications of funds for the

year 2002.

Solution:

Statement of Changes in Working Capital

Particulars 1/1/2002 31/12/02 Increase Decrease

Current Assets:

Cash 50,409 40,535

9,874

Sundry Debtors 77,180 73,150 4,030

Temporary Investment 1,10,500 84,000 26,500

Prepaid Expenses 1,210 1,155 55

Inventories 92,154 1,05,538 13,384

3,31,453 5,20,380

Current Liabilities:

Sundry Creditors 1,03,087 95,656 7,431

Outstanding Expenses 12,707 21,663 8,956

Allowance for Inventory Loss 2,000 8,500 6,500

1,17,794 1,25,819

Working Capital 2,13,659 1,78,559

Net Decrease in W.C. 35,100 35,100

2,13,659 2,13,659 59,915 59,915

Note :

1) Surrender value of the life insurance policy is not considered as a current asset.

2) Allowance for inventory loss which is a provision against the current asset has been treated

as a current liability like provision for doubtful debts not to be an appropriation of profits.

Statement of Sources and Applications of Funds for the year ended 31/12/02

Sources Rs. Applications Rs.

Funds from Operation 68,957 Redemption of debentures 13,755

Sale of Machinery as scrap 1,500 Purchase of machinery 31,365

Net Decrease in W.C. 35,100 Purchase of other fixed assets 36,264

Payment of life insurance premium 2,773

Payment of Tax 11,400

Payment if Dividend 10,000

1,05,557 1,05,557

Working Notes:

4% Mortgage Debentures A/c

To Cash 5,000 By Balance b/d 82,000

To cash 8,755 By Adjusted P/L A/c(Premium) 255

To Balance c/d 68,500

82,255 82,255

Other Fixed Assets (including machinery)

To Balance b/d 1,47,778By Accumulated Depreciation 20,105

To Cash(Purchase) 31,365 By Cash (Sale) 1,500

To Cash(Purchase)balancing figure 36,264 By Adjusted P/L A/c(loss) 2,020

BY Balance c/d 1,82,782

2,15,407 2,15,407

Accumulated Depreciation A/c

To Other Fixed Assets A/c 29,105By Balance b/d 96,618

To Balance c/d 81,633By Adjusted P/L A/c(b/f) 14,120

1,10,738 1,10,738

Reserve for Contingency A/c

To Tax Paid 29,105 By Balance b/d 1,06,731

To Balance c/d 1,34,178By Adjusted P/L A/c(b/f) 28,847

1,45,578 1,45,578

Debenture Discount A/c

To Balance b/d 4,305 By Adjusted P/L A/c(b/f) 1,438

By Balance c/d 2,867

4,305 4,305

Life Policy A/c

To Balance b/d 4,607 By Adjusted P/L A/c 1,627

To Cash (Premium Paid) 2,773 By Adjusted P/L A/c 400

( Rs 1,627 given to be transferred to

P/L A/c and Rs.400 B/F being excess

of book value over surrender value)

By Balance c/d 5,353

7,380 7,380

Adjusted Profit & Loss A/c

To 4% Mortgage debenture a/c By Balance b/d 10,000

Premium on redemption 255 By Funds From Operation 68,957

To Accumulated Dep. A/c 14,120

To Other Fixed Assets A/c- loss on sale 2,020

To Reserve for Contingency A/c 38,847

To Debenture Discount A/c 1,438

To Dividend 10,000

To Life Insurance Policy 2,027

To Balance c/d 10,250

78,957 78,957

Note: If allowance for Inventory Loss is not treated as a currently liability net decrease in

working capital shall be Rs. 28,600.

Illustration 4.5: From the following Comparative Balance Sheet and

Income Statement of ABC Ltd. prepare a Statement of Changes in

Financial Position:

ABC Limited

COMPARATIVE BALANCE SHEET

For the year ended 31st Dec. 2003 and 2004

Particular 2003 2004

Current Assets:

Cash 70,000 50,000

Debtors 40,000 45,000

Stock 1,25,000 90,000

Total Current assets 2,35,000 1,85,000

Fixed Asset:

Land and Building 1,50,000 1,00,000

Plant and Machinery 22,000 2,00,000

Less: Accumulated Depreciation 82,000 80,000

Total Fixed Assets 2,88,000 2,20,000

Total Assets 5,23,000 4,05,000

Current Liabilities:

Creditors 25,000 30,000

Salaries Payable 15,000 10,000

Provision for tax 50,000 60,000

Provision for Dividend 40,000 40,000

Total Current Liabilities 1,30,000 1,40,000

Long Term Liabilities:

Bank Loan 23,000 15,000

Debentures 1,20,000 1,50,000

Total Long term Liabilities 1,43,000 1,65,000

Total Liabilities 2,73,000 3,05,000

Owner's Equity:

Share Capital 175,000 75,000

Share Premium 12,500 7,500

Reserve and surplus 62,500 17,500

Total Equities 2,50,000 1,00,000

5,23,000 4,05,000

ABC Limited

Income Statement

For the year ended 31st Dec. 2004

Particulars Rs. Rs.

Sales 5,00,000

Less: Cost of Goods Sold 2,10,000

Gross Profit 2,90,000

Less: Operating Expenses:

Office and Administration Exp. 45,000

Selling and Distribution Exp. 25,000

Interest 12,000

Depreciation 22,000 1,04,000

Operating Profit 1,86,000

Add: Gain on sale of Plant 6,000

Total Profit 1,92,000

Less: Income Tax 85,000

Net Profit 1,07,000

Additional Information:

1) During the year plant Rs. 50,000 (accumulated depreciation Rs. 20,000) was sold

2) The debentures of Rs. 30,000 were converted into share capital at per.

3) The company declared a cash dividend of Rs.40, 000 and a stock dividend of Rs.

20,000 for the year.

4) The company issued 5,000 additional shares, par value Rs.10 per share, at premium of

10% during the year.

Solution:

Schedule of Changes in Working Capital

Particulars 2003 2004 Increase Decrease

Current Assets:

Cash 50,000 70,000 20,000

Debtors 45,000 40,000 5,000

Stock 90,000 1,25,000 35,000

Total Current assets 1,85,000 2,35,000

Current Liabilities:

Creditors 30000 25000 5,000

Salaries Payable 10000 15000 5,000

Provision for tax 60000 50000 10,000

Provision for Dividend 40000 40000

Total Current Liabilities 1,40,000 1,30,000

Working Capital 45,000 1,05,000 70,000 10,000

Increase in Working Capital 60,000 60,000

Total 1,05,000 1,05,000 70,000 70,000

Funds Flow Statement

Sources:

Funds from Operations 1,21,000

Sales of plant 36,000

Loan from bank 8,000

Issue of share 55,000

2,20,000

Applications:

Purchase of land & Building 50,000

Purchase of Plant & Machinery 70,000

Payment of Dividend 40,000

Increase in Working capital 60,000

2,20,000

Note: Stock dividend and debenture converted into share do not find place in a funds flow

statement because these items are not affecting the position of the funds in the concern.

Working Notes: Adjusted Reserve and Surplus A/c

To proposed Dividend 60,000 By Balance b/d 17,500

To accumulated Depreciation 22,000 By Plant and Machinery 6,000

To Balance b/d 62,500 (Profit on Sale)

By Funds from Operations 1,21,000

1,44,500 1,44,500

Plant and Machinery A/c

To Balance b/d 2,00,000By Accumulated Depreciation 20,000

To Adjusted Reserve and Surplus A/c 6,000 By Cash (Sale) 36,000

To Cash (Purchase - B/F) 70,000 By Balance c/d 2,20,000

2,76,000 2,76,000

Accumulated Depreciation A/c

To Plant A/c 20,000 By Balance b/d 80,000

To Balance c/d 82,000 To Adjusted Reserve and Surplus A/c 22,000

(Depreciation)

1,02,000 1,02,000

Further practice can be done with the help of textbooks.

4.8 SELF-ASSESSMENT QUESTIONS

1. What is the Funds Flow Statement? Examine its managerial uses.

2. “Funds flow statement represents a stock to flow linkage”, Justify.

3. Discuss the Procedure of making a Funds Flow Statement.

4. What are the Causes for Change in Working Capital? Discuss.

5. Briefly discuss the meaning, importance and objectives of the Funds Flow

Statement.

6. From the following Balance Sheet of a company you are required to prepare 1) a

statement showing changes in working capital 2) a statement of sources and

applications of the funds.

Balance Sheet

Particular Jan.2003 Jan.2004

Cash 40,000 44,400

Account Receivable 10,000 20,700

Inventories 15,000 15,000

Land 4,000 4,000

Building 20,000 16,000

Equipment 15,000 17,000

Accumulated Depreciation -5000 -2,800

Patents 1,000 900

1,00,000 1,15,200

Current Liabilities 30000 32,000

Bonds Payable 22,000 22,000

Bonds Payable Discount -2,000 -1,800

Capital Stock 35,000 43,500

Retained Earnings 15,000 19,500

1,00,000 1,15,200

Additional Information:

1. Income for the period Rs.10,000

2. A building that cost Rs.4000 and which had a book value of Rs.1000 was sold

for Rs. 1400.

3. The depreciation charge for the period was Rs. 800.

4. There was Rs. 5000 issue of common stock.

5. Cash Dividend Rs. 2000 and a Rs. 3500 stock dividend were declared.

[Ans. Net Increase in working capital: Rs. 13,100 , Source of Funds: Rs. 17,100,

Application of funds: Rs. 4,000 Funds From Operations: Rs. 10,700]

7. A balance Sheet of retained earning of X Ltd. is given below:

Balance of retained earning, 1st Jan. 2003 3,25,600

Add: Net Profit after tax. 6,48,480

Tax Refund 25,470

9,99,550

Less: Loss on sale of Plant & Machinery 14,460

Goodwill written off 95,370

Dividend Paid 4,70,350

5,80,180

Balance of Retained Earning, 31st Dec.2003 4,19,370

Additional Information:

1. Plant and Machinery having a written off value of Rs.54,360 was sold on

Oct. 200.

2. Depreciation of Rs.68,250 has been deducted while arriving at net profit for

the year.

3. Plant and Machinery was purchased during the year at a cost of Rs. 1,60,000

but the payment was made in the form of 8% debentures of Rs. 100 Each for

the same.

4. Rs. 72,800 dentures have been redeemed during year 2003.

You are required to prepare a statement of Sources and Applications of the funds for

the Year ended on 31st Dec.2003.

[Ans. Funds from operations Rs. 7,16,730 Funds flow statement. Rs.7,82,100

increase in the working capital Rs.2,38,950]

8. The following is the Balance Sheet of Sri Krishna Limited:

As on As on As on As on

31/3/2002 Liabilities 31/3/2003 31/3/2002 Assets 31/3/2003

(in Lakhs) (in Lakhs) (in Lakhs) (in Lakhs)

Share capital: 15 Plant 18.00

100.00 Equity Shares of Rs. 100

Each 15.00 6.00 Stock 3.00

9% redeemable preference 15.00 Debtors 10.00

Share of Rs. 100 each Rs.50 1.00 Cash Balance 1.00

5.00 Called up Nil 1.00 Misc. Expenditure 4.00

0.25 Share Premium Nil

Nil Capital Redemption Reserve 5.00

10.00 General Reserve 7.00

2.75 Profit & Loss A/c 3.00

10.00 Other Liabilities 6.00

38.00 36.00 38.00 36.00

Further information furnished:

1. The company declared a dividend of 20% to equity share on 30/6/2002.

2. The company issued notice to preference share for redemption at a premium

of 5% on 1/7/2002 and the entire proceeding were completed before

15/8/2002/in accordance with the law after making a call of Rs. 50 per share,

so as to make shares fully paid.

3. The company provided depreciation at 10% on the closing of Plant. During

the year one plant of book value Rs. 1,00,000 was sold at loss of Rs. 25,000.

4. There was no change in the schedule of debtors as on 31/3/2002. However,

as the company felt that certain debtors were doubtful of recovery, a

provision was made in the account.

5. Miscellaneous expenditure included Es.5 lakh shares issue and other

expenses paid during the year.

Prepare funds flow statement for the year ended 31/3/2003.

[ Ans. Net decrease in working capital. Rs. 4 lakh, funds flow statement

Rs.24,06,250 funds from operations. Rs. 9,31,250]

4.9 SUGGESTED READINGS

1. Pandey, I.M., Management Accounting, Vikas Publishing House, N.Delhi

2. Horngren & Sundem, Introduction to Management Accounting, Prentice Hall of

India, N.Delhi.

3. Anthony R.N. and Reece J.S., Management Accounting Principles, 6th ed.,

Homewood, Illinois, Richard D.Irwin, 1995.

4. Hansen & Mowen, Management Accounting, Thomson Learning, Bombay.

5. Anthony Robert and Hawkins David, Accounting: Text & Cases, McGraw Hill,

1999

6. Mittal, S.N., Management Accounting and Financial Management, Shree Mahavir

Book Depot, N.Delhi.

7. Jain, S.P and Narang, K.L., Advanced Cost Accounting, Kalyani Publishers,

Ludhiana.

8. Gupta, R.L., and Radha Swamy, M, Advanced Accounting, Sultan chand & Sons,

N.Delhi.

9. Khan, M.Y. and Jain, P.K., Management Accounting, TMH, N.Delhi.

Objectives: After reading this chapter you will be able to: prepare a statement of changes

in cash; make out a statement of sources and applications of cash; and

understand that why after a high profit cash position become worst.

