Accounting and Finance For Managers

Accounting and Finance for Managers
MBA First Year Paper No. 3
School of Distance Education
Bharathiar University, Coimbatore - 641 046
Author: M P Pandikumar Copyright 2007, Bharathiar University All Rights Reserved Produced and Printed by EXCEL BOOKS PRIVATE LIMITED A-45, Naraina, Phase-I, New Delhi-110028 for SCHOOL OF DISTANCE EDUCATION Bharathiar University Coimbatore-641046
CONTENTS
Page No. UNIT-I Lesson 1 Lesson 2 Lesson 3 Lesson 4 Financial Accounting Trial Balance Final Accounts Depreciation Accounting UNIT-II Lesson 5 Lesson 6 Lesson 7 Lesson 8 Financial Statement Analysis Ratio Analysis Funds Flow Statement Analysis Cash Flow Statement Analysis UNIT-III Lesson 9 Lesson 10 Lesson 11 Cost Accounting & Preparation of Cost Statement Budgetary Control Marginal Costing UNIT-IV Lesson 12 Lesson 13 Lesson 14 Lesson 15 Lesson 16 Lesson 17 Lesson 18 Lesson 19 Financial Management Time Value of Money Sources of Long Term Finance Capital Market Developments in India Indian Financial System SEBI in Capital Market Issues Capital Budgeting Risk and Return UNIT-V Lesson 20 Lesson 21 Lesson 22 Lesson 23 Cost of Capital Leverage Analysis Capital Structure Theories Working Capital Management 281 291 298 304 207 214 222 230 235 240 246 269 149 167 178 87 95 120 136 7 33 47 67
ACCOUNTING AND FINANCE FOR MANAGERS
Number of Credit Hours: 3 Subject Description: This course presents the principles of accounting, preparation of financial statements, analysis of financial statements, costing techniques, financial management and its functions. Goals: To enable the students to learn the basic principles of accounting and preparation and analysis of financial statements and also the various functions of financial management. Objectives: On successful completion of the course the students should have: 1. 2. 3. 4. understood the principles and objectives of accounting. learnt the preparation of financial statements and the various techniques of analyzing the financial statements. learnt the costing methods and its application in decision making. learnt the basic objectives of financial management , functions and its application in financial decision making . UNIT I Financial Accounting - Definition - Accounting Principles - Concepts and conventions - Trial Balance Final Accounts (Problems) - Depreciation Methods-Straight line method, Written down value method. UNIT II Financial Statement Analysis - Objectives - Techniques of Financial Statement Analysis: Accounting Ratios: construction of balance sheet using ratios (problems)-Dupont analysis. Fund Flow Statement - Statement of Changes in Working Capital - Preparation of Fund Flow Statement - Cash Flow Statement Analysis- Distinction between Fund Flow and Cash Flow Statement. Problems UNIT III Cost Accounting - Meaning - Distinction between Financial Accounting and Cost Accounting - Cost Terminology: Cost, Cost Centre, Cost Unit - Elements of Cost - Cost Sheet - Problems. Budget, Budgeting, and Budgeting Control - Types of Budgets - Preparation of Flexible and fixed Budgets, master budget and Cash Budget - Problems -Zero Base Budgeting. Marginal Costing - Definition - distinction between marginal costing and absorption costing - Break even point Analysis - Contribution, p/v Ratio, margin of safety - Decision making under marginal costing system-key factor analysis, make or buy decisions, export decision, sales mix decisionProblems UNIT IV Objectives and functions of Financial Management - Role of Financial Management in the organisation - Risk-Return relationship- Time value of money concepts - Indian Financial system - Legal, Regulatory and tax framework. Sources of Long term finance - Features of Capital market development in India - Role of SEBI in Capital Issues. Capital Budgeting - methods of appraisal - Conflict in criteria for evaluation - Capital Rationing Problems - Risk analysis in Capital Budgeting. UNIT V Cost of Capital - Computation for each source of finance and weighted average cost of capital -EBIT -EPS Analysis - Operating Leverage - Financial Leverage - problems. Capital Structure Theories - Dividend Policies - Types of Divided Policy. Working Capital Management - Definition and Objectives - Working Capital Policies - Factors affecting Working Capital requirements - Forecasting Working Capital requirements (problems) - Cash Management - Receivables Management and - Inventory Management - Working Capital Financing Sources of Working Capital and Implications of various Committee Reports.
UNIT-I
LESSON
1
FINANCIAL ACCOUNTING
CONTENTS
1.0 Aims and Objectives 1.1 Introduction 1.2 Process of Accounting 1.2.1 What is Cash System? 1.2.2 What is Accrual System? 1.2.3 Value at Which it is to be Recorded ? 1.3 Utility of the Financial Statements 1.3.1 To Management 1.3.2 To Shareholders, Security Analysts and Investors 1.3.3 To Lenders 1.3.4 To Suppliers 1.3.5 To Customers 1.3.6 To Govt. and Regulatory Authorities 1.3.7 To Promote Research and Development 1.4 Accounting Principles 1.5 Accounting Concepts 1.5.1 Money Measurement Concept 1.5.2 Business Entity Concept 1.5.3 Going Concern Concept 1.5.4 Matching Concept 1.5.5 Accounting Period Concept 1.5.6 Duality or Double Entry Accounting Concept 1.5.7 Cost Concept 1.6 Accounting Conventions 1.6.1 Convention of Consistency 1.6.2 Convention of Conservatism 1.6.3 Convention of Disclosure 1.6.4 Persons of Nature 1.6.5 Persons of Artificial Relationship 1.6.6 Persons of Representations 1.6.7 Receiver of the Benefits 1.6.8 Giver of the Benefits 1.7 Real Accounts 1.8 Nominal Accounts 1.9 Transactions in between the Real A/c 1.9.1 What is Movement-In? 1.9.2 What is Movement-Out? 1.10 Journal entries in between the accounts of two different categories 1.10.1 What is meant by Ledger? 1.10.2 Ledgering 1.11 Case Let 1.12 Let us Sum up 1.13 Lesson-end Activity 1.14 Keywords 1.15 Questions for Discussion 1.16 Suggested Readings
1.0 AIMS AND OBJECTIVES

In this less we shall discuss about financial accounting. After going through this lesson you will be able to: (i) (ii) analyse process of accounting and accounting concepts. discuss accounting conventions.
1.1 INTRODUCTION
Accounting is a business language which elucidates the various kinds of transactions during the given period of time. Accounting is defined as either recording or recounting the information of the business enterprise, transpired during the specific period in the summarized form. What is meant by accounting? Accounting is broadly classified into three different functions viz Recording Classifying and Summarizing Is accounting an equivalent function to book keeping ? No, accounting is broader in scope than the book keeping., the earlier cannot be equated to the later. Accounting is a combination of various functions viz Transactions of Financial Nature
Accounting
Recording of Transactions
Classification
Sum m arisation
Interpretation
American Institute of Certified Public Accountants Association defines the term accounting as follows "Accounting is the process of recording, classifying, summarizing in a significant manner of transactions which are in financial character and finally results are interpreted." Qualities of Accounting: In accounting, transactions which are non- financial in character can not be recorded. Transactions are recorded either individually or collectively according to their groups.
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Users should be able to make use of information.
1.2 PROCESS OF ACCOUNTING

Step 1 Identification of Transaction Recording
They are as follows What to record: Financial Transaction is only to be recorded When to record: Time relevance of the transaction at the moment of recording How to record: Methodology of recording - It contains two different systems of accounting viz cash system and accrual system
Financial Accounting
Step 2 Preparation of Business Transactions
Step 3 Recording of Transactions in Journal Grouping
Step 4 Posting In Ledgers
Financial Accounting is described as origin for the creation of information and the continuous utility of information After the creation of information, the developed information should be appropriately recorded. Are there any scales/guide available for the recording of information? Yes, What are they?
1.2.1 What is cash system?

The revenues are recognized only at the moment of realization but the expenses are recognized at the moment of payment. For e.g. sale of goods will be considered under
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Summarizing Preparation
Step 5 Preparation of Unadjusted Trial Balance
Step 6 Pass of Adjustment Entries
Step 7 Preparation of Adjusted Trial Balance
Trading and P& L A/c
Balance Sheet
this method that only at the moment of receipt of cash out of sale of goods. The charges which were paid only will be taken into consideration but the outstanding, not yet paid will not be considered. For e.g. Rent paid only will be considered but not the outstanding of rent charges.
1.2.2 What is accrual system?

The revenues are recognized only at the time of occurrence and expenses are recognized only at the moment of incurring. Whether the cash is received or not out of the sales, that will be registered/counted as total value of the sales. The next most important step is to record the transactions. For recording, the value of the transaction is inevitable, to record values, the classification of values must be
1.2.3 Value at which it is to be recorded ?

There are four different values in the business practices, among the four, which one should be followed or recorded in the system of accounting? Original Value: It is the value of the asset only at the moment of purchase or acquisition Book Value: It is the value of the asset maintained in the books of the account. The book value of the asset could be computed as follows Book Value = Gross(Original) value of the asset - Accumulated depreciation Realizable Value: Value at which the assets are realized Present Value: Market value of the asset Classifying: It is one of the important processes of the accounting in which grouping of transactions are carried out on the basis of certain segments or divisions. It can be described as a method of Rational segregation of the transactions. The segregation generally into two categories viz cash and non-cash transactions. The preparation of the ledger A/cs and Subsidiary books are prepared on the basis of rational segregation of accounting transactions. For example the preparation of cash book is involved in the unification of cash transactions. Summarizing: The ledger books are appropriately balanced and listed one after another. The list of the name of the various ledger book A/cs and their accounting balances is known as Trial Balance. The trial balance is summary of all unadjusted name of the accounts and their balances. Preparation: After preparing, the summary of various unadjusted A/cs are required to adjust to the tune of adjustment entries which were not taken into consideration at the time of preparing the trial balance. Immediately after the incorporation of adjustments, the final statement is readily available for interpretations. Purposes of preparing financial statements: Financial accounting provides necessary information for decisions to be taken initially and it facilitates the enterprise to pave way for the implementation of actions It exhibits the financial track path and the position of the organization Being business in the dynamic environment, it is required to face the ever changing environment. In order to meet the needs of the ever changing environment, the policies are to be formulated for the smooth conduct of the business It equips the management to discharge the obligations at every moment
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Obligations to customers, investors, employees, to renovate/restructure and so on.
1.3 UTILITY OF THE FINANCIAL STATEMENTS

The financial statements are found to be more useful to many people immediately after presentation only in order to study the financial status of the enterprise in the angle of their own objectives.
Check Your Progress
1.3.1 To Management
The financial statements are most inevitable for the management to take rational decisions to maintain the sustainability in the business environment among the other competitors.
1.3.2 To Shareholders, Security Analysts and Investors

The information extracted from the financial statements are processed by the above mentioned people to identify not only the financial status but also to determine the qualities of getting appropriate rate of return out of the prospective investment.
1.3.3 To Lenders
The lenders do study about the business enterprise through the available information of its financial statements normally before lending. The aim of the study is to analyse the status of the firm for the worthiness of lending with reference to the payment of interest periodicals and the repayment of the principal.
1.3.4 To Suppliers
The suppliers are in need of information about the business fleeces before sale of goods on credit. The Suppliers are very cautious in supplying the goods to the business houses based on the various capacities of themselves. The most important capacity required as well as expected from the buyer firms is that prompt repayment of dues of the credit purchase from the suppliers. This quality of prompt payment could be known through culling out the information from the balance sheet. It mainly plays pivotal role in answering the status inquiries about the buyer
1.3.5 To Customers
The legal relationship of the transferability of ownership of the products is obviously understood through financial information available in the statements. The agreement of warranty and guarantee is tested through the financial status of the enterprise.
1.3.6 To Govt., and Regulatory Authorities

The taxes to be paid to the central and state govts on the revenues only through presentation of information.
1.3.7 To Promote Research and Development

For research and development, the amount of investment required is voluminous, which has to be mobilized from either internally or externally to the requirement of the future prospects of the enterprise. The following questions should be answered one after the another in meeting raising needs of the research and development How much to be raised? When the required amount to be raised? How to raise the required resources?
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The above questions could be answered through immense financial planning exercise by way of extracting and utilizing the financial information from the Accounting statements of the enterprise.
Check Your Progress
(1)
Financial Accounting is
(a) (b) (c) (d) Recording Classifying Summarising Recording, Classifying, Summarizing, Interpretation of financial information
(2)
Book value of the asset is

(a) (b) (c) (d) Gross value of the asset - Depreciation Gross value of the asset Gross value of the asset - Accumulated depreciation None of the above
1.4 ACCOUNTING PRINCIPLES

The transactions of the business enterprise are recorded in the business language, which routed through accounting. The entire accounting system is governed by the practice of accountancy. The accountancy is being practiced through the universal principles which are wholly led by the concepts and conventions. The entire principles of accounting are on the constructive accounting concepts and conventions
Accounting Concepts
Accounting Conventions
Accounting Principles
1.5 ACCOUNTING CONCEPTS

The following are the most important concepts of accounting: Money Measurement concept Business Entity concept Going Concern concept Matching concept Accounting Period concept Duality or Double Entry concept Cost concept
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1.5.1 Money Measurement Concept

This is the concept tunes the system of accounting as fruitful in recording the transactions and events of the enterprise only in terms of money. The money is used as well as expressed as a denominator of the business events and transactions. The transactions which are not in the expression of monetary terms cannot be registered in the book of accounts as transactions. For e.g. 5 machines, 1 ton of raw materials, 6 fork lift trucks, 10 lorries and so on. The early mentioned items are not expressed in terms of money instead they are illustrated only in numbers. The worth of the items are getting differed from one to another. To record the above enlisted items in the book of accounts, all the assets should be converted in to money. For e.g. 5 lathe machines worth Rs 1,00,000; 1 ton of raw materials worth amounted Rs. 15,00,000 and so on. The transactions which are not in financial in character cannot be entered in the book of accounts.
Recording of transactions are only in terms of money in the process
1.5.2 Business Entity Concept

This concept treats the owner as totally a different entity from the business. To put in to nutshell "Owner is different and Business is different". The capital which is brought inside the firm by the owner, at the commencement of the firm is known as capital. The amount of the capital, which was initially invested should be returned to the owner considered as due to the owner; who was nothing but the contributory of the capital. For e.g. Mr Z has brought a capital of Rs.1 lakh for the commencement of retailing business of refrigerators. The brought capital of Rs. 1 lakh has utilized for the purchase of refrigerators from the Godrej Ltd. He finally bought 10 different sized refrigerators. Out of 10 refrigerators, one was taken away by the owner Mr. Z
Type of Capital
Real Capital 10 Refrigerators @Rs.1 lakh
Monetary Capital Rs.1lakh provided by Mr. Z
In the angle of the firm The amount of the capital Rs.1 lakh has to be returned to the owner Mr. Z, which considered to be as due. Among the 10 newly bought refrigerators for trading, one was taken away by the owner for his personal usage. The one refrigerator drawn by the owner for his personal usage led the firm to sell only 9 refrigerators. It means that Rs. 90,000 out of Rs. 1 Lakh is the volume of real capital and the Rs.10,000 worth of the refrigerator considered to be as drawings; which illustrates the capital owed by the firm is only Rs. 90,000 not Rs. 1 lakh. In the angle of the owner The refrigerator drawn worth of Rs.10,000 nothing but Rs.10,000 worth of real capital of the firm was taken for personal use as drawings reduced the total volume of the capital of the firm from Rs.1 lakh to Rs. 90,000, which expected the firm to return the capital due amounted Rs. 90,000.
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Owner and business organizations are two separate entities 1.5.3 Going Concern Concept
The concept deals with the quality of long lasting status of the business enterprise irrespective of the owners' status, whether he is alive or not. This concept is known as concept of long-term assets. The fixed assets are bought in the intention to earn profits during the season of the business. The assets which are idle during the slack season of the business retained for future usage, in spite of that those assets are frequently sold out by the firm immediately after the utility leads to mean that those assets are not fixed assets but tradable assets. The fixed assets are retained by the firm even after the usage is only due to the principle of long lastingness of the business enterprise. If the business disposes the assets immediately after the current usage by not considering the future utility of the assets in the firm which will not distinguish in between the long-term assets and short-term assets known as tradable in categories.
Accounting concept for long lastingness of the business enterprise

1.5.4 Matching Concept
This concept only makes the entire accounting system as meaningful to determine the volume of earnings or losses of the firm at every level of transaction; which is an outcome of matching in between the revenues and expenses. The worth of the transaction is identified through matching of revenues which are mainly generated from the sales volume and the expenses of the firm at every level. For example, the cost of goods sold and selling price of the pen of ABC Ltd are Rs. 5 and Rs. 10 respectively. The firm produced 100 ball pens during the first shift and out of 100 pens manufactured 20 pens are considered to be damage which cannot be supplied to the customers, rejected by the quality circle department. There was an order from the firm XYZ Ltd., which amounted 80 pens to be supplied immediately. The worth of the transaction of the firm at every level of the transaction is being studied only through the matching of revenues with the expenses. At first instance, the firm produced 100 pens which incurred the total cost of Rs 500 required to match with the expected revenues of Rs 1,000; illustrated the level of profit how much would it accrue if the entire level of production is sold out ? If the entire production capacity is sold out in the market the profit level would be Rs 500. Out of the 100 pens manufactured 20 were identified not ideal for supply as damages, the remaining 80 pens were supplied to the individual retailer The retailer has been dispatched 80 pens amounted Rs 400 which equated to Rs 800 of the expected sales At the moment of dispatching, the firm expected to earn a profit of Rs 400 at the level of 80 pens supplied. After the dispatch, the retailer found that 50 pens are in accordance with the order placement but the remaining are to the tune of the retailers' specifications. Finally, the retailer has agreed to make the payment of the bill only in accordance with the order placed which amounted Rs 500 out of the expenses of the manufacturer Rs 250. This concept facilitates to identify the worth of the transaction at every moment.
Concept of fusion in between the expenses and revenues 1.5.5 Accounting Period Concept
Though the life period of the business is longer in span, which is classified into the operating periods which are smaller in duration. The accounting period may be either calendar year of Jan-Dec or fiscal year of April-Mar. The operating periods are not
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equivalent among the trading firms, which means that the operating period of one firm may be shorter than the other one. The ultimate aim of the concept is to nullify the deviations of the operating periods of various traders in the trading practice. According to the Companies Act, 1956, the accounting period should not exceed more than 15 months.
Concept of uniform accounting horizon among the firms to evade deviations
1.5.6 Duality or Double entry accounting concept

It is the only concept which portrays the two sides of a single transaction. The law of entire business revolves around only on mutual agreement sharing policy among the players. How mutual agreement is taking place ? The entire principle of business is mainly conducted on mutual agreement among the parties from one occasion to another. The payment of wages are only made by the firm out of the services of labourers. What kind of mutual agreement in sharing the benefits is taking place? The services of the labourers are availed by the firm through the payment of wages. Like-wise, the labourers are regularly getting wages for their services in the firm. Payment of Wages = Labourers' service In the angle of accounting aspects of a firm, the labourer services are availed through the payment of wages nothing but the mutual sharing of benefits. Availing of services or taking the services of the labourers only through the cash payment whatever you make at the end i.e., giving wages. This is being denominated into two different facets of accounting viz Debit and Credit. Every debit transaction is appropriately equated with the transaction of credit. The entire above sample of transactions are being carried out by the firm through the raising of financial resources. The resources raised were finally deployed in terms of assets. It means that the total funds raised by the firm is equated to the total investments. From the below table illustration, it is clearly evidenced that the entire raised financial resources are applied in the form of asset applications. It means that the total liabilities are equivalent to the total assets of the firm.
Total Financial Resources
Total Assets
Liabilities Share capital Preference Share Capital Debentures/Long Term Borrowings Retained Earnings Commercial Paper Public Deposits Bank Loan Overdraft Pre received Income Outstanding Expenses Sundry Creditors Bills Payable Provision for Taxation
Assets Plant and Machinery Land and Buildings Fixtures and Tools Delivery vehicles Furniture Industry and office Office administrative devices Marketable securities Short-term investments Closing stock Pre paid expenses Outstanding Income Sundry debtors Bill Receivable Cash at Bank Cash in Hand
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Concept of mutual agreement and sharing of benefits 1.5.7 Cost Concept

It is the concept closely relevant with the going concern concept. Under this concept, the transactions are recorded only in terms of cost rather than in market value. Fixed assets are only entered in terms of the purchase price which is a original cost of the asset at the moment of purchase. The depreciation is deducted from the original value which is the initial purchase price of the asset will highlight the book value of the asset at the end of the accounting period. The marketing value of the asset should not be taken into consideration, Why? The main reason is that the market value of the asset is subject to fluctuations due to demand and supply forces. The entry of market value of the asset will require the frequent update of information to the tune of changes in the market. Will it be possible to record the changes taken place in the market then and there? This is not only not possible for regular updating of information but also leads to lot of consequences. Though the firm is ready to register the market value; which market value has to be taken into consideration? The market value can be bifurcated into two categories viz Realizable value and Replacement value. Realizable value is the value of the asset at the moment of sale or realization. Replacement value is the another value which considered at the moment of replacing the old asset with the new one. These two cannot be the same at single point of time and the wear and tear of the asset will play pivotal role in fixing the realization value which has the demarcation over the later.
1.6 ACCOUNTING CONVENTIONS

Accounting conventions are bearing the practical considerations in recording the transactions of the business enterprise in systematic manner. Convention of consistency Convention of conservatism Convention of disclosure
1.6.1 Convention of consistency

The nature of recording the transactions should not be changed at any cause or moment. It should be maintained throughout the life period of the firm. If a firm follows the straight line method of charging the depreciation since its inception should be followed without any change . The firm should not alter the method of charging the depreciation from one method to another. The change cannot be entertained. If any change has to be incorporated, the valid reason for change should be emphasized.
1.6.2 Convention of conservatism

The conservatism wont give any emphasis on the anticipation of the firm, instead it gives paramount importance to all possible uneventualities of the firm without considering the future profits. The most important of the rule of guidance at the moment of valuing the stock is as follows: Stock Valuations: "Stock of the goods should be valued either market price or cost whichever is lower" To anticipate the future losses due to default in the payments of the customers;
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Provision is created for bad and doubtful debts of the firm in order to meet the losses expected. out of the defaulters.
1.6.3 Convention of disclosure

According to this convention, the entire status of the firm should be highlighted / presented in detail without hiding anything; which has to furnish the required information to various parties involved in the process of the firm. Next stage is to classify the accounts into various categories. Classification of Accounts: The entire process of accounting brought under three major segments ; which are broadly grouped into two categories.
Check Your Progress
(1)
Accounting principles are

(a) (c) Accounting concepts only conventions Accounting concepts & conventions only (b) (d) Accounting None of the above
(2)
Money measurement concept is

(a) (c) Financial transactions only Both (a) & (b) (b) (d) Non financial transactions only None of the above
(3)
Distinction of the assets is on the basis of

(a) (c) Going concern concept Business entity concept (b) (d) Time period concept Duality concept
(4)
The worth of transactions are identified only through

(a) (c) Cost concept Business entity concept (b) (d) Matching concept Double entry accounting concept
(5)
Total Liabilities = Total Assets is dealt

(a) (c) Business entity concept Going concern concept (b) (d) Cost concept Duality concept
Accounts
Personal Accounts
Impersonal Accounts
Persons Out of Nature
Persons Out of Law Relationship
Persons Out of Representations
Real Accounts
Nominal Accounts
The entire accounts of the enterprise is broadly classified into two categories viz Personal Accounts and Impersonal Accounts. The Impersonal accounts is further classified into two categories viz Real accounts and Nominal accounts. What is personal accounts? It is an account which deals with a due balance either to or from these individuals on a particular period. It is an account normally reveals the outstanding balance of the firm to individuals e.g. suppliers or outstanding balance from individuals e.g. customers. This
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is the only account which emphasizes the future relationship in between the business firm and the individuals. The personal accounts can be classified into three categories.
1.6.4 Persons of Nature

Persons who are nothing but outcome of nature i.e., almighty.
1.6.5 Persons of Artificial relationship

Persons who are made out of artificial relationship through legal structure is known as organizations, corporate, partnership firm and so on. The companies and partnership firm are governed by the Companies Act 1956 and the partnership act. The relationship among the owners of the company or partners of the firm are totally structured through respective laws. E.g.: LIC, SBI, Companies are most important illustrations governed by the artificial relationship among the members through LIC act, SBI act and the Companies act 1956 and so on respectively.
1.6.6 Persons of representations

This classification represents amount outstanding or prepaid in connection with the individual transactions. (i) Outstanding of electricity charges: Electricity charges outstanding is with reference to the electricity board TNEB, Rent prepaid refers that rent of the office is made as an advance payment for the forthcoming month to the owner of the building. The personal account is the account of future relationship; to maintain the relationship of future in two different angles viz Receiver of the benefits from the firm and giver of the benefits to the firm.
1.6.7 Receiver of the benefits

For E.g.: The credit sale of the goods worth of Rs 1,500 to Mr X. In this transaction Mr. X is the receiver of the benefits through the credit sale of the firm. Till the collection of the sale benefits, the firm should maintain the relationship of business with the Mr. X in the books of accounts.
1.6.8 Giver of the benefits

For E.g: The credit purchase of the goods worth of Rs 3,000 from Mr. Y. The giver of the goods nothing but the supplier of the goods Mr. Y should be recorded in the books of the firm till the payment of dues of the credit purchase. The future relationship is maintained in the books of the accounts till the payment process is over.
Debit the Receiver Credit the Giver
1.7 REAL ACCOUNTS

It is a major classification which highlights the real worth of the assets. This is the account especially deals with the movement of assets. It is an account not only reveals the value and movement of the assets taking place in between the firm and also other parties due to any transactions.
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The movement of the assets can be classified into two categories viz the assets which are coming into the firm and the assets which are going out of the firm. Whenever any movement of the assets taking place with reference to any transactions either coming into the firm or going out of the firm should be recorded in accordance with the set golden rules of this account.
Debit What comes in Credit What goes out
1.8 NOMINAL ACCOUNTS

This is an account deals with the amount of expenses incurred or incomes earned. It includes all expenses and losses as well as incomes and gains of the enterprise. This nominal account records the expenses and incomes which are not carried forwarded to near future.
Debit all the expenses and losses Credit all incomes and gains
The process of the accounting in normal practice as follows: The practice starts with the journalizing of entries. After journalisation, the entries passed in the journal will be passed into the ledger A/c. The immediate next stage is to prepare the trial balance. What is meant by the journal entry ? It is an entry systematically recorded to the tune of golden rules of accounting in the journal book is known as journal entries. How the journal entries are entered? The journal entries are recorded in the sequential order. The order of recording is conventionally done on the basis of date. The journal entry usually contains two different parts, which are nothing but two different accounts affecting the transactions.
Date Number of the day in the month, Name of the month and Year in full Particulars To Debit the Name of the account To credit the Name of the account Ledger Folio Page number in the respective ledger Debit Rs Credit Rs
Journalising the entries are different from one transaction to another The difference is only due to nature and characteristics of the transactions. To journalise as easy as possible, the systematic approach to be adopted to post the transactions without any ambiguity. Journalising can be generally categorized into following various categories. Taking place within the same natured accounts Taking part in between accounts of two different in categories First, we will discuss the journalizing of entries of the same natured accounts. This can be classified into various segments Transactions only in between the personal accounts Transactions only in between the real accounts Under the category of transactions which affect only the personal accounts are as follows: Between the persons of the nature
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Between the persons of the artificial relationship Between the persons of Representations What are the points to observed at the moment of journalizing ? The nature of the accounts to be identified The accounts to be correlated to the golden rules Once the accounts are finalized, the next stage is to pass the entry through proper debiting and crediting of the accounts respectively. The meaning of the transaction should be made explicit for easier understanding through brief and catchy narration to follow as well as evade the ambiguity in near future. Mr Sundar is a debtor who has paid Rs 1,500, in the bank A/c
Mr. Sundar
Bank
Personal A/cs Persons of Nature Giver Receiver
Transaction is identified which is in between two different persons under the personal A/c, they are nothing but persons of nature. The benefits are shared in between two persons viz. Mr. Sundar and Banker who are nothing but giver and receiver of the benefits respectively. It means that Sundar is the giver of Rs 1,500 to Banker who is the receiver of the same Rs. 1,500.
Debit the Receiver Credit the Giver Bank Sundar Debit the Melvin A/c Credit the Sundar A/c
Final step is to pass the journal entry Bank A/c To Sundar A/c Dr Cr Rs. 1,500 Rs. 1,500
(Being cash is paid by sundar to Bank A/c)
1.9 TRANSACTIONS IN BETWEEN THE REAL A/C

Real A/c is an account to highlight the movement of the assets. If any simultaneous movement is taking place in between two different assets of the enterprise can be explained with the following example: Purchase of a Plant and Machinery of Rs.15,000. The purchase of a plant and machinery is only through cash payment to the vendor. What are the two different type of assets involved in the movement during the purchase? There are two different type of assets viz. Cash and Plant & Machinery To put in nutshell, among the two assets, Cash is one of the current assets and the Plant & Machinery is one of the fixed assets. In general, these two are brought under the category of assets or applications of the firm.
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If the assets are involved in the transaction, Real account should only be referred. How the movement of assets is taking place at the moment of purchase ? The movement of the assets classified into two segments viz. movement in and movement out. 1.9.1 What is movement - in? The movement - in is the movement of the assets to the business enterprise. With reference to above cited example which asset is coming into the business enterprise? Plant & Machinery is the asset which comes into the business enterprise only at the moment of purchase. 1.9.2 What is movement - out? The movement-out is the movement of the assets from the business enterprise. From the above illustrated example, which asset is going out of the firm during the purchase? Cash resources are going out of the firm in order to make the payment of the purchase to the supplier of the assets.
Cash Resources
Business Enterprise
Supplier
Plant & Machinery
Next stage is to highlight the movement of the assets during the purchase
Movement - In Movement - Out Plant & Machinery Cash Resources Debit What Comes in Credit What goes out
What is coming in ?- Plant & Machinery What is going out ?- Cash Resources Plant & Machinery A/c Dr To Cash resources A/c Cr (Being Plant & Machinery is purchased) What is the basic point to be registered ? During the purchase, the plant & machinery worth of Rs.15,000 is coming into the firm, in turn Rs.15,000 worth of cash resources are going out of the firm. During the cash purchase, the assets are moving from one entity to another viz. from business enterprise to supplier and vice versa. Rs.15,000 Rs.15,000
1.10 JOURNAL ENTRIES IN BETWEEN THE ACCOUNTS OF TWO DIFFERENT CATEGORIES

Transactions are in between the Real A/c and Personal A/c: This type of the transaction is mainly governed by one important principle that future relationship. It major focus on the maintenance of future relationship among the parties involved, till the realization of the transaction is over. Goods sold to Gopal Rs.15,000. Meaning: The goods were sold on credit to Gopal amounted Rs.15,000.
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First, what are the various A/cs involved in the transaction ? There are two different A/cs viz Real A/c and Personal A/c How Real A/c and Personal A/c are considered for journalizing the entries? During the sales, irrespective of nature, Goods are moving out of the firm, which finally will reach the individual Gopal. The goods, which are sold out to Gopal led to movement of goods out of the firm. Any movement of asset should be referred only to the tune of Real A/c. The goods which are going out of the firm could be recorded as transaction under the Real A/c i.e."Credit what goes out". While recording the transaction, it should not be entered as Goods A/c, Why ? Instead of recording as Goods A/c, which are going out of the firm should be mentioned only with reason of going out. The reason for goods going out of the firm is only due to sales; has to registered in the books of accounts at the time of entering the journal entries. The second account which gets affected is the personal A/c of representations. The goods sold out on credit led to register the receiver of goods who has not paid at the moment of sale. Gopal is the individual received the goods on credit during the sales expected to make the payment as per the terms of credit period. Till the maturity of the credit period agreed, the firm should wait and collect the amount from the individual who is nothing but the receiver of goods.
Movement-out-Real A/c Receiver of benefits- Personal A/c Goods are moving out of the firm Receiver of the goods on credit with future relationship Credit what goes out Sales A/c Debit the receiver Gopal A/c
Next step is to record the journal entry Gopal A/c To Sales A/c Dr Cr Rs.15,000 Rs.15,000
(Being goods sold on credit to Gopal) Transaction in between the Real A/c and Nominal A/c Office Rent paid Rs.10,000 What are the two different accounts involved in the above illustrated transaction? First one is the Rent A/c and another is Cash A/c only due to cash payment at the moment of making the payment of rent. What is the nature of Rent A/c? The Rent which is paid to the owner is an expense out of the benefits derived out of the asset during the previous month. In accordance with the Nominal A/c all the expenses are to be recorded, i.e. "Debit all the expenses and losses." The second is in relevance with the cash payment which finally led to the movement of cash resources from the firm to the owner of the Asset. This mobility of the assets leads to movement - out which in connection with the Real A/c is the account for the assets.
Rent paid Movement - out Expense - Office Rent paid Cash moving out of the firm Nominal A/c - Debit All expenses and losses Real A/c - Credit what goes out
Check Your Progress
(1)
Rent paid
(a) (c) Debit - Rent ; Credit - The giver Debit - Rent; Credit - Cash (b) (d) Debit - Cash; Credit - Rent None of the above
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(2)
Purchase of assets in between the two different accounts
Contd...
(a) (c)
Real A/c and Personal A/c Personal A/c and Personal A/c
(b) (d)
Real A/c and Nominal A/c Real A/c and Real A/c
(3)
Identify nature of the transactions: Sundar has purchased goods on credit from M/s Melvin & Co Rs.15,000. The portion of the goods were found to damaged which worth of Rs 5,000. Sundar immediately returned the damaged goods to Melvin & Co.
(a) (b) Identify the various types of accounts involved in the above illustrated transactions. Pass the journal entries with regards to the nature of accounts involved.
Illustration 1 Pass the following various journal entries. (i) (ii) Jan 1, 2006 Mr. Sundar has started business with a capital of Rs 50,000 Jan 2,2006 Goods purchased Rs 10,000
(iii) Jan 5, 2006 Goods sold Rs 5,000 (iv) Jan 10, 2006 Goods purchased from Mittal & Co Rs 10,000 (v) Jan 11, 2006 Goods sold to Ganesh & Co Rs 10,000
(vi) Jan 12,2006 Goods returned to Mittal & Co Rs 1,500 (vii) Jan 20,2006 Goods returned from Ganesh Rs 2,000 (viii) Jan 31,2006 Office Rent paid Rs 500 (ix) Feb 2,2006 Interim Cash Dividend paid Rs 3000 (x) Feb 8, 2006 Cash withdrawn from bank Rs 2,000 (i) Jan 1, 2006 Mr. Sundar has started business with a capital of Rs 50,000 Rs
Jan 1, 2006 Cash A/c Dr To Sundars capital A/c Cr Being capital brought by sundar as cash 50,000 50,000
Rs
(ii)
Jan 2, 2006 Goods purchased Rs 10,000 Rs Rs

10,000 Purchase A/c To Cash A/c Dr Cr Being cash purchase is made 10,000
Jan 2, 2006
(iii) Jan 5, 2006 Goods sold Rs 5,000 Rs

Jan 5, 2006 CashA/c To Sale A/c Dr Cr Being cash sale is made 5,000 5,000
Rs
(iv) Jan 10, 2006 Goods purchased from Mittal & Co Rs 10,000 Rs
Jan 10, 2006 Purchase A/c To Mittal A/c Dr Cr Being credit purchase from Mittal 10,000 10,000
Rs
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(v)
Jan 11, 2006 Goods sold to Ganesh & Co Rs. 10,000 Rs Rs

10,000 Ganesh A/c To SaleA/c Dr Cr Being credit sale made to Ganesh 10,000
Jan 11, 2006
(vi) Jan, 12, 2006 Goods returned to Mittal & Co Rs. 1,500 Rs
Jan 12, 2006 Mittal &Co A/c Dr 1,500 To Purchase Return A/c Cr (Being the goods returned to supplier Mittal &Co)
Rs
1,500
(vii) Jan 20, 2006 Goods returned from Ganesh Rs. 2,000 Rs
Jan 20, 2006 Sales ReturnA/c Dr To Ganesh&co Cr Being sales return made by Ganesh & Co 2,000 2,000
Rs
(viii) Jan 31, 2006 Office Rent paid Rs. 500 Rs

Jan 31, 2006 Office Rent A/c To Cash A/c Dr Cr Being office rent paid 500 500
Rs
(ix) Feb 2, 2006 Interim Cash Dividend received Rs. 3000 Rs

Feb 2, 2006 Cash A/c Dr To Interim Dividend Cr Being cash interim dividend received 3,000 3,000
Rs
(x)
Feb 8, 2006 Cash withdrawn from bank Rs. 2,000 Rs Rs

2,000 Cash A/c To Bank Dr Cr Being cash withdrawn from the bank 2,000
Feb 8, 2006
Classification of transactions is being done only on the basis of preparing the ledger accounts. The accounts are classified on the basis of nature and characteristics. How the account transactions are classified ? The accounts are classified through the preparation of ledger. 1.10.1 What is meant by Ledger? Ledger is nothing but preliminary book of accounting transactions at which, each account is separately maintained through the allotment of various pages for exclusive recording. The exclusive allotment of pages for every account to finalize their balances. Finally, ledger can be understood that is a document of grouping the transactions under one heading . It is a fundamental book of accounts which mainly highlights the status of the accounts. Example: Plant & Machinerys ledger A/c should reveal the transactions of the sale & purchase of the plant and machinery. How the transactions are recorded in the ledger ? The journal entries which are recorded nothing but posting of the entries in the ledger book of accounts. Posting / entering the journal entries are routinely carried out immediately after the transactions.
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Prior to discuss the posting of journal entries into the ledger accounts, every body should know the contents of the ledger. The ledger is segmented into two different categories.
Proforma of the Ledger Account
Dr
Date Particular To
Name of the Account

Date Particulars By
Cr
Journal entries are divided into two categories viz 1. 2. Debit item of the transaction Credit item of the transaction
Once the journal entries are identified for classification, the entries should be recorded in accordance with the date order of the transactions in the respective pages. While recording a transaction, normally a journal entry has got an impact on two or even three different accounts.
1.10.2 Ledgering
It is a process of recording the transactions under one group from the early process of journalizing. Without journalizing, ledgering is not meaningful. The process of ledgering involves with various steps. The process commences from only at the completion of journalizing and ends at the end of balancing of journal accounts.
Process of Ledgering
Identify the transaction
Krishna started the business with a capital of Rs 50,000
Identify the two accounts involved
Two accounts - Cash A/c & Krishna Capital A/c
Open the ledger accounts involved in the journal entries
Open Ledger accounts Cash A/c & Krishna Capital A/c
Dr
Cash A/c
Cr
Dr Krishna Capital A/c
Cr
Enter the journal entry in the Ledger A/c Cash A/c Dr Rs. 50,000 To Krishnas capital A/c Rs. 50,000 Credit item of the journal transaction Krishna capital A/c to be recorded in the debit side of the A/c i.e. Cash A/c Debit item of the journal transaction Cash A/c to be recorded in the credit side of the remaining A/c i.e
Dr
Cash A/c
Cr
Dr Krishna Capital A/c

By Cash Rs. 50,000
Cr
To Krishna capital Rs. 50,000
Krishna capital A/c debited into cash A/c
Cash A/c credited into Krishna capital A/c
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Next step is to Balance the individual Ledger A/c: How to balance the ledger A/c? The individual ledger A/c may have more than two transactions during the specified period. The first step is to find out the totals of debit and credit side of the ledger account. The second step is to compare the totals of the two different sides The third step is to find out the total of which side is greater over the other The fourth step is to identify the difference among the two different side balances i.e., debit and credit side totals. The fifth step is most important step which balances the difference on the total of the side which bears lesser total over the greater. If the balance of the debit side of the ledger is more than the credit side of the ledger is called as Debit balance ledger and vice versa in the case of Credit balance ledger The closing balance of one ledger account will become automatically a opening balance of the same ledger account for next accounting period. Post the journal entries into respective ledger accounts. And list out their accounting balances. (i) Jan 1, 2006 Mr. Sundar has started business with a capital of Rs. 50,000 Rs
Jan 1, 2006 Cash A/c Dr To Sundars capital A/c Cr Being capital brought by Sundar as cash 50,000 50,000
Rs
(ii)
Jan 2, 2006 Goods purchased Rs 10,000 Rs Rs

10,000 Purchase A/c To Cash A/c Dr Cr Being cash purchase is made 10,000
Jan 2, 2006
(iii) Jan 5, 2006 Goods sold Rs 5,000 Rs

Jan 5, 2006 CashA/c To Sale A/c Dr Cr Being cash sale is made 5,000 5,000
Rs
(iv) Jan, 10, 2006 Goods purchased from Mittal & Co Rs 10,000 Rs
Jan 10, 2006 Purchase A/c To Mittal A/c Dr Cr Being credit purchase from Mittal 10,000 10,000
Rs
(v)
Jan, 11, 2006 Goods sold to Ganesh & Co Rs.10,000 Rs Rs

10,000 Ganesh A/c To SaleA/c Dr Cr Being credit sale made to Ganesh 10,000
Jan 11, 2006
(vi) Jan, 12, 2006 Goods returned to Mittal & Co Rs. 1,500 Rs
Jan 12, 2006
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Rs
1,500
Mittal & Co A/c Dr 1,500 To Purchase Return A/c Cr Being the goods returned to supplier Mittal & Co
(vii) Jan 20, 2006 Goods returned from Ganesh Rs. 2,000 Rs
Jan 20, 2006 Sales ReturnA/c Dr To Ganesh& co Cr Being sales return made by Ganesh & Co 2,000 2,000
Rs
(viii) Jan 31, 2006 Office Rent paid Rs. 500 Rs

Jan 31, 2006 Office Rent A/c To Cash A/c Dr Being office rent paid 500 500
Rs
(ix) Feb 2, 2006 Interim Cash Dividend received Rs. 3000 Rs

Feb 2, 2006 Cash A/c Dr To Interim Dividend Cr Being cash interim dividend received 3,000 3,000
Rs
(x)
Feb 8, 2006 Cash withdrawn from bank Rs. 2,000 Rs Rs

2,000 Cash A/c To Bank Dr Cr Being cash withdrawn from the bank 2,000
Feb 8, 2006
List out the various accounts which are involved in the enterprise during the year? I. II. Cash Account Sundar Capital Account
III. Purchase Account IV. Sales Account V. Mittal & Co Account
VI. Ganesh & Co Account VII. Sales Return Account VIII. Purchase Return Account IX. Office Rent Account X. Interim Dividend Account
XI. Bank Account Dr

Date Jan 1 Jan 5 Feb 2 Feb 8
Cash Account
Date Jan 2 Jan 31 Particulars By Purchase By Office Rent By Balance c/d
Cr
Rs 10,000 500 49,500
Particular Rs To Sundar Capital 50,000 To Sale 5,000 To Interim Dividend 3,000 To Bank 2,000 60,000
60,000
To balance b/d
49,500
Note: Debit side total is greater than the credit side total of the cash account. After determining the difference, the cash account shows Debit Balance.
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Dr
Date Particular To Balance c/d
Sundar Capital Account

Rs 50,000 Date Jan 1 Particulars By Cash Rs 50,000
Cr
50,000
50,000
By Balance B/d
50,000
Note: Sundar capital account is having the greater credit balance over the debit balance account which led to credit balance account. Dr
Date Jan 2 Jan 10 Particular To Cash To Mittal & Co
Purchase Account
Rs 10,000 10,000 20,000 Date Particulars By Balance c/d Rs 20,000
Cr
20,000
To Balance B/d
20,000
Note: Purchase account is bearing the debit balance account Dr

Date Particulars To Balance c/d
Sale Account
Rs 15,000 Date Jan 5 Jan 11 Particulars By Cash By Ganesh Rs 5,000 10,000 15,000
Cr
15,000
By Balance B/d Note: Sale account is bearing the credit balance account Dr
Date Jan 20 Particulars To Ganesh
15,000
Sales Return Account

Rs 2000 Date Particulars By Balance c/d Rs 2000
Cr
2000
2000
To Balance B/d
2000
Note: Sales return account is having the debit balance account Dr

Purchase Return Account

Rs 1,500 Date Jan 12 Particulars By Mittal &Co Rs 1500
Cr
1,500
By Balance B/d Note: Purchase return account is bearing credit balance account Dr
Date Jan 12 Particulars To Purchase Return To Balance c/d
1,500
Mittal & Co Account

Rs 1,500 8,500 10,000 Date Jan 10 Particulars By Purchase Rs 10,000
Cr
10,000
By Balance B/d
8,500
Note: Mittal & Co account is having the greater total in the credit side than the debit side led to credit balance at the closing
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Dr
Date Jan 11 Particulars To Sale
Ganesh & Co Account

Rs 10,000 Date Jan 20 Particulars By Sale Return By Balance c/d Rs 2,000 8,000 10,000
Cr
10,000
To Balance B/d
8,000
Note: Ganesh & Co account is bearing a greater debit side total than the credit side total which led to have debit balance account Dr
Date Jan 31 Particulars To Cash
Office Rent Account

Rs 500 Date Particulars By Balance c/d Rs 500
Cr
500
500
To Balance B/d
500
Note: Office rent account is bearing debit balance Dr

Interim Dividend Account

Rs 3,000 Date Feb 2 Particulars By Cash Rs 3,000
Cr
3,000
3,000
By Balance B/d Note: Interim dividend account is having the credit balance Dr
Date Particular To Balance c/d Rs 2,000
3,000
Bank Account
Date Feb 2 Particulars By Cash
Cr
Rs 2,000
2,000
2,000
By Balance B/d Note: Bank account is having the credit balance
2,000
1.11 CASE LET

Singania Chartered Accountants Firm established in the year 1956, having very good number of corporate clients. It continuously maintains the quality in audit administration with the clients since its early inception. The firm is eagerly looking for promising students who are having greater aspirations to become auditors. The firm is having an objective to recruit freshers to conduct preliminary auditing process with their corporate clients. For which the firm would like to select the right person who is having conceptual knowledge as well as application on the subjects. It has given the following Balance sheet to the participants to study the conceptual applications. The participants are required to enlist the various concepts and conventions of accounting.
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Balance sheet as on dated 31st Mar, 2006

Capital(A.Pandit) (+) Commission (+)Net profit (-)Drawings Capital( B.Pandit) (+)Commission (+) Net profit (-)Drawings Bank overdraft Sundry creditors Liabilities 1,00,000 4,925 1,04,925 11,869 1,16,794 16,000 1,00,794 1,00,000 1,187 1,01,187 11,869 1,13,056 16,000 Building Depreciation 2.5% Furniture Depreciation 10% Closing stock Sundry Debtors Cash in hand Assets 80,0000 2,000 78,000 23,000 2,050 20,950 1,14,500 25,000 400
97,056 29,000 12,000 2,38,850
2,38,850
List out the various accounting concepts dealt in the above balance sheet. Explain the treatment of accounting concepts
Check Your Progress
(1)
Financial Accounting is:

(a) (b) (c) (d) Accounting of business transactions Accounting of Financial transactions only Accounting of Non-financial transactions Accounting of both financial and non-financial transactions
(2)
Accounting concept is:

(a) (c) Theory of accounting Rules of accounting (b) (d) Procedures of accounting Practice of accounting
(3)
Journal is:
(a) (b) (c) (d) Preliminary step of accounting Intermediate step of accounting Both (a) & (b) Final step of accounting
(4)
Ledger account is prepared

(a) (b) (c) (d) On the basis of single entry system of accounting On the basis of double entry accounting system Both (a) & (b) None of the above
1.12 LET US SUM UP

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" Accounting is the process of recording, classifying, summarizing in a significant manner of transactions which are in financial character and finally results are interpreted."
The revenues are recognized only at the moment of realization but the expenses are recognized at the moment of payment. The charges which were paid only will be taken into consideration but the outstanding, not yet paid will not be considered. The revenues are recognized only at the time of occurrence and expenses are recognized only at the moment of incurring. The financial statements are found to be more useful to many people immediately after presentation only in order to study the financial status of the enterprise in the angle of their own objectives. The entire accounting system is governed by the practice of accountancy. The accountancy is being practiced through the universal principles which are wholly led by the concepts and conventions. Money measurement concept tunes the system of accounting as fruitful in recording the transactions and events of the enterprise only in terms of money. Business entity concept treats the owner as totally a different entity from the business. Going concern concept deals with the quality of long lasting status of the business enterprise irrespective of the owners' status, whether he is alive or not. Matching concept only makes the entire accounting system as meaningful to determine the volume of earnings or losses of the firm at every level of transaction. Duality or Double entry accounting concept is the only concept which portrays the two sides of a single transaction. The law of entire business revolves around only on mutual agreement sharing policy among the players. Personal accounts is an account which deals with a due balance either to or from these individuals on a particular period. Real Accounts is the account especially deals with the movement of assets. Nominal Accounts is an account deals with the amount of expenses incurred or incomes earned. It includes all expenses and losses as well as incomes and gains of the enterprise.
1.13 LESSON-END ACTIVITY

Assume you are a new-appointed Senior Manager of a firm. How what would you suggest to the accounting department for better accounting circulation?
1.14 KEYWORDS
Record Accounting Revenues Personal Account Normal Account Real Account Classifying Summarizing Business Entity Concept Money Measurement Concept Going Concern Concept Matching Concept Duality Concept Ledger
1.15 QUESTIONS FOR DISCUSSION

1. 2. Define Accounting. Illustrate the Accounting process.
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3. 4. 5. 6. 7.
Classify the various kinds of values in the accounting process. Highlight the journalizing process of accounting. Explain the process of ledgering of transactions of the business firm. Write brief note on the various classification of accounts. Explain the golden rules of accounting.
1.16 SUGGESTED READINGS

M.P. Pandikumar Accounting & Finance for Managers, Excel Books, New Delhi. R.L. Gupta and Radhaswamy Advanced Accountancy. V.K. Goyal, Financial Accounting, Excel Books, New Delhi. Khan and Jain Management Accounting. S.N. Maheswari Management Accounting. S. Bhat Financial Management, Excel Books, New Delhi. Prasanna Chandra, Financial Management Theory and Practice, Tata McGraw Hill, New Delhi (1994). I.M. Pandey, Financial Management, Vikas Publishing, New Delhi. Nitin Balwani Accounting & Finance for Managers, Excel Books, New Delhi.
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LESSON
2
TRIAL BALANCE
CONTENTS
2.0 Aims and Objectives 2.1 Introduction 2.2 Grouping of Various Accounting Transactions 2.3 Preparation of the Trial Balance 2.4 Why the Subsidiary Accounts have to be prepared? 2.4.1 Purchase Book 2.4.2 Purchase Returns Book 2.4.3 Sales Book 2.5 Steps involved in the Sales Book 2.5.1 Sales Return Book 2.6 Steps Involved in the Sales Return Book 2.6.1 Trade Bills Book 2.6.2 Bills Receivable Book 2.7 What is meant by the Cash Transaction? 2.7.1 Double Columnar Cash Book 2.7.2 Three Columnar Cash Book 2.7.3 Multi Columnar Cash Book 2.7.4 Petty Cash Book 2.8 Let us Sum up 2.9 Lesson-end Activity 2.10 Keywords 2.11 Questions for Discussion 2.12 Suggested Readings

In this lesson we shall discuss about trial balance. After going through this lesson you will be able to: (i) (ii) discuss grouping of various accounting transactions analyse preparation of the trial balance.
2.1 INTRODUCTION
The next most important stage is to prepare the statement (summary) of accounting balances and their names for the specified accounting period to the tune of principle of grouping transactions, known as Trial Balance.
Trial Balance is a list of accounting balances and their names; of the enterprise during the specified period which includes debit and credit balances of the various balanced ledger accounts out of the journal entries.
2.2
GROUPING OF VARIOUS ACCOUNTING TRANSACTIONS
There are eleven different ledger accounts involved out of the journal entries which already transacted are finally balanced. The balanced ledger accounts should be prepared as a summary list of their balances and names. The total of both balances are equivalent to each other. The major reason for the equivalent balances on both sides is only due to posting of entries to the tune of "Double Entry Accounting Concept (Or) Duality Concept". This is the concept which equates the total amount of resources raised with the total amount of applications of the enterprise. Purposes of preparing the Trial Balance: To prepare a statement of disclosure of final accounting balances of various ledger accounts on a particular date To prepare a statement of cross checking device of accounting while in the process of posting of entries which mainly on the basis of Double entry accounting principle. It facilitates the accountant to have systematic posting of entries It facilitates the enterprise for the preparation of Trading & Profit and Loss Accounts for the year ended.. and the Balance sheet as on dated .. It provides the birds' eye view of accounting balances of various ledger accounts during the specified period.
2.3 PREPARATION OF THE TRIAL BALANCE

The preparation of the trial balance is classified on the basis of three different accounts viz Real Account (R) Nominal Account (N) Personal Account (P) The classification of the transactions not only on the basis of accounts but also on the basis of payments and receipts. These payments and receipts classification further segmented into following categories Payments category - Debit Balance Debit Balance is the source of following golden rules of the three different accounts Personal Account - Debit the Receive Nominal Account-Debit all the expenses and losses Real Account - Debit what comes in & Debit all assets Trading Expense Category (TE) Profit and Loss Category (PL) Assets- Balance Sheet (BA) Receipts category-Credit Balance Credit Balance is the major source of other half of the golden rules of accounting Personal Account-Credit the Giver Nominal Account- Credit all income and gains Real Account- Credit what goes out & Credit all liabilities Trading Income Category (TI) Profit and Loss Category (PL) Liabilities - Balance Sheet (BL)
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The detailed Proforma of the trial balance is given in the Annexure -I for better understanding The following trial balance of the Sundar firm is prepared from the previous list of journal entries and ledger accounting balances.
Table 2.1: Trial Balance
Sl. No. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. Particulars Cash A/c Sundar Capital A/c Purchase A/c SalesA/c Sales ReturnA/c Purchase ReturnA/c Mittal &CoA/c Ganesh &CoA/c Office Rent A/c Interim Dividend A/c BankA/c Total Debit Balances Rs 49,500 20,000 15,000 2,000 1,500 8,500 8,000 500 3,000 2,000 80,000 Credit Balances Rs 50,000
Trial Balance
80,000
From the Table 2.1, it is obviously understood that the total amount of debit balances are equated to the total of credit balances of the enterprise. The above statement of accounting balances are the resultant out of the ledger accounts which is easier in preparation only at the moment, the firm has limited number of transactions.
Check Your Progress
(1)
Trial balance is
(a) (b) (c) (d) The statement of accounting balances The statement of various account names The statement of accounting balances and their names None of the above
(2)
Trial balance contains

(a) (b) (c) (d) Debit balance only Credit balances only Debit and credit balances only None of the above
(3)
Trial balance is the statement prepared on the basis of

(a) (b) (c) (d) Business entity concept Matching concept Double entry accounting concept Realization concept
Prepare trial balance from the following text of information extracted from the book of accounts of Ms. Selvi. Ms Selvi has brought a monetary capital of Rs. 1,00,000 for the conduct of business on 1st April, 2007. The brought capital was converted into real capital for the business in the form of tradable goods and commodities. She purchased household articles for trade which amounted Rs. 60,000. She has bought a service vehicle for Rs 1,500. She keeps Rs. 20,000 in the form of deposit at bank for contingencies. The remaining balance is kept in the form of cash in hand for meeting the day today expenses.
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2.4 WHY THE SUBSIDIARY ACCOUNTS HAVE TO BE PREPARED?

If the transactions of the enterprise are voluminous, to ease the process of posting the transactions, the transactions should be classified into two categories. The transactions are segmented one on the basis of regular and another on the basis of non-regular occurrence. The regular / frequent occurrence of transactions are recorded only in the separate books which are known as subsidiary book of accounts or subsidiary journals instead to record in the regular journal. The infrequent transactions are recorded / posted in the original journal or Journal proper which do not have any specific subsidiary journal or subsidiary books. The subsidiary journals or books are developed by the firms only based on the occurrence of the transactions. Normally the frequent occurrence of the transactions of the firm are major formation of the subsidiary books of the accounting system. The following are the subsidiary books on the major frequent occurrence of transactions
Subsidiary Books
Cash Transaction
Non-Cash Transaction
Cash Book
Sales Book
Purchase Book
Sales Return Book
Purchase Return Book
Bills Receivable Book
Bill Payable Book
Subsidiary books are classified on the basis of transactions viz Cash transactions and Non-cash transactions First , let us discuss the Non-cash transactions What is meant by the Non-cash transaction? The Non-cash transaction is a transaction out of credit terms and conditions of the enterprise. The Non cash transactions shall include the following transactions of the enterprise, which do not involve any cash ; are as follows Credit Sales Book Credit Purchases Book Credit Sales Return Book Credit Purchases Return Book Bills Payable Book - Out come of Credit transaction Bill Receivable Book - Out come of Credit transaction
2.4.1 Purchase Book

36
The purchase book is called in other words as purchase journal . It is a book meant for credit purchases only for resale
Proforma of the Purchases Book

Date Name of the Supplier Ledger Folio Inward Invoice No. Amount Rs
Trial Balance
The purchase book usually contains various components viz. Name of the supplier Ledger folio Inward Invoice No Amount (Rs) - From whom the raw material were procured on credit - It is the number of the page where the journal entry is transacted. - The book contains the invoice number of the credit purchase of the goods from the supplier -The book contains the value of credit purchase transactions from the supplier.
Steps involved in posting the entries: Posting the entries pertaining to the individual accounts into the Purchase journal The total of the purchase journal is determined on monthly and finally should be posted into debit side of the purchase account- To satisfy the rule of Real Account; which not only contains the cash purchase but also the credit purchase of the firm during the year.
2.4.2 Purchase Returns Book

This is a book of goods returned to the supplier which are out of credit purchases. The return of goods out of the credit purchase is due to non confirmation with the specification mentioned in the order.
Proforma of the Purchase Returns Book
Date Name of the Customer Ledger Folio Out ward Invoice No. Amount Rs
The purchase returns book consists of various components viz Name of the supplier - To whom the goods/ raw material purchased , were returned Ledger folio Debit Note No Amount (Rs) Steps involved: Posting the entries of the purchase returns to the individual suppliers' account into the purchase return journal The monthly total of the purchase journal is credited into the purchase return account 2.4.3 Sales Book It is a book maintained by the enterprise only during the moment of selling the goods on credit. It is pronounced in other words as sales journal.
Proforma of the Sales Book
Date Name of the Customer Ledger Folio Credit Noted No. Amount Rs
- It is the number of the page where the journal entry is posted -It is the page number on the original copy of the document sent to the firm to whom the goods are sent -The book should illustrate the value of goods/raw materials returned out of credit purchase
The sales normally contains the following components Name of the customer - The sales book usually records the name of the buyer who has been sold the goods or raw materials on credit
37
Ledger Folio
- The page number where the journal entry is posted / transacted This book registers the invoice number of the goods / raw materials sold out to the buyers on credit. It is fundamental document to earmark the value of the goods/raw materials sold out on credit to the various buyers. It facilitates the firm to identify the amount of sales transacted on credit as well as to collect the amount of dues from the buyers.
Out Ward Invoice NoAmount (Rs)-
2.5 STEPS INVOLVED IN THE SALES BOOK

Sale of the goods/raw materials to the individual buyers are entered on daily basis The monthly total of sales book is credited into the sales account of the firm which includes both the sale transactions of cash as well as credit
2.5.1 Sales Return Book

It is a book which registers the goods sold on credit and received from the buyers. The sales return from the buyers is due to non confirming to the specifications mentioned at the moment of placement of the order. It is known as sales return journal.
Proforma of the Sales Return Book
Date Name of the Supplier Ledger Folio Debit Note No. Amount Rs
The following are the various components dealt in the design of the book Name of the customer - It includes the most important information about the buyer who returned the goods /raw materials, non-confirming to specifications of the placed. Ledger folio - It contains the page number of the journal entry posted.
Credit Note No - It is a number on the original copy of the document sent to the firm from whom the goods are received i.e., buyer
2.6 STEPS INVOLVED IN THE SALES RETURN BOOK

Sales return of the enterprise from the individual buyers are recorded immediately after the transactions The monthly total of the sales return is posted into the debit side of the sales return account in accordance with the rule of Real account
2.6.1 Trade Bills Book

The trade bills book can be classified into two categories viz Bills receivable book and Bills payable book.
2.6.2 Bills Receivable Book

It is a book maintained especially for promissory notes & Bill of exchanges accepted by the customers out of their dues , as an out come of credit sale of the enterprise. The bills receivable and promissory notes are nothing but the resultant of the credit sale transactions of the enterprise not only to safe guard the interest of enterprise but also to collect the dues from the customers as per the terms of the trade agreed earlier.
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Proforma of the Bills Receivable Book

Sl.No. Date From whom Received Acceptor Date of the bill Term Date of the Maturity Where Receivable Amt Rs How Disposed
Trial Balance
The various components of the Bills payable book are as follows From whom Received- The either bill or promissory received from whom? .The name of the party should entered at the moment of receiving the negotiable instruments of the trade. Acceptor Date of the bill Term Date of Maturity Where payable Amount (Rs) How disposed - The person / institution who/which accepts the terms of the bill to make the payment -At when the bill is drafted/ drawn for obtaining the acceptance of the buyer ;who bought the goods on credit -Modalities involved in the process of payment of the dues mentioned in the bill - Date at when the bill to be presented for collection from the customer. -The place of amount payable by the customers or buyers who bought the goods on credit. -It reveals the amount How much to be collected from the customer through either bill of receivable or promissory note . -The process of the collection done should be recorded for future verification in settling the dues of the customer.. Bills Payable Book: It is a book of bills payable or promissory notes accepted by the enterprise to the suppliers at the moment of carrying out the credit purchase.
Proforma of the Bills Payable Book
Sl.No. Date Name of the Drawer Payee Date of the bill Term Date of the Maturity Where Payable Amt Rs Remarks
The following are the some of the important components normally included in the book: Name of the drawer - Name of the person or concern , who or which draws the bill nothing but either seller or manufacturer or supplier of the goods or raw materials. - To whom the payment has to be paid - Normally included to know the date at when the bill was drafted which is under the possession of the seller or supplier. - It is the date at when the payment has to be made as per the terms of trade. - At where the amount of the bills to paid
Payee Date of the bill Date of Maturity Where payable
2.7 WHAT IS MEANT BY THE CASH TRANSACTION?

