Financial and Management Accounting

LESSON - 1
ACCOUNTING - THE LANGUAGE OF BUSINESS

Objectives
After reading this lesson the student should be able to:
know the evolution and meaning of accounting
understand the nature and role of accounting
appreciate the importance of accounting as an information system
understand the profession of accounting and its specialised branches
Structure
1.1 Introduction
1.2 Evolution of accounting
1.3 Definition of accounting
1.4 Scope and functions of accounting
1.5 Accounting as an information system
1.6 Users of accounting information
1.7 The profession of accounting
1.8 Specialised accounting fields
1.9 Summary
1.10 Key words
1.11 Exercises
1.12 Further readings
1.1 INTRODUCTION
Accounting is aptly called the language of business. This designation is applied to
accounting because it is the method of communicating business information. The basic
function of any language is to serve as a means of communication. Accounting duly
serves this function. The task of learning accounting is essentially the game as the task
of learning a new language. But the acceleration of change in business organisation has
contributed to increasing the complexities in this language. Like other languages, it is
undergoing continuous change in an attempt to discover better means of
communicating.
1.2 EVOLUTION OF ACCOUNTING
Accounting is as old as money itself. It has evolved as have medicine, law and most other
fields of human activity in response to the social and economic needs of society. For the
most part, early accounting dealt only with limited aspects of the financial operations of
private or governmental enterprises. Complete accounting system for an enterprise
which came to be called as "Double Entry System" was developed in Italy in the 15th
century. The first known description of the system was published there in 1494 by a
Franciscan monk by the name Luca Pacioli.
The expanded business operations initiated by the Industrial Revolution required
increasingly large amounts of money which in turn resulted in the development of the
corporation form of organisations. As corporations became larger, an increasing number
of individuals and institutions looked to accountants to provide economic information
about these enterprises. For e.g. prospective investors and creditors sought information
about a corporation's financial states. Government agencies required financial
information for purposes of taxation and regulation. Thus accounting began to expand
its function of meeting the needs of relatively few owners to a public role of meeting the
needs of a variety of interested parties.
1.3 DEFINITION OF ACCOUNTING
Before attempting to define accounting, it may be made clear that there is no unanimity
among accountants as to its precise definition. Anyhow, let us examine three popular
definitions on the subject.
Accounting has been defined by the American Accounting Association
Committee as: ".... the process of identifying measuring and communicating economic
information to permit informed judgments and decisions by users of the information."
This may be considered as a good definition because of its focus on accounting as an aid
to decision making.
The American Institute of Certified and Public Accountants Committee on
Terminology defined accounting in 1961 as : "Accounting is the art of recording,
classifying and summarising in a significant manner and in terms of money, transaction
and events which are, in part at least of financial character and interpreting the results
thereof." Of all definitions available, this is the most acceptable one because it
encompasses all the functions which the modern accounting system performs.
1.4 SCOPE AND FUNCTIONS OF ACCOUNTING
Individuals engaged in such areas of business as finance, production, marketing,
personnel and general management need not be expert accountants but their
effectiveness is no doubt increased if they have a good understanding of accounting
principles. Everyone engaged in business activity, from the bottom level employee to the
chief executive and owner, comes into contact with accounting. The higher the level of
authority and responsibility, the greater is the need for an understanding of accounting
concepts and terminology.
A recent study conducted in United States revealed that the most common background
of chief executive officers in United States Corporations was finance and accounting.
Interviews with several corporate executives drew the following comments - "my
training in accounting and auditing practice has been extremely valuable to me
throughout."
"Knowledge of accounting carries with it understanding on that establishment and
maintenance of sound financial controls - an area which is absolutely essential to a
chief-executive to a chief executive officer."
Though accounting is generally associated with business, it is not only business which
makes use of accounting, but also many individuals in non-business areas make use of
accounting data and need to understand accounting principles and terminology. For e.g.
an engineer responsible for selecting the most desirable solution to a technical
manufacturing problem may consider cost accounting data to be the decisive factor.
Lawyers use accounting data in tax cases and damages from breach of contract.
Governmental agencies rely on accounting data in evaluating the efficiency of
government operations and for approving the feasibility of proposed taxation and
spending programs. Accounting thus plays an important role in modern society and
broadly speaking, all citizens are affected by accounting in some way.
Accounting which is so important to all discharges the following vital functions:
1.4.1 Keeping systematic records: This is the fundamental function of accounting.
The transactions of the business are properly recorded, classified and summarised into
final financial statements income statement and the balance sheet.
1.4.2 Protecting the Business Properties: The second function of accounting is to
protect the properties of the business by maintaining proper record of various assets
and thus enabling the management to exercise proper control over them.
1.4.3 Communicating the results: As accounting has been designated as the
language of business, its third function is to communicate financial information in
respect of net profits, assets, liabilities, etc, to the interested parties.
1.4.4 Meeting legal requirements: The fourth and last function of accounting is
to devise such a system as well meet the legal requirements. The provisions of various
laws such a Companies Act, Income Tax Act, etc., require the submission of various
statements like Income Tax Returns, Annual Accounts and so on, Accounting system
aims at fulfilling this requirements of law.
It may be noted that the functions stated above are those of financial accounting alone.
The other branches of accounting, about which we are going to see later in this chapter
have their special functions with the common objective of assisting the management in
its task of planning, control and coordination of business activities. Of all the branches
of accounting, management accounting is the most important from management point
of view.
1.5 ACCOUNTING AS AN INFORMATION SYSTEM
As accounting is the language of business, the primary aim of accounting like any other
language is to serve as a means of communication. Most of the world's work is done
through organisation-groups of people who work together to accomplish one or more
objectives. In doing its work, an organisation uses resources - men, material, money and
machine and various services. To work effectively the people in an organisation need
information about these resources and the results achieved by using them. People
outside the organisation need similar information to make judgments about the
organisation. Accounting is the system that provided such information.
Any system has three features, viz. input, processes and output. Accounting as a social
science can be viewed as an information system since it has all the three features, i.e.,
inputs (raw data) processes (men and equipment) and outputs (reports and
information). Accounting information is composed principally of financial data about
business transactions. The mere records of transactions are of little use in making
informed judgments and decisions. The recorded data must be sorted and summarized
before significant reports and analyses can be prepared. Time of the reports to
enterprise manager and to others who need economic information may be made
frequently. Other reports are issued only at longer intervals. The usefulness of reports is
often enhanced by various types of percentages and trend analyses. The "basic raw
materials" of accounting are composed of business transactions data. Its "primary end
products" are composed of various summaries, analyses and reports.
The information needs of a business enterprise can be outlined and illustrated with the
help of the following Chart 1.1
Chart 1.1
Chart showing Types of Information
The chart clearly presents the different types of information that might be useful to all
sorts of individuals interested in the business enterprise. As seen from the chart
accounting supplies the quantitative information. The special feature of accounting as a
kind of quantitative information and as distinguished from other types of quantitative
information is that it usually is expressed in monetary terms. In this connection it is
worthwhile to recall the definitions of accounting as given by the American Institute of
Certified and Public Accountants and by the American Accounting Principles Board.
The types of accounting information may be classified into four categories: 1) Operating
information, 2) Financial accounting information, 3) Management accounting
information, and 4) Cost accounting information.
1.5.1 Operating information: By operating information we mean the
information which is required to conduct day-to-day activities. Examples of
operating information are: amount of wages paid and payable to employees,
information about the stocks of finished goods available for sale and each one's
cost and selling price, information about amounts owed to and by the business
enterprise, information about stocks of raw materials, spare parts and accessories
and so on. By far the largest quantity of accounting information consists of
operating information. This is well suggested by the arrows at the bottom of the
chart as operating information provides the raw data (input) for financial
accounting, management accounting and cost accounting.
1.5.2 Financial Accounting: Financial accounting information is intended both
for owners and managers and also for the use of individuals and agencies external
to the business. This accounting is concerned with the recording of transactions
for a business enterprise and the periodic preparation of various reports from such
records. The records may be general purposes or for a special purpose. A detailed
account of the function of financial accounting has been given earlier in this
chapter.
1.5.3 Management Accounting: Management accounting employs both
historical and estimated data in assisting management in daily operations and in
planning for future operations. It deals with specific problems that confront
enterprise managers at various organisational levels. The management accountant
is frequently concerned with identifying alternative courses of action and then
helping to select the best one. For example, the accountant may help the finance
manager in preparing plans for future financing or may help the sales manager in
determining the selling price to be placed on a new product by providing suitable
data. Generally management accounting information is used in three important
management functions: 1) control 2) co-ordination 3) planning.
1.5.4 Cost Accounting: The Industrial Revolution in England posed a challenge
to the development of accounting as a tool of industrial management. This
necessitated the development of costing techniques as guides to management
action. Cost accounting emphasizes the determination and the control of costs. It
is concerned primarily with the cost of manufacturing processes. In addition one
of the principal functions of cost accounting is to assemble and interpret cost data,
both actual and prospective for the use of management in controlling current
operations and in planning for the future.
All of the activities described above are related to accounting and in all of them the
focus is on providing accounting information to enable decisions to be made.