Lesson Structure:

5.1 Introduction

5.2 Meaning

5.3 Purpose and Uses

5.4 Structure of Cash Flow Statement

5.5 Treatment of Some Typical Items

5.6 Format of Cash Flow Statement

5.7 Procedure for preparing Cash Flow Statement

5.8 Limitations of Cash Flow Statement

5.9 Comparison between Cash Flow Statement and Funds Flow Statement

5.10 Self-Assessment Questions

5.11 Suggested Reading

Subject: Management Accounting

Subject Code: 105 Author: Ashish Garg

Lesson No: 5 Vetter: Dr. B.S.Bodla

CASH FLOW STATEMENT

100

5.1 INTRODUCTION

The statement of changes in financial position based on working

capital is of immense use in long-range financial planning. The long-

term financing and investment activities are specifically portrayed.

The net working capital requirements are shown as residual figures.

However, the working capital concept may conceal or exclude too

much. It treats increases in inventories and account receivable as

equaling to an increase in bank overdraft. This is not a correct

treatment. In fact, accrued expenses like wages and salaries may

become payable in next 10 days or so: sundry creditor’s bills may fall

due for payment during the next one month, where as bank overdraft

may be for a longer period of, say three months or even more.

Similarly, inventories and account receivables undergo a

transformation before they become money assets. It is possible that

there is sufficient net working capital as revealed by the statement of

changes in financial position, and yet the firm may be unable to meet

its current liabilities as and when they fall due. It may be due to a

sizeable piling up of inventories and an increase in debtors. Caused by

a slow-down in collections. The firm’s failure to meet its short-term

commitments, in spite of its sound long-range financial position and

adequate profitability, may plunge it to technical insolvency.

Therefore, in making plans for the more immediate future, the

management is vitally concerned with a statement of cash flow, which

provides more detailed information. Such a statement is useful for

the management to assess its ability to meet obligation to trade

creditors, to pay bank loans, to pay interest to debenture-holders and

dividends to its shareholders. Furthermore, the projected cash flow

statement prepared month wise or so can be useful in presenting

information of excess cash in some months and shortage of cash in

others. By making available such information in advance the

statement of cash flow enables the management revise its plan. So

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avoid the technical insolvency and to get aware about the short-term

liquidity position management have to make Cash Flow Statement.

5.2 MEANING OF THE CASH FLOW STATEMENT

Cash Flow Statement is a statement that describes the inflow

(sources) and outflow (applications) of cash and cash equivalent in an

enterprise during a specified period of time. Such a statement

enumerates net effect of the various business transactions on cash

and its equivalent and takes into account receipts and disbursement

of cash. Cash flow statement summaries the causes of changes in

cash position of a business enterprise between dates of two balance

sheets. According to AS-3 (revised), an enterprise should prepare a

cash flow statement and should present it for each period for which

financial statements are prepared. The term cash, cash equivalent and

cash flow are used in the statement with the following meanings:

Cash comprises cash on hand and demand deposit with bank.

Cash Equivalents are short term highly liquid investments that are

readily convertible into known amounts of cash and which are subject

to an insignificant risk of changes in value. Cash equivalent are held

for the purpose of meeting short term cash commitments rather than

for investment or other purposes. An investment normally qualifies as

a cash equivalent only when it has a short-maturity, of say, three

months or less from the date of acquisitions.

Cash flow means movement of funds that may be toward outside

called outflow of cash and that may be from outside to inside business

called inflow of cash. In another words flow of cash is said to have

taken place when any transaction makes changes in the amount of

cash and cash equivalent before happening of the transaction.

Cash flows exclude movements between items that constitute cash or

cash equivalent because these components are part of the cash

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management of an enterprise rather than part of its operating,

investing and financing activities. Cash management includes the

investment of excess cash in cash equivalent.

In another words a cash flow statement is a statement depicting

changes in cash position from one period to another. For example, if

the cash balance of a business is shown by its Balance Sheet in 31st

Dec. 2003 at Rs. 20,000 while the cash balance as per its Balance

Sheet on 31St Dec. 2004 is Rs.30,000, there has been an inflow of

cash of Rs.10,000 in the year 2004 as compared to the year 2003. The

cash flow statement explains the reasons for such inflows or outflows

of cash, as the case may be. It also helps management in making

plans for the immediate future. A projected cash flow will be available

to meet obligation to trade creditors, to pay bank loans and to pay

dividend to the shareholders.

5.3 PURPOSE AND USES OF CASH FLOW STATEMENT

The main purpose of the statement of cash flows is to provide relevant

information about the cash receipts and cash payments of an

enterprise during a period. The information will help users of financial

statements to assess the amounts, timing and uncertainty of

prospective cash flows to the enterprise. The statement of the cash

flows is useful to them in assessing an enterprise’s liquidity, financial

flexibility, profitability and risk. It also provides a feedback about the

previous assessments of these factors. Investors, analyst, creditors,

managers and others will find the information in the statement of

cash flows helpful in assessing the following:

1. It is very useful in the evaluation of cash position of a firm.

2. A projected cash flow statement can be prepared in order to know

the future cash position of a concern so as to enable a firm to plan

and coordinates its financial operations properly.

103

3. A comparison of historical and projected cash flow statement can

be made so as to find the variation and deficiency or otherwise in

the performance so as to enable the firm to take immediate and

effective actions.

4. A series of intra firm and inter firm cash flow statement reveals

whether the firm’s liquidity is improving or deteriorating over a

period of time.

5. Cash flow statement helps in planning the repayment of loans,

replacement of fixed assets and other similar long term planning of

cash.

6. Cash flow analysis is more useful and appropriate than funds flow

analysis for short-term financial analysis as in a very short period

it is cash, which is more relevant, then the working capital for

forecasting the ability of the firm to meet its immediate obligations.

7. Cash flow statement prepared according to AS-3 is more suitable

for making comparison than the funds flow statement, as there is

no standards format used for the same.

8. Cash flow statement provides information of all activities classified

under operating, investing and financing activities.

5.4 STRUCTURE OF CASH FLOW STATEMENT

According to AS-3, the cash flow statement should report cash flows

during the period classified by operating, investment and financing

activities as follows:

• Cash flow from operating activities

• Cash flow from investing activities

104

• Cash flow from financing activities

1. Cash flow from operating activities involves cash generated by

producing and delivering goods and providing services. Cash inflow

includes receipts from customers for sales of goods and services

(including collection of debtors). Cash outflow from operating activities

include payments to suppliers for purchase of material and for

services, payment to employees for services and payment to

governments for taxes and duties. Then by comparing the inflow and

outflow of cash we can determine the net value of cash flows. If the

inflows are more than outflows then it is called cash generated from

operating activities or if cash outflows are more than cash inflows

then it is called cash lost in operating activities. This cash flow is a

key indicator of the extent to which the operations of the enterprise

have generated sufficient cash flows to maintain the operating

capability of the enterprise, pay dividend, repay loans and make new

investments without recourse to external sources of financing.

Information about the specific component of historical operating cash

flows is useful, in conjunction with other information, in forecasting

future operating cash inflows.

Examples of cash flows from operating activities are:

• Cash receipts from the sale of goods and rendering the

services.

• Cash receipts from royalties, fees, commission and other

revenue.

• Cash payment to suppliers of goods and services.

• Cash payment to and on behalf of employees.

• Cash receipts and cash payment of an insurance enterprise for

premium and claims, annuities and other policy benefits.

105

Cash payment and refund of income tax unless can be specifically

identified with financing and investing activities.

• Cash receipts and payments relating to futures contract, forward

contracts, option contracts and swap contracts when the contracts

are held for dealing or trading purpose.

Some transactions, such as the sale of an item of plant, may rise to a

gain or loss that is included in the determination of the net profit or

loss. However, the cash flow relating to such transactions are cash

flows from investing activities.

2. Cash flow from investing activities involves the cash generated by

making and collecting loans and acquiring and disposing of debts and

equity instruments and fixed assets. Cash inflows from investing

activities are receipts from collection of loans, receipts from sales of

shares, debts or similar instruments of other enterprises, receipts

from sale of fixed assets and interest and dividend received firm loans

and investments. Cash outflows from investing activities are

disbursement of loans, payments to acquire share debts or similar

instruments of other enterprise and payment to acquire fixed assets.

Cash receipts and payments relating to futures contract, forward

contracts, option contracts and swap contracts except when the

contracts are held for dealing or trading purpose or the payments or

receipts are classified as financing activities.

3. Cash flows from financing activities involves cash generated by

obtaining resources from owners and providing them with a return on

their investment, borrowing money and repaying amounts borrowed

and obtaining and paying for other resources obtained from creditors

on long-term credit. Cash flows from financing activities involve the

proceeding from issuing share or other similar instrument,

debentures, mortgages, bonds and other short term or long-term

borrowings. Cash outflow from financing activities are payments of

106

dividend, payments to acquire or redeem shares to other similar

instruments of the enterprise, payment of amount borrowed, principal

payment to creditors who have extended long-term credit and interest

paid.

It is important to note down that the classification of the cash flows

into operating, investing and financing categories will depend upon

the nature of the business. For example, for financial institutions like

banks lending and borrowing are parts of their business operations.

So the income and expenditure regarding the borrowing and lending

will be included in the cash flow from operating activities.

Figure 5.1 : Structure of Cash Flows

Cash Inflows Activities Cash

Outflows

Receipts from

customers for sale

of goods and

services.

Operating Activities

Payments to suppliers

and employees for

material and services

Payments to

government for taxes

and duties.

Receipts from

sales of assets.

Payment for

107

5.5 TREATMENT OF SOME TYPICAL ITEMS

AS-3 (Revised) has also provided for the treatment of cash flow from

some peculiar items as discussed below:

1) Extraordinary items: The cash flow from extraordinary items just

like winning the lottery, loss by fire etc. either classified as arising

from operating, investing or financing activities as appropriate and

separately disclosed in the cash flow statement to enable users to

understand their nature effect on the present and future cash flows of

the enterprise.

2) Interest and Dividend: A great care have to be taken regarding the

interest and dividend as receivable of the interest and dividend is a

Receipts from sale

of investments

and from

collection of loans

Receipts from

interest and

dividend on loan

and investments

Investing Activities

Receipts from

issuance of

Receipts from

issuance of

debentures

Receipts from

other long-term

borrowing

Financing Activities

Payment for purchase

of investments and for

making of loans

Payment for

dividend on share

capital

Payments for

principal on

debentures and

other borrowin

Payments for

interest on

debenture and

other borrowin

108

result of investment so it is considered as cash inflow from investing

activities while payment of dividend and interest arise due to

collection of finance so it is termed as cash outflow from financing

activities. But in case of a financial institution payment and receipts

of interest and dividend are related to their main business so these

items are treated under the head of cash flow from operating

activities.

3) Taxes on Income: Taxes paid by the business should be treated as

cash outflow generated by operating activities if nothing is stated in

the problem but if it is specified in question that the tax arise due to

financing and investing activities then that tax should be treated

under respective activities.

4) Acquisitions and Disposal of Subsidiaries and other Business

Units: The aggregate cash flows arising from acquisitions and from

disposal subsidiaries or other business units should be presented

separately and classified as investing activities. The separate

presentation of the cash flow effects of acquisitions and disposal of

subsidiaries and other business units as single line items helps to

distinguish these cash flows from other cash flows. The cash flow

effects of disposal are not deducted from those of acquisitions.

5) Foreign Currency Cash Flow: Cash flows arising from transactions in

a foreign currency should be recorded in an enterprise’s reporting

currency by applying to the foreign currency amount the exchange

rate between the reporting currency and the foreign currency at the

date of the cash flow. The effect of the changes in exchange rates on

cash and cash equivalents held in a foreign currency should be

reported as a separate part of the reconciliation of the changes in cash

and cash equivalents during the period.

Unrealized gains and loss arising from changes in foreign exchange

rates are not cash flows. However, the effect of exchange rate changes

on cash and cash equivalent held is reported in the cash flow

109

statement in order to reconcile the value of cash and cash equivalent

at the beginning and the end of the period. This amount is presented

separately from cash flows from operating, investing and financing

activities and includes the difference, if any.

6) Non-Cash Transactions: There are some transactions, which do not

affect the cash positions of the business directly but affect the capital

and asset structure of an enterprise. Such as the conversion of debts

into equity, the acquisitions of an enterprise by means of issue of

shares etc. These transactions should not be included in the cash flow

statement but due to their importance these can be shown as

additional information under the statement.

5.6 FORMAT OF CASH FLOW STATEMENT

AS-3 (Revised) has not provided any specific format for preparing a

cash flow statement. The cash flow statement should report cash flows

during the period classified by operating, investing and financing

activities. A widely used format of cash flow statement is given below.

COMPANY’S NAME:…………………………

Cash Flow Statement

For the year ended…………..

Cash flow from Operating Activities

(List of the individual inflows and outflows) ………...

Net Cash Flow from Operating Activities ………

Cash Flows from Investing Activities

(List of individual inflows and outflows) ……….

Net Cash Flows from Investing Activities ……….

Cash Flows from Financing Activities

(List of individual inflows and outflows) ……….

Net Cash Flows from Financing Activities ……….

Net increase (Decrease) in Cash and Cash Equivalents ……….

Cash and cash Equivalent at the Beginning of the period ……….

Cash and cash Equivalent at the End of the period ……….

Particulars Rs. Rs.

110

5.7 PROCEDURE FOR PREPARING A CASH FLOW STATEMENT

Let us study how to construct the cash flow statement. As shown in the format of the

cash flow statement all the cash inflows and outflows will be classified according to

operating, investing and financing activities. Following are the procedures of the

calculation of cash flow from different activities: -

Determination of cash flow from operating activities: The profit and loss accounts

shows whether an enterprise’s operations have results in profit or loss, but it does not

indicate cash inflows and cash outflows from operating activities. This is because bet

profit is computed using the accrual basis of accounting. Revenue is recorded when

earned although the cash for some of them may not have been collected, and expenses

are recorded when incurred although all of them may not have been paid in cash.