The Cash transaction is a transaction carried out only out of cash . The cash transactions are recorded in the subsidiary book known as cash book. The cash book can be classified into three categories Single columnar cash book Double columnar cash book
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Three columnar cash book Single columnar cash book: It is a book generally records the transactions into two classification viz Payments and Receipts. The receipts and payments are recorded in the debit and credit side of the cash book respectively. The debit and credit side transactions of the cash book are prefixed with "To" and "By" respectively.
Proforma of the Single columnar Cash Book
Date Receipts To Opening Balance B/d Rs Date Payments Rs
By Closing Balance B/d
2.7.1 Double Columnar Cash Book

It is another kind of cash book which is nothing but extension of earlier versioned single columnar cash book. The double columnar cash book includes the operations of the enterprise into two different categories viz transactions through Cash and Bank. It means that the entire receipts and payments of the business routed through cash and bank. The transaction of the business with the bank either at the moment of cash withdrawal or cash deposit leads to register the movement of cash from one entity to another through the contra entries. The contra entries are posted in two different occasions viz cash withdrawal and cash deposit. During the cash withdrawal, the movement of cash is depicted below for easier understanding, which is nothing but the movement of asset from bank to firm. Firm
Bank SAVINGS BANK A/c Firm OPERATIONS
Bank
Transaction No 1 Jan 5, 2006, Cash withdrawal Rs.10,000 from the bank is having the following journal entry Cash A/c To Bank A/c Dr Cr Rs.10,000 Rs.10,000
(Being cash withdrawn from the bank A/c) From the above entry, it is obviously understood that the bank is the giver of the cash resources from the savings bank a/c and cash receipts are made only due to withdrawal of cash from the bank There are two different angles of cash withdrawal one is in the dimension of firm and another is bank. Firm Bank
Cash receipts Cash Payments
Dr
Date
Proforma of Double columnar cash book

Receipts To Balance B/d To Bank C1 To Cash C2 Bank Cash Date Payments By Balance c/d* By cash C1 By Bank C2 By Balance B/d Bank
Cr
Cash
Jan 5 Jan 20
10,000 5,000
Jan 5 Jan 20
10,000 5,000
40
* Bank overdraft
The above table of double columnar cash book clearly elucidates the contra entry process taken place in between two entities viz firm and bank .
Trial Balance
2.7.2 Three Columnar Cash Book

It is another dimension of cash book which has three component of operations of the enterprise viz Cash, Bank and Discount. This cash book is extension of the early one, not only which incorporates the receipts and payments of the firm through cash and bank but also discount allowed and received. Dr
Date Receipts To Balance B/d
Proforma of Three columnar cash book

Bank Cash Discount Allowed Date Payments By Balance c/d By Balance B/d Bank Cash
Cr
Discount Received
Why discount allowed is brought under the debit side? The discount is allowed at the time of receipts out of sale . The discounts are categorized into two categories viz cash discount and trade discount. Cash discount is the discount allowed by the firm only at the moment of making the payment with in the stipulated time frame i.e. 7% @ 10 days means that 7% discount will be given to the parties who are able to make the payment of dues within 10 days of stipulated time period. Trade discount is the discount allowed by the firm to encourage the regular customers to buy more and more. This type of discount is allowed by the firm only on the total value of the invoice. The discount is granted on the gross value of the goods purchased by the regular customer from the enterprise. Why discount received is brought under the credit side? The reason for showing the discount received under the credit side of the cash book is that the amount of discount received availed only during the moment of payment of overdue only due to credit purchase
2.7.3 Multi columnar Cash Book

The regular receipts and payments on various heads require the firm to design not only a most suited cash book which is in a position to incorporate all the entries of cash in nature but also to reduce the excessive labour involved in the process of sorting out them. To replace the bottlenecks of the three columnar cash book, multi columnar cash book is developed which is in a position to highlight the receipts and payments of a firm under various accounting heads within a specified period. Under this system of cash book, the firm is required to register the payments and receipts of the respective heads only in the columns especially provided for determining the balance under each at the end of the specified month.
2.7.4 Petty cash Book

It is a book maintained by the petty cashier who is especially appointed for the purpose to assist the cashier of the business enterprise in order to meet the day to day expenses of meager in volume. The cashier normally hands over a certain sum of money to the petty cashier to meet out tiny expenses of the enterprise based on the early estimation on the daily requirement e.g., postage, refreshment charges. The meager amount which is
41
given by the cashier is known in other words as petty cash or float. The vouchers and receipts are finally examined by the cashier based on the presentation of petty cash book balance.
Check Your Progress (1) Subsidiary books are: (a) b) (c) (d) (2) Additional records of accounting for future reference To administer only few transactions of the business Accounting record for the administration of voluminous transactions None of the above
Subsidiary books are prepared for: (a) (b) (c) (d) Cash transactions only Both cash and Non-cash transactions Non cash transactions only None of the above
(3)
Sales book is the record to enter: (a) (b) (c) (d) Regular credit sale transactions Regular cash sale transactions Regular credit and cash sale transactions None of the above
(4)
The monthly closing balance of purchase book Rs.10,000 to be posted at: (a) (b) (c) (d) Credit side of the purchase a/c To be added with the final closing balance Debit side balance of the purchase a/c None of the above
Example 1: The following are extracted information from the books of M/s Brown & Co. Prepare the trial balance
Particulars Sundry Debtors Sundry Creditors Bills receivable Plant and machinery Purchases Capital Free hold premises Salaries Wages Postage and stationery Closing stock Rs 30,600 10,000 5,000 75,000 1,90,000 70,000 50,000 21,000 24,400 1,750 30,000 Particulars Carriage inwards Carriage outwards Bad debts Bad debts provision Office general expenses Cash at bank Cash in hand Bills payable Reserve Sales Rs 1,750 1,000 950 350 1,500 5,300 800 7,000 20,000 3,31,700
The first step is to determine the debit and credit balance of the business transactions in terms of Expense, Revenue, Assets and Liabilities
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Trial Balance M/s Brown

Particulars Sundry Debtors Sundry Creditors Bills receivable Plant and machinery Purchases Capital Freehold premises Salaries Wages Postage and stationery Closing stock Rs 30,600 10,000 5,000 75,000 1,90,000 70,000 50,000 21,000 24,400 1,750 30,000 Nature of balance Debit Credit Debit Debit Debit Credit Debit Debit Debit Debit Debit Particulars Carriage inwards Carriage outwards Bad debts Bad debts provision Office general expenses Cash at bank Cash in hand Bills payable Reserve Sales Rs 1,750 1,000 950 350 1,500 5,300 800 7,000 20,000 3,31,700 Nature of balance Debit Debit Debit Credit Debit Debit Debit Debit Credit Credit
Trial Balance
Particulars Sundry Debtors Bills receivable Plant and machinery Sundry Creditors Carriage inwards Carriage outwards Bad debts Bad debts provision Purchases Capital Freehold premises Salaries Wages Postage and stationery Closing stock Office general expenses Cash at bank Cash in hand Bills payable Reserve Sales Total
Debit Rs 30,600 5,000 75,000 1,750 1,000 950
Credit
Rs
10,000
350 1,90,000 70,000 50,000 21,000 24,400 1,750 30,000 1,500 5,300 800 7,000 20,000 3,31,700 4,39,050
4,39,050
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Annexure-I Proforma Trial Balance
Debit / Payment Balances Sl. Expenses or Asset No. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. Carriage Inward Carriage Clearing chargesImport Authority Coal & Coke Energy Factory Expenses Freight charges Fuel & Power Gas & Water Manufacturing Expense Motive Power Octroi Oil Purchases Purchases Wages Water Return Inward(to be deducted from Sales) Audit fees Bad Debt Advertisement Bank Charges Clearing chargesCheque Commission Paid Depreciation Discount Paid Donation Paid Electricity General Expenses General Expenses Interest on capital Interest Legal charges Lighting charges
Miscellaneous expenses
Credit / Receipt Balance Final Sl. Incomes or Liabilities A/c No. Trading Accounting Heads N TE 1. Sales A/c N N N N N N N N N N N N N N N N PE TE TE TE TE TE TE TE TE TE TE TE TE TE TE TE 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18.
A/c
Final A/c TI
19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40. 41. 42. 43. 44. 45.
Profit & Loss Accounting Heads N PE 19. Commission received N PE 20. Discount received N PE 21. Donation N PE 22. Interest received N PE 23. Rent received N N N N N N N N N N N N N N N N N N N N N N P P P PE PE PE PE PE PE PE PE PE 24. 25. 26. 27. 28. 29. 30. 31. 32. Trading profits
N N N N N N
PI PI PI PI PI PI
Office expenses Packaging charges Printing & Stationery Postage Rent, Rates, Taxes Stable expenses Subscription paid Sundry expenses Travelling expenses Telephone charges
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46. Bank balance 47. Bank Deposit 48. Bill Receivable
PE 33. PE 34. PE 35. PE 36. PE 37. PE 38. PE 39. PE 40. PE 41. PE 42. PE 43. PE 44. PE 45. Balance sheet BA 46. BA 47. BA 48.
Bank loan Bank overdraft Bills payable
P O P
BL BL BL Contd...
49. 50. 51. 52. 53.
54. 55. 56. 57. 58. 59. 60. 61. 62. 63. 64. 65. 66. 67. 68. 69. 70. 71.
Cash in deficit Cash in Hand Copy right Deferred Revenue Expenses Drawings Deducted from the capital Finished goods Fixtures and Fittings Furniture Freehold property Goodwill Investment Leasehold property Livestock Loose Tools Outstanding Incomes Patent Petty cash Plant & Machinery Preliminary expenses Prepaid expenese Raw materials Sundry debtors Suspense payment
P R N N P
BA BA BA BA BL
49. 50. 51. 52. 53.
Capital Cash excess Debentures Donation - Building Loan received
P P P N P
BL BL BL BL BL
Trial Balance
R R R R N P R R R P N R R N N N P P
BA BA BA BA BA BA BA BA BA BA BA BA BA BA BA BA BA BA
54. 55. 56. 57. 58. 59. 60. 61. 62. 63. 64. 65. 66. 67. 68. 69. 70. 71.
Loan from Mr Y Mortgage Loan Net profit Outstanding expenses Pre received Income Suppliers Share premium Suspense receipt Unpaid dividend
P P N P P P N P P
BL BL PL BL BL BL BL BL BL
2.8 LET US SUM UP

Purposes of preparing the Trial Balance include: To prepare a statement of disclosure of final accounting balances of various ledger accounts on a particular date. The classification of the transactions not only on the basis of accounts but also on the basis of payments and receipts. These payments and receipts classification further segmented into categories. The subsidiary journals or books are developed by the firms only based on the occurrence of the transactions. Normally the frequent occurrence of the transactions of the firm are major formation of the subsidiary books of the accounting system. The Cash transaction is a transaction carried out only out of cash. The cash transactions are recorded in the subsidiary book known as cash book. The cash book can be classified into three categories Single columnar cash book Double columnar cash book Three columnar cash book

Prabhat Kumar is very disturbed. Who says consistent accounting? He asks, Look at these two statements! Two retailers with identical delivery trucks. I know I sold them both to these guys less than a week apart. They cost Rs. 6,00,000 and would you believe it? After one year Kiran Store has depreciated it Rs. 1,00,000. The exclusive Madams shop took Rs. 2,00,000 depreciation the first year. How can you wear out a truck hauling around womens clothing so much in one year? It doesnt make sense. Explain how and why the differences could be justified.
2.10 KEYWORDS
Trial Balance Subsidiary Journals
45
Purchase books Acceptor Cash Transaction Double Columnar Cash book Petty Cash book

1. Write short notes on (a) (b) (c) (d) 2. 3. 4. Credit balance Trial Balance Transaction Receiver
What is the need of having subsidiary Account? What is outward invoice no. meant for? Explain why? (a) (b) Discount allowed is brought under the debit side Discount received is brought under the credit side
5.
What are the elements of Non cash Transaction?

M.P. Pandikumar, Accounting & Finance for Managers, Excel Books, New Delhi. R.L. Gupta and Radhaswamy, Advanced Accountancy V.K. Goyal, Financial Accounting, Excel Books, New Delhi. Khan and Jain, Management Accounting S.N.Maheswari, Management Accounting S. Bhat, Financial Management, Excel Books, New Delhi. Prasanna Chandra, Financial Management Theory and Practice, Tata McGraw Hill, New Delhi (1994). I.M. Pandey, Financial Management, Vikas Publishing, New Delhi. Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.
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LESSON
3
FINAL ACCOUNTS
CONTENTS
3.0 Aims and Objectives 3.1 Introduction 3.2 Trading Account 3.2.1 Balancing Process 3.3 Profit & Loss Account 3.4 Balance Sheet 3.4.1 Cash Method of Accounting 3.4.2 Mercantile Method of Accounting 3.5 Let us Sum up 3.6 Lesson-end Activity 3.7 Keywords 3.8 Questions for Discussion 3.9 Suggested Readings

In this lesson we shall discuss about final accounts. After going through this lesson you will be able to: (i) (ii) analyse trading account discuss profit and loss account and balance sheet
3.1 INTRODUCTION
The preparation of Final accounts the business firm involves two different stages viz Preparation of Accounting and Positional Statements of the enterprise. The preparation of Accounting statements involve two different categories viz Trading account and Profit & Loss account. The preparation of the positional statement involves only one statement viz Balance sheet. In this chapter the accounting statements as well as Balance sheet will be elaborately discussed to the tune of adjustments. First the trading account contents and format are discussed to determine the Profit and Loss under the trading account of the business firm, i.e. Gross profit. Second part of this chapter deals with the preparation of Profit & Loss account in order to determine the operating profit & loss of the enterprise. Third part of the chapter involves in the preparation of financial position of the enterprise in terms of Liabilities and Assets.
3.2 TRADING ACCOUNT

This is first financial statement prepared by the owner of the enterprise to determine the gross profit during the year through the matching concept of accounting. The gross
profit of the enterprise is calculated through the comparison of purchase expenses, manufacturing expenses, and other direct expenses with the sales. It is prepared normally for one year in accordance with accounting period concept i.e., operating cycle of the enterprise which should not exceed 15 months with reference to the Companies Act 1956. Dr Trading Account for the year ended .
XXXX By Cash Sales XXXX Add Credit Sales XXXX By Total Sales XXXX Less Sales Return XXX By Net Sales By Closing Stock By Gross Loss C/d**
Cr
To Opening Stock To Cash Purchases XXXX Add Credit Purchases XXXX To Total Purchases XXX Less Purchase Return XXX To Net Purchases To Wages To Carriage Inward To Factory lighting To Fuel, Coal, Oil To duty on Import of Materials To Octroi duty To Gross Profit* C/d
XXXX XXXX XXXX XXXX XXXX XXXX XXXX XXXX
XXXX XXXX XXXX
3.2.1 Balancing Process

* Gross profit is the resultant of an excess of the credit side total over the total of debit side. It means that the gross profit is the excess of incomes in the credit side over the expenses in the debit side.
Gross Profit = [INCOMES (CREDIT) > EXPENSES(DEBIT)]
** Gross Loss is the outcome of an excess of the debit side total over the total of credit side. It means that the gross loss is the excess of expenses in the debit side over the incomes in the credit side.
Gross Loss = [EXPENSES (DEBIT) > INCOMES(CREDIT)]
Illustration 1 with no opening stock and closing stock Prepare the trading account for M/s Shan &Co Ltd., for the year ended 31st Mar, 2006 Total Purchases during the year Rs. 10, 000 Total Sales during the year Rs. 15, 000 In this problem, the Gross profit is simply found by deducting the sales volume from the purchases. Gross profit = Sales Purchases First step open the Trading account for the year ended 31st Mar, 2006 Solution 1
Trading Account for the ended 31st Mar, 2006 Dr Rs
To Sales
Rs Cr
15,000
To Purchases 10,000 To Gross profit c/d 5,000* Balancing figure(Rs.15,000-Rs.10,000)
*Gross profit Rs. 5, 000 is the resultant of excess income over the expenses. The total of the credit side more than the debit side total of the trading account. Illustration 2 with Opening stock, various kinds of purchases and sales, Closing stock
48
From the following information, prepare the trading account for the year ended 31st Mar, 2006.
Rs. Stock on 1st April 2005 (Opening stock) Purchases i. ii. Sales i. ii. Cash sales Credit sales 20, 000 60, 000 6, 000 Cash purchases Credit purchases 20, 000 50, 000 4, 000
Final Accounts
Stock on 31st Mar, 2006 (Closing Stock)
In this problem, the sales and purchases are given in two different categories viz. cash and credit. The credit and cash purchases and sales of a firm should be added to determine the total volume of purchases and sales made during the year. The purpose of crediting the closing stock in the trading account is to find out the materials or goods consumed for trading purposes. In order to find out the total amount of goods or materials consumed during a year, three different components to be separately considered. Opening Stock Purchases and Closing Stock Opening Stock: It is a stock of goods or raw materials available at the opening of the accounting period, which is nothing but a closing stock of the yester accounting period utilized for trading during the current year. Purchases: Purchase of goods or raw materials is either for resale or manufacturing. Closing Stock: It is a stock nothing but an outcome of lesser volume of sales than the aggregate of opening stock and purchases Material consumed could be calculated Material consumption=Opening stock + Purchases - Closing stock The closing stock is credited in the trading account in stead of deducting it directly from the aggregate of opening stock and purchases during the year. The posting of the closing stock under the credit side of the trading account not only facilitates the firm to find out the consumption during the year as well as reduces the cost of goods sold incurred during the year. Solution
Trading Account for the year ended 31st Mar, 2006 Dr
To Opening stock To Credit purchases 20,000 To Cash purchases 50,000 To Total purchases To Gross profit c/d
Rs
4,000 By Credit sales 20,000 By Cash sales 60,000 By Total sales By Closing stock
Rs Cr
80,000 6,000 86,000
70,000 12,000 86,000
By Gross profit B/d Illustration 3
12, 000
Prepare trading account of M/s Sundar & Sons as on 31st Mar, 2005 from the following information extracted from the book of accounts Rs Opening stock on 1st April 12004 Purchases 50, 000
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Cash Credit Sales Cash Credit Purchase Returns Carriage Inwards Marine insurance on purchase Other direct expenses Sales Returns Stock as on 31st Mar, 2005
1, 20, 000 1, 00, 000
40, 000 1, 00, 000 20, 000 10, 000 6, 000 4, 000 30, 000 10, 000
In this problem, Return out wards and in wards are given in addition to cash and credit purchases and sales of a firm to find out the Net purchases and the Net sales of the firm. Net Sales = Cash Sales + Credit Sales - Sales Returns
Net Purchases = Cash Purchases + Credit Purchases - Purchase Returns Solution

Trading Account for the year ended 31st Mar, 2005
Dr
To opening stock To Cash Purchaes 1,20,000 Add: Credit purchase 1,00,000 To total purchase 2,20,000 Less: Purchase Return 20,000 To Net Purchase To carriage Inwards To Marine Insurance To other direct expenses
Rs
50,000 By Cash sales 40,000 Add:Credit Sales 1,00,000 By total Sales 1,40,000 Less: Sales Return 30,000 By Net Sales By Closing stock By Gross Loss c/d
Rs
Cr
2,00,000 10,000 6,000 4,000 2,70,000
1,10,000 10,000 1,50,000
2,70,000
To Gross Loss B/d
1, 50, 000
Gross Loss is due to en excess of the debit side total over the credit side total
3.3 PROFIT & LOSS ACCOUNT

It is a second statement of accounting in connection with the earlier to determine the Net profit/loss of the enterprise out of the early found Gross profit/loss. This is an accounting statement matches the administrative, selling and distribution expenses with the gross profit and other incomes of the enterprise. This is an account prepared for one operating cycle of the firm i.e. 12 months in period. The transactions are recorded in accordance with golden rules of nominal account. In the profit & loss account, the expenses and losses are debited and incomes and gains are credited. The reason for bringing down the gross loss /gross profit of the trading account into the debit and credit side of Profit & Loss A/c respectively, are only to the tune of nominal accounting ruling with reference to debit all expenses and losses and credit all incomes and gains. The expenses which are matched with the credit total of the profit and loss account. Classified into various categories
50
i.
Administrative Expenses
ii. iii. iv. Dr
Selling & Distribution Expenses Financial Expenses Legal Expense.

Profit and Loss Account for the year ended..
Final Accounts
Rs
XXXX By Gross Profit B/d
Rs Cr
XXXX
To Gross Loss B/d Balancing figure Office and Administrative Expenses To Salaries To Rent , Rates and Taxes To Office Lighitng To Printing and Stationery To Insurance premium To postage To General expenses To miscellaneous expenses Selling and Distribution Expenses To Salary to sales staff To commission charges To Advertising expenses To Carriage outward To Bad debts To Packing expenses Financial Expenses To interest on capital To interest on loans To trade discount allowed To cash discount allowed Maintenance Expenses To Depreciation on Fixed assets To Repairs and maintenance of Productive assets To loss on sale of assets Other Expenses To Provision for debts To Net profit c/d*
By Rent received
By commission received
By interest on drawings By interest on investments By trade discount received By cash discount received
To profit on sale of assets
By Net loss c/d**
The balancing process of the profit and loss account leads to two different categories *Net profit is the resultant of excess of income in the credit side over the expenses in the debit side of the Profit and Loss account ** Net Loss is an outcome of excess of expenses in the debit side over the incomes in the credit side Illustration 4 From the following information, Prepare the Profit and Loss account Debit Rs Gross profit from the trading account Manager Salary Office lighting Office Rent Local Taxes Salary paid to salesmen 1, 00, 000 30, 000 5, 000 15, 000 1, 000 20, 000
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Credit Rs
Commission charges paid Legal charges paid Bad debts Advertising charges Package charges Discount allowed Discount received Dividend received Rent received Depreciation charges Repairs and Maintenance Interest on loans Dr
10, 000 3, 000 1, 500 25, 000 7, 500 3, 000 4, 000 2, 000 1, 000 10, 000 2, 500 1, 500 500
Profit and Loss account for the year ended Cr Rs Rs

By Gross profit B/d By Discount received By Dividend received By Rent received By Interest received By Net Loss c/d* 1,00,000 4,000 2,000 1,000 500 24,500 30,000 5,000 15,000 20,000 10,000 3,000 1,500 25,000 7,500 10,000 2,500 1,500 1000 1,32,000
To Manager Salary To Office lighting To Office Rent To Salary paid salesman To commission charges To Legal charges To Bad debts To Advertising charges To Package charges To Depreciation charges To Repairs and maintenance To Interest on loan To Local taxes
1,32,000
* Net loss is the excess of the expenses total in the debit side Rs. 24, 500 over the incomes total in the credit side of the profit and loss account.
3.4 BALANCE SHEET

Balance sheet is the third financial statement which reveals the financial status of the enterprise through the total amount of resources raised and applied in the form of assets. This is the fundamental statement of the firm which explores the firm financial stature through the resources mobilized and investments applied i.e. Liabilities and Assets respectively. From the early, according to double entry concept or Duality concept, the balance sheet can be divided into two distinct sides, known as liabilities and assets. The balance sheet can be disclosed in two different orders (i) (ii) in the order of long lastingness - permanence in the order of liquidity
Proforma Balance Sheet as on dated. (In the order of Long lastingness)
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Final Accounts
Liabilities Capital XXXX Less: Drawings XXX Add: Net profit XXXX Long-term borrowings Sundry creditor Bills payable Bank overdraft Outstanding expenses Pre received income Total liabilities Total liabilities
Rs
XXXX XXXX XXX XXX XXX XXX XXX XXXX XXXX
Assets Land & Building Plant & Machinery Furniture& fittings Fixtures& tools Marketable securities Closing stock Sundry debtors Bills receivable Pre paid expenses Cash at Bank Cash in hand Total Assets Cash in hand Total Assets
Rs XXXX XXXX XXXX XXXX XXXX XXXX XXXX XXXX XXXX XXXX XXXX XXXX XXXX XXXX
The downward arrow shows the order / arrangement of the assets and liabilities on the basis of permanence or long lastingness The upward arrow shows the order /arrangement of the assets and liabilities basis of liquidity. Methods of determining the accounting income includes: i. ii. Cash method of accounting Mercantile method of accounting on the
3.4.1 Cash Method of Accounting

Under this method, cash receipts are matched with the cash payments irrespective of the time period in order to determine the income.
3.4.2 Mercantile Method of Accounting

Under this method, time period is given greater importance than the actual receipts and payments. It records the receipts and expenses pertaining to the specified period whether them are actually received /paid or not. The receipts as well as payments of the other periods should be ignored /eliminated in determining the income of the stipulated duration. It is popularly known in other words as "Accrual Accounting System". Next stage is to classify the types of income of the enterprise: To determine income of the business, what should be in character ? Either in accounting income or taxable income. Taxable income can be computed from the transactions of the enterprise but they are subject to frequent modifications on the tax provisions from one year to another year. This cannot be uniquely found out unlike the accounting income. The accounting income should have to be found out only to the tune of accounting principles and concepts. The process of final accounts diagram is illustrated in the next page for easier understanding not only to adopt the mercantile system of accounting but also to implement the duality principle of accounting throughout the transactions.
Check Your Progress
1. 2.
Why land and building is given greater priority under the order of permanence? Why cash in hand is given greater priority under the order of liquidity?
Adjustment entries The adjustment entries are classified into three segments viz on expenses, incomes and others.
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On expenses The adjustment entries on expense can be classified into two categories (i) Outstanding Expenses: These are incurred expenses but not paid in cash E.g. Rent of the office is Rs. 22, 000 for 11 months only The enterprise has failed to remit the payment of last month rent amounted Rs. 2, 000. According to mercantile system of accounting, the rent of the office, whether fully paid or not, it should be totally considered for the entire duration to determine the income of the enterprise. Finally, what is to be done ? The amount of actual rental should be added with the rent which has not been paid by the enterprise i-e (Rs. 22, 000+Rs. 2, 000=Rs. 24, 000) Treatment of the transaction Debit the expense account Credit the liability i-e of the person to whom the amount to be paid
Profit &Loss A/c:- Add the outstanding amount with the total expenses already paid Balance sheet:-Include it as an item of responsibility under the liabilities side
(ii)
Prepaid expenses: Normally, some of the expenses paid for availing the services are not fully extracted during the term; which left / unused should be normally carried forward to the next term. It means that the expense which is paid in advance to make use of the service for forthcoming period to whom is known as debtor; the person who keeps the money of the enterprise for the definite duration is nothing but an asset.
Debit the asset - Advance payment for service Credit expense Profit the &Loss A/c:- Deduct the prepaid amount from the total expenses already paid
Balance sheet:-Include it as an item of application under the assets side
Next major segment in the adjustment entry is on Incomes Income Outstanding Perceived Income (iii) Income outstanding: It happens during the enterprise then and there ; which means income earned but not received. It happens in the case of certain income of dividend on shares, interest on loans granted not yet received. The income earned but not received is also an income that should be credited in the income account to know the total volume of the income pertaining to the accounting period. The income earned but not received is nothing but an asset not yet received. The income not yet received from whom should be debited as an asset due to the enterprises' money income with the other person / institution.
Profit &Loss A/c:- Add the income outstanding amount to the total incomes already received Balance sheet:-Include it as an item of unrealized income under the assets side i.e the firms money with the others
54
(iv) Income received in advance: Any income received in advance cannot be considered as an income which should be calculated and deducted from the total income received; known as advance receipt. It is the income of the other period; should be eliminated from the income received in accordance with the mercantilist accounting system in determining the income. The income which is received in advance pertaining to the period of non rendered service should removed from the total income received, in order to determine the original income of the period should be known exactly. The amount received in advance of non rendered service is the responsibility to return nothing but the liability of the firm.
Debit the Income account Credit the Income received in advance - Liability of the balance sheet
Profit &Loss A/c:- Deduct the Income received in advance from the total incomes which were already received. Balance sheet:-Include it as an item of responsibility for non rendered service under the liabilities side
Final Accounts
(v)
Bad debts: Bad debts is the result of credit sales which only due to the inability of customers / consumers to settle the overdue. The inability may be due to poor repaying capacity or insolvent during the moment of the sales. The bad debt due to the inability cannot be deducted from the sales volume which was already transacted. The debts cannot be recovered has to be treated as a loss of the firm. Debit all losses of the firm. The losses due to bad debts should be appropriately effected as well as adjusted in the individuals' account i-e in the consumers' account who received the goods on credit
Profit &Loss A/c:- Non recovery of credit sales is deemed to be a losses should be debited to Profit & Loss A/c Balance sheet:-Non recovery of credit sales should be deducted from the volume of credit sales transacted by the firm under the Assets side in order to determine the original amount of credit outstanding
Check Your Progress
1.
If the closing stock is given, the effect of the entry is

(a) (b) (c) (d) Profit & Loss A/c Credit Balance Sheet- Liabilities Profit & Loss A/c-Debit Balance Sheet- Liabilities Trading A/c- Credit Balance Sheet-Assets Trading A/c- Debit Profit & Loss A/c- Credit
2.
The income received in advance is

(a) (b) (c) (d) Asset of the enterprise Income of the enterprise Liability of the enterprise Expense of the enterprise
3.
The depreciation charge is only to the tune of

(a) (b) (c) (d) Convention of consistency Time period concept Business entity concept Convention of conservatism
4.
The value of the asset shown in the balance sheet is

(a) (b) (c) (d) Book Value Market value Realisable value Original value Contd...
55
5.
Rent paid in advance is to be effected
(a) (b) (c) (d)
Deduct the amount from the Original rent paid P&L A/c Include the rent paid in advance as an item of current asset- Balance sheet Deduct the rent paid in advance in the Trading A/c Both (a) & (b)
Illustration 5 From the following information extracted from the books of Jain & Co, Prepare Trading, Profit & Loss A/c for the year ended and Balance sheet as on that date.
Particulars Purchase Sales Return inward Stock 1.1.96 Drawing Building Machinery Furniture Debtors Wages Carriage inwards Rent and Rates Bad debts Cash Investment Postages Insurance Return outwards Capital Creditors Interest Commission Provision Bad debts Bank O/d Salaries Total Debit Rs 90,300 2,200 40,000 5,000 30,000 20,000 8,000 25,000 3,000 2,000 1,500 1,000 3,500 10,000 2,500 2,000 1,300 50,000 24,000 500 3,250 750 40,000 11,000 2,57,000 2,57,000 Credit Rs 1,37,200
Additional Information: 1. 2. 3. 4. 5. Value of the stock on 31. 12. 96 Rs. 65, 000 Goods worth Rs 800 for his personal use of the proprietor Rs. 400 of insurance paid is nothing but advance payment Salary Rs. 1000 for the month of Dec 1996 has not yet paid outstanding Charge depreciation a. b. c. 6. Dr
To Opening stock To Purchases (-)Purchase Return (-) Goods taken by proprietor
Building 2% per annum Machinery 10% per annum Furniture 15% per annum
Maintain provision for doubtful debts @ 5% on sundry debtors. Prepare Trading and Profit & Loss Account of Jain & Co for the year ended 1995-96 Rs
90,300 1,300 800
Rs
40,000 By Sales (-) Return Inward By Closing Stock
Rs
1,37,200 2,200
Rs Cr
1,35,000 65,000 Contd...
56
To Net purchases To Wages To Carriageinward To Gross Profit c/d (Balancing figure) To Rent & Rates To Bad Debts To Postages To Insurance (-) Prepaid To Salaries (+)O/s of Salary To New Provision 5% on Sundry DebtorsRs.25,000 (-)Old Provision To Depreciation Building 2% Machinery 10% Furniture15% To Net profit c/d (Balancing figure)
88,200 3,000 2,000 66,800 2,00,000 1,500 1000 2,500 2,000 400 1,600 11,000 1,000 12,000 1,250 2,00,000 66,800 3,250 500
Final Accounts
By Gross profit B/d By Commission By Interest
750 500 600 2,000 1,200
3,800 47,650 70,550 70,550
Balance Sheet as on 31st Dec, 1996

Liabilities Capital (+)Net Profit transferred from P&L Account (-)Drawings Cash + Goods Rs5000+Rs.800 Bank OD Creditors Salary O/s Rs 50,000 47,650 Rs Assets Building (-)Depreciation 2% Rs 30,000 600 Rs
29,400 5,800 91,850 40,000 24,000 1,000 Machinery (-)Depreciation 10% Furniture (-)Depreciation 15% Debtors (-)Provision Investment Closing stock Prepaid Insurance Cash in hand 1,56,850 20,000 2,000 18,000 8,000 1,200 6,800 25,000 1,250 23,750 10,000 65,000 400 3,500 1,56,850
Illustration 6 From the following information drawn from the books of M/s Sundaran & Co prepare Trading, Profit & Loss account for the year ended 31st Mar, 2004 and Balance sheet as on dated
Particulars Sundarans Capital Sundarans Drawings Plant and Machinery Balance on 1st April 2003 Plant and machinery additions on 1st Oct,2003 Stock opening Purchases Return Inwards Debit (Rs.) 36,000 1,20,000 25,000 95,000 7,82,000 12,000 Contd... Credit (Rs.) 1,81,000
57
Sundry debtors Furniture & Fixture Freight duty Rent Rate and Taxes Printing stationery Trade expenses Sundry creditors Sales Return outwards Postage & Telegsundaram Provision for bad debts Discounts Rent of the premises sub let for the year upto 30th Sept2004 Insurance charge Salaries & wages Cash in hand Cash at bank Carriage outwards Total
20,600 15,000 2,000 24,600 3,800 5,400 40,000 9,80,000 3,000 800 400 1,800 7,200 2,700 31,300 6,200 30,500 500 12,13,400
12,13,400
Additional Information 1. 2. 3. 4. 5. 6. 7. 8. Stock on 31st Mar, 2004 Rs. 94, 600 Write off Rs. 600 as bad debts Provision for doubtful debts 5%on debtors Create a provision on for discount on debtors & Reserve for creditors 2% Provide a depreciation on furniture and fixture at 5% per @ Plant machinery depreciation 20% Insurance unexpired Rs. 100 A fire occurred on 25th Mar 2004 in God own and the stock of the value of the 5000 destroyed fully insured the insurance admitted claim fully yet to be paid.
Trading account M/s. Sundaran &Co for the year ended 2003-04
Dr
To opening stock To Purchase (-)Returns To Net purchases
Rs
95,000 7,82,000 3000
Rs
By sales (-) Return Closing stock Goods destroyed by fire
Rs
9,80,000 12,000
Rs
9,68,000 94,600 5,000
Cr
7,79,000
Freight Duty To Gross Profitc/d
2,000 1,91,600 10,67,600
10,67,600
Profit & Loss Account of M/s. Sundaran &Co for the year ended 2003-04
Dr
To Carriage Outwards
Rs
Rs
By Gross profit B/d 500 Transferred from trading account 24,600 By discount 3,800 5,400 By Rent of Sublet (-) Advance receipt rent of sublet for 6 months:7,200/12 monts= Rs.600 P.M For 6 months By 2% reserve on sundry creditors
Rs
Rs
1,91,600
Cr
To rent, rate and taxes To painting & stationery Trade expenses
1,800 7,200 3,600
Postage and telegram Insurance charge

58
800 2,700
3,600 800 Contd...
(-) unexpired Salaries and wages ToDepreciation Furniture and Fixture @5% on Rs.15,000 Plant and machinery 1st April 2003@20% on Rs.1,20,000 (12 months) Plant and machinery 1st Oct,2003 @20% on Rs.25,000(6 months) To Bad debts write off To New provision (-)Old provision To provision to be created To discount on debtors 2% To Net profit c/d Transferred to Balance sheet
100 2,600 31,300 750
Final Accounts
24,000
2,500
26,500 600 1000 400 600 380 99,970
1,97,800
1,97,800
Balance sheet of M/s. Sundaran &Co as on dated 31st Mar, 2004
Rs
Liabilities Capital (+)Net profit (-)Drawings 1,81,000 99,970 36,000
Rs
Assets Furniture & fixture Depreciation @ 5% 2,44,970 Plant Machinery
Rs
15,000 750
Rs
14,250 1,20,000 24,000 25,000 2,500 22,500 94,600 100 18,620 5,000 30,500 6,200 2,87,770 96,000
Sundry creditors (-)2% Reserve
40,000 800
Pre received rental income
Depreciation @ 20% Plant Machinery 39,200 Depreciation @20% for 6 months 3,600 Closing stock Insurance unexpired Sundry debtors Goods fire insurance Cash at bank Cash in hand 2,87,770
Illustration 7 From the following figures extracted from the books of M/s Amal &Vimal 31st Mar, 02
Particulars Opening stock Purchases Sales Building Wages Carriage inwards Bills payable Furniture Salaries Advertisement Debit(Rs) 30,000 1,10,000 55,000 23,000 3,000 10,000 9000 42,000 24,000
59
Credit (Rs)
2,50,000
Contd...
Coal and coke Cash at bank Pre paid wages Depreciation fund investment Machinery at cost(Rs.10,000 New) Sundry debtors Bad debts Depreciation fund Sundry creditors Rent rate and taxes Trade expense Capital Amal Vimal Petty expenses Provision for doubtful debts Gas and water Cash in hand Outstanding rent Bank loan
2,000 14,000 1,000 25,000 60,000 20,000 3,000 25,000 24,000 4,000 4000 50,000 40,000 4,000 1,000 1,200 800 400 4,35,000 34,600 4,35,000
Adjustment entries: a. b. c. d. e.
Dr
The partners share profit and losses Amal 2/5 and Vimal 3/5 closing stock Rs. 15, 000 stock valued at Rs. 10, 000 was destroyed by fire but insurance company admitted a claim of 8, 500 only and the claim is not yet paid. Wages include Rs. 2, 000 for installation of anew machinery on 1st Dec., 2005 Depreciate the machinery at 10% per annum
Trading account of M/sVimal & Amal & Co for the year ended 2001-02 Rs Rs Rs
30,000 1,10,000 23,000 2,000 21,000 2,000 1,200 3,000 1,07,800 2,75,000 By sales By closing stock By goods destroyed
Rs Cr
2,50,000 15,000 10,000
To opening stock To purchases To wages (-)Erection To Coal and coke To Gas and water To Carriage inwards To Gross profitc/d
2,75,000
Profit & Loss account of M/s Vimal& Amal &Co for the year ended 2001-02
Dr
To Salaries To Advertisement To Bad debts To Trade expenses To Rent, rates & Taxes To Depreciation(d) To Insurance Loss Admitted claim To petty expenses To Net profit Amal Vimal
60
Rs
Rs
42,000 24,000 3,000 4,000 4,000 5,400 By Gross profitB/d
Rs
Rs Cr
1,07,800
10,000 8,500 1,500 4,000 l 7,960 11,940 19,900 1,07,800 Total 1,07,800
Total
Balance sheet of M/s Vimal & Amal &Co as on dated 31st Mar, 2002
Liabilities Capital Amal (+) Net profit Capital Vimal (+) Net profit Rs 50,000 7,960 57,960 40,000 11,940 51,940 Depreciation fund Bank loan Sundry creditors 25,000 34,600 24,000 Out standing Insurance claim Pre paid wages Cash at bank Cash in hand .Rs Assets Depreciation investment Plant and Machinery (-) Depreciation Furniture Building Closing stock Sundry debtors Provision for bad debts Rs Rs 25,000
Final Accounts
62,000 5,400 56,600 9,000 55,000 15,000 20,000 1000 19,000 8,500 1000 14,000 800 2,03,900
Outstanding rent Bills payable
400 10,000 2,03,900
SS Jain Bros for the year ended 31st Dec., 2003

Particulars Capital Drawings Buildings Furniture and fittings Depreciation on Reserve Buildings Furniture Depreciation for the year Purchases Sundry creditors Sales Debtors Establishment charges Electricity charges Postage and telegram Travelling and conveyance Advance for sales commission Insurance Rent received Motor van (purchased 1.1.03) Motor van maintenance Fixed deposit (1.9.2003) Cash in hand Cash at bank Debit Rs 12,000 2,00,000 30,000 10,000 3,000 13,000 4,00,000 40,000 5,00,000 1,20,000 20,000 6,575 1,284 3,816 1,000 2,500 12,000 80,000 23,425 1,00,000 1,823 1,47,977 Credit Rs 6,00,000
Due to the difference in the trial balance, an examination of the goods was conducted which reveals following errors. Rs. 25 paid to the conveyance was debited to motor van maintenance account Rs. 2, 000 drawn from bank towards for establishment charges was omitted to posted in to ledger. Cash column in the cash book on the receipt side stands excess total by Rs. 400 Adjustment entries: a. Establishment of charges have been paid only up to Nov & provision of Rs 2, 000 has to be made for Dec.
61
b. c. d. e. f.
Electricity charges are O/s Rs. 25 () commission on total sales is payable to salesmen, towards which Rs. 1000 as paid in advance. Fixed deposit earns interest at 9% per annum Provide depreciation 20% per annum on motor car Closing stock 31st Dec., 2003
To prepare the trial balance, the following necessary corrections should be made on the respective accounting heads given. I. Rs. 25 paid to the conveyance was debited to motor van maintenance accountThe errors to be rectified which is known as error without affecting the trial balance. Rs. 25 should be deducted from the Motor maintenance account for the wrong entry debited already but at the same time right entry has to be made under the conveyance account through the addition of Rs. 25 i.e., Rs. 25 to be debited. To put it in to nutshell, Rs 25 should be deducted from the total of Motor maintenance account in order to cancel the wrong debit entry i.e. Rs. 23, 425-Rs. 25=Rs. 23, 400 To effect the correct entry, Rs. 25 should be to the original conveyance account i.e. Rs. 3, 816+Rs. 25= Rs. 3, 841/II. Rs. 2, 000 was drawn from the bank omitted in the establishment charges account; which is meant for the purpose. Rs. 2, 000 should be added to the establishment charges account total in order to identify the total of establishment charges. Total establishment charges = Rs. 22, 000+ Rs. 2000= Rs. 24, 000 III. Cash column in the cash book on the receipt side excess total Rs. 400 i.e. Rs. 400 excess total should corrected on the given balance of cash in hand in order to determine the real volume of cash in hand. Real volume of cash in hand = Rs. 1, 823-Rs. 400 = Rs, 1423 Now we have to illustrate the corrected trial balance by incorporating the above given changes.
Particulars Capital Drawings Buildings Furniture & Fittings Depreciation Reserve Purchases Sundry creditors Sales Debtors Establishment charges Rs.20,000 Electricity charges Postage & telegram Traveling& Conveyance Advance for salesmen commission Insurance Rent received
Trial Balance Debit Rs

12,000 2,00,000 30,000
Credit Rs 6,00,000
13,000 4,00,000 40,000 5,00,000 1,20,000 22,000 6,575 1,284 3,841 1,000 2,500 12,000 Contd...
62
Motor van (purchased 1.1.2003 Motor van maintenance Fixed deposit Cash in hand Cash at bank Depreciation Total
80,000 23,400 1,00,000 1,423 1,47,977 13,000 11,65,000
Final Accounts
11,65,000
Dr
Trading account for the year ended 31st Dec, 2003 Rs

To Purchases To Gross profit c/d
Cr Rs
5,00,000 1,00,000 6,00,000
Rs
4,00,000 2,00,000 6,00,000
Rs
By Sales By Closing stock
Profit & Loss account for the year ended 31st Dec, 2003
To Insurance To motor maintenance To establishment charge Dec provision To Traveling & conveyance To Postage and telegram To electricity charges O/s E.B charges To depreciation To sales commission paid To commission O/s To Depreciation of motor van @ 20% To Net profit c/d 2,500 23,400 22,000 2,000 24,000 3,841 1,284 6,575 25 6,600 13,000 1,000 1,500 2,500 16,000 1,21,875 2,15,000 By Gross profitB/d By Rent received Interest received 2,00,000 12,000 3,000
2,15,000
Balance sheet as on dated 31st Dec, 2003

Liablities Capital (+)Net profit (-)Drawings Sundry creditors Provision for establishment charges Electrical charges O/s Commission Rs 6,00,000 1,21,875 7,21,875 12,000 Rs Assets Cash in hand Cash at bank Fixed Deposit Interest Motor van Sundry debtors Building Rs Rs 1,423 1,47,977 1,00,000 3,000 64,000 1,20,000
7,09,875 40,000 2,000
2,00,000
25 1,500
(-)Reserve Furniture (-) Reserve Closing stock
10,000 30,000 3,000
1,90,000 27,000 1,00,000 7,53,400

63
7,53,400
Pandit Broths for the year ended 31st Mar, 2006

Capital Drawings Particulars A.Pandit B.Pandit A Pandit B.Pandit Debit Rs Credit Rs 1,00,000 1,00,000
Buildings Furniture & fittings Purchases Sales Stock 1.4.2005 Wages & salaries Rates & Taxes Office expenses Sundry debtors Sundry creditors Cash in hand Cash at Bank O/D Freight inwards Total
16,000 16,000 80,000 20,000 2,00,000 3,00,000 50,000 44,000 1,600 60,000 25,000 12,000 400 29,000 28,000 5,41,000 5,41,000
Adjustment: a. b. c. d. e. f.
Dr
Closing stock Rs. 1, 14, 500 There was fire in the premises on 25th Nov, 2005, which damaged the portion of the stock the loss was estimated Rs. 17, 500 A. Pandit is the in-charge of purchases of stock item & he is to be paid 2. 5% on such purchases A steel table purchased 1st Feb Rs. 3, 000 debited to purchase account B. Pandit who looks after all aspect other than purchases is entitled to the commission of 5% on Net profits of after charging commission Depreciation is to be charged at 2. 5% per annum on building & 10% on furniture fittings profits or losses or share equally for the partners.
Trading account for the year ended 2005-06 Cr
Rs
To Opening Stock Purchases (-)Purchase of table (+)Commission to A.Pandit To Carriage inwards To Wages & Salary To Gross profit c/ d Total 2,00,000 3,000 1,97,000 4,925
Rs
50,000 By Sales By Closing stock By Goods Loss by fire
Rs
Rs
3,00,000 1,14,500 17,500
2,01,925 28,000 44,000 1,08,075 4,32,000 Total. 4,32,000
Dr
To Rates & Taxes To office expenses To Depreciation Building To Depreciation
64
Profit & Loss account for the ended 2005-06

1,600 60,000 2,000 2,000 By Gross profitB/d 1,08,075
Cr
Existing Furniture 20,00010/100
Contd...
New Furniture 300010/1002/12 To Loss on fire To commission B.Pandit To Net profit C/d A.Pandit B.Pandit
Final Accounts
50 2050 17,500 1187 11,869 11,869
23,738 1,08,075 1,08,075

Liabilities 1,00,000 4,925 1,04,925 11,869 1,16,794 16,000 1,00,794 Capital( B.Pandit) (+)Commission (+) Net profit (-)Drawings Bank overdraft Sundry creditors 1,00,000 1,187 1,01,187 11,869 1,13,056 16,000 Assets 80,0000 2,000 78,000 Furniture Depreciation 10% Closing stock Sundry Debtors Cash in hand 23,000 2,050 20,950 1,14,500 25,000 400
Capital(A.Pandit) (+) Commission (+)Net profit (-)Drawings
Building Depreciation 2.5%
97,056 29,000 12,000 2,38,850
2,38,850
3.5 LET US SUM UP

Trading Account is first financial statement prepared by the owner of the enterprise to determine the gross profit during the year through the matching concept of accounting. The purpose of crediting the closing stock in the trading account is to find out the materials or goods consumed for trading purposes. In order to find out the total amount of goods or materials consumed during a year, three different components to be separately considered. Opening stock Purchases and Closing Stock Profit & Loss Account is a second statement of accounting in connection with the earlier to determine the Net profit/loss of the enterprise out of the early found Gross profit/loss. Balance sheet is the third financial statement which reveals the financial status of the enterprise through the total amount of resources raised and applied in the form of assets.

If it is uncertain whether an expenditure will benefit one or more than one accounting period, or whether it will increase the capacity or useful life of an operational asset, most firms will expense rather than capitalise the expenditure. Why?
3.7 KEYWORDS
Trading account: It is the accounting statement of revenues and expenses
65
Balance Sheet: It is nothing but a positional statement of assets and liabilities of the firm on a particular date G. P- Gross profit: Resultant of excess of trading incomes over the expenses G. L-Gross Loss: Resultant of excess of trading expenses over the incomes/ revenues N. P- Net profit: Resultant of excess of Profit & Loss incomes /revenues over the expenses N. L-Net Loss: Resultant of excess of Profit & Loss expenses over the incomes

1. 2. Illustrate the interrelationship in between the accounting statements and statement of position. Highlight the effect of the following entries in the (a) (b) (c) 3. 4. Closing stock Interest received in advance Rent outstanding
Explain the various accounting concepts and conventions through additional information or adjustments. Illustrate various kinds of drawing and their treatment in the financial statements.

M. P Pandikumar Accounting & Finance for Managers, Excel Books, New Delhi. R. L. Gupta and Radhaswamy, Advanced Accountancy V. K. Goyal, Financial Accounting, Excel Books, New Delhi. Khan and Jain, Management Accounting S. N. Maheswari, Management Accounting S. Bhat, Financial Management, Excel Books, New Delhi. Prasanna Chandra, Financial Management Theory and Practice, Tata McGraw Hill, New Delhi (1994). I. M. Pandey, Financial Management, Vikas Publishing, New Delhi. Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.
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CHAPTER
4
DEPRECIATION ACCOUNTING
CONTENTS
4.0 Aims and Objectives 4.1 Introduction 4.2 Meaning of Depreciation 4.3 Reasons and Aims of Depreciation 4.3.1 Reasons for Depreciating 4.3.2 Aims of Charging Depreciation 4.4 Methods for Charging Depreciation 4.4.1 Straight Line Method 4.5 Diminishing Balance/Written Down Value Method 4.6 Dissimilarities in between the Straight Line Method and Written Down Value Method 4.7 Let us Sum up 4.8 Lesson-end Activity 4.9 Keywords 4.10 Questions for Discussion 4.11 Suggested Readings

In this lesson we shall discuss about depreciation accounting. After studying this lesson you will be able to: (i) (ii) discuss meaning of depreciation analyse reasons and aims of depreciation
(iii) understand methods for charging depreciation
4.1 INTRODUCTION
The depreciation accounting is mainly based on the concept of income. The concept of income is matching of revenues with expenses. The goods purchased are frequently matched through immediate sale or within a year. The crux of the concept of income is that the expenses are to be matched against the revenues. The ultimate aim of matching is done in order to determine the volume of profit or loss of the transaction. If the assets are nothing but long term assets procured by the enterprise should be matched against
the revenues of them. The matching of expenditure of the assets incurred by the firm at the time of purchase against the revenues is the hard core task of the firm. Why it is being considered as a cumbersome task in matching ? The benefits/revenues of the fixed assets expected to accrue for many number of years but not within a year. The initial investment on the assets at the time of purchase should be matched against the revenue pattern of the same year after year in order to find out the profitability of the long term investment. To have an effective matching against the revenues on every year, the amount of purchase has to be stretched. The stretching of expenses into many years is known as depreciation.
4.2 MEANING OF DEPRECIATION

It is a matching in between the fixed charge expense against the current years revenue. The remaining /left which is unrecovered portion should be carried forward to forthcoming years in order to match against the respective revenues What is the ultimate of the purpose of the depreciation? The ultimate purpose of the depreciation is to replace the fixed assets only at the moment of becoming useless through the current revenues. According to Dickens, depreciation is the permanent and continuous diminution in the quality /quantity / value of the asset. In simple words to understand the terminology depreciation is the permanent decrease in the value of the fixed assets.
4.3 REASONS AND AIMS OF DEPRECIATION

4.3.1 Reasons for Depreciation
(1) (2) Wear and Tear of the Asset: The long term assets are becoming less efficient and poor quality in operations due to the continuous usage of the asset. Exhaustion: Nothing will be remaining due to the continuous extraction of resources. The resources in the oil wells, mine fields will become nothing due to continuous extraction should be replaced by new exploration. To invest on the new exploration in order to have continuous exploration which requires the depreciation as a charge against the revenues of the fields. Example, Oil & Natural Gas Corporation Ltd. (ONGC) indulges in the process of new oil exploration projects through research projects. Then the new projects should be identified and invested by huge initial investment outlay through the current revenues out of the existing projects on account of replacement due to depletion of resources.. (3) To Face Technological Obsolescence: To replace the old machinery with new machinery before the expiry of the economic life period of the asset in order to maintain the efficiency and economy of the asset. The type writer was replaced by the electronic typewriter during the yester periods of office automation. To replace the old type writer which is not efficient as well as economical, should be replaced by the new electronic typewriter through the depreciation charge on the old one. Accident: The value of the asset mainly depends upon the efficiency and economy; which gets affected due to the accident.
(4)
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4.3.2 Aims of Charging Depreciation

To recover the cost: The depreciation charge is a mean to recover the cost of operations of the enterprise. More specifically to recover the cost of asset procured which is in usage. To facilitate the induction of new asset: To replace the old one, the new asset has to be purchased only with the help of depreciation charge To find out the correct P&L accounting balance To know the original position of the enterprise through proper adjustments on the fixed assets
Check Your Progress
Depreciation Accounting
(1)
Depreciation is
(a) Capital expenditure (c) Expense (b) Revenue expenditure (d) Non recurring expenditure
(2)
Depreciation accounting facilitates to know

(a) Original value of the asset (c) Book value of the asset (b) Realisable value of the asset (d) Both (a) & (c)
(3)
Depreciation is an item to be recorded finally in the

(a) Trading account (c) Balance sheet (b) Profit & Loss account (d) Profit & Loss A/c and Balance Sheet
4.4 METHODS FOR CHARGING DEPRECIATION

There are various methods of depreciation: 1. 2. 3. 4. 5. 6. 7. 8. Straight line method Depletion or Output method Machine hour rate method Diminishing Balance or Written down method Sum of digits method Annuity method Sinking fund method Insurance policy method
Among the above mentioned methods, Straight line method and Diminishing balance or written down method are more important methods. These two methods are preferable and renowned methods among the industrialists in charging the depreciation on the fixed assets. The first method is as follows
4.4.1 Straight Line Method

This method, depreciation is calculated as a fixed proportion on the original value of the asset. The depreciation is charged as fixed in volume on the original value of the asset at which it was purchased. The original value of the asset is nothing but the purchase value of the asset.
69
Illustration 1 I. Cost of Machine Rs. 1, 00, 000 Estimated life of the machine 5 years Scrap value-Nil
Depreciation =
Cost of the machine - Scrap value Economic Life period of the asset in years
According to the concept of depreciation, the value of the asset is dispersed throughout the life of the period in order to match against the respective earnings of the year after year The purchase value of the asset is an expenditure to be stretched to many number of years in order to equate with the revenues. To equate the revenues, the scrap value of the asset at the end of the life period is realized should be deducted and apportioned to the total number of the economic life period of the asset. The aim of deducting the scrap value of the asset is reducing the original value of the investment
Deprecation =
Rs. 1, 00, 000 = Rs. 20, 000 5
To understand the above calculation, the following table is most inevitable

Value of the asset (Begin) Rs Col.1 1 year .1,00,000 2nd year-.80,000 3rd year-.60,000 4 year-.40,000 5th year-.20,000
th st
Depreciation Rs Col.2 20,000 20,000 20,000 20,000 20,000
Value of the asset End Rs Col 3=Col.1-Col.2 80,000 60,000 40,000 20,000 0
From the above table, Rs. 20, 000 is charged on every year to recover Rs. 1, 00, 000 during its life period i.e. 5 years Illustration 2 Original value of the investment- Rs. 1, 00, 000 Scrap value Rs. 10, 000 Life of the asset -5 years
Deprecation =
Rs. 1,00,000 - Rs.10,000 Rs. 90.000 = = Rs. 18.000 5 year 5 year
To understand the methodology of straight line depreciation, the following table will illustrate the process
Value of the asset (Begin) Rs 1st year .1,00,000 2nd year-.82,000 3 year-.64,000 4th year-.46,000
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rd
Depreciation Rs 18,0000 18,0000 18,0000 18,0000 18,0000
Value of the asset End Rs .82,000 .64,000 46,000 28000 10,000(Scrap value )*
5th year-.28,000
The scrap value of the asset is expected to realize only at the end of the life period of the asset i.e. 5 years. Illustration 3 Mr. Shankar purchased machine for Rs. 90, 000 on 1st April 1999. It probable working life was estimated at 5 years and its probable scrap value at the end of that time is Rs. 10, 000. You are required to prepare necessary account based on straight line method of depreciation for five years To prepare the various accounts of the enterprise connected to depreciation is as follows
The depreciation charge process is carried out in three stages

The asset to be initially purchased- Purchase entry has to be carried out. How the purchase is made ? While making the purchase there are two different accounts get affected which are normally known as real accounts. At the moment of purchase on one side the asset is coming inside the firm ; on the other side the cash resources are depleted due to the payment of purchase bill of the asset. Dr. Rs
1 April,1999 Plant & Machinery A/c To Cash A/c Being plant & machinery purchased 90,000 90,000
Cr. Rs
The next account involved in the process of accounting is depreciation account. Before transacting the depreciation entry in the books of accounts, we must find the amount of depreciation to be charged against on every years revenue. The amount of depreciation is to be calculated as follows:
Deprecation =
Original value of the asset - Scrap value Estimated life of the asset in years Rs. 90,000 -10,000 = = Rs. 16,000 5 year
Depreciation is a fixed charge to be calculated on the value of the asset on every year and deducted from the original value. Depreciation is nothing but charged as an expenditure against the revenues in accordance with the matching concept. Hence the depreciation non recurring expenditure account and the plant & machinery account should be debited and credited respectively For the accounting entry I year depreciation
31st March, 2000 Depreciation A/c Dr To Plant Machinery A/c Cr Being the first year depreciation is charged
Rs
16,000
Rs
16,000
For the accounting entry II year depreciation

31st March, 2001 Depreciation A/c Dr To Plant Machinery A/cCr Being the second year depreciation is charged
Rs
16,000
Rs
16,000
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For the accounting entry III year depreciation

31st March, 2002 Depreciation A/c Dr To Plant Machinery A/c Cr Being the Third year depreciation is charged
Rs
16,000
Rs
16,000
For the accounting entry IV year depreciation

31 March, 2003
st
Rs
16,000
Rs
Depreciation A/c Dr To Plant Machinery A/c Cr Being the fourth year depreciation is charged
16,000
For the accounting entry V year depreciation

31 March, 2004
st
Rs
16,000
Rs
Depreciation A/c Dr To Plant Machinery A/c Cr Being the fifth year depreciation is charged
16,000
The next account involved is the scrap value account which amounted Rs 10, 000 While selling the residual portion of the asset, the firm is able to receive Rs. 10, 000 as receipt as cash. The sale of residual part of the machinery leads to bring cash resources inside the firm and inturn the plant and machinery is going out of the firm. For the accounting entry of scrap value
31st March, 2004 Cash A/c Dr To Plant Machinery A/c Cr Being the residual part of the machinery is sold
Rs
10,000
Rs
10,000
The next transaction is the final transaction pertaining to the posting of depreciation accounting balance under the P& L account It is nothing but the transfer of Depreciation accounting balance into P&L account At the end of every year immediately after finalizing the accounting balance of depreciation is regularly posted under the P&L account. The journal entry transfer is carried out as follows For the I year depreciation transfer to P&L A/c
31st March, 2000 P&L A/c Dr To Depreciation A/c Cr Being the first year depreciation is transferred to P&L A/c
Rs
16,000
Rs
16,000
For the II year depreciation transfer to P&L A/c

31 March, 2001
st
Rs
16,000
Rs
P&L A/c Dr To Depreciation A/c Cr
16,000
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Being the second year depreciation is transferred to P&L A/c
For the III year depreciation transfer to P&L A/c

31st March, 2002 P&L A/c Dr To Depreciation A/c Cr Being the third
Rs
16,000
Rs
16,000
year depreciation is transferred to P&L A/c
For the IV year depreciation transfer to P&L A/c

31 March, 2003
st
Rs
16,000
Rs
16,000
Being the fourth year depreciation is transferred to P&L A/c
For the V year depreciation transfer to P&L A/c

31 March, 2004
st
Rs
16,000
Rs
16,000
Being the fifth year depreciation is transferred to P&L A/c
The preparation of Plant & Machinery account : It is very simple to prepare the machinery Ledger account
Dr Date 1 April,1999 Plant & Machinery Particular To Cash A/c Rs 90,000 Date 31st Mar,2000 I Yr Particulars By Depreciation Rs 16,000 Cr
By Balance c/d transferred to Second year Plant & Machinery A/C 74,000 90,000 To Balance B/d 74, 000 Dr Date 1 April,2000 Particular To Balance B/d (transferred from I Yr Plant & Machinery) Plant & Machinery A/c Rs 74,000 Date 31st Mar,2001 II Yr Particulars By Depreciation By Balance c/d transferred to III Yr Plant & Machinery A/C 58,000 74,000 To Balance B/d 58, 000 74,000 Rs 16,000 Cr 90,000
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Dr Date 1 April, 2001 Particular
Plant & Machinery A/c Rs 58,000 Date 31st Mar,2002
III Yr Particulars By Depreciation Rs 16,000
Cr
To Balance B/d
(transferred from II Yr Plant & Machinery)
By Balance c/d (transferred to IV Yr Plant & Machinery A/C) 42,000 58,000
58,000 To Balance B/d Dr Date 1 April, 2002 45, 000 IV Yr Date 31 Mar,2003
st
Plant & Machinery A/c Particular To Balance B/d (transferred from III Yr Plant & Machinery) Rs 42,000
Cr Rs 16,000
Particulars By Depreciation By Balance c/d (transferred to V Yr Plant & Machinery A/C)
26,000 42,000
42,000
To Balance B/d
26, 000
Dr
Date 1st April, 2003
Plant & Machinery A/c

Particular Rs Date 31st Mar,2004
VYr
Particulars Rs
Cr
To Balance B/d 26,000 (transferred from IV Yr Plant & Machinery) 26,000
By Depreciation 16,000
By Cash
10,000 26,000
The next ledger account to be prepared is Depreciation A/c

Depreciation A/c
Date 31st Mar,2000 31St Mar,2001 31St Mar,2002 31St Mar,2003 31St Mar,2004
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Particulars To Plant & Machinery To Plant & Machinery To Plant & Machinery To Plant & Machinery To Plant & Machinery
Amount Rs 16,000
Date 31st Mar,2000 31St Mar,2001 31St Mar,2002 31St Mar,2003 31St Mar,2004
Particulars By P& L A/c
Amount Rs 16,000
16,000
By P& L A/c
16,000
16,000
By P& L A/c
16,000
16,000
By P& L A/c
16,000
16,000
By P& L A/c
16,000
Illustration 4 M/s Muruganand &Co is a trader bought furniture costing Rs 2, 20, 000 for his new branch on 1st April, 2000. As the furniture bought was superior quality material. The auditors estimated its residual valued at Rs. 20, 000 after a working life of ten years. Further additions were made into the same category on 1st Oct, 2001 and 1st April, 2002 which costing Rs 16, 800 and Rs. 19, 000 (with a scrap value of Rs 800 and Rs. 1000 respectively). The trader closed his accounts on 31st Mar every year and wanted to apply straight line method of depreciation. Show the furniture a/c for four years. First step is to find out the depreciation of the furniture for various number of years i-e 4 years. The depreciation is to be calculated on every year. The most important point to be borne in our mind while calculating depreciation, the following points to be taken into consideration First, is there any % of depreciation charge given. If given, the depreciation to be calculated on the volume of available balance at the end. Secondly, if the % of depreciation charge is not given in our problem, How the volume of depreciation can be calculated ? The depreciation can be calculated as follows
Deprecation =
Original value of the asset - Scrap value Life period of the asset
In this problem, due to absence of depreciation %, the above illustrated formula should have to be applied throughout the problem
Date of Purchase First Furniture 2000 Rs Cost of the furniture R1 Scrap value at the end (-) R2 Depreciable value of the furniture R3 Life of the furniture R4 Depreciation R5=R3/R4 Depreciation for 2000-01 Depreciation for 2001-02 2,20,000 20,000 Second furniture 2001 Rs 16,800 800 Third Furniture 2002 Rs 19,000 1000 Total Depreciation cost Rs
Particulars
2,00,000
16,000
18,000
10 years 20,000 20,000 20,000
10 years 1,600 -----For 6 months 800
10 years 1,800 ------------20,000 20,800
Depreciation for 2002-03 Depreciation for 2003-04
20,000 20,000
1,600 1,600
1,800 1,800
23,400 23,400
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Accounting Entries are as follows:
ACCOUNTING ENTRIES FOR THE ACCOUNTING YEAR 2000-2001

During the year 1st April 2, 000; Rs. 2, 20, 000 worth of furniture was bought
Rs
1 April,2000 Furniture A/c Dr To Bank A/cCr Being the furniture is purchased 2,20,000 2,20,000
Rs
Depreciation for the year 2000 for the first furniture

31 Mar,2001
st
Rs
20,000
Rs
Depreciation A/cDr To Furniture A/c Being depreciation charged
20,000
ACCOUNTING ENTRIES FOR THE ACCOUNTING YEAR FOR 2001-02

Second new furniture bought during the month 1st Oct, 2001
1 April, 2001 Furniture A/c Dr To Bank A/c Being new furniture procured
Rs
16,800
Rs
16,800
Depreciation for the first furniture

31st March, 2002 Depreciation A/c Dr To Furniture A/c Being the depreciation charged 20,000 20,000
Depreciation for the second furniture

31st March, 2002 Depreciation A/c Dr To Furniture A/c Being the depreciation charged for the second furniture for 6 months 800 800
ACCOUNTING ENTRIES FOR THE ACCOUNTING YEAR FOR 2002-03

Third new furniture bought during the month of 1st April, 2002
1st April, 2002 Furniture A/c To Bank A/c
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19,000 19,000
Being the furniture purchased during the year
Depreciation charged for the first furniture

31st March, 2003 Depreciation A/c Dr To Furniture A/c Being the depreciation charged for the first furniture 20,000 20,000
Depreciation charged for the second furniture

31st March, 2003 Depreciation A/c Dr To Furniture A/c Being the depreciation charged for the second furniture 1,600 1,600
Depreciation for the third furniture

31st March, 2003 Depreciation A/c Dr To Furniture A/c Being the depreciation charged for the third furniture 1,800 1,800
ACCOUNTING ENTRIES FOR THE FOURTH YEAR 2003-04

Depreciation charged for the first furniture
31st March, 2004 Depreciation A/c Dr To Furniture A/c Being the depreciation charged for the first furniture 20,000 20,000
Depreciation charged for the second furniture

31st March, 2004 Depreciation A/c Dr To Furniture A/c Being the depreciation charged for the second furniture 1,600 1,600
Depreciation for the third furniture

31st March, 2004 Depreciation A/c Dr To Furniture A/c Being the depreciation charged for the third furniture 1,800 1,800
In the next step, the furniture account to be prepared for every year
Furniture A/c (2000-01)
Date Particulars Amount Rs 2,20,000 Date Particulars Amount Rs 20,000 2,00,000 2,20,000
1April,2000
To Bank
31 Mar,2001
By Depreciation By Balance c/d
2,20,000
31st Mar, 2001 To Balance B/d
2, 20, 000
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Furniture A/c (2001-02)

Date 1April,2001 1st Oct ,2001 Particulars To Balance B/d To Bank Amount Rs 2,00,000 16,800 Date 31 Mar,2002 Particulars By Depreciation By Depreciation By Balance c/d 2,16,800 31st Mar, 2002 To Balance B/d 1,96,000 Amount Rs 20,000 800 1,96,000 2,16,800
31st Mar, 2002 To Balance B/d 1, 96, 000

Furniture (2002-03)
Date Particulars Amount Rs 1 April, s2002 1 St April, 2002
st
Date
Particulars
Amount Rs
To Balance B/d To Bank
1,96,000 19,000
31 M ar,2003
st
By Depreciation By Depreciation By Depreciation By Balance c/d
20,000 1,600 1,800 1,91,600 2,15,000
2,15,000 31 st M ar,2003 To Balance B/d 1,91,600
31st Mar, 2003 To Balance B/d 1, 91, 600

Furniture (2003-04)
Date Particulars Amount Rs 1 April, 2003
st
Date
Particulars
Amount Rs
To Balance B/d
1,91,600
31 March, 2004
st
By Depreciation By Depreciation By Depreciation By Balance c/d
20,000 1,600 1,800 1,68,200 1,91,600
1,91,600 31 March, 2004 To Balance B/d 1,68,200
31 Mar, 2004
To Balance B/d 1, 68, 200
Merits
It is simple to calculate only due to fixed depreciation charge on the value of the asset The value of the asset is depleted to either zero or scrap value of the asset This method is most suited for patents trade marks and so on
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Demerits
The utility of the asset is not considered at the moment of charging constant depreciation over the asset During the later years of the asset, the efficiency will automatically come down and simultaneously the maintenance cost of the asset will rigger up which is illogical in charging fixed charge throughout the life period of the asset
4.5 DIMINISHING BALANCE/WRITTEN DOWN VALUE METHOD

This method also having the same methodology in charging depreciation on the fixed assets like fixed percentage Though it is bearing similar approach in charging depreciation but different in application from the straight line method. Under this method, the depreciation is charged on the value of the asset available at the beginning of the year. The following formula highlights the application of this method in charging depreciation
= 1-(S/C)1/n
The meaning of the above illustrated formulae is discussed through the explanation of two different components. First one is (S/C)1/n , the ration of the scrap value of the asset on the original value of the asset is appropriately apportioned throughout the life period of the assets. It is nothing but the percentage of scrap value widened across the life period of the asset. Once the scrap value percentage is known, the next important step is to determine the depreciable value of the asset. The depreciable value of the asset can be derived by deducting the percentage from No 1. Illustration 5 Life of the asset (n)=3 years Expected scrap value at the end of 3 years= Rs. 12, 800 Original Investment=Rs. 2, 00, 000 Find out the percentage of depreciation to be charged Under this method, to charge depreciation as well as to find out the value of the asset as on a particular date, the depreciation percentage must be given. In this problem, depreciation % is not given, in order to determine the above illustrated formulae should be applied
= 1-(S/C)1/n
=1-(Rs. 12, 800/Rs. 2, 00, 000)(1/3) =1-4/10=6/10=60% The following workings will obviously facilitate to understand the charge of depreciation The value of the Asset at the beginning of 1st Year (-) Depreciation 60% on Rs. 2, 00, 000 (Original value ) Value of the asset at the beginning of 2nd Year (-)Depreciation 60% on Rs 1, 20, 000. (Book Value) = Rs. 2, 00, 000 = Rs. 1, 20, 000 = Rs. 80, 000 = Rs. 48, 000
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Value of the asset at the beginning of 3rd Year (-)Depreciation 60% on Rs 32, 000( Book Value) Value of the asset at the end of the year
Check Your Progress
= Rs. 32, 000 = Rs. 19, 200 = Rs. 12, 800
(1)
Treatment of Depreciation in the Profit &Loss A/c is

(a) Profit & Loss A/c Dr To Depreciation A/c (c) Depreciation A/c Dr To Fixed Asset A/c (b) Fixed Asset A/c Dr To Profit & Loss A/c (d) Depreciation A/c Dr To Profit & Loss A/c
(2)
Under straight line method, depreciation is charged on

(a) The value of the asset at the beginning (c) The value of the asset at the end (b) The average value of the asset (d) None of the above
4.6 DISSIMILARITIES IN BETWEEN THE STRAIGHT LINE METHOD AND WRITTEN DOWN VALUE METHOD
Under this method of charging depreciation unlike the straight line method, the percentage is usually given for calculation. While calculating this method, the depreciation is calculated on two different values
Depreciation
Depreciation for initial year
Depreciation for sub sequent years
Depreciation on original value - at the beginning
Depreciation on Book value during later period
Illustration 6 On 1st April, 2000, a firm purchases machinery worth Rs. 3, 00, 000. On 1st Oct, 2002 it buys additional machinery worth Rs. 60, 000 and spends Rs. 6, 000 on its erection. The accounts are closed normally on 31 Mar. Assuming the annual depreciation to be 10% Show the machinery account for 3 years under the written down value method.
ACCOUNTING JOURNAL ENTRIES FOR THE YEAR 2000-01

During the year 1st April 2, 000; Rs. 3, 00, 000 worth of machinery was bought Rs
1 April, 2000 Machinery A/c Dr To Bank A/c Cr
80
Rs
3,00,000
3,00,000
(Being the machinery is purchased)
Depreciation for the year 2000 for the first machinery

31st Mar,2001 Depreciation A/c Dr To Machinery A/c (Being depreciation charged )
Rs
30,000
Rs
30,000
ACCOUNTING JOURNAL ENTRIES FOR THE YEAR 2001-02

31 Mar,2001
st
Rs
27,000
Rs
27,000
Depreciation A/c Dr To Machinery A/c (Being depreciation charged)
JOURNAL ENTRIES FOR THE YEAR 2002-03

During the year 2002 new machinery worth of Rs. 60, 000 was purchased. Before determining the volume of depreciation, the amount of original value of the machinery should be found out. Original value of the asset = The purchase price of the asset + Erection charges incurred = Rs. 60, 000 + Rs. 6, 000 = Rs. 66, 000 Rs
1 April,2002 Machinery A/c Dr To Bank A/c Cr (Being the machinery is purchased) 66,000 66,000
Rs

31st Mar,2003 Depreciation A/c Dr To Machinery A/c (Being depreciation charged )
Rs
24,300
Rs
24,300
Depreciation for the year 2002 for the second machinery

31 Mar,2003
st
Rs
3,300
Rs
Depreciation A/cDr To Machinery A/c (Being depreciation charged)
3,300
After passing the journal entries, the next step is to prepare ledger account of machinery
Machinery A /c (2000-01) Dr
Date 1st April,2000 Particulars To Bank Amount Rs 3,00,000 Date 31st Mar,2001 Particulars By Depreciation By Balance c/d 3,00,000 31st Mar,2001 To Balance B/d Transfer to Machinery A/c (20001-02) 2,70,000
Cr
Amount Rs 30,000 2,70,000 3,00,000
81
MachineryA/c (2001-02) Dr
Date 1st April,2000 Particulars To Balance B/d Amount Rs 2,70,000 Date 31 st Mar,2001 Particulars By Depreciation By Balance c/d 2,70,000 31st Mar,2001 To Balance B/d Transfer to Machinery A/c (2002-03) 2,43,000
Cr
Amount Rs 27,000 2,43,000 2,70,000
Machinery A/c (2002-03) Dr

Date 1st April,2000 1st Oct,2002 Particulars To Balance B/d To Bank Amount Rs 2,43,000 66,000 Date 31st Mar,2001 Particulars By Depreciation First machinery By Depreciation Second machinery By Balance c/d 3,09,000 31st Mar,2003 To Balance B/d 2,81,400
Cr
Amount Rs 24,300 3,300 2,81,400
31st Mar, 2003 To Balance B/d 2, 81, 400 Merits: The depreciation is charged under this method only in line with the efficiency. It means that during the early years of the usage, the efficiency of the asset is more than that of the later part of the life of the asset. The depreciation volume under this method is greater during the early years of the asset than the later periods of the asset. It evades the possibility of incurring losses due to obsolescence. Demerits: It is a tedious method in computation. Under this method, the book value of the asset at end of the economic life period is never equivalent to zero. Suitability: This method is most suitable in the case of depreciating the worth of patent which is subject greater risk of technological obsolescence. This method is most suitable in the case of patent design of a car, cellular phone design, pharmaceutical patent and so on. These are having greater technological risk which prefers the firms to write off the expenditures in more volume during the early years in order to recover the investment through matching early period revenues. Early recovery is better the principle
4.7 LET US SUM UP

Depreciation is the permanent and continuous diminution in the quality /quantity / value of the asset. The long term assets are becoming less efficient and poor quality in operations due to the continuous usage of the asset. The value of the asset mainly
82
depends upon the efficiency and economy; which gets affected due to the accident. According to the concept of depreciation, the value of the asset is dispersed throughout the life of the period in order to match against the respective earnings of the year after year The purchase value of the asset is an expenditure to be stretched to many number of years in order to equate with the revenues. The value of the asset after deducting the depreciation from the value of the asset at the beginning.