1.6 USERS OF ACCOUNTING INFORMATION
There are several groups of people who are interested in the accounting information
relating to the business enterprise. Some of them are:
1.6.1. Shareholders: Shareholders as owners are interested in knowing the
profitability of the business transactions and the distribution of capital in the
forms of assets and liabilities. In fact accounting developed several centuries ago
to supply information to those who had invested their funds in business
enterprise.
1.6.2. Management: With the advent of Joint Stock Company form of
organisation the gap between ownership and management widened. In most cases
the shareholders act merely as renters of capital and the management of the
company passes into the hands of professional ma Augers. The accounting
disclosures greatly help them in knowing about what has happened and what
should be done to improve the profitability and financial position of the enterprise.
1.6.3. Potential Investors: An individual who is planning to make an
investment in a business would like to know about its profitability and financial
position. An analysis of the financial statements would help him in this respect.
1.6.4. Creditors: As creditors have extended credit to the company, they are
much worried about the repaying capacity of the company. For this purpose they
require its financial statements an analysis of which will tell about the solvency
position of the company.
1.6.5. Government: Any popular Government has to keep a watch on big
businesses regarding the manner in which they build business empires without
regard to the interests of the Community. Restricting monopolies is something
that is common even in capitalist countries. For this, it is necessary that proper
accounts are made available to the Government. Also, accounting data are
required for collection of sales-tax, income-tax, excise duty, etc.
1.6.6. Employees: Like creditors, employees are interested in the financial
statements in view of various profit sharing and bonus schemes. Their interest
may further increase when they hold shares of the companies in which they are
employed.
1.6.7. Researchers: Researchers are interested in interpreting the financial
statements of the concern for a given objectives.
1.6.8. Citizens: Any citizen may be interested in the account records of business
enterprises including public utilities and Government companies as a voter and
tax payer.
Please use headphones
1.7 THE PROFESSION OF ACCOUNTING
Accounting can very well be viewed as a profession with stature comparable to that of
law or medicine or engineering. The rapid development of accounting theory and
technique especially after the late thirties of this century has been accompanied by an
expansion of the career opportunities in accounting and an increasing number
professionally trained accountants. Among the factors contributing to the growth has
been the increase in number, size and complexity of business enterprises, the imposition
of new and increasingly complex taxes and other governmental restrictions on business
operations.
Coming to the nature of accounting function, it is no doubt a service function. The chief
of accounting department holds a staff position which is quite in contradistinction to the
roles played by production or marketing executives who hold line authority. The role of
the accountant is advisor in character. Although accounting is a staff function performed
by professionals within an organisation, the ultimate responsibility for the generation of
accounting information, whether financial or managerial rests with management. That
is why one of the top officers of many businesses is the controller. The controller is the
person responsible for satisfying other managers' demands for management accounting
information and for complying with the regulatory demands of financial reporting. With
these ends in view, the controller employs accounting professionals in both
management and financial accounting. These accounting professionals employed in a
particular business firm are said to be engaged in private accounting. Besides there
are also accountants who render accounting services on a fee basis through staff
accountant employed by them. These accountants are said to be engaged in public
accounting.
1.8 SPECIALISED ACCOUNTING FIELDS
As in many other areas of human activity, a number of specialised fields in accounting
also have evolved besides financial accounting, management accounting and cost
accounting as a result of rapid technological advances and accelerated economic growth.
The most important among them are explained below:
1.8.1 Tax Accounting: Tax accounting covers the preparation of tax returns and
the consideration of the tax implications of proposed business transaction on
alternative courses of action. Accountants specialising in this branch of accounting
are familiar with the tax administrative regulations and court decisions on tax
cases.
1.8.2 International Accounting: This accounting is concerned with the special
problem associated with the international trade of multinational business
organisations. Accountants specialising in this area must be familiar with the
influences that custom, law and taxation of various countries bring to bear on
international operations and accounting principles.
1.8.3 Social Responsibility Accounting: This branch is the newest field of
accounting and is the most difficult to describe concisely. It owes its birth to
increasing social awareness which has been particularly noticeable over the last
two decades or so. Social responsibility accounting is so called because it not only
measures the economic effects of business decisions but also their social effects,
which have previously been considered to be immeasurable. Social responsibilities
of business can no longer remain as a passive chapter in the text books of
commerce but are increasingly coming under greater scrutiny. Social workers,
people welfare organisations and consumer protection societies all over the world
have been drawing the attention of all concerned towards the social effects of
business decisions. The management is being held responsible not only for
efficient conduct of business as reflected by increased profitability also for what it
contributes to social well being and progress.
1.8.4 Inflation Accounting: Inflation has now become a world-wide
phenomenon. The consequences of inflation are dire in case of developing and
under developed countries. At this juncture when financial statements or reports
are based on historical costs, they would fail to reflect the effect of changes in
purchasing power on the financial position and profitability of the firm. Thus the
utility of the accounting records, not taking care of price level changes is seriously
lost. This imposes a demand on the accountants for adjusting financial accounting
for inflation to know the real financial position and profitability of a concern and
thus, emerged a further branch of accounting called inflation accounting or
accounting for price level changes. It is a system of accounting which regularly
records all items in financial statements at their current values. The system
recognises the fact that the purchasing power of money is decreasing day-by-day
due to inflation and reveals profit or loss or states the financial position of the
business on the basis of the current prices prevailing in the economy.
1.8.5 Human Resources Accounting: Human Resources Accounting is yet
another new field of accounting which seeks to report and emphasise the
importance of human resources in a company's earning process and total assets. It
is based on the general agreement that the only real long lasting asset which an
organisation possesses is the quality and caliber of the people working in it. This
system of accounting is concerned with "the process of identifying and measuring
data about human resources and communicating this information to interested
parties.''
1.9 SUMMARY
Accounting is rightly called the "language of business". It is as old as money itself. It is
concerned with the collecting, recording, evaluating and communicating the results of
business transactions. Initially meant to meet the needs of a relatively few owners, it
gradually expanded its function to a public role of meeting the needs of a variety of
interested parties. Broadly spacing all citizens are affected by accounting in some way.
Accounting as an information system possesses all the three features of a system.
Accounting is also viewed as a profession with accountants engaging in private and
public accounting. As in many other areas of human activity a number of specialised
fields in accounting also have evolved as a result of rapid changes in business and social
needs.
1.10 KEYWORDS
Language of Business: Accounting is the language of business.
Accounting: Accounting is the art of recording, classifying, summarising and
interpreting business transactions.
Accounting in an information system: As an information system accounting
provides operating information, financial accounting information, management
accounting information and cost accounting information.
Accounting is a service function: Accounting function is a service function. The
role of accountant is advisory in character.
Tax Accounting: Deals with preparation of tax returns and analyses tax implications.
International Accounting: Concerned with the special problems associated with the
international trade of multi - national business organisations.
Social responsibility accounting: This branch of accounting measures the social
effects of business decisions.
Inflation Accounting: This system of accounting regularly records all items in
financial statements at their current values.
Human resources accounting: The importance of human resources in a company's
earning process and total assets is reported in this kind of accounting.
1.11 EXERCISES
1. Why accounting is called the language of business?
2. What are the functions of accounting?
3. Accounting as a social science can be viewed as an information system. Examine.
4. Distinguish between Public accounting and private accounting.
5. Is accounting a staff function or a line function? Explain with reasons.
6. Give an account of the various branches of accounting.
7. Accounting is a service function Discuss this statement in the context of a modern
manufacturing business.
8. Distinguish between Financial Accounting and Management Accounting.
1.12 FURTHER READINGS
1. Antony and Reece: 'Accounting Principles', Richard D. Irwin, Inc. Home wood,
Illinois.
2. Fess/Warren: 'Financial Accounting', South Western Publishing Company. Ohio.
3. M.C. Shukla & T.S. Grewal: Advanced Accounts, S.Chand & Company New Delhi
- End of Chapter -
LESSON 2
ACCOUNTING FOR MANAGERIAL DECISION MAKING A CONCEPTUAL
APPROACH
Objectives
Understand the meaning of management accounting
Understand the objectives of management accounting
Appreciate the importance of management accounting in decision making
Distinguish management accounting from cost-accounting and financial
accounting
Realise the limitations of management accounting
Comprehend the role of management account
Structure
2.1 Introduction
2.2 Evolution of Management Accounting
2.3 Meaning of Management Accounting
2.4 Functions / Objectives of Management Accounting
2.5 Meaning of Management Accounting
2.6 Limitations of Management Accounting
2.7 Management Accounting vs. Financial Accounting
2.8 Management Accounting vs. Cost Accounting
2.9 Summary
2.10 Keywords
2.11 Exercises
2.12 Further Readings
2.1 INTRODUCTION
Accounting can no longer be considered a mere language of business. The need for
maintaining the financial chastity of business operations, ensuring the reliability of
recorded experience resulting from these operations and conduction a frank appraisal of
such experience has made accounting a prime activity along with such other activities as
marketing, production and finance. Accounting may be broadly classified into two
categories accounting that is meant to serve all parties external to the operating
responsibility of the firms, and the accounting that is designed to serve internal parties
who take care of the operational needs of the firm. The first category, which is
conventionally referred to as "Financial Accounting" looks to the interest of those who
have primarily a financial stake in the organisation's affairs - creditors, investors,
employees, etc. On the other hand the second category of accounting is primarily
concerned with providing information relating to the conduct of the various aspects of a
business like cost 01 profit associated with some portions of business operations to the
internal parties viz., management. This category of accounting is called as "Management
Accounting."