Further, depreciation, amortization and provision for doubtful debts do not reflect

cash outflows in both current and future periods. Thus, the net profit will not indicate

the net cash flow from operations. In order to arrive at net cash flow from operating

activities, it is necessary to restate revenues and expenses on a cash basis. This is done

by adjusting for the effects of transactions considered in preparing the profit and loss

account that did not involve cash inflows or cash outflows. There are two methods for

reporting the net cash flow from operating activities.

1) Direct method

2) Indirect method

1) Direct method: Under this method, cash receipts from operating

activities and cash payments for operating expenses are calculated to

arrive at cash flows from operating activities. The difference between

111

the cash receipts and cash payments is the net cash flow provided by

operating activities. Cash flow from operating activities can be

calculated as follows:

Cash Flow from Operating Activities:

Cash received from customers XXX

Cash paid to suppliers and employees (XXX)

Cash generated from operations XXX

Income tax paid (XXX)

Cash flow before extraordinary item XXX

Extraordinary item (XXX)

Net cash flow from operating activities XXX

Cash received from customers: Cash receipts from customers from

cash sales and collections of debtors arising from credit sales. Cash

sales result in cash inflows in the current period. However, collections

from customers require additional calculations, sales from an earlier

period may be collected in the current period, sales from the current

period may be collected in future period or some debtors may not be

collected at all. As result, collections from customers in current period

are seldom equal to credit sales. The relationship among the credit

sales, change in debtors and collections from customers may be stated

in equation form as follows:

Cash received form customers= Sales + Opening balance of trade debtors (Debtors &

B/R) – Closing balance of trade debtors.

Cash paid to suppliers and employees: After calculation of cash received from

customers the second thing that would be calculated is cash paid to suppliers and

employees in lieu of services and goods received from them. Cash paid to customers

and employees can be calculated by using following equation:

112

Cash Paid to suppliers and employees = Purchases for the year as per statement of

profit + Opening trade creditors (Creditors & B/P) – Closing trade creditors + selling

and administrative expenses + prepaid expenses at the end of the year – prepaid

expenses in the beginning of the year.

Income tax paid: The amount of the income tax paid usually differs from the

estimated income tax expense, appearing on the profit and loss account. Also a part of

the income tax expenses for a year is paid in the following year. The difference

between income tax payment and income tax expense result in a change in income tax

payable. The following equation shows this relationship:

Tax paid during the year = Opening balance of tax unpaid + Provision made during

the year – Closing balance of tax unpaid.

Let us take an example to understand these treatments.

Illustration 5.1: The Board of Director of Amit ltd. was not able to decide that why

the Co. are not having adequate cash balance. The amount of profit of the company

for the year 2003 was Rs. 90,000. This was highest amount as compared to previous

years. You have been asked to prepare a Cash Flow Statement with the help of

following information using direct method.

Balance Sheet

(Rs. in thousands)

Liabilities Dec.2002 Dec.2003 Assets Dec.2002 Dec.2003

Issue and paid up capital 1,575.00 1,575.00 Long term assts 1,125.00 2.047.50

Profit and Loss A/c 157.00 225.00 Closing stock 337.50 900.00

Mortgage Loan 900.00 Prepayments 45.00 90.00

Tax unpaid 22.50 67.50 Trade debtors 112.50 450.00

Trade creditors 315.00 877.50 Cash 450.00 157.50

2,070.00 3,645.00 2,070.00 3,645.00

Statement of Profit

(For the year ended Dec.2003)

113

Particulars Rs. ,000 Rs. ,000

Sales 2,250.00

Opening stock 337.50

Add. Purchases 2205.00

2,542,50

Less Closing stock 900.00 1642.50

Gross profit 607.50

Less:

Administrative expenses 247.50

Depreciation 180.00

Taxes (Provision) 90.00 517.50

Net Profit 90.00

Payment of dividends 22.50

67.50

Add. Profit and loss a/c (Jan.2003) 157.50

Balance on Dec. 2003 225.00

You are also informed that a new building was purchased on 15th June 2003 for Rs.

11,02,500.

Solution:

Cash Flow Statement

(For the year ended 31st Dec.2003)

Particulars Rs., 000 Rs., 000

Cash Flow from Operating Activities

Cash Received from Customers (Note-1) 1,912.50

Cash Paid to Suppliers and Employees (Note-2) (1,935.00)

Cash generated from Operating Activities (22.50)

Income Tax Paid (Note-3) (45.00)

Net Cash Used in Operating Activities (67.50)

Cash Flow from Investing Activities

Purchase of New Building (1,102.50)

Net Cash Used in Investing Activities (1,102.50)

Cash Flow from Financing Activities

Raising of Mortgage Loan 900.00

Dividend Paid (22.50)

Net Cash Provided by Financing Activities 877.50

Net decrease in cash and cash equivalent (292.50)

Opening balance of cash 450.00

Closing balance of cash 157.50

Working Notes:

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1. Calculation of cash received from customers:

Sales for the year as per the statement 2,250.00

Add: Trade debtors in the beginning 112.50

2362.50

Less: Trade debtors at the end 450.00

Cash received from customers 1912.50

2. Calculation of cash paid to suppliers and employees:

Purchase for the year as per the statement of profit 2,205.00

Add: Trade creditors in the begging 315.00

2520.00

Less: Trade creditors at the end 877.50

Cash paid to creditors for purchase of goods (A) 1642.50

Administrative expenses as per the statement of profit 247.50

Add: Prepaid exp. at the end 90.00

337.50

Less: Prepaid Exp. In the begging 45.00

Cash paid for services (B) 292.50

Cash paid to suppliers and employees (A+B) 1,935.00

3.Calculation of tax paid:

Opening balance of tax unpaid 22.50

Add: Provision made during the year 90.00

112.50

Less: Closing balance of tax unpaid 67.50

Tax paid during the year 45.00

3) Indirect Method: Under the indirect method, the net cash flow from

operating activities is determined by adjusting net profit or loss for the

effect of:

i) Non cash items such as depreciation, provision, deferred taxes and

unrealized foreign exchange gains and losses

ii) Changes during the period in inventories and operating receivables and

payables.

iii) All other items for which cash effects are investing or financing flows.

115

The indirect method is also called the reconciliation method as it involves reconciliation of

net profit or loss as given in the profit and net cash flow from operating activities as shown in

the cash flow statement. Cash flow from operating activities by using the indirect method can

be calculated as follows:

Net Profit before Tax and Extraordinary Items XXX

Add: Non-cash and non-operating items, which have already been

Debited to P/L A/c;

Depreciation

Transfer to reserve and provisions

Goodwill written off

Preliminary expenses written off

Other intangible assets written off just as discount or loss on issue of

Shares, debentures and underwriting commission

Loss on disposal of fixed assets

Loss on sale of investment

Foreign exchange loss XXX

XXX

Less: Non-cash and non-operating items, which have already been

Credited to P/L A/c

Gain on the sale of fixed assets

Profit on sale of investment

Income from interest or dividend

Appreciation in values of fixed assets

Reserve written back

Foreign exchange gains (XXX)

Operating profit before adjustment of working capital changes XXX

Adjustment for changes in current operating assets and liabilities:

Add: Decrease in accounts of current assets (except cash and cash equivalents) XXX

Add: Increase in accounts of current operating liabilities (except Bank overdraft) XXX

Less: Increase in accounts of current assets (XXX)

Less: Decrease in accounts of current liabilities (XXX)

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Cash generated from operation before tax

XXX

Less: Tax paid (XXX)

Cash flow before extra-ordinary items XXX

Add/Less: Extra-ordinary items XXX

Net cash flow from operating activities XXX

Let us take an example to clear the above points.

Illustration 5.2: The following are the comparative Balance Sheet of Ashish Ltd. as

on 31st Dec.2003 and 2004.

Balance Sheet

Liabilities 2003 2004

Assets

2003 2004

Share capital

(share of Rs.10 each) 3,50,000 3,70,000 Land 1,00,000 1,50,000

Profit & Loss A/c 50,400 52,800 Stock 2,46,000 2,13,500

9% Debentures 60,000 30,000 Goodwill 50,000 25,000

Creditors 51,600 59,200 Cash & Bank 42,000 35000

Temporary Investment 3,000 4000

Debtors 71,000 84,500

5,12,000 5,12,000 5,12,000 5,12,000

Other particulars provided to you are: A) Dividend declared and paid during

the year Rs.17,500 B) Land was revaluated during the year at Rs. 1,50,000

and profit on the revaluation transferred to P/L A/c. you are required to

prepare a cash flow statement for the year ended 31/12/04.

Solution:

Cash Flow Statement

(for the year ended 31St Dec.2004)

Particulars Rs. Rs.

Cash Flow from Operating Activities

Increase in the balance of P/L A/c 2,400

Adjustment for non-cash and non-operating items:

Profit on revaluation of land (50,000)

Goodwill written off 25,000

Dividend declared 17,500

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Operating profit before working capital changes (5,100)

Adjustment for changes in current operating assets and liabilities:

Increase in creditors 7,600

Decrees in stock 32,500

Increase in debtors (13,500)

Cash generated from operating activities 21,500

Income tax paid --------

Cash flow from extra ordinary items ---------

Net cash flow from operating activities 21,500

Cash flow from investing activities -------- --------

Cash flow from financing activities

Proceeds from issue of share capital 20,000

Redemption of debentures (30,000)

Dividend paid (17,500)

Net cash used in financing activities (27,500)

Net decrease in cash and cash equivalent (6,000)

Cash and cash equivalent at the begging of the year 45,000

Cash and cash equivalent at the end of the year 39,000

5.8 LIMITATIONS OF CASH FLOW STATEMENT

Despite a numbers of uses, cash flow statement suffers from the

following limitations:

1. As cash flow statement is based on cash basis of accounting, it ignores the basic

accounting concepts of accrual basis.

2. Some people feel that as working capital is a wider concept of funds flow

statement provides a more complete picture than cash flow statement. So it is

based on narrow concept.

3. Cash flow statement is not suitable for judging the profitability of a firm as non-

cash charges are ignored while calculating cash flows from operating activities.

5.9 COMPARISON BETWEEN FUNDS FLOW AND CASH FLOW STATEMENT

The term funds have a variety of meaning. In narrow sense it means

cash and the statement of changes in the financial position prepared

on cash basis is called a cash flow statement. In the most popular

sense, the term funds refer to working capital and a statement of

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changes in the financial position prepared on this basis is called a

funds flow statement. A cash flow statement is much similar to a

funds flow statement as both are prepared to summarize the causes of

changes in the financial position of a business. However the following

are the main differences between funds and a cash flow statement.

Difference between Funds Flow Statement and Cash Flow Statement

Basis of Difference Funds Flow Statement Cash Flow Statement

1. Basis of Concept It is based on a wider concept of

funds, i.e. working capital

It is based on a narrow concept of

funds, i.e. cash

2. Basis of Accounting It is based on accrual basis of

accounting.

It is based on cash basis of

accounting.

3. Schedule of changes

in working capital

Schedule of changes in working

capital is prepared to show the

changes in current assets and current

liabilities.

No schedule of changes in

working capital is prepared.

4. Method of Preparing Funds flow statement reveals the

sources and applications of funds.

The net difference between sources

and applications of funds represents

net increase in working capital.

It is prepared by classifying all

inflows and outflows in term of

ing , investing and financing

ies. The net difference represents

t increase or decrease

5. Basis of Usefulness It is useful in planning intermediate

and long term financing.

It is useful in planning intermediate

and long term financing.

6.Discription It describes the reasons for change in

working capital.

It describes the reasons for changes

in cash and cash equivalent.

Illustration 5.3: Western Telecommunication Company’s profit and loss account for the year

ended January 31,2004, and its balance sheet as on Dec.2003 and Dec.2004 are as follows:

Western Telecommunication Company: Profit and Loss Account

(For the year ended Dec. 2004)

Sales Rs 5,70,000

Interest Income 2,000

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Gain on sale of investment 7,000

Cost of goods sold 4,45,000

Depreciation Expenses 89,000

Selling and Distribution Exp. 46,000

Interest Exp. 14,000

Loss on sale of plant and machinery 3000

Profit before income tax and extraordinary items (18000)

Income Tax -----------

Profit before extraordinary items (18,000)

Extraordinary item: Insurance proceeds from Earthquake loss claim ----------

Net Profit (18,000)

WESTERN TELECOMMUNICATION COMPANY: Balance Sheet as on 31St

December

Sources of Funds 2003 2004

Shareholder funds

Equity share capital 1,55,000 85,000

Profit and loss account 1,02,000 1,20,000

Total share holder fund 2,57,000 2,05,000

Loan funds

Secured loans 97,000 57,000

Unsecured loans 1,81,000 1,91,000

Total loan funds 2,78,000 2,48,000

Current liabilities

Bill payable 6,000 9,000

Creditors 24,000 1,78,000

Income tax payable 9,000 17,000

Total current liabilities 39,000 2,04,000

Total source of funds 5,74,000 6,57,000

Applications of funds

Fixed assets

Plant and machinery 7,20,000 5,40,000

Less accumulated depreciation 3,62,000 3,05,000

Fixed assets (net) 3,58,000 2,35,000

Investment 18,000 66,000

Current assets

Inventories 1,51,000 1,19,000

Debtors (less provision of doubtful debts 8,000 & 12,000) 29,000 1,66,000

Prepaid expenses 6,000 2,000

Cash and cash equivalent 12,000 69,000

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Total current assets 1,98,000 3,56,000

Total application of funds 5,74,000 6,57,000

Additional information:

i. Purchased machinery costing Rs.1,50,000 with cash.

ii. Sold machinery with cost of Rs.45,000 and accumulated depreciation of

Rs.32,000 for Rs.10,000.

iii. Purchased investment for Rs. 30,000.

iv. Sold investment costing Rs. 78,000 for Rs.85,000

v. Purchased machinery for Rs 75,000 in exchange for secured debentures.

vi. Issued at par share for Rs. 50,000

vii. Converted secured debentures of Rs. 20,000 to equity share of Rs. 10 at par

viii. Repaid unsecured debentures of Rs. 10,000.

ix. Redeemed secured debentures of Rs. 15,000 at par

x. Wrote off Rs. 14,000 of debtors when a customer become insolvent and provided

Rs. 10,000 for doubtful, included in selling and distribution expenses.