Companies usually depreciate assets such as buildings even though those assets may be increasing in value. Give your opinion as an expert.
4.9 KEYWORDS
Depreciation: Continuous reduction/ decrease /diminution in the value of the asset Depreciation accounting: Recording the entries of depreciation through journal, ledger accounts of Depreciation, Fixed asset and Profit & Loss account. Original Value of the asset: The value of the asset at the time of purchase or acquisition Book Value of the asset: The value of the asset after deducting the depreciation from the value of the asset at the beginning. Scrap value of the asset: It is the value at the end of the life period of the asset; at when the asset cannot be put for further usage.

1. 2. 3. 4. Define Depreciation. Explain the meaning of the term Depreciation. Elucidate the process of Depreciation Accounting. Explain the various methods of depreciation and their merits and demerits. Highlight the suitability of depreciation method to the tune of business environment.

M. P. Pandikumar, Accounting & Finance for Managers, Excel Books, New Delhi. R. L. Gupta and Radhaswamy, Advanced Accountancy. V. K. Goyal, Financial Accounting, Excel Books, New Delhi. Khan and Jain, Management Accounting. S. N. Maheswari, Management Accounting. S. Bhat, Financial Management, Excel Books, New Delhi. Prasanna Chandra, Financial Management Theory and Practice, Tata McGraw Hill, New Delhi (1994). I. M. Pandey, Financial Management, Vikas Publishing, New Delhi. Nitin Balwani Accounting & Finance for Managers, Excel Books, New Delhi.
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UNIT-II
LESSON
5
FINANCIAL STATEMENT ANALYSIS
CONTENTS
5.0 Aims and Objectives 5.1 Introduction 5.2 Definition & Classification of Financial Statement Analysis 5.3 Comparative Financial Statements 5.4 Trend Percentage Analysis 5.5 Let us Sum up 5.6 Lesson-end Activity 5.7 Keywords 5.8 Questions for Discussion 5.9 Suggested Readings

In this lesson we shall discuss about financial statement analysis. After going through this lesson you will be able to: (i) understand definition and classification of financial statement analysis (ii) analyse comparative financial statements and trend percentage analysis
5.1 INTRODUCTION
The financial statements are affording many facts though they are absolute and concrete in terms; but not in a position to interpret and analyse the stature of the enterprise. To analyse and interpret, the financial statement analysis is being applied across the financial statements viz Trading, Profit & Loss Account and Balance sheet. Under the financial statement analysis, the information available are grouped together in order to cull out the meaningful relationship which is already available among them; for interpretation and analysis.
5.2 DEFINITION & CLASSIFICATION OF FINANCIAL STATEMENT ANALYSIS

According to Kennedy and Muller The analysis and interpretation of financial statements are an attempt to determine the significance and meaning of financial statement data so that the forecast may be made of the prospects for future earnings, ability to pay interest and debt maturities and profitability and sound dividend policy The entire financial statement analysis can be classified into various categories Comparative financial statements Common size financial statements
Trend percentages Fund flow statements Cash flow statements Ratio analysis
Comparative financial statements
Comparative study of Profit & Loss Accounts and Balance sheets
Comparison in between financial statements of two or more years
Comparison in between the financial statements of various firms or industrial average
Intra firm comparison
Inter firm comparison
5.3 COMPARATIVE FINANCIAL STATEMENTS

Objectives of comparative financial statements Changes taken place in the financial performance are taken into consideration for further analysis To reveal qualitative information about the firm in terms of solvency, liquidity profitability and so on are extracted from the analysis of financial statements With reference to yester financial data of the enterprise, the firm is facilitated to undergo for the preparation of forecasting and planning. The major part of financial statement analysis is mainly focused on the comparative analysis. The comparative analysis classified into four different analyses viz Comparative Balance sheet Comparative Profit and Loss account Common Size statement Trend percentage First we will discuss the comparative Balance sheet. The first and foremost important step is to have the following information and should take preparatory steps i. While preparing the comparative statement of balance sheet, the particulars for the financial factors are required ii. The second most important for the preparation of the comparative balance sheet is yester financial data extracted from the balance sheet or balance sheets iii. The next most important requirement to have an effective comparison with the yester financial data is current year information extracted from the balance sheet or balance sheet of the firms. iv. After having been procured the financial data pertaining to various time periods are ready for comparison; to determine or identify the level of increase or decrease taken place in the financial position of the firms v. To determine the level of increase or decrease in financial position, the percentage analysis to carried out in between them.
88
Illustration 1 From the following information, Prepare comparative Balance sheet of X Ltd.
Particulars Equit share capital Fixed Assets Reserves and surpluses Investments Long-term loans Current assets Current liabilities 31st Mar,2004 50,00,000 60,00,000 10,00,000 10,00,000 30,00,000 30,00,000 10,00,000 31st Mar,2005 50,00,000 72,00,000 12,00,000 10,00,000 30,00,000 21,00,000 11,00,000
Financial Statement Analysis
The first step we have to segregate the available information into two different categories viz Assets and Liabilities
Particulars Fixed Assets Investments Current assets Total Assets Equity share capital Reserves & surpluses Long-term loans Current liabilities 2004 Rs 60,00,000 10,00,000 30,00,000 1,00,00,000 50,00,000 10,00,000 30,00,000 10,00,000 1,00,00,000 2005 Rs 72,00,000 10,00,000 21,00,000 1,03,00,000 50,00,000 12,00,000 30,00,000 11,00,000 1,03,00,000 Absolute Change Rs 12,00,000 N.C (9,00,000) 3,00,000 N.C 2,00,000 N.C 1,00,000 3,00,000 3 20 10 3 % Increase 20 % Decrease 30 -
N. C = No change in the position during the two years From the above table, the following are basic inferences The fixed assets volume got increased 20% from the year 2004 to 2005, amounted Rs. 12, 00, 000 Rs 9, 00, 000 worth of current assets decrease from the year 2004 to 2005 recorded 30% The total volume of assets recorded 3% increase from the year 2004 to 2005 It obviously understood that 20% increase taken place on the reserves and surpluses It clearly evidenced that the current liabilities of the firm increased 10% from the year 2004 to 2005 The firm has not recorded any changes in the investments, equity share capital and long-term loans The next one in the comparative financial statement analysis is that Income statement analysis Comparative (Income) financial statement analysis: This analysis is being carried out in between the income statements of the various accounting durations of the firm, with other firms in the industry and with the industrial average. This will facilitate the firm to know about the stature of itself regarding the financial performance. It facilitates to understand about the changes pertaining to various financial data which closely relevantly connected with the financial performance Change in the gross sales Change in the net sales
89
Change in gross profit and net profit Change in operating profit Change in operating expenses Change in the volume of non operating income Change in the non operating expenses The ultimate purpose of the comparative (Income) financial statement analysis is as follows i. ii. To study the income earning and expenditure spending pattern of the firm for two or more years To identify the changing pattern of the income and expenditure of the firms. The preparatory steps for the preparation of the comparative financial statement (Income) analysis
The first and foremost important step is to have the following information and should take preparatory steps i. ii. While preparing the comparative statement of Profit and Loss Account, the particulars for the financial factors are required The second most important for the preparation of the comparative Profit & Loss account is yester financial data extracted from the Profit & Loss A/c or Profit & Loss Accounts The next most important requirement to have an effective comparison with the yester financial data is current year information extracted from the balance sheet of the firm or of the other firms After having been procured the financial data pertaining to various time periods are ready for comparison ; to determine or identify the level of increase or decrease taken place in the operating financial performance of the firms To determine the level of increase or decrease in financial performance, the percentage analysis to be carried out in between them.
iii.
iv.
v.
Illustration 2 Prepare the comparative income statement from the following:

Particulars Sales Cost of goods sold Operating expenses Net profit 2004 Rs 2,00,000 1,00,000 1,00,000 10,000 90,000 2005 Rs 2,50,000 1,30,000 1,20,000 10,000 1,10,000
Comparative Income Statement

Particulars 2004 Rs 2005 Rs Absolute Change Rs 50,000 30,000 20,000 N.C 20,000 % Increase 25 30 20 22.22 % Decrease -
Sales (-)Cost of goods sold (-)Operating expenses

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2,00,000 1,00,000 1,00,000 10,000 90,000
2,50,000 1,30,000 1,20,000 10,000 1,10,000
Net profit
From the above table, the following inferences can be had: The firm has registered 25% increase in sales from the year 2004 to 2005 Cost of goods sold raised 30% from the year 2004 to 2005 There is no change in the level of operating expenses The firm has got 22. 22% increase in the level of net profits from the year 2004 to 2005 Illustration 3 From the following information, prepare a comparative income statement:
Particulars Sales Cost of goods sold Administration Expenses Other Income Income tax 2001 Rs 10,00,000 6,00,000 2,00,000 40,000 1,20,000 2002 Rs 8,00,000 4,00,000 1,40,000 20,000 1,40,000
Comparative Income Statement

Particulars 2001 Rs 2002Rs Absolute Change Rs (2,00,000) (2,00,000) (60,000) 60,000 (20,000) 40,000 20,000 20,000 % Increase 30 16.66 16.66 % Decrease 20 33.33 30 50 16.66 -
Sales ()Cost of goods sold () Administration Expenses Operating Income (+)other income Total Net Income Before tax Income tax Net Income after the tax
10,00,000 6,00,000 4,00,000 2,00,000 2,00,000 40,000 2,40,000 1,20,000 1,20,000
8,00,000 4,00,000 4,00,000 1,40,000 2,60,000 20,000 2,80,000 1,40,000 1,40,000
For this problem, the inferences could be enlisted according to the comparative statement analysis on Profit & Loss Accounts of two different year viz 2001 and 2002. The next important tool of financial statement analysis is a common size statement analysis which known as predominant tool in intra firm analysis in studying the share of each component. The components are translated into percentage for analysis and interpretations. For profit and loss account, Net sales is considered as a base for the computation of a share of each financial factor available. For Balance sheet, total volume of assets and liabilities are taken into consideration for the computation of a share of each financial factor available under the heading of assets and liabilities. Illustration 4 Prepare the common size statement analysis for the firm ABC ltd
Liabilities Share capital Reserves and surpluses Bank overdraft Quick liabilities 1990Rs 2,00,000 1,00,000 60,000 40,000 4,00,000 1991Rs 3,00,000 2,00,000 2,00,000 1,00,000 8,00,000 Assets Fixed assets Stock Quick assets 1990Rs 2,25,000 1,29,000 46,000 1991 Rs 4,00,000 2,00,000 2,00,000
4,00,000
8.,00,000
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Common size statement analysis of the Balance sheet of the firm ABC Ltd.
Particulars Assets Fixed assets Stock Quick assets Total Liabilities Share capital Reserves and surpluses Bank overdraft Quick liabilities Amount 1991 Rs 4,00,000 2,00,000 2,00,000 8,00,000 3,00,000 2,00,000 2,00,000 1,00,000 8,00,000 % of Balance sheet total 1990 1991 56.25 50 32.25 25 11.5 25 100 100 50 25 15 10 100 37.5 25 25 12.5 100
1990 Rs 2,25,000 1,29,000 46,000 4,00,000 2,00,000 1,00,000 60,000 40,000 4,00,000
The above illustration highlights the share of every component in the balance sheet out of the total volume of assets and liabilities. This will certainly facilitate the firm to easily understand not only the share of every component but also facilitates to have a meaningful and relevant comparison with various time horizons. From the following table, prepare the common size statement analysis:
Sales Miscellaneous Income Materials consumed Wages Factory expenses Office expenses Interest Depreciation Profit 2000 Rs. 20,00,000 20,000 20,20,000 11,00,000 3,00,000 2,00,000 90,000 1,00,000 1,40,000 90,000 20,20,000 2001 Rs. 24,00,000 16,000 24.16,000 12,96,000 4,08,000 2,16,000 1,00,000 1,20,000 1,50,000 1,26,000 24,16,000
Common size statements Profit & Loss Account

Particulars Sales Miscellaneous Income Materials consumed Wages Factory expenses Office expenses Interest Depreciation Profit 2000 Rs. 20,00,000 20,000 20,20,000 11,00,000 3,00,000 2,00,000 90,000 1,00,000 1,40,000 90,000 20,20,000 % Percentage 100 .9 100.9 54.46 14.85 9.90 4.47 4.95 6.94 4.47 100.9 2001 Rs. 24,00,000 16,000 24.16,000 12,96,000 4,08,000 2,16,000 1,00,000 1,20,000 1,50,000 1,26,000 24,16,000 Percentage % 100 .67 100.67 53.64 16.82 8.92 4.95 4.92 6.21 5.21 100.67
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Check Your Progress
(1)
Financial statement analysis is to

(a) (b) (c) (d) Inter firm comparison only Intra firm comparison only Industrial average comparison (a), (b) & (c)
(2)
Intra firm analysis is

(a) (b) (c) (d) With in a year In between the years Comparison with the projected (a), (b) & (c)
(3)
Comparative financial statement analysis is into

(a) (b) (c) (d) Comparison of Income& Position statements Common size statements Trend percentage analysis (a), (b) & (c)
(4)
Main objectives of the Financial statements analysis are

(a) (b) (c) (d) To study the changes in the financial performance To study the liquidity, solvency of the firm To undergo financial planning based upon the yester financial performance (a), (b) & (c)
5.4 TREND PERCENTAGE ANALYSIS

The next important tools of analysis is trend percentage which plays significant role in analyzing the financial stature of the enterprise through base years performance ratio computation. This not only reveals the trend movement of the financial performance of the enterprise but also highlights the strengths and weaknesses of the enterprise The following ratio is being used to compute the trend percentage
Current year 100 Base year
This trend ratio is being computed for every component for many number of years which not only facilitates comparison but also guides the firm to understand the trend path of the firm.
5.5 LET US SUM UP

Under the financial statement analysis, the information available are grouped together in order to cull out the meaningful relationship which is already available among them; for interpretation and analysis. To reveal qualitative information about the firm in terms of
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solvency, liquidity profitability and so on are extracted from the analysis of financial statements. Comparative (Income) financial statement analysis is being carried out in between the income statements of the various accounting durations of the firm, with other firms in the industry and with the industrial average. After having been procured the financial data pertaining to various time periods are ready for comparison ; to determine or identify the level of increase or decrease taken place in the operating financial performance of the firms.

In financial statement analysis, what is the basic objective of observing trends in data and ratios? Suggest some other standards of comparison.
5.7 KEYWORDS
Balance Sheet Financial Statement Financial data Assets Firm

1. 2. 3. 4. 5. Write elaborative note on the financial statement analysis. Elucidate the common size statement analysis. List out the objectives of the financial statement analysis. Explain the steps involved in the process of comparative statement of balance sheet. Write brief note on the trend analysis.
5. 9 SUGGESTED READINGS
R. L. Gupta and Radhaswamy, Advanced Accountancy. V. K. Goyal, Financial Accounting, Excel Books, New Delhi. Khan and Jain, Management Accounting. S. N. Maheswari, Management Accounting. S. Bhat, Financial Management, Excel Books, New Delhi. Prasanna Chandra, Financial Management Theory and Practice, Tata McGraw Hill, New Delhi (1994). I. M. Pandey, Financial Management, Vikas Publishing, New Delhi. Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.
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LESSON
6
RATIO ANALYSIS
CONTENTS
6.0 Aims and Objectives 6.1 Introduction 6.2 Definition 6.3 How the Accounting Ratios are Expressed? 6.4 Purpose, Utility & Limitations of Ratio Analysis 6.5 Classification of Ratios 6.6 Short-term Solvency Ratios 6.6.1 Current Assets Ratio 6.7 Standard Norm of the Current Ratio 6.7.1 Implication of High Ratio of Current Assets over the Current Liabilities 6.7.2 Limitation of the Current Ratio 6.7.3 Acid Test Ratio 6.7.4 Super Quick Assets Ratio 6.8 Capital Structure Ratios 6.9 Debtequity Ratio 6.9.1 Long-Term Debt-equity Ratio 6.9.2 Standard Norm of the Debt-equity Ratio 6.9.3 Total Debtequity Ratio 6.10 Proprietary Ratio 6.11 Fixed Assets Ratio 6.12 Standard Norm of the Ratio 6.13 Coverage Ratios 6.13.1 Interest Coverage Ratio 6.13.2 Dividend Coverage Ratio 6.14 Return on Capital Employed 6.15 Stock Turnover Ratio 6.16 Debtors Turnover Ratio 6.16.1 Debtors Velocity 6.16.2 Creditors Turnover Ratio 6.17 Dupont Analysis 6.18 Let us Sum up 6.19 Lesson-end Activity 6.20 Keywords 6.21 Questions for Discussion 6.22 Suggested Readings

In this lesson we shall discuss about ratio analysis. After going through this lesson you will be able to: (i) (ii) understand purpose, utility and limitations of ratio analysis analyse classifications of ratios and Du pont analysis
6.1 INTRODUCTION
The ratio analysis is an one of the important tools of financial statement analysis to study the financial stature of the business fleeces, corporate houses and so on. How the ratios are able to facilitate to study the financial status of the enterprise ? What is meant by ratio? The ratio illustrates the relationship between the two related variables What is meant by the accounting ratio? The accounting ratios are computed on the basis available accounting information extracted from the financial statements which are not in a position to reveal the status of the enterprise. The accounting ratios are applied to study the relationship between the quantitative information available and to take decision on the financial performance of the firm.
6.2 DEFINITION
According to J. Betty, The term accounting is used to describe relationships significantly which exist in between figures ratio shown in a balance sheet, Profit & Loss A/c, Trading A/c, Budgetary control system or in any part of the accounting organization. According to Myers Study of relationship among the various financial factors of the enterprise
6.3 HOW THE ACCOUNTING RATIOS ARE EXPRESSED?

To understand the methodology of expressing the ratios, the expression of ratios are highlighted in the following discussion
Expression
Quotient
Percentage
Time
Fraction
Current Ratio /Leverage Ratio
Net Profit Ratio
Stock Turnover Ratio
Fixed assets to capital
6.4 PURPOSE, UTILITY & LIMITATIONS OF RATIO ANALYSIS

Purposes of the Ratio Analysis are: To study the short term solvency of the firm liquidity of the firm To study the long term solvency of the firm leverage position of the firm To interpret the profitability of the firm Profit earning capacity of the firm To identify the operating efficiency of the firm. turnover of the ratios
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Utility of the Ratio Analysis are: i. ii. iii. Easy to understand the financial position of the firm: The ratio analysis facilitates the parties to read the changes taken place in the financial performance of the firm from one time period to another. Measure of expressing the financial performance and position: It acts as a measure of financial position through Liquidity ratios and Leverage ratios and also a measure of financial performance through Profitability ratios and Turnover Ratios. Intra-firm analysis on the financial information over many number of years: The financial performance and position of the firm can be analysed and interpreted with in the firm in between the available financial information of many number of years; which portrays either increase or decrease in the financial performance. Inter-firm analysis on the financial information within the industry: The financial performance of the firm is studied and interpreted along with the similar firms in the industry to identify the presence and status of the respective firm among others. Possibility for Financial planning and control: It not only guides the firm to earn in accordance with the financial forecasting but also facilitates the firm to identify the major source of expense which drastically has greater influence on the earnings.
Ratio Analysis
iv.
v.
Limitations of the Ratio Analysis are: i. It is dependant tool of analysis: The perfection and effectiveness of the analysis mainly depends upon the preparation of accurate and effectiveness of the financial statements. It is subject to the availability of fair presentation of data in the financial statements. ii. Ambiguity in the handling of terms: If the tool of analysis taken for the study of inter firm analysis on the profitability of the firms lead to various complications. To study the profitability among the firms, most required financial information are profits of the enterprise. The profit of one enterprise is taken for analysis is Profit After Taxes (PAT) and another is considering Profit Before Interest and Taxes (PBIT) and third one is taking Net profit for study consideration. The term profit among the firms for the inter firm analysis is getting complicated due to ambiguity or poor clarity on the terminology. iii. Qualitative factors are not considered: Under the ratio analysis, the quantitative factors only taken into consideration rather than qualitative factors of the enterprise. The qualitative aspects of the customers and consumers are not considered at the moment of preparing the financial statements but while granting credit on sales is normally considered. iv. Not ideal for the future forecasts: Ratio analysis is an outcome of analysis of historical transactions known as Postmortem Analysis. The analysis is mainly based on the yester performance which influences directly on the future planning and forecasting ; it means that the analysis is mainly constructed on the past information which will also resemble the same during the future analysis. v. Time value of money is not considered: It does not give any room for time value of money for future planning or forecasting of financial performance ; the main reason is that the fundamental base for forecasting is taken from the yester periods which never denominate the timing of the benefits.
Check Your Progress
(1)
Ratio is an expression of
(a) (b) (c) (d) (e) Quotient Time Percentage Fraction (a), (b), (c) & (d)
(2)
Accounting ratios are to study

(a) Accounting relationship among the variables Contd...
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(b) (c) (d)
the relationship in between the variables of financial statements The relationship in between the variables of financial statements for analysis and interpretations None of the above Income statement ratios Positional statement ratios Both (a) & (b) None of the above
(3)
Accounting ratios are

(a) (b) (c) (d)
6.5 CLASSIFICATION OF RATIOS

The accounting ratios are classified into various categories on the basis of 1. 2. Financial statements Functions
On the basis of Financial Statements: I. Income statement Ratios: These ratios are computed from the statements of Trading, Profit & Loss account of the enterprise. Some of the major ratios are: GP ratio, NP ratio, Expenses Ratio, and so on. Balance sheet or Positional Statement Ratios: These type of ratios are calculated from the balance sheet of the enterprise which normally reveals the financial status of the position i.e. short term, Long term financial position, Share of the owners on the total assets of the enterprise and so on.
II.
III. Inter statement or Composite Mixture of Ratios: Theses ratios are calculated by extracting the accounting information from the both financial statements, in order to identify stock turnover ration, debtor turnover ratio, return on capital employed and so on. On the basis of Functions: I. II. On the basis of Solvency position of the firms: Short term and Long term solvency position of the firms. On the basis of Profitability of the firms: The profitability of the firms are studied on the basis of the total capital employed, total asset employed and so on.
III. On the basis of Effectiveness of the firms: The effectiveness is studied through the turnover ratios Stock turnover ratio, Debtor turnover ratio and so on. IV. Capital Structure ratios: The capital structure position are analysed through leverage ratios as well as coverage ratios.
6.6 SHORT-TERM SOLVENCY RATIOS

To study the short term solvency or liquidity of the firm, the following are various ratios Current Assets Ratio Acid Test Ratio or Quick Assets Ratio Super Quick Assets Ratio Defensive Interval Ratio
6.6.1 Current Assets Ratio

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It is one of the important accounting ratios to find out the ability of the business fleeces to meet out the short financial commitment This is the ratio establishes the relationship
in between the current assets and current liabilities. What is meant by current assets /Current assets are nothing but available in the form of cash, equivalent to cash or easily convertible in to cash. What is meant by the current liabilities? Current liabilities are nothing but short term financial resources or payable in short span of time within a year.
Ratio Analysis
Current =
Current Assets Current Liabilities

Current Ratio
Current Assets
Current Liabilities
M arketable Secu ities In ven to ry D eb tors B ill R eceivable P re p aid exp en ses O utstan d in g In com es C ash at B an k C ash in H an d
T rad e cred itors B an k o verd raft B ills P ayab le P ro visio n fo r taxatio n O utstan d in g exp en ses P re received in com es
6.7 STANDARD NORM OF THE CURRENT RATIO

The ideal norm is that 2:1; which means that every one rupee of current liability is appropriately covered by Two rupees of current assets.
6.7.1 Implication of High Ratio of Current Assets over the Current Liabilities
High ratio leads to greater the volume of current assets more than the specified norm denotes that the firm possess excessive current assets than the requirement portrays idle funds invested in the current assets.
6.7.2 Limitation of the Current Ratio

Under this ratio, the current assets are equally weighed each other to match the current liabilities. Under the current ratio, One rupee of cash is equally weighed at par with the one rupee of closing stock, but the closing stock and prepaid expenses cannot be immediately realized like cash and marketable securities.
6.7.3 Acid Test Ratio

It is a ratio expresses the relationship in between the quick assets and current liabilities. This ratio is to replace the bottleneck associated with the current ratio. It considers only the liquid assets which can be easily translated into cash to meet out the financial commitments.
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Acid Test Ratio ( Quick Assets Ratio) =
Liquid Assets Current Liabilities
Liquid Asset = Current Assets ( Closing Stock +Pre paid expenses)
Quick Liquid Assets Ratio
Quick Assets
Current liabilities
Marketable Securities Debtors Bill Receivable Cash at Bank Cash in Hand
Trade creditors Bank overdraft Bills Payable Provision for taxation Outstanding expenses Pre received incomes
Standard norm of the ratio; The ideal norm is that 1:1 means; One rupee of current liabilities is matched with one rupee of quick assets.
6.7.4 Super Quick Assets Ratio

It is the ratio which establishes the relationship in between the super quick assets and quick liabilities of the firm. The super quick assets are nothing but the current assets which can be more easily converted into cash to meet out the quick liabilities. The super quick liabilities are the current liabilities should have to be met out at faster pace within shorter span in duration. Super Quick Assets = Cash + Marketable Securities . Super Quick Liabilities= Current Liabilities Bank Over Draft Super Quick Assets Ratio =
Super Quick Assets Super Quick Liabilities
Standard norm of the ratio

Higher the ratio is the better the position of the firm Illustration 1 From the following calculate current ratio Current Assets: Rs Cash in hand
100
4,00,000 1,60,000
Sundry Debtors
Stock Current Liabilities: Sundry creditors Bills Payable

Current Ratio = Current Assets Current Liabilitie s = Rs. 8,00,000 =2 Rs. 4,00,000
2,40,000
Ratio Analysis
3,00,000 1,00,000
Illustration 2 The firm satisfies the standard norm of the current asset ratio and Liquid assets ratio M/s Shanmuga &Co
Particulars Share capital Reserve Annual Profit Bank overdraft Sundry creditors Total Rs. 42,000 3,000 5,000 4,000 12,000 66,000 Particulars Fixed Assets Net Stock Debtors Cash Total Rs. 34,000 12,400 6,400 13,200 66,000
Current Ratio =
Current Assets Current Liabilities Rs. 32,000 = Rs.16,000 =2
It satisfies the standard norm of the current asset ratio

Liquid assets ratio = Quick assets Current Assets - Closing Stock = Current Liabilities Current Liabilities Rs. 19,600 = = 1.225 Rs. 16,000
The firm financial position satisfies the standard norm of the Liquid assets ratio. Illustration 3 Liquid Assets Rs. 65,000; Stock Rs. 20,000; Pre paid expenses Rs. 5,000; Working capital Rs. 60, 000 Calculate current assets ratio and liquid assets ratio For the computation of current assets ratio, current assets volume must be known. It is not available in our problem, instead the liquid assets and prepaid expenses are given together which will facilitate to find the total volume of current assets. Current Assets= Liquid Asset + Prepaid expenses + closing stock = Rs. 65,000 + Rs. 5,000+20,000 = Rs. 90,000 The next step is to find out the current liabilities. The volume of current liabilities could be found out through the available information of working capital. Net working capital= Current Assets- Current Liabilities
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Rs. 60,000
Rs. 70,000 - Current liabilities
Current liabilities = Rs. 90,000 - Rs. 60,000= Rs. 30,000 From the above, the current ratio could be found out
Current Ratio = Rs. 90,000 =3> 2 Rs. 30,000
The firm satisfies the more than the norm of the current ratio. It means that the firm keeps excessive current assets more than that of requirement.
Quick Assets Ratio = Rs. 65,000 = 2.17 Rs. 30, 000
The firm keeps more liquid assets than that of the specified norm means that excessive liquid assets are held by the firm than the requirement in the form of idle not productive in utility. Illustration 4 The current ratio of Bicon Ltd. is 4.5 :1 and liquidity ratio is 3:1 stock is Rs. 6,00,000 Find out the current liabilities. To find out the volume of current liabilities, initially the share of closing stock should be found out in the total of current assets. Share of stock =Current Assets Ratio Liquid Assets Ratio =4.5-3. 0=1.5 Share of the stock=1.5 If the share of the stock is 1.5 which amounted Rs. 6,00,000 What is the volume of current liabilities for the ration of 1?
Current Liabilities =
Rs. 6,00,000 = 4,00,000 1.5
6.8 CAPITAL STRUCTURE RATIOS

The capital structure ratios are classified into two categories Leverage Ratios Long term solvency position of the firm Principal repayment Coverage Ratios Fixed commitment charge solvency of the firm Dividend coverage and Interest coverage
Capital Structure
Leverage Ratios
Coverage Ratios
Debt Equity Ratio Total Debt Equity Ratio Proprietary Ratio Fixed assets Ratio
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Interest Coverage Ratio Dividend Coverage
Under the capital structure ratios, the composition of the capital structure is analysed only in the angle of long term solvency of the firm.
Ratio Analysis
6.9 DEBT-EQUITY RATIO

It is the ratio expresses the relationship between the ownership funds and the outsiders funds. It is more specifically highlighted that an expression of relationship in between the debt and Shareholders funds. The debtequity ratio can be obviously understood into two different forms Long term debtequity ratio Total debtequity ratio
6.9.1 Long-term Debt-equity Ratio

It is a ratio expresses the relationship in between the outsiders contribution through debt financial resource and Share holders contribution through equity share capital, preference share capital and past accumulated profits. It reveals the cover or cushion enjoyed by the firm due to the owners contribution over the outsiders contribution.
Debt - Equity Ratio =
Debt (Long term debt = Debentures/Term Loans) Net worth/Equity (Shareholders' fund)
Higher ratio indicates the riskier financial status of the firm which means that the firm has been financed by the greater outsiders fund rather than that of the owners fund contribution and vice versa.
6.9.2 Standard Norm of the Debt-equity Ratio

The ideal norm is that 1:2 which means that every one rupee of debt finance is covered by the 2 rupees of shareholders fund
The firm should have a minimum of 50% margin of safety in meeting the long term financial commitments. If the ratio exceeds the specification, the interest of the firm will be ruined by the outsiders during the moment at when they are unable to make the payment of interest in time as per the terms of agreement reached earlier. During the moment of liquidation, the greater ratio may facilitate the creditors to recover the amount due lesser holding held by the owners.
6.9.3 Total Debt-equity Ratio

The ultimate purpose of the ratio is to express the relationship total volume of debt irrespective of nature and shareholders funds. If the owners contribution is lesser in volume in general irrespective of its nature leads to worse situation in recovering the amount of outsiders contribution during the moment of liquidation.
Total Debt Equity Ratio =
Short term debt + Long term debt Equity (Shareholders' fund)
6.10 PROPRIETARY RATIO

The ratio illustrates the relationship in between the owners contribution and the total volume of assets. In simple words, how much funds are contributed by the owners in financing the assets of the firm. Greater the ratio means that greater contribution made by the owners in financing the assets.
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Pr oprietary Ratio =
Owners' Funds or Equity or Shareholders' funds Total assets
Standard Norm of the ratio

Higher ratio is better position for the firm as well as safety to the creditors.
6.11 FIXED ASSETS RATIO

The ratio establishes the relationship in between the fixed assets and long term source of funds. Whatever the source of long term funds raised should be used for the acquisition of long term assets; it means that the total volume of fixed assets should be equivalent to the volume of long term funds i.e. , the ratio should be equal to 1
Fixed Assets Ratio =
share holders' funds + Outsiders' funds Net Fixed Assets
If the ratio is lesser than one means that the firm made use of the short term fund for the acquisition of long term assets. If the ratio is greater than one means that the acquired fixed assets are lesser in quantum than that of the long term funds raised for the purpose. In other words, the firm makes use of the excessive funds for the built of current assets.
6.12 STANDARD NORM OF THE RATIO

The ideal norm of the ratio is 1:1 which means that the long term funds raised only utilised for the acquisition of long term assets of the enterprise
It facilitates to understand obviously about the over capitalization or under capitalization of the assets of the enterprise.
6.13 COVERAGE RATIOS

These ratios are computed to know the solvency of the firm in making the periodical payment of interest and preference dividends. The interest and preference dividends are to be paid irrespective of the earnings available in the hands of the firm. In other words, these are known as fixed commitment charge of the firm.
6.13.1 Interest Coverage Ratio

The firms are expected to make the payment of interest on the amount of borrowings without fail This ratio facilitates the prospective lender to study the strength of the enterprise in making the payment of interest regularly out of the total income. To study the capacity in making the payment of interest is known as interest coverage ratio or debt service coverage ratio. The ability or capacity is analysed only on the basis of Earnings before interest and taxes (EBIT) available in the hands of the firms. Greater the ratio means that better the capacity of the firm in making the payment of interest as well as greater the safety and vice versa Interest coverage ratio =
Earning before interest and taxes Interest
Lesser the times the ratio means that meager the cushion of the firm which may lead to affect the solvency position of the firm in making payment of interest regularly.
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6.13.2 Dividend Coverage Ratio

It illustrates the firms ability in making the payment of preference dividend out of the earnings available in the hands of the firm after the payment of taxation. If the size of the Profits after taxation is greater means that greater the cushion for the payment of preference dividend and vice versa. The preference dividends are to be paid without fail irrespective of the profits available in the hands of the firm after the taxation. Dividend coverage ratio = Standard norm of the ratio
Higher the ratio means that the firm has greater cushion in meeting the needs of preference dividend payment against Earnings after taxation(EAT) and vice versa
Ratio Analysis
Earnings after taxatation Preference Dividend
Profitability Ratios
The ratios are measuring the profitability of the firms in various angles viz On sales On investments On capital employed and so on While discussing the measure of profitability of the firm, the profits are normally classified into various categories Gross Profit Net Profit Earnings before interest and taxes Earnings after taxation and so on All profitability ratios are normally expressed only in terms of (%). The return is normally expressed only in terms of percentage which warrant the expression of this ratio to be also in percentage. GP Ratio: The ratio elucidates the relationship in between the Gross profit and sales volume. It facilitates to study the profit earning capacity of the firm out of the manufacturing or Trading operations. Gross Profit Ratio =
Gross Profit 100 Sales
Standard Norm of the ratio:

Higher the ratio is better the position of the firm which means that the firm earns greater profits out of the sales and vice versa.
NP Ratio: The ratio expresses the relationship in between the Net profit and sales volume. It facilitates to portray the overall operating efficiency of the firm. The net profit ratio is an indicator of over all earning capacity of the firm in terms of return out of sales volume. Net Profit Ratio =
Net Profit 100 Sales
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Standard Norm of the Ratio:

Higher the ratio is better the operating efficiency of the firm which means that the firms earns greater volume of both operating as well as non operating profit out of sales and Vice versa.
Operating profit ratio: The operating ratio is establishing the relationship in between the cost of goods sold and operating expenses with the total sales volume. Operating ratio =
Cost of goods sold + Operating expenses 100 Net sales

Lower the ratio is better as well as favourable position for the firm, which highlights % of absorption cost of goods sold and operating expenses out of sales and vice versa. The lower ratio leads to have the higher margin of operating profit.
Return on Assets: This ratio portrays the relationship in between the earnings and total assets employed in the business enterprise. It highlights the effective utilization of the assets of the firm through the determination of return on total assets employed. Return on Assets =
Net Profit After Taxes 100 Average Total Assets
Standard norm of the ration

Higher the ratio illustrates that the firm has greater effectiveness in the utilization of assets, means greater profits reaped by the total assets and vice versa.
6.14 RETURN ON CAPITAL EMPLOYED

The ratio illustrates that how much return is earned in the form of Net profit after taxes out of the total capital employed. The capital employed is nothing but the combination of both non current liabilities and owners equity. The ratio expresses the relationship in between the total earnings after taxation and the total volume of capital employed. Return on total capital employed = Standard norm of the ratio
Higher the ratio is better the utilization of the long term funds raised under the capital structure means that greater profits are earned out of the total capital employed.
Net profit after taxes 100 Total capital employed
Activity turnover ratio: It highlights the relationship in between the sales and various assets. The ratio indicates that the rate of speed which is taken by the firm for converting the assets into sales.
6.15 STOCK TURNOVER RATIO

The ratio expresses the speed of converting the stock into sales. In other words, how fast the stock is being converted into sales in a year? The greater the ratio of conversion leads to lesser the number of days /weeks /months required to convert the stock into sales. Stock turnover ratio =
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Cost of Goods Sold Sales Or Average stock Closing stock
Standard norm of the ratio:

Higher the ratio is better the firm in converting the stock into sales and vice versa
Ratio Analysis
The next step is to find out the number of days or weeks or months taken or consumed by the firm to convert the stock into sales volume. Stock velocity =
365 days/52 weeks/12 months Creditors Turnover Ratio

Lower the duration is better the position of the firm in converting the stock into sales and vice versa.
6.16 DEBTORS TURNOVER RATIO

This ratio exhibits the speed of the collection process of the firm in collecting the overdues amount from the debtors and against Bills receivables. The speediness is being computed through debtors velocity from the ratio of Debtors turnover ratio. Debtors turnover ration = Standard norm of the ratio
Higher the ratio is better the position of the firm in collecting the overdue means the effectiveness of the collection department and vice versa.
Net Credit Sales Net Credit Sales Or Average Debtors Debtor + Bills Receivable
6.16.1 Debtors Velocity

This is an extension of the earlier ratio to denote the effectiveness of the collection department in terms of duration. Debtors velocity =
365days/52weeks/12months Debtor turnover ratio

Lesser the duration shows greater the effectiveness in collecting the dues which means that the collection department takes only minimum period for collection and vice versa.
6.16.2 Creditors Turnover Ratio

It shows effectiveness of the firm in making use of credit period allowed by the creditors during the moment of credit purchase. Creditors Turnover ratio = Standard norm of the ratio
Lesser the ratio is better the position of the firm in liquidity management means enjoying the more credit period from the creditors and vice versa.
Credit Purchase Credit Purchase Or Average creditors Bills payable + Sundry
Creditors velocity =
365 days/52 weeks/12 months Creditors Turnover Ratio

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Greater the duration is better the liquidity management of the firm in availing the credit period of the creditors and vice versa. Check Your Progress
(1)
Solvency position of the firm studied and interpreted through

(a) (b) (c) (d) Short-term solvency ratios Long-term solvency ratios Coverage ratios (a) (b) & (c)
(2)
Efficiency and effectiveness of the firm is studied through

(a) (b) (c) (d) Liquidity ratios Leverage ratios Turnover ratios Profitability ratios
(3)
Profitability ratios to study the potential to earn profits on

(a) (b) (c) (d) On Assets On Capital employed On Sales (a) (b) & (c)
Illustration 5 Sundaram &co sells goods on cash as well as credit basis. The following particulars are extracted from the books of accounts for the calendar 2005
Particulars Total Gross sales Cash sales ( included in above) Sales returns Total Debtors Bills receivable Provision for doubtful debts Total creditors Rs 2,00,000 40,000 14,000 18,000 4,000 2,000 20,000
Calculate average collection period To find out the average collection period, first Debtors turnover ratio has to computed Debtors turnover ratio =
Net Credit sales Bills receivable + Debtors
Net credit sales= Gross sales cash sales sales return = Rs. 2, 00, 000 Rs. 40, 000 Rs. 14, 000=Rs. 1, 46, 000 Debtor turnover ratio =
Rs. 1, 46,000 Rs. 4,000 + Rs.18,000 = 6.64 times
Debtors velocity =
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365 days 365 days = Debtors turnover ratio 6.64 times
= 55 days
Illustration 6 Find out the value of creditors from the following Sales Rs. 1,00,000 Gross profit on Sales 10% Creditors velocity 73 days Opening stock Rs10,000 Closing stock Rs. 20,000 Bills payable Rs. 16,000
Ratio Analysis
Note: All purchases are credit purchases To find out the volume of purchases, the formula of cost of goods sold should taken into consideration Cost of goods sold = Opening stock +Purchases- Closing stock X = Rs. 10,000 + Y Rs. 20,000
Cost of goods sold = Sales Gross profit = Rs. 1,00,000 10% on Rs 1,00,000 = Rs. 90,000 The next step is to apply the found value in the early equation Purchases = Rs. 90,000 Rs. 10,000 +Rs. 20,000 = Rs. 1,00,000 To find out the value creditors, the creditor velocity and creditors turnover ratio Creditors velocity =
365 days Creditors turnover ratio

Credit purchases Bills payable + Sundry creditors Rs.1,00,000 = Rs.16,000 + Sundry creditors
Creditors turnover ratio =
The next step is to find out the sundry creditors, the reversal process to be adopted 73 days =
365 days Creditors turnover ratio

365 days = 5 times 73 days
The next step is to substitute the found value in the equation of creditors turnover ratio Rs. 16,000 + Sundry creditors =
Rs. 1,00,000 5
Sundry creditors= Rs. 20,000 Rs. 16, 000= Rs. 4,000 Illustration 7 From the following information, prepare a balance sheet show the workings 1. 2. 3. working capital Reserves and surplus Bank overdraft Rs. 75,000 1,00,000 60,000
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4. 5. 6. 7.
Current ratio Liquid Ratio Fixed assets to proprietors fund Long term liabilities
1.75 1,15 .75 Nil (B.Com. Madras, April 1980)
First step is to find out the current liabilities Current ratio =
Current assets 1.75 = Current liabilities 1
Working capital = Rs. 75,000 =1.751= 0.75 If 0.75 is the share of working capital, what would be the share of current assets ? Current assets =
Rs. 75,0001.75 = Rs.1,75,000 .75
Working capital = Current assets current liabilities Current liabilities = Current assets working capital CL= Rs. 1, 75, 000 Rs. 75, 000=Rs. 1, 00, 000 Quick assets ratio = 1. 15 =
1.15 = Quick assets Quick liabilities Quick assets = Current liabilities BOD
1.15(Rs. 1,00,000Rs. 60,000) = Quick assets 1.15(Rs. 40,000)= Quick assets Rs 46, 000= Quick assets The next step is to find out the amount of the closing stock. This can be found out through finding out the difference in between the current assets and quick assets. Closing stock = Current assets Quick assets = Rs. 1,75,000 Rs. 46,000= Rs. 1,29,000 The next one is to find out the proprietors fund The fixed assets to proprietors fund is 0.75 This has to be found out on the basis of Double Entry Accounting Concept Total liabilities = Total Assets....................(1) Long term funds + Short term financial resources = Total liabilities In the long term funds, there is no long term liabilities, which means the structure of long term funds consist of the share holders funds The share holder funds are known as proprietors fund Short term financial resources are known as current liabilities Proprietors fund + Current liabilities = Total liabilities Current assets + Fixed assets = Total assets
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To substitute the values in the equation (1)
Proprietors fund + Current liabilities= Current assets + Fixed assets Proprietors fund Fixed assets= Current assets Current liabilities 1 0.75=Rs. 1,75,000 Rs. 1,00,000 0.25=Rs. 75,000 If 0. 25 is bearing the volume of Rs 75, 000; what would be the volume of investment of fixed assets for 0. 75 and proprietors fund for 1
Ratio Analysis
proprietor' s fund =
Rs. 75, 000 Rs. 3,00,000 0.25
0.75 portion of the owners funds are contributed to fixed assets i.e. 0.75 on Rs. 3,00,000 = Rs. 2,25,000 To find out the exact share of the equity share capital, the following formula has to be used. Share holders funds = Equity share capital + Reserves and surpluses In this problem, reserves and surpluses is given Rs. 3,00,000=Equity share capital +Rs 1,00,000 Equity share capital= Rs. 2,00,000 The balance sheet of the company as on dated
Liabilities Share capital Reserves and surpluses Bank overdraft Quick liabilities Rs 2,00,000 1,00,000 60,000 40,000 4,00,000 Assets Fixed assets Stock Quick assets Rs 2,25,000 1,29,000 46,000
4,00,000
Check Your Progress
(1)
Standard norm of the current ratio is

(a) (b) (c) (d) 2:1 1:. 5 1:2 3:1
(2)
Super quick assets do not include

(a) (b) (c) (d) Closing stock Prepaid expenses Sundry debtors Both (a) & (b)
(3)
Standard norm of the Debt to Capital

(a) (b) (c) (d) 1:2 1:1 2:1 1:5
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Illustration 8 Debtors velocity Creditors velocity Stock velocity Capital turnover ratio Fixed assets turnover ratio Gross profit turnover ratio 3 months 2 months 8 times 2. 5 times 8 times 25%
Gross profit in a year amounts to Rs. 1, 60, 000. There is no long term loan or overdraft. Reserves and surplus amount to Rs. 56, 000. Liquid assets are Rs. 1, 94, 666. Closing stock of the year is Rs. 4, 000 more than the opening stock Bill receivable amount to Rs. 10, 000 and bills payable to Rs. 4, 000 Find out Sales Sundry debtors Sundry creditors Closing stock Fixed assets Proprietors fund
Draft the balance sheet with as many as details possible. The first step is to find out the sales Gross profit ratio = 25% The total volume of gross profit is given = Rs. 1,60,000
Gros Profit 100 Sales Rs. 1,60,000 25% = 100 Sales Rs.1,60,000 Saels = = Rs. 6,40,000 25% GP ratio =
The next step is to find out the closing stock value In our problem, two important information given are stock velocity and details about the closing stock in terms of opening stock Stock velocity = 8 times Closing stock is Rs. 4, 000 excess of opening stock The information stock velocity given denotes that the stock turnover ratio.
Stock trunover ratio =
cost of goods sold Average Stock
Now the volume of cost of goods sold has to be found out from the early available information i.e., sales and gross profit Cost of goods sold= Sales Gross profit = Rs. 6,40,000 Rs. 1,60,000= Rs. 4,80,000 The next step is to find out the volume of average stock through the earlier formula
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8 times =
Rs. 4,80,000 Average stock
Average stock = Rs. 60,000 The next step is to apply the conditionality with regards to closing stock
Ratio Analysis
Opening Stock + Closing Stock = Rs. 60,000 2 Opening stock + Opening stock + Rs. 4, 000 = Rs. 60,000 2
2 Opening stock +Rs. 4, 000= Rs. 1, 20, 000 2 Opening stock = Rs. 1, 20, 000 Rs. 4, 000 Opening stock = Rs. 58, 000 Closing stock = Opening stock + Rs. 10, 000= Rs. 58, 000+ Rs. 10, 000=Rs. 68, 000 The next fact is to be found that sundry debtors To find out the debtors, the most information given debtors velocity and bills receivable have to be made use of
12 months Debtors turnover ratio 12 months = 4 times Debtors turnover ratio = 3 months Credit sales 4 times = Bills receivable + Sundry debrors Rs. 6,40,000 Rs. 10,000 + Sundry debtors = 4 Debtors Velocity =
Sundry debtors = Rs. 1, 60, 000Rs. 10, 000= Rs. 1, 50, 000 The next important stage is to find out the sundry creditors To find out the sundry creditors, the creditors velocity has to be applied in the formula In addition to the earlier, one missing information has to be found out i-e Credit purchases The volume of purchase to be found out through the formula of cost of goods sold Cost of goods sold= Opening stock +Purchases Closing stock Rs. 4,80,000 = Rs. 58,000+Purchases Rs. 68,000 Purchases = Rs. 4,80,000Rs. 58,000+Rs. 68,000 = Rs. 4,80,000+Rs. 10,000= Rs. 4,90,000
Creditors velocity =
12 months Creditors turnover ratio

12 months 6 times 2 months

6 times =
Rs. 4,90,000 + Sundry creditors Rs. 4,000
Rs. 4,000+ Sundry creditors= Rs. 81,667 Sundry creditors = Rs 77,667

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The next step is to find out the volume of fixed assets This could be found out with the help of fixed assets turnover ratio =5 times Fixed assets turnover ratio = 5 times =
Sales Fixed Assets Rs. 6,40,000 = Rs.1, 28, 000 5 times
=
Proprietors fund
Proprietors fund = Fixed assets+ Current Assets Current liabilities The above equation is coined on the basis of Double accounting concept Fixed assets + Current assets = Total assets = Total Liabilities Total Assets Current liabilities = Total Liabilities Current liabilities Current assets volume is not known, In such cases the stock volume should be added with the Liquid assets to derive the early mentioned. Current assets= Closing stock + Liquid Assets = Rs. 68,000+ Rs. 1,94,666 = Rs2,62,666 Proprietors fund = Rs. 1,28,000+ Rs. 2,62,666 Rs. 81,667 = Rs. 3,08,999
Share capital = Proprietors fund Reserves and surpluses = Rs. 3,08,999 Rs. 56,000= Rs. 2,52,999 Cash and Bank Balances to be found out in the next stage
Liquid Asset Less : Debtors Bills receivable Rs. 1,50,000 10,000
= Rs. 1,94,666
Rs. 1,60,000 Rs. 34,666
From the above found information the detailed balance sheet with as many as information possible to portray Balance sheet as on dated Liabilities Share capital Reserves and surpluses Bills receivable Sundry creditors Rs 2,52,999 56.000 4,000 77,667 3,90,666 Assets Fixed assets Stock Debtors Bills receivable Cash and Bank Balance Rs 1,28,000 68,000 1,50,000 10,000 34,666 3,90,666
Illustration 9 From the following particulars, prepare trading, profit and loss account and a balance sheet Current ratio -3 Liquid ratio -1.8
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Bank overdraft Rs. 20,000
Working capital Rs. 2,40,000 Debtors velocity -1 month ; Gross profit ratio -20% Proprietary ratio (Fixed assets / share holders fund) - .9 Reserves and surpluses -. 25 of share capital Opening stock Rs. 1,20,000; 8% Debentures Rs. 3,60,000 Long term investments Rs. 2,00,000 Stock turnover ratio -10 times Creditors velocity -1/2 month Net profit to share capital -20% (B. Com Bharathidasan, April 1989) First step is to find out the current assets and current liabilities through current ratio
Ratio Analysis
Current ratio =
Current Assets =3 Current Liabilities
Current Assets- Current Liabilities = Working capital 3 1 = 2 = Rs. 2, 40, 000
The volume of working capital Rs 2,40,000 is equated to share 2 What is the volume of current liabilities for the share of 1 Current liabilities = Rs. 2, 40, 000 = Rs. 1,20,000 2 The volume of current assets = Rs. 1,20,000 3= Rs. 3,60,000 The next step is to find out the volume of liquid assets
Liquid assets ratio = 1.8 =
Liquid assetss Liquid Liabilities
When the Bank overdraft is given, the liquid liabilities should be computed. Liquid liabilities = Current liabilities Bank overdraft = Rs. 1,20,000 Rs. 20,000 = Rs. 1,00,000 Liquid assets is 1.8 times greater than the Liquid liabilities Liquid assets = 1.8 Rs. 1,00,000 = Rs. 1,80,000 To find out the volume of the stok Stock = Current assets Liquid assets =Rs. 3,60,000 Rs. 1,80,000 = Rs. 1,80,000 The next step is to find out the cost of goods sold To find out the cost of goods sold, the stock turnover ratio has to be found out
10 times = cost of goods sold Average stock Opening stock + Closing stock Rs.1,20,000 + Rs.1,80,000 = = Rs. 1,50,000 Average stock = 2 2
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Cost of goods sold = Rs. 1,50,000 10= Rs. 15,00,000 Next step is to find out the volume of sales in order to find out the volume of debtors The volume of sales could be found out through Gross profit ratio Sales Profit = Cost of goods sold 100 20=80 The Rs15, 00, 000 worth of cost of goods sold is equated to share of 80 What would be the volume of sales?
Sales =
Rs.15,00,000 = Rs.18,75,000 80
Gross profit = Rs. 18, 75, 000 Rs. 15, 00, 000= Rs. 3,75,000 The next step is to find out the volume of debtors The debtors could be found out with the help of debtors turnover ratio and collection period
Debtors velocity or collection period = Debtors turnover ratio =
12 months Debtors turnover ratio
12 months = 12 times 1 month Credit Sales 12 times = Average debtors Rs. 18,75,000 = Rs.1,56,250 Average Debtors = 12
The next step is to find out the creditors. The volume of creditors ; to find out the volume of the creditors, the creditors turnover ratio and creditors average payment period should have to be applied Creditors average payment period =
12 months Creditors turnover ratio
12 months = 24times 0.5
credit purchase Creditors turnover ratio = Average creditors

Average creditors =
credit purchase 24 times
Now the volume of credit purchase to be found out with the help of cost of goods sold formula Cost of goods sold= Opening stock+ Purchases- Closing stock Rs. 15,00,000Rs. 1,20,000+Rs. 1,80,000= Purchases Rs. 15,60,000 = Purchases
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Average creditors = Rs. 65,000
The next step is to find out the proprietary fund ; this could be found out by using the ratio proprietary fund to fixed assets ratio Total Assets= Total Liabilities Long term liabilities + Short term liabilities = Fixed assets + Current assets + Investments Share holders fund Fixed assets = Current assets + Investment Current liabilities Debenture 1 0.9= Rs. 2,00,000+Rs. 3,60,000Rs. 1,20,000Rs. 3,60,000 1 0.9= Rs. 80,000 0.1=Rs. 80,000 If 0.1 share is the volume of Rs. 80,000 what is the volume of proprietary fund for the share of 1? The volume of proprietary fund = Rs. 8,00,000 The volume of fixed assets = Rs. 80,000 0.9= Rs. 7,20,000 The next step is to find out the volume of the share capital. This could be found out only with the help of the ratio given Reserves and surpluses to share capital Reserves and surpluses = 25 % of share capital It means that % is Share capital. Share capital + Reserves and surpluses = Shareholders fund 100+25=125 To find out the share of share capital from the shareholders fund, the following is the computation
Ratio Analysis
Rs.8,00,000 100 = Rs. 6,40,000 = share capital 125

Reserves and surpluses = 25% on the Share capital = 25% on Rs. 6,40,000 =Rs. 1,60,000 The last step is to find out the Net profit, which could be found out through the Net profit to share capital Net profit is 20% on share capital Net profit = 20% on Rs. 6,40,000= Rs. 1,28,000 Next stage is to prepare the Trading, Profit & Loss A/c for the year ended and Balance sheet as on dated Trading Profit & Loss Account for the year ended Dr
Particulars To opening stock To purchases To Gross profit c/d To Debenture Interest 8% Rs.3,60,000 To Balancing figure other expenses To Net profit c/d* Rs 1,20,000 15,60,000 3,75,000 20,55,000 28,800 2,18,200 1,28,000 3,75,000 Particulars By sales By closing stock Rs 18,75.000 1,80,000 20,55,000 3,75,000
Cr
By Gross profit B/d
3,75,000
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Balance sheet as on dated

Liabilities Share capital Reserves and Surpluses Profit during the year 8% Debentures Current liabilities Overdraft Creditors Others Rs 32,000 1,28,000 1,60,000 3,60,000 20,000 65,000 35,000 Current Assets Stock Debtors Other current asset 1,80,000 1,56,250 23,750 Rs 6,40,000 Assets Fixed assets Investments Rs Rs 7,20,000 2,00,000
1,20,000 12,80,000
3,60,000 12,80,000
6.17 DUPONT ANALYSIS

This was an analysis established by the DUPONT INC. , USA to study the Return on investment. It was the first company developed the chart which depicted the influences of Return on Investment. The company underwent for the consideration two important ratios for the return on investment is Net profit ratio and Capital turnover ratio A change in the any one of the two ratios that will immediately reflect on the Return on investment. The various associated factors are considered to study the impact of the profitability of the firm. This type of analysis to correct the problems not only to identify the with specific cause which drastically affects the profitability but also to find the possible ways and means to improve the profitability. Having developed the chart for analysis was called as DUPONT Chart.
Net profit Net profit ratio Sales Expenses Administrative, Selling and distribtution expense Sales Cost of goods sold
Roce
Return on capital employed
sales
Working capital
Current assets
Capital turnover ratio Capital employed Fixed asset Current liabilities
6.18 LET US SUM UP

The accounting ratios are applied to study the relationship in between the quantitative information available and to take decision on the financial performance of the firm. The financial performance and position of the firm can be analysed and interpreted with in the firm in between the available financial information of many number of years; which portrays either increase or decrease in the financial performance. The perfection and effectiveness of the analysis mainly depends upon the preparation of accurate and effectiveness of the financial statements. It is subject to the availability of fair presentation of data in the financial statements. Current liabilities are nothing but short term financial resources or payable in short span of time within a year. The super quick assets are nothing but the current assets which can be more easily converted into cash to meet out
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the quick liabilities. Under the capital structure ratios, the composition of the capital structure is analysed only in the angle of long term solvency of the firm. All profitability ratios are normally expressed only in terms of (%). The return is normally expressed only in terms of percentage which warrant the expression of this ratio to be also in percentage.
Ratio Analysis

Identity four ratios or other analytical tools used to evaluate profitability. Explain briefly how each is computed.
6.20 KEYWORDS
Ratio Stock term over ratio Acid Test ratio Fixed assets ratio Accounting ratio GP ratio Coverage ratio Stock velocity Du analysis

1. 2. 3. 4. 5. 6. 7. 8. 9. Define ratio. Define Accounting ratio. What is meant by Accounting ratio analysis ? Elucidate the importance of the ratio analysis. Explain the Liquidity ratios. Highlight the Leverage ratios. Discuss in detail about the Profitability ratios. Illustrate the various kinds of Turnover ratios. List out the limitations of the ratio analysis.