2.2 EVOLUTION OF MANAGEMENT ACCOUNTING
A perusal of the accounting history from the very beginning to some recent years reveals
that accounting has primarily been developed to meet those needs which arise from the
fiduciary relationships between parties like firm, owners, creditors, management etc.
But the last few decades have witnessed a dramatic change in the development of
accounting from a mere device of recording business transactions to a formidable
instrument of forecasting, planning and regulating business activity. No longer could an
accountant remain a mere book-keeper. He is something more than that. The change in
his duty is being associated with the change in the objectives of the accounting as such.
At present the objective of accounting is not only to keep records and prepare final
accounts but also to help management in its basic functions which are becoming day-by-
day more complex and complicated. But it was found that the traditional accounting i.e.
financial accounting could not meet the requirements of the management today due to
many reasons.
The first and foremost reason is that financial accounting provides information only
about past records i.e. a post-mortem of what has already happened. It could give a
story of how a business has fared financially during a given period of trading or how its
affairs stand at a particular point of time. It does not tell the management as to how the
business has fared at each stage of operation. It also does not tell what should be the
future policy of the management in order to achieve the targets set or to set new targets.
Further there are many 'No's in financial accounting - no analysis and interpretation of
data, no modern approach, no standards for comparison, no provision for control
measures, no accountancy for price level changes, etc. Thus financial recounting cannot
cope with the varied business problems. So to overcome the defects and limitations of
financial accounting which is said to be static, management accounting which is a
dynamic process has been evolved.
2.3. MEANING OF MANAGEMENT ACCOUNTING
The term management accounting is of very recent origin. As already stated it evolved
due to inherent limitations of financial accounting. It is a tool of Management in
contrast to the conventional annual or half-yearly accounts prepared mainly for
information of proprietor. Top management wants concise but distilled information for
decision-making. Management is the task of planning, organising, directing and
controlling. It constantly needs accounting information to base its decisions upon;
Management accounting provides this information. The essence of the subject can be
simply expressed that management accounting saves the needs of management.
Definitions of Management Accounting:
A number of definitions are available on the subject management accounting. Before
attempting to see the various definitions it may be added that there is no unanimity
among the management accountants as to its precise definition.
The Institute of Chartered Accountants of England has defined management
accounting as: "Any form of accounting which enables a business to be conducted more
efficiently can be regarded as Management Accounting". This definition is of a general
nature and hence it is not of much use.
Robert N. Anthony has defined it as: "Management Accounting is concerned with
accounting information that is useful to management". Anthony's sweet and simple
definition does not shed much light on all phases of Management Accounting.
As per American Accounting Association, "Management Accounting includes the
methods and concepts necessary for effective planning, for choosing among alternative
business actions and for control through the evaluation and interpretation of
performances". As compared to other definitions this definition is broader in nature
covering three vital areas of management, viz. planning, decision-making and
controlling.
Some other standard definitions on the subject are given below:
Institute of Chartered Accountants of India - "Such of its techniques and
procedures by which accounting mainly seeks to aid the management collectively have
come to be known as management accounting".
John Sizer - "Management Accounting may be defined as the application of
accounting techniques to the provision of information designed to assist all levels of
management in planning and controlling the activities of the firm".
2.4 FUNCTIONS OR OBJECTIVES OF MANAGEMENT ACCOUNTING
The following excerpt taken from "Management through Accounts", the second treatise
of James H. Bliss prescribes functions of management accounting which also becomes
its objectives.
"The service lies in placing before business executives the most complete information on
their affairs analysed and interpreted so as to be readily understood and used effectively
in guiding and controlling their operations and transactions more profitably,
economically and conservatively".
From the above statement we get the following two functions:
(a) Operating functions: To present the required facts and information for the use of
management in a quantitative form.
(b) Theoretical functions: To help in effective performance of managerial functions
i.e. planning, organising, control etc.
The first category i.e. operating functions is discussed under the heading 'Functions of
Management Accounting' and the second category, viz. theoretical functions is discussed
under the heading 'Objectives of Management Accounting'.
2.4.1 Functions of management accounting (or Operating functions):
a. Modifi cation of data: The main function of any accounting system is recording of
business transactions. Management accounting system is not an exception to this. It
supplies the accounting data required for decision making purpose. For this purpose it
modifies the data furnished by financial accounting to serve the managerial needs. This
is done through resort to a process of classification and combination which enables to
retain similarities of details without eliminating dissimilarities.
b. Vali dati ng the data: In the present day competitive and complex business world
quick decision alone is not enough, decision must also be a reliable one. To make
decisions reliable, valid data should be made available to managers. The effectiveness of
managerial function depends too much upon the accuracy and adequacy of the data. It is
the function of management accounting to present before the management the required
data with some sort of reasonable accuracy. It may be noted in this connection that
management accounting provides the required data with reasonable accuracy and not
with perfect accuracy.
c. Analysi s and i nter pr etation of data: Though management accounting is
concerned with recording of business transactions, the analysis and interpretation of
such data, in analysing and interpreting the data lies the essence of management
accounting. Data as such is mere figures and would not speak anything. Unless these are
analysed quantitatively or qualitatively, management cannot take any step. Analysis and
interpretation of data opens up new directions for its use by management and makes
data more meaningful. To discharge this function management accounting uses a
number of tools like Ratio Analysis, Funds Flow Analysis, Cash Flow Analysis, etc.
d. Communicati ng the data: The collected and interpreted data must be
communicated to those who are interested in it or to whom it has some meaning.
Otherwise these data may not yield any meaningful result and the whole process of
collecting, validating and interpreting would amount to be a futile exercise. The
communication of the data should be done within a reasonable time. Data delayed is
decision delayed and a delayed decision may delay the prosperity of its concern. To
accomplish this motion of management accounting several reports and statements are
being used. Thus accounting reporting or managerial reporting is also an important
function.
2.4.2 Objectives of Management Accounting (or Theoretical functions):
The primary object of management accounting is to help the management. It helps the
management in the areas of planning, organising, controlling, co-ordinating and
decision making.
a. To help i n planni ng: Planning is the primary function of management.
Management accounting assists the management in this vital area by making forecasts
about the production, the selling, the inflow and outflow of cash i.e. in planning a very
wide range of activities of the business. Not only that, it may also forecast how much
may be needed for alternative courses of action or the expected rate of return therefrom
and at the same time decides upon the programme of activities to be undertaken.
b. To assist i n or gani si ng: The main function of organisation is to establish
structural relationship among various segments in an enterprise. It is done through
division of responsibility and delegation of authority. By preparing budgets and
ascertaining specific cost centres, it delivers the resources to each centre and delegates
the respective responsibility to ensure their proper utilization. As a result, an inter-
relationship grows among the different parts of the enterprise.
c. To hel p in contr ol l ing: It is because of controlling function that management
accountant is called as 'controller'. Management accounting helps in the controlling
function through the techniques of 'standard costing' and 'budgetary control'. To
control is the systematic examination of business results with a view to ensure that
actual result has been according to the planned one. In case of variances the reasons for
the same are ascertained and corrective action is suggested to prevent he recurrence of
such variances.
d. To help i n co-or dinati on: Management accounting helps the management in the
overall co-ordination of various operational activities. This coordination work is done by
preparing the functional budgets, then by integrating all functional budgets into one
which goes by the name of 'Master Budget'. Thus the technique of 'budgetary
control' is used by the management accountant to help in coordinating the different
segments of the enterprise. Without coordination it is not possible to achieve the set
objectives of the enterprise.
e. To hel p in decision-making: Like planning, decision making also is an important
and prime function of top-management. By decision-making is meant choosing of such
an alternative amongst various alternatives which would yield the maximum return.
Management accounting helps the management in the process of decision-making by
providing significant the formation relating to various alternatives in term of costs and
revenues.
The techniques of 'marginal costing', 'breakeven analysis', 'capital budgeting'
etc are used by the management accountant for this purpose.
2.5 UTILITY OF MANAGEMENT ACCOUNTING
As management accounting has emerged to overcome the limitations of financial
accounting it is needless to point out that many advantages which are not associated
with financial accounting are available with management accounting. These are already
discussed while explaining the objects and functions of management accounting.
However for ready reference the advantages of management accounting are summarised
below:
1. Through efficient planning and effective organisation, management accounting
brings systematic regularity in the business activities.
2. Management accounting increases the efficiency of the concern by comparing
actual performance with expected performance and by suggesting remedial
action to avoid the recurrence of adverse variances.
3. The application of various types of controls in accounting areas results in cost
reduction and finally in price reduction. This increases the competitive power of
the concern.
4. Management accounting acts as a binding force in bringing about coordination
among various accounting departments. This enables greater total achievement
of the set objectives of each accounting department.
5. The 'control' function of management accounting eliminates various types of
wastages and production defectives, and increases workers' efficiency.
6. Management accounting removes the unacceptable or sub-standards which often
are responsible for strained relations between management and labour class. It
improves industrial relations.
7. The overall effect of installation of management accounting system is that return
on capital employed is maximised.