Required

1. Prepare the statement of cash flows according to direct method.

2. Prepare the statement of cash flows according to indirect method.

Solution:

1. Statement of Cash Flows- Direct Method

WESTERN TELECOMMUNICATION COMPANY: Statement

of Cash Flows

(For the year ended Dec.2004)

Cash Flow from Operating Activities

Cash received from customers (I) 6,97,000

Cash paid to suppliers and employees (ii) (674,000)

Cash generated from operations 23,000

Income tax Paid (iii) (8,000)

Cash flow before extraordinary items 15,000

Extraordinary items 0

Net cash provided by Operating Activities 15,000

Cash Flows from Investing Activities

Purchase of plant and machinery (150,000)

Proceeds from sale of plant and machinery 10,000

Purchase of investments (30,000)

Proceeds from sale of investment 85,000

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Interest received 2,000

Net Cash Used in Investing Activities (83,000)

Cash Flows from Financing Activities

Proceeds from Issuance of share capital 50,000

Repayment of unsecured loans (10,000)

Redemption of secured debentures (15,000)

Interest paid (14,000)

Net Cash Provided By Financing Activities 11,000

Net Decrease in Cash and Cash Equivalent (57,000)

Cash and Cash Equivalent at beginning of period 69,000

Cash and Cash Equivalent at end of period 12,000

Supplemental schedule of non-cash investing and financing activities

1. The company purchased for Rs. 75,000 in exchange for secured debentures.

2. The company converted secured debentures of Rs. 20,000 to equity shares of Rs. 10 at

par.

Working Notes:

i. (5,70,000 + 1,78,000 - 37,000 - 14000)

ii. (4,45,000 + 46,000 - 1,19,000 - 2,000 + 9,000 + 1,78,000 + 1,51,000 +

6,000 - 6,000 - 24,000 - 10,000)

iii. (17,000 – 9,000)

2. Statement of Cash Flows – Indirect Method

WESTERN TELECOMMUNICATION COMPANY: Statement

of Cash Flows

(For the year ended Dec.2004)

Cash Flow from Operating Activities (18,000)

Net profit before income tax and extraordinary items

Adjustment to reconcile Net Profit to net cash flow from

Operating Activities

Depreciation 89,000

Provision for doubtful debts 10,000

Loss on sale of plant and machinery 3,000

Gain on sale of investment (7,000)

Interest expenses 14,000

Interest income (2,000)

Operating profit before working capital changes 89,000

Decrease in Debtors 1,27,000

Increase in inventories (32,000)

Increase in Prepaid expenses (4,000)

Decrease in bills payable (3,000)

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Decrease in creditors (154,000)

Cash generated from operations 23,000

Income tax paid (8,000)

Cash flow before extraordinary items 15,000

Extraordinary items: Proceed from Earthquake Insurance

Claim 0

Net Cash Provided by Operating Activities 15,000

Cash Flows from Investing Activities

Purchase of plant and machinery (150,000)

Proceeds from sale of plant and machinery 10,000

Purchase of investments (30,000)

Proceeds from sale of investment 85,000

Interest received 2,000

Net Cash Used in Investing Activities (83,000)

Cash Flows from Financing Activities

Proceeds from Issuance of share capital 50,000

Repayment of unsecured loans (10,000)

Redemption of secured debentures (15,000)

Interest paid (14,000)

Net Cash Provided By Financing Activities 11,000

Net Decrease in Cash and Cash Equivalent (57,000)

Cash and Cash Equivalent at beginning of period 69,000

Cash and Cash Equivalent at end of period 12,000

Supplemental schedule of non-cash investing and financing activities

1.The company purchased for Rs. 75,000 in exchange for secured debentures.

2. The company converted secured debentures of Rs. 20,000 to equity shares of Rs. 10 at

par.

5.10 SELF-ASSESSMENT EXERCISE

1. Define the term ‘Cash Flow’. Explain the objective of cash flow analysis.

2. How does the statement of cash flows differ from the funds flow statement?

3. What is the purpose of statement of cash flows? How is it

prepared? Explain and illustrate.

4. Why is the statement of cash flow considered necessary in addition to the profit and loss

account and balance sheet?

5. Explain the procedure of preparing a cash flow statement.

6. The comparative balance sheet for Varun Ltd. are given below:

Dec.2002 Dec.2003

Assets:

Cash and Bank Balance 82,000 22,000

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Debtors 1,04,000 24,000

Stock 1,12,000 60,000

Prepaid Expenses 22,000 14,000

Plant and Machinery 3,80,000 3,60,000

Goodwill 36,000 40,000

7,36,000 5,20,000

Liabilities:

Creditors 30,000 14,000

Provision for Depreciation 1,00,000 60,000

Debentures 1,02,000 1,02,000

Premium on Debenture Issue 12,000 18,000

Share Capital 1,90,000 90,000

Share Premium 30,000

Reserve and Surpluses 2,72,000 2,36,000

7,36,000 5,20,000

The following additional informations is available from the accounting records for 2002.

1. Debenture premium of Rs. 6,000 was amortized during the year.

2. Dividend paid Rs. 6,000.

You are required to prepare a cash flow statement.

(Answer: Net cash used in operating activities Rs.44,000; Net cash used in investing activities

Rs. 20,000; Net cash provided by financing activities Rs. 1,24,000; net increase in cash and cash

equivalent Rs. 60,000)

7. Prepare a cash flow statement of Anoop Business Corporation from the following

informations:

Balance Sheet

As on Jan, 1st & Dec. 31st 2002

Jan.1 Dec.31

Assets

Cash and Bank 40,000 44,400

Account Receivables 10,000 20,700

Inventories 15,000 15,000

Land 4,000 4,000

Business Premises 20,000 16,000

Plant and Equipment 15,000 17,000

Accumulated Deprecation (5,000) (2,800)

Patents and Trade marks 1,000 900

Total Assets 1,00,000 1,15,200

Liabilities:

Current Liabilities 30,000 32,000

Bonds Payable 22,000 22,000

Bonds Payable Discount (2,000) (1,800)

Capital Stock 35,000 43,500

Retained Earning 15,000 19,500

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Total Liabilities 1,00,000 1,15,200

Additional Information

• Income for the period Rs.10,000.

• A building the cost Rs.4,000 and which had a book value of Rs. 1,000 was sold for

Rs. 1,400.

• Depreciation charged for the year Rs. 800

• There was Rs. 5,000 issue of capital stock

• Cash dividend of Rs. 2,000 and stock dividend of Rs. 3,500 was declared.

(Answer: Net cash operating activities Rs2,000; Net cash used in investing activities Rs. 600;

Net cash from financing activities Rs. 3,000; net increase in cash and cash equivalent Rs. 4,000)

8. From the following particulars, prepare a cash flow statement for the year ended 31st March 2004

i) Total sale for the year were Rs. 20,50,000 out of which cash sales amounted to Rs. 14,20,000.

ii) Total purchases for the year were Rs. 15,30,000 out of which cash purchases amounted to Rs.

10,20,000.

iii) Cash collected from creditors during the year amounted to Rs. 4,80,000.

iv) Cash paid to suppliers was Rs.4, 50,000.

v) Income tax paid Rs. 80,000.

vi) Equity shares of the face value of Rs. 2,00,000 were issued at a premium of 5% during the year.

vii) Rs. 25,000 was paid as dividend for the year ended 31st March 2004.

viii) Redeemable preference share of the face value of Rs. 1,00,000 were redeemed during the year at a

premium of 10%.

ix) New machinery war purchased for Rs. 30,000on 1st Jan. 2004.

x) Depreciation for the year was Rs. 40,000 where as salary and other expenses amounted to Rs.

1,80,000 out of which Rs. 20,000 are outstanding.

xi) The balance of the cash & bank as on 1st April 2003 was Rs. 85000.

(Answer: Net cash flows from operating activities Rs 1,90,000; Net cash used in investing

activities Rs. 30,000; Net cash from financing activities Rs. 75,000; net increase in cash and cash

equivalent Rs. 2,35,000)

9. The following are the Balance Sheets of GOYAL enterprises

Jan.1 Dec.31

Assets

Cash and Bank 5,000 8,000

Account Receivables 35,000 38,000

Inventories 25,000 22,000

Land 20,000 30,000

Business Premises 50,000 5,50,000

Machinery less Dep. 80,000 87,000

125

Delivery van 25,000

Total Assets 2,15,000 2,65,000

Liabilities:

Current Liabilities 35,000 40,000

Loan from Banks 30,000 25,000

Mrs. Goyal’s Loan 20,000

Capital 1,00,000 1,60,000

Hire Purchase vendor 20,000

Total Liabilities 2,15,000 2,65,000

Additional Information

The delivery van was purchased on hire purchase basis on Dec.2003, Payment of Rs. 5,000

was made at the time of agreement and the balance of amount is to be paid in 20 monthly installments

of Rs. 1,000 each together with interest @10% per annum. During the year the proprietor withdraw Rs.

25,000 for household expenses. The provision for depreciation on machinery on 1/1/03 was Rs. 27,000

and on 31/12/03 was Rs. 35,000. You are required to prepare the cash flow statement.

(Ans. Cash operating Profit Rs. 43,000)

5.11 SUGGESTED READINGS

1. Sharma, R.K. & Gupta, Shashi K., Management Accounting, Kalyani Publication,

New Delhi.

2. Horngren & Sundem, Introduction to Management Accounting, Prentice Hall of

India, N.Delhi.

3. Anthony R.N. and Reece J.S., Management Accounting Principles, 6th ed.,

Homewood, Illinois, Richard D.Irwin, 1995.

4. Hansen & Mowen, Management Accounting, Thomson Learning, Bombay.

5. Anthony Robert and Hawkins David, Accounting: Text & Cases, McGraw Hill,

1999

6. Jain, S.P and Narang, K.L., Advanced Cost Accounting, Kalyani Publishers,

Ludhiana.

126

Objective: The present lesson explains the CVP analysis. Further, it discusses the use of

the marginal costing technique for tactical decisions in different

manufacturing concerns.

LESSON STRUCTURE

6.1 Introduction

6.2 CVP Assumptions and Uses

6.3 Break-Even Point and Margin of Safety Equation Method

6.4 Graphical Representation of CVP Relationship

6.5 Marginal Costing Techniques

6.6 Summary

6.7 Self-Test Questions

6.8 Suggested Readings

6.1 INTRODUCTION

It is important for managers to ascertain the cost behavior pattern and use it to

estimate the total cost, total revenues and thereby profits at various sales volumes.

The cost revenue relationship holds for a short period. Therefore, this relationship

cannot be used to estimate long-term performance of the firm. However, this short--

term validity helps to maximise profit with given resources. For the purpose of taking

tactical decisions managers use the marginal costing techniques because these short-

term decisions influence fixed costs. To understand the use of Marginal costing

techniques, we have to study Cost-volume-profit (CVP) analysis. The Cost-volume-

profit (CVP) analysis is the study of the effects on future profit of changes in fixed

COURSE: MANAGEMENT ACCOUNTING

COURSE CODE: MC-105 AUTHOR: SURINDER S. KUNDU

LESSON: 06 VETTER: PROF. H. L. VERMA

MARGINAL COSTING AND PROFIT PLANNING

127

cost, variable cost, sales price, quantity and mix. The aim of CVP analysis is to

estimate the total cost, total revenue and thereby profit of various sales volumes.

Managers use this technique extensively to determine the break-even point and

margin of safety. Break-even point is the level of activity at which there is neither

profit nor loss. Margin of safety ratio indicates the percentage by which forecast

turnover exceeds or falls short of breakeven turnover. The CVP analysis assumes that

output is the only cost and revenue driver.

6.2 CVP ASSUMPTIONS AND USES

The assumptions of the CVP analysis are: (a) Fixed and variable cost patterns can be

established with reasonable accuracy, (b) Total fixed costs and variable cost per unit

will not change during the period under consideration, (c) Selling price will remain

constant at all sales volumes, (d) Factor price per unit (e.g. material prices, wage

rates) will remain constant at all sales volumes, (e) Efficiency and productivity will

remain unchanged during the period under consideration, (f) In a multi-product

situation, sales-mix will remain unchanged during the period, (g) Output is the only

relevant factor affecting costs and revenue, and (h) The volume of production will be

equal to the volume of sales that is accretion decoration to inventory level will be

insignificant during the period.

The uses of CVP analysis are: (a) To determine the 'Break-even point' in terms of

sales volume or sales value, (b) To ascertain the Margin of safety ratio, (c) To

estimate profits or losses at various activity levels, (d) To assess the likely effect of

management decisions such as an increase or a reduction in selling price, adoption of

a new method of production which will reduce fixed costs and increase variable costs

on the profitability of the firm, and (e) To determine the optimum selling price.

6.3 BREAK-EVEN POINT AND MARGIN OF SAFETY EQUATION METHOD

Break-even point is the sales volume or sales value at which the firm neither makes

128

profit nor incurs loss. In other words, at the break-even point, revenue equals total

costs.

6.3.1 Marginal Cost Equation

Revenue - Variable costs - Fixed costs = Operating income

Or S – V – F = P

Or S-V=F+P=C

Where S = revenue, V = total variable cost, C = total contribution F = total fixed cost

6.3.2 Contribution/Sales Ratio (C/S Ratio)

C/S = Total contribution/Total turnover x 100

Or (S-V)/S x 100 or (F+P)/S x 100

The C/S ratio represents the percentage of sales, which contributes towards fixed

costs and operating profit. CVP analysis assumes that C/S ratio does not change with

changes in output or sales volumes. It is also termed as Profit Volume ratio or PV

ratio.