R. L. Gupta and Radhaswamy, Advanced Accountancy V. K. Goyal, Financial Accounting, Excel Books, New Delhi. Khan and Jain, Management Accounting S. N. Maheswari, Management Accounting S. Bhat, Financial Management, Excel Books, New Delhi. Prasanna Chandra, Financial Management Theory and Practice, Tata McGraw Hill, New Delhi (1994). I. M. Pandey, Financial Management, Vikas Publishing, New Delhi. Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.
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LESSON
7
FUND FLOW STATEMENT ANALYSIS
CONTENTS
7.0 7.1 7.2 7.3 Aims and Objectives Introduction Meaning & Objectives of Fund Flow Statement Analysis Methods of Preparing Fund Flow Statement 7.3.1 Schedule of Changes in Working Capital 7.3.2 Net Profit Method 7.3.3 Sales Method 7.3.4 First Method 7.3.5 Second Method
7.4 Advantages of Preparing Fund Flow Statement 7.4.1 Illustrative Statement of Financing 7.4.2 To fulfil the Primary Objective of the Financial Management 7.4.3 Facilitation through Financial Planning 7.4.4 Guide to Working Capital Management 7.4.5 Indicator of Yester Track Path of the Firm 7.5 Let us Sum up 7.6 Lesson-end Activity 7.7 Keywords 7.8 Questions for Discussion 7.9 Suggested Readings

In this lesson we shall discuss about fund flow statement analysis. After going through this lesson you will be able to: (i) understand meaning and objectives of fund flow statement analysis (ii) analyse methods of preparing fund flow statement (iii) discuss advantages of preparing fund flow statement.
7.1 INTRODUCTION
Every business establishment usually prepares the balance sheet at the end of the fiscal year which highlights the financial position of the yester years It is subject to change in the volume of the business not only illustrates the financial structure but also expresses the value of the applications in the liabilities side and assets side respectively. Normally, Balance sheet reveals the status of the firm only at the end of the year, not at the beginning of the year. It never discloses the changes in between the value position of the firm at two different time periods/dates. The method of portraying the changes on the volume of financial position is the statement fund flow statement. To put them in nutshell, fund between two different time periods. It is further illustrated that the changes in the financial position or the movement or flow of fund.
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7.2
MEANING & OBJECTIVES OF FUND FLOW STATEMENT ANALYSIS
Fund Flow Statement Analysis
A report on the movement of funds or working capital. In a narrow sense the term fund means cash and the fund flow statement depicts the cash receipts and cash disbursements/ payments. It highlights the changes in the cash receipts and payments as a cash flow statement in addition to the cash balances i.e., opening cash balance and closing cash balance. Contrary to the earlier, the fund means working capital i.e., the differences between the current assets and current liabilities. The term flow denotes the change. Flow of funds means the change in funds or in working capital. The change on the working capital leads to the net changes taken place on the working capital i.e., especially due to either increase or decrease in the working capital. The change in the volume of the working capital due to numerous transactions. Some of the transactions may lead to increase or decrease the volume of working capital. Some other transactions neither registers an increase nor decrease in the volume of working capital. According Foulke A statement of source and application of funds is a technical device designed to analyse the changes to the financial condition of a business enterprise in between two dates Various Facets of Fund flow statement are as follows: Statement of sources and application of funds Statement changes in financial position Analysis of working capital changes and Movement of funds statement Objectives of fund flow statement analysis: (1) It pinpoints the mobilization of resources and the further utilization of resources (2) It highlights the financing of the general expansion of the business firms (3) It exemplifies the utilization of debt finance in the structure of financing (4) It portrays the relationship between the financing, investment, liquidity and dividend decision of the firm during the given point of time.
7.3
METHODS OF PREPARING FUND FLOW STATEMENT
Steps in the preparation of Fund Flow Statement: First and fore most method is to prepare the statement of changes in working capital i.e., to identify the flow of fund / movement of fund through the detection of changes in the volume of working capital. Second step is the preparation of Non- Current A/c items-Changes in the volume of Non current a/cs have to be prepared only in order to quantify the flow fund i-e either sources or application of fund. Third step is the preparation Adjusted Profit& Loss A/c, which already elaborately discussed in the early part of the chapter. Last step is the preparation of fund flow statement.
7.3.1 Schedule of Changes in Working Capital

The ultimate purpose of preparing the schedule of changes in the working capital is to illustrates the changes in the volume of net working capital which envisages either sources or application of fund. The schedule of changes are focused as follows:
Increase in Current Assets Increase in Working Capital
Decrease in Current Assets
Decrease in Working Capital
Increase in Current Liabilities
Decrease in Working Capital
Decrease in Current Liabilities
Increase in Working Capital
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Particulars
Previous Year
Current Year
Increase inWorking Capital (+)
Decrease in inWorking Capital ()
(A) Current Assets: Cash In Hand Cash at Bank Marketable Securities Bills Receivable Sundry Debtors Closing Stock Prepaid Expenses (B) Current Liabilities: Creditors Bills Payable Outstanding expenses Pre received Income Provision for doubtful and bad debts Net Working Capital(A-B) Increase/Decrease Working Capital
The next important step is to prepare that Adjusted profit and loss account
Method of Fund From Operations
Net Profit Method Add Non Operating Expenses Less Non Operating Incomes
Sales Method Less-Payments(Application)
The first method is widely used method by all in determining the volume of Fund from Operations (FFS) Under the Net Profit Method, Fund flow from operations can be computed 7.3.2 Net Profit Method Under this method, Fund from operations can be determined in two different ways .The first method is through the statement format Net Profit from the Profit & Loss A/c xxxxx Add: (A) Non Funding Expenses: Loss on Sale of Fixed Assets xxxx Loss on Sale of Long Term Investments xxxx Loss on Redemption Debentures/Preference Shares xxxx Discount on Debentures /Share xxxx (B) Non Operating Expenses: Depreciation of fixed Assets xxxx (C) Intangible Assets: Amortization of Goodwill xxxx Amortization of Patent xxxx Amortization of Trade Mark xxxx (D) Fictitious Assets: Writing off Preliminary expense xxxx Writing off Discount on Shares/Debentures xxxx
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(E) Profit Appropriation Transfer to General Reserve Less: (F) Non funding Profits: Profit on Sale of Fixed Assets Profit on Sale of Long Term Investments Profit on Redemption Debentures/Preference Shares (G) Non Operating Incomes: Dividend Received Interest Received Rent Received Fund From operations / Fund Lost in Operations
xxxx
xxxx xxxx xxxx xxxx xxxx xxxx xxxxx
The second method of determining the fund from operations under the first classification is the Accounting Statement Format.
Adjusted Profit & Loss A/c
Dr
To Depreciation xxxx To Goodwill Written off xxxx To Patent Written off xxxx To Loss on Sale of Fixed Asset xxxx To Loss on Sale of Investment xxxx To Loss on redemption of Liability xxxx To Preliminary Expenses off xxxx To Proposed Dividend xxxx To Transfer to General Reserve xxxx To Current Year Provision for Taxation xxxx To Current Year Provision for Depreciation xxxx To Balancing Figure xxxx (Fund Lost in Operations) By Opening Balance Profit By Profit on sale of Fixed Assets By Profit on Sale of Investments By Profit on redemption of Liability By Transfer from General Reserve By Balancing Figure Fund From Operations(FFS) xxxx xxxx xxxx xxxx xxxx xxxx
Cr
7.3.3 Sales Method Under this method, the following is the statement format is used to arrive fund flow from operations: Sources: Sales Stock at the end Less: xxxxx xxxxx
Application: Stock at Opening xxxx Net Purchases (Purchase-Returns) xxxx Wages xxxx Salaries xxxx Telephone expenses xxxx Electricity charges xxxx Office stationery expenses xxxx Other operating cash expenses xxxx Fund from operations From the following details calculate funds from operations: Salaries Rent Rs. 10,000 6,000
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Refund of Tax Profit on Sale of Building Depreciation on Plant Provision for Taxation Loss on Sale of plant Closing Balance of Profit & Loss A/c Opening balance on Profit & Loss A/c Discount on Issue of Debentures Provision for bad debts Transfer to general reserve Preliminary expenses written off Good will written off Dividend Received Proposed Dividend Calculation of fund from operation 7.3.4 First Method Closing balance of Profit & Loss A/c Less Opening Balance Balance Forward Add: Non Fund / Non Operating Charges: Depreciation on Plant Provision for Taxation Loss on Sale of Plant Discount on issue of debentures Provision for bad debts Transfer to general reserve Preliminary expenses off Good will written off Proposed Dividend Less Refund of Tax Profit on Sale of Building Dividend Received Fund from operations 7.3.5 Second Method
Depreciation on Plant 10,000 Provision for Taxation 8,000 Loss on Sale of Plant 4,000 Discount on issue of debentures 4,000 Provision for bad debts 2,000 Transfer to general reserve 2,000 Preliminary expenses off 6,000 Good will written off 4,000 Proposed Dividend 12,000 To Closing Profit B/d 1,20,000 1,72,000
6,000 10,000 10,000 8,000 4,000 1,20,000 50,000 4,000 2,000 2,000 6,000 4,000 10,000 12,000
1,20,000 50,000 70,000 10,000 8,000 4,000 4,000 2,000 2,000 6,000 4,000 12,000 1,22,000 6,000 10,000 10,000 96,000
By Opening Balance B/d By Profit on Sale of Building By Dividend Received By Refund of Tax By Balancing Figure Fund From operations
50,000 10,000 10,000 6,000 96,000
1,72,000
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The next step is to prepare the fund flow statement. The proforma of the fund flow statement
Sources of funds Funds from Business Operation Non trading Incomes Sale of Non-Current Assets Sale of Long Term Investments Issue of shares Acceptance of deposits Long Term Borrowings Decrease in Working Capital Uses of funds Funds Lost in Operations Redemption of Preference Share Capital Repayment of Loans Purchase of Long Term Investments Purchase of Fixed Assets Payment of Taxes Payment of Dividends Drawings Loss of Cash Increase in Working Capital
Check Your Progress
(1)
Fund flow means a study of

(a) (b) (c) (d) working capital change Cash position change Long investment change Change in the current liabilities
(2)
Normally Working capital means

(a) (b) (c) (d) Current assets- current liabilities Current assets Gross working capital Net working capital
(3)
Increase in working capital

(a) (b) (c) (d) Increase in current assets Increase Net working capital Increase in current liabilities Increase in long term source of financing
7.4 ADVANTAGES OF STATEMENT
PREPARING FUND FLOW
Structured analysis on the Working capital of a firm: It is the only statement to study the changes in the working capital in between two different periods from the balance sheet of a firm through structured analysis on the basis of working capital position.
7.4.1 Illustrative Statement of Financing

It is a statement which highlights the role of various kinds of financing not only in the dimension of project development and expansion but also growth rate of the organization.
Financial Structure
Capital Structure-Long Term Financial Resources
Medium &Short term Financial Resources
External Sources Share Capital and so on
Internal Sources: Retained Earnings
Institutional lending: Banker-Loans & Advances
Money Market: Public Deposit, Commercial paper
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7.4.2 To fulfil the Primary Objective of the Financial Management

It not only elucidates the mode of financing but also the application of resources after raising. It answers to the following queries viz: How the outsider's liabilities are redeemed? What is the role of the fund from operation generated? How the raised funds applied into business? How the decrease in working capital was applied? What is the mode of raising of financial resources for an increase in the working capital?
7.4.3 Facilitation through Financial Planning

The projected fund flow statement from the past performance facilitates the firm to anticipate the future requirement of financial resources. It guides the management to prioritize the application in the future to the tune of scarce resources.
7.4.4 Guide to Working Capital Management

It acts as a guide to the management to maintain the working capital at optimum level through either purchase or sale of marketable securities during the periods of adequate and inadequate working capital respectively.
7.4.5 Indicator of Yester Track Path of the Firm

The insight on the financial performance of the firm can be had by the lending institutions through fund flow statement at the time of extending financial assistance to the firm. Limitations: It is an extension of financial statements but it cannot be leveled with the emphasis of them. It is not a resultant of the transaction instead it is an arrangement of among the available information. Projected fund flow statement ever only to the tune of financial statements which are historic in feature.
Check Your Progress
(1)
Adjusted profit and loss account is prepared for

(a) (b) (c) (d) Determining the fund from operations Determining the fund lost in operations (a) or (b) None of the above Fund in flow & Fund out flow Cash in flow & Cash out flow Sources & Applications None of the above Sources of the firm Applications of the firm Neither sources nor applications None of the above
(2)
Fund flow statement is categorized into two parts

(a) (b) (c) (d)
(3)
Fund from operations is

(a) (b) (c) (d)
126
Illustration 1 Form the following details prepare a statement showing changes in working capital during 1985:
Balance sheet of Pioneer ltd. as on 31st December
Liabilities Share capital Reserves Profit and Loss A/c Debentures Creditors for goods Provision for tax 1984 Rs 5,00,000 1,50,000 40,000 3,00,000 1,70,000 60,000 12,20,000 1985 Rs. 6,00,000 1,80,000 65,000 2,50,000 1,60,000 80,000 13,35,000 Assets Fixed assets Less:Depreciation Stock Book Debts Cash in hand Preliminary expeneses 1984 Rs. 10,00,000 3,70,000 6,30,000 2,40,000 2,50,000 80,000 20,000 12,20,000 1985 Rs. 11,20,000 4,60,000 6,60,000 3,70,000 2,30,000 60,000 15,000 13,35,000
(B.com., Bharathidasan November, 1986) The first step is to prepare the schedule of changes in working capital.
Schedule of changes in working capital
1984 1985 Increase In working capital 1,30,000 ------1,30,000 10,000 1,40,000 1,40,000 Decrease In working capital -----------20,000 20,000 40,000 ------40,000 1,00,000 1,40,000
Current asset: Stock Book debts Cash in hand Current liability Creditors for goods Working capital Increase in working capital
2,40,000 2,50,000 80,000 5,70,000 1,70,000 4,00,000 1,00,000 5,00,000
3,70,000 2,30,000 60,000 6,60,000 1,60,000 5,00,000 -----------5,00,000
Illustration 2 From the following two balance sheet as at December 31, 2004 and 2005. Prepare the statement of sources and uses of funds.
Liabilities Share capital Trade creditors Profit & Loss a/c Assets Cash Debtors Stock in trade Land 2004 Rs. 80,000 20,000 4,60,000 2005 Rs. 90,000 46,000 5,00,000 2004 Rs. 2005 Rs.
5,60,000
6,36,000
60,000 2,40,000 1,60,000 1,00,000 5,60,000
94,000 2,30,000 1,80,000 1,32,000 6,36,000
The first step is to prepare the schedule of changes in working capital.

2004 2005 Increase In working captial 34,000 10,000 20,000 Decrease In working capital
Current asset: Cash Debtors Stock in trade Current liability Trade creditors Working capital Increase in working capital
60,000 2,40,000 1,60,000 4,60,000 20,000 4,40,000 18,000 4,58,000
94,000 2,30,000 1,80,000 5,04,000 46,000 4,58,000 ------------4,58,000
54,000 ---------54,000
26,000 36,000 18,000 54,000
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The next step is to prepare the non current accounts of the firm.
Dr
To Balance B/d To Cash(Purchase) balancing fig.
Land A/c
Rs. 1,00,000 32,000 1,32,000
Cr
Rs.
By Balance c/d
1,32,000 1,32,000
Next non-current account item is the share capital account in the liability side. The closing balance of the share capital is more than that of the opening balance which means that the firm has undergone the issue of further more share capital. During the issue of share capital, the cash resources are raised by the firm through the sale of shares.
Dr
To Balance c/d
Share capital A/c

Rs. 90,000 By Cash( Issue of shares) Balancing fig. By Balance b/d Rs. 10,000 80,000 90,000
Cr
90,000
Then the next step is to prepare the adjusted profit and loss account to determine the fund from the operations
Dr Adjusted Profit & Loss A/c
Rs. To Balance c/d 5,00,000 5,00,000 By Balance B/d By Fund from operation Balancing fig. Rs. 4,60,000 40,000 5,00,000
Cr
The next step is to prepare the fund flow statement of the firm
Fund flow statement
Sources Issue of Shares unds from operation Rs. 10,000 40,000 50,000 Applications Purchase of Land Increase in working capital Rs. 32,000 18,000 50,000
Illustration 3 From the following relating to Panasonic ltd., prepare funds flow statement.
Balance sheet of Pioneer ltd. as on 31st December
Liabilities Share capital Reserves Retained earnings Accounts payable 1994 Rs 6,00,000 2,00,000 60,000 90,000 9,50,000 1995 Rs 8,00,000 1,00,000 1,20,000 2,70,000 12,90,000 Assets Fixed assets Accounts receivable Stock Cash 1994 Rs 3,80,000 2,10,000 3,00,000 60,000 9,50,000 1995 Rs 4,20,000 3,00,000 3,90,000 1,80,000 12,90,000
Additional information: The company issued bonus shares for Rs.1,00,000 and for cash Rs.1,00,000 Depreciation written off during the year Rs.30,000 The first step is prepare the statement of changes in working capital
1994 1995 Increase In working captial 1,20,000 Decrease in working capital ---------Contd...
Current asset: Cash

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60,000
1,80,000
Stock in trade Accounts receivable Current liability Accounts payable Working capital Increase in working capital
3,00,000 2,10,000 5,70,000 90,000 4,80,000 1,20,000 6,00,000
3,90,000 3,00,000 8,70,000 2,70,000 6,00,000 6,00,000
90,000 90,000
-------------------
3,00,000 3,00,000
1,80,000 1,80,000 1,20,000 3,00,000
The next step is to prepare the non - current account First non-current asset account should have to be prepared
Dr
To Balance B/d To Cash (Purchase) Balancing fig.
Fixed Assets A/c

Rs 3,80,000 70,000 4,50,000 By Depreciation(Adjusted Profit &Loss A/c ) By Balance c/d Rs 30,000
Cr
4,20,000 4,50,000
The next non-current account is that non-current liability which is nothing but Share capital.
Dr
To Balance c/d
Share capital A/c

Rs 8,00,000 By Cash( Issue of shares) By General reserve By Balance b/d Rs 1,00,000 1,00,000 6,00,000 8,00,000
Cr
8,00,000
And another non current account is to be prepared that General reserve account.
Dr
To Share capital To Balance c/d
General Reserve A/c

Rs 1,00,000 1,00,000 2,00,000 By Balance b/d
Cr
Rs 2,00,000 2,00,000
The next step is to prepare the Adjusted Profit & Loss A/c
Dr
To (Fixed Assets) depreciation To Balance c/d

Rs 30,000 1,20,000 1,50,000 By Balance B/d(Retained Earnings) By Fund from operation Balancing fig.
Cr
Rs 60,000 90,000 1,50,000
The next step is to prepare the fund flow statement of the enterprise
Fund flow statement
Sources Issue of Shares Funds from operation Rs 1,00,000 90,000 1,90,000 Applications Purchase of Land Increase in working capital Rs 70,000 1,20,000 1,90,000
Illustration 4 Balance sheets of M/s Black and White as on 1-1-1986 and 31-12-1986 were as follows:
Liabilities Creditors Mrs.WhitesLoan Loan from P.N.Bank Captial 1-1-86 Rs 40,000 25,000 40,000 1,25,000 31-12-1986 Rs 44,000 50,000 1,53,000 Assets Cash Debtors Stock Machinery Land Building 1-1-86 Rs 10,000 30,000 35,000 80,000 40,000 35,000 2,30,000 31-12-1986 Rs 7,000 50,000 25,000 55,000 50,000 60,000 2,47,000
2,30,000
2,47,000
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Additional information During the year machine costing Rs.10,000 (accumulated depreciation Rs.3,000) was sold for Rs.5,000 . The provision for depreciation against machinery as on 1-1-1986 was Rs.25,000 and on 31-12-1986 Rs.40,000 Net profit for the year 1986 amounted to Rs.45,000. You are required to prepare funds flow statement (M.Com MKU April 1980). The very first step is to prepare the statement of changes in working capital Changes in working capital in between the various current assets and current liabilities are as follows:
Statement of changes in working capital
1-1-86 Rs Current asset: Cash Debtors Stock Current liability Sundry creditors Working capital Increase in working capital 31-12-1986 Rs Increase In working capital ----------20,000 --------Decrease In working capital 3,000 ---------10,000
10,000 30,000 35,000 75,000 40,000 35,000 3,000 38,000
7,000 50,000 25,000 82,000 44,000 38,000 38,000
----------20,000 20,000
4,000 17,000 3,000 20,000
The next step is to determine the cost of the machinery before the charge of depreciation i.e., to find out the Gross value of the assets, in other words Original cost of the assets to be found out at the moment of purchase.
1-1-1986 Written down value of the machinery extracted from the balance sheet as on dated Add: Accumulated depreciation or Provision for depreciation Original Cost of Machinery Rs.80,000 25,000 1,05,000 31-12-1986 Rs.55,000 40,000 95,000
The ultimate aim is to find out the original cost of the machinery for the preparation of the machinery account: Before preparing the Machinery account, the worth of the sale transaction of the machinery should be found out . Original cost of the Machinery (-)Depreciation Machinery worth for sale (-)Machinery sold Loss on sale of the portion of the machinery sold
Dr
To Balance B/d
Rs.10,000 Rs.3,000 Rs.7,000 Rs.5,000 Rs.2,000

Cr
Rs 5,000 3,000 2,000 95,000 1,05,000
Machinery A/c
Rs 1,05,000 By Cash (Sales) By Provision for machinery By loss on sale(Adjusted profit and loss account) By Balance c/d
1,05,000
The next one is the provision for depreciation account or Accumulated depreciation account.
130
Dr
To Machinery A/c To Balance c/d
Provision for Depreciation A/c

Rs 3,000 40,000 43,000 By Balance B/d By depreciation provided during the current year Rs 25,000 18,000 43,000
Cr
Dr
To Drawings (Balancing fig) To Balance c/d Rs 17,000 1,53,000 1,70,000
Capital A/c
By Balance B/d By Net profit Rs 1,25,000 45,000 1,70,000
Cr
Dr
Rs To Balance c/d 50,000 50,000
Loan P.N. Bank

By BalanceB/d By Cash (Balancing fig) Rs 40,000 10,000 50,000
Cr
Dr
To Cash( Loan paid) To Balance c/d Rs 25,000 ----------25,000
Mr. White's A/c

By Balance B/d Rs 25,000 25,000
Cr
The next step is to prepare the Adjusted Profit & Loss Account.
Adjusted Profit & Loss Account
To Machinery (Loss on sale) To Provision for taxatio To Balance c/d(Net profit) Rs 2,000 18,000 45,000 65,000 By Balance B/d By fund from operations Rs ----------65,000 65,000
The next step is to prepare the fund flow statement.

Fund flow statement
Sources Sale of machinery Loan from P.N.Bank Fund from operation Rs 5,000 10,000 65,000 Applications Purchase of land Purchase of Building Drawings Repayment of Mr White Loan Increase working capital Rs 10,000 25,000 17,000 25,000 3,000 80,000
80,000
Illustration 5 From the following balance sheets of A Ltd on 31st Dec, 1982 and 1983, you are required to prepare Fund flow statement The following are additional information has also been given Depreciation charged on plant was Rs.4,000 and on building Rs.4,000 Provision for taxation of Rs.19,000 was made during the year 1983 Interim Dividend of Rs.8,000 was paid during the year 1983
Balance sheet
Liabilities Share capital General Reserve Profit & Loss A/c Sundry creditors Bills payable Provision for taxation Provision for doubtful debts 1982 Rs 1,00,000 14,000 16,000 8,000 1,200 16,000 400 1,55,600 1983 Rs 1,00,000 18,000 13,000 5,400 800 18,000 600 1,55,800 Assets Good will Building Plant Investments Stock Bill receivable Debtors Cash 1982 Rs 12,000 40,000 37,000 10,000 30,000 2,000 18,000 6,600 1,55,600 1983 Rs 12,000 36,000 36,000 11,000 23,400 3,200 19,000 15,200 1,55,800
131
(M.Com.Madras,1984)
The first step is to prepare the Statement of changes in the working capital
Statement of changes in working capital
1982 Rs Current asset: Stock Bill receivable Debtors Cash Current liability Sundry creditors Bills payable Provision for doubtful debts Working capital Increase in working capital 1983 Rs Increase In working capital Decrease In working capital 6,600 1,200 1,000 8,600
30,000 2,000 18,000 6,600 56,600 8,000 1,200 400 9,600 47,000 7,000 54,000
23,400 3,200 19,000 15,200 60,800 5,400 800 600 6,800 54,000 54,000
2,600 400 200 13,800 13,800 6,800 7,000 13,800
The next step is to prepare the non current accounts. First, Non current asset account to be prepared. The first non-current asset account is Building account.
Dr
To Balance B/d Rs 40,000
Building account
By (Depreciation)Adjusted profit & Loss A/c By Balance c/d Rs 4,000 36,000 40,000
Cr
40,000
The next non- current asset account is Plant account

Dr
To Balance B/d To Cash (Purchase) balancing fig. Rs 37,000 3,000 40,000
Plant account
By (Depreciation)Adjusted profit & Loss A/c By Balance c/d Rs 4,000 36,000 40,000
Cr
The next non-current asset account is Investments account.

Dr
To Balance B/d To Cash(purchase) Balancing figure
Investments account
Rs 10,000 1,000 Rs By Balance c/d 11,000
Cr
The next one is the non-current liability account.

Dr General Reserve account
Rs To Balance B/d 18,000 By Balance B/d By Adjusted profit and loss A/c (Profit transferred during the current year) Rs 14,000 4,000
Cr
18,000
18,000
The next non-current liability account is Provision for taxation account

Dr
To Cash(Tax paid previous year taxation) Balancing figure To Balance B/d
132
Provision for taxation account

Rs 17,000 18,000 By Balance B/d By Adjusted profit & Loss A/c (provision for taxation made during the year) Rs 16,000 19,000
Cr
35,000
35,000
The next step is to prepare the Adjusted profit and loss account.
To Depreciation Building To Depreciation Plant To Transfer to General Reserve To Provision for taxation To Interim dividend To Balance c/d Rs 4,000 4,000 4,000 19,000 8,000 13,000 52,000 By Balance B/d By Fund from operations Rs 16,000 36,000
52,000
The next step is to prepare the fund flow statement.

Fund flow statement
Sources Fund from operations Rs 36,000 Applications Purchase of the plant Purchase of the Investment Increase working capital Tax paid Interim dividend Rs 3,000 1,000 7,000 17,000 8,000 36,000
36,000
Check Your Progress
(1)
Purchase of plant & machinery Rs.10 lakh through the issue of 1 Lakh shares at Rs.10 per share ; affect the following accounts
(a) (b) (c) (d) Non current asset and Non current liability accounts Non current asset and Current liability accounts Current asset account and Non current liability accounts Current asset and current liability accounts
(2)
XYZ Ltd. has made a credit purchase of Rs.1 lakh worth of goods led to Rs.1 lakh worth of additional stock of tradable goods for the enterprise, leads to
(a) (b) (c) (d) Increase in the working capital - Applications No change in the working capital position -Neither an application nor resource Decrease in the working capital-Resource None of the above
(3)
The meaning of the "To cash ( Tax paid)" entry posted in the Provision for taxation account is
(a) (b) (c) (d) Last year taxation is paid through the current year provision Current year taxation is paid through the current year provision Last year tax is paid through the last year taxation Current year taxation is paid through the last year provision Resource to the enterprise Non operating income Application of the enterprise None of the above
(4)
Profit on sale of the fixed assets are considered to be

(a) (b) (c) (d)
(5)
The treatment of current year depreciation with the closing balance of profit in determining the fund from operations
(a) (b) (c) (d) To be added To be multiplied To be deducted To be divided
Contd...
133
(6)
The redemption bank term loan leads to change in the

(a) (b) (c) (d) Non current liability account and current asset account Current asset account and current liability account Non current asset account and current liability account Non current asset account and current liability account
7.5 LET US SUM UP

Normally, Balance sheet reveals the status of the firm only at the end of the year, not at the beginning of the year. It never discloses the changes in between the value position of the firm at two different time periods/ dates. A report on the movement of funds or working capital. In a narrow sense, the term fund means cash and the fund flow statement depicts the cash receipts and cash disbursements/payments. The projected fund flow statement from the past performance facilitates the firm to anticipate the future requirement of financial resources. It guides the management to prioritize the application in the future to the tune of scarce resources.

In the long run, is it more important for a business to have positive cash flows from its operating activities, investing activities, or financing activities? Why? Give your opinion.
7.7 KEYWORDS
Fund: Fund means working capital Flow: Flow means changes occurred in between two different time periods Statement of changes in working capital: Enlisting the changes taken place in between the Current assets and current liabilities of two different time horizons Current assets: Assets which are in the form of cash, equivalent to cash or easily convertible into cash . Current liabilities: Short term financial resources of the firm Non-current assets: Long term assets Non current liabilities: Long term financial resources Increase in working capital: Increase in Net working capital i.e. Excess of current assets over the current liabilities- Applications side of the fund flow Decrease in working capital: Decrease in Net working capital i.e. Excess of current liabilities over the current assets - Resources side of the fund flow Fund from operations: Income generated from only operations Fund lost in operations: Loss incurred in the operations

1. 2. 3.
134
Define fund. Define flow. What is meant by fund flow ? List out the various objectives of preparing the fund flow statement.
4.
5. 6. 7. 8. 9.
Enumerate the various advantages in the preparation of fund flow statement. Briefly explain the limitations of fund flow statement. What are the steps involved in the process of fund flow statement ? Explain the various methods of determining the fund from/lost (in ) operations. Explain the process of preparing the statement of changes in working capital.
10. Draft the pro forma of the Fund flow statement. 11. Explain any non current account transactions affecting the fund position of the firm.

R.L. Gupta and Radhaswamy, "Advanced Accountancy". V.K. Goyal, "Financial Accounting", Excel Books, New Delhi. Khan and Jain, "Management Accounting". S.N. Maheswari, "Management Accounting". S. Bhat, "Financial Management", Excel Books, New Delhi. Prasanna Chandra, "Financial Management - Theory and Practice", Tata McGraw Hill, New Delhi (1994). I.M. Pandey, "Financial Management", Vikas Publishing, New Delhi. Nitin Balwani, "Accounting & Finance for Managers", Excel Books, New Delhi.
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LESSON
8
CASH FLOW STATEMENT ANALYSIS
CONTENTS
8.0 Aims and Objectives 8.1 Introduction 8.2 Meaning & Motives of Cash Flow Statement 8.3 Utility of Cash Flow Statement 8.4 Steps in the Preparation of Cash Flow Statements 8.4.1 Preparation of Adjusted Profit and Loss Account 8.4.2 Comparison of Current Items to determine the Inflow of Cash or Outflow of Cash 8.4.3 Preparation of Cash Flow Statement 8.5 Let us Sum up 8.6 Lesson-end Activity 8.7 Keywords 8.8 Questions for Discussion 8.9 Suggested Readings

In this lesson we shall discuss about cash flow statement analysis. After going through this lesson you will be able to: (i) discuss meaning and motives of cash flow statement. (ii) analyse utility of cash flow statement and steps in the preparation of cash flow statements.
8.1 INTRODUCTION
Cash is considered one of the vital sources of the firm to meet day to day financial commitments. The cash is considered to be as most important source of life blood of the business. The day to day financial commitments are met out only out of the available resources. The cash resources are availed through two different type of receipts viz. sales, dividends, interests known as regular receipts and sale of assets, investments known as irregular receipts of the business enterprise. To have smooth flow of business enterprise, it should have ample cash resources for its operations. The availability of cash resources is mainly depending on the cash inflows of the enterprises. The smoothness in operations of the enterprise is obtained through an appropriate matching of cash inflows and cash outflows. To have smoothness in the operations of the enterprise, the firm should have an appropriate volume of cash resources at speedier rate as well as more than the financial commitments of the firm. This smoothness could be attained by way of an appropriate planning analysis on the cash resources of the firm. The meaningful analysis is only possible through cash flow statement analysis which facilitates the firm to identify the possible sources of cash as well as the expenses and expenditures of the firm.
136
8.2 MEANING & MOTIVES OF CASH FLOW STATEMENT

The cash flow statement is being prepared on the basis of an extracted information of historical records of the enterprise. Cash flow statements can be prepared for a year, for six months , for quarterly and even for monthly. The cash includes not only means that cash in hand but also cash at bank. Motives of preparing the cash flow statement: To identify the causes for the cash balance changes in between two different time periods, with the help of corresponding two different balance sheets. To enlist the factors of influence on the reduction of cash balance as well as to indicate the reasons though the profit is earned during the year and vice versa.
Cash Flow Statement Analysis
8.3 UTILITY OF CASH FLOW STATEMENT

Utility of cash flow statements are as follows: To identify the reasons for the reduction or increase in the cash balances irrespective level of the profits earned by the firm. It facilitates the management to maintain an appropriate level of cash resources. It guides the management to take futuristic decisions on the prospective demands and supply of cash resources through projected cash flows.
L L L L
How much cash resources are required? How much cash requirements could be internally settled? How much cash resources are to be raised through external sources? Which type of instruments are going to be floated for raising the required resources?
It helps the management to understand its capacity at the moment of borrowing for any further capital budgeting decisions. It paves way for scientific cash management for the firm through maintenance of an appropriate cash levels i-e optimum level cash of resources. It avoids in holding excessive or inadequate cash resources through proper planning of cash resources. It moots control through identification of variations occurred in the cash expenses and expenditures.
Cash flow statement vs Fund flow statement
Cash flow statement Cash inflow and outflow are only considered Causes & changes of cash position Considers only most liquid assets pertaining to cash resource ; which fosters only for very short span of planning Opening and closing balances of cash resources are considered for the preparation The flow in the statement means real cash flow Fund flow statement Increase or decrease in the working capital is registered Causes & changes of working capital position Considers in general i-e current assets ; the duration of the liquidity of the current assets are longer in gestation than the liquid assets ; which paves way for long span of planning Increase or decrease of working capital is considered but not the opening and closing balance for preparation The flow in the statement need not be real cash flow
137
8.4 STEPS IN THE PREPARATION OF CASH FLOW STATEMENTS

Prepare Non current accounts to identify the flow cash
Cash Inflows
Cash out flows
Sale of Assets or Investments, Raising of financial resources
Purchase of Assets or Investments, Redemption of financial resources
Balancing Figure
8.4.1 Preparation of Adjusted Profit and Loss Account

Net profit method
Accounting Profit to be adjusted
To find out the cash Profit/Loss
Addition of Non cash & Non Operating Expenses
Deduction of Non cash & Non operating Incomes
Cash from operations or Cash lost in operations
138
Alternate method:
Decrease in current assets & Increase in current liabilities
Net Profit ( +)
Increase in current assets & Decrease in current liabilities
(-)
Sales Method
Cash Sales
Deduct Cash Purchases & Cash Operating Expenses
Cash from operations or Cash lost in operations
8.4.2 Comparison of Current items to determine the inflow of cash or outflow
of cash
Increase in current assets Outflow of cash
Decrease in current assets
Inflow of cash
Decrease in current liabilities
Outflow of cash
Increase in current liabilities
Inflow of cash
8.4.3 Preparation of cash flow statement

The cash flow statement can be prepared either in statement form or in accounting format.
Inflow cash Opening cash balance Cash from in operations Sale of assets Issue of shares Issue of debentures Raising of loans Collection from debentures Refund of tax XXXX XXXX XXXX XXXX XXXX XXXX XXXX XXXX XXXX Outflow cash Redemption of preference shares Redemption fo debentures Repayment of loans Payment of dividends Payment of tax Cash lost in operations XXXX XXXX XXXX XXXX XXXX XXXX
XXXX
139
Check Your Progress
(1)
Cash flow means

(a) (b) (c) (d) Change in cash position Change in working capital position Change in current assets position Change in current liabilities position Cash from operations Cash lost in operations Cash from operations or Cash lost in operations None of the above Cash inflow Cash out flow Both (a) & (b) None of the above
(2)
Adjusted profit and loss account is to determine

(a) (b) (c) (d)
(3)
Comparison in between the current assets and current liabilities to determine

(a) (b) (c) (d)
(4)
Non current accounts are prepared for the cash inflows and cash outflows on the basis of which of the following relationship
(a) (b) (c) (d) Non current asset account and Cash Non current liability account and Cash Both (a) & (b) only None of the above
Illustration 1 From the following balances you are required to calculate cash from operations:
Particulars Debtors Bills receivable Creditors Bills payable Outstanding expenses Prepaid expenses Accrued Income Income received in advance Profit made during the year December 31 1992 Rs 1,00,000 20,000 40,000 16,000 2,000 1,600 1,200 600 1993 Rs 94,000 25,000 50,000 12,000 2,400 1,400 1,500 500 2,60,000
According to net profit method , the cash from operation has to be found out Cash from operations = Net profit (+)
Decrease in current assets & Increase in current liabilities Increase in current assets & Decrease in current liabilities
(-)
The next step is to quantify the decrease in current assets and increase in current liabilities, in order to add with the closing net profit of the given statements and then the added volume should be deducted from the increase in current assets and decrease in current liabilities.
140
Cash from operations Profit made during the year Add Decrease in debtors Increase in creditors Outstanding expenses Prepaid expenses Less Increase in Bills receivable Decrease in Bills payable Increase in accrued income Income received in advance Cash from operations
Rs
Rs s
6,000 10,000 400 200 16,600 5,000 4,000 300 100 9,4000 2,67,200
Illustration 2 From the following profit and loss account you are required to compute cash from operations
Profit and loss account for the year ending 31st Dec, 1983
To salaries To Rent To Depreciation To loss on sale of plant To Good will written off To proposed dividend To provision for taxation To Net profit Rs 10,000 2,000 4,000 2,000 8,000 10,000 10,000 20,000 66,000 By Gross profit By profit on sale of land By income tax refund Rs 50,000 10,000 6,000
66,000
Cash from operations

Net profit made during the year Add: Non cash expenses Depreciation Loss on sale of plant Good will return off Non operating expenses Proposed dividend Provision for taxation Less Non cash income Profit on sale of land Non operating income Income tax refund
Rs
Rs
20,000
4,000 2,000 8,000 10,000 10,000
34,000
10,000 6,000 16,000 38,000
Illustration 3 The comparative balance sheets of M/s Ram Brothers for the two years were as follows
Liabilities Capital Loan from Bank Creditors Bills payable Loan from SBI Mar,31 1984 3,00,000 3,20,000 1,80,000 1,00,000 9,00,000 Assets 1985 3,50,000 2,00,000 2,00,000 80,000 50,000 8,80,000 Land &Building Machinery Stock Debtors Cash Mar,31 1984 2,20,000 4,00,000 1,00,000 1,40,000 40,000 9,00,000 1985 3,00,000 2,80,000 90.000 1,60,000 50,000 8,80,000
141
Additional Information i. ii. Net profit for the year 1985 amounted to Rs. 1,20,000 During the year a machine costing Rs.50,000 ( accumulated depreciation Rs. 20,000) was sold for Rs. 26,000. The provision for depreciation against machinery as on 31 Mar, 1984 was Rs.1,00,000 and 31st Mar, 1985 Rs.1,70,000 You are required to prepare a cash flow statement First step is to prepare non current accounts Non current account includes both non current liability and asset First start with non current liability
Dr
To Drawings. Balancing Fig. To Balance c/d(Closing ) Rs 70,000 3,50,000 4,20,000
Capital A/c
By Balance B/d (Opening) By Net profit
Cr
Rs 3,00,000 1,20,000 4,20,000
The next step is to find out the depreciation provided during the year, which affects non current asset account of the firm is Machinery account. Before discussing the accounting transactions, the journal entry for provision for depreciation should be known.
Provision for depreciation Account
Dr
To Machinery To Balance C/d Rs 20,000 1,70,000 By Balance B/d By Adjusted profit and loss account ( Depreciation provided during the year)
Cr
Rs 1,00,000 90,000
1,90,000
1,90,000
Cash sale of the machinery amounted Rs.26,000 What happens during the cash sale of a machinery ? Debit what comes in - Cash resources are coming in Credit what goes out- Machinery is going out of the firm While selling the machinery, it is most important to identify the worth of the sale transaction of the machinery ?
Original cost of the Asset Accumulated Depreciation Sale price Loss on sale of the assets Rs.50,000 Rs.20,000 Rs.30,000 Rs.26,000 Rs.4,000
Once the loss of the transaction is found out, the amount of the loss should be appropriately recorded
Machinery Account
Dr
To Balance B/d (Opening) Rs 5,00,000 By cash sale By Profit and loss a/c Loss Balancing Fig By Depreciation Provision By Balance c/d(Closing ) 2,80,000+1,70,000
Cr
Rs 26,000 4,000 20,000 4,50,000 5,00,000
5,00,000
142
Dr
To Balance B/d(Opening) To Purchase
Land and Building

Rs 2,20,000 80,000 3,00,000 Rs By Balance c/d(Closing ) 3,00,000 3,00,000
Cr
The next step is to prepare adjusted profit and loss account

Dr Adjusted profit and loss account
Rs. 4,000 90,000 1,20,000 2,14,000 By Balance B/d By cash from operations Rs. 2,14,000
Cr
To Machinery A/c(Loss on sale ) To Depreciation provided during the year To Balance c/d
2,14,000
The next most important step is to compare the current assets Increase in creditors Loan from SBI Decrease in stock Loan repaid Decrease in Bill payable
Inflow Opening cash balance Creditors Loan from SBI Stock Machinery cash sale Cash from operations
-Rs.20,000 -Rs 50,000 -Rs.10,000 -Rs.1,20,000 -Rs.20,000

Rs 40,000 20,000 50,000 10,000 26,000 2,14,000 3,60,000
- cash inflow -cash inflow - cash inflow -cash outflow - cash outflow
Out flow Loan repaid Bills payable Debtors Land and buildings purchased Drawings Closing cash balance Rs 1,20,000 20,000 20,000 80,000 70,000 50,000 3,60,000
Cash flow statement
Illustration 4 Data ltd, supplies you the following balance on 31st Mar 1995 and 1996
Liabilities Share capital Bonds Accounts payable Provision for debts Reserves and Surpluses 1995 1,40,000 24,000 20,720 1,400 20,080 2,06,200 1996 1,48,000 12.000 23,680 1,600 21,120 2,06,400 Assets Bank balance Accounts Receivable Inventories Land Good will 1995 18,000 29,800 98,400 40,000 20,000 2,06,200 1996 15,600 35,400 85,400 60,000 10,000 2,06,400
Additional information i. ii. iii. iv. v. Dividends amounting to Rs 7,000 were paid during the year 1996 Land was purchased for Rs. 20,000 Rs.10,000 were written off on good will during the year Bonds of Rs.12,000 were paid during the course of the year You are required to prepare a cash flow statement
The first step is to prepare non current accounts The first step is to prepare non current assets and liabilities account As far as non current asset account - Land account has to be prepared
Dr
To Balance B/d(Opening) To Purchase (Given) Rs 40,000 20,000 60,000
Land
Rs By Balance c/d(Closing ) 60,000 60,000
Cr
143
The non current liability account to be prepared The first non current liability account got affected is Share capital account
Dr Share capital account
Rs To Balance c/d (Closing ) 1,48,000 1,48,000 By Balance B/d(Opening ) By cash Balancing figure
Cr
Rs 1,40,000 8,000 1,48,000
The next non current liability account is that Bonds account

Dr
To cash redemption (Given) To Balance c/d(Closing )
Bond account
Rs 12,000 12,000 24,000 By Balance B/d(Opening ) Rs 24,000 24,000
Cr
The next step is to prepare the Adjusted profit and loss account
Dr
To provision for doubtful debts To Good will written off To dividends paid To Balance c/d
Adjusted profit and loss account

200 10,000 7000 21,120 38,320 By Balance B/d By cash from operations 20,080 18,240
Cr
38,320
The next most important step is to compare the current assets during the two years Increase in Accounts payable Decrease in Inventories Increase in Bank Balance Increase in accounts receivable - Rs. 2,960 -Rs. 7,000 - Rs. 2,400 -Rs. 5,600
Cash flow statement
Inflow Opening cash balance Issue of shares Increase in Bills payable Decrease in stock Cash from operations Rs 18,000 8,000 2,960 13,000 18,240 60,200 Out flow Increase in Bills receivable Purchases of land Dividends paid Bonds repaid Closing cash balance Rs 5,600 20,000 7,000 12,000 15,600 60,200
- Cash inflow - Cash inflow -Cash outflow - Cash outflow
The next step is to draft the Cash flow statement
Check Your Progress
(1)
Cash flow statement analysis is an analysis of short span of analysis due to

(a) (b) (c) (d) Current assets position is only considered Super quick assets position only considered Working capital position is considered None of the above
(2)
How cash flows are denominated in terms of both current assets and current liabilities?
(a) (b) (c) Increase in current assets & Decrease in current liabilities Decrease in current assets & Increase in current liabilities Increase in current assets & Increase in current liabilities
Contd...
144
(d)
Both (a) & (b)
(3)
Cash position at the opening and closing comprises of

(a) (b) (c) (d) Cash in hand Cash at bank Both cash in hand and at bank None of the above
(4)
Cash flow analysis superior than the fund flow analysis due to
(a) (b) (c) (d) Shorter span of cash resources are considered Real cash flows only taken into consideration Opening & closing cash balances are only considered (a), (b) & (c)
(5)
Sale of the Plant & Machinery falls under the category of

(a) (b) (c) (d) Non current asset sale- cash in flow Current asset sale - cash out flow Non current asset sale -cash out flow None of the above
8.5 LET US SUM UP

The cash resources are availed through two different type of receipts viz sales, dividends, interests known as regular receipts and sale of assets , investments known as irregular receipts of the business enterprise. Cash flow statements can be prepared for a year, for six months , for quarterly and even for monthly The cash includes not only means that cash in hand but also cash at bank.

Parle Food Products experiences a considerable seasonal variation in its business. The high point in the years activity comes in November, the low point in July. During which month would you expect the companys ratio to be higher? If the company was choosing a fiscal year for accounting purposes, what advice would you give?
8.7 KEYWORDS
Cash Cash Flow Statement Fund Flow Statement

1. 2. 3. 4. Define cash flow. Highlight the steps involved in the process of Cash flow statement analysis. Draw the proforma of the Adjusted profit and loss account. Illustrate the impact of the changes taken place on the current assets and current liabilities to the tune of cash flows determination of the firm.
145
5. 6. 7.
Briefly explain the objectives of preparing the cash flow statement. Explain the various utilities of the cash flow statement analysis. Illustrate the various differences in between the cash flow and fund flow statements analysis.

R.L. Gupta and Radhaswamy, "Advanced Accountancy". V.K. Goyal, "Financial Accounting", Excel Books, New Delhi. Khan and Jain, "Management Accounting". S.N. Maheswari, "Management Accounting". S. Bhat, "Financial Management", Excel Books, New Delhi. Prasanna Chandra, "Financial Management - Theory and Practice", Tata McGraw Hill, New Delhi (1994). I.M. Pandey, "Financial Management", Vikas Publishing, New Delhi. Nitin Balwani, "Accounting & Finance for Managers", Excel Books, New Delhi.
146
UNIT-III
LESSON
9
COST ACCOUNTING & PREPARATION OF COST STATEMENT
CONTENTS
9.0 Aims and Objectives 9.1 Introduction 9.2 Meaning of Cost Accounting 9.2.1 What is a Cost of a Product? 9.3 Cost Classification 9.3.1 By Nature or Element or Analytical Segmentation 9.3.2 By Functions 9.3.3 Direct and Indirect Cost 9.3.4 By Variability 9.3.5 By Controllability 9.3.6 By Normality 9.3.7 By Time 9.3.8 For Planning and Control 9.3.9 For Managerial Decisions 9.4 Distinction between Financial Accounting & Cost Accounting 9.5 Unit Costing 9.5.1 Cost Sheet - Definition 9.5.2 Direct Material 9.5.3 Direct Labour 9.5.4 Direct Expenses 9.5.5 Indirect Material 9.5.6 Indirect Labour 9.5.7 Indirect Expenses 9.6 Direct Cost Classification 9.7 Indirect Cost Classification 9.8 Stock of Raw Materials 9.9 Stock of Semi Finished Goods 9.10 Stock of Finished Goods 9.11 Let us Sum up 9.12 Lesson-end Activity 9.13 Keywords 9.14 Questions for Discussion 9.15 Suggested Readings

In this lesson we shall discuss about cost accounting and preparation of cost statement. After going through this lesson you will be able to: (i) discuss meaning of cost accounting and distinction between financial accounting and cost accounting. (ii) analyse unit costing and direct, indirect and classification
9.1 INTRODUCTION
Cost accounting is that branch of the accounting information system, which records, measures and reports information about costs. The primary purpose of cost accounting is cost ascertainment and its use in decision-making and performance evaluation. It is also useful in planning and controlling.
9.2 MEANING OF COST ACCOUNTING

It is the process of classifying, recording and appropriate allocation of expenditure for the determination of costs of products or services through the presentation of data for the purpose to take decisions and guide the business organization. The next one important aspect is the differences between the cost accounting and management accounting.
Sl.No. 1. Point of Difference Objectives Cost Accounting Its main purpose is to ascertain the cost and control Management Accounting Its major objective is to take decisions through supplement presentation of accounting information It not only deals with the cost but also revenue. It is wider than the cost accounting It uses both qualitative and quantitative information for decision making But it starts from where the cost accounting ends; means that the cost information are major inputs for decisionmaking But it deals with future policies and course of actions
2.
Scope
It deals only with the cost and related aspects It uses only quantitative information pertaining to the transactions It ends only at the presentation of information
3.
Utilization of Data
4.
Utility
5.
Nature
It deals with the past and present data
9.2.1 What is a cost of a product ?

Cost denominates the use of resources only in terms of monetary terms. In brief, cost is nothing but total of all expenses incurred for manufacturing a product or attributable to given thing. In clear, the cost is nothing but ascertained expression of expenses in terms of monetary, incurred during its production and sale. To ascertain a cost, the firm should atleast smallest division of activity or responsibility for which costs are accumulated, at where the costs ascertained and controlled. In brief, cost centre normally a location where a specified activity takes place. Accumulation of all cost incurred for an activity leads to ascertainment of cost for the specified activity, but the control is being done by the head or incharge of that activity is responsible for control of costs of his centre.
Cost Centre
Product Centre
150
Service Centre
Product centre is a centre at where the cost is ascertained for the product which passes through the process.
Raw materials Cost centre Finished goods
Cost Accounting & Preparation of Cost Statement
Cost Ascertainment
Service centre is the centre or division which normally incurs direct or indirect costs but does not work directly on products. Normally, Maintenance dept. and general factory office are very good examples of the service centre. Apart from the above classification, one more important centre is profit centre. What is meant by profit centre? It is a centre not only responsible for both revenue as well as expenses but also for the profit of an activity.
9.3 COST CLASSIFICATION

The costs are classified into various categories according to the purpose and requirements of the firm. Some of the most important classifications are as follows. i. ii. iii. iv. v. vi. vii. By nature or Element or Analytical segmentation By functions Direct and Indirect cost By variability By controllability By normality By time
viii. According to planning and control ix. For Managerial Decisions
9.3.1 By Nature or Element or Analytical segmentation

The costs are classified into three major categories Materials, Labour, and Expenses.
9.3.2 By Functions
Under this methodology, the costs are classified into various divisions or functions of the enterprise. viz Production cost, Administration cost, Selling & Distribution cost and so on. The detailed classification is that total of production cost sub classified into cost of manufacture, fabrication or construction. And another classification of cost is commercial cost of operations; which is other than the cost of manufacturing and production. The major components of commercial costs are known as administrative cost of operations and selling and distribution cost of operations.
9.3.3 Direct and Indirect Cost

Direct cost: This classification of costs are incurred for the manufacture of a product or service ; can be conveniently and easily identified.
151
Material cost for the product manufacture- Direct material-For garments factory- cloth is the direct material for ready made garments. Labour cost for production- Labour who directly involved in the production of a product as well as attributable to single product expenses and so on. Indirect cost: The costs which are incurred for and cannot be easily identified for any single cost centre or cost unit known as indirect cost. Indirect material cost, Indirect labour cost and Indirect expenses are the three different components of the indirect expenses. Indirect material- Cost of the thread cannot be conveniently measured for single unit of the product. Indirect Labour-Salary paid to the supervisor.
9.3.4 By Variability
The costs are grouped according to the changes taken place in the level of production or activity. It may be classified into three categories: Fixed cost: It is cost which do not vary irrespective level of an activity or production Rent of the factory, salary to the manager and so on. Variable cost: It is a cost which varies in along with the level of an activity or production. e.g. Material consumption and so on. Semi variable cost: It is a cost which is fixed upto certain level of an activity, then later it fluctuates or varies in line with the level of production. It is known in other words as step cost. e.g. Electricity charges.
9.3.5 By Controllability
The cost are classified into two categories in accordance with controllability, as follows: Controllable costs: Cost which can be controlled through some measures known as controllable costs. All variable cost are considered to be controllable in segment to some extent. Uncontrollable costs: Costs which cannot be controlled are known as uncontrollable costs. All fixed costs are very difficult to control or bring down; they rigid or fixed irrespective to the level of production.
9.3.6 By Normality
Under this methodology, the costs which are normally incurred at a given level of output in the conditions in which that level of activity normally attained. Normal cost: It is the cost which is normally incurred at a given level of output in the conditions in which that level of output is normally achieved. Abnormal cost: It is the cost which is not normally incurred at a given level of output in the conditions in which that level of output is normally attained.
9.3.7 By time
According to this classification, the costs are classified into Historical costs and Predetermined costs:
152
Historical costs: The costs are accumulated or ascertained only after the incurrence known as Past cost or Historical costs. Predetermined costs: These costs are determined or estimated in advance to any activity by considering the past events which are normally affecting the costs.
9.3.8 For Planning and Control

The following are the two major classifications viz standard cost and budgetary control: Standard cost is a cost scientifically determined by way of assuming a particular level of efficiency in utilization of material, labour and indirect expenses. The prepared standards are compared with the actual performance of the firm in studying the variances in between them. The variances are studied and analysed through an exclusive analysis. Budget: A budget is detailed plan of operation for some specific future period. It is an estimate prepared in advance of the period to which it applies. It acts as a business barometer as it is complete programme of activities of the business for the period covered. The control is exercised through continuous comparison of actual results with the budgets. The ultimate aim of comparing with each other is to either to secure individuals' action towards the objective or to provide a basis for revision.
9.3.9 For Managerial Decisions

The major classifications are sunk cost and marginal cost. Marginal cost is the amount at any given volume of output by which aggregate costs are changed if the volume of output is decreased or increased by one unit.
9.4 DISTINCTION BETWEEN FINANCIAL ACCOUNTING & COST ACCOUNTING

The next one important aspect is the differences in between the Financial accounting, cost accounting and management accounting.
Sl. No. 1. 2. 3. 4. 5. Point of Difference Objectives Scope Utilization of Data Utility Nature Financial Accounting To determine the volume of earnings and financial position It deals with only the monetary transactions of the business It uses only the financial transactions alone It reveals the capacity & status of the firm It deals only the past of the firm Cost Accounting Its main purpose is to ascertain the cost and control It deals only with the cost and related aspects It uses only quantitative information pertaining to the transactions It ends only at the presentation of information It deals with the past and present data
Check Your Progress
1.
Fixed cost is the cost under the classification of

(a) (c) Variability Controllability (b) (d) Normality Functions Contd...
153
2.
Standard costing is brought under the classification of

(a) (c) Controllability Planning and control (b) (d) Functions Both (a) & (c)
3.
Marginal costing is classified on the basis of

(a) (c) Variability Time (b) (d) Managerial decisions Both (a) & (b)
4.
Electricity charges incurred by the firm is

(a) (c) Fixed cost Variable cost (b) (d) Semi-Variable cost None of the above
9.5 UNIT COSTING

Under costing, the role of unit costing is inevitable tool for the industries not only to identify the volume of costs incurred at every level but also to determine the rational price on the commodities in order to withstand among the competitors. The determination of the selling price is being done through the process of determining the cost of the product. After having been finalized the cost of the product, the profit margin has to be added in order to derive the final selling price of the product.
9.5.1 Cost Sheet - Definition

"It is a statement of costs incurred at every level of manufacturing a product or service". "It is a statement prepared to depict the output of a particular accounting period alongwith break up of costs". How to find a total cost of the product or service ? To find the total cost of the product or service, the costs incurred are grouped under various categories.
Cost
Material
Labour
Expenses
Direct
. Direct
. Direct
Indirect
Indirect
Indirect
Production Overheads
Administrative Overheads
Selling Overheads
Distribution Overheads
154
The cost of the product or service should have to come across many stages. The determination of the unit cost involves two different major stages viz Direct and Indirect costs.
What is meant by direct cost ? Direct cost is the cost incurred by the firm which can be ascertained and measured for a product. Direct cost of the product can be classified into three major categories.
9.5.2 Direct Material

Direct material which is especially used as a major ingredient for the production of a product. For Example: The wood is a basic raw material for the wooden furniture. The cost of the wood procured for the furniture is known direct material cost. The cotton is a basic raw material for the production of yarn. The cost of procuring the cotton is known as direct material for the manufacturing of yarn.
9.5.3 Direct Labour

Direct labour is the cost of the labour which is directly involved in the production of either a product or service. For e.g. The cost of an employee who is mainly working for the production of a product /service at the centre, known as direct labour cost.
9.5.4 Direct Expenses

Direct expenses which are incurred by the firm with the production of either a product or service. The excise duty, octroi duty are known as direct expenses in connection with the production of articles and so on. Indirect cost is the cost whatever incurred by the firm can be ascertained but not measured more specifically for a product.
9.5.5 Indirect Material

The material which is spent cannot be measured for a product is known as indirect material. For e.g. the thread which is used for tailoring the shirt cannot be measured or quantified in specific length as well as ascertained the cost.
9.5.6 Indirect Labour

Indirect labour is the cost of the labour incurred by the firm other than the direct labour cannot be apportioned. For e.g: Cost of supervisor, cost of the inspectors and so on.
9.5.7 Indirect Expenses

Indirect expenses are the expenses other than that of the direct expenses in the production of a product. The expenses which are not directly part of the production process of a product or service known as indirect expenses. For e.g.: Rent of the factory, salesmen salary and so on. Advantages of preparing the cost sheet: 1. It is a only statement reveals the cost of the output as well as unit cost of the output 2. It facilitates the manufacturer to access the control on the costs through breakups in the cost 3. It extends room for the management to study the variations of the cost with the help of an effective comparison of standard costs 4. The businessman is able to get an insight on the various components of cost as well as able to exercise the control on the excessive costs incurred 5. It poses the firm to supply the goods against the orders with reasonable accuracy in submitting the orders.
Check Your Progress
1.
Cost is
(a) (c) An expense incurred An income received (b) (d) An expenditure incurred None of the above Contd...
155
2.
Cost is
(a) (c) Direct cost only Both (a) & (b) (b) (d) Indirect cost only None of the above
3.
Direct cost is
(a) (c) Direct Materials Direct Expenses (b) (d) Direct labour Prime cost
To find out the unit cost of the product, the statement of cost plays pivotal role in determining the cost of production, cost of goods sold, cost of sales and selling price of the product at every stage. During the preliminary stage of preparing the cost statement of the product, there are two things to be borne in our mind at the moment of classification. 1. 2. Direct cost classification Indirect cost classification
9.6 DIRECT COST CLASSIFICATION

Under this classification, the direct costs of the product or service are added together to know the volume of total direct cost. The total volume of direct cost is known as "Prime Cost" Direct Materials +Direct Labour+ Direct Expenses = Prime cost
Prime cost
Direct Material
Direct Labour
Direct Expenses
The next stage in the unit costing to find out the factory cost. The factory cost could be computed by the combination of the indirect cost classification.
9.7 INDIRECT COST CLASSIFICATION

Among the classification of the overheads, the first and foremost is factory overheads. The factory overheads and work overheads are synonymously used. The factory overheads are nothing but the indirect costs incurred at the factory site. To find out the total factory cost or works cost incurred in the factory could be derived by adding the both direct cost and indirect cost incurred during the factory process.
Factory Cost =Prime cost + Factory overheads

Factory overheads are nothing but the indirect expenses incurred during the industrial process.
156
Factory cost Factory overheads Wages for foreman Electric power Storekeepers wages Oil and water Factory rent Repairs and Renewals Depreciation Prime cost
Check Your Progress
1.
Direct materials is
(a) (b) (c) (d) Opening stock + Purchases Purchases + Closing stock Opening stock + Purchases closing stock Purchases Closing stock
2.
Salary paid to Supervisor

(a) (b) (c) (d) Manufacturing overheads Administrative overheads Direct labour Selling & Distribution overheads
The next stage in the process of the unit costing is to find out the cost of the production The cost of production is the combination of both the factory cost and administrative overheads.
Cost production = Factory cost + Administrative overheads

Administrative overheads is the indirect expenses incurred during the office administration for the smooth flow production of finished goods.
Cost of Production Administrative Overheads Office Rent Repairs Office Office lighting Depreciation-office Manager salary Telephone charges Postage and telegram Stationery
157
Factory Overheads
Immediate next stage to determine in the process of unit costing is the component of cost of sales. The cost of sales is the blend of both viz. Selling overheads and cost of production. What ever the cost involved in the production process in the factory as well in the administrative proceedings are clubbed with the selling overheads to determine the cost of sales.
Cost of sales = Cost of production + Selling overheads
Selling overheads are nothing but the indirect expenses incurred by the firm at the moment of selling products. In brief, whatever the expenses in relevance with the selling and distribution are known as Selling overheads.
Cost of sales Selling Overheads Salesman salary Carriage outward Salesmen commission Travelling expenses Advertising Free samples Ware housing Delivery charges Cost of production
The last but most important stage in the unit costing is determining the selling price of the commodities. The selling price of the commodities is fixed by way of adding both the cost of sales and profit margin out of the product sales.
Sales = Cost of sales + Margin of Profit

Under the unit costing, the selling price of the product can be determined through the statement form. The cost sheet or cost statement is as follows in the determination of the selling price of the product.
Check Your Progress
1.
Overheads is
(a) (c) Manufacturing expenses Selling & Distribution expenses (b) (d) Administrative expenses a,b, & c
2.
Cost of the Cloth incurred at the moment of purchase made by the Ready garments manufacturer is
(a) (c) Direct materials Direct expenses (b) (d) Indirect materials Indirect expenses
Contd...
158
3.
Salesman salary given by the firm to promote the sales is

(a) (c) Direct labour Direct expenses (b) (d) Indirect expenses Indirect labour
4.
Selling price is
(a) (c) Cost of sales Profit margin + Cost of goods sold (b) (d) Cost of production Profit margin + Cost of sales
Illustration 1 Calculate the prime cost, factory cost, cost of production cost of sales and Profit form the following particulars: Rs.
Direct Materials Direct wages Direct expenses Wages of foreman Electric power Lighting :Factory Office Storekeepers wages Oil and water Rent: Factory :Office Depreciation Plant office Consumable store Managers salary Directors fees 2,00,000 50,000 10,000 5,000 1,000 3,000 1,000 2,000 10,00 10,000 5,000 1000 2,500 5,000 10,000 2,500 Office stationery Telephone charges Postage and telegrams Salesmens salaries Travelling expenses Repairs and renewal Plant Office premises Carriage outward Transfer to reserves Discount on shares written off Advertising Warehouse charges Sales Income tax Dividend 1000 250 500 2500 1,000 7,000 1,000 750 1,000 1000 2,500 1000 3,79,000 20,000 4,000
Rs.
Cost statement /Cost Sheet

Particulars Direct Materials Direct wages Direct expenses PRIME COST Factory Overheads: Wages of foreman Electric power Lighting :Factory Storekeepers wages Oil and water Rent:Factory Depreciation Plant Consumable store Repairs and renewal Plant Factory cost Administration overheads Rent Office Depreciation office 5,000 2,500 Contd...
159
Rs 2,00,000 50,000 10,000
Rs
2,60,000 5,000 1,000 3,000 2,000 1000 10,000 1000 5,000 7,000 35,000 2,95,000
Managers salary Directors fees Office stationery Telephone charges Postage and telegrams Office premises Lighting Cost of production Selling and distribution overheads Carriage outward Sales mens salaries Travelling expenses Advertising Warehouse charges Cost of sales Profit Sales Office
10,000 2,500 1000 250 500 1,000 1,000 23,750 3,18,750 750 2500 1,000 2500 1000 7,750 3,26,500 52,500 3,79,000
The Next stage in the preparation of the cost statement is to induct the stock of raw materials, work in progress and finished goods.
9.8 STOCK OF RAW MATERIALS

The raw materials stock should be taken into consideration for the preparation of the cost sheet. The cost of the raw materials is nothing but the direct materials cost of the product. The cost of the materials is in other words cost of the materials consumed for the production of a product.
Particulars Opening stock of Raw materials (+)Purchases of Raw materials (-)Closing stock of Raw materials Cost of Materials consumed Rs XXXXX XXXXX XXXXX XXXXX
9.9 STOCK OF SEMI FINISHED GOODS

The treatment of the stock of semi finished goods is mainly depending upon the two different approaches viz prime cost basis and factory cost basis. The factory cost basis is considered to be predominant over the early one due to the consideration of factory overheads at the moment of semi finished goods treatment. The indirect expenses are the expenses converting the raw materials into semi finished goods which should be relatively considered for the treatment of the stock valuation rather than on the basis of prime cost.
Particulars Prime cost (+)Factory overheads incurred (+)Opening work in progress (-)Closing work in progress Factory cost
160
Rs XXXXXX XXXXXX XXXXXX XXXXXX XXXXXX
9.10 STOCK OF FINISHED GOODS

The treatment of the stock of finished goods should carried over in between the opening stock and closing stock and adjusted among them before the finding the cost of goods sold.
Particulars Cost of production (+)Opening stock of finished goods (-)Closing stock of finished goods Cost of goods sold Rs XXXXX XXXXX XXXXX XXXXX
Illustration 2 The following data has been from the records of Centre corporation for the period from June 1 to June 30, 2005
2005 1st Jan Cost of raw materials Cost of work in progress Cost of finished good Transaction during the month Purchase of raw materials Wages paid Factory overheads Administration overheads Selling overheads Sales 9,00,000 4,60,000 1,84,000 60,000 40,000 18,00,000 60,000 24,000 1,20,000 2005 31st Jan 50,000 30,000 1,10,000
Draft the cost sheet

Cost Sheet
Particulars Opening stock of raw materials 1sr Jan (+)Purchase of raw materials ()Closing stock of raw materials 31st Jan Raw materials consumed during the year (+)Wages paid Prime cost Factory overheads (+)Opening stock of semi goods ()Closing stock of semi goods Factory overheads Factory or Works cost (+)Administration overheads Cost of Production (+)Opening stock of finished goods ()Closing stock of finished goods Cost of goods sold (+)Selling overheads Cost of Sales Net profit Sales 1,20,000 1,10,000 16,18,000 40,000 16,58,000 1,42,000 18,00,000
161
Rs 60,000 9,00,000 50,000
Rs
9,10,000 4,60,000 13,70,000 1,84,000 24,000 30,000 1,78,000 15,48,000 60,000 16,08,000
Check Your Progress
1.
The cost classifications in the cost sheet is

(a) (c) Functions Controllability (b) (d) Variability Functions
2.
Rs.10,000 paid on every month to the owner of the factory site is

(a) (c) Fixed cost Variable cost (b) (d) Semi-Variable cost Semi-Fixed cost
Illustration 3 From the following information extracted from the records of the M/s sundaram &co Stock position of the firm
Particulars Stock of raw materials Stock of finished goods Stock of work in progress Particulars Indirect labour Oil Insurance on fixtures Purchase of raw materials Sale commission Salaries of salesmen Carriage outward Rs 1,00,000 20,000 6,000 8,00,000 1,20,000 2,00,000 40,000 Particulars Administrative expenses Electricity Direct labour Depreciation on Machinery Factory rent Property tax on building Sales Rs 1-4-1994 80,000 2,00,000 20,000 Rs 31-3-1995 1,00,000 3,00,000 28,000 Rs 2,00,000 60,000 6,00,000 1,00,000 1,20,000 22,000 24,00,000
Prepare cost statement of the M/s Sundaram & Co

Cost Sheet
Particulars Opening stock of raw materials 1 April,1994 (+)Purchase of raw materials (-)Closing stock of raw materials 31st Jan Raw materials consumed during the year (+)Direct labour Prime cost Factory overheads: Indirect labour Oil Insurance on fixtures Electricity Depreciation on machinery Factory rent Property tax on factory building (+)Opening stock of semi goods ()Closing stock of semi goods Factory cost (+)Administration overheads
162
st
Rs 80,000 8,00,000 1,00,000
Rs
7,80,000 6,00,000 13,80,000 1,00,000 20,000 6,000 60,000 1,00,000 1,20,000 22,000 4,28,000 2,0,000 28,000 18,00,000 2,00,000 Contd...
Cost of Production (+)Opening stock of finished goods (-)Closing stock of finished goods Cost of goods sold Selling overheads: Sales commission Salaries of salesmen Carriage outward Cost of sales Profit margin Sales
20,00,000 2,00,000 3,00,000 19,00,000 1,20,000 2,00,000 40,000 22,60,000 1,40,000 24,00,000
Note: Property tax on the plant is to included under the factory overheads. The tax is paid by the firm on the plant which is engaging in the production process. Illustration 4 Prepare the cost sheet to show the total cost of production and cost per unit of goods manufactured by a company for the month of Jan, 2005. Also find the cost of sale and profit.
Particulars Stock of raw materials1.1.2005 Raw materials procured Stock of raw material31.1.2005 Direct wages Plant depreciation Loss on the sale of plant Sales Rs 6,000 56,000 9,000 14,000 3,000 600 Partiuclars Factory rent and rates Office rent General expenses Discount on sales Advertisement expenses Income tax paid Rs 6,000 1,000 4,000 600 1,200 2000
Rs.,1,50,000
The number of units produced during Jan 2005 was 6,000 The stock of finished goods was 400 and 800 units on 1st Jan, 2005 and 31st Jan, 2005 respectively. The total cost of the units on hand on 1st Jan 2005 is Rs. 5,600. All these had been sold during the month. The first and foremost step is to find out the cost per unit i.e. cost production per unit. The opening stock and their values are given, but at the same time the value of the closing stock is ascertained by Rs. 3. The total number of units are almost
Particulars Stock of Raw materials 1.1.2005 (+)Raw materials procured ()Closing stock of raw material Materials consumed Direct wages Prime cost Factory overheads: Depreciation on plant Factory rent and rates Factory cost Office and Administration overheads: Office rent General expenses Cost of production =Rs. 3 per unit (+)Opening stock of finished goods 3,000 400 Units Rs 6,000 56,000 9,000 71,000 14,000 85,000 3,000 6,000 94,000 1,000 4,000 99,000 5,600 Contd...
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(-)closing stock of finished goods Cost of goods sold Selling and distribution expenses Advertisement expenses Cost of sales Net profit Sales
800
2,400 1,02,200 600 1,02,800 47,200 1,50,000
Illustration 5 XYION Co Ltd., is an export oriented company manufacturing internal -communication equipment of a standard size. The company is to send quotations to foreign buyers of your product. As the cost accounts chief you are required to help the management in the matter of submission of the quotation of a cost estimate based on the following figures relating to the year 1984 Total output (in units ) 20,000
Rs. Local Raw materials Imports of raw materials Direct labour in works Indirect labour in works Storage of raw materials and spares Fuel Tools consumed Depreciation on plant Salaries of works personnel 20,00,000 2,00,000 20,00,000 4,00,000 1,00,000 3,00,000 40,000 2,00,000 2,00,000 Excise duty Administrative office expenses Salary of the managing director Salary of the joint managing director Fees of directors Expenses on advertising Selling expenses Sales depots Packaging and distribution Rs. 4,00,000 4,00,000 1,20,000 80,000 40,000 3,20,000 3,60,000 2,40,000 2,40,000
Note: i. ii. iii. Local raw materials now cost 10% more A profits margin of 20% on sales is kept The government grants subsidy of Rs. 200 per unit of exports
Prepare the cost statement in columnar form

Cost Statement of XYION Ltd.
Rs
Particulars Local raw materials (+) Increase in local raw materials (+)Imports of raw materials Direct Materials Direct labour Prime cost Factory overheads: Indirect labour in works Storage of raw materials and spares Fuel Tools consumed
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Rs
Cost Rs 20,00,000 2,00,000 22,00,000 2,00,000 24,00,000 20,00,000 44,00,000 4,00,000 1,00,000 3,00,000 40,000 Rs Unit/Price Cost20,000
Contd...
Depreciation on plant Salaries of works personnel Excise duty Works cost Administrative & office Expenses Salaries of Managing director Salaries of Joint Managing Director Fees of directors Cost of Production Selling & Distribution expenses Expenses of Advertising Selling expenses Sales depots Packaging and distribution Cost of sales Profit Margin Sales Export subsidy per unit Selling price for local market sales 80% 20% 100%
2,00,000 2,00,000 4,00,000 4,00,000 1,20,000 80,000 40,000 6,40,000 66,,80,000 3,20,000 3,60,000 2,40,000 2,40,000 11,60,000 78,40,000 19,60,000 98,00,000/20,000units 58,00,000/20,000units 98,00,000 40,00,000 58,00,000 490 200() 290 16,40,000 60,40,000
9.11 LET US SUM UP

Cost denominates the use of resources only in terms of monetary terms. In brief, cost is nothing but total of all expenses incurred for manufacturing a product or attributable to given thing. In clear, the cost is nothing but ascertained expression of expenses in terms of monetary, incurred during its production and sale. Service centre is the centre or division which normally incurs direct or indirect costs but does not work directly on products. Normally, Maintenance dept. and general factory office are very good examples of the service centre. Costs which cannot be controlled are known as uncontrollable costs. All fixed costs are very difficult to control or bring down ; they rigid or fixed irrespective to the level of production. A budget is detailed plan of operation for some specific future period. It is an estimate prepared in advance of the period to which it applies. It acts as a business barometer as it is complete programme of activities of the business for the period covered. Under costing, the role of unit costing is inevitable tool for the industries not only to identify the volume of costs incurred at every level but also to determine the rational price on the commodities in order to withstand among the competitors. Direct labour is the cost of the labour which is directly involved in the production of either a product or service. For e.g. The cost of an employee who is mainly working for the production of a product /service at the centre, known as direct labour cost. Indirect expenses are the expenses other than that of the direct expenses in the production of a product. The expenses which are not directly part of the production process of a product or service known as indirect expenses. For e.g.: Rent of the factory, salesmen salary and so on.