2.6 LIMITATIONS OF MANAGEMENT ACCOUNTING
No system is perfect, and this applies to accounting system also. The management
accounting system suffers from certain limitations. Unless these limitations are taken
into account the so-called benefits or advantages cannot be reaped. The various
limitations of management accounting are listed below:
1. Most of the data used in management accounting are derived from financial
accounting records or cost accounting records or other records. Just as the title of
a transferee of a property depends upon the title of the transferor, similarly the
conclusions arrived at by management accountants depend to a large extent on
the accuracy of the data provided by financial accounting and cost accounting.
The flaws which are there in these two records are also reflected in management
accounting. In other words the merits and demerits of management accounting
depends upon the merits and demerits of these two records.
2. Management accounting is of recent origin. It is only a few decades old. Still it is
in a state of evolution. Consequently it comes across the same difficulties which
any new discipline has to face. The analytical tools used by it need to be
sharpened, the techniques adopted by it need to be improved and the uncertainty
prevailing about the application of its concepts is to be removed.
3. Intuitive decision-making still dominates the scene i.e. there is a consistent
tendency to replace scientific decisions with intuitive decisions despite the fact
that management accounting provides for rational analysis based on facts. There
always prevails a temptation to take an easy course of arriving at decisions by
intuition rather than taking the tortuous path of scientific decision making. Even
if an analysis and interpretations of data is done, it is affected by the personal
prejudice and bias of the accounting people. This limits the utility of
management accounting.
4. Management accounting has a very wide and diverse scope. It unites two broad
areas - management and accounting - each of which is very broad in itself. It
makes use of both accounting as well as non-accounting sources and also
quantitative as well as qualitative information. This wide and diverse scope of
management accounting creates many difficulties.
5. It follows from the above i.e. in view of the wide scope of the subject, for taking
decisions, the management should have a thorough knowledge in different fields
such as accounts, finance, statistics, taxation, credit, etc. But in practice, it is
found that the persons entrusted with taking some decisions do not have the
required knowledge. This dearth of knowledge affects the quality of the decision
taken by them.
6. Resistance to change is a common phenomenon. Whenever any system is
introduced, people who are acquainted with the old or traditional system tend to
resist it. The installation of a system of management accounting involves a radical
transformation in the established state of affairs. If the people concerned are not
psychologically ready to adopt themselves, they resist to any change.
7. The introduction of management accounting system in a concern requires an
elaborate organisation structure which is very costly. Therefore, small concerns
cannot afford to adopt this system.
8. Conclusions derived or decisions taken by the management accountant are of
little value unless these are properly executed at various levels of the
organisation. Thus there is a consistent and constant need for the execution of
the various decisions at each management level.
2.7 MANAGEMENT ACCOUNTING VS. FINANCIAL ACCOUNTING
Financial Accounting and Management Accounting are two interrelated facets of the
accounting system. They are not independent of each other; they are interdependent.
They are supplementary in nature.
Financial accounting provides the basic data which is analysed and interpreted suitably
and in the required manner by management accounting.
Even though in the words of Robert N. Anthony a close relationship exists between
financial accounting and management accounting yet there are certain
fundamental differences between the two. A distinction is always drawn between
financial accounting and management accounting since they differ in their emphasis
and approaches. Some of the points of differences between these two accounting
systems are given below:
1. The essential difference between financial accounting and management accounting
lies in their objective. The primary object of financial accounting is to make
periodical reports for shareholders, creditors, debenture holders and the
Government. The primary object of management accounting is to provide
information for internal management.
2. Financial accounting is concerned with assessing the results of a business as a
whole, whereas management accounting is concerned with assessing the activities
of different sections or divisions or departments i.e. financial accounting is
general in nature whereas management accounting is analytical in nature.
3. Financial accounting is concerned almost exclusively with historical records
whereas management accounting is concerned with the future plans and
policies. Financial accounting reports tell what has happened in the past. Through
financial statements, investors are revealed the manner in which the resources
entrusted by them to the firm have been utilised. Management accounting being a
decision-making process, focuses on future. It analyses past data and adjusts them in
the light of future expectations to make plans.
4. In management accounting there is more emphasis on furnishing information
quickly than in financial accounting.
5. In management accounting there is lesser emphasis on precision; approximate
figures which are promptly available are considered to be more valuable than very
precise data received too late.
6. In financial accounting records are maintained in the form of personal,
property and nominal accounts. In management accounting costs and revenues
are mostly reported by responsibility centers or cost centers.
7. The generally accepted accounting principles and conventions govern the
financial accounts and statements. These accounting principles and conventions
are not binding on management accounting. Information outside the debit and credit
structure is often as valuable as others.
8. For every business, financial accounting has become more or less compulsory
indirectly, if not directly, due to a number of factors. It is obligatory for joint stock
companies to satisfy statutory provisions. It is not mandatory to install a system of
management accounting but its usefulness makes it highly desirable.
9. They also differ in the period of reporting. Financial accounting adopts twelve
months period for reporting performance to shareholders and other investors. In
contrast accounting reports are for shorter durations. Management accounting
information is also collected for preparing long term plans for five or more years. Capital
expenditure plans, for example, cover a longer duration.
10. Financial accounting limits the role of the accountant to a book-keeper.
Management accounting transcends the role of the accountant beyond book-
keeping into the managerial process of planning, organising, control and evaluating
and also to different functional areas.
2.8 MANAGEMENT ACCOUNTING VS. COST ACCOUNTING
Costing has been defined as classifying, recording and appropriate allocation of
expenditure for the determination of the costs of products or services. Cost accounting
will tell the management as to how the business has fared at each stage of operation. But
cost accounting will not tell them anything about the future policy to be adopted. It is
here that management accounting differs from cost accounting. The aim of management
accounting is not to collect information as such but to utilise the information collected
in order to help the management to formulate their future policy and to make important
policy decisions.
Though there is a difference between management accounting and cost accounting in
their objective, yet their functions are complementary in nature. Management
accounting depends heavily on cost data and other information derived from cost
records. In one way, management accounting is an expansion of cost accounting. Like
cost accounting, management accounting involves reporting at frequent intervals rather
than at the end of a year or half-year.
Cost accounting deals primarily with cost data. But management accounting involves
the consideration of both costs and revenues. It is a broader concept than cost
accounting. It not only reports costs but also uses them to assist management in
planning possible alternate courses of action.
Conceptually speaking management accounting is a blending together of cost
accounting, financial accounting and all aspects of financial management. It has a wider
scope as a tool of management. But it is not a substitute for other accounting functions.
It is a continuous process of reporting cost and financial data as well as other relevant
information to management.
2.9 SUMMARY
Accounting can no longer be considered as a mere language of business. Now a need has
arisen for accounting to provide information relating to the conduct of the various
aspects of a business like cost or profit associated with some portions of business
operations to the internal parties viz. management. Traditional accounting i.e. financial
accounting cannot provide this. Hence management accounting was evolved to fulfill
this need. Thus the objectives of management accounting are to present the required
facts and information for the use of management in a quantitative form and to help in
effective performance of managerial functions i.e. planning, organising, controlling,
decision-making etc. A concern will derive many advantages with the help of
management accounting like systematic regularity in the business activities through
efficient planning and effective organisation, increase in efficiency of the concern by
comparing actual performance with expected performance and suggesting remedial
measures to avoid the recurrence of adverse variances, cost reduction and consequent
price reduction by the application of various types of controls in accounting areas, etc.
Of course management accounting is not without limitations. But the advantages that
one can derive from management accounting far outweigh the limitations.
2.10 KEY WORDS
Management Accounting: Such of its techniques and procedures by which
accounting mainly seeks to aid the management collectively.
Modification of Data: Management accounting modifies its data furnished by
financial accounting to serve the managerial needs.
Validating the Data: Management accounting presents before the management the
required data with some sort of reasonable accuracy.
Analysis and interpretation of Data: Management accounting analyses and
interprets data to open up new directions for their use by management and makes data
more meaningful.
Communicating the Data: Management accounting, through several reports and
statements, communicates the collected and interpreted data to those who are
interested in it or to whom it has some meaning.
2.11 EXERCISES
1. What is management accounting? How does it help management?
2. In what respect does management accounting differ from financial accounting? Is
there any difference between cost accounting and management accounting?
Explain.
3. Explain the functions of a controller. What is the status of a controller in an
organisation?
4. "Management accounting has been evolved to meet the needs of management".
Explain this statement fully.
5. a) Discuss the objectives of management accounting. b) What are the important
characteristics of management accounting?
6. "Management accounting is concerned with accounting information that assists
management". Explain.
7. "Management accounting emerged out of the limitations of financial accounting".
Do you agree? Explain in detail.
8. "The terms Financial Accounting and Management Accounting are not precise
descriptions of the activity they comprise. Despite their close interrelationship,
there are some fundamental differences". Discuss.
9. What has accounting to do with management? Why is it necessary to make
distinction between management accounting and financial accounting?
10. Differentiate between 'Management Accounting' from both 'Financial
Accounting' and 'Cost Accounting'.
11. What is management accounting? Explain its scope and functions.
12. "Management Accounting begins where Financial Accounting ends". With
reference to the above statement, explain the functions of management
accounting and financial accounting.
1. M.Y. Khan and P.K. Jain: 'Management Accountancy', Tata McGraw-Hill
Publishing, New Delhi.