6.3.3 Break-even Sales

In determining break-even sales, we need to know

(a) Fixed costs and (b) Contribution per unit or the C/S ratio.

At break-even point (BEP), total contribution equals fixed costs. Therefore, BEP in

terms of unit is calculated by dividing total fixed costs by contribution per unit. BEP

in terms of sales value is calculated by dividing total fixed costs by the C/S ratio.

Example 6.1: The following information is available from the annual budget of a

company manufacturing only one item.

Budgeted output and sales 5000 units

Budgeted selling price per unit Rs. 40

Budgeted cost per unit:

Material Rs. 15

Direct labour Rs. 5

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Variable overhead Rs. 10

Fixed cost per unit Rs. 5 (35)

Budgeted profit per unit Rs. 5

Calculate the break-even point both in terms of the number of units and sales value.

Solution:

Contribution per unit of the given product is as follows:

Selling price Rs. 40; Variable cost: Material Rs.15; Direct labour Rs.5; Variable

overhead Rs.10 and Contribution margin per unit Rs.10. Fixed cost per unit, included

in the total cost per unit, is the average fixed cost per unit, calculated on the basis of

budgeted fixed cost (total) and budgeted output. Therefore, budgeted fixed cost (total)

= Rs. 5 x 5,000 = Rs. 25,000.

The two factors (e.g. fixed costs and contribution margin per unit) are now known to

us, and, therefore, we can calculate the BEP

BEP = Fixed Cost/Contribution per unit

= 25000/10= 2500 units.

At BEP, total contribution (2,500 x Rs. 10), that is, Rs. 25,000 is equal to fixed

costs.

C/S ratio = C per unit/ Selling price per unit

= 10/40 x 100 =25%.

BEP = Fixed cost/ C/S ratio

= 25000/25% = Rs. 1,00,000.

6.3.4 Margin of Safety

Margin of safety is the difference between the estimated sales and sales at BEP. It

provides very useful information to management, i.e. by how much can sales drop

below the budgeted sales before a loss is incurred. Margin of safety is usually

expressed as a percentage of budgeted sales.

In the example 6.1, margin of safety is (5,000 - 2,500) units or 2,500 units that is 50%

of the budgeted sales.

6.3.5 C/S Ratio and Break-even Point in a Multi-Product Situation

In a multi-product situation, it is not possible to express the break-even point in terms

of units. It is quite likely that different measuring units are used to measure sales

130

quantity of different products. Even if a single unit is used, products may not be

comparable and contribution per unit would be different. Therefore, under a multi-

product situation, BEP is calculated in terms of sale value by using weighted average

C/S ratio. Weight of each product in the sales-mix is used to calculate the weighted

average C/S ratio. The underlying assumption is that the same percentage movement

in sales of all the products in the product-mix accompanies a percentage movement in

total sales.

Break-even point is calculated with the following assumptions: (a) Constant C/S ratio

for each product; (b) Constant sales-mix; and (c) Constant fixed cost. The steps

involved in calculating the break-even points are: (a) Calculate the C/S ratio for each

product; (b) Calculate weighted average C/S ratio in relation to estimated proportion

of sales; and (c) Use the weighted average C/S ratio to calculate break-even point in

terms of sale-value.

Example 6.2: (A) SSK manufactures and sells four types of products under the

brand names A, B, C and D. The sales-mix in value comprises 3

33 %, 3

41 %,

16 % and 3

8 % of A, B, C and D respectively. The total budgeted sales (100%) are

Rs. 60,000 per month. Operating costs are:

Variable costs: Product: A 60% of selling price; B 68% of selling price; C 80% of

selling price; D 40% of selling price; and Fixed cost Rs. 14,700 per month. Calculate

the break-even point for the products on an overall basis.

(B) It has been proposed to introduce a change in the sales mix as follows, the total

sales per month remaining Rs. 60,000:

Product A 25%

B 40%

C 30%

D 5%

Assuming that the proposal is implemented, calculate the break-even point

Solution:

131

C/S ratio for each product

Product Variable cost to sales ratio C/S ratio (100- variable cost to sales ratio)

A 60% 40%

B 68% 32%

C 80% 20%

D 40% 60%

Weighted average C/S ratio:

Product C/S ratio (Percentage)

A 3

33 x 40% 13.33

B. 3

41 x 32% 13.44

C 3

16 x 20% 3.33

D 3

8 x 60% 5.00

Weighted average c/s ratio

BEP = ratioSC

tsFixed

cos = %35

700,14.

Rs = 42,000 per month

Weighted average C/S ratio with changed sales-mix, without any change in individual

C/S ratio.

Weighted average C/S ratio:

Product C/S ratio (Percentage)

A 25% x 40 10.00

B. 40% x 32 12.80

C 30% x 20 6.00

D 5% x 60 3.00

Weighted average c/s ratio

BEP = ratioSC

tsFixed

cos = %80.31

700,14 = 46,226 per month

Proof (Nor required in examination)

Product Old sales-mix New sales-mix

Sales(Rs.) Contribution(Rs.) Sales(Rs.) Contribution(Rs.)

A 60,000 x 3

33 % 20,000 x 40% 60,000 x 25% 15,000 x40%

i.e. 20,000 i.e. 8,000 i.e. 15,000 i.e. 6,000

B 60,000 x

41 25,000 x 32% 60,000 x 40% 24,000 x 32%

i.e. 25,000 i.e. 8,000 i.e. 24,000 i.e. 7,680

132

C 60,000 x 3

16 10,000 x 20% 60,000 x 30% 18,000 x 20%

i.e. 10,000 i.e. 2,000 i.e. 18,000 i.e. 3,600

D 60,000 x 3

8 5,000 x 60% 60,000 x 5% 3,000 x 60%

i.e. 5,000 i.e. 3,000 i.e. 3,000 i.e. 1,800

Total Rs. 60,000 Rs. 21,000 Rs. 60,000 Rs. 19,080

Weighted average C/S ratio Weighted average C/S ratio

000,60

000,21 x 100 i.e. 35% 000,60

080,19 x 100 i.e. 31.80%

6.4 GRAPHICAL REPRESENTATION OF CVP RELATIONSHIP

As an aid to management, CVP analysis is presented in graphical

form. This graph is popularly known as the 'break-even chart'. Break-

even chart can be drawn in many ways. The construction of break-

even chart is exemplified in Graphs 6.1 to 6.5.

Example 6.3: You are given the following data for the coming year for a factory.

Budgeted output 80000 units; Fixed expenses Rs. 400000; Variable expenses per unit

Rs. 10; Selling price per unit Rs. 20; 80,000 units Rs. 4, 00,000. Draw a break-even

chart showing the break-even point. If the selling price be reduced to Rs. 18 per unit,

what will be the new break-even point?

Solution:

Detailed notes: (i) The horizontal axis shows the units of output; (ii) The vertical axis

shows the cost and revenue in terms of value; (iii) The fixed cost line at Rs. 4, 00,000

is assumed to be same at all output levels; (iv) The revenue line (assuming the same

selling price per unit at all output levels) starts at nil and progresses evenly; (v) The

total cost line commences at the fixed cost of Rs. 4, 00,000 (fixed cost is incurred

even at nil production) and increase by the addition of variable cost per unit as output

increases; (vi) The break-even point is the point of intersection (which reads at 40,000

units on the graph) between total cost and revenue lines. This can be proved

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arithmetically. Contribution at 40,000 units is 40,000 x Rs. (20 - 10), i.e. Rs. 4, 00,000

which is equal to the fixed cost; and (vii) Revised revenue (revised on account of

reduction in selling price) shown by dotted line intersects total cost line at an output

of 50,000 units. The new break-even point is 50,000 units.

Graph 6.1: Break-even Chart

Graph 6.2: Break-even Chart with variable cost line

Detailed notes: (i) As in the conventional chart, the horizontal axis shows the units of

output and the vertical axis shows the cost and the revenue; (ii) The variable cost line

starts at nil and progresses evenly as the output increases. The conventional chart does

not show the variable cost line; (iii) Total cost line is parallel to variable cost line; the

gap between the two represents the fixed cost (Rs. 4, 00,000); and (iv) Revenue line

has been drawn in the same way as is drawn on conventional chart.

6.4.1 Volume contribution chart in Graph 6.3 is another way of presenting the

134

break-even point. Information in Example 6.3 has been used to draw the chart.

In this chart the contribution line starts at nil for nil output and progresses

evenly with increase in output. Break-even point is the point of intersection

between the contribution line and the fixed cost line. The advantage of this

method is that several lines at various selling prices and variable costs may be

drawn without the chart becoming too overburdened.

Graph 6.4 shows another method of depicting the break-even point. The horizontal

axis not only shows the sales volume in quantities, it shows the revenue (in rupee)

too. The chart clearly shows the profit or loss area, which starts at Rs. 4, 00,000 below

the break-even line (because Rs. 4, 00,000 being the fixed costs to be recovered to

break-even). Contribution line starts at nil with nil output and progresses evenly with

increase in sales. The point of intersection between the fixed cost line and the

Graph 6.3: Volume contribution chart

Graph 6.4: Volume contribution break-even chart.

135

contribution line shows the break-even point.

The chart with reduction in selling price has to be drawn separately to avoid

confusion. (It will be a good practice for the reader to draw the chart with a reduced

selling price.) The fixed cost line and the revenue line will look the same as in Graph

6.4 except a change in the scale for revenue (Rs.) at the horizontal axis.

6.4.2 Limitation of break-even chart

In actual practice, Break-even charts are quite unlikely to resemble the chart shown

above because underlying assumptions in CVP analysis do not hold good in real-life

situations. The cost and revenue lines are not straight lines. They are rather curvilinear

and the chart might show more than one break-even point. Such a break-even chart

may look like the chart given in Graph 6.5.

6.4.3 Angle of incidence

This is the angle at which the sales line cuts the total cost line (Graphs 6.1 and 6.2). If

the angle is large, the firm (or product) is earning .profit at a high rate. If used in

conjunction with the margin of safety, it indicates an extremely favourable condition.

A small angle of incidence shows that although the firm (or the product) is making

profit, it is being achieved under less favorable conditions.

6.4.4 MULTI-PRODUCT PROFIT GRAPH

When a firm manufactures and sells more than one product of varying profitability; a

Graph 6.5: Curvilinear break- even chart.

136

CVP chart may be drawn to show the relative profitability of different products. This

graph is known as ‘Sequential profit graph’ or ‘Profit path chart’. The following steps

are involved in drawing the graph: (a) The C/S ratio is determined for different

products and products are arranged in order of the descending C/S ratio, i.e. the

product showing the highest C/S ratio is shown first and so on; (b) A statement is

prepared showing the cumulative sales and the cumulative profit; (c) Sales are plotted

on horizontal axis; (d) Fixed cost is plotted on vertical axis below the horizontal axis;

(e) Starting from the fixed cost point a profit path is drawn which terminates at the

profit point reached by the last product; (f) The end of the profit path is connected

with the fixed cost point. This line is called the total profit line; (g) The point of

intersection between the total profit line and the total sale line is called the break-even

point for a group of products.

Example 6.4: A manufacturing company produces three products: P, Q and R. The

following are the results for 2003.

Product Sales (Rs.) Variable cost (Rs.)

P 5000 2000

Q 3000 1800

R 2000 2500

Fixed Costs Rs. 2200

Prepare a marginal cost statement and calculate C/S ratio for the product. Draw a

profit-graph of products and comment on the results.

Solution:

Product P (Rs.) Q (Rs.) R (Rs.) Total (Rs.)

Sales 5,000 3,000 2,000 10,000

Variable cost (2,000) (1,800) (2,500) (6,300)

Contribution 3,000 1,200 (500) 3,700

C/S ratio 100

5000

3000 x 100

3000

1200 x 100

2000

500 x 100

10000

3700 x

= 60% = 40% = 25% = 37%

Break-even point = Fixed cost/ c/s ratio= 2,200/37%= Rs. 5,946.

137

Data for graph

Products are arranged in order of descending C/S ratio.

Product Sales

(Rs.) Cumulative

sales (Rs.) Contribution

(Rs.) Cumulative

contribution

(Rs.)

Fixed

cost

(Rs.)

Cumula

tive

profit

P 5,000 5,000 3,000 3,000 2,200 800

Q 3,000 8,000 1,200 4,200 2,200 2,000

R 2,000 10,000 (500) 3,700 2,200 1,500

Product R’s contribution is negative. Therefore, it should be discontinued, if possible.

The production of P, which has the highest contribution, should be increased.

However, non-cost factors should also be considered before taking the final decision.

6.4.5 Effects of Income Taxes

Generally, we know S-V-F= P or operating income,

After income tax effects, it will

Net income = Operating income - [(Operating income) x (Tax-rate)]

Or Net income = (Operating income) x (1 - Tax rate)

Or Operating income = Net Income/ (1 - Tax rate)

Thus, Revenue - Variable costs - Fixed costs = Net Income/ (1 - Tax rate)

Example 6.5: Football Shoe Company produces different products-all of which has

the same C/S ratio of 20%. The present sale is Rs. 60,000 per month and fixed cost is

Rs. 80,000 per annum. The following information is available from the budgeted

forecasts for the coming year:

Volume of sales No change

Increase in variable cost 5%

Estimated fixed cost Rs. 90,000

You are required to calculate: (a) The present yearly profit and (b) The percentage

increase required in selling prices during the forthcoming budget year in order to

maintain the existing level of profit.

Solution:

(a) The present yearly profit: Rs.