Once standard costs are established, what conditions would require the standards to be revised? Give your opinion.
9.13 KEYWORDS
Cost: Expense incurred at the either cost centre or service centre. Cost sheet: It is a statement prepared for the computation of cost of a product/service.
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Direct cost: cost incurred which can be easily ascertained and measured for a product. Indirect cost: cost incurred cannot be easily ascertained and measured for a product. Cost centre: The location at where the cost of the activity is ascertained. Product centre: It is the location at where the cost is ascertained through which the product is passed through. Service centre: The location at where the cost is incurred either directly or indirectly but not directly on the products. Profit centre: It is responsibility centre not only for the cost and revenues but also for profits for the activity. Prime cost: combination of all direct costs viz Direct materials, Direct labour and Direct expenses. Factory cost: It is the total cost incurred both direct and indirect at the work spot during the production of an article. Cost of production: It is the combination of cost of manufacturing an article or a product and administrative cost. Cost of sales: It is the entire cost of a product. Selling price or Sales: The summation of cost of sales and profit margin.

1. 2. 3. 4. 5. What is cost classification? Classify it, in detail. What do you mean by unit costing? Explain Direct and Indirect Costing. What is cost-sheet definition? Express Indirect and Direct Expenses.

R.L. Gupta and Radhaswamy, Advanced Accountancy V.K. Goyal, Financial Accounting, Excel Books, New Delhi. Khan and Jain, Management Accounting. S.N. Maheswari, Management Accounting. S. Bhat, Financial Management, Excel Books, New Delhi. Prasanna Chandra, Financial Management Theory and Practice, Tata McGraw Hill, New Delhi (1994). I.M. Pandey, Financial Management, Vikas Publishing, New Delhi. Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.
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LESSON
10
BUDGETARY CONTROL
CONTENTS
10.0 Aims and Objectives 10.1 Introduction 10.2 Types of Budget 10.3 Cash Budget 10.4 Fixed & Flexible Budget 10.4.1 Fixed Budget 10.4.2 Flexible Budget 10.5 Master Budget 10.6 Zero Base Budgeting (ZBB) 10.6.1 Traditional Budgeting vs Zero Base Budgeting 10.6.2 Steps involved Zero Base Budgeting 10.6.3 Benefits of Zero Base Budgeting 10.6.4 Criticism 10.7 Let us Sum up 10.8 Lesson-end Activity 10.9 Keywords 10.10 Questions for Discussion 10.11 Suggested Readings

In this lesson we shall discuss about budgetary control. After going through this lesson you will be able to: (i) understand types of budget and cash budget (ii) analyse fixed and flexible budget (iii) discuss zero base budgeting (ZBB)
10.1 INTRODUCTION
Budget is an estimate prepared for definite future period either in terms of financial or non financial terms. Budget is prepared for any course of action or business or state or Nation, as a whole. The budget is usually expressed in terms of total volume. According to ICMA, England, a budget is as follows "a financial and or quantitative statements prepared and approved prior to a defined period of time, of the policy to be pursed during the period for the purpose of attaining a given objective". It is in other words as " detailed plan of action of the business for a definite period of time". What is meant by Budget? It is a statement of financial affairs/quantitative terms of an activity for a defined period, to achieve the enlisted objectives.
What is budgeting? Budgeting is the course involved in the preparation of budget of an activity. What is Budgetary Control? Budgetary control contains two different processes one is the preparation of the budget and another one is the control of the prepared budget. According to ICMA, England, a budgetary control is " the establishment of budgets relating to the responsibilities of executives to the requirements of a policy and the continuous comparison of actual with budgeted results, either to secure by individual action the objectives of that policy or to provide a basis for its revision". According to J.Batty "Budgetary control is a system which uses budgets as a mans of planning and controlling all aspects of producing and/or selling commodities and services".
Preparation of the Budget for definite future
Actual performance has to be recorded
Comparison in between the actual and budget figures
Corrective steps Deviations in between Actual & Budget
Revision of the budget
Check Your Progress
Choose the appropriate answer: 1. Budget is a statement of

(a) (c) Qualitative affairs Financial affairs By functions By flexibility (b) (d) (b) (d) Quantitative affairs Both (b) & (c) By time (a), (b) & (c)
2.
Budgets can be classified into

(a) (c)
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10.2 TYPES OF BUDGET

The budgets can be classified into three categories:
Budgets
Budgetary Control
Functions
Flexibility
Time
Sales Budget
Fixed Budget
Long Term
Production Budget Material Budget
Flexible Budget
Medium Term
Short Term Labour Budget
Manufacturing overhead budget Selling overheads budget Cash budget
10.3 CASH BUDGET

Cash budget is nothing but an estimation of cash receipts and cash payments for specified period. It is prepared by the head of the accounts department i.e., chief accounts officer. The utility of the cash budget is as follows: To meet the revenue and capital expenditures with adequate funds It should highlight the additional requirement cash whenever the need arises Keeping of excessive funds available in the business firm wont fetch any return to the enterprise but this estimate of future cash needs and resources will guide the firm to plan for an effective investment out of the surplus funds estimated ; enhances the wealth of the investors through proper investment planning out of the future funds available. Cash budget can be prepared in three different ways: 1. 2. 3. Receipts and payments method Adjusted profit and loss account Balance Sheet Method
Cash receipts can be classified into various categories

Cash Receipt
Sales Debtors Bills receivable Dividends Sale of Investments
Other Incomes
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Cash payments are as follows:

Cash payments
Purchase of Assets
Materials bought
Salary paid
Rent paid
Other payments
Illustration 1 From the following information prepare a cash budget for the months of June and July
Month April May June July Credit sales Rs 80,000 84,000 90,000 84,000 Credit purchase Rs 60,000 64,000 66,000 64,000 Manufacturing Overheads Rs 2,000 2,400 2,600 2,000 Selling overheads Rs 3,000 2,800 2,800 2,600
Additional Information: 1. 2. 3. 4. 5. Advance tax of Rs 4,000 payable in June and in December 1994 Credit period allowed to debtors is two months Credit period allowed by the vendors or suppliers Delay in the payment of other expenses one month Opening balance of cash on 1st June is estimated as Rs. 20,000/-
Solution: First step is in the preparation of a cash budget is to open the statement with the opening cash balance available. Secondly, if any cash receipts are available that should be added one after another. In this problem, Sales can be bifurcated into two classifications, the first one is cash sales. If the cash sales is given, the amount of cash receipt due to cash sales should have to be immediately brought under the respective period i-e during the same month or week. The next is the credit sales of the firm, the volume of sales should only be effected only at the amount of realization of sales or collection of credit sales from the consumers and customers. If cash sales is not given instead credit sales only the component given, that should be added in the list of cash receipts ; by registering the credit period involved for the customers and consumers. Being as credit sales, the amount of sales realization should only relevantly be considered during the specified period. Third step is to list out the various items of cash expenses expected to incur during the specified period. The text of the problem deals with the delay of making the payment of expenses is one month in all cases; It means the expenses like Manufacturing overheads, selling overheads are expected to pay one month later i-e these expenses will be paid one month after. It means that the May month of other expenses are paid only in the month of June and during the month of June month expenses are met out. The purchases requires same kind of treatment in the case of sales. Normally, the purchases are classified into two divisions viz cash purchases and credit purchases.
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The cash purchases should be given effect only at the moment of cash payment is paid on the volume of purchase, but, if the credit purchases are made by the firm, the credit
allowed by the vendor/supplier to make the payments should be relatively considered for the expected outflow of cash i-e payment of purchase one month later or two months later. The expected time period occurrence of a either cash receipt or cash payment should be considered for the preparation of the cash budget. The cash budget should be prepared separately in the statement to derive the closing balance of the specified year/month. The closing balance of the yester period or previous period has to be carried forward to the next period as opening balance of the preparation of a budget. The closing balance of the month June will be the opening balance of the month July. Once the statement has been completed in the preparation of budget of respective periods should be consolidated for the specified periods.
Cash Budget for the Months of June and July 1998
Particulars Opening balance Receipts: Sales Total Cash Receipts I Payments: Purchases Manufacturing Overheads Selling Overheads Tax payable Total Payments II Balance I-II June Rs 20,000 80,000 1,00,000 64,000 2,400 2,800 4,000 73,200 26,800 July Rs 26,800 84,000 1,10,800 66,000 2,600 2,800 ------------71,400 39,400
Budgetary Control
Illustration 2 From the estimates of income and expenditure, prepare cash budget for the months from April to June.
Month Feb Mar Apr May June Sales Rs 1,20,000 1,24,000 1,30,000 1,22,000 1,20,000 Purchases Rs 80,000 76,000 78,000 72,000 76,000 Wages Rs 8,000 8,400 8,800 9,000 9,000 Office Exp. Rs 5,000 5,600 5,400 5,600 5,200 Selling Exp. Rs 3,600 4,000 4,400 4,200 3,800
i. ii. iii.
Plant worth Rs. 20,000 purchase in June 25% payable immediately and the remaining in two equal installments in the subsequent months Advance payment of tax payable in Jan and April Rs 6,000 Period of credit allowed a. By suppliers 2 months
iv. v.
b. To customers 1 month Dividend payable Rs.10,000 in the month of June Delay in payment of wages and office expenses 1 month and selling expenses month. Expected cash balance on 1st April is Rs. 40,000.
Solution: a. Plant worth Rs 20,000/ purchased, payable immediately is 25% i-e Rs.5,000 should be paid in the month of June. The remaining cost of the machine has to be paid in the subsequent months, after June. The payments whatever are expected to make after June is not relevant as far as the budget preparation concerned.
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b.
Delay in the payment of wages and office expenses is only one month. It means wages and office expenses of Feb month are paid in the next month, March. Selling expense From the above coloured boxes, it is obviously understood that during the months of April, May and June ; the following will be stream of payment of selling expenses. April= Rs. 2,000 of Mar (Previous Month) and Rs. 2,200 of April (Current month)= Rs.4,200/ May= Rs. 2,200 of April (Previous Month) and Rs.2,100 of May (Current month)=Rs. 4,300/ June= Rs. 2,100 of May (Previous Month) and Rs.1,900 of June (Current month)=Rs. 4,000/
c.
Selling expenses is having the delay of month, which means 50% of the selling expenses is paid only in the current month and the remaining 50% is paid in the next
Feb 3,600 1,800 Mar 4,000 2,000 April 4,400 2,200 May 4,200 2,100 June 3,800 1,900
Particulars Selling Expenses Payment 50% in the current month Delay 50%will be paid in the subsequent month
1,800
2,000
2,200
2,100
1,900
Every month 50% of the selling expenses of the current month and 50% of the previous month selling expenses are paid together ; the above coloured boxes depict the payment of 50% of the current selling expenses along with 50% expenses of previous month.
Cash Budget for the Periods ( April and June)
Particulars Opening Cash Balance Cash Receipts Sales Total Receipts (A) Payments Plant Purchased Tax payable Purchases Dividend payable Wages Office expenses Selling expenses Total Payments(B) Balance (A-B) 1,24,000 1,64,000 ---------6,000 80,000 --------8,400 5,600 4,200 1,04,200 59,800 1,30,000 1,89,800 ----------------76,000 --------8,800 5,400 4,300 94,500 95,300 1,22,000 2,17,300 5,000 -------78,000 10,000 9,000 5,600 4,000 1,11,600 1,05,700 April Rs 40,000 May Rs 59,800 June Rs 95,300
10.4 FIXED & FLEXIBLE BUDGET

10.4.1 Fixed Budget
It is a budget known as constant budget, never registers the changes in the preparation of a budget, being prepared for irrespective level of output or production. This budget is mainly meant for the fixed overheads of the firm which are constant in volume irrespective level of production. The ultimate utility of the budget is to control the cost as a cost controlling measure, but the fixed budget is meaningless in having comparison with the actual performance.
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10.4.2 Flexible Budget

Flexible budget is prepared for any level of production as an estimate of statement of all expenses i-e the expenses are classified into three categories viz variable, semi-variable and fixed expenses. The structure of the budget for any output is only to the tune of the actual performance achieved. This is the budget facilitates not only to have comparison in between various levels of production but also to identify the level of lowest production cost. Utilities of the flexible budget: This budget is most useful tool of analysis in studying the sales at when the circumstances are not warranting to predict It is mostly suited to the seasonal business, where the sales volume is getting differed from one period to another due to changes taken place in the taste and preferences of the buyers The production is being done on the basis of demand of the products in the market. The demand of the products is studied only through demand forecasting. The flexible budget is more applicable in the case of products, which are greatly finding difficult to forecast the demand The budget is prepared only during the time of acute shortage of resources of production viz Men, Material and so on Illustration 3 Draft a flexible budget for overhead expenses on the basis of following information and determine the overhead rates at 70% 80% and 90% plant capacity.
Particulars Variable Overheads Indirect Labour Stores including spares Semi-variable overheads Power( 30% fixed ,70%) Repairs and maintenance 80% fixed and 20% variable Fixed Overheads Depreciation Insurance Salaries Total overheads 70% capacity --------------------------------------------------------------------------------------------------------------------------------80% capacity Rs 24,000 8,000 40,000 4,000 22,000 6,000 20,000 1,24,000 90% capacity -----------------------------------------------------------------------------------------------------------------------------
Budgetary Control
Solution:
Flexible Budget for the various capacities
Particulars Variable overheads Indirect labour Stores including spares Semi- variable Expenses - Power* Fixed 30% **Variable Repairs and mainternance ***Fixed 80% ****Variable 20% Fixed Overheads Depreciation Insurance Salaries Total Overheads 70% capacity 21,000 7,000 8,000 28,000 3,200 700 22,000 6,000 20,000 1,15,900 80% capacity 24,000 8,000 8,000 32,000 3,200 800 22,000 6,000 20,000 1,24,000 90% capacity 27,000 9,000 8,000 36,000 3,200 900 22,000 6,000 20,000 1,32,100
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Illustration 4 The expenses for budgeted production of 10,000 units in a factory are furnished below
Particulars Material Labour Variable overheads Fixed overheads (1,00,000) Variable expenses (Direct) Selling expenses (10% fixed) Distribution expenses(20% fixed) Administration expenses(Rs.50,000) Total cost per unit Per unit 70 25 20 10 5 13 7 5 155
Prepare a budget for production of i. ii. iii. 8,000 units 6,000 units Calculate the cost per unit at both levels
Assume that administration expenses are fixed for all level of production
10,000 units Per Unit Rs Production Expenses: Material Labour Overheads Direct Variable expenses Fixed Overheads Rs.1,00,000 Selling Expenses: Fixed Variable Distribution Expenses: Fixed Variable Administration Expensses Total Cost 70.00 25 20 5 10 Amount Rs 7,00,000 2,50,000 2,00,000 50,000 1,00,000 8,000 units Per Unit Rs 70.00 25.00 20.00 5 12.5 Amount Rs 5,60,000 2,00,000 1,60,000 40,000 1,00,000 6,000 units Per Unit Rs 70.00 25.00 20.00 5 16.667 Amount Rs 4,20,000 1,50,000 1,20,000 30,000 1,00,000
1.3 11.7 1.4 5.6 5.0 155.00
13,000 1,17,000 14,000 56,000 50,000 15,50,000
1.625 11.7 1.75 5.6 6.25 159.425
13,000 93,600 14,000 50,000 12,75,400
2.167 11.7 2.334 5.6 8.333 166.801
13,000 70,200 14,000 30,600 50,000 10,00,800
Illustration 5 From the following information relating to 1963 and conditions expected to prevail in 1964, prepare a budget for 1964: State the assumption you have made, 1963 actuals Sales Raw materials Wages Variable overheads Fixed overheads
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1,00,000 (40,000 units) 53,000 11,000 16,000 10,000
1964 prospects Sales Raw Materials Wages Additional plant 1,50,000(60,000 units) 5 per cent price increase 10 per cent increase in wage rates 5 per cent increase in productivity One lathe Rs. 25,000 One drill Rs,12,000 (I.C.W.A Inter) Budget for the year 1964
Sales for 60,000 units @ Rs. 2.50 Less: Cost production Raw materials Wages Variable overhead Fixed Overheads Estimated Profit 83,475 17,286 24,000 13,700 1,38,461 11,539
Budgetary Control
Rs
Rs
1,50,000
10.5 MASTER BUDGET

Immediately after the completion of functional or departmental level budgets, the major responsibility of the budget officer is to consolidate the various budgets together, which is detailed report of all operations of the firm for a definite period
10.6 ZERO BASE BUDGETING (ZBB)

Zero base budgeting is one of the renowned managerial tool, developed in the year 1962 in America by the Former President Jimmy Carter. The name suggests, it is commencing from the scratch, which never incorporates the methodology of the other types of budgeting in determining the estimates. The Zero base budgeting considers the current year as a new year for the preparation of the budget but the yester period is not considered for consideration. The future activities are forecasted through the zero base budgeting in accordance with the future activities. Peter A Pyher A planning and budgeting process which requires each manager to justify his entire budget request in detail from scratch (Hence zero base) and shifts the burden of proof to each manger to justify why he should spend money at all. The approach requires that all activities be analysed in decision packages which are evaluated by systematic analysis and ranked in order of importance This type of budgeting requires the manager to reason out the aim of spending , but in the case of traditional budgeting is unlike , which are never emphasize the reasons of spending in terms of expenses.
10.6.1 Traditional Budgeting vs Zero Base Budgeting

Basis of Difference Emphasis Approach Focus Communication Method Traditional Budgeting It is accounting oriented; emphasis on How Much It is monitoring towards the expenditures To study the changes in the expenditures It operates only Vertical communication It is based on the extrapolation i.e. from the yester figures future projections are carried out Zero Base Budgeting It is more decision oriented; emphasis on Why It is towards the achievement of objectives To study the cost benefit analysis It operates in both directions horizontally and vertically Its decision package is totally based on the cost benefit analysis.
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10.6.2 Steps involved Zero Base Budgeting

1. 2. 3. 4. 5. The very first step is to prepare the Zero Base Budgeting is to enlist the objectives. The extent of application should be decided in the next phase of the ZBB. The next important stage is to prioritize the activities. The Most important step involved in the process of ABB is cost benefit analysis. The final step is to select, approve the decision packages and finalise the budget.
10.6.3 Benefits of Zero Base Budgeting

1. 2. 3. 4. 5. It acts as guide for the management to allocate the resources more accurately depends upon the priority for an effective implementation. It enhances capability of the managers who prepares the budget for future action. It paves way for optimum utilization of resources available. It is a technique of utilitarian of the resources with reference to the activity involved It is dome shaped only towards the achievement of organizational goals.
10.6.4 Criticism
1. 2. 3. Non financial matters cannot be considered for the cost & benefit analysis Difficulties involved in the process of ranking of the decision packages It needs more time span for preparation and cost of operations is more and more
10.7 LET US SUM UP

Budgeting is the course involved in the preparation of budget of an activity. Budgetary control contains two different processes one is the preparation of the budget and another one is the control of the prepared budget. "Budgetary control is a system which uses budgets as a mans of planning and controlling all aspects of producing and/or selling commodities and services". Cash budget can be prepared in three different ways: 1. 2. 3. Receipts and payments method Adjusted profit and loss account Balance Sheet Method
Fixed Budget is a budget known as constant budget, never registers the changes in the preparation of a budget, being prepared for irrespective level of output or production.

Identify at least three roles budgeting plays in helping managers control a business.
10.9 KEYWORDS
Budget: A financial statement prepared for specified activity for future periods Budgeting: Activity of preparing the budget is known as budgeting Budget control: Quantitative controlling technique to assess the performance of the organization Cash Budget: It is a statement prepared by the organization to identify the future needs and receipts of cash from the yester activities Flexible Budget: It is a financial statement prepared on the basis of principle of flexibility to identify the cost of the unknown level of production from the existing level of operational capacity.
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1. 2. 3. 4. 5. 6. Define budget. Define budgetary control. Highlight the various types of budget. Elucidate the process of production budget. Illustrate the methodology of purchase budget. Draw the process of preparing the cash budget.
Budgetary Control

R.L. Gupta and Radhaswamy, Advanced Accountancy V.K. Goyal, Financial Accounting, Excel Books, New Delhi. Khan and Jain, Management Accounting. S.N. Maheswari, Management Accounting. S. Bhat, Financial Management, Excel Books, New Delhi. Prasanna Chandra, Financial Management Theory and Practice, Tata McGraw Hill, New Delhi (1994). I.M. Pandey, Financial Management, Vikas Publishing, New Delhi. Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.
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LESSON
11
MARGINAL COSTING
CONTENTS
11.0 Aims and Objectives 11.1 Introduction 11.2 Meaning & Definition of Marginal Costing 11.3 Why Marginal Cost is called as Incremental Cost? 11.4 Why Marginal Cost is called in other words as Variable Cost? 11.4.1 Fixed Cost 11.4.2 Variable Cost 11.4.3 Semi-variable Cost 11.4.4 Method of Difference 11.4.5 Method of Coverages 11.5 Break Even Point Analysis 11.5.1 Break Even Point in Units 11.6 Verification 11.6.1 Selling Price Method 11.6.2 PV Ratio Method 11.6.3 Graph Method 11.7 Margin of Safety 11.8 Determination of Sales Volume in Rupees at Desired Level of Profit 11.9 Applications of Marginal Costing 11.9.1 Make or Buy Decision 11.9.2 Worth of Production 11.9.3 Worth of Purchase 11.10 Accepting the Export Offer 11.11 Key Factor 11.12 Selecting the Suitable Product Mix 11.13 Determining Optimum Level of Operations 11.14 Alternative Method of Production 11.15 Let us Sum up 11.16 Lesson-end Activity 11.17 Keywords 11.18 Questions for Discussion
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11.19 Suggested Readings

In this lesson we shall discuss about marginal costing. After going through this lesson you will be able to: (i) (ii) understand meaning and definition of marginal costing analyse break even point analysis
Marginal Costing
(iii) discuss applications of marginal costing and selecting the suitable product mix.
11.1 INTRODUCTION
It is one of the premier tools of management not only to take decisions but also to fix an appropriate price and to assess the level of profitability of the products/services. This is a only costing tool demarcates the fixed cost from the variable cost of the product/ service in order to guide the firm to know the minimal point of sales to equate the cost of production. It is a tool of analysis highlighting the relationship in between the cost, volume of sales and profitability of the firm.
11.2 MEANING & DEFINITION OF MARGINAL COSTING

Definition: According to ICMA, London "Marginal cost is the amount at any given volume of output, by which aggregate costs are charged, if the volume of output is increased or decreased by one unit." Meaning: Marginal cost is the cost nothing but a change occurred in the total cost due to changes taken place on the level of production i.e., either an increase / decrease by one unit of product.. The firm XYZ Ltd. incurs Rs 1000/- for the production of 100 units at one level of operation. By increasing only one unit of product i.e. 101 units, the firm's total cost of production amounted Rs 1010. Total cost of production at first instance (C')=Rs. 1000/ Total cost of production at second instance (C")=Rs. 1010/Total number of units during the first instance (U')=100 Total number of units during the second instance (U")=101 Increase in the level of production and Cost of production: Change in the level of production in units= U"-U'= U Change in the total cost of production = C"-C, prime= C Marginal Cost = = Rs. 10 If the same firm reduces the total volume from 100 units to 99 units. The total cost of production Rs. 990. Decrease in the Level of production and Cost of production: Marginal Cost = = Rs. 10
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C Rs. 10 Change (Increase) in the total cost of production = = U 1 Change (Increase) in the level of production
C Rs.10 Change(Decrease) in the total cost of production = = U 1 Change(Increase) in the level of production
11.3 WHY MARGINAL COST IS CALLED AS INCREMENTAL COST?

From the above example, it is obviously understood that marginal cost is nothing but a cost which incorporates the incremental changes in the cost of production due to either an increase or decrease in the level of production by one unit, meant as incremental cost.
11.4 WHY MARGINAL COST IS CALLED IN OTHER WORDS AS VARIABLE COST?

From the following classifications of cost, the inter twined relationship in between the variable cost and marginal cost is explained as below
Table 11.1: Statement of Fixed, variable and total costs and per unit
Sl.No. Units Fixed Cost Rs 500 500 500 500 Fixed cost per unit Rs 500 100 5 3.333 Variable Cost Rs 10 500 1000 1500 Variable Cost per unit Rs 10 10 10 10 Marginal Cost Rs ? C/? U 10 10 10 10 Total Cost Rs 510 1000 1500 2000
1. 2. 3. 4.
1 50 100 150
11.4.1 Fixed Cost

It is a cost remains constant or fixed irrespective level of production. Example: Rent Rs 5,00 is to be paid irrespective level of production. It remains constant/ fixed irrespective of changes taken place on the level of production.
Total fixed Cost Line Fixed Cost per unit Line X

X'- Units Y'- Cost in Rupees
11.4.2 Variable Cost

It is a cost which varies with level of production.
Variable Cost Variable cost per unit
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X'- Units Y'- Cost in Rupees The following are the various components of variable cost. Direct Materials: Materials cost consumed for the production of goods Direct Labour: Wages paid to the labourers who directly involved in the production of goods. Direct Expenses: other expenses directly involved in the production stream. Variable portion of Overheads: Generally the overheads can be classified into two categories. Viz- Variable overheads and Fixed overheads. The variable overheads is the cost involved in the procurement of Indirect materials Indirect labour and Indirect Expenses. Indirect Material- cost of fuel, oil and soon Indirect Labour- Wages paid to workers for maintenance of the firm. From the above table -1 the marginal cost is equivalent to the variable cost per unit of the various levels of production. The fixed cost of Rs.500 is the cost remains the same at not only irrespective levels of production but also already absorbed at the initial level of production. The initial absorption of fixed overhead led the marginal cost to become as variable cost.
Marginal Costing
11.4.3 Semi-Variable Cost

Another major classification is semi variable/fixed cost which is a cost partly fixed / variable to the certain level of production or consumption e-g Electricity charges, telephone charges and so on. It jointly discards the importance of the fixed cost and the semi- variable cost for analysis while ascertaining the marginal cost. Marginal Costing is defined as "the ascertainment of marginal cost and of the effect on profit of changes in volume or type of output by differentiating between fixed and variable costs." In marginal costing, the change in the level of cost of operation is equivalent to variable cost due to fixed cost component which is fixed irrespective level of outputs. Importance of Marginal costing: The costs are classified into two categories viz fixed and variable cost. Variable cost per unit is considered as marginal cost of the product. Fixed costs are charged against contribution of the transaction. Selling price of the product = marginal cost + contribution.
Contribution
Method of Difference Sales- Variable Cost
Method of Meeting Fixed cost+Profit
Marginal costing profitability statement as follows: Sales Variable Cost xxxx xxxx
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Contribution Fixed Cost Profit
xxxx xxxx xxxx
Sales Rs.100,000/-, variable cost Rs.25,000/- and fixed cost Rs.20,000/- find-out the contribution and profit. Rs. Sales 1,00,000 Variable Cost 50,000 Contribution 50,000 Fixed Cost 20,000 Profit 30,000
11.4.4 Method of Difference

Under this method, the contribution can be computed through finding the differences in between Sales and Variable Cost i.e. Contribution= Sales Variable Cost= Rs.1,00,000 50,000= Rs.50,000
11.4.5 Method of Coverages

In this method, the contribution is equated with the summation of Fixed cost and Profit. i.e. Contribution=Fixed Cost+ Profit =Rs.20000+30000=Rs.50,000
Marginal Costing(MC)
Cost Volume Profit Analysis (CVP)
Break Even Point Analysis (BEP)
11.5 BREAK EVEN POINT ANALYSIS

This meaning of the analysis is explained through three different components viz.
Break
Divide
Even
Equal
Point
Place (or) Position
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Break Even Point is the point at which the Total Cost is equivalent to Total Revenue. At the break even point the business neither earns profit nor incurs a loss. It means that the firm's cost is recovered at the minimum level of production.
Marginal Costing
Break Even Point
Total Cost
Total Revenue/ Total Sales
No Profit / No Loss
If Sales > BEP Sales earn profit i.e. Total Sales> Total Cost which leads to earn profit. If Sales< BEP Sales incur loss i.e. Total Sales< Total Cost which registers incurrence of loss. This Break even point analysis can be interpreted into two classifications. The first classification is narrow sense of BEP, which mainly emphasizes on BE Point. The second segment is the broader sense which elucidates the role of BEP towards managerial decisions Fixation of Selling price Acceptance of Special / Foreign order Incremental Analysis- On cost as well as revenue Make or Buy Decision Key factor analysis Selection of production mix Maintaining the specified level of profit and so on The enlisted decisions will be discussed immediately after the preliminary aspects of marginal costing i.e. Break even analysis.
Check Your Progress 1. Marginal costing is a study on (a) (c) 2. Variable costing Fixed costing (b) (d) Profit Volume of sales
BEP means (a) (c) Break even point Break event point (b) (d) Bright even point Bright even position
3.
BEP is the point at which (a) (c) Profit & No Loss No profit & No Loss (b) (d) No Profit & Loss Profit & Loss
4.
CVP analysis is the combination of three predominant factors of influence (a) (c) Cost, Value and Profit Cost, Volume and Profit (b) (d) Component, Value and Profit None of the above
Contd...
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5.
In BEP analysis, which cost is to be considered to meet out (a) (c) Fixed cost Variable cost (b) (d) Semi variable cost None of the above
The Break even point in accordance with narrow sense can be classified into two categories Break Even Point in Units Break Even Point in Sales
11.5.1 Break Even Point in Units Illustration 1:

Assume the selling price of product Rs.20/-per unit and variable cost per unit Rs.10/and the fixed cost Rs.1000/- Find out the break even point. Sales Variable Cost Contribution Fixed Cost Profit Rs.20/Rs.10/Rs 10/Rs.1000/(-) Rs. 990/-
If the firm produces only one unit, the amount of loss is Rs.990/-. To avoid the amount of loss how many units are to be produced ? As already highlighted, BEP is the point at which the firm neither earns profit nor incurs loss. Profit/Loss is a resultant out of Contribution while meeting out the fixed cost volume of the transaction. From the above example, the contribution per unit is Rs.10/ not sufficient to meet out the fixed cost volume of Rs.1000/-. The purpose of finding out the BEP in units is to identify the level of contribution which is not only equivalent as well as to meet fixed cost of the transaction but also to avoid loss. To raise the volume of contribution at par with the fixed cost volume, fixed cost has to be related to the contribution margin per unit through the ratio given below Fixed cost= "X" units x Contribution Margin Per Unit "X" units can be found out from the following "X" units =
Fixed Cost Contribution Margin Per Unit
The total number of units "X" which equate the contribution volume of "X" units with the total fixed cost is the Break Even Point (Units). Break Even Point (Units) =
Fixed Cost Contribution Margin Per Unit
Rs.1000/= 100 Units Rs.10/-
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The above illustration reveals that how many number of times the contribution margin per unit should be equivalent to the total fixed cost volume. Hence the number of times is nothing but the units required to have equivalent volume of contribution to the tune of fixed cost.
11.6 VERIFICATION
At the level of 100 units Sales Variable Cost Contribution Fixed Cost Profit/Loss Break Even Point ( Sales Volume Rs): Break even point in sales can be found out in two methods. 1. 2. Selling Price Method PV Ratio Method. 100Rs.20 100Rs.10 100Rs.10 Rs.2,000/ Rs.1,000/ Rs.1,000/ Rs.1,000/ 0 d
Marginal Costing
11.6.1 Selling Price Method

Under this method Break even sales volume in rupees is found out through the product of Break Even Point in Units and Selling price per unit BEP (Rs)=Break Even Point (units) Selling price per unit
11.6.2 PV Ratio Method

Under this method, Break even sales volume in rupees can be determined through the following ratio. BEP(Rs) = What is PV ratio? PV ratio is Profit Volume ratio which establishes the relationship in between the profit and volume of sales. It is a ratio normally expressed in terms of contribution towards volume of sales. It is expressed in terms of percentage. Utility of PV ratio: To find out the Break Even Point in sales volume To identify the desired level of profit at any sales volume To determine the sales volume to earn required level of profit To identify better product mix among the alternatives available etc. Profit Volume Ratio (PV ratio) = From the above example PV ratio at the level of 100 units PV ratio =
Fixed Cost PV ratio
Sales-Variable Cost Contribution = Sales Sales
Rs.1000/100 = 50% Rs. 2000/-
PV ratio at the level of one unit PV ratio =
Rs.10/ 100 = 50% Rs. 20/185
From the above workings, it obviously understood that every unit of sale contributes 50% towards in covering the fixed cost and profit.
Break Even Sales: At the level of 100 units Sales Variable Cost Contribution Fixed Cost Profit/Loss
Fixed Cost PV ratio

In Percentage 100Rs.20 100Rs.10 100Rs.10 Rs. 2,000/ Rs.1,000/ Rs.1,000/ Rs.1,000/ 0 f 100% 50% 50%
PV Ratio = Rs.1000/Rs.2000 = 50% 50 % of what ? If Rs.100 is Sales ; Rs.50 is Contribution and the remaining Rs.50 variable cost. Break even sales =
Fixed cost Rs.1000 Contribution Rs.1000/ = Rs.2000/ = 50% 50%
At Break even level, the fixed cost volume is equivalent to contribution; the later which is related in terms of sales i.e. PV ratio will be applicable to the earlier i.e. fixed cost. At Break even sales, Fixed Cost = Contribution; is the volume which neither earns nor incurs loss. Illustration 2: Calculate Break Even Point from the following particulars Fixed Cost Variable Cost Per Unit Selling Price Per Unit Break Even Point (Units) = Rs.3,00,000 Rs.20/Rs.30/Fixed Cost Contribution Margin Per Unit
Contribution Sales = Sales Contribution
First Step to find out Contribution margin per unit Contribution Margin Per Unit = Selling Price Per Unit Variable Cost Per Unit = Rs.30 Rs.20 = Rs. 10 =
Rs.3,00,000 = 30,000 units Rs.10
Break Even (Rupees) can be found out in two ways Method I: = B.E.P (Units) Selling Price = 30,000 units Rs.30= Rs.9,00,000/(Or) Method II: Under this method PV ratio component has to be found out PV ratio =
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Contribution 100 Sales
Rs 10 = 100 = 33.33% Rs.30

= Illustration 3: Calculate Break even point Sales Fixed Cost Variable Expenses Direct Material Direct Labour Overhead Expenses 2,00,000/1,20,000/80,000/Rs. 6,00,000/1,50,000/-
Marginal Costing
Fixed Cost Rs.3,00,000/ = = 9000 100 = 900,000/PV ratio 33.33%
First step to find out the total volume of Variable expenses Variable Expenses = Direct Material + Direct Labour + Overhead Expenses = Rs.2,00,000 + 1,20,000 + 80,000 = Rs.4,00,000/Second Step to find out the contribution Contribution = Sales- Variable Expenses = Rs.6,00,000- 4,00,000= Rs. 2,00,000/Third step to find out PV ratio PV ratio= Contribution/ Sales= Rs,2,00,000/Rs.6,00,00= 1/3 Final Step to find out Break even sales Break Even Point (Rupees) =
Fixed Cost Rs.1,50,000 = = Rs.4,50,000/PV ratio 1/3
Note: Break even point in units is not possible to find out due to non availability of selling price and variable cost per unit ; which constrained the computation of contribution margin per unit. Illustration 4: From the following particulars find out the BEP. What will be the selling price per unit if BEP is brought down to 900 units? Variable Cost Fixed Cost Rs 75/ Rs.27,000/
Selling price per unit Rs.100/ First step is to find out the Break even Point in Units BEP (Units) =
Fixed Cost Contribution Margin per unit
Second step is to find out Contribution margin per unit Contribution margin per unit = Selling price per unit- variable cost per unit
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= Rs.100-75 = Rs.25 =
Rs.27,000 = 1080 units Rs.25
If break even point is reduced to the level of 900 units; what is the new selling price? First step to find out the contribution margin per unit; contribution margin per unit will be computed from the BEP (units) formula. BEP (Units) = 900 =
Rs.27,000 Contribution Margin per unit
Contribution margin per unit = Rs. 27,000/900 units = Rs.30 The second step is to determine the new selling price through the following equation Contribution = selling price-variable cost; X = Selling Price Rs.30 = X-Rs.75 ; X = 30+75 = Rs.105/The new selling price for new break even level of 900 units is Rs.105/-
11.6.3 Graph Method

Statement of Fixed, variable and total costs and per unit
Sl.No 1) 2) 3) 4) Units 1 50 100 150 Fixed Cost Rs 500 500 500 500 Variable Cost Rs 10 500 1000 1500 Sales Rs 20 1000 2000 3000 Total Cost Rs 510 1000 1500 2000
Cost/ Volume Rs 3000 2000 1500 BEP 1000 500 10 50 Units 100
TS
TC Margin of Sa fety FC
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11.7 MARGIN OF SAFETY

Margin of safety is the excess volume of sales over the break even sales. It is highlighted in the form absolute sales or in percentage. It is the difference in between the actual sales and break even sales. It elucidates the extent in which sales can be reduced without incurring a loss.
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Margin of Safety = Actual Sales - Break Even Sales (Or) =
Marginal Costing
Profit PV ratio
The greater the margin of safety leads to soundness of the firm's business.
11.8 DETERMINATION OF SALES VOLUME IN RUPEES AT DESIRED LEVEL OF PROFIT

To determine the sales volume (Rupees) at desired level of profit, the existing formula for finding out the break even sales has to be redesigned. Break Even Sales (Rupees) =
Fixed Cost PV ratio
The above formula is in accordance with the method of coverage i-e covering the fixed cost and profit. Contribution = Fixed Cost + Profit To earn desired level of profit, which the firm intends to earn should have to be combined with the fixed cost, are the two different components to be covered only in order to find out the contribution level to the tune of unchanged selling price and variable cost per unit. New volume of Sales (Rupees) = Illustration 5: From the following information relating to quick standards ltd., you are required to find out i) PV ratio ii) break even point iii) margin of safety iv) calculate the volume of sales to earn profit of Rs.6,000/ Total Fixed Costs Rs.4,500/ Total Variable Cost Rs.7,500/ Total Sales Rs.15,000/First step to find out the Contribution volume Sales Variable Cost Contribution Fixed Cost Profit (i) Rs 15,000/ Rs. 7,500/ Rs.7,500/ Rs.4,500/Rs.3,000
Fixed Cost + Desired Level Profit PV ratio
Second step to determine the PV ratio PV ratio =

7,500 Contribution 100 = 100 = 50% 15,000 Sales
Third step to find out the Break even sales (ii) Break even sales =
Fixed cost 4,500 = = 9,000/PV ratio 50%
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(iii) Margin of safety can be found out in two ways (a) Margin of Safety = Actual sales- Break even sales = Rs.15,000-Rs.9,000 = Rs.6,000 (b) Margin of Safety =
Profit Rs.3,000 = = Rs.6,000/PVratio 50%
(iv) Sales required to earn profit = Rs.6,000/ To determine the sales volume to earn desired level of profit =
Fixed cost + Desired Profit PV ratio Rs.4,500 + Rs.6,000 = Rs.21,000/50%
= Illustration 6:
Break even sales Sales for the year 1987 Profit for the year 1987 Calculate (a) (b)
Rs.1,60,000 Rs.2,00,000 Rs.12,000
Profit or loss on a sale value of Rs.3,00,000 During 1988, it is expected that selling price will be reduced by 10%. What should be the sale if the company desires to earn the same amount of profit as in 1987 ?
The major aim to compute fixed expenses. In this problem, the profit volume is given which amounted Rs.12,000 Profit = contribution- Fixed expenses From the above equation, the volume of contribution only to be found out To find out the volume of contribution, the PV ratio has to be found out Before finding out the PV ratio, the margin of safety should be found out Margin of safety = Actual sales - Break even sales = Rs.2,00,000-Rs.1,60,000 = Rs.40,000 Another formula for to find out the Margin of safety is as follows Margin of safety =
Profit PV ratio
PV ratio = What is PV ratio ? PV ratio =
Rs.12,000 Profit = = 30% Rs.40,000 Margin of safety
30% =
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Contribution Rs.2,00,000
Contribution = Rs.2,00,000 30% = Rs.60,000 Now with the help of the available information, the fixed expenses to be found out from the illustrated formula Fixed expenses = Contribution- Profit = Rs.60,000 Rs,12,000 = Rs.48,000 The next one is to find out the corresponding variable cost. The variable cost could be found out with the help of the following formula Sales- Variable cost = Contribution Rs.2,00,000- Rs.60,000= Variable cost= Rs.1,40,000 (a) Profit or loss on the sale value of Rs 3,00,000 For a sale value of Rs.3,00,000 what is the contribution ? Contribution for Rs.3,00,000 sale= Rs.3,00,000 30%= Rs.90,000 Profit or Loss= Contribution Fixed expenses= Rs.90,000Rs,48,000= Rs 42,000 (Profit) (b) Sales to be found out to earn same level of profit Sale value reduced 10% from the actual Rs. 2,00,000Rs.20,000 Variable cost Contribution Rs.1,80,000 Rs.1,40,000 Rs.40,000
Rs.40,000 Contribution 100 = 100 = 2/9 times Rs.1,80,000 Sales
Marginal Costing
For the new level of sale volume in rupees, the new PV ratio has to be found out PV ratio =
The next important step is to determine the volume of the sales to earn the desired level of profit =
Fixed expenses + Desired level profit PV ratio Rs.48,000 + Rs.12,000 = Rs.2,70,000 2/9
= Illustration 7:
SV ltd a multi product company, furnishes you the following data relating to the year 1979
Particulars Sales Total cost First half of the year Rs.45,000 Rs40,000 Second half of the year Rs.50,000 Rs.43,000
Assuming that there is no change in prices and variable costs that the fixed expenses are incurred equally in the two half year periods calculate for the year 1979 Calculate (a) (b) (c) (d) PV ratio Fixed expenses Break even sales Margin of safety (C.A. Inter May, 1980)
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(a)
The first step is to find out the PV ratio Formula for PV ratio =
Change in Profit 100 Change in Sales
To identify the change in profit, the profits of the two different periods should be known Profit= Sales-Total cost Profit of the first half of the year = Rs.45,000Rs.40,000 = Rs.5,000 Profit of the second half of the year= Rs.50,000Rs.43,000 = Rs.7,000 Change in profit= Rs.7,000Rs.5,000= Rs.2,000 Change in sales= Rs.50,000Rs.45,000=Rs.5,000 PV ratio = (b)
Rs.2,000 100 = 40% Rs.5,000
Fixed expenses, to find out the contribution should be initially found out Contribution = Sales PV ratio = Rs.50,000 40% = Rs.20,000 The fixed expenses to be found out through the following equation Contribution-Fixed expenses= Profit Rs.20,000Rs.7,000= Rs.13,000= Fixed expenses The fixed expenses found only for six months ; for the entire year = Rs.13,000 2=Rs. 26,000
(c)
BE Sales =
Fixed expenses Rs. 26,000 = = Rs.65,000 PV ratio 40%
(d)
Margin of safety = Total sales- BE sales The next component to be found out is total sales Total sales = Sale of the first half of the year + Sale of the second half of the year = Rs.45,000 + Rs.50,000 = Rs.95,000 Margin of safety= Rs.95,000 Rs.65,000= Rs.30,000 Margin of safety in percentage of sales =
Rs. 30,000 100= 31.578% Rs. 95,000
11.9 APPLICATIONS OF MARGINAL COSTING

11.9.1 Make or Buy Decision
The firms which are routinely in need of spares, accessories are bought from the outsiders instead of any production or manufacturing, though the requirement is at regular intervals. Most of the automobile manufacturers are usually buying the components from outside instead of producing them on their own. The Maruthi Udyog ltd had given a contract to the Nettur Technical Training Foundation, Bangalore to design the tool for the panel and to manufacture regularly to the tune of the orders.
192
The leading four wheeler manufacture in India is buying the panel from the NTTF on contract basis instead of manufacturing.
Why don't they manufacture in spite of buying them from the NTTF ? The main reason of buying is cheaper than the production of an article. Illustration 8 The management of a company finds that while the cost of making a component part is Rs. 20, the same is available in the market at Rs. 18 with an assurance of continuous supply. Give a suggestion whether to make or buy this part. Give also your views in case the supplier reduces the price from Rs. 18 to Rs. 16. The cost information is as follows Material Direct Labour Other variable expenses Fixed expenses Total Rs 7,00 Rs. 8.00 Rs. 2.00 Rs. 3.00 Rs.20.00
Marginal Costing
The first point to be found out that the contribution of the transaction. The cost of manufacturing should be compared with the price of the product which is available in the market. To find out the worth of the transactions, first the cost of manufacturing should be found out Material Direct Labour Other variable expenses Total Rs. 7.00 Rs. 8.00 Rs. 2.00 Rs.17.00
The cost of manufacturing a component is Rs.17.00. While calculating the cost of manufacturing a component, the fixed expenses was not considered. The fixed expenses were not considered for computation. Why? The costs will be incurred irrespective of the production status of the firm; for which the expenses should not be added. If the company manufactures the product/ component at Rs.17 which will facilitate to book profit Rs. 1 from the price of Rs.18 which is available from the market. The next stage is decision criteria.
11.9.2 Worth of Production

Cost of the production < Price of the product available in the market The firm is better advised to take the course of production rather than purchase of the product.
11.9.3 Worth of Purchase

Cost of the production > Price of the product available in the market The product available in the market is dame cheaper than the manufacturing of a product. The firm is better advised to buy the product rather than the manufacturing of a product If the product price comes down to the price of Rs.16 facilitates the firm to save Re 1 from the cost of manufacturing.
193
Illustration 9 A refrigerator manufacturer purchases a certain component @ Rs.50 per unit. If he manufactures the same product he has to incur a fixed cost of Rs.20,000 and variable cost per unit is Rs. 40/- when can the manufacturer make on his own or when he can buy from outside ? When the requirements is Rs. 5,000 units, will you advise to make or buy? The very first point to be found that Break even point in units. The break even point in units at which the cost of buying is equivalent to the cost of manufacturing. The cost of purchase per unit - Rs 50/If the same product is manufactured, what would be the total cost of manufacture ? Total cost of manufacture= Total fixed cost + Variable cost The cost of buying is felt that an exorbitant one than the cost of manufacturing. Having observed, as a manufacturer undergoes for the manufacturer of a component. If he manufactures a component, he could save Rs.10=( Rs.50Rs.40) Which in other words known as contribution per unit Before finding out the Break even point in units, the contribution of the product should be found out. Contribution margin per unit= Selling price in the market Cost of manufacture Contribution margin per unit is nothing but the amount of savings to the manufacture. Amount of savings out of the manufacture = Purchase price Variable cost Though the firm enjoys savings, it is required to additionally incur fixed cost of operations Rs.20,000 Break even point in units =
Fixed cost Purchase price- Variable cost
Rs.20,000 = 2,000 units Rs.50Rs.40
At 2,000 units, the firm considers both alternatives are incurring equivalent volume of Cost in manufacturing. Cost of buying for 2,000 units =2,000 units Rs.50 per unit= Rs. 1,00,000 Cost of Buying = Rs.20,000 + 2,000 units Rs.40 = Rs.1,00,000 From the above, it obviously understood that both are bearing equivalent amount of costs. It means both are neither profitable nor non- profitable. Which one is better for the firm?
No of Units @ 2,001 units Manufacturing cost Rs.20,000+ Rs.80,0040 =Rs.1,00,040 Buying cost 2001 Rs.50 = Rs.1,00,050 Decision Manufacturing cost < Buying cost Advisable to manufacture Manufacturing cost > Buying cost Advisable to Buy
Break even in Rupees
@1,999 units
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Rs.20,000+Rs.79,960 =Rs.99,960
1,999 Rs.50 Rs.99,950
The next step is to identify the worth of either manufacturing the units or buying the units at 5,000 If the manufacturer buys from the outsider= 5,000 Rs.50= Rs.2,50,000 If the same manufacturer produces the component instead of buying =Rs.20,000+ Rs.2,00,000= Rs.2,20,000 From the above, the company is finally advised to manufacture the component due to low cost of manufacture.
Marginal Costing
11.10 ACCEPTING THE EXPORT OFFER

Illustration 10 The cost statement of a product is furnished below Direct material Direct wages Factory overhead Fixed Variable Administrative expenses Selling or distribution overheads Fixed Variable Selling price per unit Rs.24.00 Rs.0.50 Rs.1.00 Rs.1.50 Rs.21.00 The above figures are for an output of 50,000 units. The capacity for the firm is 65,000 units A foreign customer is desirous of buying 15,000 units a price of Rs.20 per unit. Advise the manufacturer whether the order should be accepted, what will be your advise if the order were from the local merchant? The acceptance of the order is mainly based on the two important covenants viz Additional cost and Additional revenue. If the additional demand of the foreign buyer is able to generate the additional revenue more than the additional cost of the operations, the firm should have to accept the foreign order. Decision criteria Marginal/Additional cost for the additional order of 15,000 units
Per unit (Rs) Selling price Less:Marginal cost Direct material Direct wages Variable overhead Factory Selling & Distribution 1.00 1.00 18 2 2,70,000 30,000 Rs 10.00 6.00 20 15,000 units 3,00,000
Rs.10.00 Rs.6.00 Rs1.00 Rs.1.00 Rs.2.00 Rs.1.50
The acceptance of the order will generate marginal profit of Rs.30,000 which should be accepted. The fixed portion of the factory and selling overheads were already met out
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which should not be included again in the computation of the marginal or additional cost of the foreign order placed by the business enterprise. Instead, If the firm accepts the local order at the rate of Rs.20 which automatically will spoil the relationship with the very good customers who regularly purchase at the rate of Rs.24. This will lead to cannibalization of the existing pricing strategy.
11.11 KEY FACTOR

Key factor is nothing but a limiting factor or deterring factor on sales volume, production, labour, materials and so on. The limiting factor normally differs from one to another Volume of sales- the limiting factor is that production of required number of articles Volume of production- the limiting factors are as follows in adequate supply of raw materials, labor, inability to sell the produced articles and so on The limiting factors are studied in the lights of the contribution. The limiting factor is bearing the inverse relationship with the volume of contribution. To study the worth of the business proposals among the limiting factors, the contribution is considered as a parameter to rank them one after another. Illustration 11 From the following data, which product would you recommend to be manufactured in a factory, time being the key factor?
Particulars Direct Material Direct Labor @ Re 1per hr Variable overhead Rs.2 per hr Selling price Standard time to produce Per unit of Product A Rs 24 2 4 100 2 Hours Per unit of Product B Rs 14 3 6 110 3 Hours
(I.C.W.A.Inter) The product is being chosen by the manufacturer based on the ability of generating higher contribution. The higher the contribution leads to a better the position for the firm The worth of the product is being selected on the basis of
Particulars Selling price Less :Direct Material Direct Labor @ Re 1per hr Variable overhead Rs.2 per hr Contribution Standard time to produce Contribution per hour per product 2 Hours Rs.70/2 Hrs= Rs.35 24 2 4 30 70 3 Hours Rs.87/3 Hrs= Rs 29 Per unit of Product A Rs 100 14 3 6 23 87 Per unit of Product B Rs 110
From the above calculation, it is obviously understood that the firm is having higher contribution margin per hour in the case of product A over the other one, portrays the product A is better than B. Illustration 12 The following particulars are obtained from costing records of a factory:
Particulars Direct Material Rs.20 per Kg
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Per unit of Product A Rs 80 100
Per unit of Product B Rs 320 200
Direct Labor @ Re 10per hr
Contd...
Variable overhead Selling price Total fixed overheads
40 400 Rs.30,000
80 1,000
Marginal Costing
Comment on the profitability of each product during the following conditions: (a) (b) (c) (d) In adequate supply of raw material Production capacity is limited Sales quantity is limited Sales value limited
The first step is to determine the Contribution per product. According to the constraints given in the problem, contribution of two products should be compared.
Particulars Selling price Direct Material Rs.20 per Kg Direct Labor @ Re 10per hr Variable overhead Contribution margin per unit 80 100 40 220 180 Per unit of Product A Rs 400 320 200 80 600 400 Per unit of Product B Rs 1,000
Now the contribution per unit has found out with the help of above given information the next step is to study the contribution margin per unit to the tune of given constraints of the firm. (a) The first constraint is in adequate supply of the raw material: The raw materials are considered to be precious due to insufficient supply to the requirement of the firm. Having considered the scarcity of the raw material, the constraint in availing the raw material is denominated in terms of ability of contribution generation.
Particulars Contribution margin per unit Consumption of raw material per unit Cost of raw material per unit Cost of material per Kg Contribution per Kg Per unit of Product A Rs 180 Per unit of Product B Rs 400
Rs 80 = 4 Kgs Rs.20 Rs. 180 = Rs.45 4 Kgs
Rs.320 = 16 Kgs Rs20 Rs.400 = Rs.25 16 Kgs
It obviously understood that the firm enjoys greater contribution margin per k.g in the case of Product A during the scarcity of raw material than the product B. (b) Then the production capacity of the firm is subject to the availability of the labour and the hours normally consumed by them for the production of a single product. Due to shortage of the labour, the firm should identify the product which requires lesser labour hours as well as able to generate more contribution margin per labour hour. In the next step, Contribution margin per hour should be calculated.
Particulars Contribution margin per unit Consumption of Labor Hrs Cost of Labor per unit Cost of Labor per Hour Contribution per Hr of the product Per unit of Product A Rs 180 Per unit of Product B Rs 400
Rs100 = 10 Hrs Rs.10 Rs. 180 = Rs.18 10 Hrs
Rs.200 = 20 Hrs Rs10 Rs.400 = Rs. 20 20 Hrs
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The contribution per hour is greater in the case of the product B, considered to be as a better product among the given. It means that the firm has better opportunity to earn greater contribution in the case of product B than A. (c) The next one is that sale of the quantities is the major limiting factor. It means that the vendor finds some what difficulties in selling the articles. While considering the difficulties in selling the quantities, the firm should identify the product which is able to generate greater contribution. From the earlier calculation, it is clearly understood that, the product B is bearing greater value of contribution margin per unit than the product. (d) If the sales value is considered to be a limiting factor, to choose one among the given products PV ratio is being applied as a measure. It means that the sales value of the products are ignored for comparison in between them. To identify the better product, irrespective of the price, PV ratio should be applied. The PV ratio of the Product A & B are calculated as follows Profit volume ratio = For A = 45% For B = 40% The PV ratio is greater in the case of product A than B. The product A has to be chosen
Check Your Progress 1. Which is the following factor equated to the Contribution at the level of Break Even Point ? (a) (c) 2. Fixed cost Variable cost (b) (d) Sales Semi-Variable cost
What is the change to be made on the BEP formula to find out the volume of sales at the desired level of profit ? (a) (c) Desired profit Desired profit with Fixed cost (b) (d) Fixed cost Desired cost + Fixed profit
11.12 SELECTING THE SUITABLE PRODUCT MIX

In the market, dealership is offered by the various companies to the individual intermediaries in promoting the sale of products. Before reaching an agreement with the company to act as a dealer, normally every individual consider the profitability of the product mix offered by the firm. For e-g There are two different companies brought forth their advertisements in offering the dealership to the individual trading firms viz HCL and IBM. The profitability under the dealership banner should be appropriately considered prior to take decision. To take rational decision, the firm should compare the profitability of both different dealership of two different giant industrial brands. The greater the share of the profitability in volume will be selected and vice versa.
Check Your Progress 1. If the supply of the material is considered to be scared in the market for two different units of production of ABC ltd. How the worth of the units of production could be studied through Key factor analysis? Contd...
198
(a) (c) 2.
Contribution per unit Contribution per hour
(b) (d)
Contribution per labour None of the above
Marginal Costing
While accepting export order, which component of influence should not be taken into consideration? (a) (c) Direct material Direct labour (b) (d) Direct expenses Fixed cost
3.
If Licon co ltd wants to induct a product B along with the existing product line, what would be the deciding factor to undertake or reject? (a) (c) Composite contribution Contribution margin per unit (b) (d) Fixed cost None of the above
Illustration 13 From the following information has been extracted of EXCEL rubber products ltd
Direct materials A Direct materials B Direct wages A Direct wages B Variable overheads Fixed overheads Selling price A Selling price B Rs 16 Rs12 24 Hrs at 50 paise per hour 16 Hrs at 50 paise per hour 150% of wages Rs. 1,500 Rs.50 Rs.40
The directors want to be acquainted with the desirability of adopting any one of the following alternative sales mixes in the budget for the next period. (a) (b) (c) (d) 250 units of A and 250 units of B 400 units of B only 400 units of A and 100 units of B 150 units of A and 350 units of B
State which of the alternative sales mixes you would recommend to the management? The first step is to determine the contribution margin per unit of A and B. The determination of the contribution of product A and B are through the preparation of Marginal costing statement.
Particulars Selling price Less: Direct Materials Direct wages Variable overheads Variable cost Contribution 16 12 18 46 4 Product A Rs 50 12 8 12 32 8 Product B Rs 40
The next step is to determine the profit level of every mix. (a) 250 units of A and 250 units of B The first step is to determine the total contribution of the mix. Why the total contribution has to be found out? The main reason is to determine the profit level of the mix through the deduction of the fixed overheads
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Product of A Product of B Contribution Fixed overheads
250 units Rs.4= 250 units Rs.8=
Rs.1,000 Rs.2,000 Rs.3,000 Rs.1,500
Profit (b) 400 units of B only Product B Contribution Fixed overheads Profit (c) 400 units of A and 100 units of B Product of A Product of B Contribution Fixed overheads Profit (d) 150 units of A and 350 units of B Product A Product B Contribution Fixed overheads Profit
Mix Contribution A Rs.1,500 B 1,700 C 900
Rs.1,500
400 units Rs.8 =
Rs.3,200 Rs.1,500 Rs.1,700
400 units Rs.4 100 units Rs.8
Rs.1,600 Rs. 800 Rs.2,400 Rs.1,500 Rs.900
150 units Rs.4
Rs.600 Rs.2,800 Rs.3,400 Rs.1,500 Rs.1,900

D 1,900
350 units Rs.8
The profit level among the given various mixes, the mix (d) is able to generate highest volume of profit over the others
11.13 DETERMINING OPTIMUM LEVEL OF OPERATIONS

Under this method, the level has to be found out which is having lesser selling price, cost of operations and greater profits known as optimum level of operations. Illustration 14 A factory engaged in manufacturing plastic buckets is working at 40% capacity and produces 10,000 buckets per annum. The present cost break up for bucket is as under Material Rs.10 Labour Rs.3 Overheads Rs.5(60% fixed) The selling price is Rs 20 per bucket
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If it is decided to work the factory at 50% capacity, the selling price falls by 3%. At 90 % capacity the selling price falls by 5% accompanied by a similar fall in the prices of material.
You are required to calculate the profit at 50% and 90% capacities and also calculate break even point for the same capacity productions. (C.A.Inter May,1976) The very first step is to compute number of units at every level of capacity i.e. 50% and 90%. But in this problem, 40 % capacity utilization given which amounted 10,000 units. For 50% =
Marginal Costing
10,000 units 50 = 12,500 units 40 10,000 units 90 = 22,500 units 40
For 90 % =
The important information is that the changes taken place in the selling price of the product. Selling price = Rs.20 @ 40% i.e., 10,000 units Selling price @ 50% i.e. 12,500 units = Rs.203% on Rs.20 = Rs.19.40 Selling price @90% i.e. 22,500 units=Rs.205% on Rs.20 = Rs.19 While preparing the marginal costing statement, the fixed cost portion should not be included for the computation of the contribution. The next step is to prepare the marginal costing statement.
Particulars Selling price Less: Direct Materials Direct wages Variable overheads Variable cost Contribution Fixed costs Profit 50 % capacity(12,500 Units) Per unit Rs 19.40 10 3 2 15 4.40 55,000 30,000 25,000 Total Rs 2,42,500 1,25,000 37,500 25,000 90% capacity Rs(22,500 units Per unitRs 19.00 9.50 3 2 14.50 4.50 1,01,250 30,000 71,250 TotalRs 4,27,500 2,13,750 67,500 45,000
The last step is to determine that the break even point

Particulars Break even point in units = Fixed cost Contribution margin per unit Break even point in value BEP in units Selling price 50 % capacity 12,500 units Rs.30,000 Rs.4.40 =6,818 units 6,818 units Rs 19.40 =Rs.1,32,269.2 90% capacity 22,500 units Rs.30,000 Rs.4.50 =.6,667units 6,667units Rs.19 =Rs.1,26,673
11.14 ALTERNATIVE METHOD OF PRODUCTION

It is a method to identify the best method of production to generate greater contribution as well as profit. The method which is able to earn greater profit only will be considered, known as limiting factor method. Illustration 15 Product X can be produced either by machine A or machine B. Machine A can produce 100 units of X per hour and machine B 150 units per hour. Total machine hours available during the year are 2,500. Taking into account the following data determine the method of profitable manufacture.
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11.15 LET US SUM UP

"Marginal cost is the amount at any given volume of output, by which aggregate costs are charged, if the volume of output is increased or decreased by one unit." Marginal Costing is defined as "the ascertainment of marginal cost and of the effect on profit of changes in volume or type of output by differentiating between fixed and variable costs." In marginal costing, the change in the level of cost of operation is equivalent to variable cost due to fixed cost component which is fixed irrespective level of outputs. Break Even Point is the point at which the Total Cost is equivalent to Total Revenue. At the break even point the business neither earns profit nor incurs a loss. It means that the firm's cost is recovered at the minimum level of production. PV ratio is Profit Volume ratio which establishes the relationship in between the profit and volume of sales. It a ratio normally expressed in terms of contribution towards volume of sales. It is expressed in terms of percentage. Key factor is nothing but a limiting factor or deterring factor on sales volume, production, labour, materials and so on. The limiting factor normally differs from one to another Volume of sales- the limiting factor is that production of required number of articles In the market, dealership is offered by the various companies to the individual intermediaries in promoting the sale of products. Before reaching an agreement with the company to act as a dealer, normally every individual consider the profitability of the product mix offered by the firm.

Should we evaluate a managers performance on the basis of controllable or noncontrollable costs? Why? Give your opinion.
11.17 KEYWORDS
Marginal cost: Change occurred in the cost of operations due to change in the level of production. B E P (Units): It is the level of units at which the firm neither incurs a loss nor earns profit. BEP (Volume): It is the level of sales in Rupees at which the firm neither incurs a loss nor earns profit. Fixed cost: It is a cost which is fixed or remains the same for irrespective level of production. Variable cost: It varies along with the level of production. Contribution: It is an amount of balance available after the deduction of variable cost from the sales. Key factor: Factor of influence on the component of contribution. PV ratio: Profit volume ration which is nothing but the ratio in between the contribution and sales. Desired profit: It is a profit level desired by the firm to earn at the given level of sales volume.