2. S.N. Maheswari: 'Management Accounting and Financial Control', Sultan Chand
& Sons. New Delhi.
- End of Chapter -
LESSON - 3
FINANCIAL ACCOUNTING - BASIC POSTULATES, CONVENTIONS AND
CONCEPTS
Objectives
understand the nature of accounting principles
appreciate the importance of accounting principles
develop an understanding of the various accounting concepts and
conventions
realise the need for accounting standards developed by IASC and ICAI
Structure
3.1 Introduction
3.2 Nature and meaning of accounting principle
3.3 Accounting concepts
3.4 Accounting conventions
3.5 Accounting Standards and International Accounting Standards Committee
3.6 India and Accounting Standards
3.7 Summary
3.8 Key words
3.9 Exercises
3.1 INTRODUCTION
Since accounting is the language to communicate business information, it should be
made to convey the same meaning to all people as far as practicable. This requires that
the accounting language should be made standard. With a view to making it a standard
language, certain accounting principles, concepts, conventions and standards have been
developed over a period of time. If there is no such accounting principles or standards
then the accounting personnel of each business enterprise may develop their own
accounting procedures and methods. The danger of this is that the accounting
information becomes incomparable, inconsistent and unreliable, and as a result
accounting loses its characteristic feature of being the language of business. Hence the
need for accounting principles.
3.2 NATURE AND MEANING OF ACCOUNTING PRINCIPLE
What is an accounting principle or concept or convention or standard? Do they mean
the same thing? Or does each one has its own meaning? These are all questions for
which there are no definite answers because there is ample confusion and controversy as
to the meaning and nature of accounting principle. We do not want to enter into this
controversial discussion because the reader may fall prey to the controversies and
confusions and lose the spirit of the subject.
The rules and conventions of accounting are commonly referred to as principles. The
American institute of Certified public Accountants have defined the accounting
principle as "a general rule adopted or professed as a guide to action; a settled ground or
basis of conduct on practice". It may be noted that the definition describes the
accounting principle as a general law or rule that is to be used as a guide to action.
The peculiar nature of accounting principles is that they are man-made. Unlike the
principles of physics, chemistry etc., they were not deducted from basic axiom. Instead
they have evolved. Since the accounting principles are man-made they cannot be static
and are bound to change in response to the changing needs of the society. It may be
stated that accounting principles are changing but the change in themis
permanent.
Accounting principles are judged on their general acceptability to the makers and users
of financial statements and reports. They represent a generally accepted and uniform
view of the accounting profession in relation to good accounting practice and
procedures. Hence the name 'generally accepted' accounting principles.
Accounting principles, rules of conduct and action are described by various terms such
as concepts, conventions, doctrines, tenets, assumptions, axioms, postulates etc. But for
our purpose we shall use all these terms synonymously except for a little difference
between the two terms 'concepts' and 'conventions'. The term 'concept' is used to
connote accounting postulates i.e. necessary assumptions or conditions upon which
accounting is based. The term 'convention' is used to signify customs or traditions as
guide to the preparation of accounting statements. The Financial Accounting Standards
Board (FASB) is currently the dominant body in the development of accounting
principles.
3.3 ACCOUNTING CONCEPTS
The important accounting concepts are:
3.3.1 Business Entity concept: It is generally accepted that the moment a business
enterprise is started it attains a separate entity as distinct from the persons who own it.
This concept is extremely useful in keeping business affairs strictly free from the effect
of private affairs of the proprietors. In the absence of this concept, the private affairs
and business affairs would mingle together in such a way that the true profit or loss of
the business enterprise cannot be ascertained nor its financial position. To quote an
example, if the proprietor has taken Rs.5000 from the business for paying house tax for
his residence, the amount should be deducted from the capital contributed by him.
Instead, if it is added to the other business expenses, then the profit will be reduced by
Rs.5000, and also his capital will be more by the same amount. This affects the results
of the business and also its financial position. Not only this, since the profit is lowered,
the consequential tax payment also will be less which is against the provisions of the
Income Tax Act.
3.3.2 Going Concern concept: This concept assumes that unless there is valid
evidence to the contrary, a business enterprise will continue to operate for a fairly long
period in the future. The significance of this concept is that the accountant while valuing
the assets of the enterprise does not take into account their current re-sale values, as
there is no immediate expectation of selling it. Moreover, depreciation on fixed assets is
charged on the basis of their expected lives rather than on their market values.
When there is conclusive evidence that the business enterprise has a limited life the
accounting procedures should be appropriate to the expected terminal date of the
enterprise. In such cases, the financial statements should clearly disclose the limited life
of the enterprise and should be prepared from the 'quitting concern' point of view rather
than from a 'going concern' point of view.
3.3.3 Money Measurement concept: Accounting records only those transactions
which can be expressed in monetary terms. This feature is well emphasized in the two
definitions on accounting as given by the American Institute of Certified Public
Accountants and American Accounting Principles Board. The importance of this concept
is that money provides a common denomination by means of which heterogeneous facts
about a business enterprise can be expressed and measured in a much better way. For
example, when it is stated that a business owns Rs.1,00,000 cash, 500 tons of raw
materials, 10 machinery items, 3000 square meters of land and building etc., these
amounts cannot be added together to produce a meaningful total of what the business
owns. However, by expressing these items in monetary terms - Rs.1,00,000 cash; Rs
5,00,000 worth of raw materials; Rs.10,00,000 worth of machinery items; and
Rs.30,00,000 worth of land and building - such an addition is possible.
A serious limitation of this concept is that accounting does not take into account
pertinent non-monetary items which may significantly affect the enterprise. For
instance accounting does not give information about the poor health of its President,
serious misunderstanding between the production and sales managers and so on, which
have serious bearing on the prospects of the enterprise. Another limitation of this
concept is that money is expressed in terms of its value at the time a transaction is
recorded in the accounts. Subsequent changes in the purchasing power of money are not
taken into account.
3.3.4 Cost concept: This concept is yet another fundamental concept of accounting
which is closely related to the Going Concern concept. As per this concept:
i) an asset is ordinarily entered in the accounting records at the price paid to acquire it
i.e., at its cost and
ii) this cost is the basis for all subsequent accounting for the asset.
The implication of this concept is that the purchase of an asset is recorded in the books
at the price actually paid for it irrespective of its market value. For example, if a business
buys a building for Rs.3,00,000 the asset would be recorded in the books at
Rs.3,00,000 even if its market value at that time happens to be Rs.4,00,000. However
this concept does not mean that the asset will always be shown at cost. This cost
becomes the basis for all future accounting for the asset. It means that the asset may
systematically be reduced in its value by charging depreciation. The significant
advantage of this concept is that it brings in objectivity in the preparation and
presentation of financial statements. But like the Money Measurement concept, this
concept also does not take into account subsequent changes in the purchasing power of
money due to inflationary pressures. This is the reason for the growing importance of
inflation accounting.
3.3.5 Dual Aspect concept: This concept is the core of accounting. According to this
concept every business transaction has a dual aspect. This concept is explained in detail
below:
The properties owned by a business enterprise are referred to as assets and the rights or
claims to the various parties against the assets are referred to as equities. The
relationship between the two may be expressed in the form of an equation:
Equities = Assets
Equities may be subdivided into two principal types: the rights of creditors and the
rights of owners. The rights of creditors represent debts of the business and are called
liabilities. The rights of the owners are called capital. Expansion of the equation to
give recognition to the two types of equities results in the following equation, which is
known as the accounting equation:
Liabilities + Capital = Assets
It is customary to place liabilities before capital because creditors have priority in the
repayment of their claims as compared to that of owners. Sometimes greater emphasis
is given to the residual claim of the owners by transferring liabilities to the other side of
the equation as:
Capital = Assets Liabilities
All business transactions, however simple or complex they are result in a change in the
three basic elements of the equation. This is well explained with the help of the following
series of examples:
(i) Mr. Prasad commenced business with a capital of Rs.30,000. The result of this
transaction is that the business being a separate entity, gets cash - an asset of Rs.30,000
and has to pay to Mr. Prasad Rs.30,000 his capital. This transaction can be expressed in
the form of the equation as follows:
Capital = Assets
Prasad 30,000 = Cash 30,000
(ii) Purchased furniture for Rs.5000. The effect of this transaction is that cash is
reduced by Rs.5,000 and a new asset viz. furniture worth Rs.5.000 comes in, thereby
rendering no change in the total assets of the business. The equation after this
transaction will be:
Capital = Assets
Prasad = Cash + Furniture
30,000 = 25,000 + 5,000
(iii) Borrowed Rs.20,000 from Mr. Gopal. As a result of this transaction both sides of
the equation increase by Rs.20,000 - cash balance is increased and a liability to Mr.
Gopal is created. The equation will appear as follows:
Creditors + Prasad = Cash + Furniture
20,000 + 30,000 = 45,000 + 5,000
(iv) Purchased goods for cash Rs.30,000. This transaction does not affect the liabilities
side total nor the asset side total. Only the composition of the total assets changes i.e.
cash is reduced by Rs.30,000 and a new asset viz. stock worth Rs.30,000 comes in. The
equation after this transaction will be as follows:
Creditors + Prasad = Cash + Stock + Furniture
20,000 + 30,000 = 15,000 + 30,000 + 5,000
(v) Goods worth Rs.10,000 are sold on credit to Mr. Ganesh for Rs.12,000. The result is
that stock is reduced by Rs.10,000, a new asset namely debtor (Mr. Ganesh) for Rs.