Sales for the current year 60,000 x 12 720000

Variable cost (80% of sales) Contribution (576000)

Fixed cost 144000

138

Present yearly profit (80000)

64000

(b) Percentage increase required in selling price:

Budgeted fixed cost 90000

Required profit 64000

Required contribution 154000

Variable cost (5, 76,000 + 5%) 604800

Required revenue 758800

Increase in price: increase

x%39.5

720000

100)720000758800( =

−

6.4.6 Break-even point and profit planning

Now, in the ensuing examples, we will explain the profit planning decisions.

Example 6.6: A company sells its product at Rs. 15 per unit. In a period, if it

produces and sells 8000 units, it incurs a loss of Rs. 5 per unit; if the volume is raised

to 20000 units, it earns a profit of Rs. 4 per units. Calculate break-even point both in

terms of rupees as well as units.

Solution:

Suppose, the contribution margin is c and fixed cost of F; therefore, contribution on

sale of 8000 units is 8000 c.

Thus,

8000 c = F-8000 x Rs. 5 or 8000c = F-Rs. 40000 (1)

Similarly, on sale of 20000 units, contribution is 20000 c

Thus,

20000c = F + 20000 x Rs. 4 or 20000c = F + Rs. 80000 (2)

Deducting Eq. (1) from Eq. (2) we get:

12000 c = Rs. 120000 or c + Rs. 10

Substituting c = Rs. 10 in Eq., (1) we get F = Rs. 120000

Break-even pointy in units = Rs. 120000/Rs. 10 units = 12000 units,

Break-even point in rupees = 1200 units x Rs. 15 = Rs. 180000.

139

Example 6.7: Indian Traders and Indian Corporation sell the same type of products

in same type of market. Their budgeted profit and loss account for the ending 2003

are as follows:

Indian Traders

Indian Corporation

Rs. Rs. Rs. Rs.

Sales 300000 300000

Variable cost 240000 200000

Fixed costs 30000 (270000) 70000 (270000)

Net Profit 30000 30000

You are required to:

a) Calculated the break-even points of each business; b) Calculated the sales-

volume at which each of the business will earn Rs. 10000 profit; and state which

business is likely to earn greater profit in condition of: Heavy demand for the profit;

and Low demand for the product. Give your reasons.

Solution:

(a) Break-even point

Indian Traders Indian Corporation

(Rs.) (Rs.)

Sales 300000 300000

Variable cost (240000) (200000)

Contribution 60000 100000

C/S ratio= 60000 x 100/300000= 20% 100000x100/ 3000000= 33.33%

Break-even point Rs. 30000 = Rs. 150000 Rs. 70000 = Rs. 21000

20% 33%

(b) Total contribution required:

Fixed costs 30000 70000

Profit required 10000 10000

40000 80000

Rs. 40000/20% Rs. 80000/33.33%

= Rs. 200000 = Rs. 240000

Let the sales volume be a

Profit of Indian Traders: a x 20 % - Rs. 30000 = 0.20 a – 30000

Profit for Indian Corporation: a x 33*1/3 % - Rs. 70000

The profit for both the firms being equal,

0.20a – a/3 – Rs. 30000 + Rs. 70000 = 0 or a = Rs. 300000

140

The C/S ratio of Indian Corporation at 33.33% is higher than that of Indian Traders at

20% Therefore, Indian Corporation will earn a higher profit if the sales volume

exceeds Rs. 300000 level. However, below that level profit for Indian Traders will be

higher. It may be concluded that Indian Corporation is likely to earn a higher profit

under conditions of heavy demand for the product. Similarly, Indian Traders is likely

to earn a higher profit under conditions of low demand for the product.

Example 6.8: Two manufacturing companies, which have the following operating

details, decide to merge.

Company 1

Company 2

Capacity utilization % 90 60

Sale (Rs. Lakh) 540 300

Variable costs (Rs. Lakh) 396 225

Fixed costs (Rs. Lakh) 80 50

Assuming that proposal is implemented, calculate:

(a) Break-even sales of the merged plant and the capacity

utilization at that stage

(b) Profitability of the merged plant at 80% capacity utilization

lakh

(d) When the merged plant is working at a capacity to earn a profit

of Rs. 75 lakh, what percentage increase in selling price is required to

sustain as increase of 5 % in fixed overhead?

Solution: Operating data of the merged plant at 100% capacity:

Company 1 Company 2 Total merged

plant

Capacity 100% 100% 100%

(Rs. lakh) (Rs. lakh) (Rs. lakh)

Sales 54010.90 = 600 30010.60 = 500 1,100

Variable cost 396/0.90 = (440) 22510.60 = (375) (815)

Contribution 160 125 285

Fixed cost (80) (50) ( 130)

Profit 80 75 155

(a) Break-even point of the merged plant:

141

C/S ratio: Contribution x 100/Sales = 285 x 100/1100 = 25.91 %

Break-even point of the merged plant:

Fixed cost of the merged plant/ (c/s ratio) =130/25.91% = Rs. 501.74 lakh

Capacity utilization at break-even level:

= Sale value at break-even level/ Sale value at 100% capacity

= Rs. 501.74 lakh x 100/1100 = 45.6%

(b) Profitability of the merged plant at 80 % capacity utilization:

Sales at 80% capacity utilization = Rs. 1,100 lakh x 80% Rs. 880 lakh

Contribution at 80% capacity = Rs. 880 x 25.91 % Rs. 228 lakh

Fixed cost (Rs. 130 lakh)

Profit Rs. 98 Lakh

Profitability at 80% level 98 x 100/880 = 11.14%

Required contribution: (Rs. 75,000 + 1, 30,000) = Rs. 205 lakh

Sales turnover required: Required contribution

= Rs. 205 lakh = Rs. 781.20

C/S ratio 25:91 %

(d) Required percentage increase in selling price to sustain 5% increase in relaxed

cost:

Fixed cost at current level: Rs. 130 lakh

Increase in fixed cost 5% of Rs. 130 lakh Rs. 6.50 lakh

Hence, additional contribution required Rs. 6.50 lakh

Increase in selling price required =6.5 x 100/791.20 = 0.8215%

Example 6.9: X limited has been offered an order from A Ltd. for 10,000 units of

output @ Rs. 100 each which has a variable cost of Rs. 60 and will involve an outlay

of Rs. 60,000 to set-up jigs and dies. At the same time, there is another offer of B

Ltd., for 8,000 units of output at Rs. 110 each. Variable costs are estimated at Rs. 68

each and involve an outlay of Rs. 50,000 to set-up jigs and dies. Which offer should

the company accept?

Solution:

a) Contribution per units:

Price per unit Rs. 100 Rs. 110

Variable cost per unit (60) (68)

Contribution per unit Rs. 40 Rs. 42

b) Statement of profitability: A Ltd. B Ltd.

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Output of units 10000 8000

Total contribution per unit Rs. 400000 Rs. 336000

Net profit (60000) (50000)

Net profit Rs. 340000 Rs. 286000

Profit from the offer of A Ltd., would be higher as compared to profit from the offer

of B Ltd. Therefore, the offer of A Ltd. should be accepted.

6.5 MARGINAL COSTING TECHNIQUES

Marginal costing technique assumes that fixed costs are given and only variable costs

and revenue can be influenced by short-term managerial actions. Therefore, in the

short-term, profit can be maximised by maximising total contribution, which is the

difference between total revenue and total variable costs. Managers decide the use of

scarce resources to maximise total contribution by evaluating alternative uses of

available resources. Underlying assumptions that fixed costs do not change with

change in the activity level and that there is a linear relationship between revenue and

variable costs, which do not hold good beyond the relevant range. Similarly, in

practice, it is difficult to segregate the total cost into fixed and variable elements

accurately. All these limit the reliability of marginal costing techniques. In spite of

these limitations, the marginal costing technique has emerged as an important

management tool.

6.5.1 PRODUCT MIX

6.5.1.1 Product Profitability

If the same facilities can be used to produce more than one product, contribution per

unit is taken as the profitability index for each product. The assumption is that there is

no limiting factor and there is no limit on the number of units of each product, which

can be produced and sold. In normal absorption costing, fixed costs are apportioned

equitably over products to determine each product's profitability. Apportionment is

based on the estimated usage of common resources by each product. The result may

143

be misleading because it may lead to the conclusion that products, which show a net

loss, should be discontinued.

6.5.1.2 Limiting Factor Analysis

Limiting factor or key factor is defined as anything which limits the activity of an

entity. An entity seeks to optimize the benefit it obtains from the limiting factor.

Examples are a shortage of supply of a resource and a restriction on sales at a

particular price. Limiting factors restrict the number of units that can be produced or

sold. Typical examples of limiting factors are: a) Sales demand in quantity, b) Sales

demand in value, c) A limit to availability of material, d) A limit to availability of a

particular grade of labour, e) A limit to machine capacity, and f) A shortage of

working capital. More than one limiting factor may operate at a particular point in

time. Under such a situation, the factor, which keeps the activity level at the

minimum, should be considered as the key factor. However, the impact of other

factors should also be considered in arriving at the final decision. Optimal utilization

of a scarce resource implies that all the available supply of that resource is used up.

Therefore, the contribution fund can be maximised by maximising the production and

sale of the product, which earns the highest contribution per unit of the limiting factor.

Thus, to determine the optimum production plan, the contribution per unit of the

limiting factor for each product is calculated and products are ranked in descending

order of contribution per unit of the limiting factor.

Example 6.10: A firm can produce two products A and B. The following are the cost

structures:

Product A (Rs.) Product B (Rs.)

Selling price per unit 20 22

Variable manufacturing cost per unit 5 6

Variable selling expenses per unit 3 2

Labour hours per unit 2 3

144

Total available labour hours are 1,200 per week. Assuming that the availability of

labour hours is the only limiting factor, determine which product should be

manufactured and sold.

Solution:

Contribution Statement

Product A Product B

(a) Selling price Rs.20 Rs.22

(b) Variable costs:

Manufacturing 5 6

Selling expenses 3

Total cost per unit Rs. 8

Rs. 8

(d) Labour hours per unit 2 3

(e) Contribution per labour hour (c/d) Rs. 6 Rs. 4.67

If the firm utilizes all the available machine hours to produce product A, it will earn a

total contribution of Rs. 6 x 1,200, i.e. Rs. 7,200. On the other hand, if it uses the

available labour hours to produce product B, it will earn a total contribution of Rs.

4.67 x 1,200, i.e. Rs. 5,600. Therefore, product A should be manufactured. This can

also be verified as follows:

Product A Product B

(a) Available labour hour Rs. 1200 Rs. 1200

(b) Labour hours per unit 2 3

(d) Contribution per unit Rs. 12 Rs. 14

Total contribution (c x d) Rs. 7200 Rs. 5600

These calculations show that product A is more profitable than B. The same result

was reflected by the method of ranking products based on the contribution per labour

hour. Determination of the limiting factor poses problems because it changes rapidly.

A detailed analysis of the economic environment and the supply market of various

resources as well as internal factors are necessary to identify potential limiting factors.

Identification of limiting factors facilitates performance planning. The determination

145

of limiting factor is comparatively simple when only one product is produced or when

more than one product is produced using the same raw materials, labour and other

resources using the same process. However, it becomes very complex when a number

of products are manufactured from a variety of materials with different types of

labour using different types of machines or applying different processes. When there

is more than one limiting factor operating at a particular point in time, the profit

maximising budget could be determined by formulating and solving a linear

programming problem. This is beyond the scope of this book. However, simpler

decision models may be used when activities are restricted by only two limiting

factors.

6.5.2 MAKE OR BUY DECISION

If no limiting factor is in operation, the decision to buy or to manufacture a product

rests on whether the bought-out price of an article is lower than its marginal cost. The

fixed cost is irrelevant for our decision because fixed cost will not change as a result

of buying the product/component from outside. If the bought-out price of an article is

lower than its marginal cost, it will be profitable to buy the article from outside in all

circumstances. The firm will save marginal cost and will spend lower than the

marginal cost to buy the article. If the bought-out price is higher than the marginal

cost, the total cost of production will increase, if the firm decides to buy the article

from outside. Therefore, if it has a choice, it will buy the article for which the

difference between the bought-out price and the marginal cost is the lowest among

article under consideration. If a limiting factor is in operation, the excess of bought-

out price over marginal cost per unit of the limiting factor is to be considered. The

article having the lowest excess of bought out price over its marginal cost per unit of

the limiting factor will be selected for buying out from outside.

146

Example 6.11: The cost of manufacturing and bought-out prices of four articles is as

follows:

Article A B C D

Production cost per article:

Marginal cost Rs. 10.00 Rs. 12.00 Rs. 15.00 Rs. 15.00

Fixed cost 2.00 4.00 5.00 15.00

Total cost 12.00 16.00 20.00 30.00

Production per-man hour 0.25 0.20 0.20 0.33

Production per machine hour 1.00 0.50 0.25 0.20

Bought-out price Rs. 9.00 Rs. 17.00 Rs. 22.00 Rs. 26.00

Rank the products in the order of your preference for buying them from outside (a)

when there is no limiting factor; (b) if man-hour is the limiting factor, (c) if machine

capacity is the limiting factor.

Solution:

Articles A B C D

Bought-out price per unit Rs. 9.00 Rs. 17.00 Rs. 22.00 Rs. 26.00

Marginal cost (per unit) of

production 10.00 12.00 15.00 15.00

Excess of bought-out price

over

marginal cost per article

-1.00 5.00 7.00 11.00

Excess per man-hour -1.00 x 0.25

= - 0.25 5.00 x 0.20

= 1.00 7.00 x 0.20

= 1.40 11.00 x 0.33

= 3.63

Excess per machine hour -1.00 x 1

= -1.00 5.00 x 0.50

= 2.50 7.00 x 0.25

= 1.75 11.00 x 0.20

= 2.20

In case of article A, the bought-out price is lower than the marginal cost, hence to

purchase A from outside is always profitable.