1.
202
Define marginal cost. Define marginal costing.
2.
3. 4. 5. 6. 7. 8. 9.
What is Break Even Point Analysis? Explain the Graphic approach of BEP analysis. Briefly explain the profit volume ratio. Explain the various kinds of managerial decisions. Elucidate the key factor analysis. List out the advantages of marginal costing. Highlight the limitations of marginal costing.
Marginal Costing

R.L. Gupta and Radhaswamy, Advanced Accountancy. V.K. Goyal, Financial Accounting, Excel Books, New Delhi. Khan and Jain, Management Accounting. S.N. Maheswari, Management Accounting. S. Bhat, Financial Management, Excel Books, New Delhi. Prasanna Chandra, Financial Management Theory and Practice, Tata McGraw Hill, New Delhi (1994). I.M. Pandey, Financial Management, Vikas Publishing, New Delhi. Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.
203
UNIT-IV
LESSON
12
FINANCIAL MANAGEMENT
CONTENTS
12.0 Aims and Objectives 12.1 Introduction 12.2 Finance and Related Disciplines 12.2.1 Finance and Economics 12.2.2 Finance and Accounting 12.3 Profit Maximization 12.3.1 Criticism 12.4 Wealth Maximization 12.5 Objectives & Functions of Financial Management 12.6 Let us Sum up 12.7 Lesson-end Activity 12.8 Keywords 12.9 Questions for Discussion 12.10 Suggested Readings

In this lesson we shall discuss about financial management. After going through this lesson you will be able to: (i) discuss finance and related disciplines (ii) analyse profit maximisation and wealth maximisation (iii) understand objectives and functions of financial management
12.1 INTRODUCTION
The financial management was initially perceived that the study with reference to only procurement of funds but later it was extended to one more additional feature that efficient utilization of funds. It is imperative to understand the meaning of the term Finance Money with objective Money with purpose Money with direction Money with target Money with achievement Money with aim The above explanation is able to understand the real meaning of the term finance which is nothing but effective utilization raised money with some purpose to achieve in desired direction.
12.2 FINANCE AND RELATED DISCIPLINES

The study of role of finance in the organization is with reference to financial management. The financial management is the course which has drawn major focus points from the many more disciplines. To study them, the inter relationship in between the financial management and other related disciplines. The following are the related disciplines viz Finance and Economics Finance and Accounting Finance and Marketing Finance and production Finance and Quantitative Methods
12.2.1 Finance and Economics

The relationship in between these two disciplines are studied in two different headings viz Micro and Macro economics The major part of the financial management is to raise the financial resource to the requirements. While raising the financial resources, the availability is subject to the macro economic influences. Banking system Money and capital markets Financial intermediaries Monetary and credit policies
12.2.2 Finance and Accounting

The two are embedded with different disciplines. The finance is the discipline which is mainly based on the cash basis of operations but the accounting is totally governed by the accrual system. Accounting is mainly vested with the collection and presentation of data, but the finance is closely connected with the decision making of the organization. Till this moment, the differences are discussed only to know the role of finance over the accounting of any organization. The following is the major relationship which lies in between the finance and accounting as follows "Finance begins where accounting ends" Finance and Marketing: These two are disciplines are interrelated to plan for introduction of new product. The major reason is that the introduction of new product normally warrants huge sum of money for research and development ; which needs immense planning and execution to succeed over the other competitors Finance and Production: The changes in the production policy of the organization will impact the capital expenditures. The fixed assets of the organization should be effectively utilized which neither over capitalization nor under capitalization Finance and Quantitative methods: These are inter related to solve complex problems in order to take decisions. The objectives of the financial management are classified into two categories viz Profit maximization Wealth maximization Let us discuss these two one after the another. The objectives of the financial management is discussed only to the tune of normative framework in between the financing, investment and dividend functions of the management.
208
Check Your Progress
Financial Management
Financial management is the course which has drawn major focus points from the many more disciplines. Discuss.
12.3 PROFIT MAXIMIZATION

The projects are considered on the basis of the following criterion: If the project is having the scope to have an increase in the volume of profits, the project is suggested to accept and vice versa. The financing, investment and dividend decisions of the enterprise is dome shaped towards the profit maximization. Under this, the profit is defined in two different angles viz. Owner's and Operational perspective. Owners' perspective definition of profit is the share of national income paid to the owners. Operational perspective defines the term profit as when the output exceeds the inputs of the process. The testing, selecting of the assets and projects are normally on the basis of the profitability of the firm. If the firm is found to be profitable, suggested to accept, otherwise, the decision is vice versa. Profit is a test of economic efficiency which is individual aim to achieve at always though it is closely associated with the social welfare.
12.3.1 Criticism
There is misapprehension about the workability of the private enterprise which normally strives for the profit maximization but not by considering the welfare of the society The next most important criticism is that in ability to fit into the practical considerations The second set of criticism is that the set of technical flaws or set backs associated with the financial management. The technical flaws of the profit maximization is studied under three different headings viz: Ambiguity Timing of benefits Quality of benefits Ambiguity: Profit is to be maximized; which profit has to be maximized? Either Net profit or Gross profit is to be maximized? Whether the short term or long term profit is to be maximized? Whether total profit or rate of profit is to be maximized? Whether the return on the total assets employed or the return on the total capital employed is to be maximized? The maximization of profit is vague due unclear definition of the term profit.
Timing of Benefits
Project Period 1 Period 2 Period 3 Total Alternative A Rs Lakh 50 100 50 200 Alternative B Rs Lakh ------100 100 200
From the above table, the two alternative projects A and B are found to be identical with reference to profit maximization due to equivalent volume of profits of them. Really speaking, these two projects are not identical, why?
209
One missing phenomenon is that timing of benefits. The timing of benefits should be relatively given greater importance for weighing the project at the moment of consideration. Project alternative A is better than the project alternative B, why? Project alternative A is able to generate the benefits during the period 1 which is known as earlier benefits, facilitating the A alternative to go for reinvestment, but in the case of reinvestment opportunity is denied due to non availability of profits during the early season i.e. period 1
Quality of Benefits
Project Recession Normal Boom Total Alternative A Rs Lakh 9 10 11 30 Alternative B Rs Lakh 0 10 20 30
Under the profit maximization, the quality of benefits are not considered what is meant by the quality of benefits? It means the certainty of benefits. The more certain the benefits is better the quality of benefits and vice versa. The profit maximization failed in its attempt to consider the quality of benefits. It has considered the both project are identical but really they are not. Alternative B project is more volatile returns in other words they are more uncertain unlike the project A. The project A is having only least volatility in the earning pattern during the three seasons. A is the better project which has greater certainty in accruing benefits over the others, are normally preferred by the risk averters.
12.4 WEALTH MAXIMIZATION

The next important set of objectives taken for discussion is Wealth maximization Only in order to replace bottlenecks which were associated with the profit maximization. Wealth maximization means that value / net worth maximization. The Worth of Action normally happens only at when the Value of benefits are more than the Cost of its undertaking. In other words, the wealth maximization is defined in the angle of the concept of cash flows. The Cash flows are clearly dealt only in accordance with the "CASH SYSTEM"-Definite Connotation It eliminates the ambiguity associated with accounting profits Second feature - timing of benefits and quality of benefits are jointly considered Operational implications of timing of benefits and quality of benefits The timing and quality of benefits are given greater importance under the wealth maximization through the incorporation of capitalization rate which is applied to the tune of risk and timing of benefits associated with the project. The discounting component mainly depends upon the time and risk preferences of the owners of the capital The importance of the wealth maximization is explained through the discount rate component Higher the discount Rate reveals that Higher Risk and Higher uncertainty
210
Lower the discount Rate portrays that Lower Risk and Lower uncertainty
The Decision Criterion is based on the comparison in between the Value and Cost The Creation of Value takes place only at when the economic benefits are more than Cost The Reduction of wealth just contrary to the earlier which normally produces lesser Economic Benefits than Cost The decision of either acceptance or rejection is subject to the net present value It is imperative to refer the words of Ezra's Solomon to illustrate the importance of the wealth maximization "The gross present worth of a course of action is equal to the capitalised value of the flow future expected benefit, discounted at a rate which reflects their certainty/uncertainty. Wealth or net present worth is the difference between gross present worth and the amount of capital investment required to achieve the benefits being discussed. Any financial action which rates wealth or which has a net present worth above zero is a desirable one and should be undertaken. Any financial action which does not meet this test should be rejected. If two or more desirable courses of action are mutually exclusive, then the decision should be to do that which creates most wealth or shows the greatest amount of net present worth" W = V-C W = Net present worth V = Gross present worth C = Investment required to acquire the asset/purchase the course of action V = E/K E = Size of the benefits available to the suppliers of capital K = capitalization rate reflecting quality and Timing of benefits attached to E E = G(M+I+T) G = Average future flow of gross earnings expected from the course of action, before the maintenance charges, taxation, expected flow of interest, preference dividend M = Average annual required investment to maintain G I =Expected flow of annual payments of Interest, Preference Dividend and other prior charges T=Expected annual outflow of taxes Alternate method:
A1 A2 A3 An + + -C ....... + 1 2 3 (1 + K) (1 + K) (1 + K) (1 + K) n
A1, A2, A3--------depicts the flow of cash resources from a course of action over the period of time K=is an appropriate discount rate C=Initial outlay to acquire the asset If the out come is positive means that net present worth is positive i.e., more than the initial investment, considered to be fruitful for the investment and vice versa Wealth of the investors= market value of the shareholding of the investors If net worth is positive then the wealth of the investors will go up ; it means that the market value of the share holding of the investors will pile up. It is called in other words as Maximization of market value of the shares.
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12.5 OBJECTIVES & FUNCTIONS OF FINANCIAL MANAGEMENT

The next aspect is that organization of finance function. The finance function is classified into two categories viz routine functions and functions of special importance. The routine functions are normally Accounting aspects of transactions of the business enterprise which mainly given controller of the finance department. The functions of special importance are normally involved in the process of preparing the policies of the organization with reference to finance administration ; which is mainly earmarked to the Treasurer of the finance department of the organization The following are the important functions of the Treasurer which normally have special importance in characteristics: Obtaining finance Banking relationship Investor relationship Short-term financing Cash management Credit administration Investments Insurance The following are the vital functions of the Controller which regularly include: Financial accounting Internal audit Taxation Management accounting and control Budgeting, planning and control Economic appraisal and so on
Check Your Progress
1.
Finance is the
(a) (c) Money with motive Money with objective (b) (d) Money with purpose (a), (b) and (c)
2.
Wealth is defined as
(a) (c) Gross cash flow Initial investment (b) (d) Net cash flows None of the above
3.
Why profit maximization is sidelined ?

(a) (c) Ambiguous Timing of benefits (b) (d) Lack of quality of benefits (a), (b) and (c)
4.
Which of the following function is the treasurer of the organisation?

(a) Obtaining finance Internal audit (b) (d) Financial accounting None of the above
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(c)
12.6 LET US SUM UP

The major part of the financial management is to raise the financial resource to the requirements. While raising the financial resources, the availability is subject to the macro economic influences. Accounting is mainly vested with the collection and presentation of data. But the finance is closely connected with the decision-making of the organization. The objectives of the financial management are classified into two categories viz Profit maximization Wealth maximization Profit is defined in two different angles viz. Owner's and Operational perspective. Owners' perspective definition of profit is the share of national income paid to the owners. Operational perspective defines the term profit as when the output exceeds the inputs of the process. "The gross present worth of a course of action is equal to the capitalised value of the flow future expected benefit, discounted at a rate which reflects their certainty/uncertainty. Wealth or net present worth is the difference between gross present worth and the amount of capital investment required to achieve the benefits.

What factors would you look at while taking capital structure decisions? Give your opinion.
12.8 KEYWORDS
Finance: A study of money with objective and desired direction Profit: In terms of operations - Input < Output Treasurer: Who carries out the financial management operation with special importance Controller: Who carries out the routine functions of finance Wealth maximization: Net present worth maximization; maximization of the market value of the shares

1. 2. 3. 4. 5. 6. What is meant by finance? Explain the relationship in between the finance and their related disciplines. Explain the objectives of financial management. Elucidate the profit maximization in detail. List out the drawbacks associated with the profit maximization. Highlight the importance of Wealth maximization.

R.L. Gupta and Radhaswamy, Advanced Accountancy V.K. Goyal, Financial Accounting, Excel Books, New Delhi. Khan and Jain, Management Accounting S.N. Maheswari, Management Accounting S. Bhat, Financial Management, Excel Books, New Delhi. Prasanna Chandra, Financial Management Theory and Practice, Tata McGraw Hill, New Delhi (1994). I.M. Pandey, Financial Management, Vikas Publishing, New Delhi. Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.
213
LESSON
13
TIME VALUE OF MONEY
CONTENTS
13.0 Aims and Objectives 13.1 Introduction 13.2 Foundations of The Time Value of Money 13.3 Classifications of The Time Value of Money 13.3.1 Rule of 72 13.3.2 Rule of 69 13.4 Frequency of Compounding 13.5 Effective Rate of Interest 13.6 Future Value of an Annuity 13.6.1 Future Value of Annuity Due 13.6.2 Sinking Fund Factor Method 13.7 Present Value of Single Cash Flow 13.8 Present Value of Annuity 13.9 Capital Recovery Factor Method 13.10 Let us Sum up 13.11 Lesson-end Activity 13.12 Keywords 13.13 Questions for Discussion 13.14 Suggested Readings

This lesson is intended to discuss the concept of time value of money and its role in studying the viability of the project by comparing the initial investment future benefits. After studying this lesson you will be able to: (i) (ii) describe concept and components of the time value of money classify the time value of money and describe rules of 72 and 69
(iii) understand effective rate of interest and future value of an annuity
13.1 INTRODUCTION
The time value of money has gained greater importance in studying the viability of the project by comparing the initial investment with the anticipated future benefits. If the anticipated future benefits are more than the initial investment then the investment is found to be viable in generating the economic benefits.
214
Why the time value of money principle is warranted to study under the financial management ? The following are the many reasons involved: To determine the real rate of return With reference to Money employment on productive assets In an inflationary period, a rupee today has greater purchasing power than rupee in the future The future is uncertain- Individuals prefer current consumption rather than future consumption
Time Value of Money
13.2 FOUNDATIONS OF THE TIME VALUE OF MONEY

There are two, one is the time preference of money and another one is reinvestment opportunity which are identified and inter related with each other. Early receipt of money paves way for the reinvestment opportunity but the later receipt does not carry the things. Time value of money normally contains three different components viz: Real rate of return: It is the return which consider original return of the investment but it never considers the inflation rate. Expected/Anticipated rate of return: It is the positive rate of return normally expected by every one on the amount of investment from the future. Risk premiums: This an allowance is normally given to the investors to compensate the uncertainty.
13.3 CLASSIFICATIONS OF THE TIME VALUE OF MONEY

The concept of time value of money can be classified into two major classifications: Future value of money Present value of money Future value of money: It is further bifurcated into two different categories viz Future value of single sum and Future value of an Annuity Present value of money: It is further classified into two major classes viz Present value of single sum and Present value of and Annuity Future value of single sum: It could be found from the inbound relationship in between the future value of money and present value of money. FVn = PV(1+K)n FVn = Future Value of Cash Inflow PV = Initial Cash Flow K = Annual Rate of Return N = Life of Investment Illustration 1 If you deposit Rs.1,000 today in a Indian bank which pays 10% interest, find out the future value of money after 3 years.
215
Future value of Rs.1,000 after three years will be = Rs.1,000(1+.10)3 = Rs.1,000(1.331)= Rs. 1,331 Doubling period: It is the period which makes the investment as "Doubled" There are two different approaches viz Rule of 72 Rule of 69
13.3.1 Rule of 72
The initial amount of investment gets Doubled within which 72/I I = Interest Rate of the investment Illustration 2 The amount of the investment is Rs.1,000. The annual rate of interest is 12%. When this amount of Rs.1,000 will get doubled ? = 72/12 = 6 years
13.3.2 Rule of 69
The amount method is found to crude method in determining the doubling period which has its own limitations. The Rule of 69 was developed only in order to remove the bottlenecks associated with the early model of doubling period. The rule of 69 is found to be a scientific method as well as rational method in determining the doubling period of the investment =.35+ 69/I Illustration 3 The amount of the investment is Rs.1,000. The annual rate of interest is 11% When this amount of Rs 1,000 will get doubled? =.35+ 69/11= 6.6227 yrs
Check Your Progress
1. 2.
State Bank of India announces that your money is getting doubled in 99 months. What is the rate of interest payable ? The next aspect in the Future value of money is interest frequency of compounding.
13.4 FREQUENCY OF COMPOUNDING

Whenever any compounding is taking place, the following methodology has to be adopted for the determination of the future value of money. FV = PV(1+k/m)mxn M = Number of Times Compounding is done during the year N = number of years K = compounding rate
216
Illustration 4 How much does a deposit of Rs. 5,000 grow to at the end of 6 years. If the nominal rate of interest is 12% and frequency is 4 times a year? The future value of Rs. 5,000 will be = Rs.5,000(1+.12/4)46 = Rs.5,000(2.033)= Rs.10,165
Time Value of Money
13.5 EFFECTIVE RATE OF INTEREST

It is the rate of interest at which mount of the principal grows with regards to the rate of compounding. r = (1+K/m)m - 1 K = Nominal Rate of Interest r = Effective Rate of Interest m = Frequency of Compounding Illustration 5 A bank offers 8% nominal rate of interest with quarterly compounding. What is the effective rate of interest ? R = (1+.08/4)4 -1=1.082-1=.082 i.e 8.2%
13.6 FUTURE VALUE OF AN ANNUITY

Annuity may be a series of either payments or receipts The annuity can be classified into two categories
L L
Annuity at the end of the period- Regular / Deferred Annuity Annuity at the beginning of the period - Annuity Due Annuity at the end of the period FVAn = =
A (1 + K) n 1 Future Value Interest Factor Annuity (FVIFA) k
Illustration 6 Suppose you deposit Rs.1,000 annually in a bank for 5 years and your deposits earn a compound interest rate of 10% What will be value of the deposit at the end of 5 years? Assuming the each deposit occurs at the end of the year, the future value of this annuity? FVAn = Rs.1,000(FVIFA) for 10% and 5 years = Rs.1,000
[(1 + .10)5 -1] .10
= Rs.1,000 6.105 = Rs.6,105
13.6.1 Future Value of Annuity Due

FVAn = =
A (1 + K) n 1 (1+k) k
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Illustration 7 If you invest Rs 1,000 at the beginning of every year, for four years. What will be the value of the investment finally.
.10 = Rs.1,000 6.7155= Rs.6,715.5
FVAn = Rs.1,000
[(1 + .10) 1] (1+.10)

5
Check Your Progress
1.
Four annual equal payments of Rs.2,000 are made into a deposit account that pays 8% interest per year. What is the future value of this annuity at the end of 4 years ? You can save Rs.2,000 a year for 5 years, and Rs.3,000 a year for 3 years thereafter. What will these savings cumulate to at the end of 8 years. If the rate of interest is 10?
2.
13.6.2 Sinking Fund Factor Method

It means that the amount to be deposited at the end of every year for the period of "n" years at the rate of interest "K" in order to aggregate Re.1 at the end of the period. A = FVA [K/(1+K)n -1] Illustration 8 How much you should save annually to accumulate Rs.20,000 by the end of 10 years. If the saving earns an interest of 12 %? A = Rs.20,000[.12/(1+.12)10 -1] = Rs.20,000(.05698)=Rs.1,139 The next most important segment is present value of money. First we will discuss the present value of single cash flow
Check Your Progress
1. 2.
How much you should save annually to accumulate Rs.20,000 by the end of 10 years. If the saving earns an interest of 12%? Mr vinay plans to send his son for higher studies abroad after 10 years. He expects the cost of these studies to be Rs.1,00,000. How much should he save annually to have a sum of Rs 1,00,000 at the end of 10 years. If the interest rate is 12%?
13.7 PRESENT VALUE OF SINGLE CASH FLOW

It is the process in which the future value of single cash flow is reckoned to "0" time horizon i.e on today. PVn = FVn /(1+R)n Illustration 9 Find the present value of Rs.1,000 receivable 6 years hence if the rate of discount is 6 percent PVn = Rs.1,000/(1+.06)6 = Rs.1,000(.705)
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= Rs.705
Shorter Discounting Periods

The discounting may be frequent in times like intra year compounding, intra month compounding and so on. Subject to
L L L L L
Time Value of Money
Number of periods in the analysis- increases Discount rate applicable per period decreases PV= FV 1 + k /m M = number of times discounting K = Discount rate
1
m xn
Illustration 10 Consider the following cash inflow of Rs.10,000 at the end of four years. The present value of cash inflow when the discount rate is 12% and discounting quarterly. PV = Rs.10,000 (.623)=Rs.6,230
Check Your Progress
To get Rs.20,000, how much should be invested per year (at the end). The important information of the banking investment reveals the following are the rate of interest is 10% and the normal compounding process is once in 6 months.
13.8 PRESENT VALUE OF ANNUITY

Present value of an annuity - Present value of future cash series - To identify the value of future cash flows on present value
(1 + K) n -1 PVAn,k = Present value factor annuity K(1 + k)n

Illustration 11 If you expect to receive Rs.1,000 annually for 3 years, each receipt is expected to be at the end of the years. What would be the present value of future cash inflows @ discount rate of 10% ? PVA n,k = Rs.1,000 (2.487)= Rs.2,487
Check Your Progress
1. 2. 3.
What is the present value of an annuity of Rs.2,000 at 10% ? What is the present value of a 4 year annuity of Rs.10,000 discounted at 10 % ? A 10 payments annuity of Rs.5,000 will begin 7 years hence. (The first payment occurs at the end of 7 years) what is the value of this annuity now if the discount rate is 12 per cent ?
13.9 CAPITAL RECOVERY FACTOR METHOD

K(1 + k) A = PVA Reciprocal to Present value of an annuity (1 + K) n -1
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Illustration 12 If your father deposits Rs.1,00,000 on retirement in a bank which pays 10% annual interest. How much can be withdrawn annually for a period of 10 years? A = PVA(1/PVIFA) A = Rs.1,00,000 (1/6.145)= Rs.16,273
Present Value of Perpetuity

Perpetuity means that series with indefinite duration P? = A PVIFA k, ? Illustration 13 The present value of perpetuity of Rs.10,000@ 10%, how much should be invested on today ? A = P?/ PVIFA k, ? = Rs.10,000/.10= Rs.1,00,000
Check Your Progress
1.
Time value of money is applicable in

(a) (c) Pay back period method Discounted cash flows method (b) (d) Accounting rate of return method None of the above
2.
Compounding factor is to determine

(a) (c) Present value Present value and Future value (b) (d) Future value None of the above
3.
Annuity due means that

(a) (c) Series at the end (b) Series at the beginning None of the above
Neither at the beginning nor at the end (d)
4.
Capital recovery factor method is to find out the value of annuity through
(a) (b) (c) (d) Present value of an annuity Reciprocal to the present value of annuity Future value of annuity None of the above
5.
Rule of 72 is for
(a) (b) (c) (d) To determine the present value of the cash flows To find out future value of cash flows To find out the doubling period None of the above
13.10 LET US SUM UP

The time value of money has gained greater importance in studying the viability of the project by comparing the initial investment with the anticipated future benefits. Real rate of return is the return which consider original return of the investment but it never considers the inflation rate. Expected/Anticipated rate of return is the positive rate of return
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normally expected by every one on the amount of investment from the future. Risk premiums is an allowance is normally given to the investors to compensate the uncertainty.
Time Value of Money

How much would you invest now at 5% per annum compounded annual if you want to get Rs. 5,00,000 after 20 years.
13.12 KEYWORDS
Time value of money: Money value in terms of time, money value in between the present and future Future value of money: Present value of money in terms of future through compounding process Present value of money: Future value of money is reckoned to "0" time period horizon FVIF: Future value interest factor component for compounding FVIFA: Future value interest factor component for compounding the series of cash payments or receipts PVIF: Present value interest factor of single cash flow PVIFA: Present value of interest factor of multiple cash flows Regular annuity: Series which normally happen at the end of the specified horizon Annuity Due: Series which normally happen at the beginning Doubling period: During which the amount of the investment gets doubled within the given compounding factor component Effective rate of interest: It is the rate of interest which the investment grows

1. 2. 3. 4. 5. 6. Define time value of money Explain the foundations of the time value of money Explain the classifications of the time value of money Illustrate the rule of 69 with live example from the banking industry Explain the applications of the time value of money in the banking companies Which method is applied for EMI calculation by the financing companies?

R.L. Gupta and Radhaswamy, Advanced Accountancy. V.K. Goyal, Financial Accounting, Excel Books, New Delhi. Khan and Jain, Management Accounting. S.N. Maheswari, Management Accounting. S. Bhat, Financial Management, Excel Books, New Delhi. Prasanna Chandra, Financial Management Theory and Practice, Tata McGraw Hill, New Delhi (1994). I.M. Pandey, Financial Management, Vikas Publishing, New Delhi. Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi. M.P. Pandikumar Accounting & Finance for Managers Excel Books, New Delhi.
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LESSON
14
SOURCES OF LONG TERM FINANCE
CONTENTS
14.0 Aims and Objectives 14.1 Introduction 14.2 Equity Shares 14.2.1 Sweat Security 14.2.2 Non Voting Shares 14.2.3 Bonus Issue 14.3 Preference Shares 14.3.1 Cumulative Preference Shares 14.3.2 Non Cumulative Preference Shares 14.4 Debentures 14.5 Bonds 14.6 Warrants 14.7 Let us Sum up 14.8 Lesson-end Activity 14.9 Keywords 14.10 Questions for Discussion 14.11 Suggested Readings

In this lesson we will study about long term finances of companies. After studying this lesson you will be able to: (i) (ii) describe the concepts of equity share, sweat security, non-voting shares and bonus issues. distinguish between cumulative and non-cumulative preference share.
(iii) explain the features of debentures, bonds and warrants.
14.1 INTRODUCTION
The sources of long-term finance could be classified into the following categories: Equity shares Preference shares Debentures Bonds Warrants
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The combination of the sources of long-term finance is known as capital structure. From the above classification, we will discuss one after the another.
Sources of Long Term Finance
14.2 EQUITY SHARES

Shares and Stock are synonymous in usage. Shares are the expression of smaller units of Share capital of the organization. The raising of equity share capital from the investors in various segments viz Application money, First call money and Subsequent calls money are collected subject to the capital clause of the Memorandum of Association of the organization. After the issue, the share certificates are issued which normally depicts the expression of right of shares. Right of Equity Shares: Sec. 85(2) of the Companies Act, 1956 expresses the right of the equity shareholders who hold the equity shares To vote To control the management To share the profits To claim on the residual portion during the winding up To exercise pre-emptive To apply the court To receive the copy of the statutory report, copy of the annual accounts To apply the central government for AGM - failure on the part of the company To apply company law board for Extraordinary general meeting
14.2.1 Sweat Security

It is one kind of Equity share, which was introduced in the Ordinance 1998, facilitating the companies to acquire the technical know-how, intellectual property through the issue of equity shares. Definition The equity shares which are issued at discount to employees and directors and consideration other than cash for Technical know-how, intellectual property are known as sweat security. Normally the sweat security is issued by the companies in two different categories: Sweat security which is issued at preferential pricing more specifically for employees Sweat security which is issued at face value, that may be either at par or above par
14.2.2 Non Voting Shares

These type of equity shares never carry any voting rights. These type of shares are also eligible to enjoy the bonus issue and exclusive listing for the holding of the shares. When Two year Dividends are continuously missing, the nature of the non voting shares will automatically become as Voting shares. The Non voting shares are to be declared 20% dividend more than the ordinary dividend. The issue size of the Non voting shares should not exceed the maximum limit of the voting stock i.e. 25%.
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14.2.3 Bonus Issue

This type of issue is merely considered as book entry in between the two different sources of long term finance viz Free Reserves and Equity Share capital. This type of issue is normally restricted to the companies which are having the partly paid equity shares. The bonus issue is permitted by making the partly paid up shares into fully paid shares. The bonus issue is normally decided in the board meeting.
14.3 PREFERENCE SHARES

These type of shares are annexed with preferential rights over the equity shares in sharing the benefits organization at the moment of declaration. It is nothing but the combination of both equity shares and debentures; why ? It has some features of equity shares and debenture through redemption. The dividends are normally paid only to the tune of fixed rat which was agreed only at the moment of issue in between the issuing company and investors. The dividends are normally declared by them only subject to the availability of profits. Type of Preference Shares: The following are the various type of preference shares which the company normally issues:
14.3.1 Cumulative Preference Shares

The unpaid preference dividends are paid before anything paid to equity shareholders. The unpaid preference dividends are called in other words as Arrearages. The arrearages should not go beyond three years. The arrearages never carry any interest rate. If any provision is available in the Articles of Association, the arrearages are paid to preference shareholders at the moment of liquidation.
14.3.2 Non Cumulative Preference Shares

The dividends are paid subject to the availability of profits. If the availability of profits are not sufficient for the declaration of preference dividend, which do not bear any right to receive. Due to non declaration of dividends during the previous years, these types of shareholders are not entitled to share in the surplus benefits of the company, but they are having the right to receive the dividend prior to the equity shareholders in any particular year.
No Rights to Share in the Surplus Profits

Right to receive the dividend prior to the equity shareholders in any particular year. The repayment of share capital normally takes place only at the moment of winding of the companies. Convertible preference shares: These types of shares are issued by the company along with the right of conversion to convert the holding into equity shares at the specified period. Normally, during the process of conversion, the companies charge higher premium from the shareholders. The voting powers, bonus issue, higher dividends and so on are subject to the availability of rights out of the conversion. Redeemable preference shares: Under this category, the amount of raised capital is subject to redemption/repayment, which means that when any preference shares are revealing the definite time period of repayment is known as redeemable preference shares. Non redeemable preference shares: These types of preference share never carry any definite period of repayment but at the moment of winding up the repayment is made immediately after the creditors. Participating preference shares: The type of preference shares facilitates the holders to share the surplus benefits immediately after declaring the dividend benefits to preference shareholders and equity shareholders.
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Non Participating preference shares: Except the earlier, all are nothing but non participating preference shares in category.
14.4 DEBENTURES
Sec 2(12) of the Companies Act defines "Debenture includes debenture stock, bonds and any other securities of a company whether constituting a charge on the assets of the company". Debenture is an evidencing document i.e., long-term promissory note.
Unique Features of the Debentures

Debentures are issued on indebtedness It is an instrument which indicates the time/date schedule of repayment of principal or interest The Charge is created on the assets of the company ; to protect the interest of lenders. If any default arises - the due amount of either principal or interest will be claimed through direct or debenture trustees action for the realization assets in order to secure the debt Debentures are classified on the following basis: On the basis of security On the basis of holding On the basis of redemption On the basis of convertibility On the basis of Security: Under this type the debentures are further classified into two categories viz secured and unsecured debentures: Secured/Naked Debentures: There is no charge on the assets of the company which means that there is no claim on the company at the moment of default. These debentures are normally issued by the company through their well built good will during the past. Secured or Mortgage Debenture: The type of the debentures bearing the security through the creation of charge either whole or part of the assets of the company are known as secured or mortgage debentures. These types of debentures warrant registration and finally immediately after the registration process the title deeds should be deposited under the custody of the lender. On the basis of holding: These types of debentures are further divided into two categories viz Bearer and Registered Debentures. Bearer Debenture: The interest periodical is payable to the bearer and transferable by mere delivery. It never requires registration to enter in the books. The holder is simply having the eligibility for redemption Registered Debentures: The holders are required to register in the register in accordance with the Sec 152 of the Companies Act. On the basis of redemption: This classification has two types viz Redeemable and Irredeemable: Redeemable Debentures: Redeemable after the expiry period - Re issuance is possible with reference to Sec 121 of the companies act 1956 Irredeemable Debentures: These debentures are issued to redemption of specific event which is non happening in nature for indefinite period for e.g. Winding up of the company.
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On the basis of Conversion: This type of debentures are trifurcated into the following viz Fully convertible, Partly convertible and Non convertible: Fully Convertible Debentures This type of debentures are fully converted into Equity shares with premium or without premium. The Conversion is normally takes after expiry of the period. The conversion is optional purely left with the discretion of the debentureholders which normally ranges in between 18 and 36 months. The interest periodical is payable till the process of conversion is over. Non Convertible Debentures: This type of debentures never carry any option of conversion to avail the equity shares of the company immediately after conversion. In other words, these debentures are denial of option of conversion. Partly Convertible Debentures: Under this category, there are Two parts involved, one part is meant for conversion; second part is non convertible portion: Convertible portion is the portion which can be availed for conversion at or after 18 months upto 36 months, it is at the optional right of the debentureholders. Non convertible portion - It does not carry any convertible portion instead it bears the redeemable portion for redemption after the expiry period. The next important classification under the long-term sources of finance is Bonds
14.5 BONDS
It is a long-term debt instrument issued by the company to raise the financial resources from the market, for specific period and it carries fixed rate of interest which has its own salient features Issued at face value i.e Par value and Par or Discount. Rate of interest is fixed or flexible i.e. variable / floating rate of bond - coupon rate of bond. Maturity date is specified but not in the case of perpetual bonds. Redemption value - in the bond certificate - may be par or premium - terms of the issue. Bonds are traded in the market.
Type of Bonds
Secured Bond: Issued on the assets of the issuer. Unsecured Bond: Issued by the issuer on the basis of name and fame. Perpetual bond: Bonds do not have maturity. Redeemable bond: Redemption or Repayment of the principal is specified by the issuer. Fixed rate bonds: Rate of Interest is fixed at. Flexible/Floating rate bonds: Rate of interest is subject to prefixed norms. The further more classification of bonds are available. They are following: Zero Coupon bonds: These bonds are sold at discounted value and will be given at the face value after the maturity period.
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Deep discount bonds: It is another kind of zero coupon bond. Large discount is made on their nominal value. Interest is paid only at the time of maturity - 3-25 years. Pay in kind bonds: This another kind of long-term instrument of raising funds. During the First three years, these bonds need not pay any interest to the holders of the bonds, in stead the interest bonds are issued which are known as additional bonds. These additional bonds are called as baby bonds or kid bonds which are derived out of the parent bond. It is identified by the many of the companies as wonderful instrument to raise the capital from the market at the early stage of commencement of business. The next type long-term instrument is that Warrants.
14.6 WARRANTS
These are nothing but Bearer documents which are title to buy the specified number of equity shares at specified price during the future period. The life period of the warrants are normally too long. The warrants are normally issued by the company only in order to attract the issue of fixed bearing securities viz preference shares and debentures. The following are the various type of warrants: Detachable warrants: Warrants which are issued along with the host securities; detachable Puttable warrants: The warrants issued are sold back to company before expiry date Naked warrants: Warrants issued without any host securities Advantages of the warrants Making other host securities more attractive It facilitates the companies to stand on its own leg and reduces the rate to depend on the intermediaries The exercise of the warrants only during the future period which fosters better planning for the company Lower cost of debt due to greater attraction towards warrants - denominated in terms of equity shares - which are at later date Warrants are highly liquid which means they are traded in the Stock Exchanges provided the warrants should not be exercised.
Check Your Progress
Select the most appropriate one: 1. Equity share means

(a) (b) (c) (d) Equal share in the volume Equal share in the assets claim Equal and Small units of the share capital None of the above
2.
Preferential share is
(a) (b) (c) (d) Issued at preferential price Preferential rights over the debentures Preferential rights over the equity shares None of the above Contd....
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3.
When non voting share will become as a voting shares

(a) (b) (c) (d) For the continuous payment of dividends For the continuous non payment of dividends for the period of 3 years For the continuous payment of dividends None of the above
4.
In which case the bond are issued instead of interest payment

(a) (c) Naked bonds Cumulative bonds (b) (d) Pay in kind bonds Secured bonds
5.
Non convertible portion of the debenture is

(a) (c) Convertible at later date Redeemable (b) (d) Irredeemable None of the above
6.
Warrants are
(a) (c) Title to buy the preference shares Title to buy the equity shares (b) (d) Title to buy debentures Title to buy bonds
14.7 LET US SUM UP

Shares and Stock are synonymous in usage. Shares are the expression of smaller units of Share capital of the organization. The raising of equity share capital from the investors in various segments. Normally the sweat security is issued by the companies in two different categories: Sweat security which is issued at preferential pricing more specifically for employees Sweat security which is issued at face value, that may be either at par or above par The unpaid preference dividends are paid before anything paid to equity share holders. The unpaid preference dividends are called in other words as Arrearages. Debentures are classified on the following basis: On the basis of security On the basis of holding On the basis of redemption On the basis of convertibility Bond is a long-term debt instrument issued by the company to raise the financial resources from the market, for specific period and it carries fixed rate of interest which has its own salient features. Warrants are nothing but Bearer documents which are title to buy the specified number of equity shares at specified price during the future period. The life period of the warrants are normally too long.

Distinguish between preference and non-preference shares. What are the advantages of preference share?
14.9 KEYWORDS
Share: smaller unit of the share capital of the company
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Preference share: Preferential rights are pegged with this type of a share to share anything from the company prior to the equity shareholders
Bond: Long-term debt instrument Debenture: Long-term debt instrument floated by the company with or without charge on the assets of the company. Security: The amount of lending is secured through the charge on the assets Redemption: Time period of repayment and payment of the principal and interest respectively are known Warrants: Title to buy equity shares at the specified price in the future date Host securities: These are the securities which are normally issued by the company along with the warrants viz preference share and debenture Naked warrants: Without any host securities, if any warrants are issued

1. 2. 3. 4. 5. 6. 7. 8. 9. Define equity share. Define debentures. Briefly explain the sweat security. What is meant by preference shares? Explain various types of preference shares. Explain the various types of debentures. Define bonds. Explain the various types of bonds. Define warrants.
10. Explain the advantages of issuing the warrants. 11. Elucidate the various classifications of warrants.
12. Why warrants are issued?

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LESSON
15
CAPITAL MARKET DEVELOPMENTS IN INDIA
CONTENTS
15.0 Aims and Objectives 15.1 Introduction 15.2 Capital Market Reforms - In General 15.3 Reforms in Primary Market 15.3.1 Reforms in the Primary Market: 1996-97 15.3.2 Reforms in 1997-98 15.3.3 Reforms in 1998-2001 15.4 Reforms in the Secondary Market 15.4.1 Capital Market Reforms: 1996-97 15.4.2 Capital Market Reforms: 1997-98 15.4.3 Capital Market Reforms: 1998-2001 15.4.4 Capital Market Reforms: 2005-2007 15.5 Let us Sum up 15.6 Lesson-end Activity 15.7 Keywords 15.8 Questions for Discussion 15.9 Suggested Readings

This lesson is intended to discuss about primary and secondary capital markets in India. After studying this lesson you will be able to: (i) (ii) describe overall capital market reforms explain reforms in primary market
(iii) discuss reforms in secondary market
15.1 INTRODUCTION
The capital market is one of the important constituents of the economy to groom and develop to attain the required growth rate through the attraction of corpus from not only in domestic market but also from international markets. In India, the capital market is more vibrant in the modern days due to many more developments routed through the structured mechanism of the market. The structured market facilitates to bring forth many developments in the capital market only in order to facilitate the companies to attract more investors to contribute financial resources to the requirement.
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The participation of the investors is subject to the market environment conditions. To attract more investors from the various corners of the market, the developments are inevitable. The development of the capital market in India are many fold and multi structured. The series of development could be studied one after the another.
Capital Market Developments in India
15.2 CAPITAL MARKET REFORMS - IN GENERAL

Replacement of the office of CCI by the SEBI guidelines during the year 1992, February Exchange of powers of the SCRA/1956 57,2000 were transferred to office of SEBI - notification issued Inducement for investor claims through consume courts and redressal forum of investor associations Permission of the foreign equity participation With the permission of RBI, NRIs were permitted to invest in the equity shares and debentures Norms relaxed for the Indian firms to raise financial resources Sebi's autonomy reinforced through the Section of 30 - without any consultation of the central govt Introduction of OTCEI and NSE - electronic nationwide trading
15.3 REFORMS IN PRIMARY MARKET

Merchant banking and banking code installed Due diligence certificate from the lead managers Disclosure norms Companies details - facts and risk factors associated with their projects Stock exchanges required to ensure the formalities with the companies during the issues Restriction in the usage of Stock invest - institutional investors Disclosure norms for the advertisement Underwriting is optional and if it is not carried out due to bring down the issue cost 90% of the amount offered to the public - should be refunded Bonus guidelines were relaxed New system introduced for preferential issue - pertaining to pricing Shri Y H Malegam disclosure requirements and issue procedures SEBI to vet the prospectus within 21 days from the date of issue and approval by the registrar companies is given a time period of 14 days Abridged prospectus - should be vetted by the SEBI
15.3.1 Reforms in the Primary Market: 1996-97

Norms were tightened - to enhance the quality of the paper First time issuers - dividend payment record in three of the immediately preceding five years If this requirement is not applicable in the case of companies - appraisal should be done through commercial banks or financial institutions -10% contribution from the issuer out of the total size of the issue
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For banks - no restriction but if the issues are premium priced - two years profitability record Prohibition on direct or indirect discounts during the moment of allotment 90% of the subscription waived due to minimum share holding Housing finance companies allowed to function as registered issue facilitating companies in along with the refinancing from the National housing bank The promoters contribution should be in a phased manner if it crosses Rs.100 cr Debt securities could be listed in the stock exchanges without any listing of equity shares.
15.3.2 Reforms in 1997-98

Entry for unlisted companies modified Partly paid up shares should be either fully converted or forfeit 3 years profitability required for the unlisted companies for the issuance of share capital For rights issue - Registrar should be separately deputed Details of the promoters should be given in the offer document Only body corporates allowed to function as merchant bankers Merchant bank classifications abolished Merchant banks are not permitted to carry out the fund related activities; if any corporates are available - suitable breathing time was given to restructure the activities
15.3.3 Reforms in 1998-2001

Entry norms revised Pre issue net worth should not be less than 1 cr in 3 preceding years out of 5 Merchant banks registered with RBI as NBFCs eligible to trade Govt securities Mutual funds permitted to derivatives Further updating was made in the companies act to protect the investors Additional power granted to SEBI for the violation of the companies act SEBI compendium 2000 issued On line offerings were encouraged by SEBI Regulation of rating agencies framed ESOP guidelines Changes introduced on mutual funds the P.K.Kaul committee Issue freedom is given to companies but not less than Re 1 100% book building route introduced
15.4 REFORMS IN THE SECONDARY MARKET

Guidelines with reference to substantial takeovers and acquisitions - disclosures Guidelines with regards to mandatory public offer to the investors Several mutual funds were allowed UTI brought under the sebi Advertising code was initiated as well as the requirements of pre-vetting of advertisement removed To improve the role of the Mutual fund as well as to develop the market of mutual fund in India, mutual funds were given - right to underwrite the public issues and to make investments in the money market Jumbo transfer was introduced for the institutions
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Carry forward system of transactions are permitted to SEs after getting the consent and surveillance Carry forward transactions are limited in the case of lenders of the transactions Carry forward transactions should be disclosed on the basis of scrip and broker at the beginning of carry forward session Capital adequacy norms were introduced Depositories were introduced during the year 1995 Sept.; to record the ownership in the book form The introduction of depository requires the changes in the following enactments
L L L
Capital Market Developments in India
Companies Act Stamp Duty Act Income Tax Act
15.4.1 Capital Market Reforms: 1996-97

Depositories Act 1996 - promulgated in order to reduce the problems associated with the handling of securities Guidelines for the custodian of securities were clearly drafted Custodian of securities- compliance officer should be appointed - to bridge the gap in between Changes are expected to discuss during the monthly meetings of Association of Custodian of security services Bad delivery cell was set up and code was specified System of clearing house or clearance corporation to be set up in the stock exchange Separate committee has been set up for surveillance - inter stock exchange transactions Mumbai and other stock exchanges were allowed to install terminals - where no exchange exists - to have on line trading Norms of the OTCEI were eased to promote more transactions

Daily carry forward margin reduced to 10% from 15% Over all carry forward increased to Rs.20 crs per broker

Buy back of securities were permitted Circuit breaker system was introduced to control volatility Dematerialized trading was installised Rolling settlement introduced Internet trading was introduced Guidelines were issued in the angle of maintaining the transparency Clause 49 - to maintain corporate governance introduced Stock watch system was introduced Steps introduced to reduce the transaction costs Trading of stock index and futures - BSE and NSE commenced For trading of debt securities - to promote debt market - steps taken

Golden pegged return funds permitted
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IPO norms are tightened Grading of IPOs are suggested
15.5 LET US SUM UP

In India, the capital market is more vibrant in the modern days due to many more developments routed through the structured mechanism of the market. The development of the capital market in India are many fold and multi structured. Dematerialisation is Transforming the physical securities into electronic transformation sheets through the maintenance of Demat A/c. Book building is a process for identifying the right price of the process.

Discuss critically about the reforms initiated in capital market in India.
15.7 KEYWORDS
IPO: Initial Public offering BSE: Bombay Stock Exchange NSE: National Stock Exchange OTCEI: Over the Counter Exchange of India SEBI: Securities Exchange Board of India SCRA: Securities Contract Regulation Act Grading: Rating from the credit rating agencies Dematerialisation: Transforming the physical securities into electronic transformation sheets through the maintenance of Demat A/c Book building: It is a process for identifying the right price of the process CCI: Controller of Capital Issues Act ESOP: Employees Stock Option Scheme

1. 2. 3. 4. Give brief introduction about the capital market reforms in India. Write an elaborate note on the primary market reforms in India. Elucidate the secondary market reforms in India. Why SEBI requires the IPOs to obtain grading from the agencies?

M.P Pandikumar Accounting & Finance for Managers, Excel Books, New Delhi. R.L. Gupta and Radhaswamy, Advanced Accountancy. V.K. Goyal, Financial Accounting, Excel Books, New Delhi. Khan and Jain, Management Accounting. S.N. Maheswari, Management Accounting. S. Bhat, Financial Management, Excel Books, New Delhi. Prasanna Chandra, Financial Management Theory and Practice, Tata McGraw Hill, New Delhi (1994). I.M. Pandey, Financial Management, Vikas Publishing, New Delhi.
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Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.
LESSON
16
INDIAN FINANCIAL SYSTEM
CONTENTS
16.0 Aims and Objectives 16.1 Introduction 16.2 Organised Capital Market 16.3 Un-organized Capital Market 16.4 Organized Money Market 16.4.1 Market for Banking Financial Institutions 16.4.2 Market for Non Banking Financial Institutions 16.5 Un-organized Money Market 16.6 Let us Sum up 16.7 Lesson-end Activity 16.8 Keywords 16.9 Questions for Discussion 16.10 Suggested Readings

The purpose of this lesson is to discuss the typical structure of the Indian financial system. After studying this lesson you will be able to: (i) (ii) describe components of financial markets understand organised and unorganised capital markets
(iii) explain various segments of money market
16.1 INTRODUCTION
The Indian financial system coined more particularly immediately after the independence 1947. Since 1947, the role of the financial system is more vibrant in meeting the needs and demands of not only the country but also the corporate sectors. It outperformed in the economy for the development of the nation through the collection of saving from the households for development of the nation as well as the corporate sectors. The Indian financial system could be bifurcated into two different segments viz.
Capital Market and Money market

These two markets are further classified into organized and unorganized.
Indian financial System Capital market Organised Un organized Kerb trading IPOs Public Issues Private Placement Underwriting Institutional offer Secondary Bills Market Discount Market Gilt edged
Short term financial Short term instruments market
Money market Organised Un organized Pawn Brokers Chit funds
Primary market
16.2 ORGANISED CAPITAL MARKET

The capital market which was initially controlled and organized by the Controller of Capital Issues act and then it was replaced by the Securities Exchange Board of India for the governance of capital market in India. The capital market in India is known as regulated in spheres by SEBI then and there. The organised capital market is bifurcated into two categories viz Primary market and Secondary market. Primary market: It is the market for the fresh issuance of securities by the new as well as existing companies, in order to raise the capital from the investors. The Primary market is further classified into many segments Initial Public offering: As a new company registered under the Companies Act 1956 is permitted to raise the capital from the market through the abridged prospectus. Public issue: It is another mode of raising the capital from the common public by the existing companies. Private placement: During the issue, the larger investment houses are invited for the subscription of the issue of securities in bulk quantities at a discount price prior to the issue. After the issue, according to the investment policy of the Institutional investors, they sell them at higher price to the individual investors. This facilitates the institutional investors to book profits through the process of private placement. Underwriting: It is another mode of issuing the securities during the issue, more particularly this mode of issue is found to be an avenue to off-load the risk of managing the issue of securities as well as to secure the issue as fully subscribed. Secondary market: It is the market for the securities which are already available in the market, to buy and sell among the players. This is the market further classified into two different categories viz mutualisation and demutualisation of stock exchanges. Mutualised Stock exchanges: These are the exchanges never have any distinction among the members, management and governing body of the stock exchange. These are purely administered by the members/brokers of the stock exchange, e.g.,. Traditional stock exchanges. Demutualised stock exchanges: These are separate distinct faces among themselves. The roles and responsibilities of the brokers, governing body members and people in the management are clearly defined and performed by them without any ambiguity e.g. OTCEI, NSE and so on.
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16.3 UN-ORGANIZED CAPITAL MARKET

Due to stringent guidelines of SEBI, unofficial market trading activities are banned only in order to safeguard the interest of the investors. Kerb trading which was taken place among the players of the stock market during the non working hours of the stock exchange. This trading is known in other words as unofficial trading or black trading among the players. The next segment is nothing but the money market which controlled and monitored by the Reserve Bank of India.
Indian Financial System
16.4 ORGANIZED MONEY MARKET

The organised money market can be further segmented into two categories:
16.4.1 Market for Banking Financial Institutions

Under this the entire banking network is administered by RBI, which has the following many more classification viz Public sector banks, Scheduled banks, Private sector bank, Co-operative banks, Regional Rural banks and Land development banks
16.4.2 Market for Non Banking Financial Institutions

The non banking financial institutions are nothing but development banks, state financial institutions The money market is further divided into various segments viz Bills market Discounting market Acceptance market Marketable securities market Gilt edged securities market and so on Bill market: In this market only, the bills are bought and sold among the players. It is the market for both commerce bill and finance bill. The commerce bill is nothing but the bill of exchange defined in accordance with the Sec. 5 of the Negotiable Instruments Act. It arises only due to credit sales among the parties, only in order to safeguard the interest of the suppliers who supplied the goods and articles on credit. Discounting market: It is another most important market for discounting of the bills of the trade. These are normally carried out by the banking and financial institutions in addition to Discounting Housing Finance of India which is the apex body for rediscounting in India next to Reserve Bank of India. The bills are discounted by the banking and non banking financial institutions only on the basis of the credibility of the parties involved in the bill who has accepted to make the payment on the maturity of the bill. Acceptance market: In India, there is no separate acceptance market for accepting the bills before discounting, but in U.K., there is greater scope for accepting the bill before the process of discounting. Normally, the discounting is carried out only on the basis of the extent of acceptance given by the acceptance houses on the bills produced. Govt Securities market: The govt securities are also tradable in the secondary market immediately after the issuance. According to the Public debt act, the central and state govt are empowered to issue the securities to raise financial resources from the public for developmental aspects of the state or region.
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The treasury bills are mainly traded in the market immediately after the issuance The following are the major type of treasury bills traded in the market are 91 days treasury bills, 182 days treasury bill and 364 days treasury bill Bonds market: It is a separate market available to raise the financial resources through long term debt instrument. The bonds are normally issued by the corporate sectors and govt organizations. They are many in categories viz Secured and unsecured bonds Pay in kind bonds Redeemable bonds and irredeemable bonds and so on.
16.5 UN-ORGANIZED MONEY MARKET

This particular market is dominated by the pawn brokers, chit funds, nidhis, and so on. There is no stringent guidelines prevailing to control and monitor the role of the above mentioned players. In addition to the above classifications, one more classification is that of insurance companies which are separately governed by the IRDA Which has got its own segments as following: Life insurance sector Non life insurance sector Pension funds Health insurance and so on.
Check Your Progress
What are the main components of Indian financial system?
16.6 LET US SUM UP

The Indian financial system could be bifurcated into two different segments viz. Capital Market and Money Market. The money market is further divided into various segments viz Bills market Discounting market Acceptance market Marketable securities market Gilt edged securities market and so on.

Examine critically the role of Financial markets in industrial development of India.
16.8 KEYWORDS
Organised Capital Market
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Primary market
Initial Public offering Public issue Secondary market Mutualised Stock exchanges Demutualised Stock exchanges Unorganized Capital market Bill market Discounting market Acceptance market Govt Securities market Bonds market Un-organized money market
Indian Financial System

1. 2. 3. 4. 5. Write elaborate note on the organized capital market. Explain the role of SEBI in controlling the capital market. Draw the role of RBI in controlling and monitoring the various entities in the regulated money market environment. Explain the various steps involved in the bills market. Illustrate the role of acceptance market. Explain the various type of bonds and treasury bills under the organized money market.

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LESSON
17
SEBI IN CAPITAL MARKET ISSUES
CONTENTS
17.0 Aims and Objectives 17.1 Introduction 17.2 Objectives of the SEBI 17.3 Entity of SEBI 17.4 Organisational Grid of the SEBI 17.5 Powers and Functions of SEBI 17.6 Role of SEBI 17.6.1 Promoters Contribution 17.6.2 Disclosures 17.6.3 Book Building 17.6.4 Allocation of Shares 17.6.5 Market Intermediaries 17.6.6 Debt Market Segment 17.6.7 Brokers 17.6.8 Suspension of a Broker 17.6.9 Recent Developments 17.7 Critical Review of SEBI 17.8 Let us Sum up 17.9 Lesson-end Activity 17.10 Keywords 17.11 Questions for Discussion 17.12 Suggested Readings

This lesson is intended to discuss the role of SEBI in regulating the Indian capital market. After studying this lesson you will be able to: (i) describe objectives behind instituting SEBI (ii) know the organisational structure of SEBI (iii) understand powers and functions of SEBI (iv) examine the role of SEBI in Indian financial market
17.1 INTRODUCTION
During the late 80, the GOI decided to replace the Controller of Capital Issues Act, by way of inducting the Securities Exchange Board of India, in order to introduce the regulatory environment in the Indian capital market, to pave way for the promotion of congenial and conducive climatic condition for the investing public. Hence the Government
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of India has instituted the supreme authority SEBI to monitor and control the proceedings of the capital market in the country.
SEBI in Capital Market Issues
17.2 OBJECTIVES OF THE SEBI

To replace the office of the following major acts of implementation and to attain the following objectives:
L L L
Control of Capital Issues Act (1947) The Companies Act (1956) - issue, allotment of the securities and disclosures Securities contract regulation Act (1956) - to control over the stock exchanges
In May, 1992 - the controller of issue of capital, pricing of the issues, fixing premia and rates of debentures were ceased in operation, provided the SEBI was promulgated.
L L L
Protecting the interest of the investors Promoting the development of the securities market Regulating the securities market
17.3 ENTITY OF SEBI

It was registered with the common seal and with the power to acquire, hold and dispose any property Power to sue or to be sued in its own name The Head office is situated in Mumbai; in addition the regional offices were established in the following metropolitan cities viz Kolkata, Chennai and Delhi, to monitor and control the capital market operations across the country
17.4 ORGANISATIONAL GRID OF THE SEBI

Six members in the committee Headed by the chairman One member each from the ministries of Law and Finance One member from the officials of Reserve Bank of India Two nominees from the central government It contains 4 different departments viz Primary department, Issue management and intermediaries department, Secondary department and Institutional Investment department
17.5 POWERS AND FUNCTIONS OF SEBI

Section 11 of the Act Chapter IV highlights the Powers and Functions of SEBI Regulating the business of the stock exchanges Regulating the role of the intermediaries Registering and regulating of depositories, participants and custodian of securities, credit rating agencies Regulating of mutual funds and venture capital funds Prohibiting the unfair trade practices Prohibiting of insider trade activities Regulating substantial takeovers and acquisitions Frequent conduct of research activities To conduct any enquiry which warrants the situation to safeguard the interest of the investors
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Civil Court Procedure 1908: The SEBI has been given additional powers and functionswith reference to Civil Court Procedure 1908 to regulate the capital market in addition to the above enlisted powers and functions Discovery and production of books of account of the errant during the inspection and enquiry. Summoning and enforcing the attendance of the persons to stand before for the examination of oath. Acc to Sec 12 SEBI is empowered to conduct Inspection of books.
17.6 ROLE OF SEBI

Entry norms for the companies at the moment of raising the capital from the market:
L L
The companies are expected to produce 3 years dividend track record of preceding the issue. At the entry level, immediately after listing, important point to be ensured is that Post issue of networth should be 5 times greater than the Pre issue networth. If it is a manufacturing company without any track record, wants to raise any capital from the market, the appraisal has to be done through development banks or commercial banks. Having three years track record, the SEBI never vets offer document of the issue of capital.
17.6.1 Promoter's Contribution

Promoter's contribution should not be less than 20% and should be made before the issue. If the size of the issues is Rs. 100 cr -50% of the contribution should be made before the opening of issue and the remaining should be paid before the calls are made to the investors.
17.6.2 Disclosures
Acc.Bhave committee- Financial results i.e., unaudited and audited financial results should be published. Risk factors and positions of the company should be highlighted in detail in the prospectus .
17.6.3 Book Building

75% route was specified at the early moment in the process of book building. Then the book building process was opened to 100% route to the public. Sufficient opportunities are to be furnished to the investors to represent through the terminal to take part in the process of Book building. The company during the process requires 30 centers atleast for book building process to raise the share capital from the market.
17.6.4 Allocation of Shares

The Minimum application was -100 Nos for subscribing the issue of share capital. Then the Minimum application was hiked to 500 Nos. Then SEBI has felt that the Minimum application was too high, which did not pave the small investors to within the available surplus, then the minimum application brought down to 200 Nos.
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Small investors are who hold 1000 shares or few securities Allotment should be done within 30 days from the date of closure of the issue. During the non allotment of the shares, the company should refund the amount of the application money.
17.6.5 Market Intermediaries

The various merchant bank categories were abolished. Each category of issue intermediary is required to undergo for specific registration process. Lead managers who manage the issue of capital should have a networth of Rs.5 cr.
17.6.6 Debt Market Segment

Depository system for the debt securities were introduced Demat facility was specifically introduced for the government securities Listing of debt securities need not rely upon the equity listing in the respective stock exchange FIIs were permitted to invest 100% in the debt instruments of the Indian companies For the issuance of debt instruments the rating has been mandatory Minimum two ratings should be obtained for the issue of debt instrument more than Rs. 500 cr. Rating agency should not be associated with the firm of issuing company
17.6.7 Brokers
Registration is given - Member of any stock exchange - key factors of registration - office space, previous experience, man power, selling or buying in securities Code of conduct-execution of orders, fairness of deals with the investors, issue of contract note Financial statements - should be submitted within 6 months of the accounting period Book of accounts - A minimum of 5 years to be preserved Regional offices - Establishment only with reference to attend the complaints of the small investors at speedy rate - Kolkata, Chennai and Delhi SEBI's final controlling measure is suspension and cancellation of the registration subject to certain conditions
17.6.8 Suspension of a Broker

Suspension - permanent - dismissal is leading to cancellation of registration - due to the problem caused Violation of rules and regulations Fails to submit the true and fair information according to the norms of disclosures Untoward conduct with the investor Guilt of misconduct Poor financial status of the brokers-deterioration Stock exchange fees - fail to pay on time to the requirement Suspension of the membership
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Indulges in any act of insider trading of securities Convicted of a any criminal offence Sub-Broker Sub- broker- to obtain the registration Agreement in between broker & sub-broker Deposit should be made with - Broker Transfer of securities - without registration of bearing stamps - considered as bad deliveries in the angle of stock exchanges -July 1, 1997.
17.6.9 Recent Developments

RBI approval copy is exempted FIIs are permitted to invest upto 100% in debt market funds FIIs which have securities worth of Rs 100 cr or more than mandatory requirement is to settle the transaction only through demat mode FIIs/NRIs/OCB -30% of the equity of the company in accordance with the union budget - 1997-98 It was hiked by the Union Finance Minister during the budget 2000
Check Your Progress What steps have been taken by SEBI regarding allocation of shares?
17.7 CRITICAL REVIEW OF SEBI

Disclosures- To present information only for the interest of investors Dissemination process - to disclose the information required which leads to undue delay. The route of dissemination of the information should be through SEBI to public and by considering the time wastage, the web sites were suggested for facilitating the investors. The Settlement for NSE are - Wednesday - Tuesday, and in the case of BSEMonday-Friday Leads to more arbitrage transactions which lead to greater fluctuations in the opening and closing prices of the securities Badla trade has been banned due to detrimental to the investors Special watch system has to be introduced to the international standards Capital adequacy: The capital required to be maintained is less than for intermediaries but at the same time the capital adequacy should be to the trading volume of them only in order to avoid the default risk of the investors.
17.8 LET US SUM UP

The Govt of India has instituted the supreme authority SEBI to monitor and control the proceedings of the capital market in the country. The SEBI has been given additional powers and functions with reference to civil court procedure 1908 to regulate the capital market. Recent Developments RBI approval copy is exempted. FIIs permitted to invest upto 100% in debt market funds. FIIs which have securities worth of Rs 100 cr or more
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than mandatory requirement is to settle the transaction only through demat mode, FIIs/ NRIs/OCB -30% of the equity of the company in accordance with the union budget 1997-98. It was hiked by the union finance minister during the budget 2000.

Discuss critically the power and functions of SEBI.
17.10 KEYWORDS
Broker: member of the stock exchange, facilitates the client to buy and sell on behalf in the stock market Sub-broker: who assists the broker and does the buying and selling transactions for the client through the broker in the stock exchange Arbitrage: Buying the security at lesser price at one stock exchange and disposing them off at higher price at another stock exchange during the same moment Lead manager: Who takes active role in the process of issue management.

1. 2. 3. 4. 5. 6. 7. When SEBI was established ? For what ? Briefly highlight the objectives of the SEBI. Explain the role of SEBI in administering the primary market. Explain the important enactments on the market intermediaries of the stock market. Elucidate the recent developments with the help of SEBI mandate. What are the steps taken by SEBI to suspend the registration of a broker? Why the companies are expected to highlight about the prospects and risk factors of the issue with relevance to the project?

