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
V
ETTER: Prof. M S Turan
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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
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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
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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
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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
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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
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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
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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.
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(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)
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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
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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.
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(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
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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
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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.
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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
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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
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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:
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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.
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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.
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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
V
ETTER: Dr. Karam Pal
21
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
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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.
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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
24
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
25
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.
26
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
27
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
28
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
29
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.
30
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
31
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.
32
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) *****
33
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) *****
34
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.
35
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
36
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
37
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
38
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
39
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
40
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
41
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
42
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
43
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
44
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.
45
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.
46
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
47
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.
48
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.
49
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
50
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.
51
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
52
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,
53
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
54
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.
55
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
56
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)
57
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
58
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:
59
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
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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.
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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
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(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
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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%
(c) Stock turnover ratio= Cost of goods sold
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
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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
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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:
66
(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
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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.
68
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
69
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
70
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
71
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
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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.
73
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
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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
75
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
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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
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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
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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.
79
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
ii
)
Loss of sale of Machinery
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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
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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
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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
83
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.
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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:
85
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-
86
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
87
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
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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.
89
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
90
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
91
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
92
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
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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
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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.
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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.
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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:
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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.
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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.
99
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
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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.
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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
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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.
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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
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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
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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
shares
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
g
s
Payments for
interest on
debenture and
other borrowin
g
s
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
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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.
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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
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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)
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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.
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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
t
ing , investing and financing
t
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
1
33 %, 3
2
41 %,
3
2
16 % and 3
1
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
1
33 x 40% 13.33
B. 3
2
41 x 32% 13.44
C 3
2
16 x 20% 3.33
D 3
1
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
1
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
3
2
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
2
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
1
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
133
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
(c) Sales-volume at which both the firms would earn equal profit:
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
(c) Sales turnover of the merged plant to earn a profit of Rs. 75
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%
(c) Sales to earn profit of Rs. 75,000:
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.
142
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
2
Total cost per unit Rs. 8
Rs. 8
(c) Contribution per unit (a - b) Rs. 12. Rs. 14
(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
(c) Maximum output (a/b) 600 Units 400 Units
(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
(c) When machine capacity is the limiting factor 1st A, 2nd C, 3rd D, 4th B
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
(c) to produce by machine, one operator to two machines (Method C); 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.
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(b) If man-power is the limiting factor, method D should be adopted.
(c) If machine capacity is the limiting factor, method C 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;
(c) there is no possibility for dumping, i.e. re-export by the supplier; and
(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
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X Y Z (Rs. ‘000)
Contribution 2.5 30.00 15.00 47.50
Fixed costs 25.00
Operating profit (1 - 2) 22.50
(c) Break-even point in terms of units and sales
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.
(c) Range of sale where one machine is more profitable than the other.
(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
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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.
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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.
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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
is known as standard costing. Brown and Howard define “standard
costing is a technique of cost accounting which compares the
standard cost of each product or service with actual cost to determine
the efficiency of the operation so that any remedial action may be
taken immediately”. The terminology of Cost Accountancy defines
standard costing as “the preparation and use of standard costs, their
comparison with actual costs, and the analysis of variance to their
causes, and points of incidence”. The London Institute of Cost and
Works Accountants define it as "An estimate cost, prepared in
advance of production or supply correlating a technical