Ranking of products in order of preference for buying out:

(a) When there is no limiting factor 1st A, 2nd B, 3rd C, 4th D

(b) When man-power is the limiting factor 1st A, 2nd B, 3rd C, 4th D

6.5.3 DECISION ON METHODS OF MANUFACTURING

Marginal costing technique can be used to choose from alternative methods of

manufacturing. The method, which generates the highest contribution, is the most

desirable method. The decision, therefore, rests on the contribution per unit or the

contribution per unit of the limiting factor, if a limiting factor is identified.

147

Example 6.12: An undertaking is producing an article, the selling price of which is

Rs. 20 per unit. A decision has to be taken whether:

(a) to produce by hand (Method A); or

(b) to produce by machine, one operator to one machine (Method B); or

(d) to produce by machine, one operator to three machines (Method D).

The cost of manufacturing the article by different methods is as follows:

Method A B C D

Cost per article (Rs.):

Material 1 unit 5.00 5.00 5.00 5.00

Direct labour @ Rs. 3 per man-hour 5.00 3.00 1.70 1.50

Variable overhead @ Rs. 2 per man-hour 3.30 2.00 1.10 1.00

Variable overhead @ Re. 1 per machine-

Hour - 1.00 1.10 1.50

Total marginal cost 13.30 11.00 8.90 9.00

Fixed overhead @ Re. 1 per man-hour 1.70 1.00 0.90 0.50

Fixed overhead @ Rs. 6 per machine-

Hour - 6.00 6.60 9.00

Total cost 15.00 18.00 16.40 18.50

Production per man-hour 0.60 1.00 1.75 2.00

Production per machine-hour - 1.00 0.875 0.66

Solution:

Method A B C D

Selling prices per unit (Rs.) 20.00 20.00 20.00 20.00

Marginal cost per unit (Rs.) (13.30) (11.00) (8.90) (9.00)

Contribution per unit 6.70 9.00 11.10 11.00

Contribution per unit of material

6.70/1

= Rs. 6.70 9.00/1

= Rs. 9.00 11.10/1

= Rs. 11.00 11.00/1

= Rs. 11.00

Contribution per man hour

6.70 x 0.6

= Rs. 4.20 9.00 x 1

= Rs. 9.00 11.10 x 1.75

= Rs. 19.40 11.00 x 2

= Rs. 22.00

Contribution per machine hour

9.00 x 1

= Rs. 9.00 11.10 x 0.875

= Rs. 9.70 11.00 x 0.66

= Rs. 7.30

If there is no limiting factor, Method C should be selected as it generates the highest

contribution per unit. If a limiting factor is in operation, the method to be adopted

should be the one, which gives the highest contribution per unit of the limiting factor.

Thus,

(a) If material is the limiting factor, method C should be adopted.

148

(b) If man-power is the limiting factor, method D should be adopted.

6.5.4 SHUTTING DOWN DECISIONS

Marginal costing technique can be used in deciding whether to discontinue a section

of the business. If we assume that discontinuance will not influence the total fixed

costs of the firm, the decision will hinge on whether the particular section of the

business is contributing towards fixed overheads. Closure of an activity, which

generates positive contribution, reduces the current operating profit or increases the

operating loss. In certain situations, a part of the fixed cost is avoided by temporary

closure. In such a situation, if avoidable fixed cost is higher than expected

contribution, the business segment should be closed.

Example 6.13: A company making a single product has a factory at Howrah (near

Kolkata) and distributes its product through three depots situated in Kolkata, Kanpur

and Chennai. It is estimated that during the year 1, 00,000 units will be manufactured

and sold at a price of Rs. 30 per unit, the sales being spread is as follows:

Kolkata 70,000 units

Kanpur 20,000 units

Chennai 10,000 units

Standard costs of production are:

Direct materials Rs. 6 per unit

Direct wages Rs. 5 per unit

Factory variable overheads 160% of direct wages

Factory fixed overheads Rs. 6, 00,000 per annum

The cost of selling and distribution incurred by the depots are:

Calcutta Kanpur Chennai

Fixed Cost per annum 100000 70,000 30000

Variable cost (% of sales value) 10% 8% 7%

The budget for the business prepared from these figures caused the management to

consider the closure of Kanpur and/or Chennai depots. If this is done, all sales in these

areas will be lost, but sales from the Kolkata depot will remain unaffected.

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You are required to

(a) Prepare a budget for the business from the figures provided; and

(b) Advise the management on the desirability of closing down Kanpur and Chennai

depots.

Solution:

This presentation shows that operations of Kanpur and Chennai depots have resulted

in losses and this leads the management to consider their closure. An alternative

presentation using the marginal cost approach helps the management to take correct

decision.

Kolkata Kanpur Chennai Total

Sales 2100 600 300 3000

Variable costs of production

Direct materials 600

Direct wages 500

Variable factory overheads 800

Allocated pro-rata to units 1330 380 190 1900

770 220 110 1,100

Variable costs of selling and distribution 210 48 21 279

Contribution to all fixed expenses 560 172 89 821

Fixed costs of selling and distribution assuming 100 70 30 200

that they are specific to each depot

Contribution to fixed factory overheads 460 102 59 621

Fixed factory overheads 600

Net profit. 21

Calcutta Kanpur Chennai Total

Unit 70,000 20,000 10.000 100,000

Sales Rs. '000 Rs. '000 Rs. '000 Rs. '000

2,100 600 300 3000

Production Cost :

Direct Material 600

Direct Wages 500

Factor Variable

overheads 800

Factory fixed overheads 600

Allocated pro-rata to

units 1,750 500 250 2500

Gross Profit 350 100 50 500

Selling and distribution

Variable 210 48 21 279

Fixed 100 70 30 200

Local costs 310 118 51 479

Net Profit/(loss) 40 (18) (1) 21

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This presentation shows that sales at Kanpur and Chennai depots make contribution of

Rs. 1, 02,000 and Rs. 59,000 respectively, towards fixed factory overheads.

Therefore, none of those two depots should be closed down. In the above

presentation, it is assumed that fixed selling and distribution costs could be avoided

by closing those depots. This may not happen in the short term.

6.5.5 MARGINAL COST AND PRODUCT PRICING

A long-term pricing policy should aim to recover more than the 'full cost' to ensure a

reasonable return on capital employed. A firm cannot survive if it has to sell its

products continuously below 'full cost'. Marginal cost may be used as a basis for

short-term pricing decisions. Usually, marginal cost is used to determine prices for

non-repetitive orders under difficult business conditions or to use spare capacity when

acceptance of lower contributions and profit margins may be necessary. When

capacity is unused, acceptance of an order with lower contribution helps partial

recovery of the fixed cost. Factors to be considered in fixing selling prices when

demand is below normal are the amount and the rate of contribution which the

proposed selling price would yield; probability of securing an order with higher

contribution during the period of execution of the order; proposed concession, when

compared with the normal selling price on full cost basis; probable adverse effects on

future sales. When one or more resources are scarce, (e.g. material is scarce), the first

consideration must be to reserve the same for orders that would yield the highest

contribution per unit of the scarce resource (the limiting factor). A decision to sell at a

lower price might also have an adverse effect on the firm's general level of selling

prices in its established market. This aspect should also be carefully examined before

accepting an order with contribution lower than the normal contribution.

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Other factors, which strongly justify acceptance of an order with lower contribution at

the time adverse trade situations, are to: (a) hold together the skilled labour force; (b)

keep the plant and machinery in operation and the workers busy; (c) utilize materials

already received; (d) avoid costs involved in the closing and re-opening of the plant;

(e) maintain the sales of complementary products at a satisfactory level; and (f)

maintain position in established markets to avoid additional sales promotion expenses

in reestablishing the markets.

Selling below full cost prices, even under a normal situation, may be adopted in order

to: (a) introduce a new product, (b) execute an order in a special market segment (say,

defense supply) which is immune from other market segments; (c) expand the export

market; and (d) dispose of a product which deteriorates fast.

Example 6.14: The Everest Snow company manufactures and sells direct to

consumers 10,000 jars of 'Everest Snow' per month at Rs. 1.25 per jar. The company's

normal production capacity is 20,000 jars of snow per month. An analysis of cost for

10,000 jars is given below:

Direct material Rs. 1000

Direct labour 2475

Power 140

Miscellaneous supplies 430

Jars 600

Fixed expenses of manufacturing, selling and administration 7955

Total Rs. 12600

The company has received an offer for the export, under a different brand name for

1, 20,000 jars of snow at 10,000 jars per month at 75 paise a jar. Write a short report

on the advisability or otherwise of accepting the offer.

Solution:

Statement of Contribution from the Export Order

Selling price per unit Rs. 0.7500

Variable cost per unit:

Direct material Rs. 1,000/10,000 0.1000

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Direct labour Rs. 2,475/10,000 0.2475

Power Rs. 140/10,000 0.0140

Misc. supplies Rs. 430/10,000 0.0430

Jars Rs. 600/10,000 0.0600 (0.4645)

Contribution margin per unit Rs. 2855

Contribution per month: Rs. 0.2855 x 10,000 Rs. 2855

Acceptance of the export order would result in incremental contribution of Rs. 2,855

per month. The following statement reveals monthly profit, with and without

acceptance of order.

Present position Proposed offer Total

(10,000 jars) (10000 jars) (20000 jars)

Sale Value Rs. 12,500 7500 20000

Variable cost of sales @ Rs. 0.4645 (4,645) (4,645) (9290)

Contribution 7,855 2855 10710

Fixed Cost (7,955) - (7955)

Profit -100 2855 2755

It is advisable to accept the order provided:

(a) interest on incremental working capital would be lower than the total contribution

from the export order;

(b) acceptance of the export order with lower contribution would not adversely affect

the price in home-maker or the future sales;

(d) there is no possibility of securing an order with higher contribution during the

period of execution of the order.

Example 6.15: AB Ltd. manufactures three products X, Y, and Z. Standard selling

process and costs have been established for 2003 as follows: .

X Y Z

Selling price per unit Rs. 28 Rs. 60 Rs. 125

Direct materials per unit 8 15 20

Direct wages per unit 10 20 50

Variable overheads per unit 5 10 25

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Direct wages are paid at the rate of Rs. 2 per hour in each case. Fixed overheads are

budgeted at Rs. 25,000 for the coming year.. In the short run, the company cannot

increase its direct labour strength and as a result, only 35,000 direct labour hours will

be available in the coming year. The company has commitments to produce 500 units

of each product. It has been suggested that after meeting the minimum requirements

for X, Y and Z, the balance of available direct labour hours should be used to produce

product Z. You are required:

A) To prepare an income statement showing the expected results if the proposal is

adopted.

B) Comment on the statement you have produced in (a) and prepare an income

statement for any alternative policy, which you consider would be more

profitable.

C) Basing your calculations on your suggestion in (b), show the company's break-

even point in terms of units and sales value.

D) Show the sale value which is required to produce an after tax return of 10% on

capital employed of Rs. 1, 00,000 assuming tax rate of 50%.

Solution:

(a) Income Statement Showing Results if the Proposal is Adopted (Rs. '000)

Product X Product Y Product Z Total

1. Sales value 14.00 30.00 137.50 181.50

2. Variable costs:

Direct materials 4.00 7.50 22.00 33.50

Direct wages 5.00 10.00 55.00 70.00

Variable overheads 2.50 5.00 27.50 35.00

Total 11.50 22.50 104.50 138.50

3. Contribution fund (1 - 2) 2.50 7.50 33.00 43.00

4. Fixed overheads 25.00

5. Operating profit (3 - 4) 18.00

Thus, the operating profit will be Rs. 18,000.

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Notes: (i) Total available direct labour hours 35,000

Labour hours to be utilized to meet commitments:

(500 x 5 + 500 x 10 + 500 x 25) 20,000

Balance hours available 15,000

(ii) Additional units of Z to be produced 15,000/25, i.e. 600 units

Thus, total production of Z will be (500 + 600), i.e. 1,100 units

(iii) Required direct labour hours for each unit of production of

X: 10/12, i.e. 5 hours, Y: 20/2, i.e. 10 hours and Z: 50/2, i.e. 25 hours.

(b) Profitability Statement

Product X Product Y Product Z

1. Selling price Rs.28 Rs.60 Rs. 125

2. Variable costs per unit:

Direct materials 8 15 20

Direct wages 10 20 50

Variable overheads 5 10 25

Total Rs.23 Rs.45 Rs.95

3. Contribution per unit (1 - 2) Rs. 5 Rs.15 Rs.30

4. Required labour hours per unit 5 10 25

5. Contribution per labour hour (3/4) Re. 1.00 Rs. 1.50 Rs. 1.20

6. Ranking III I II

Availability of labour hours being limited, AB Ltd. should produce as many unit of T

as possible. There being no restriction on the units of Y that can be sold, available

labour hours, after meeting the commitments for products X and Z should be allocated

to Y. Thus, optimal product mix is:

Product Units to be produced Allocated Labour hours

X 500 2500

Y 2,500 20000 (Balancing figure)

Z 500 12500

35,000

Income Statement with the above Alternative

Products Total

155

X Y Z (Rs. ‘000)

Contribution 2.5 30.00 15.00 47.50

Fixed costs 25.00

Operating profit (1 - 2) 22.50

Contribution from committed production and sales:

Production X: 500 x Rs. 05.00 Rs. 2,500

Production Y: 500 x Rs. 15.00 7,500

Production Z: 500 x Rs. 30.00 15,000

Rs. 25,000

Fixed cost being Rs. 25,000, break-even sales of AB Ltd. is sales of 500 units of each

of the three products X, Y and Z. Break-even sales in terms of value is (500 x 28 +

500 x 60 + 500 x 125), i.e. Rs. 1,06,500.