M.P. Pandikumar, Accounting & Finance for Managers, Excel Books, New Delhi. R.L. Gupta and Radhaswamy, Advanced Accountancy. V.K. Goyal, Financial Accounting, Excel Books, New Delhi. Khan and Jain, Management Accounting. S.N. Maheswari, Management Accounting. S. Bhat, Financial Management, Excel Books, New Delhi. Prasanna Chandra, Financial Management Theory and Practice, Tata McGraw Hill, New Delhi (1994). I.M. Pandey, Financial Management, Vikas Publishing, New Delhi. Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.
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LESSON
18
CAPITAL BUDGETING
CONTENTS
18.0 18.1 18.2 18.3 Aims and Objectives Introduction Aim of Capital Budgeting Methods of Capital Budgeting 18.3.1 Pay Back Period Method 18.3.2 Accounting or Average Rate of Return 18.3.3 Discounted Cash Flows Method 18.4 18.5 18.6 18.7 18.8 18.9 18.10 18.11 18.12 18.13 Present Value Method Capital Rationing Divisible Project Indivisible Project Risk Analysis in Capital Budgeting Let us Sum up Lesson-end Activity Keywords Questions for Discussion Suggested Readings

After studying this lesson you will be able to: (i) decide why capital budgeting is most important decision of the financial management (ii) describe various objectives and methods of capital budgeting (iii) distinguish between divisible and indivisible projects.
18.1 INTRODUCTION
The capital budgeting is one of the important decisions of the financial management of the enterprise. The decisions pertaining to the financial management of the firm are following:
Decisions of Financial Management
Financing
Investment
Dividend
Liquidity
Long Term Investment
Short Term Investment
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Capital Budgeting
Working Capital Management
Why the capital budgeting is considered as most important decision over the others? The capital budgeting is the decision of long term investments, which mainly focuses the acquisition or improvement on fixed assets. The importance of the capital budgeting is only due to the benefits of the long term assets stretched to many number of years in the future. It is a tool of analysis which mainly focuses on the quality of earning pattern of the fixed assets. The capital budgeting decision is a decision of capital expenditure or long term investment or long term commitment of funds on the fixed assets. Charles T. Horngreen A long-term planning for making and financing proposed capital outlays.
Capital Budgeting
18.2 AIM OF CAPITAL BUDGETING

To make rational investment: The study of capital budgeting on capital expenditures evades not only over capitalization but also under capitalization. The long-term investment normally demands heavy volume of investment which is met out by the firm either through external or internal source of financing. Hence, the amount of capital raised by the firm should neither greater nor lesser than the investment. Locking up of capital: The amount invested is requiring longer gestation to recover. The longer gestation is connected with future horizon in getting back the investment. The future is uncertain unlike the present. If the longer is the gestation in the future leads to greater risk involved. Effect on the profitability of the enterprise: The profitability of the enterprise is mainly depending on the proper planning of the capital expenditure. Nature of Irreversibility: The improper/ unwise capital expenditure decision cannot be immediately corrected as soon as it was found. Once it is invested is invested which cannot be reversed. The poor investment decision will require the firm either to keep it as an idle in the form of investment or to unnecessarily meet out fixed commitment charge of the capital which excessively raised more than the requirement.
18.3 METHODS OF CAPITAL BUDGETING

The methods are the nothing but the instruments of the capital budgeting to study the quality of the investments/fixed assets. The investments are studied by the firms in the following angles: Based on the number of years taken for getting back the investment Pay Back Period Method Based on the profits accrued out of the investment Accounting Rate of Return/ Average Rate of Return Based on the timing of benefits Present value of future benefits of the investment Discounted cash flow methods L Based on the comparison in between the cash outlay and receipts discounted with the help of minimum rate of return - Net present value method L Based on the identification of maximum rate of return, in between the initial cash outlay and discounted expected future receipts - Internal Rate of return method L Based on the ration in between the present values of cash inflows and outflows Present value index method
Check Your Progress
(1)
Capital budgeting means a study of

(a) (b) Budgeting of long-term capital Budgeting of short-term capital Contd....
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(c) (d)
Budgeting of short-term assets Worthiness of long-term assets Yearly basis On the basis of return On the basis of present value of money (a), (b) & (c) Acceptance of the investment proposal Rejection of investment proposal Neither can be accepted nor rejected
(2)
Capital budgeting tools are classified into

(a) (b) (c) (d)
(3)
Selection criterion are classified into

(i) (ii) (iii)
(a) (b) (c) (d)
(i) only (ii) only (iii) only (iv), (ii) & (iii)
The classification of methods are generally in two categories: Traditional methods L Pay Back Period method L Accounting Rate of Return Discounted cash flow methods L Net present value method L Internal Rate of Return method L Present value index method L Discounted pay back period method
18.3.1 Pay Back Period Method

What is pay back period? The pay back period is the period taken by the firm to get back the investment. The pay back period is nothing but number of years/months/days required by the firm to get back its investment invested in the project. To find out the pay back period, the following are two important covenants required: Initial outlay / Initial investment/ Original investment Cash inflows How the pay back period is calculated? The pay back period is calculated by way of establishing the relationship between the volume of investment and the annual earnings While calculating the pay back period, the nature of annual earnings should be identified. The nature of the annual earnings can be classified into two categories: Cash flows are equivalent or constant Cash flows are not equivalent or constant If the cash flows are equivalent, How the pay back period is to be calculated ? The cost of the project is Rs.1,00,000. The annual earnings of the project is Rs.20,000. Calculate the pay back period.
Pay back period =

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Initial Investment Average Annual Earnings Rs. 1,00,000 = = 5 Years Rs. 20,000
It is obviously understood that, Rs.20,000 of annual earnings (cash inflows) requires 5 years time period to get back the original volume of the investment. If the cash flows are not equivalent, How the pay back period is to be calculated ? The cost of the project is Rs.1,00,000. The annual earnings of the project are as follows
Year Net Income Amount Rs 1st 40,000 2nd 30,000 3rd 20,000 4th 20,000 5th 20,000
Capital Budgeting
The ultimate aim of determining the cumulative cash inflows to find out how many number of years taken by the firm to recover the initial investment. The next step under this method is to determine the cumulative cash flows
Year 1. 2. 3. 4. 5. Annual Net Incomes Rs 40,000 30,000 20,000 20,000 20,000 Cumulative cash flows Rs. 40,000 70,000 90,000 1,10,000 1,30,000
3 years full time required to recover the major portion of investment Rs.90,000
The uncollected portion of the investment is Rs,10,000. This Rs.10,000 is collected from the 4th year Net income / cash inflows of the enterprise. During the 4th year the total earnings amounted Rs.20,000 but the amount required to recover is only Rs.10,000. For earning Rs.20,000 one full year is required but the amount required to collect it back is amounted Rs.10,000. How many months the firm may require to collect Rs.10,000 out of the entire earnings Rs.20,000? Pay back period consists of two different components Pay back period for the major portion of the investment collection in full course E.g.: 3 years Pay back period for the left /uncollected portion of the investment For the second category =
Rs.10,000 = 0.5 years Rs. 20,000
Total pay back period= 3 Years +.5 year = 3.5 years Criterion for selection: If two or more projects are given for appraisal, considered to be mutually exclusive to each other for selection, the pay back period of the projects should tabulated in accordance with the ascending order. The project which has lesser pay back period only to be selected over the other projects given for scrutiny. Why lesser pay back has to be chosen? The reason behind is that the project which has lesser pay back period got faster recovery of the initial investment through cash inflows/Net income. Selection criterion
Lesser the pay back period is better for acceptance of the project
Illustration 1: A project costs Rs.2,00,000 and yields and an annual cash inflow of Rs.40,000 for 7 years. Calculate pay back period First step is identify the nature of the annual cash inflows
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In this problem, the annual cash inflows are equivalent throughout life period of the project Pay Back Period =
Initial Investment Rs. 2,00,000 = = 5 years Annual Cash Inflows Rs. 40,000
Illustration 2: Calculate the pay back period for a project which requires a cash outlay of Rs.20,000 and generates cash inflows of Rs 4,000 Rs.8,000 Rs. 6,000 and Rs. 4,000 in the first, second, third, and fourth year respectively First step is to identify the nature of the cash inflows The cash inflows are not equivalent/constant Year Cash Inflows Rs 4,000 8,000 6,000 4,000 Cumulative Cash Inflows Rs 4,000 12,000 18,000 22,000
1. 2. 3. 4.
Cost of the project is to be recovered Rs.20,000. The project takes 3 full years time period to recover the major portion of the initial investment which amounted Rs.18,000 out of Rs.20,000 The remaining amount of the initial investment is recovered only during the fourth year. The left portion Rs.2,000 has to be recovered only from the fourth year cash inflows of Rs.4,000. Pay Back Period = Pay Back period of the major portion + Pay Back period of the remaining portion Pay Back period of the major portion = 3 years Pay Back period of the remaining portio: For the entire earnings of Rs.4,000, the firm consumed one full year/12 months time period. How many number of months required to recover Rs.2,000 ?
Rs. 2,000 = 0.5 12 months = 6 months Rs. 4,000
Total pay back period = 3 years + 6 months = 3 years 6 months Illustration 3: A project cost of Rs.10,00,000 and yields annually a profit of Rs.1,60,000 after depreciation and depreciation at 12% per annum but before tax 50% calculate pay back period. Pay Back Period =
Initial Investment Annual Cash inflow
In this problem, the initial investment is given which amounted Rs.5,00,000. The annual cash inflow is not given directly; to determine the cash inflow; what is meant by the cash inflow ? Cash inflow = Profit after tax + Depreciation
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Profit Before taxation
= Rs.1,60,000
(-)Taxation Profit after taxation (+)Depreciation 12% on Annual Cash Inflow Pay Back Period
= Rs. 80,000 = Rs. 80,000 = Rs. 10,00,000 = Rs. 1,20,000 = Rs. 2,00,000 = Rs.10,00,000 = 5 years = Rs.2,00,000
Capital Budgeting
Illustration 4: A company proposing to expand its production can go in either for an automatic machine costing Rs.2,24,000 with an estimated life of 5 years or an ordinary machine costing Rs.60,000 having an estimated life of 8 years. The annual sales and costs are estimated as follows: Particulars Sales Costs Material Labour Variable overheads Automatic Machine Rs 1,50,000 50,000 12,000 24,000 Ordinary Machine Rs 1,50,000 50,000 60,000 20,000
Compute the comparative profitability of the proposals under the pay back period method. Ignore Income Tax (I.C.W.A.Final) The first step is to find out the Annual profits of the two different machines The next step is to find out the pay back period of the two different machines respectively Profitability Statement Automatic Machine Rs Sales Less : Material Labour Variable overheads Annual profit 1,50,000 50,000 12,000 24,000 64,000 Pay Back Period Particulars Cost of the Machine Annual Profit Pay Back Period Initial Investment Annual profit Automatic Machine Rs 2,24,000 64,000 Rs.2,24,000 Rs.64,000 = 3 years Ordinary Machine Rs 60,000 20,000 Rs 60,000 Rs 20,000 = 3 years Ordinary Machine Rs 1,50,000 50,000 60,000 20,000 20,000
The pay back period method highlights that the ordinary machine is more ideal than the automatic machine due to lesser pay back period i.e., 3 years. It means that the ordinary machine is bearing the faster rate in getting back the investment invested than the automatic machine.
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The another method to discuss is post pay back impact of the two different machines Post pay back profit is the profit of the two different machines after the recovery of the initial investment. The machine which has greater post pay back profit construe. Post Pay Back Profit Particulars Annual Profit R.No.1 Estimated Life R.No.2 Pay Back Period R.No.3 Post Pay Back Period R.No. 4=R.No.2-R.No.3 Post Pay Back Profit R.No5=R.No.1R.No.4 2 years = Rs.64,0002 years = Rs.20,0005years 5 years = Rs.1,28,000 = Rs.1,00,000 Automatic Machine Rs 64,000 5 years 3 years Ordinary Machine Rs 20,000 8 years 3 years
Post pay back profit of the Automatic machine is higher than the Ordinary machine ; which amounted Rs.1,28,000.. It means that the profit of the automatic machine after the recovery of the initial investment is greater than that of the ordinary machine. Illustration 5: A company has to choose one of the following two mutually exclusive projects. Investment required for each project is Rs 30,000. Both the projects have to be depreciated on straight line basis The tax rate is 50%. Year Profit Before Depreciation Project A Rs 1. 2. 3. 4. 5. Calculate pay back period First step is to find out the depreciation under the straight line method The next step is to determine the pay back period of the both projects A and B respectively The next step is to compare both pay back periods of two different projects. The depreciation under the straight line method is as follows For Project A 8,400 9,600 14,000 14,000 4,000 Project B Rs 8,400 9,000 8,000 10,000 20,000
Initial Investment Rs. 30,000 = = Rs.6,000 Life of the Project 5 years

For Project B
Initial Investment Rs. 30,000 = = Rs.6,000 Life of the Project 5 years

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Project A Add Depreciation Less Depreciation Cumulative Cash inflows Profit Before Depreciation
Capital Budgeting
Profit after tax
Less Tax 50%
1. 2. 3. 4. 5.
8,400 9,600 14,000 14,000 4,000
6,000 6,000 6,000 6,000 6,000
2,400 3,600 8,000 8,000 -(2000)
1,200 1,800 4,000 4,000 0
1,200 1,800 4,000 4,000 -(2000)
6,000 6,000 6,000 6,000 6,000
7,200 7,800 10,000 10,000 4,000
Cash in flows
Years
Profit
7,200 15,000 25,000 35,000 39,000
Pay back period = Pay back period of a major portion + Pay back period for remaining Pay back period of the major portion= the firm has recovered a major portion of the initial investment of Rs.25,000 within 3 full years out of Rs.30,000 The second half of the equation is that pay back period for the remaining i.e., Rs.5000 of initial investment which is to be recovered during the fourth year out of Rs.10,000 If Rs.10,000 earned throughout the year /12 months, how many months taken by the firm in recovering Rs.5,000 out of Rs10,000
= Rs. 5,000 = .5 12 months = 6 months Rs.10,000
Pay back period (Project A) = 3.6 years The next stage to find out the pay back period of the project B Project B Add Depreciation Less Depreciation Cumulative Cash inflows 7,200 14,700 21,700 29,700 42,700 Profit Before Depreciation Profit after tax Less Tax 50%
1. 2. 3. 4. 5.
8,400 9,000 8,000 10,000 20,000
6,000 6,000 6,000 6,000 6,000
2,400 3,000 2,000 4,000 14,000
1,200 1,500 1,000 2,000 7,000
1,200 1,500 1,000 2,000 7,000

Rs. 300 Rs. 13,000
6,000 6,000 6,000 6,000 6,000
7,200 7,500 7,000 8,000 13,000
Pay back period of the project B= 4 years +
= 4 years +.02 365 days = 4 years + 8 days = 4 years and 8 days Pay back period of the project B is greater than that of the earlier Project A. It means that the Project A is bearing the faster rate in getting back the investment invested.
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Cash in flows
Years
Profit
Merits It is a simple method to calculate and understand It is a method in terms of years for easier appraisal Demerits: It is a method rigid It has completely discarded the principle of time value of money It has not given any due weight age to cash inflows after the pay back period It has sidelined the profitability of the project. 18.3.2 Accounting or Average Rate of Return: Under this method, the profits are extracted from the book of accounts to denominate the rate of return. The profits which are extracted are nothing but after depreciation and taxation and not cash inflows. Selection criterion of the projects:
Highest rate of return of the project only is given appropriate weightage. The Accounting rate of return can be computed as follows
Accounting Rate of Return (ARR)=
Annual Return 100 Original Investment Average Annual Return 100 Average Investment
Accounting Rate of Return (ARR)=
Average annual return= Average profit after depreciation and taxation of the entire life of project i.e. for many number of years Average Investment =
Opening Investment + Closing Investment 2
= Illustration 6
Opening Investment Scrap 2
Calculate the average rate of return for Projects X and Y from the following Project X Investments Expected Life Rs.40,000 4 years Project Y Rs.60,000 5 years
Projected net income ( after interest, depreciation and taxes) Year Project X Rs Project Y Rs 1. 2. 3. 4. 5.
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4,000 3,000 3,000 2,000 12,000
6,000 6,000 4,000 2,000 2,000 20,000
If the required rate of return is 10% which project should be undertaken? Average Rate of Return =
Capital Budgeting
Average Annual Income 100 Original Investment
The first step is to find out the average annual income of the two different projects X and Y Average Annual Income =
Total income throughout the Project Life of the Project Rs.12,000 = Rs. 3,000 4 years Rs. 20,000 = Rs. 4,000 5 years
Average Annual Income( Project X) =
Average Annual Income ( Project Y) =
The next step is to find out the Average rate of return : Average rate of return ( Project X) = Average rate of return ( Project Y) =
Rs. 3,000 100 = 7.5% Rs.40,000 Rs.5,000 100 = 8.33% Rs. 60,000
Both the projects are lesser than the given required rate of return. These two projects are not advisable to invest only due to lesser accounting rate of return. Illustration 7 The alpha limited is considering the purchase of a machine to replace a machine which has been in operation in the factory for the last 5 years. Ignoring interest pay but considering tax at 50% of net earnings suggest which on the two alternatives should be preferred. The following are the details Particulars Purchase price Economic life of the machine Machine running hours per annum Units per hour Wages running per hour Power per annum Consumable stores per annum Other charges per annum Material cost per unit Selling price per unit Old Machine Rs.80,000 10 years 2,000 24 3 2,000 6,000 8,000 .50 1.25 New Machine Rs,1,20,000 10 years 2,000 36 5.25 3,500 7,500 9,000 .50 125
First step is to consider that few assumptions to proceed the problem without any technical difficulties. First assumption is that there is no closing stock i.e. what ever goods produced are sold out in the market. Second assumption is that the volume of the sales is expected to be remain throughout the life of the period. Third assumption is that the depreciation charged by the firm is on the basis of straight line method.
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Steps involved in the computation of the accounting rate of return The first is to compute the total number of units expected to produce Total number of units of production = Total machine hours per annum Units per hour For old machine For new machine Total volume of sales For old machine For new machine = 2,000 Hrs 24= 48,000 units = 2,000 Hrs 36= 72,000 units = Total number of units Selling price per unit = 48,000 units Rs 1.25= Rs.60,000 = 72,000 units Rs.1.25= Rs.90,000
The second step is to determine the volume of annual sale of units:
According to the second assumption, the volume of sales is known as unaffected throughout the life period of the projects. The next step is to find out the volume of the wages Total wages For old machine For new machine = wages per hour Machine running hours = Rs.3 2000 Hrs= Rs.6,000 = Rs5.25 2000 Hrs=Rs.10,500
The next step is to find out the total material cost Total material cost per unit = Total number of units Material cost per unit For old machine For new machine = 48,000 .5= Rs.24,000 = 72,000 .5=Rs.36,000
The last step is to find out the depreciation
Initial investment Depreciation under straight line method = Economic life period of the asset
For old machine For new machine = Rs.8,000 = Rs.12,000
The next step is to draft the profitability statement of the enterprise under the head of two different machine viz old and new. To find out the annual income of the enterprise under two different machines
Profitability Statement
Particulars Sales Less Direct Material Wages Power Consumable stores Other charges Depreciation Profit before tax Tax at 50% Profit after tax Old Machine Rs Rs 60,000 24,000 6,000 2,000 6,000 8,000 8,000 54,000 6,000 3,000 3,000 New Machine Rs Rs 90,000 36,000 10,500 4,500 7,500 9,000 12,000 79,500 10,500 5,250 5,250
The Average rate of return =
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Average Annual Return 100 Original Investment Average Annual Return = 100 Average Investment
Capital Budgeting
Particulars Average Rate of Return On the basis of original investment Average Rate of Return On the basis of average investment
Old Machine Rs3,000 100 Rs.80,000 =3.75% Rs.3,000 100 Rs.40,000 =7.5%
New Machine Rs.5,250 Rs.1,20,00 =4.375% Rs.5,250 Rs.60,000 =8.75%
Merits It is simple method to compute the rate of return Average return is calculated from the total earnings of the enterprise through out the life of the firm The entire rate of return is being computed on the basis of the available accounting data Demerits Under this method, the rate of return is calculated on the basis of profits extracted from the books but not on the basis of cash inflows The time value of money is not considered It does not consider the life period of the project The accounting profits are different from one concept to another which leads to greater confusion in determining the accounting rate of return of the projects
18.3.3 Discounted Cash Flows Method
Discounted cash flows method
Present value Index Method Net Present value method Internal Rate of Return method
The discounted cash flows method is the only method nullifies the drawbacks associated with the traditional methods viz Pay back period method and Accounting rate of return method. The underlying principle of the method is time value of money. The value of 1 Re which is going to be received on today bears greater value than that of 1 Re expected to receive on one month or one year later. The main reason is that "Earlier the benefits better the principle". It means that the benefits whatever are going to be accrued during the present will be immediately reinvested again to maximize the earnings, so that the earlier benefits are weighed greater than the later benefits. The later benefits are expected to receive only during the future which is connected with the future i.e., future is uncertain. It means that there is greater uncertainty involved in the receipt of the benefits connected with the future. Why the time value of money concept is inserted on the capital budgeting tools? The main reason is that the capital expenditure is expected to extend the benefits for many number of years. The 1 Re is expected to receive one year later cannot be treated at par with the 1 Re of 2 years later. This is the only method considers the profitability as well as the timing of benefits. This method gives an appropriate qualitative consideration to the benefits of various time periods.
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The time value of money principle is used for an analysis to study about the quality of the investments in receiving the future benefits. There are general classifications which are as follows Net present value method Present value index method Internal rate of return method
18.4 PRESENT VALUE METHOD

Under this method, the initial outlay or initial investment available in terms of present value is compared with the present value of future earnings of the enterprise. Why the present value of the future earnings are found out? The ultimate reason to find out the present value future earnings is that the comparison in between inflows and outflows should be meaningful as well as effective. The present value of the initial outlay cannot be converted into the future value for comparison, even otherwise the conversion takes place, the comparison cannot be meaningful. To be meaningful comparison, the future earnings are converted into the present value which is known as discounting process through the discount rate. The rate at which the future earnings are discounted is known as required rate of return. Selection criterion of Net present value method If the present value of future cash inflows are greater than the present value of initial investment ; the proposal has to be accepted. If the present value of future cash inflows are lesser than the present value of initial investment ; the proposal has to rejected.
Initial Outlay <Present value of Benefits=> +ve NPV:- Project can be accepted Initial Outlay>Present value of Benefits=>-ve NPV:-Project can be rejected
What is present value index? The major lacuna of the Net present value method is unable to rank the projects one after the another, only due to the volume of the investment involved. To rank the projects meaningfully, the present value index method is adopted. The present value index of the investment can be calculated with the help of following formula: Present value index method Selection criterion If the present value index is greater than one, accept the proposal; otherwise vice versa
Present value index>1:- Accept the investment proposal Present value index<1:-Reject the investment proposal
Pr esent value of the cash inflows Pr esent value of the cash outflows
What is internal rate of return method? IRR is the rate at which initial investment is equal to the Present Value of future case in -flows. Under this method, while matching, these two are known but the rate which is taken for equation not given or known. The rate of discounting for matching should be determined through trial and error method.
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Once the Internal rate of return is found out, the found IRR should be compared with the required rate of return. Decision criterion If the IRR is more than the Required rate of return, the project has to be accepted If the IRR is less than the Required rate of return, the project has to be rejected
Check Your Progress
Capital Budgeting
(1)
The utility of discounting principle is

(a) (b) (c) (d) To determine the future value of the cash inflow To convert the Present value of Initial outlay into Future value To determine the present value of the future cash inflows for comparison with the Initial Outlay None of the above
(2)
Why Discounted cash flows method is considered to be a superior than the Traditional method ?
(a) (b) (c) (d) Simple to understand Accuracy Time value of money Easy to calculate
Illustration 8 Project ABC Ltd. costs Rs 1,00,000. It produces the following cash flows
Year Cash Inflows Rs Present value of Re1 at 10% 1 40,000 .909 2 30,000 .826 3 10,000 .751 4 20,000 .683 5 30,000 .621
Advise either the project to be accepted or not.

Cash inflows Rs 1. 40,000 2. 30,000 3. 10,000 4. 20,000 5. 30,000 Total Present value of cash inflows Total present value of cash outlay Net present value Year Present value factor @10% .909 .826 .751 .683 .621 Present value of cash inflows Rs 36,360 24,780 7,510 13,660 18,630 1,00,940 1,00,000 940(+ve)
The investment proposal has to be accepted only due to positive Net present value. It means that the present value of the cash inflows are greater than the present value of the outlay. It means the discounted future earnings are greater than the present initial investment outlay. Illustration 9 The Alpha Co Ltd., is considering the purchase of a new machine. Two alternative machines (A and B) have been suggested, each having an initial coast of Rs.4,00,000 and requiring of Rs.20,000 an additional working capital at the end of 1st year. Earnings after taxation are expected to be follows
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Year 1. 2. 3. 4. 5.
Cash inflows Machine A Rs Machine B Rs 40,000 1,20,000 1,20,000 1,60,000 1,60,000 2,00,000 2,40,000 1.,20,000 1,60,000 80,000
Present value factor 10% .91 .83 .75 .68 .62
(CA Final Nov, 1972) The profitability statement of Two machines -Alpha company
Year Present value factor@ 10% Machine A Cash Inflow Rs 1. .91 40,000 2. .83 1,20,000 3. .75 1,60,000 4. .68 2,40,000 5. .62 1,60,000 Present value cash inflows Present value cash outflows= Rs.4,00,000+ 20,000 X.91 Net present value Present Value Rs 36,400 99,600 1,20,000 1,63,200 99,200 5,18,400 4,18,200 1,00,200 Machine B Cash Inflow Rs 1,20,000 1,60,000 2,00,000 1.,20,000 80,000 Present Value Rs 1,09,200 1,32,000 1,50,000 81,600 49,600 5,23,200 4,18,200 1,05,000
In the above problem, among the given machines, the firm is required to chose only one machinery. To chose the ideal machinery among the given two, the net present value should be ranked. The Machine B has been considered as preferable over the machine A due to higher net present value. The ranking of the machines do not indulge any difficulties. Why it so ? The main reason is that both machines are having equivalent volume of investment outlay. Out of the same initial outlays, we can rank that both machines one after the another based upon the net present value. Illustration 10 The initial cost of an equipment is Rs. 50,000. Cash inflows for 5 years are estimated to be Rs.20,000 per year. The management's desired minimum rate of return is 15%. Calculate Net present value and Excess present value index. At the end of every year, the firm expects to earn Rs.20,000. The amount expects to earn Rs.20,000 on every year is nothing but future value of money. The future value of money should be converted into the present value for having comparison with the initial investment. On every Rs.20,000 expected to receive forms a series of future cash inflows which should be converted into present value. This conversion process i.e the process of converting the future value into present value is known as discounting process. For discounting, the rate which is used for the process pronounced as discount rate or minimum rate of return. The conversion process can be done in two different ways. Discounting process :- PV= FV/ (1+r)n For first year cash inflow Rs.20,000:PV=20,000/(1.15)=20,000.870 For second year cash inflow Rs.20,000;PV=20,000/(1.15)2 =20,000.756
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=Rs.17,400
=Rs.15,120
For third year cash inflow Rs.20,000:PV=20,000/(1.15)3=20,000.658 For fourth year cash inflow Rs.20,000:PV=20,000/(1.15)4=20,000.572 For fifth year cash inflow Rs.20,000:PV=20,000/(1.15)5=20,000.497 =Rs.9,940 Rs.67,060 OR Alternately, the discounting can be done as follows Being Rs.20,000 is nothing but as common cash inflow throughout 5 years of the project, considered to be a series of cash inflows Rs.20,000(.870+.756+.658+.572+.497) =Rs.67,060 =Rs.11,440 =Rs.13,160
Capital Budgeting
Net present value = Present value of cash inflows - Present value of cash outlay =Rs.67,060- Rs.50,000= Rs.17,060 The net present value of the project is +ve. Hence, the project can be accepted. Illustration 11 A project costs Rs.36,000 and is expected to generate cash inflows of Rs.11,200 annually for 5 years. Calculate the IRR of the project. First step is to find out the fake pay back quotient Pay back =
Initial Investment Rs. 36,000 = = 3.214 Annual average return Rs. 11,200
The next step is to locate the pay back quotient in the table M-4. The present value of 1 Re should be computed for 5 number of years. The location of the pay back quotient is in between the values of table M-4 The value 3.214 which lies in between 3.274 of 16% and 3.199 of 17% The next step in the IRR calculation is that locating the maximum rate of return which equates the initial outlay with the cash inflows of various time periods. While equating the initial outlay with discounted cash inflows at certain percentage will derive the original rate of return. The process may be started from two different angles viz Low discount rate High discount rate The computation of IRR can be had through either low discount rate or high discount rate. This is further extended to different methods of calculation., which are as follows On the basis of values extracted from the table On the basis of volume
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Calculation on the basis of discount rate table value

Lower discount Rate 3.274 Origin value i.e., unknown IRR -3.214 Higher discount rate 3.199
On the basis of Lower % of discount rate =Lower discount rate + Discount rate difference
(Pay Back quotient - Higher discount rate) (Lower discount - Higher discount rate) 3.214 3.199 = 17% 1% = 17% .2% = 16.8% 3.274 3.199
Alternately, on the basis of volume, the methodology to be adopted for the determination of IRR The cash inflows of Rs.11,200 for 5 years are discounted @ 16% which amounted Rs.36,668.8. Like wise the cash inflows of the same should be discounted at the rate of 17% which amounted Rs.35,828.8 The next step is to find out the IRR. The IRR can be found out either on the basis of lower discounted cash inflows or higher discounted cash inflows.
On the basis of discounted cash inflows Lower rate Rs.36.668.8 On the basis of discounted cash inflows Higher rate-Rs.35.828.8
(+)
Rs.36,000-Origin value@ IRR
(-)
On the basis of discounted cash inflows at lower rate @16% =16% + 1%
(Rs.36.668.8 Rs. 36,000) (668.8) = 16% + % (Rs. 36.668.8 - 35.828.8) (840)
=16%+.796=16.796% On the basis of discounted cash inflows at higher rate @ 10%
(Rs. 36,000 - Rs. 35.828.8) (172) = 17% - 1% (Rs. 36.668.8 - 35,828.8) (840)
== 17% -.204=16.796% Merits of DCF methods It is only the best method incorporates the timing of benefits - time value of money It considers the economic life of the project It is a best method for both even and uneven cash inflows Demerits of DCF methods It involves with tedious method of computation It is very difficult to locate or identify the exact discounting factor
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It never performs functions of discounting to the tune of accounting concepts.
Illustration 12 XYZ company is considering an investment proposal to install new drilling controls at a cost of Rs.1,00,000. The facility has a life expectancy of 5 years and no salvage value. The tax rate is 35%. Assume the firm uses straight line depreciation and the same is allowed for tax purposes. The estimated cash flows before depreciation and tax form the investment proposal are as follows:
Year 1. 2. 3. 4. 5. Cash flows Before Tax Rs 20,000 21,384 25,538 26,924 40,770
Capital Budgeting
Calculate the following 1. 2. 3. 4. Pay back period Average rate of return Net present value at 10 percent discount rate Profitability index at 10 percent discount rate
The first and foremost step is to find out the Cash Flows After Taxation For finding out the Cash flows after taxation, the amount of depreciation i.e non recurring expenditure should be appropriately considered for calculation. The depreciation has to be computed in accordance with the stipulation given in the problem. The depreciation charged by the firm is nothing but straight line method. Straight line method of depreciation =
Initial Investment - Scrap value Economic life period of the machine Rs.1,00,000 = = Rs. 20,000 5 Years
The depreciation has to be deducted initially from the cash flows before taxation, after the deduction of taxation, the earnings after taxation should be added with the depreciation which was already deducted in order to find out the total cash flows after taxation. The purpose of deducting the depreciation is nothing but an amount to be charged under the Profit & Loss account against the total revenue. Being as a non-recurring expenditure not created any outflow cash resources. When there is no cash outflow, the amount of depreciation should be added finally to derive CFAT(Col 7)
Table
Year Col 1 CFBT Rs Col 2 Depreciation Rs Col 3 Profits Before Tax Rs Col 4=Col2Col3 Nil 1,384 5,538 6,924 20,770 Taxes (.35) Col 5 Earnings After tax Rs Col6=Col4 -Col5 Nil 900 3,600 4,500 13,500 22,500 Cash flows after tax Rs Col7= Col6+Col3
1. 2. 3. 4. 5.
20,000 21,384 25,538 26,924 40,770
20,000 20,000 20,000 20,000 20,000
Nil 484 1,938 2,423 7,270
20,000 20,900 23,600 24,500 33,500 1,22,500
1.
Pay back period method: Under this, method most important step is to identify the nature of the cash flows after taxation. Are they uniform ? No, they are not even cash flows. Hence, the cumulative cash flows after taxation has to be found in order to find out the pay back period of the investment.
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Year 1. 2. 3. 4. 5.
Cash flows After Tax Rs 20,000 20,900 23,600 24,500 33,500
Cumulative CFAT Rs 20,000 40,900 64,500 89,000 1,22,500
Pay back period= Pay back period for the major portion of the investment + Pay back period for the remaining portion unrecovered = 4 year +
Rs.11,000 = 4 year + .328 year Rs. 33,500
= 4.328 years 2. Average rate of return (ARR):
ARR =
Average Income 100 Average Investment
Average Income is the average of earnings after taxation of the entire duration. Why earnings after taxation has to be taken into consideration ? Why not the cash flows after taxation to be taken for consideration ? The main purpose of considering the earnings after taxation is that the amount extracted from the book of accounts and taken for the computation of ARR, and immediately after the payment of taxation. Average investment is the average of opening and closing investment. If the depreciation charge given is nothing but straight line method, automatically final value of the asset will become equivalent to zero. The closing balance of the asset /investment is zero. How the closing balance of the investment could be adjudged as equivalent to zero?
Table of Depreciation
Year 1. 2. 3. 4. 5. Opening balance of the year Rs 1,00,000 80,000 60,000 40,000 20,000 Closing balance of the year Rs 80,000 60,000 40,000 20,000 0
At the end of the year, the closing balance amounted Rs.0 after charging the depreciation year after year constantly in volume
Opening balance + Closing balance 2 Rs. 1,00,000 + Rs. 0 = 2 = Rs. 50.000 Rs. 22,500 Average Income = = Rs.4,500 5 years Rs. 4,500 Average rate of return = 100 = 9% Rs.50,000 Average =
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3.
Net present value method: Under this method, the future cash flow after taxation should be discounted at the rate 10%
Capital Budgeting
Year Cash flows after tax 1. 20,000 2. 20,900 3. 23,600 4. 24,500 5. 33,500 Total Present value Less Initial outlay Net present value
Present value factor @ 10% .909 .826 .751 .683 .621
Total Present Value Rs 18,180 17,263 17,724 16,734 20,803 90,704 1,00,000 ( 9,296)
The net present value is negative due to excessive investment more that of the present value of future earnings of the enterprise. Under this method, the investment is not advisable to procure for the firm's requirements. 4. Profitability Index The profitability index method is more useful in the case of more number of investments, having uneven investment outlays, but this problem comes with only one investment proposal It is much easier to assess even in the case of Net present value method. Profitability Index (PI) =
Pr esent value of cash inflows Rs.90,704 = Pr esent value of cash outflows Rs. 100,000 =.90704
The present value index quotient is less than that of the norms which should be greater than one but it secures only 90704. It means that the present value earnings are not sufficient to meet the initial cost of the machine.
Check Your Progress
(1)
Why the depreciation is added at the end of computation to derive the cash flow ?
(a) (b) (c) (d) Being as recurring charge Being considered as tax shield Being as non recurring charge None of the above
(2)
Why "0" value is taken as closing balance of the investment for the computation of Average investment ?
(a) (b) (c) (d) No value for the closing balance No value due to the application of straight line method of depreciation No scrap value at the end of the life of the asset None of the above
18.5 CAPITAL RATIONING

The capital rationing means that selection of investment proposals with reference to capital budget by considering the financial constraints. The selection of the investment proposals should be to the tune of required NPV which the firm wants to earn during the future. Under the capital rationing, there are two stages involved viz
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(i) (ii)
Identification of the investment proposals Selection of investment proposals
The selection of the investment proposals are on the basis of Discounted cash flows method. The selection of the investment proposals are subject to two different categories viz indivisible and divisible. The investment which is wholly accepted or rejected due to decision criterion which is known as indivisible project but the divisible projects are able to either accept or reject in parts.
18.6 DIVISIBLE PROJECT

A company has Rs. 7 Crore available for investment. It has evaluated its options and has found that only 4 projects given below have positive NPV. All these investment are divisible Advise the management which investments projects it should select.
Project X Y Z W Project Z W Y X Initial Investment Rs Cr 3.00 2.00 2.50 6.00 Initial Investment Rs Cr 2.50 6.00 2.00 3.00 NPV Rs Cr .60 .50 1.50 1.80 NPV Rs Cr 1.50 1.80 .50 .60 PI 1.20 1.25 1.60 1.30 PI 1.60 1.30 1.25 1.20
Out of the available Rs. 7 Cr, the first two projects selected on the basis of Profitability index viz Z and W. The total amount of investment required to invest in both the projects amounted Rs 8.50 Cr but the financial constraint is Rs.7 Cr. By considering the constraint, the first project fully accepted and the part of the next project W accepted for the remaining amount of corpus available by considering to maximize the NPV of the project as a whole.
18.7 INDIVISIBLE PROJECT

A company working against a self imposed capital budgeting constraint of Rs 70 Cr is trying to decide which of the following investment proposals should be undertaken by it. All these investment proposals are indivisible as well as independent. The list of investments along with the investment required and the NPV of the projected cash flows are given below
Project A. B. C. D. E. Initial Investment Rs Cr 10 24 32 22 18 NPV Rs Cr 6 18 20 30 20
The D, E and B are the project for making an investment which jointly amounted Rs 64 Cr and the remaining the Rs 6 cr to be invested into the project.
18.8 RISK ANALYSIS IN CAPITAL BUDGETING

In capital budgeting decisions, the risk component of the investment is not taken into consideration. The risk which is nothing but the business risk of the investment varies from one to another, to be considered in the real world situations. The risk which is nothing but the variability in between the actual returns and expected returns. The risk in the investment has to be incorporated in the discount rate for studying the worth of the project. To incorporate the risk in the discount rate, the meaning of the term risk should
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be known and distinguished from the uncertainty. The risk situation is one in which the probabilities of one particular event are known but the uncertainty is the situation in which the probabilities are not known. In the case of risk situation, the future losses can be foreseen unlike the uncertainty situation. The incorporation of the risk factor in the discount rate in accordance with the variability of the returns. If the variability of the returns are more, the investor may prefer higher return in the form of risk premium for risky project unlike in the case of government securities. The government securities are not having any variability in the returns which require the risk free return to discount only in order to know the worth of the investment but the risky projects are to be discounted only with the help of higher discount rates. There quite number of techniques available for incorporating the risk component in the capital budgeting are follows: Sensitivity analysis Standard deviation Coefficient of variation and so on.
Capital Budgeting
18.9 LET US SUM UP

The capital budgeting is the decision of long term investments, which mainly focuses the acquisition or improvement on fixed assets. The importance of the capital budgeting is only due to the benefits of the long term assets stretched to many number of years in the future. It is a tool of analysis which mainly focuses on the quality of earning pattern of the fixed assets. The methods are the nothing but the instruments of the capital budgeting to study the quality of the investments/fixed assets. The pay back period is the period taken by the firm to get back the investment. The pay back period is nothing but number of years / months/days required by the firm to get back its investment invested in the project. The capital rationing means that selection of investment proposals with reference to capital budget by considering the financial constraints. The selection of the investment proposals should be to the tune of required NPV which the firm wants to earn during the future. Under the capital rationing, there are two stages involved viz (i) (ii) Identification of the investment proposals Selection of investment proposals

Elucidate the advantages and disadvantages of the traditional methods of capital budgeting.
18.11 KEYWORDS
Capital budgeting: A study on Long term investment decision in terms of quality of benefits Pay back period: It is a time period during which the initial investment is recovered ARR: Accounting rate of return - It is being calculated in accordance with the financial statements PV: Present value IO: Initial outlay which is nothing but initial investment NPV: Net present value which is the difference in between the Initial investment and Present value of future cash inflows IRR: Internal rate of return which is nothing but highest rate of return expected to earn
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PI: Profitability Index is the ratio in between the present value of future cash inflows and present value of initial

1. 2. 3. 4. 5. 6. 7. 8. 9. Define capital budgeting. Highlight the importance of capital budgeting. "Success of the firm relies upon the rational capital budgeting decisions"- Discuss. What are two different classification of capital budgeting tools? Illustrate the Pay back period method with an example. Explain the process of computing the Accounting rate of return and their merits and demerits. List out the various methods of discounted cash flows. Explain the meaning of IRR and the process of calculating the IRR. List out the merits and demerits of the Discounted cash flows method.

M.P. Pandikumar According & Finance for Managers Excel Books, New Delhi. R.L. Gupta and Radhaswamy, Advanced Accountancy. V.K. Goyal, Financial Accounting, Excel Books, New Delhi. Khan and Jain, Management Accounting. S.N. Maheswari, Management Accounting. S. Bhat, Financial Management, Excel Books, New Delhi. Prasanna Chandra, Financial Management Theory and Practice, Tata McGraw Hill, New Delhi (1994). I.M. Pandey, Financial Management, Vikas Publishing, New Delhi. Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.
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LESSON
19
RISK AND RETURN
CONTENTS
19.0 Aims and Objectives 19.1 Introduction 19.2 Meaning of Return & Rate of Return 19.3 Concept and Types of Risk 19.3.1 Interest Rate Risk 19.3.2 Market Risk 19.3.3 Inflation Risk 19.3.4 Business Risk 19.3.5 Financial Risk 19.3.6 Liquidity Risk 19.3.7 Measurement of Risk 19.4 Risk and Return of the Portfolio 19.4.1 Diversification of the Risk of Portfolio 19.5 Relationship between the Risk and Return 19.6 19.7 19.8 19.9 19.10 Let us Sum up Lesson-end Activity Keywords Questions for Discussion Suggested Readings

This lesson is intended to study the various aspects of risk and return of investment projects. After studying this lesson you will be able to: (i) distinguish between return and rate of return (ii) describe meaning and types of risk (iii) diversify the risk of portfolio (iv) establish relationship between the risk and returns.
19.1 INTRODUCTION
Risk and Return of the investments are interrelated covenants in the selection any investments, which should be studied through the meaning and definition of risk and return and their classification of themselves in the first part of this chapter and the relationship in between them is illustrated in the second half of the chapter.
19.2 MEANING OF RETURN & RATE OF RETURN

Return is the combination of both the regular income and capital appreciation of the investments.
The regular income is nothing but dividend/interest income of the investments. The capital appreciation of the investments are nothing but the capital gains of the investments i.e the difference in between the closing and opening price of the investments. Return symbolized as follows D1 + Pt Pt 1 Pt 1 If the price of a share on April 1 (current year) is Rs 25 and dividend received at the end of the year is Re 1 and the year end price on Mar 31 is Rs. 30 Re 1 + (Rs30 Rs25) Rate of Return = Rs.25 =. 24 = 24% The next aspect is current yield which is nothing but denomination of the income of the investments only in terms of market price These two categories, Earnings yield and Capital gains yield Annual Income + beginning price Annual Income = Rs. 1/Rs. 25 = .04 = 4%* Capital Gains = Rs. 5/Rs. 25 = 0.20 = 20%** Earnings per share *Earnings Yield = Market price per share*** ** Capital gains yield =
Price Change Market price per share***
***Beginning Price of the share/Investment
Stock & Debenture Rate of Return

If it is a share - Dividend will be the annual income and the second one is a capital appreciation If it is a Debenture - Interest will be the annual income, i.e., coupon rate of interest And if any capital appreciation is available that could be considered.
19.3 CONCEPT AND TYPES OF RISK

The variability of the actual return from the expected return which is associated with the investment /asset known as risk of the investment. Variability of return means that the Deviation in between actual return and expected return which is in other words as variance i.e., the measure of statistics. Greater the variability means that Riskier the security/ investment. Lesser the variability means that More certain the returns, nothing but Least risky e.g. Treasury Bills, Savings Deposit. The risk can be further classified into six different categories Interest rate risk Inflation risk Financial risk Market risk Business risk and Liquidity risk
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19.3.1 Interest Rate Risk

It is risk variability in a security's return resulting from the changes in the level of interest rates. Security prices - inverse relationship with
L
Risk and Return
Recent announcement of the monetary policy by RBI- Hike in CRR 5. 50 points to 6 points; change in the rate of interest - change in the prime lending rate of the banks - Due to Rs. 14,000 cr. amount to be deposited in the Reserve Bank of India by the Banks - to curtail the Inflation
Impact on the Security Prices

If the rate of interest increases then the price of the existing securities will come down due to more attraction on the new instruments due to lesser demand on the existing securities more particularly during the periods of inflationary period If the rate of interest decreases means that the price of the existing securities will go up due to lesser attraction on the new investment avenues which are found to be greater demand for new securities during the periods of deflationary period.
19.3.2 Market Risk

It refers to variability of returns due to fluctuations in the securities market which is more particularly to equities market due to the effect from the wars, depressions etc. E.g., Greater/lesser investments by the mutual funds, banks, Foreign institutional investors and so on due to entry into or out of the market reflects the market index is the market risk.
19.3.3 Inflation Risk

Rise in inflation leads to Reduction in the purchasing power which influences only few people to invest due to Interest Rate Risk which is nothing but the variability of return of the investment due to oscillation of interest rates due to deflationary and inflationary pressures.
19.3.4 Business Risk

Risk of doing business in a particular industry / environment is known as business risk. Business risk is nothing but Operational risk which arises only due to the presence of the fixed cost of operations. The Higher the fixed cost of operations requires the firm to have Greater BEP to avoid the firm to incur losses. It is normally transferred to the investors who invest in the business or company, the major reason is that EBIT of the firm is subject to the fixed cost of operations.
19.3.5 Financial Risk

Connected with the raising of fixed charge of funds viz Debt finance & Preference share capital. More the application of fixed charge of financial will lead to Greater the financial Risk which is nothing but the Trading on Equity.
19.3.6 Liquidity Risk

This is the risk pertaining to the secondary Market, in which the securities can be Bought and sold quickly and without any concession in the price.
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Liquidity risk reflects only due to the quality of benefits with reference to certainty of return to receive after some period which is normally revealed in terms of quality of benefits. The more the certainty of benefits leads to lesser the liquidity risk and vice versa.
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The government & Treasury bills are bearing greater certainty to receive the benefits which have least probabilities to fail, denominates that is Lesser Liquidity Risk. The Equity shares of the companies are bearing the Greater Liquidity Risk is subject to the quality of benefits, due to the declaration of dividends, which is subject to the availability of earnings i.e., EBIT, EAT, EPS and DPS; which are nothing but the determinants of Demand and supply them in the market among the investors.
19.3.7 Measurement of Risk

Assessment of risk Behavioural Statistical
Sensitivity Analysis
Probability Standard. Co.-variance Distribution Deviation
The first one is that sensitivity analysis taken for discussion. It considers all possible outcomes/return estimates in evaluating risk to study the deviation of the expected returns which is nothing but the Sense of Variability among return estimates. It is being studied through the classification of the span of the investments into following categories viz pessimistic, most likely and optimistic. The above set of classifications are on the basis of cycle of the industry or product which it belongs or markets the product. The next one is to highlight the risk component through the sensitivity analysis
Particulars Initial outlay (t = 0) Pessimistic Most Likely Optimistic Range Asset A 50 14 16 18 4 Asset B 50 8 16 24 16
The risk is nothing but the difference in between the optimistic and pessimistic returns, in other words range of the returns. The range of the returns is nothing but the difference in between highest and lowest returns which normally arise during the periods of boom and recession. The greater the range refers to the greater the amount of risk and vice versa. From this table we identify that Asset B is found to be more risky than the asset A, the reason is higher rang in the case of Asset B unlike Asset A; which highlights the difference in between the returns of optimistic and pessimistic. This method is found to be a crude method in studying the risk of the securities. To nullify the bottlenecks associated with the sensitivity analysis, probability distribution is considered for the discussion of risk to study more in detail than the earlier sensitivity analysis. The probabilities are assigned to reveal the possibilities of occurrence of the event which ranges in between 1-100% of occurring. If it is certain to occur means that P= 1 If is not certain to occur means that Q = 1 Based on the probabilities, the expected return of the investment could be found out through the multiplication of the respective returns of the horizon which in relevance with possibility of occurrences. Expected rate of return of the security is as follows :- it is weighted average of all possible returns multiplied by the respective probabilities. Probabilities of various Outcomes during the various seasons are known as weights
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KP
The risk can be determined through the statistical measure of dispersion of returns of an expected value of return of the security. Risk is the Standard deviation of returns from the mean/expected value of return Square root of squared deviations of the individual expected returns ( (KK)2 P)1/2 Standard Deviation: Greater the standard deviation - Greater the risk Does not consider the variability of return to the expected value This may be misleading - if they differ in the size of expected values In order to replace the bottlenecks associated with the standard deviation in studying the risk of the security, the co-variation is suggested to study the risk of the security It is a measure of dispersion/ measure of risk per unit of expected return It converts the standard deviation of expected values into relative values to enable comparison of risks with assets having different expected values. Coefficient of variation =
Risk and Return
S.D Mean
19.4 RISK AND RETURN OF THE PORTFOLIO

Portfolio is the Combination of two or more assets or investments. Portfolio Expected Return is the weighted average of the expected returns of the securities or assets in the portfolio. Weights are the Proportion of total funds in each security which form the portfolio Wj Kj. Wj = funds proportion invested in the security. Kj = expected return for security J. The risk of the portfolio could be determined what it was in the process of individual assets? Benefits of portfolio holdings are bearing certain benefits to single assets. Including the various type of industry securities - Diversification of assets. The portfolio construction leads to bring down the risk of the portfolio than the risk of single assets. It is not the simple weighted average of individual security. Risk is studied through the correlation/co-variance of the constituting assets of the portfolio. The Correlation among the securities should be relatively considered to maximize the return at the given level of risk or to minimize the risk. Correlation of the expected returns of the constituent securities in the portfolio. It is a Statistical expression which reveals the securities earning pattern in the portfolio as together. Positive correlation means that Return of the securities in the portfolio are moving together in same direction. Negative correlation which illustrates that the Return of the securities are moving in opposite direction. Zero correlation reveals that there is - No relationship in between the earnings pattern among the securities of the portfolio. The Co-efficient of correlation normally ranges in between 1 and +1.
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19.4.1 Diversification of the Risk of Portfolio

Diversification of the portfolio can be done through the selection of the securities which have negative correlation among them which formed the portfolio. The return of the risky and riskless assets are only having the possibilities to bring down the risk of the portfolio. The following example will certainly facilitate to understand the diversification process of the securities in the portfolio through the correlation co efficient of the returns of the securities which formed the portfolio:
Year A 1 2 3 4 5 Expected return Standard deviation 10 12 14 16 18 14 2.83 Assets/Securities % B 18 16 14 12 10 14 2.83 C 10 12 14 16 18 14 2.83 Portfolio % AB 14 14 14 14 14 14 0 AC 10 12 14 16 18 14 2.83
The above table reveals that Portfolio AB is the better one to diversify the risk as minimum as possible, the reason is that the returns of the respective securities are having negative correlation among A&B unlike A &C. The negative correlation of the returns between the A&B only facilitated to reduce the risk to the levels of minimum. The risk of the portfolio cannot be simply reduced by way adopting the principle of correlation of returns among the securities in the portfolio. To reduce the risk of the portfolio, the another classification of the risk has to be studied, which are as follows: The risk can be further classified into two categories viz Systematic and Unsystematic risk of the securities Systematic Risk - which cannot be controlled due to market influences which is known as Uncontrollable risk, cannot be avoided Unsystematic Risk-Which can be minimized or reduced this type of risk through diversification of the securities in the portfolio Systematic Risk- Unavoidable, Uncontrollable risk - finally Market risk War, inflation, political developments Unsystematic Risk- Avoidable, Controllable risk. Strike, Lock out, Regulation Systematic Risk: Which only requires the investors to expect additional return/ compensation to bear the Unsystematic Risk: The investors are not given any such additional compensation to bear unlike the earlier. The relationship could be obviously understood through the study of Capital Asset Pricing Model (CAPM). Developed by William F. Sharpe Explains the relationship in between the risk and expected / required return Behaviour of the security prices Extends the mechanism to assess the dominance of a security on the total risk and return of a portfolio Highlights the importance of bearing risk through some premium Efficiency of the markets L Investors are well informed
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No transaction costs - No intermediation cost during the transaction
No single investor is to influence the market
Risk and Return
Investor preferences
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Highest return for given level of risk Or Lowest risk for a given level of return Risk - Expected value, standard deviation
19.5 RELATIONSHIP BETWEEN THE RISK AND RETURN

Total Return - Risk free rate of return= Excess return (Risk premium) Total return = Risk free return + Risk premium Kj = Rf + bj (KmRf) Bj is nothing but Beta of the security i.e., market responsiveness of the security. Beta differs from one security to another. It is normally expressed as a b b=
Non Diversifiable risk of asset or Portfolio Risk of the Market Portfolio
Risk of the portfolio = After diversification, the risk of the market portfolio is non diversifiable
Check Your Progress 1. Return means (a) (c) 2. Regular income only (a) & (b) (b) (d) Capital appreciation income None of the above
Risk means (a) (c) Variability of returns Mean of the returns (b) (d) Non variability of returns None of the above
3.
Interest rate risk means (a) (b) (c) (d) Affects the price of the existing securities due to change in the rate of interest Affects the price of the new securities due to change in the rate of interest Affects the price of the existing and new securities due to change in the rate of interest None of the above
4.
Systematic risk is (a) (c) Controllable (b) Uncontrollable None of the above
Neither controllable nor uncontrollable (d)
5.
Beta is (a) (b) (c) (d) Diversifiable risk Undiversifiable risk Neither diversifiable nor undiversifiable None of the above
6.
Return is (a) (b) Risk free return Risk premium

Contd...
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(c) (d)
Risk premium pegged with Beta Risk free return and Risk premium pegged with Beta
19.6 LET US SUM UP

The variability of the actual return from the expected return which is associated with the investment /asset known as risk of the investment. Variability of return means that the Deviation in between actual return and expected return which is in other words as variance i.e., the measure of statistics. Greater the variability means that Riskier the security/ investment. If the rate of interest increases then the price of the existing securities will come down due to more attraction on the new instruments due to lesser demand on the existing securities more particularly during the periods of inflationary period. The govt & Treasury bills are bearing greater certainty to receive the benefits which have least probabilities to fail, denominates that is Lesser Liquidity Risk. The risk is nothing but the difference in between the optimistic and pessimistic returns, in other words range of the returns. The range of the returns is nothing but the difference in between highest and lowest returns which normally arise during the periods of boom and recession. The greater the range refers to the greater the amount of risk and vice versa. Systematic Risk only requires the investors to expect additional return/compensation to bear the Unsystematic Risk investors are not given to any such additional compensation to bear unlike the earlier.

How will you diversify the risk of portfolio? Elucidate your answer with your own example.
19.8 KEYWORDS
Risk: Deviation in between the actual return and expected return Return: It is the combination of regular income and capital appreciation income Yield: Total earnings in terms of market price Income yield: Earnings in terms of market price Interest risk: Deviation of return of the security due to fluctuations of interest Inflation risk: Deviation of return of the security due fluctuations in the purchasing power with reference to money supply Operation risk: Risk which is due to fixed cost of operations Finance risk: Risk due to the application fixed charge of funds Beta: Co efficient of market responsiveness of the security Systematic risk: Risk which cannot be diversified Unsystematic risk: Risk which can be diversified Risk free return: Return on risk less investments Risk premium: Return for the undiversifiable risk to bear CAPM: Capital Asset Pricing Model for the relationship in between Risk and Return

1.
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Define return. Define risk.
2.
3. 4. 5. 6. 7. 8.
Explain different types of risk. Explain different types of return. Explain the various statistical measures available for risk. Define Beta. Elucidate the systematic and unsystematic risk. Highlight importance and assumptions of CAPM.
Risk and Return

R. L. Gupta and Radhaswamy, Advanced Accountancy. V. K. Goyal, Financial Accounting, Excel Books, New Delhi. M. P. Pandikumar Accounting and Finance for Managers, Excel Books, New Delhi. Khan and Jain, Management Accounting. S. N. Maheswari, Management Accounting. S. Bhat, Financial Management, Excel Books, New Delhi. Prasanna Chandra, Financial Management Theory and Practice, Tata McGraw Hill, New Delhi (1994). I. M. Pandey, Financial Management, Vikas Publishing, New Delhi. Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.
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UNIT-V
LESSON
20
COST OF CAPITAL
CONTENTS
20.0 20.1 20.2 20.3 20.4 20.5 20.6 20.7 20.8 20.9 Aims and Objectives Introduction Meaning and Assumptions of Cost of Capital Measurement of Cost of Debt Cost of Preference Share Capital Cost of Retained Earnings Weighted Average of Cost of Capital Let us Sum up Lesson-end Activity Keywords
20.10 Questions for Discussion 20.11 Suggested Readings

The purpose of this lesson is to discuss about the cost of capital which is used as a phenomenon for the decision criterion in the case of studying the worth of long-term assets. After studying this lesson you will be able to: (i) (ii) understand meaning and assumptions of cost of capital describes measurement of cost of debt
(iii) solve problems on cost of debt (iv) solve problems on cost of preference share of capital (v) describe cost of retained earnings.
20.1 INTRODUCTION
It is imperative to study the importance of cost of capital to the tune of financing decision of the firm. The financing decision of the firm normally facilitates the firm to raise the financial resources to the requirements of the firm. The raising of the financial resources should be carried out not only to the tune of financial requirements but also it should mind about the cost of availing the resource; which means that the cost of raising and applying the resources in and of the organization. The cost is the most limiting factor of influence for the success of the firm, the reason is that the cost of capital is the major determinant of success of the business firm. The firm must be facilitated to raise the financial resources at cheaper cost in order to earn more and more.
The cost of capital is used as a phenomenon for the decision criterion in the case of studying the worth of long-term assets, which have got greater importance in the success of the firm. The cost of capital is instrumented in the Net present value method and Internal rate of return method of studying the worth of long-term assets under the capital budgeting decisions of the enterprise.
20.2 MEANING AND ASSUMPTIONS OF COST OF CAPITAL

It is the Minimum rate of return which the firm should or must earn only in order to maintain the value of the shareholders. Classification of the cost of capital: The cost of capital can be classified into two categories viz specific cost of capital and weighted cost of capital.
Assumptions
It is on the basis of Operating Risk i.e., Business Risk of the firm which is nothing but determinant of influence is Fixed Cost of Operations. The cost of capital is subject to the volume of fixed cost of operations of the firm. On the basis of Financial Risk i.e., with reference to Financial Commitments of the firm which in other words as financial Risk. The Interest on debenture, Preference Dividend on Preference share capital should be paid without fail irrespective of the firms' earnings according to the terms and conditions of the issue. The greater the fixed financial commitments require the firm to earn more and more in order to retain the interest of the shareholders of the firm. Operational Terms - capital structure remain unchanged; unless the cost of capital of the firm would change. For new projects, funds are raised only at same proportion. How the cost of capital is to be denominated in terms ? Whether the cost of capital is to be denominated in terms of after tax or before tax. Why it has to be expressed in terms of after tax ? Why not the before tax cost should be taken into consideration? For appraising the projects, the return of the investments are considered for comparison which are nothing but the resultant of earnings of the firm immediately after the payment of tax. To study the quality of the projects, both factors must be at common at parlance for comparison. While computing the cost of capital, the cost of specific sources should be to the tune of after tax only in order to have an effective comparison.
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Then, the cost of capital is further bifurcated into two categories viz Explicit cost of capital and Implicit cost of capital. Explicit cost of capital: The discount rate that equates the present value of the cash inflows that are incremental to the taking of the financing opportunity with the present value of its incremental cash outflows.
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It is further explained that rate of return of cash flow of the financing opportunity. It normally takes place only at the moment of raising of financial resources. Implicit cost of capital: It is nothing but the Opportunity cost of capital of the firm to earn through investing elsewhere by the shareholders themselves or by the company itself. It is rate of return which is associated with the best investment opportunity for the firm and its shareholders that would have to be forgone, which were presently considered by the firm. Specific cost of specific source of capital: Each source of capital has its own cost at the moment of raising which form part of the computation of total cost of capital of the firm.
20.3 MEASUREMENT OF COST OF DEBT

The cost of the perpetual debt is nothing but the cost of raising the debt financial resource, in which the time period of repayment of the principal is not known. This particular specific source has two different classifications viz cost of interest and cost of debt.
Cost of interest (Ki) = Interest Sale value
Cost of Capital
Cost of Debt (Kd) =
Tax adjusted Interest Sale value
Problem on Cost of Debt

A company has 10 percent perpetual debt of Rs.1,00,000. The tax rate is 35 per cent. Determine the cost of capital (before tax as well as after tax) assuming the debt is issued at i) at par ii) at 10% discount iii) at 10% premium.
At par Cost of Interest Ki= Rs.10,000/Rs.1,00,000=10% Cost of Debt Kd= Rs.10,000(1-.35)/Rs.1,00,000= 6.5% At Discount Cost of Interest Ki=Rs.10,000/ Rs.90,000= 11.11% Cost of Debt Kd= Rs.6,500/90,000= 7.22% At Premium Cost of Interest Ki= Rs.10,000/Rs.1,10,000=9.09% Cost of Debt Kd=Rs 6,500/Rs.1,10,000=5.90%
Check Your Progress
1.
A company is considering raising Rs 100 lakh by one of the two alternative methods. viz 14 percent institutional term loan and 13 percent non - convertible debentures. The term loan option would attract no major incidental cost. The debentures would have to be issued at a discount of 2.5 per cent and would involve Rs. 1 lakh as cost of issue. Advise the company as to the better option based upon the effective cost of capital in each case. Assume tax rate of 35 per cent.
The next method of computing the cost of debt is only for the debt finance which knows the repayment period of the principal and the payment of the interest periodicals. This process of computation could be divided into two categories First one is the periodical repayment of the principal along with the periodical payment of interest periodicals.
CIo =
COIt + COPn (1 + kd) t
The second one is the lump sum repayment of the principally only at the end of the term of the debenture.
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CIo =
COIt COPn + (1+kd)t (1+Kd)n
Problem on cost of debt

A company issues a new 10 percent debentures of Rs.1,000 face value to be redeemed after 10 years. The debenture is expected to be sold at 5 percent discount. It will also involve flotation cost of 5 per cent of face value. The companys tax rate is 35 per cent what would be the cost of debt be ? Illustrate the computations i) trial and error approach and ii) shortcut method. Trial Error approach: The first step is to determine the cash flows involved in the process of the debentures issue
Years 0 Particulars Rs.900 at the moment of raising i.e., cash in flow during the issue of debentureRs.1,000Rs.50 Rs.50 Regular flow interest payment The interest outflow which is subject to the adjustment of taxation Rs100(1 0.35)=Rs.65 Final repayment of the principal The last payment is nothing but the repayment of the principal Rs.1,000
1-10
10
Rs. 900 =
Rs 65 Rs. 1,000 + t T =1 (1+kd) (1+Kd) n
10
The present value of the future cashflows should be found out one after the another. The determination of present value at 7% and 8%
Years Cash Present value @ 7% 1-10 10 Rs.65(Annuity Table) 1,000(Single flow table) 7.024 0.508 @ 8% 6.710 .463 Total Present value @7% Rs.456.56 Rs.508.00 964.56 @ 8% Rs.436.15 Rs.463.00 899.15
The value of Cost of debt is 8% The short cut method is as follows
Kd =
I(1 t) + (f + d + pred - pi)/N (RV + SV)/2
I=Annual interest payment T=tax rate F=Flotation cost d=Discount on debentures pred=premium on redemption pi=premium on issue of debentures RV=Realisable value SV=Sale value Kd= 7.9%
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Check Your Progress
Cost of Capital
A company issues 11 percent debentures of Rs.100 for an amount aggregating Rs.1,00,000 at 10 percent premium, redeemable at par after five years. The companys tax rate is 35 per cent. Determine the cost of debt using the shortcut method.
20.4 COST OF PREFERENCE SHARE CAPITAL

The next specific source of cost is cost of preference share capital Cost of preference share capital - From the angle of interest on the amount of debentures it is also like a fixed in charge but not contractual obligation, but the interest payment is contractual in obligation in accordance with the terms and conditions of the issue agreement reached earlier with the company, irrespective of the profits earned. Preference dividend is to be paid only with reference to availability of profits. Normally the Expectations of the preference shareholders are nothing but the preference dividends. The preference shares are classified into two categories viz Redeemable and Irredeemable Let us discuss at first about the Irredeemable preference shares during the issue The first one is the methodology for the computation of the cost of irredeemable preference share
Kp =
Dividend preference share P0 (1f)
The second methodology incorporates the dividend taxation which is normally borne by the company during the moment of declaration.
Kp =
Kp=Dividend prefernce(1+Dt) P0 (1f)
ABC company issues 11 percent irredeemable preference shares of the face value of Rs. 100 each. Flotation costs are estimated at 5 per cent of the expected sale price a) par value b) 10% premium c) 5% discount and also compute the Dividend tax at 13.125%
At par Cost of Preference share capital Kp= Rs11./Rs 95.=11.57% Cost of preference share with dividend tax Kp = Rs.11(1+.13125) = 13.09% Rs.95 At Discount Cost of Preference share capital Kp=Rs.11/ Rs.110(.95).= 10.5% Cost of preference share with dividend tax Kp = Rs.11(1+.13125) = 13.81% Rs 110(.95) At Premium Cost of Preference share capital Ki= Rs.11/Rs.95(.95)=12.2% Cost of preference share capital with dividend tax Kd = Rs.11(1+.13125) = 13.78% Rs 95(.95)
The next methodology under the preference share capital is the cost computation for redeemable preference share capital. Under this the period of payment of capital is known along with the payment periodical preference dividends.
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Po (1-f) =
Dp Pn + t (1+kp) (1+kp)n
Problem on the preference share capital

Xion Ltd has issued 11% preference shares of the face value of Rs.100 each to be redeemed after 10 years. Floatation cost is expected to be 5% Determine the cost of preference shares Kp
10
Rs. 95 =
T =1
Rs 11 Rs. 1,000 + (1+kp) t (1+Kd)10
The value of the Kp is lying in between the two rates of discounts viz 11% and 12% Determination of present value in between 11% and 12%
Year 1 to 10 years 10th yr completion Cash outflow Rs11 Rs.100 Present value @ 5.889 .362 5.65 .322 Total Present value @ Rs 64.78 35.15 99.93 62.15 32.20 94.35
Cost of preference share capital is Kp= 11.9% The next important cost to be determined is that cost of equity share capital: Equity dividends is not at par with Interest and Preference dividends, these two are subject to fixed in principle. The payment of dividends are subject to the availability of earnings and the future prospects of the firm in the future to grow. Equity shareholders are the last claimants of the company not only in sharing the profits of the company at the end of every year immediately after anything paid to the preference shareholders. It never carries any fixed rate of dividends subject to the availability of profits to disburse. Market value of shares are determined by the Equity dividends which are nothing but the return expect to get. Ke= a minimum rate of return which the firm should earn from the equity portion of financing of the project in order to maintain the value of the share prices. There are many more models in the computation of cost of equity i) ii) Dividend valuation model Capital Asset Pricing Model Dividend valuation model: The Cost of equity capital Ke is in terms of required rate of return to the tune of future dividends to be paid to the investors.
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It is discount rate which equates the present value of future dividends per share with sale proceeds of a share (after adjusting the expenses of flotation of a share)
Po =
Dividend of the first year1 Ke g

Dividend of the first year1 + G Po
Ke =
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Problem: Dividend per share Re 1 Growth rate = 6% Assuming the market price is Rs. 25 What would be market price of a share after 1 year and 2 year Ke= Re.1/25+ 6%= 4%+ 6%= 10% The market price at the end of 1 year
Cost of Capital
P1 =
Rs.1.06 10%-6%
= Rs.26.5
The market price at the end of 2nd year
P2 =
Rs.1.12 = Rs.28 10%-6%

Capital Asset Pricing Model approach: The cost of equity share capital is computed by registering the Beta with reference to the non diversifiable risk in addition to the diversifiable risk of the equity share with reference to market responsiveness.
The basic assumptions of the CAPM approach (i) (ii) The efficiency of the security markets Investor preferences
The efficiency of the security markets is embedded with the following assumptions: (a) (b) (c) (d) (e) All investors are common expectations about the expected returns, variances and correlation of the expected returns among the various securities in the market All investors have equivalent amount of information All investors are rational No transaction costs No single investor influence the market (i) (ii) Highest level return at minimum level risk or Lowest level of risk for given level of return
The investors' preference with reference to two different types of returns
The above alternatives are subject to two different type of risk viz Systematic and Unsystematic risk. Systematic risk which cannot be reduced i.e., undiversifiable risk for which allowances are given to the investors. Unsystematic risk which can be reduced to the level of minimum for which no other allowances are given to the investors. The allowances are given to the investors only subject to the market responsiveness Beta coefficient Ke= Rf+ b(KmRf) Problem The hypothetical ltd wishes to calculate the cost of equity capital using the CAPM approach. From the information that the risk free rate of return equals 10% ; the firms beta equals 1.50 and the return on the market portfolio equals 12.5% Compute the cost of equity capital Ke= 10% + 1.5(12.5%-10%)=13.75%
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20.5 COST OF RETAINED EARNINGS

The next important cost of specific source of capital is cost of retained earnings. The cost of retained earnings is to be computed on the basis of opportunity cost. It does not have any direct cost, instead, the amount of retained earnings loses the opportunity of the investors to earn in the form of dividends due to retained earnings; which are foregone by them one side and on the other side the earnings which are retained are invested in some other investments, would be in a position to yield the return, is the cost of retained earnings. It could be defined as "cost of retained earnings is the opportunity cost in terms of dividends foregone by with held from the equity shareholders." The cost of retained earnings is nothing but the external criterion which is equal to the Ke. Practically speaking, Ke is more than the Kr due to the floatation cost involved in the process of issue of shares.
20.6 WEIGHTED AVERAGE OF COST OF CAPITAL

The term cost of capital is nothing but the overall cost of capital which is to be computed to the tune of the proportion of the funds in the mixture; should computed only to the tune of assignment of weights. The weight average cost of capital has its own steps to follow during the process of computation. Assigning the weights Multiplying the weights with the specific cost of the fund Dividing the total cost immediately after adding them together by the summation of weights It is denominated by Ko The weights are normally classified into two major classification viz Marginal weights Historical weights Marginal weights: Assignment of weights to the specific cost by the proportion of the each fund to be raised to the total fund Historical weights: The weights are assigned to the specific source of fund to the tune of the proportion of the fund in the existing capital structure. This type of historical weight is further classified into two different categories viz: Book value weights and Market value weights. Book value weights are assigned to the tune of book values to measure the proportion of each type of capital. Market value weights are assigned to the tune of market value to measure the proportion of each type of capital. Problem A company has on its books the following amounts and specific cost of each type of capital.
Type of capital Debt Preference Equity Retained earnings
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Book value Rs.4,00,000 1,00,000 6,00,000 2,00,000 13,00,000
Market value 3,80,000 1,10,000 12,00,000 16,90,000
Specific cost Rs 5 8 15 13
Determine the weighted average cost of capital using (a) Book value weights and (b) Market value weights. The determination of the weighted average cost of capital using book value weights
Type of capital Debt Preference Equity Retained earnings Market value 3,80,000 1,10,000 9,00,000 3,00,000 16,90,000 Specific cost Rs 5 8 15 13 Total costs BV* K Rs.20,000 8,000 90,000 26,000 1,44,000
Cost of Capital
Ko =
Rs.1,44,000 100 = 11.1% Rs.13,00,000
The determination of Market value weights

Type of capital Debt Preference Equity Retained earnings Book value Rs.4,00,000 1,00,000 6,00,000 2,00,000 13,00,000 Specific cost Rs 5 8 15 13 Total costs BV* K 19,000 8,000 1,35,000 39,000 2,01,000
Ko =
Rs.2,01,000 100=11.9% Rs.13,00,000
20.7 LET US SUM UP

The cost is the most limiting factor of influence for the success of the firm, the reason is that the cost of capital is the major determinant of success of the business firm. The cost of capital is used as a phenomenon for the decision criterion in the case of studying the worth of long-term assets. Cost of capital is the minimum rate of return which the firm should or must earn only in order to maintain the value of the shareholders. The cost of the perpetual debt is nothing but the cost of raising the debt financial resource, in which the time period of repayment of the principal is not known. This particular specific source has two different classifications viz cost of interest and cost of debt. The term cost of capital is nothing but the overall cost of capital which is to be computed to the tune of the proportion of the funds in the mixture; should computed only to the tune of assignment of weights. The weight average cost of capital has its own steps to follow during the process of computation.

A company has issued 15% preference shares of the face value of Rs.100 each to be redeemed after 20 years. Flotation cost is expected to be 5% of the expected sales price. Determine the cost of preference shares.
20.9 KEYWORDS
Cost of capital: It is the minimum rate of return to be earned at which the capital is raised Implicit cost of capital: It is the minimum rate of return to be earned by the firm, at the moment of retaining the earnings, towards the investment decision
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Explicit cost of capital: It is the cost incurred by the firm at the moment of raising Specific cost of capita: It is the cost incurred at every moment for raising the specific resource of capital Book value weights: Weights assigned to the tune of the book value of the capital Weighted average cost of capital: The aggregate of the weighted specific resources cost of capital is weighted average cost of capital

1. 2. 3. 4. Define cost of capital. Explain the various types of cost of capital. Explain the methodology involved in the process of computing the weighted average cost of capital. Explain the meaning of assigning the weights on the specific sources of capital.