12,000 comes into picture and the capital of Mr. Prasad increases by Rs. 2,000 as the
profit on the sale of goods belongs to the owner. Now the accounting equation will look
as under:
Creditors + Prasad = Cash + Debtors + Stock + Furniture
20,000 + 32,000 = 15,000 + 12,000 + 20,000 + 5,000
(vi) Paid electricity charges Rs.300. This transaction reduces both the cash balance and
Mr. Prasad's capital by Rs.300. This is so because the expenditure reduces the business
profit which in turn reduces the owner's equity. The equation after this will be:
Creditors + Prasad = Cash + Debtors + Stock + Furniture
20,000 + 31,700 = 14,700 + 12,000 + 20,000 + 5,000
Thus it may be seen that whatever is the nature of transaction, the accounting equation
always tallies and should tally. The system of recording transactions based on this
concept is called double entry system.
3.3.6 Accounting Period concept: In accordance with the going concern concept it
is usually assumed that the life of a business is indefinitely long. But owners and other
interested parties cannot wait until the business has been wound up for obtaining
information about its results and financial position. For example, if for ten years no
accounts have been prepared and if the business has been consistently incurring losses,
there may not be any capital at all at the end of the tenth year which will be known only
at that time. This would result in the compulsory winding up of the business. But if at
frequent intervals information is made available as to how things are going, then
corrective measures may be suggested and remedial action may be taken. That is why,
Pacioli wrote as early as in 1494 - "frequently accounting makes for long friendship".
This need leads to the accounting period concept.
According to this concept accounting measures activities for a specified interval of time
called the accounting period. For the purpose of reporting to various interested parties,
one year is the usual accounting period. Though Pacioli wrote that books should be
closed each year especially in a partnership, it applies to all types of business
organisations.
3.3.7 Periodic matching of costs and revenues: This concept is based on the
accounting period concept. It is widely accepted that desire of making profit is the most
important motivation to keep the proprietors engaged in business activities. Hence a
major share of attention of the accountant is being devoted towards evolving
appropriate techniques for measuring profits. One such technique is periodic matching
of costs and revenues.
In order to ascertain the profits made by the business during a period, the accountant
should match the revenues of the period with the costs (expenses) of that period. By
'matching' we mean appropriate association of related revenues and expenses pertaining
to a particular accounting period. To put it in other words, profits made by a business in
a particular accounting period can be ascertained only when the revenues earned during
that period are compared with the expenses incurred for earning that revenue. The
question as to when the payment was actually received or made is irrelevant. For
example, in a business enterprise which adopts calendar year as accounting year, if rent
for December 1989 was paid in January 1990, the rent so paid should be taken as the
expenditure of the year 1989, revenues of that year should be matched with the costs
incurred for earning that revenue including the rent for December 1989, though paid in
January 1990. It is on account of this concept that adjustments are made for
outstanding expenses, accrued incomes, prepaid expenses etc while preparing financial
statements at the end of the accounting period.
The system of accounting which follows this concept is called as mercantile system.
In contrast to this there is another system of accounting called as cash systemof
accounting where entries are made only when cash is received or paid, no entry being
made when a payment or receipt is merely due.
3.3.8 Realisation Concept: Realisation refers to inflows of cash or claims to cash like
bills receivables, debtors etc. arising from the sale of assets or rendering of services.
According to realisation concept, revenues are usually recognized in the period in which
goods were sold to customers or in which services were rendered. Sale is considered to
be made at the point when the property in goods passes to the buyer and he becomes
legally liable to pay. To illustrate this point, let us consider the case of A, a manufacturer
who produces goods on receipt of orders. When an order is received from B, A starts the
process of production and delivers the goods to B when the production is complete. B
makes payment on receipt of goods. In this example, the sale will be presumed to have
been made not at the time of receipt of the order but at the time when goods are
delivered to B. But there are certain exceptions to this aspect of the concept. Two among
them are:
(i) Sale on hire purchase basis wherein the ownership of the goods passes to the hire
purchaser only when the last hire is paid but still sales are presumed to have been made
to the extent of installments received and installments outstanding; and
(ii) Contract accounts - though the contractee is liable to pay only when the whole
contract is complete as per terms of the contract, yet the profit is calculated on the basis
of work certified year after year according to certain accepted accounting norms.
A second aspect of the realisation concept is that the amount recognized as revenues is
the amount that is reasonably certain to be realized. However, lot of reasoning has to be
applied to ascertain as to how certain 'reasonably certain' is. Yet, one thing is clear, that
is, the amount of revenue to be recorded may be less than the sale value of the goods
sold and services rendered. For example, when goods are sold at discount, revenue is
recorded not at the list price but at the amount at which sale is made. Similarly, it is on
account of this aspect of the concept that when sales are made on credit, though the
entry is made for the full amount of sales, the estimated amount of bad debts is treated
as an expense and the effect on net income is the same as if the revenue were reported as
the amount of sales minus the estimated amount of bad debts. For instance, if a
businessman makes credit sales of Rs.50,000 during a period and if the estimated
amount of bad debts is Rs.2,500, the revenue is reported as Rs.50,000 and there is a
bad debt expense of Rs.2,500. The effect on net income is the same as if the revenue
were reported as Rs.47,500.
3.4 ACCOUNTING CONVENTIONS
3.4.1 Convention of Conservatism: It is a world of uncertainty. So it is always
better to pursue the policy of playing safe. This is the principle behind the convention of
conservatism. According to this convention the accountant must be very careful while
recognising increases in an enterprise's profits rather than recognising decreases in
profits. For this, the accountants have to follow the rule - anticipate no profit but
provide for all possible losses - while recording business transactions. It is on account of
this convention that the inventory is valued 'at cost or market price whichever is less',
i.e., when the market price of the inventories has fallen below its cost price it is shown at
market price, i.e., the possible loss is provided; and when it is above the cost price it is
shown at the cost price i.e., the anticipated profit is not reduced. It is for the same
reason that provision for bad and doubtful debts, provision for fluctuation in
investments, etc. are created. This concept affects principally the current assets.
The main function of accounting is to provide correct and full information about the
business enterprise. But this is affected by the convention of conservatism as pointed
out by the critics of this convention. They argue that it encourages the accountant to
build secret reserves by resorting to excess provision for bad and doubtful debts etc. as a
result of which not only the income is affected but also the financial state of affairs of the
business. Further it is also against the convention of full disclosure about which we are
going to see right now.
3.4.2 Convention of Full Disclosure: The emergence of joint stock company form
of business organisation resulted in the divorce between ownership and management.
This necessitated the full disclosure of accounting information about the enterprise to
the owners and various other interested parties. Thus it became the 'convention of full
disclosure' is very important. By this convention it is implied that accounts must be
honestly prepared and all material information must be adequately disclosed therein.
But it does not mean that all information that someone desires are to be disclosed in the
financial statements. It only implies that there should be adequate disclosure of
information which is of considerable importance to owners, investors, creditors,
Governments, etc. In Sachar Committee Report (1978} it has been emphasised that
openness in Company affairs is the best way to secure responsible behaviour. It is in
accordance with this convention that Companies Act, Banking Companies Regulation
Act, Insurance Act etc., have prescribed performance of financial statements to enable
the concerned companies to disclose sufficient information. The practice of appending
notes relative to various facts on items which do not find place in financial statements is
also in pursuance to this convention. The following are some examples:
a. Contingent liabilities appearing as a note
b. Market value of investment appearing as a note
c. Schedule of advances in case of banking companies.
3.4.3 Convention of Consistency: According to this concept it is essential that
accounting procedures, practices and methods should remain unchanged from one
accounting period to another. This enables comparison of performance in one
accounting period with that in the past. For example, if material issues are priced on the
basis of FIFO method, the same basis should be followed year after year. Similarly, if
depreciation is charged on fixed assets according to diminishing balance method, it
should be done in subsequent year also. But consistency never implies inflexibility as
not to permit the introduction of improved techniques of accounting. However if
introduction of a new technique results in inflating or deflating the figures or profit as
compared to the previous periods, the fact should be well disclosed in the financial
statement.
3.4.4 Convention of Materiality: The implication of this convention is that
accountant should attach importance to material details and ignore insignificant ones.
In the absence of this distinction accounting will unnecessarily be overburdened with
minute details. The question as to what is a material detail and what is not is left to the
discretion of individual accountant. Further, an item which is material for one purpose
may become immaterial for another. According to American Accounting Association, an
item should be regarded as material if there is reason to believe that knowledge of it
would influence the decision of informed investor. Some examples of material financial
information are: fall in the value of stock, loss of markets due to competition, change in
the demand pattern due to change in Government regulations etc. Examples of
insignificant financial information are: ignoring of paise while preparing company
financial statement, rounding of income to nearest ten for tax-purposes etc. Sometimes
if it is felt that an immaterial item must be disclosed, the same may be shown as
footnotes or in parenthesis according to its relative importance.