(d) Sales value to earn a post-tax return of 10% on capital employed

Required return 10% of Rs. 1,00,000 i.e. Rs. 10,000

Required operating profit = 20,000 Rs.

50.0

10,000 Rs.

0.50)(1

10,000 Rs.

ratetax (1

return Required ==

−

Committed sales will earn contribution enough to meet fixed costs. Therefore, to earn

an operating profit of Rs. 20,000 additional units of Y is to be sold to earn a

contribution of Rs. 20,000. Thus, the total number of units of Y to be sold is (500 +

Rs. 20,000/15) i.e. 1,833.33 or 1,834 units.

Thus, total sale value is

X: 500 x Rs. 28 = Rs. 14,000

Y: 1,834 x Rs. 60 = Rs. 1,10,040

Z: 500 x Rs. 125 = Rs. 62,500

Total = Rs. 1, 86,540

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Example 6.16: The costs per unit of the three products A, Band C of a company are

given below:

Product A Product B Product C

Direct material Rs.20 Rs.16 Rs. 18

Direct labour 12 14 12

Variable expenses 8 10 6

Fixed expenses 6 6 4

46 46 40

Profit 18 14 12

Selling price 64 60 52

No. of units produced 10,000 5,000 8,000

Production arrangements are such that if one product is given up the production of the

other can be raised by 50%. The directors propose that C should be given up because

the contribution from the product is the lowest. Present suitable analysis of the data

indicating whether the proposal should be accepted.

Solution:

Statement Showing Contribution per Unit

Product A Product B Product C

Selling price per unit Rs. 64 Rs.60 Rs.52

Variable costs: Direct material Rs.20 Rs. 16 Rs.18

Direct labour 12 14 12

Variable expenses 8 10 6

Rs.40 Rs.40 Rs.36

Contribution per unit Rs.24 Rs.20 Rs. 16

In the absence of any limiting factor, the company should produce as many units of A

as possible. In case a limiting factor is in operation, contribution per unit of the

limiting factor should be used to measure profitability. In this particular case, the

limiting factor is not clearly spelt out, although a restrictive condition is specified. It

indicates the discontinuance of a product, which will result in the increase in

production of other products by 50%. In this situation, a decision to abandon a

product line should consider incremental contribution from each of the three

alternatives, giving up either product A or product B or product C.

Alternative I- Discontinue product A

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Additional contribution:

Product B: 0.5 x 5,000 x Rs. 20 = Rs. 50,000

Product C: 0.5 x 8,000 x Rs. 16 = Rs. 64,000 Rs. 1,14,000

Loss of contribution A: 10,000 x Rs. 24 (Rs. 2, 40,000)

Incremental contribution (Rs. 1, 26,000)

Alternative II-Discontinue product B

Additional contribution:

Product A: 0.5 x 10,000 x Rs. 24 = Rs. 1,20,000

C: 0.5 x 8,000 x Rs. 16 = Rs. 64,000 Rs.1, 84,000

Loss of contribution B: 5,000 x Rs. 20 (1, 00,000)

Incremental contribution Rs. 84,000

Alternative III-Discontinue product C

Additional contribution:

Product A: 0.5 x 10,000 x Rs. 24 = Rs. 1,20,000

B: 0.5 x 5,000 x Rs. 20 = Rs. 50,000 Rs. 1, 70,000

Loss of contribution A: 8,000 x Rs. 16 (1, 28,000)

Incremental contribution Rs. 42,000

Incremental contribution is highest from alternative II (discontinuance of product B),

and therefore, the decision to discontinue product C is sub-optimal. Product B should

be discontinued for maximising profit and proposal to discontinue product C should

not be accepted.

6.6 SUMMARY

Cost-volume-profit (CVP) analysis is the study of the effect on future profit of

changes in fixed cost, variable cost, selling price, sales quantity and sales mix. CVP

analysis assumes that the cost structure and the relationships between fixed costs,

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variable cost and selling price will remain valid during the period under consideration.

Therefore, the analysis produces useful results for decisions within the 'relevant range'

and the ‘relevant period’. Moreover, there are certain simplistic assumptions

underlying the CVP analysis which limit the precision and reliability of the result of

the analysis. CVP analysis uses a simple equation, which captures the relationships

between different variables. Graphical methods are also used for the study. A break-

even chart represents the relationships between different variables. Managers use

different variations of the simple breakeven chart.

In this chapter, we have discussed the use of cost information for tactical decisions.

Tactical decisions are short-term decisions that aim at maximizing operating profit,

with available facilities. Therefore, usually such decisions take into consideration

marginal costs only. However, sometimes short-term decision influence fixed costs,

e.g. additional advertising expenses. Thus, incremental fixed expenses cannot be

ignored. Marginal costing technique is used to determine optimal product-mix. A firm

maximizes operating profit by producing products, which contribute highest towards

fixed costs and profit. Therefore, contribution per unit of the limiting factor is used as

profitability index. The limiting factor is the scarce resource or any other factor,

which restricts the activity level. Often other restrictive conditions determine the

optimal product-mix. Marginal costing technique is used to decide whether a

component is to be manufactured or to be purchased from outside. If spare capacity is

available, the product should be manufactured only if variable-manufacturing cost is

lower than purchase price. If spare capacity is not available, manufacturing decision

results in the discontinuance of another product. Therefore, loss of contribution due to

discontinuance should be added to the costs of manufacturing and the total should be

compared with the purchase price. If the firm has no choice but to purchase some

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components from outside, it decides in favour of the component, manufacturing of

which generates savings lowest among the alternative products. For short-term

decisions on methods of manufacturing or temporary shut down of plant/ business,

managers use marginal costing technique-considerations are similar to those discussed

above.

6.7 SELF-TEST QUESTIONS

1. Define 'marginal costing'. How are variable costs and fixed costs treated in

marginal costing? Give a journal entry for overhead accounts under marginal

costing.

2. What are the important areas of management decisions opened up by the

application of marginal costing technique? Answer briefly and to the point.

3. Explain CVP analysis and Break-even-point analysis.

4. In a purely competitive market, 10,000 pocket transistors can be manufactured

and sold, and a certain profit is generated. It is estimated that 2,000 pocket

transistors need to be manufactured and sold in a monopoly market to earn the

same profit. Profit under both the conditions is targeted at Rs. 2, 00,000. The

variable cost per transistor is Rs. 100 and the total fixed cost is Rs. 37,000. You

are required to find out the unit selling prices both under monopoly and

competitive conditions. (Ans: A: Rs. 218.50, B: Rs. 123.70).

5. Y Company has just been incorporated and plans to produce a product that will

sell for Rs. 10 per unit. Preliminary market survey shows that demand will be

around 10,000 units per year. The company has the choice of buying one of the

two machines, each of which has a capacity of 10,000 units per year. Machine A

would have fixed costs of Rs. 30,000 per year and would yield a profit of Rs.

30,000 per year on the sale of 10,000 units. Machine B would have fixed costs of

160

Rs. 18,000 per year and would yield a profit of Rs. 22,000 per year on the sale of

10,000 units. Variable costs behave linearly for both machines. Required:

(a) Break-even sales for each machine.

(b) Sales level where both machines are equally profitable.

(Ans.: (a) 5000 units, 4500 units; (b) 6,000 units; (c) As the C/S ratio in the case

of Machine A (60%) is higher than the C/S ratio in the case of Machine B (40%),

profit in the case of Machine A increases at a faster pace as compared to the

increase in profit in the case of Machine B beyond the break-even point. From the

fact that at the output level of 6,000 units both machines are equally profitable, it

is obvious that below 6,000 units output level, profit from Machine B is higher as

compared to profit from Machine A and beyond 6,000 units output level, profit

from machine A is more).

6. A company has an opening stock of 6,000 units of output. The production planned

for the current period is 24,000 units and expected sales for the current period

amounted to 28,000 units. The selling price per unit of output is Rs. 10. Variable

cost per unit is expected to be Rs. 6 per unit while it was only Rs. 5 per unit

during the previous period. What is the break-even volume for the current period

if the total fixed costs for the current period are Rs. 86,000? Assume that the first-

in-first-out system is followed. (Ans.: 20,000 units).

7. (Closure of product line) A Ltd. manufactures three products and the cost

particulars for a year are as follows:

Product X (Rs.) Product Y(Rs.) Product Z

Sales 2, 00,000 4, 00,000 2,50,000

Material 1, 00,000 1, 50,000 1, 25,000

Labour cost 30,000 50,000 40,000

161

Variable overheads 10,000 20,000 25,000

Fixed Overheads 35,000 50,000 25,000

The company imports one of the raw materials, which is used in the manufacture

of all products. The consumption of material is as follows:

X - 2,000 kgs.

Y - 5,000 kgs.

Z - 3,000 kgs.

There is a restriction on the import of the material. The management is planning to

close down one of the lines of product and utilize the material for other two lines

to improve the profitability. As the secretary of the company, prepare a report for

the closure of one line for improving the profitability.

(Ans.: Contribution per kg of imported material X: Rs. 30, Y: Rs. 36, Z: Rs. 20).

8. (Product-mix) Mega Corporation manufactures and sells three products to the

automobile industry. All the products must pass through a machining process, the

capacity of which is limited to 20,000 hours per annum, both by equipment design

and government regulation. The following additional information is available:

Product X (Rs.) Product Y (Rs.) Product Z

Selling price Rs./ unit 1,900 2,400 4,000

Variable cost Rs./ unit 700 1200 2800

Machine requirement hrs./ unit 3 2 1

Maximum possible sales units10,000 2,000 1,000

Required: A statement showing the best possible production mix which would

provide the maximum profit for Mega Corporation, together with supporting

work.

(Ans.: Product-mix X: 5,000 units, Y: 2,000 units, Z: 1,000 units. Total

contribution = Rs. 96,000).

8. (Acceptance of export order) A company produces a single product which is sold

by it presently in the domestic market at Rs. 75 per unit. The present production

and sales is 40,000 units per month representing 50% of the capacity available.

The cost data of the product are as under:

Variable cost per unit Rs. 50

Fixed cost per month Rs. 10 lakh.

162

With a view to improve the profitability, the management has three proposals on

hand as under: (a) to accept an export supply order for 30,000 units per month at a

reduced price of Rs. 60 per unit, incurring additional variable costs of Rs. 5 per

unit towards export packing, duties etc.; (b) to increase the domestic market sales

by selling to a domestic chain stores 30,000 units at Rs. 55 per unit, retaining the

existing sales at the existing price; (c) to reduce the selling price for the increased

domestic sales as advised by the sales department as under:

Reduce selling price per unit by Rs. Increase in sales expected (in units)

5 10,000

8 30,000

11 35,000

Prepare a table to present the results of the above proposals and give your

comments and advise on the proposals.

(Ans.: Operating profits: Current Nil, Proposal (a) Rs. 1,50,000; Proposal (b) Rs.

1,50,000, Proposal (c) Selling price 70 Rs. Nil, S.P. Rs. 67, Rs. 1, 90,000, S.P. Rs.

64, Rs.50, 000).

6.8 SUGGESTED READINGS

1. Ashish K. Bhattacharya, Principles and Practices of Cost Accounting (3rd.),

New Delhi: Prentice Hall of India Private Limited, 2004.

2. Charles T. Horngren, Cost Accounting, A Managerial Emphasis, Prentice Hall

Inc., 1973.

3. D. T. Decoster and E. L. Schafer, Management Accounting, New York: John

Willey and Sons, 1979.

4. John G. Blocker and Wettmer W. Keith, Cost Accounting, New Delhi: Tata

McGraw Publishing Co. Ltd., 1976.

5. R. K. Sharma and Shashi K. Gupta, Management Accounting-Principles and

Practice (7th.), New Delhi: Kalyani Publishers, 1996.

163

Objective: The present lesson explains the various facets of a standard costing system.

LWSSON STRUCTURE

7.1 Introduction

7.2 Meaning of Standard Cost And Standard Costing

7.3 Steps involved in Standard Costing

7.4 Standard Costing Vs. Budgetary Control

7.5 Standard Costs and Estimated Costs

7.6 Advantages of Standard Costing

7.7 Limitations of Standard Costing

7.8 Preliminaries for Establishing Standard Costing System

7.9 Analysis of Variances

7.10 Accounting Treatment of Variances

7.11 Summary

7.12 Self-Test Questions

7.13 Suggested Readings

7.1 INTRODUCTION

The basic function of management accounting is to facilitate the managerial control in

a business unit or organisation. Management control is the process of evaluating

performance and applying corrected measures, if required, so that performance takes

place according to plans. The major aspect of managerial control is cost control. And

the ‘Standard Costing’ is that technique which helps management to control costs and

COURSE: MANAGEMENT ACCOUNTING

COURSE CODE: MC-105 AUTHOR: SURINDER SINGH KUNDU

LESSON: 07 VETTER: PROF. H. L. VERMA

STANDARD COSTING

164

business operations. It aims at eliminating wastes and increasing efficiency in

performance through setting up standards or formulating different cost plans.

7.2 MEANING OF STANDARD COST AND STANDARD COSTING

The word ‘standard’ means a benchmark or gauge. The ‘standard cost’

is a predetermined cost which determines in advance what each

product or service should cost under given circumstances. Backer and

Jacobsen define “Standard cost is the amount the firm thinks a

product or the operation of a process for a period of time should cost,

based upon certain assumed conditions of efficiency, economic

conditions and other factors”. Chartered Institute of Management

Accountants, London defines standard cost as “a predetermined cost

which is calculated from management’s standards of efficient

operation and the relevant necessary expenditure”. They are the

predetermined costs based on technical estimate of material, labour

and overhead for a selected period of time and for a prescribed set of

working conditions.

The technique of using standard costs for the purposes of cost control