R.L. Gupta and Radhaswamy, Advanced Accountancy. V.K. Goyal, Financial Accounting, Excel Books, New Delhi. Khan and Jain, Management Accounting. S.N. Maheswari, Management Accounting. M.P. Pandikumar Accounting & Finance for Managers, Excel Books, New Delhi. S. Bhat Financial Management, Excel Books, New Delhi. Prasanna Chandra, Financial Management Theory and Practice, Tata McGraw Hill, New Delhi (1994). I.M. Pandey, Financial Management, Vikas Publishing, New Delhi. Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.
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LESSON
21
LEVERAGE ANALYSIS
CONTENTS
21.0 21.1 21.2 21.3 21.4 21.5 21.6 21.7 21.8 21.9 Aims and Objectives Introduction Operating Leverage Financial Leverage EBIT-EPS Analysis Combined Leverage Let us Sum up Lesson-end Activity Keywords Questions for Discussion
21.10 Suggested Readings

The main objective of this lesson is to discuss about operation and financial leverages and their impact. After studying this lesson you will be able to: (i) (ii) describe the concept of operating leverage and calculate the degree of operating leverage explain various aspects of financial leverage
(iii) describe EBIT-EPS analysis to study the impact of the leverage
21.1 INTRODUCTION
Leverage means the fixed commitment of the organization. The fixed commitment of the organization can be classified into two different categories viz fixed cost of operations and fixed cost of servicing. The fixed cost of operations are pertaining to the investment decisions and the fixed cost of servicing with reference to the financing decision. Fixed cost of operations Investment decisions. Fixed cost of servicing Financing decisions. If Revenues are more than the Variable Cost and Fixed Cost, that is called favorable or otherwise unfavorable.
21.2 OPERATING LEVERAGE

Operating Leverage is connected with the acquisition of assets where as the financial Leverage is connected with the Financing of activities.
Operating leverage: It is a relationship in between the Sales and Earnings before interest and taxes. Financial leverage: It is a relationship in between the Earnings before interest and taxes and Earnings per share. Operating and Financial: In the Operating and Financial leverages, the EBIT is found as a common phenomenon. During the first part of the chapter, let us discuss about the operating leverage. It emerges only due to Fixed operating expenses. By and large, the expenses are classified into two categories viz Fixed and Variable in categories for the analysis of leverage. Operating Leverage is defined as the ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes. Described as % change in profits accompanying the % change in volume. "The firms' ability to use fixed operating costs to magnify the effects of changes in the sales on its earnings before interest and taxes". A firms sells products for Rs 100 per unit has variable operating costs of Rs. 50 per unit and fixed operating cost of Rs. 50,000 per year. Show the various levels of EBIT that would result from sale of i) 1000 units ii) 2000 units iii) 3000 units.
Case B Level from the base Sales in units Sales volume in Rs Variable cost Contribution Fixed cost Profit 50% 1,000 1,00,000 50,000 50,000 50,000 Zero 100% 2,000 2,00,000 1,00,000 1,00,000 50,000 50,000 Base Case A +50% 3,000 3,00,000 1,50,000 1,50,000 50,000 1,00,000 +100%
From the above illustration, it is obviously understood that from the two different cases. Case A illustrates that 50% increase in the volume of sales led to 100% increase in the volume of profit. Case B highlights that 50% reduction in the volume of sales led to 100% decrease in the volume of profit. It is clearly evidenced that % change in the volume of sales is less than the % change in the volume of profit. The next step is to define the Degree of Operating Leverage (DOL) DOL is the measure reveals the extent or degree of operating leverage. When Operating leverage exists ? Proportionate change in EBIT of a given change in sales is greater than the Proportionate in sales
DOL =
Percentage change in EBIT Percentage change in Sales
>1
Case A= 100%/50%= =+2 Case B=(100%)/(50%)=+2

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By algebraically proven and the following formula has derived to determine the DOL through the alternate methodology
Leverage Analysis
DOL =
Total Contribution (Base Level) EBIT ( Base Level)
To determine the degree of the operating leverage, from the above illustration which is applied DOL= Rs.1,00,000/Rs.50,000= +2 The answer of the DOL has been checked in both directions to the direct methodology. If there is no fixed operating cost in the manufacturing enterprise ? What would be the Degree of Operating leverage ?
Particulars Units sold Sales price per unit Variable cost per unit Fixed operating cost Base Level 1,000 Rs.10 6 Nil New Level 1,100 Rs.10 6 Nil
Calculate the Degree of operating leverage
DOL =
Total contribution EBIT
To find out the EBIT = Sales -VC=Contribution i.e. EBIT
DOL =
R400 = +1 Rs.400
In the alternate methodology, the DOL is as follows:
DOL =
% change in EBIT 10% = = +1 % change in Sales 10
When there is no fixed cost in the cost of operations means that the firm does not have operating leverage in its operations. The operating leverage is related to the operating risk of the investments, which means that fixed cost of operations of the enterprise. It highlights that greater the fixed cost of operations means that higher the operating risk; which means that greater will be break even point and vice versa. The greater volume of fixed cost of operations are found to be more favorable only during the occasion of greater volume of earnings, unless otherwise the dominance of fixed cost of operations are found to be undesirable to magnify the volume of EBIT.
21.3 FINANCIAL LEVERAGE

The next leverage is Financial Leverage which arises due to servicing of financial resources. It results from the presence of fixed financial charges in the firms. The fixed financial charges are nothing but the preference dividend and interest on the fixed charge financial resources. Financial leverage, how the fixed charge financial resources influence the EBIT of the firm and finally provides earnings to the shareholders. It reveals the ability
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of the firm to make use of "fixed financial charges to magnify the effects of changes in EBIT on the earnings per share". The other name of the financial leverage is Trading on Equity, which illustrates the relationship in between the application of the fixed charge of funds in the capital structure and Earning per share. It is the leverage analysis highlights the relationship in between the financing decision and investment decision. The fixed financial charge should pave way for the firm to not only to earn the greater EBIT but also to magnify the EPS of the shareholders. The financial manager of the hypothetical ltd expects that its earnings before interest and taxes (EBIT) in the current year would amount to Rs.10,000. The firm has 5 percent bonds aggregating Rs.40,000 while the 10 percent preference shares amount to Rs. 20,000 what should be the earnings per share (EPS)? Assuming the EBIT being i) Rs.6,000 Rs.14,000. How EPS is affected ? The firm tax bracket 35%. Ordinary number of shares 1,000
Level from the base EBIT Interest Earnings Before Interest Taxes 35% EAT Preference dividend Earnings to share holders EPS Level Case 2 40% 6,000 2,000 4,000 1,400 2,600 2,000 600 .6 81.25% Base 10,000 2,000 8,000 2,800 5,200 2,000 3,200 3.2 Case 1 +40% 14,000 2,000 12,000 4,200 7,800 2,000 5,800 5.8 81.25%
From the above illustration, 40% increase in the level of EBIT posed 81.25% increase in the EPS and vice versa. Financial leverage can be quantified through the Degree of Financial Leverage (DFL) The degree of financial leverage is defined as the ratio of % change in the EPS and % change in the EBIT. Which always greater than 1. The degree of financial leverage is more than one due to presence of fixed charge of financial resources. This profound relationship is algebraically proven and illustrated that
DFL (Base) =
EBIT EBITIDp/1t
DFL of the above firm is as follows:
DFL =
% change in EPS 81.25% = = 2.03125 % Change in EBIT 40%
Alternately, the DFL is computed as follows through the following methodology

DFL = Rs. 10,000 Rs10,000 Rs.2,000Rs.2,000/.65
= 2.03125 The same example drawn for our better understanding by excluding the fixed charge of financial resources
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Case B Level of Change EBIT Taxes 35% EAT Earnings to share holders EPS 40% 6,000 2,100 3,900 3,900 3.9
Case A + 40% 10,000 3,500 6,500 6,500 6.5 14,000 4,900 9,100 9,100 9.1
Leverage Analysis
Degree of financial leverage =
% change in EPS % Change in EBIT
Case A =
+ 40% =+1 +40% 40% =+1 40%
Case B =
Alternately, the DFL could be found out as follows:

= Rs.10,000 = +1 Rs.10,00000
It means that the higher Degree of financial leverage means that greater the financial risk of the firm and vice versa. The greater degree of financial leverage is favorable only during the greater volume of EBIT to meet the fixed charges unless otherwise, the firm is required to undergo for liquidation. The interest of the firm may be brought under the control of the debenture holders and preference shareholders.
21.4 EBIT-EPS ANALYSIS

It is an analysis to study the impact /effect of the leverage. This could be studied through comparison of various financing plans of EBIT. (i) (ii) Exclusive use of debt Exclusive use of Equity shares
(iii) Exclusive use of Preference shares (iv) Combination of (i), (ii) & (iii) (v) Combination of (i) & (ii)
(vi) Combination of (ii) & (iii) (vii) Combination of (i) & (iii) Among the various plans, we have to identify the best plan which has highest EPS over the others. The firm which has highest EPS normally has least volume of fixed financial charge over the other firms. What is meant by financial break even point ? It is the level of EBIT to meet the fixed financial charge of the firm viz Interest on long term borrowings/Debentures and Preference dividend on Preference shares. The following formula is used to compute the financial break even point for the firm to earn at least to cover the fixed financial charges of the firm:
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Financial break even point= I + PD/1t The next analysis is nothing but Indifference point. Indifference Point: It is the point at which the EPS and EBIT are nothing but the same for two different financing plans known as the indifference point. The indifference point could be found out through the following analyses: (i) (ii) Algebraic approach Graphic approach
The measures of the Financial leverage: They are two in categories: (i) (ii) Stock terms Flow terms
Stock Terms: The following are the two ratios viz debt equity ratio and debt + preference share capital to total capitalization ratio to measure the financial leverage. Flow terms: The financial leverage means debt service ration and preference dividend coverage ratio to measure the capacity of the firm in meeting the periodical fixed financial commitments of the firm.
21.5 COMBINED LEVERAGE

It is the combination of both leverage viz Operating leverage and financial leverage. The combination means that the product of both leverages viz operating risk and financial risk, which facilitates to determine the total risk of the firm. DCL= DOL XDFL
DCL =
% change in EPS % change in Sales
The combined leverage is nothing but % change in the sales volume of the firm leads to certain % change in the EPS. DCL = Contribution/EBITI
Check Your Progress 1. 2. Elucidate the Degree of Financial leverage. Explain the detailed process of EBIT-EPS analysis.
21.6 LET US SUM UP

Leverage means the fixed commitment of the organization. The fixed commitment of the organization can be classified into two different categories viz fixed cost of operations and fixed cost of servicing. Operating leverage is a relationship in between the Sales and Earnings before interest and taxes. Financial leverage is a relationship in between the Earnings before interest and taxes and Earnings per share. The operating leverage is related to the operating risk of the investments, which means that fixed cost of operations of the enterprise. It highlights that greater the fixed cost of operations means that higher the operating risk; which means that greater will be break even point and vice versa.
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The greater volume of fixed cost of operations are found to be more favorable only during the occasion of greater volume of earnings, unless otherwise the dominance of fixed cost of operations are found to be undesirable to magnify the volume of EBIT. The other name of the financial leverage is Trading on Equity, which illustrates the relationship in between the application of the fixed charge of funds in the capital structure and Earning per share. It is the leverage analysis highlights the relationship in between the financing decision and investment decision. EBIT-EPS analysis is an analysis to study the impact /effect of the leverage.
Leverage Analysis

Discuss the role of EBIT-EPS analysis in studying the effect of leverage.
21.8 KEYWORDS
Leverage: Fixed commitments of the firm Operating leverage: It is a measure in the expression of business risk through quantification of fixed cost Financial leverage: It is an expression of financial risk due to the presence of fixed financial commitment of the firm Combined leverage: Combination of both leverages i.e. Product of Operating and Financial leverages Financial break even point: It is a level of EBIT to cover the fixed financial commitment of the firm Indifference point: It is the point at which the EBIT and EPS level of the two different financing plans are nothing but the same.

1. 2. 3. 4. 5. 6. 7. 8. What is leverage ? Classify the type of leverages. Define operating leverage. Explain the Degree of operating leverage. Define the financial leverage. Describe the combined leverage. Define Indifference point. Define Financial break even point.

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LESSON
22
CAPITAL STRUCTURE THEORIES
CONTENTS
21.0 22.1 22.2 22.3 22.4 22.5 22.6 22.7 Aims and Objectives Introduction Assumption of the Capital Structure Theories Net Income Approach Net Operating Income Approach ModiglianiMiller Approach Traditional Approach Types of Dividend Policies 22.7.1 Cash Dividend Policy 22.7.2 Bond Dividend Policy 22.7.3 Property Dividend Policy 22.7.4 Stock Dividend Policy 22.8 22.9 Let us Sum up Lesson-end Activity
22.10 Keywords 22.11 Questions for Discussion 22.12 Suggested Readings

The purpose of this lesson is to identify the optimum capital structure for business fleeces. After studying this lesson you will be able to: (i) (ii) describe different theories of capital structure explain aspects of capital structure decision-making
(iii) describe different types of dividend policies
22.1 INTRODUCTION
The capital structure theories are facilitating the business fleeces to identify the optimum capital structure. The optimum capital structure of the organization differs from one approach to another due the assumption which are underlying with reference to many factors of influence. The success of the firm is normally depending upon the rate at which the financial resources are raised, differs from one organisation to another depends upon the needs. The cost of capital is having greater influence on the EBIT level of the
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firm; which directs affects the amount of earnings available to the investors, that finally reflects on the value of the firm. The more earnings available at the end will lead to greater return on investment holdings of the investors, would enhance the value of shares due to greater demand. There are two set of approaches with reference to capital structure; which normally influences the Value of the firm through the cost of overall capital(Ko) is one approach called relevance approach capital structure theories and other do not have any influence on the value of the firm is known as irrelevance approach. The debt finance in the capital structure facilitates the firm to enhance the value of EPS on one side on the another side it is subject to the financial leverage with reference to trading on equity. The application of leverage in the capital structure enhances the value of the firm through the cost of capital.
Capital Structure Theories
The following are the various capital structure theories:

(i) (ii) Net income approach Net operating income approach
(iii) Modigliani and Miller approach (iv) Traditional approach
22.2 ASSUMPTION OF THE CAPITAL STRUCTURE THEORIES

(i) (ii) There are only two resources in the capital structure viz Debt and Equity share capital The dividend pay out ration 100% which means that there is no scope for the retained earnings
(iii) The life of the firm is perpetual (iv) The total assets of the firm do not change (v) The total financing remains constant through balancing taking place in between the debt and share capital
(vi) No corporate taxes; this was removed later
22.3 NET INCOME APPROACH

Algebraically, the relationship between the cost of equity, cost of overall capital and debt-equity ration are explained as follows: Ke=Ko+ (KoKi)B/S Net income approach was developed by Durand, in this he has portrayed the influence of the leverage on the value of the firm, which means that the value of the firm is subject to the application of debt i.e., leverage. In this approach, the cost of debt is identified as cheaper source of financing than equity share capital. The more application of debt in the capital structure brings down the overall capital, more particularly 100% application of debt finance leads to resemble the over all cost of capital as cost of debt. The weighted average cost of capital will come down due to more application of leverage in the capital structure, only with reference to cheaper cost of raising than the equity share capital cost. Ko= Ke(S/V)+Ki(B/V) The value of the firm is more in the case of lesser overall cost of capital due to more application of leverage in the capital structure. The optimum capital structure is that at
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when the value of the firm is highest and the overall cost of capital is lowest. V=B+S V= EBIT/Ko This approach highlights that the application of leverage influences the overall cost of capital and that affects the value of the firm.
22.4 NET OPERATING INCOME APPROACH

This another approach developed by Durand, which has underlying principle that the application of leverage do not have any influence on the value of the firm through the overall cost of capital. The more application of leverage leads to bring down the explicit cost of capital on one side and on the other side implicit cost of debt is expected to go up. How the implicit cost of debt will go up? The more application of debt leads to increase the financial risk among the investors, that warranted the equity share holders to bear additional financial risk of the firm. Due to additional financial risk, the share holders are requiring the firm to pay additional dividends over the existing. The increase in the expectations of the shareholders with reference to dividends hiked the cost of equity. Under this approach, no capital structure is found to be a optimum capital structure. The major reason is that the debt-equity ratio does not influence the cost of overall capital, which always nothing but remains constant. It is finally concluded that this approach highlights that application of leverage never makes an attempt to enhance the value of the firm, in other words which is known as unaffected by the application of leverage.
22.5 MODIGLIANIMILLER APPROACH

It is the approach, attempts to explain the application of leverage does not have any influence on the value of the firm through behavioural pattern of the investors. The behavioural pattern of the investors is taken into consideration for explaining the value of the firm which is unaffected by the application of debt/leverage in the capital structure through arbitrage process. The MM approach has three different propositions: (i) (ii) The overall capital structure of the firm is unaffected by the cost of capital an degree of leverage The cost of equity goes up and offset the increase of leverage in the capital structure
(iii) The cut off rate for the investment purposes is totally independent. For discussion, the proposition is only considered for the study of usage of leverage in the capital structure, which do not have any impact in the value of the firm.
Assumptions of the MM approach:

This approach is discussed under the perfect market conditions (i) (ii) Securities are divisible infinitely. Investors are allowed to buy and sell securities
(iii) Investors are rational to access the information (iv) No transaction costs involved in the process of the buying and selling of securities Arbitrage process: It is the process facilitates the individual investors to buy the investments at lower price at one market and sells them off at higher price in another market. With the help of arbitrage process, the investors are permitted to shift holding of the Levered firm to the unlevered firm which is known as undervalued. These two firms are identical in business risk except in the application of debt finance in the levered firm. In order to maintain the similar amount of the financial risk of the firm, the investor is required to undergo for personal leverage or home made leverage to maintain the same
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proportion of investment in the unlevered firm. During this process, the investor could save something and this continuous arbitrage process will level the value of the both firms. It means that the value of the firm is unaffected by the application of leverage which is explained through the arbitrage process, nothing but behavioural pattern of the investors. The same thing could be applied in the case of reverse arbitrage process in between the Unlevered and levered. This also another kind of process in which the investor could gain through the transfer of the holdings from the unlevered firm to levered firm. The value of the firm is unaffected by the application of the leverage in the capital structure.
22.6 TRADITIONAL APPROACH

The traditional approach is known as intermediate approach in between the Net income approach and NOI approach. The value of the firm and the cost of capital are affected by the NI approach but the assumptions of the NOI approach are irrelevant. The cost of overall capital will come down due to the application cheaper source of financing viz Debt financing to some extent, after certain usage, the application of debt will enhance the financial risk of the firm, which will require the share holders to expect additional return nothing but is risk premium. The risk premium which is expected by the investors will enhance the overall cost of capital. The optimum capital structure "the marginal real cost of debt, defined to include both implicit and explicit will be equal to the real cost of equity. For a debt-equity ratio before that level, the marginal cost of debt would be less than that of equity capital, while beyond that level of leverage, the marginal real cost of debt would exceed that of equity.
22.7 TYPES OF DIVIDEND POLICIES

The dividend policy is the policy that facilitates the firm to decide how much should be declared as a dividend. The declaration of dividend is normally to be taken with reference to the future prospects of the firm. The dividends are normally decided by the board of directors during the board meeting which may affect other important decisions of the firm. Most of the companies never think off about the future prospects before the declaration of the dividends to the shareholders. As a finance manager should emphasize the importance of declaring or non declaring the dividends which are having greater influence on the futuristic decisions of the enterprise. Types of dividend policies: (i) (ii) Cash dividend Bond dividend
(iii) Property dividend (iv) Stock dividend
22.7.1 Cash Dividend Policy

The dividends are paid in terms of cash. This type of dividend normally leads to cash outflow which has greater influence on the cash position of the firm. At the moment of declaring the cash dividend, future cash needs should be predetermined and dividends declared to the share holders.
22.7.2 Bond Dividend Policy

Instead of paying dividend in terms of cash, some companies are issuing bond dividends, which facilitate them to postpone the immediate cash outflows. Immediately after the
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issuance of bonds, the bond holders are receiving the interest on their holdings besides the bond values to be paid on the due date. This method is not popular in India.
22.7.3 Property Dividend Policy

Instead of paying dividends in cash, some assets are given to the shareholders as dividend payments. This is also not existing in India.
22.7.4 Stock Dividend Policy

Instead of making the payment of cash dividend, the stock are issued to the existing shareholders. The company shares are issued to existing share holder which is known other words as stock dividends.
Check Your Progress 1. 2. Write a note on the ModiglianiMiller approach. Explain the various types of dividend policies.
22.8 LET US SUM UP

The capital structure theories are facilitating the business fleeces to identify the optimum capital structure. The optimum capital structure of the organization differs from one approach to another. The cost of capital is having greater influence on the EBIT level of the firm; which directs affects the amount of earnings available to the investors, that finally reflects on the value of the firm. Net income approach, the cost of debt is identified as cheaper source of financing than equity share capital. Net Operating income approach developed by Durand, which has underlying principle that the application of leverage do not have any influence on the value of the firm through the overall cost of capital. The more application of leverage leads to bring down the explicit cost of capital on one side and on the other side implicit cost of debt is expected to go up. Under this approach, no capital structure is found to be a optimum capital structure. Arbitrage process is the process facilitates the individual investors to buy the investments at lower price at one market and sells them off at higher price in another market. The traditional approach is known as intermediate approach in between the Net income approach and NOI approach.

Assuming the condition of the original M & M (Miller-Modigliani) approach, state whether the following statement is true or false: In a world of perfect capital market, an increase in financial leverage will increase the market value of the firm. Provide an intuitive explanation of your answer.
22.10 KEYWORDS
Arbitrage process Dividend Policies Cash dividend policy

1.
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Write the various assumption of the capital structure theories. Explain the Net income approach.
2.
3. 5. 6.
Elucidate the Net operating approach. Explain briefly about the traditional approach. What is meant by the dividend policy?

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LESSON
23
WORKING CAPITAL MANAGEMENT
CONTENTS
23.0 Aims and Objectives 23.1 Introduction 23.2 Objectives of the Working Capital Management 23.3 Approaches of the Working Capital 23.4 Determinants of Working Capital 23.5 Working Capital Policies 23.6 Estimation of Working Capital Requirement 23.7 Cash Management 23.7.1 Motives of Holding Cash 23.7.2 Objectives of Cash Management 23.7.3 Basic Problems of Cash Management 23.8 Management of Inventories 23.8.1 Meaning of Inventory 23.8.2 Why Inventory is to be Controlled? 23.8.3 Major Benefits of Inventory Control 23.8.4 Centralised Stores 23.8.5 Decentralised Stores 23.8.6 Central Stores and Sub Stores 23.8.7 Recording Level 23.8.8 Minimum Level/Safety Level 23.8.9 Maximum Level 23.8.10 Danger Level 23.8.11 Average Stock Level 23.8.12 Economic Ordering Quantity 23.8.13 ABC Analysis 23.8.14 VED Analysis 23.9 Receivables Management 23.9.1 Concept of Receivables Management 23.9.2 Objectives of Accounts Receivables 23.9.3 Cost of Maintaining the Accounts Receivables 23.9.4 Factors Affecting the Accounts Receivables 23.9.5 Management of Accounts Payable/Financing the Resources 23.10 Various Committee Reports on Working Capital 23.10.1 Dheja Committee Report 1969
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Contd...
23.10.2 Tandon Committee 23.10.3 Chore Committee Report 1979 23.10.4 Marathe Committee Report 1984 23.11 Let us Sum up 23.12 Lesson-end Activity 23.13 Keywords 23.14 Questions for Discussion 23.15 Suggested Readings

After studying this lesson you will be able to: (i) (ii) describe the objectives of working capital management know how to analyse the needs of working capital
(iii) describe how to manage receivables and payables (iv) explain how inventory is managed in a company.
23.1 INTRODUCTION
The working capital is the amount revolving capital to meet the day today requirements of the firm. The other facets of the working capital is circulating capital, floating capital and moving capital which are required to meet the immediate requirements of the firm. The "working capital" means the funds available for day today operations of the enterprise. It also represents the excess of current assets over the current liabilities which include the short-term loans. Accounting standards Board, The institute of Chartered Accountant of India note the ASB has used the term working capital and not Net working capital.
23.2 OBJECTIVES OF THE WORKING CAPITAL MANAGEMENT

Estimating the working capital requirements
The working capital requirements are normally estimated to the tune of production policies, nature of the business, length of manufacturing process, credit policy and so on. Sources of the working capital: The requirement of the working capital should be met with the help of long term and shot term resources. The permanent and temporary working capital requirements should be met out of long term and short term financial resource respectively.
23.3 APPROACHES OF THE WORKING CAPITAL

The approaches of the working capital are classified into two categories viz the hedging approach and conservative approach: The hedging approach: Under this approach, the maturity of the financial resources are matched with the nature of assets to be financed.
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Permanent working capital are financed by the long-term financial resources and the seasonal working capital requirements are met out through short term financial resources. The conservative approach: Acc to this approach, all requirement of the funds should met out long-term sources. The short-term resources should be only for emergency requirements.
23.4 DETERMINANTS OF WORKING CAPITAL

Following are the major determinants of the working capital: General nature of Business: The nature of the business should be considered for the determination of working capital only to the tune of i) cash nature of business ii) sale of services rather than commodities: These are things considered only on the basis of stock , book volume of debts and so on. Production cycle: The need of the working capital is determined on the basis of duration of the production cycle. The time duration taken by the manufacturing process should be considered from the stage of raw materials to the stage of finished goods. If the duration is lengthier may require the firm to keep more amount of working capital to meet out the requirements and vice versa. Business cycle: The cycle of the business should be relatively considered for the need of working capital. The upswing of the business cycle requires the business venture to invest more amount of working capital due more volume of sales, results out of huge volume of stock, book debts and so on. During the downswing of the business require the business to have only lesser volume of working capital due lesser volume of business and so on. Production policy: The working capital requirement is determined on the basis of production policy of the firm. Normally the production policy of the firm is classified on the basis of two methodologies: (i) The firm produces the goods then and there to the tune of immediate needs of the market. This may require the firm to meet adversities due to lack of working capital to meet out, due to in adequate planning. During the peak season, it requires enormous working capital which may disturb working conditions of the business venture. The steady production policy by considering the futuristic demands, which will not disturb the long-term prospects of the business venture due to effective planning.
(ii)
Credit policy: The credit policy of the firm is another determinant for the determination of the working capital. There are two different credit policies viz liberal and stringent credit policies (i) Liberal credit policy: The liberal credit policy may lead to have greater volume of book debts, greater credit period, huge amount required for the built of stock; require the firm to have greater amount of working capital Stringent credit policy: Would not require that much of working capital like the earlier segment.
(ii)
Growth and Expansion: The growth and expansion prospects of the firm should be appropriately determined in order to identify the volume of working capital required during the future, unless otherwise that will badly affect the future development of the firm. Acute shortage of the raw materials supply: If the shortage of raw materials is acute, the firm is required to keep sufficient volume of working capital to have smooth flow of production process without any interruptions. In such cases the firm should have additional volume of working capital not only to avoid interruptions during the production process
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due lack of supply of raw materials, but also to enjoy greater trade discounts during the bulk purchase in order to bring down the purchase cost of the raw materials. Net profit: It is one of the major sources of working capital and practically speaking it is one of the sources of cash from operations. To maintain the liquidity, the net profit earning capacity should be maintained forever. Dividend policy: The cash dividend payment leads to greater amount of cash outflows which are more essential to the value of the firm to be maintained. The value of the firm could also be alternately maintained by either through the declaration of bond dividend or stock dividend or property dividend. The later specified methodologies facilitate the firm to postpone the cash out flow which normally evade the immediate cash requirement. Depreciation policy: The depreciation policy of the firm not only facilitates to bring down the taxable liability but also brings down the profit which enhances the liquidity of the firm on the other side. Price level changes: The price level changes require the firm to keep more amount of working capital to go hand in hand with the price changes which normally affect the firm's liquidity position. During the periods of inflation, the firm is required to anticipate the price level changes which drastically affect the working capital position of the firm.
23.5 WORKING CAPITAL POLICIES

The working capital has to be adequately managed by the firm , neither more nor less than its requirement to meet out the needs. If the working capital is more than the requirement means that the firm is expected to unnecessarily keep short-term assets idle in state and vice versa. The maintaining of the working capital management is mainly depending upon three major influences of the organizations i) ii) iii) Profitability Liquidity and Structural health of the organisation
Why the study of Management of working capital is required ? If the working capital is less than the requirement means that the volume of current assets are inadequate to meet the short term obligations of the firm on time, which may lead to disrepute the name and fame of the organisation. Contradictorily to the above, if the firm keeps more working capital that means more volume of current assets are maintained in the investment structure to meet out the short term obligations of the firm which poses more liquidity but on the other hand it hurdles the righteous opportunity to invest in the fixed assets to earn more income. The excessive volume of current assets drastically affects the profitability of the firm due to excess liquidity out of more amount of current assets. As a firm should always maintain the righteous volume of working capital not only to maintain the liquidity of the firm but also to earn adequately from the investment volume of fixed assets. The working capital management policies are studied in the following context viz i) ii) iii) Concerned with profitability, liquidity and risk of the firm Concerned with the composition of the current assets Concerned with the composition of the current liabilities
There are two major types of working capital policies Conservative policy of working capital: Under this policy, the firm minimizes risk by maintaining a higher level of current assets in meeting the liquidity of the firm.
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Aggressive policy of working capital: Under this policy , the firm enhances the risk by way of reducing the working capital in order to earn more and more profits.
23.6 ESTIMATION OF WORKING CAPITAL REQUIREMENT

The following is the proforma of the working capital requirement Statement of working capital required Current Assets: i) ii) iii) iv) v) Less: Current liabilities i) ii) iii) Creditors Lag in payment of expenses Outstanding expenses if any XXXX XXXX XXXX XXXX Cash Debtors Stocks Advanced payments Others XXXX XXXX XXXX XXXX XXXX
Working capital (Current assets-Current liabilities) Add: Provision for contingencies Net working capital required XXXX
XXXX
Prepare an estimate of working capital requirement from the following data of the XYZ Ltd. a) b) c) d) e) f) g) Projected annual sales volume Selling price % of net profit on sales Average credit period allowed to customers Average credit period allowed by suppliers Average holding period of the inventories Allow 10% for contingencies
Statement of working capital requirements
2,00,000 units Rs.10 per unit 25% 8 weeks 4 weeks 12 weeks
Current Assets Debtors (8 weeks)Rs.15,00,000 8/52(At cost) Stock (12 weeks) Rs.15,00,000 12/52 Less Current liabilities Creditors (4 weeks) Rs15,00,000 4/52 Net working capital Add: 10% contingencies Working capital required
Rs 2,30,769.23 3,46,153.38 1,15,384.61 4,61,538.0 46,153.8 5,07,691.8
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Check Your Progress
1. 2.
The recent release of the finance minister during the budget session on the special excise duty on the cement industry. How the construction industry is affected ? In what way? Which factor of influence affects the firm?
23.7 CASH MANAGEMENT

The management of cash resources should not be only in a position to afford liquidity but also it should not require the firm to keep the cash resources simply idle; which should be invested in the marketable securities to earn some rate of return whenever the firm feel excessive holding of cash resources.
23.7.1 Motives of holding cash

Transaction Motive: If the cash outflows are more than that of the cash inflows, the firms are expected to maintain the cash resources. Precautionary Motive: Some times the firm may be required to meet out the contingent needs which could not be foreseen during its life span; warrants the adequate maintenance of working capital. Speculative Motive: It is a motive holding the cash resources by the firm to exploit the opportunities available in the market. If the vendor of raw materials announces that there is a greater discount towards the bulky purchase of raw materials, may lead the firm to bring down the cost of purchase. For which, the cash resources are required and made use of to the tune of announcements. Compensation motive: Banks provide certain services to the firms only on the basis of the certain amount of balances in the accounts. That is the motive holding cash resources to avail services from the banker viz compensation motive.
23.7.2 Objectives of Cash Management

(i) Meeting the cash requirement: Meeting of cash requirements on time which normally involves in the maintenance of the goodwill of the firm. The firm should keep the adequate cash balances to meet the requirement which are greater in importance. Minimising the funds locked up in the cash balances: The funds locked up in the form of cash resources should be more, but it should only to the tune of the requirement.
(ii)
23.7.3 Basic Problems of Cash Management

(i) Controlling level of cash (a) Preparing the cash budget: Through the preparation of the budget, the cash requirement could be identified which would normally facilitate the firm to trim off the excessive cash in holding. Providing room for unpredictable discrepancies: The separate amount should be maintained for the purpose to meet out the discrepancies which are not easily foreseen.
(b)
(ii) Controlling of inflows of cash (a) Concentration banking: The amount of collection from the local branches are normally deposited in a particular account of the firm, as soon as the
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deposit has reached the certain limit , the amount in the respective branch account will be transferred to the account at where the firm maintains in the head office. This process of transfer is normally taking place only through telegraphic transfer during the early days but on now a days the anywhere banking is facilitated to transfer the amount of deposit instantaneously. (b) Lock box system: The process of collection is carried out with the help of local post offices only in order to avoid the postal delays in the transit . This system enhances the speed of the collection at rapid and finally the local branch messenger collects the cheques from the parties through specified post box allocated for the process of collection.
(iii) Controlling of cash outflows (a) Centralizing of disbursing the payments: The centralizing the process of payment may facilitate the enterprise to take advantage of time in settling the payments i.e., reduces the need of immediate cash requirements. Stretching payment schedule: It is another methodology to avail the maximum possible credit period to postpone the payment by making use of the cash resources most effectively. Determine the need of the surplus cash: Identify the excessive cash resources which are kept simply idle more than the requirement. Determination of the various avenues of investment: After identifying the various investment opportunities , the excessive cash resources should be invested to earn appropriate rate of return during the slack season at when the firm does not require greater volume of working capital and vice versa.
Check Your Progress
(b)
(iv) Investing the excessive cash surplus (a) (b)
1. 2.
Explain the modern instruments available in the financial market to entertain the cash management strategies. 1. Cash means
a) c) Cash in hand b) Cash in hand and at bank None of the above Cash in hand, at bank and near d) cash i.e marketable securities
2.
To avail the trade discount at the moment of bulk purchase is

a) c) Transaction motive Compensating motive b) d) Speculative motive Precautionary motive
3.
Stretching cash payment is a) c) Controlling the cash inflow a) & b) b) d) Controlling cash outflows None of the above
23.8 MANAGEMENT OF INVENTORIES

23.8.1 Meaning of Inventory
The inventory includes the following : Stock of raw materials: It means that the value of the raw materials stored for the purpose of production in the storage yard. The stock of raw materials can be
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classified normally into two categories viz opening stock and closing stock of raw materials. Stock of work in progress: During the production process, the firm usually stores the semi finished goods which are neither a raw materials nor finished goods. The purpose of the storage of work in progress in order to shorten the time duration to manufacture the finished goods. The value of the semi finished / work in progress stored in the storage house may be classified into two categories viz opening stock and closing stock. The finalizing the value of the stock of the work in progress is inevitable process in transfer pricing. The value of the work in progress normally expressed in two different ways viz on the basis of prime cost and works cost. Stock of finished goods: This is the stage at which the goods are readily available for selling in the market. The value of the stock of the goods is computed on the basis of cost of production. Stock of Stores supplies, components and accessories.
Inventory
Raw materials
Work in progress
Finished goods
23.8.2 Why inventory is to be controlled ?

The ultimate purpose of controlling the inventory arises only due to the conflicting and heterogeneous objectives of the various functional departments of the organizations. How inventory influences the various department of the organization ? Normally, the inventory influences on the following departments viz Production Purchase, Finance and Sales department How it influences the various departments at a time together. On/of the Production department: The manager production frequently insists the organisation to maintain the continuous and uninterrupted supply to have smooth flow production. This requires the production manager to build ample stock of raw materials. This is routed through the purchase requisition by the manager production to the purchase manager. Less the stock of raw materials and accessories - Risk of Lock out due to insufficient quantities and vice versa On/of the Purchase department: Due to the influence from the production manager, the purchase department is demanded to procure the requirements. As per the requisition of the production department, meeting the requirements is not tough task but the department should know about the financial intricacies of the organisation through the finance department which is especially meant for the purpose. Lesser the quantum of purchase will lead to lesser financial commitment but expected to loose the benefits out of the bulk procurement. Not advisable for the materials which are in scarcity. Lesser the quantum of purchase - Greater will be cost of procurement and lesser will the economic benefits and vice versa
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On/of the Sales department: Due to the market pressure/greater demand of the products require the sales department to supply the goods in time as well as to meet the needs and demands of the intermediaries and consumers. To supply them in time, the sales manager need not wait for the production cycle to be completed to produce the finished goods. To save time, the sales manager must be given ample facility to store the finished goods in the depot not only to meet the needs but also traps and drags the existing customers and consumers. More the stock of the finished goods - Better the position for the firm to meet the needs of the biz environment and more the cost of storage and investment on the current assets and vice versa On/of the Finance department : Due to influence from the department of the production, purchase and sales departments, the finance department is required to concentrate on the various angles. It is the only department bearing a difference of opinion in maintaining more volume of inventory in the firm; which certainly slashes the earning capacity of the firm due to least volume of assets deploy on the productive purpose. Lesser the inventory - Higher the risk in meeting the needs of production, purchase and sales - but better the return of the firm. For e.g. The famous MNC Jindal Corporation Ltd. has wound up its operations at industrial site in Bangalore due to the cost of raw materials cost. The transportation cost, acquisition cost of copper ore gone up due to escalated cost in the biz market. They were neither to store nor to transport more and more which led to the winding up of operations of the enterprise at Bangalore. The following diagram will obviously facilitate the Inventory Control:
Purchase Department
Finance Department Production Department Sales Department
Inventory control: Inventory control means that maintenance of desired level of inventory by way of taking into the economic interest of the firm. The economic interest of the firm differs from one functional dept. to another due to the heterogeneous objectives. The economic desired benefits of the dept. are illustrated to the tune of the preceding illustrated diagrams. Production department: Benefits towards less production cost through mass production. Purchase department: Benefits towards discounts, carrying cost and so on. Sales department: Timely supply of the goods to the requirements, facilitates the firm to earn greater volume of earning. To reduce the operating cycle in duration in order to realize the economic benefits as early as possible.
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Finance department: Benefits towards the carrying cost, storage cost of the entire inventory.
23.8.3 Major Benefits of Inventory Control

It leads to effective utilization of funds only through an appropriate investment on inventory It facilitates to obtain the economic supply of raw materials It possess the firm comfortably to meet the needs and wants of the consumers in time It neither allows the firm to undergo the practices of overstocking nor understocking. It leads to effectiveness in the material handing which reduces the wastage, pilferage and so on. Before discussing the methods of inventory control, every one must obviously understand the organization of the stores department. The stores department is the only department which applies all the techniques of inventory control. The organization of the inventory control are various in dimensions . The organization of differs from one industry to another industry, one firm to another within the same industry, from one nature to another, from volume to another. They are as follows: a) b) c) Centralised stores Decentralised stores Central and Sub stores
23.8.4 Centralised Stores

Under this type, the materials are received by and issued at one central place by the department to the requirements of the other functional departments. The following diagram will facilitate to understand the organisation structure of the centralized stores of the manufacturing department. The materials are continuously received by the stores dept. through the purchase department and the received material are distributed to the various assisting departments.
This type of organization of stores control has its own advantages and disadvantages in application The major advantages are following: It requires less space It facilitates to minimize the stock investment The centralization leads to lower administrative and maintenance cost of stores
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In addition to the advantages, the present organization suffers with its own limitation while in applications; which are following: The centralization of stores leads to enhance the cost of transportation as well as handling cost of materials. The centralized system leads to lot of inconvenience and delay to other department due to distance There is a greater risk of calamity loss of materials which are stored under one roof The success is subject to the effectiveness of the transportation
23.8.5 Decentralised Stores

Under this method, the separate stores are maintained by the departments on their own as well as run by the exclusive store keeper. It ensures the smooth flow material to the tune of requirements and reduces the time involved in the transit of materials from the stores to the respective departments. The following diagram will facilitate to have an insight on the organization of the stores.
23.8.6 Central stores and Sub stores

This is a method which attempts to discard the bottlenecks of the above mentioned as well as brings forth unique organization of stores. Under this method, each department is given separate sub store which is within easier access and shorter in distance to supply the material requirements through the store keeper. The sub store keeper should have to make requisition to central stores where all the materials are centrally procured and supplied then and there to the tune of the individual departments.
S u b Sto re W e ld ing D ep t P ro d u ction D e p t
S u b Sto re P la n nin g D e pt
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The role of the store keeper is most inevitable in controlling the stores. While controlling the stores, the store keeper should neither disturb the production process nor undergo the practices of overstocking. By earmarking the above enlisted objectives, every store keeper is led by the various methods of inventory valuation in addition to various methods of requisitioning of material.
First we will discuss, the various methods of requisitioning of materials.
23.8.7 Reordering Level

This is the level at which the firm should go for fresh purchase requisition of material through the store keeper to meet the requirements. The reordering level which takes into consideration of minimum level of consumption of raw material during the course of production process as well as the amount material required by the firm during period of purchase and goods in transit immediately after the order.
Reordering Level
Minimum Level
Amount of materials required during the periods of consumption
Reordering level=Minimum level of stock for uninterrupted flow of production process + Amount of materials required during the periods of consumption Or Lead time stock level Alternate method is available by using the maximum consumption and maximum reorder period Re ordering level= Maximum consumption Maximum Re- order period This method registers the maximum consumption of the firm during the production as well as the maximum time period required for the supply of required materials. Under this alternate approach, the firm at any moment will not face any difficulties due to short supply or insufficient amount of materials.
23.8.8 Minimum Level/Safety level

The firm should at always maintain minimum amount of material in its hands to facilitate the flow of production process as unaffected .due to short fall in the quantum of materials. The following points are most important in designing the minimum level of stock: Lead time should be predominantly considered to determine the time lag in between the materials ordered and received. The firm should find out the practical difficulty of the vendor in supplying the material for the determination for minimum level of stock. Amount of consumption of the material during the lead time Minimum stock level=Reordering level- (Normal level consumption Normal Reorder period) Minimum level = Reorder level + (Average level of consumption Average Reorder period) Average and normal level of consumption are synonymous with each other. If normal or average consumption is not given, the formula is as follows
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Average consumption = Minimum level consumption + Maximum level consumption 2
23.8.9 Maximum Level

This is the level at which the firm holds maximum quantity of materials as stock during the process. The ultimate aim of fixing the level of maximum level is that to avoid the overstocking. If the stock level of the firm exceeds the maximum level already fixed is known as overstocking level of the firm, more than the requirement. Why over stocking is considered not advisable ? It leads to excessive investment on inventory more than the requirement It leads to unnecessary wastage of the materials due to excessive stock The excessive storage of materials may certainly affect the price of the product Maximum stock level= Reordering level+ Reordering quantity - (Minimum consumption Minimum Reordering period)
23.8.10 Danger level

At this level, the firm should not further issue any materials to the various functional departments .At the danger level, the purchase department is vested with greater responsibility to immediately arrange the supply of raw materials in order to maintain the flow of production as uninterrupted. The consumption level of the materials is getting varied from one time period to another. During the specified period , there may be maximum consumption and minimum consumption, which should be averaged to find the mid point in between the two, in order to either fulfill the minimum consumption or maximum consumption to the extent possible. Why the maximum reorder period is taken into consideration? The purpose of considering is that the greater period taken by the supplier to supply the required materials Danger Level= Average consumption Maximum reorder period
23.8.11 Average Stock Level

Average stock level =Minimum stock level + of the reorder quantity
23.8.12 Economic Ordering Quantity

The ordering of materials usually tagged with three different component of costs viz: Acquisition cost of materials Ordering cost of materials Carrying cost of materials The ordering quantity of materials may be either larger or meager in volume, which carries its own advantages and disadvantages. If the quantity ordered is larger in volume, the following are some of the important advantages: The bulk purchase order reduces the ordering cost of the materials. The greater the size of the order which leads to reduce the number of the orders in procuring the materials. Quantity discounts: The discount can be classified into two categories viz Trade discount and Cash discount .
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What is trade discount ?
Trade discount is the discount granted by the supplier to the buyer of materials at the moment of bulk purchase. This % of discount is greatly possible only during the periods of greater volume of purchase; which reduces the over all cost of the acquisition. If the quantity is procured in meager volume, the following are construed as advantages: The carrying cost will come down in the case of lesser inventories The cost of storage is lesser as far as the meager quantities of materials Loss due to deterioration, obsolescence, wastage will be minimum Insurance cost is less due to meager volume of materials
Economic Ordering Quantity =

A = Annual requirement in units O = Ordering cost
2AO 1
I = Cost of storing per year or cost of carrying the inventory

Graph of EOQ:
Total cost Rupees
Cost of carrying Ordering cost
Units per order Insert the picture anpve
Illustration 1 Annual Requirement =20,000 units Ordering cost= Rs.100 per order Cost per unit =Rs.4 Carrying cost =16% Determine the EOQ of the firm and finally justify the EOQ
Economic Ordering Quantity (EOQ) =
2AQ I
2 20,000 Rs.100 0.16% on Rs.4
= 2,500 units
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The following Table 23.1 illustrates the justification of the EOQ at the 2,500 units level
Annual requirement of 20,000 units Particulars Size of the Orders Number of order to placed = Total Annual Need Size of the order Average stock = Size of the order 2 Average stock value =Average stock cost per unit Rs Carrying cost = Average Stock value 16% Rs Ordering cost Rs Total cost Rs 1 20,000 1 2 10,000 2 3 5000 4 4 2,500 8 5 500 40
10,000
5,000
2,500
1,250
250
40,000 6,400 100 6,500
20,000 3,200 200 3,500
10,000 1,600 400 2,000
5,000 800 800 1,600
1,000 160 4,000 4,160
Illustration 2 Calculate EOQ Annual Requirement -1600 units Cost of materials per unit Rs.40 Cost placing and receiving -Rs.50 Annual carrying cost of inventory -10% on value
Economic Ordering Quantity (EOQ)= 2 1600 Rs.50 = 200 units 10% on Rs.40
2AO 1
EOQ =
Illustration 3 Consumption during the year -600 units Ordering cost Rs. 12 per order Carrying cost 20% Price per unit Rs. 20 B.Com. (Punjab)
Economic Ordering Quantity (EOQ)=
2AO 1
EOQ =
2 600 Rs.12 20% on Rs.20

= 60 units
Illustration 4 A manufacturer purchases certain machinery from outside suppliers Rs.60 per unit. Total annual needs are 800 units. The following are the additional information
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Annual return on investments 10%
Rent, insurance, taxes per unit per year Rs 2 Cost of placing an order Rs.200 Determine the economic order unit First step to find out the earnings= 10% Rs.60= Rs.6 to be earned from the investment The amount of rent , insurance , taxes per unit year =Rs 2 I= 10% on Rs.60 + Rs.2= Rs.8
Economic Order Quantity (EOQ) =

2 800 Rs.200 10% on Rs.60 +Rs.2
2AO 1
= 200 units
Illustration 5 Given the annual consumption of material is 1,800 units , ordering costs are Rs.2 per order, price per order price per unit of material is 32 paise and storage costs are 25% per annum of stock value , find the economic order quantity. (B.Com. Calicut)
Economic Order Quantity (EOQ) =

2 1,800 Rs.2 25% on 32 paise
2 AO 1
= 300 units
Illustration 6 Find out the Re ordering level from the following information a) Minimum stock 1000 units b) Maximum stock 2000 units c) Time required for receiving the material 20 days d) Daily consumption of material 100 units
Reordering level = Minimum level + Lead time stock level The first step is to find out the Lead time stock level Lead time stock level is nothing but the amount of stock level required by the firm, till the next fresh receipt of goods, subject to the time normally taken by the supplier to supply. Lead time stock level= Time required for receiving the material Daily consumption Lead time stock level= 20 days 100 units per day= 2000 units Reordering level= 1,000 + 2,000 units= 3,000 units Illustration 7 Calculate maximum level , minimum level and reordering level from the following data Reorder quantity Reorder period Maximum consumption 2,000 units 8 to 12 weeks 800 units per week
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Normal consumption Minimum consumption
600 units per week 500 units per week
Reordering level = Minimum level + Lead time stock level Or = Maximum consumption Maximum lead time Minimum level= Reordering level (Average consumption Average lead time ) Maximum level= Reorder level + Reorder quantity (Mini consumption Mini Lead time) First step is to find out the Re ordering level Reordering level = 800 units per week 12 weeks= 9,600 units The next step is to find out the Maximum level Maximum level = 9,600 units + 2,000 units - (500 units 8 weeks) = 11,600 units- 4,000 units =7,600 units The next step is to find out the minimum level . For that Average consumption has to be found out. The average consumption is nothing but normal consumption. The normal lead time period is the average of minimum and maximum re order period of the firm in getting the supply of the materials from the suppliers Minimum level = 9,600 units (600 units 20/2) = 9,600 units 6,000 units= 3,600 units Illustration 8 Two components A and B are used as follows Normal usage Minimum usage Maximum usage Re order quantity 50 units per week each 25 units per week each 75 units per week each A: 300 units B: 500 units Re order period A: 4 to 6 weeks B: 2 to 4 weeks Calculate for each component (B.Com., Madras) (a) Re order level (b) Minimum level (c) Maximum level and (d) Average stock level First step is to find out the Reorder level for both A and B components The maximum usage is common for both A and B components but the reorder period are different from each other Reorder level = Maximum consumption /usage Maximum Reorder period (A)= 75 units 6 weeks= 450 units (B)=75 units 4 weeks= 300 units The next step is to determine the Maximum level of both Components A and B Maximum level = Reordering level + Reordering quantity (Mini Consumption Mini Lead time)
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(A)= 450 units + 300 units ( 25 units 4 weeks) = 650 units (B)=300 units + 500 units (25 units 2 weeks) = 750 units Minimum Level = Reordering level ( Average consumption Average lead time)
= 450 unit (50 unit

(A) (B)
(4 + 6)) 2
= 450 units 250 units = 200 units
= 300 unit (50 unit
(2 + 4)) 2
=300 units ( 150 units )=150 units Average stock level = Minimum stock level + Re order quantity (A)= 2 00 units + 300 units = 350 units (B)=150 units+ 500 units = 400 unit Illustration 9 The following information is available in respect of components of R 100 Maximum stock level 10,000 units Budgeted consumption Maximum 3,000 units per month Minimum 1,600 units per month Estimated delivery period Maximum 4 months Minimum 2 months You are required to calculate (i) (ii) Re-order level Re-order quantity = Maximum consumption maximum lead time = 3,000 units 4 months=1,200 Units The Reordering quantity could be found out with the help of Maximum level equation Let us assume Re ordering quantity =X Maximum level = Re-ordering level + Re-ordering quantity - (Minimum consumption Mini Re order period) = 1,200 units+ (X)-(1,600 units 2 months) (-X) = 1,200 units-3,200 Units = 2000 units X = 2,000 units
Re order level
In the stores control , there are two important documents viz Bin card system and stores ledger. Bin Card: Bin card is a record prepared by the store keeper at the moment of issuing and receiving the materials. It is maintained by the store keeper for physical verification with accuracy and effectiveness. The inventory control can be accessed through physical verification then and there, whenever the situation warrants. The bin card system is adopted by many firms for their inventory control either in the form of bin tag or stock card hanging outside the rack in order to portray the information
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immediately to facilitate the store keeper to understand the stock position of the store room. The bin card system is available in two major categories viz: Two Bin card system: Under this system two different bins are used. As soon as the goods or materials received by the store keeper, that should be recorded in terms of quantities. One among the two should be maintained for Re order level and minimum level another for Maximum stock level. To alarm the firm neither to store more than the maximum level nor to issue less than the minimum level of the stock. If the firm once reaches the maximum level, it should immediately caution the implications due to the overstocking. The same firm, if reaches the minimum level of stock, it should not go for further issue of materials to functional department or otherwise, the firm's production may be disturbed due to the poor stocking.
Bin card for Mini and Reorder level Bin card for Maximum Level Maximum Level
Reorder Level Maximum Level
Three Bin Card system: It is an extension of the early method, which incorporates the lead time stock level in addition to the other level viz Maximum, Reorder and Minimum level of the stock. Among the three , two cards are exclusively used by the firm in order to maintain the appropriate stock level, i.e., for maximum stock level and minimum stock level. The firm should neither to store beyond the maximum level nor to issue less than the Minimum level. In between, a separate bin card is used only for the Reorder level and Lead time stock level at which the firm should go for the placement of an order to get fresh delivery of materials and facilitate the firm to undergo production without any interruption by considering the time taken by the supplier to supply the ordered materials.
Reorder level
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Minimum stock level
Lead time stock level
Maximum stock level
Some other methods of the inventory control There are few models exercise the inventory control , which facilitates the firm to avoid either under or over stocking. ABC Analysis VED Analysis
23.8.13 ABC analysis

Normally the materials are classified on the basis of the following covenants viz: Volume and Value Based on the basis the materials are classified into three categories: Lesser percentage in volume and Greater percentage in Value- Category A Greater percentage in volume and Lesser percentage in Value - Category B and Percentage in volume and Percentage in value are more or less - Category C This will be explained with the help of following example for insight. A store has 4,000 items of consumption and a monthly consumption of Rs 20,00,000. 320 items will have a consumption of Rs. 15,00,000. 500 items will account for Rs 4,00,000 and 2,680 items consume material worth Rs.1,00,000 only.
Table of Items and value
Group A B No. of Items 320 1000 % of Items 8% 25% Value Rs 15,00,000 4,00,000 % of Value 75% 20%
C importance of 2,680 67% 1,00,000 5% The the analysis is exercising the control on the inventory. Total 4,000 100% 20,00,000
How the control of the inventory is being exercised ? Group A items are high valued items among the other items of the enterprise, require greater monitoring and controlling. Group B items are comparatively lesser in value among the three items given next to the Group A, require less rigid control and monitoring. Group C items are the major volume of items among the 4000 items of the enterprise which are least in value, need very little control and monitoring. The following of control of inventory on A, B and C items of the enterprise:
Group A B C No. of Items 320 1000 2,680 Level of Control Rigid Control Moderate Control Very little Control % of Items 8% 25% 67% Value Rs 15,00,000 4,00,000 1,00,000 % of Value 75% 20% 5%
From the above table, it is obviously understood that the items which have greater % (75%) in the total value requires rigid control than any other quantity of materials. The Group C items are bearing 67% of total consumption amounted which 5% of total value of the items procured by the enterprise.
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The Unique features of the ABC analysis:

Nature Level of Control Order frequency Lead time problem A Group of Items Rigid control Frequent orderingweeks, Fortnights To be cut off drastically Due to greater valueleast volume safety stock to be maintained Higher value demands centralized system of procurement By Senior officers B Group of Items Moderate control Once in 2 months To be reduced moderately Due to moderate value-lesser safety stock is required Moderate value requires centralized and decentralized system of purchase By Middle level managers C Group of Items Very little control Once in 6 months Lead time problem due to clerical should cut off Due to lower valueHigh safety stock is required Lower value needs decentralized system of purchase By clerical staff
Safety stock level
System of Purchase
Supervision
Advantages
(1) (2) It guides the management to exercise the control based on the value of goods to the total composition. Systematic inventory control can be exercised through this analysis on the basis of value of the materials. The high value materials of Group A are rigidly controlled which finally led to lesser investments. Scientific system facilitates to lessen the storage cost of the inventory.
(3)
23.8.14 VED analysis

VED analysis is applied for the inventory control of the manufacturing enterprise. V-Vital E-Essential and D-Desirable The spare parts are classified into vital, essential and desirable to the crucially to the production. The non availability of certain spares for short time leads high cost stock out known as vital spares. The non availability of spares cannot be tolerated even for few hours or one day and the cost of lost production is enormous, known as Essential spares to production. The absence of spares even more than one week, not affecting the flow production, known as desirable spares.
Check Your Progress
1)
Inventory means
a) c) Stock of Cash Stock of spares b) d) Stock of Raw materials, work in progress and Finished goods Both b) & c) only Contd...
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2)
Inventory control is for the maintenance of

a) c) High level of inventory Low level of inventory b) d) Optimum level of inventory Average level of inventory
3)
Excessive inventory holding is a) c) Better for the firm Neither better nor worse for the firm the firm b) Worse for the firm d) Either better or worse for
4)
The purpose of inventory control is a) c) To minimize the excessive stock b) consumer To maintain liquidity d) To meet the needs of the a),b) & c)
5)
Inventory control is in relevance with a) c) Storage cost Ordering cost b) d) Carrying cost (a), (b) and (c)
23.9 RECEIVABLES MANAGEMENT

23.9.1 Concept of Receivables Management
The receivables are normally arising out of the credit sales of the firm. What is meant by the accounts receivable? It is an asset owed to the firm by the buyer out of the credit sales with the terms and conditions of repayment on an agreed time period. Meaning of the receivables management: The receivables out of the credit sales crunch the availability of the resources to meet the day today requirements. The acute competition requires the firm to sustain among the other competitors through more volume of credit sales and in the intention of retaining the existing customers. This requires the firm to sell more through credit sales only in order to encourage the buyers to grab the opportunities unlike the other competitors they offer in the market.
23.9.2 Objectives of Accounts Receivables

i) ii) iii) Achieving the growth in the volume of sales Increasing the volume of profits Meeting the acute competition
23.9.3 Cost of Maintaining the Accounts Receivables

Capital cost: Due to in sufficient amount of working capital with reference to more volume of credit sales which drastically affects the existence of the working capital of the firm. The firm may be required to borrow which may lead to pay certain amount of interest on the borrowings . The interest which is paid by the firm due to the borrowings in order to meet the shortage of working capital is known as capital cost of receivables. Administrative cost: Cost of maintaining the receivables. Collection cost: Whatever the cost incurred for the collection of the receivables are known as collection cost. Defaulting cost: This may arise due to defaulters and the cost is in other words as cost of bad debts and so on.
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23.9.4 Factors Affecting the Accounts Receivables

i) ii) Level of sales: The volume of sales is the best indicator of accounts receivables. It differs from one firm to another. Credit policies: The credit policies are another major force of determinant in deciding the size of the accounts receivable. There are two types of credit policies viz lenient and stringent credit policies. Lenient credit policy: Enhances the volume of the accounts receivable due to liberal terms of the trade which normally encourage the buyers to buy more and more. Stringent credit policy: It curtails the motive buying the goods on credit due stiff terms of the trade put forth by the supplier unlike the earlier. iii) Terms of trade: The terms of the trade are normally bifurcated into two categories viz credit period and cash discount
Credit period: Higher the credit period will lead to more volume of receivables, on the other side that will lead to greater volume of debts from the side of buyers. Cash discount: If the discount on sales is more , that will enhance the volume of sales on the other hand that will affect the income of the enterprise.
23.9.5 Management of Accounts Payable/Financing the Resources

It is more important at par with the management of receivable, in order to avail the short term resources for the smooth conduct of the firm.
23.10 VARIOUS COMMITTEE REPORTS ON WORKING CAPITAL

The following committees were especially appointed for the purpose to administer the working capital i) ii) iii) iv) Dheja Committee Report 1969 Tandon Committee Report 1975 Chore Committee Report 1980 Marathe Committee Report 1984
The various committee report implications are the following:
23.10.1 Dheja Committee Report 1969

"The study carried out on the credit need of the industry and trade and how that needs inflated and such trends were checked" by the under the chairmanship of Dheja Committee.
Findings
i) ii) iii)
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General tendency was found among the firms to avail the bank credit more than their requirements Another tendency was among them that the short term credit was generally made use of by thee for the acquisition of the long term assets The lending through cash credit should be done on the basis of security in order to assess the financial position of the firm
Recommendations
i) ii) iii) Appraisal should be done by the bankers on the present and future performance of the firms The total dealings are segmented into two categories viz core and short-term needs The committee suggested the firms to maintain only one account with the one banker For huge amount of borrowing, consortium was suggested among the bankers to lend the corporate borrowers
23.10.2 Tandon Committee

The next committee was appointed Tandon Committee 1975, in an intention of granting loans and advances to the industry on the need basis through the study of the development proceeds only in order to improve the weaker section of the people.
Findings of the Committee

i) The bank should not reveal this much only to lent to the requirements of the firm in accordance with lending policy, in spite of that the banks were expected to lend to the tune of firm's requirement It should be treated as supplementary source of finance but not as major source of finance Loans were lent only in accordance on the basis of the securities produced by the borrower but not on basis of level of operations Security compliance wont provide any safety to the banks but the periodical follow up only should facilitate the banker to get back the amount of loans and advances lent
ii) iii) iv)
Recommendations: It reached the land mark in studying the need of the industries towards the requirements of the working capital. The committee has submitted its report on 9th Aug , 1975 by studying the lending policies. i) ii) iii) Necessary information about the future operations are to be supplied The supporting current assets should be shown to the banker at the moment of borrowing The bank should understand that the bank credit is only for the purposes to meet out the needs of the borrower but not for any other.
23.10.3 Chore Committee Report 1979

This committee especially constituted only for the purpose to study the sanctionable limits of the banker and the extent of the loan amount utilization of the borrower. The another purpose of the committee to appoint that to provide the alternate ways and means to afford credit facility to the industries to enhance the productive activities in the country. i) ii) iii) Continuance of the existing three system of credits by the banker viz cash credit, loans and bills No need to bifurcate the cash credit accounts of the borrower for the implementation of the differential rate of interest According to the specifications of the borrower, the banker should come to one conclusion which in normal peak level and non peak level of operations only to the tune of operations No frequent sanction of ad hoc limits of borrowing from the banker
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iv)
v)
The overdependence on the bank credit should be lessened among the practices of the industrialists through emphasizing the need of term finance.
23.10.4 Marathe Committee Report 1984

The fourth committee is Marathe committee which was instituted by the Reserve bank of India and it submitted the report on 1983. The recommendations were implemented by the Government of India from April 1,1984.
Recommendations
i) ii) iii) iv) v) Reasonability of the projection statements are to be studied by the banks more carefully Current assets and liabilities are to be classified in accordance with the norms issued by the Reserve bank of India Maintenance of the current assets ratio 1.33:1 Timely supply the information stipulated by the bankers Apt supply of annual accounting information
Illustration ABC Ltd. decides to liberalise credit to increase its sales . The liberalized credit policy will bring additional sales of Rs. 3,00,000. The variable costs will be 60% of sales and there will be 10% risk for non-payment and 5% collection cost .Will the company benefit from the new credit policy ?
Particulars Additional sales volume (-) Variable cost Additional revenue (-)Non payment risk 10% on additional sales volume (-) 5% on collection Additional revenue from increased sales due to liberal credit policy Rs 3,00,000 1,80,000 1,20,000 30,000 15,000 75,000
The new credit policy pave way for the firm to earn Rs.75,000 as an additional revenue through the volume of incremental sales.
23.11 LET US SUM UP

The "working capital" means the funds available for day today operations of the enterprise. It also represents the excess of current assets over the current liabilities which include the short term loans". The working capital requirements are normally estimated to the tune of production policies, nature of the business, length of manufacturing process, credit policy and so on. The need of the working capital is determined on the basis of duration of the production cycle. The time duration taken by the manufacturing process should be considered from the stage of raw materials to the stage of finished goods. The cycle of the business should be relatively considered for the need of working capital. The credit policy of the firm is another determinant for the determination of the working capital. There are two different credit policies viz liberal and stringent credit policies. The management of cash resources should be not only in a position to afford liquidity but also it should not require the firm to keep the cash resources simply idle; which should be invested in the marketable securities to earn some rate of return whenever the firm feel excessive holding of cash resources. Banks provide certain services to the firms only on the basis of the certain amount of balances in the accounts. That is the motive holding cash resources to avail services from the banker viz compensation motive. Timely supply
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of the goods to the requirements, facilitates the firm to earn greater volume of earning. Reordering Level is the level at which the firm should go for fresh purchase requisition of material through the store keeper to meet the requirements. There are few models exercise the inventory control, which facilitates the firm to avoid either under or over stocking ABC Analysis VED Analysis

Discuss inventory management as applicable in an industry of your choice.
23.13 KEYWORDS
Working capital: The short term asset meant for day today or immediate financial commitments Net working capital: Current assets - current liabilities Temporary working capital: Which are of immediate importance Permanent working capital: Which are regular in feature Cash: coins, notes, currencies and near cash i.e., marketable securities Cash management: maintain the adequate cash resource and excessive resources should be invested in the marketable securities Inventory: Stock of Raw materials, Stock of Work in Progress, Stock of Finished Goods and Stock of Spares but not Stock of Loose tools. EOQ: Economic Order Quantity of materials to be ordered/procured Carrying cost: Cost is incurred for carrying the materials from the place of purchase to place of production centre/profit centre Ordering Cost: Cost incurred at the moment of placing the order of goods or materials e.g. Administration costs, cost of communication and so on. Maximum level: The stock level of the firm should not be more than the determined level Minimum level: The further issues should not be done below the level of the stock of the firms Reorder level: At this level, the firm should place an order for the materials to the requirement Lead time stock level: This is level required by all the firms to maintain the stock till the next delivery from the supplier ABC Analysis: Analysis of exercising the control on the inventory on the basis of value. Always Better Control Analysis; A- High control for high value goods; B-Moderate control for lesser value goods and C- Little control on the least value goods VED Analysis: Vital, Essential and Desirable Analysis Designed for Spares and accessories Bin card: Card or Tag used to illustrate the level of the stock position of the certain materials at the stores Stores ledger: It is a official record of receipt and issuance of materials or goods in terms of quantities with value of them
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Receivables: It is an asset arises at the moment of credit sales, owed to the firm Collection cost: Cost of collection incurred by the firm due to collection of receivables Agency charges, brokerage charges for collection Default cost: Cost due to bad debts

1. 2. 3. 4. 5. 6. Define the working capital management. Explain the objectives of working capital management. Explain the various components of working capital management. Write detailed note on cash management. Elucidate the various practices of Inventory management. Highlight the importance of the receivable management through various strategies.

R.L. Gupta and Radhaswamy, Advanced Accountancy. V.K. Goyal, Financial Accounting, Excel Books, New Delhi. Khan and Jain, Management Accounting. S.N.Maheswari, Management Accounting. S. Bhat Financial Management, Excel Books, New Delhi. Prasanna Chandra, Financial Management Theory and Practice, Tata McGraw Hill, New Delhi (1994). I.M. Pandey, Financial Management, Vikas Publishing, New Delhi. Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.
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Accounting and Finance for Managers

MBA First Year Paper No. 3

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Bharathiar University, Coimbatore - 641 046