3.5 ACCOUNTING STANDARDS AND INTERNATIONAL ACCOUNTING
STANDARDS COMMITTEE
The information revealed by the published financial statements is of considerable
importance to shareholders, creditors and other interested parties. Hence it is the
responsibility of the accounting profession to ensure that the required information is
properly presented. If the accountants present the financial information using their own
discretion and in their own way, the information may not be valid and hence may not
serve the purpose. There is, therefore, the urgent need that certain standards should be
followed for drawing up the financial statements so that there is the minimum possible
ambiguity and uncertainty about the notation contained in them. The International
Accounting Standards committee (IASC) has undertaken this task of drawing up the
standards.
The IASC was established in 1973. It has its headquarters at London at present, the IASC
has two classes of membership:
(a) Founder members, being the professional accounting bodies of the following nine
countries:
Australia
Canada
France
Germany
Japan
Mexico
Netherlands
U.K. and Ireland*
U.S.A.
*treated as one country for this purpose.
(b) Members, being accounting bodies from countries other than the nine above, which
seek and are granted membership.
The need for an IAS Programme has been attributed to three factors:
1. The growth in international investment: Investors in international capital
markets are to make decisions based on published accounting which are based on
accounting policies and which again vary from country to country. The International
Accounting Statements will help investors to make more efficient decisions.
2. The increasing prominence of multinational enterprises: Such enterprises
render accounts for the countries in which their shareholders reside in local country in
which they operate. Accounting standards will help to avoid confusion.
3. The growth in the number of accounting standard setting bodies: It is
hoped that the IASC can harmonise these separate rule making efforts. The objective of
the IASC is "to formulate and publish in the public interest standards to be observed in
the presentation of audited financial statements and to promote their world-wide
acceptance and observance". The formulation of such standards will bring uniformity in
terminology, procedure, method, approach and presentation of results. Since its
inception, the IASC has so far issued 26 International Accounting Statements.
3.6 INDIA AND ACCOUNTING STANDARDS
The Institute of Chartered Accountants of India (ICAI) and the Institute of Cost and
Works Accountants of India (ICWAI) are associate members of the IASC. But the
enforcement of the standards issued by the IASC has been deferred in our country.
Instead, the ICAI is drawing up its own standards. The Accounting Standards Board
(ASB) which was established by the council of the ICAI in 1977 is formulating
accounting standards so that such standards will be established by the council of the
ICAI. So far the following eleven standards have been issued:
AS-1 : Disclosure of Accounting Policies
AS-2 : Valuation of Inventories
AS-3 : Changes in Financial Position
AS-4 : Contingencies and Events Occurring After the Balance Sheet Data
AS-5 : Prior Period and Extraordinary Items and Changes in Accounting
Policies
AS-6 : Depreciation Accounting
AS-7 : Accounting for Construction Costs
AS-8 : Accounting for Research and Development
AS-9 : Revenue Recognition
AS-10 : Accounting for Fixed Costs
AS-11 : Accounting for Foreign Exchange Transactions
The ICAI has issued a mandate to its members to adopt uniform accounting system for
the corporate sector w.e.f. 1st April 1991 in view of the fact that the International
Accounting Standards are being followed all over the world and so, the auditor of
companies will now insist on compliance of these mandatory accounting standards.
3.7 SUMMARY
Accounting information should be made standard to convey the same meaning to all
interested parties. To make it standard certain accounting principles, concepts,
conventions and standards have been developed over a period of time. These accounting
principles, by whatever name they are called, serve as a general law or rule that is to be
used as a guide to action. Without accounting principles, accounting information
becomes incomparable, inconsistent and unreliable. The FASB is developing accounting
principles. The IASC is another professional body which is engaged in the development
of accounting standards. The ICAI is an associate member of the IASC and ASB started
by the ICAI is formulating accounting standards in our country.
3.8 KEY WORDS
Accounting Principles: It denotes necessary assumptions upon which accounting is
based.
Accounting Convention: It signifies customs or traditions as guide to the
preparation of accounting statements.
Business Entity concept: The business enterprise is distinct from the persons who
own it.
Going Concern concept: A business enterprise will ordinarily continue to operate for
a fairly long period in the future.
Money Measurement concept: Accounting records only those transactions what can
be expressed in monetary terms.
Cost concept: An asset is ordinarily entered in the accounting records at the price paid
to acquire it.
Dual Aspect concept: This is a core concept. According to this, every business
transaction has a dual aspect.
Accounting Period concept: Accounting activities in a specified interval of time are
recorded. This interval of time is called the Accounting Period.
Periodic Matching of Costs and Revenues: To ascertain the profits made by a
business during a period, revenues of the period should be matched with the costs of
that period.
Realization concept: Revenues are usually recognized in the period in which goods
were sold to customers, or services were rendered.
IASC: International Accounting Standards Committee
FASB: Financial Accounting Standards Board
ASB: Accounting Standards Board
3.9 EXERCISES
1. What are the accounting concepts and conventions? What are the differences
between the two?
2. What is the significance of the dual concept?
3. Explain Money Measurement concept.
4. Write a short note on Accounting Standards.
5. What is the position in India regarding the formulation and enforcement of
accounting standards?
3.10 FURTHER READING
1. Antony and Reece: 'Accounting Principles', Richard D. Irwin, INC Homewood, Ilinois
2. N Das Gupta: 'Accounting Standards: Indian and International', Sultan Chand &
Sons, New Delhi
3. M C Shukla XTS: 'General Advanced Accounts', S Chand & Co, Delhi.
- End of Chapter -
LESSON - 4
ACCOUNTING CYCLE - RECORDING, SUMMARISING, INTERPRETING
AND REPORTING
Objectives
understand the rules of debit and credit
apply the rules of debit and credit in journalising the transactions
prepare ledger accounts and balance them
prepare a trial balance
realise the importance of adjustment entries and closing entries
Structure
4.1 Introduction
4.2 The account
4.3 Debit and Credit
4.4 The ledger
4.5 Journal
4.6 The trial balance
4.7 Closing entries
4.8 Adjustment entries
4.9 Preparation of financial statements
4.10 Interpretation of financial statements
4.11 Summary
4.12 Key words
4.13 Exercises
4.1 INTRODUCTION
During the accounting period the accountant records transactions as and when they
occur. At the end of each accounting period the accountant summarises the information
recorded and prepares the Trial Balance to ensure that the double entry system has been
maintained. This is followed by certain adjusting entries which are to be made to
account the changes that have taken place since the transactions were recorded. When
the recording aspect has been made as complete and up-to-date as possible, the
accountant prepares financial statements reflecting the financial positions and the
results of business operations. Thus the accounting process consists of three major
parts:
i) the recording of business transactions during the period;
ii) the summarizing of information at the end of the period; and
iii) the reporting and interpreting of the summary information
The success of the accounting process can be judged from the responsiveness of
financial reports to the needs of the users of accounting information
4.2 THE ACCOUNT
The transactions that take place in a business enterprise during a specific period may
affect increases and decreases in assets, liabilities, capital, revenue and expense items.
To make up-to-date information available when needed and to be able to prepare timely
periodic financial statements, it is necessary to maintain a separate record for each item.
For example, it is necessary to have a separate record devoted exclusively to record
increases and decreases in cash, another one to record increases and decreases in
supplies, a third one to machinery, etc. The types of record that is traditionally used for
this purpose is called an account. Thus an account is a statement wherein information
relating to an item or a group of similar items is accumulated. The simplest form of an
account has three parts:
i) a title which gives the name of the item recorded in the account
ii) a space for recording increases in the amount of the item
iii) a space for recording decreases in the amount of the item
This form of an account known as a 'T' account, because of its similarity to the letter T is
illustrated below.
Title
Left side (Debit side) Right side (Credit side)
Kinds of accounts
Accounts are of various types as shown below:
4.3 DEBIT AND CREDIT
The left-hand side of any account is called the debit side and the right-hand side is
called the credit side. Amounts entered on the left hand side of an account, regardless of
the title of the account, are called debits and the amounts entered on the right hand
side of an account are called credits. To debit (Dr) an account means to make an entry
on the left-hand side of an account, and to credit (Cr) an account means to make an
entry on the right- hand side. The words debit and credit have no other meaning in
accounting, though in common parlance, debit has a negative connotation, while credit
has a positive connotation.
Double entry systemof recording business transactions is universally followed. In
this system, for each transaction the debit amount must equal the credit amount. If not,
the recording of transactions is incorrect. The equality of debits and credits is
maintained in accounting simply by specifying that the left side of asset accounts is to be
used for recording increases, and the right side to be used for recording decreases. The
right side of a liability and capital accounts is to be used to record increases, and the left
side to be used for recording decreases. The account balances when they are totalled,
will then conform to the two equations:
1. Assets = Liabilities + Owners equity
2. Debits = Credits
From the above arrangement we can state the rules of debits and credits are as follows:
Debit signifies Credit signifies
1. Increase in asset accounts 1. Decrease in asset accounts
2. Decrease in liability accounts 2. Increase in liability accounts
3. Decrease in owners equity accounts 3. Increase in owners equity accounts
From the rule that credit signifies increase in owners' equity and debit signifies
decreases in it, the rules of revenue accounts and expense accounts can be derived.
While explaining the dual aspect concept in an earlier lesson, we have seen that
revenues increase the owners equity as they belong to the owners. Since owners' equity
accounts increases on the credit side, revenue must be credits. So, if the revenue
accounts are to be decreased they must be debited. Similarly, we have seen that
expenses decrease the owners equity. As owners' equity accounts decrease on the debit
side, expenses must be debits. Hence to increase the expenses accounts they must
be debited and to decrease it they must be credited. From the above we can arrive at the
rules for revenues and expenses as follows:
Debit signifies Credit signifies
Increase in expenses Decrease in expenses
Decrease in revenues Increase in revenues
4.4 THE LEDGER
A ledger is a set of accounts. It contains all the accounts of a specific business
enterprise. It may be kept in any of the following two forms:
i. Bound Ledger, and
ii. Loose Leaf Ledger
A bound ledger is kept in the form of book which contains all the accounts. These days
it is common to keep the ledger in the form of loose leaf cards. This helps in posting
transactions particularly when mechanised system of accounting is used.
4.5 JOURNAL
When a business transaction takes place, the first record of it is done in a book called
journal. The journal records all the transactions of a business in the order in which
they occur. The journal may therefore be defined as a chronological record of
accounting transaction. It shows names of accounts that are to be debited or credited,
the amounts of the debits and credits, and any additional useful information about the
transaction. A journal does not replace, but precedes the ledger. A proforma of a journal
is given in illustration 4.5.1.
Illustration 4.5.1
Journal
Date Particulars L.F. Debit Credit
1994 Cash a/c (Dr.) 3 30,000
August 2 Sales a/c (Cr.) 9 30,000
In the illustration 4.5.1., the debit entry is listed first. The debit amount appears in the
left-hand amount column; the account to be credited appears below the debit entry and
is indented, and the credit amount appears in the right-hand amount column. The data
in the journal entry is transferred to the appropriate accounts in the ledger by a process
known as posting. Any entry in any account can be made only on the basis of a journal
entry. The column L.F., which stands for Ledger Folio gives the page number of
accounts in the ledger wherein posting for the journal entry has been made. After all the
journal entries are posted in the respective ledger accounts, each ledger account is
balanced by subtracting the smaller total from the bigger total. The resultant figure may
be either debit or credit balance depending upon which total, debit or credit is bigger. If
debit total is bigger the account will show a debit balance and vice-versa.
Thus the transactions are recorded first of all in the journal and then they are posted to
the ledger. Hence the journal is called the book of original or prime entry and the ledger
is the book of second entry. While the journal records transactions in a chronological
order, the ledger records transactions in an analytical order.
4.6 THE TRIAL BALANCE
The Trial Balance is simply a list of the account names and their balances as on a given
time, with debit balances in one column and credit balances in another column. It is
prepared to ensure that the mechanics of the recording and posting of the transactions
have been carried out accurately. If the recording and posting have been accurate, then
the debit total and credit total in the Trial Balance must tally thereby evidencing that an
equality of debits and credits has been maintained. It also serves as a basis for preparing
the financial statements. In this connection it is but proper to caution that mere
agreement of the debit and credit totals in the Trial Balance is not conclusive proof of
account recording and posting. There are many errors which may not affect the
agreement of Trial Balance like total omission of a transaction, posting the right amount
on the right side, but of a wrong account etc.
The points which we have discussed so far can very well be explained with the help of
the following simple illustration
Illustration 4.6.1
January 1 Started business with Rs.3000
January 2 Bought goods worth Rs.2000
January 9 Received order for half of the goods from 'G'
January 12 Delivered the goods, G invoiced Rs.1300
January 15 Received order for remaining half of the total goods purchased
January 21 Delivered goods and received cash Rs. 1200
January 30 G makes payment
January 31 Paid salaries Rs.210
Received interest Rs.50
Let us now analyse the transactions one by one.
January 1 - Started business with Rs.3000
The two accounts involved are cash and owners equity. Cash, an asset, increases and
hence it has to be debited. Owners' equity, a liability also increases and hence it has to
be credited.
January 2 - Bought goods worth Rs.2000
The two accounts affected by this transaction are cash and goods (purchases). Cash
balance decreases and hence it is credited, and goods on hand, an asset, increases hence
it is to be debited.
January 9 - Received order for half of the goods from 'G'
No entry is required as realisation of revenue will take place only when goods are
delivered (realisation concept).
January 12 - Delivered the goods, 'G' invoiced Rs.1300
This transaction affects two accounts - Goods (Sales) a/c and Receivables a/c. Since it is
a credit transaction receivables increase (asset) aid hence is to be debited. Sales
decreases goods on hand and hence Goods (Sales) a/c is to be credited. Since the term
'goods' is used to mean purchase of goods and sale of goods, to avoid confusion
purchase of goods is simply shown as Purchases a/c and sale of goods as Sales a/c.
January 15 - Received order for remaining half of goods.
No entry.
January 21 - Delivered goods and received cash Rs.1200
This transaction affects cash a/c and Sale a/c. Since cash is realised, the cash balance
will increase and hence cash accounts is to be debited. Since the stock of goods becomes
nil due to sale, Sales a/c is to be credited (as asset in the form of goods on hand has
reduced due to sales).
January 30 - 'G' makes Payment
Both the accounts affected by this transaction are asset accounts - cash and receivables.
Cash balance increases and hence it is to be debited and receivables balance decreases
and hence it is to be credited
January 31 - Paid Salaries Rs.210
Because of payment of salaries, cash balance decreases and hence cash account is to be
credited. Salary is an expense and since expense has the effect of reducing owners'
equity, and as owners' equity account decreases on the debit side, expenses account is to
be debited.
January 31 - Received Interest Rs.50
The receipt of interest increases cash balance and hence cash a/c is to be debited.
Interest being revenue which has the effect of increasing the owners' equity, it has to be
credited as owners equity account increases on the credit side.
When journal entries for the above transactions are passed, they would be as follows:
Date Particulars L.F Debit Credit
January - 1 Cash a/c (Dr) 3000
Capital a/c
(Cr) 3000
January - 2 Purchase a/c (Dr) 2000
Cash a/c (Cr) 2000
January- 12 Receivables a/c (Dr) 1300
Sales a/c (Cr) 1300
Sales a/c (Cr) 1200
Receivables a/c (Cr) 1300
January - 31 Salaries a/c (Dr) 210
Cash a/c (Cr) 210
Interest a/c (Cr) 50
Now the above journal entries are posted into respective ledger accounts which in turn
are balanced.
Cash a/c
------------------------------------------------------------------------------------
Debit Credit
------------------------------------------------------------------------------------
Capital a/c 3,000 Purchases a/c 2,000
Sales a/c 1,200 Salaries a/c 210
Receivables a/c 1,300 Balance 3,340
Interest a/c 50
----------- ---------
5,550 5,550
----------- ---------
------------------------------------------------------------------------------------
Capital a/c
------------------------------------------------------------------------------------
Dr Cr
------------------------------------------------------------------------------------
Balance 3,000 Cash 3,000
----------- ---------
-------------------------------------------------------------------------------------
Purchases a/c
------------------------------------------------------------------------------------
Dr Cr
------------------------------------------------------------------------------------
Cash a/c 2,000 Balance 2,000
----------- ---------
-------------------------------------------------------------------------------------
Receivables a/c
------------------------------------------------------------------------------------
Dr Cr
------------------------------------------------------------------------------------
Sales a/c 1,300 Cash 1,300
----------- ---------
-------------------------------------------------------------------------------------
Sales a/c
------------------------------------------------------------------------------------
Dr Cr
------------------------------------------------------------------------------------
Balance 2,500 Receivables a/c 1,300
Cash a/c 1,200
----------- ---------
2,500 2,500
----------- ---------
-------------------------------------------------------------------------------------
Salaries a/c
------------------------------------------------------------------------------------
Dr Cr
------------------------------------------------------------------------------------
Cash a/c 210 Balance 210
----------- ---------
-------------------------------------------------------------------------------------
Interest a/c
------------------------------------------------------------------------------------
Dr Cr
------------------------------------------------------------------------------------
Balance 50 Cash a/c 50
----------- ---------
-------------------------------------------------------------------------------------
Now a Trial Balance can be prepared and when prepared it would appear as this:
Trial Balance
Debit Credit
Cash 3,340 Capital 3,000
Purchases 2,000 Sales 2,500
Salaries 210
Interest
50
5,550 5,550
4.7 CLOSING ENTRIES
Periodically, usually at the end of the accounting period, all revenue account balances
are transferred to an account called Income Summary or Profit and Loss account
and are then said to be closed. (A detailed discussion on Profit and Loss account is done
in a subsequent chapter). The balance in the Profit and Loss account, which is the net
income or net loss for the period, is then transferred to the Capital account and thus
Profit and Loss account is also closed. In the case of corporation, the net income or net
loss is transferred to Retained Earnings account which is a part of owner's equity.
The entries which are passed for transferring these accounts are called as 'closing
entries'. Because of this periodic closing of revenue and expense accounts, they are
called as temporary or nominal accounts whereas assets, liabilities and owners equity
accounts, the balances of which are shown on the balance sheet and are carried forward
from year to year are called as permanent or real accounts.
The principle of framing a closing entry is very simple. If an account is having a debit
balance, then it is credited and the Profit and Loss account is debited. Similarly if a
particular account is having a credit balance, it is closed by debiting it and crediting the
Profit and Loss account.
In our example Sales account and Interest account are revenues, and Purchases account
and Salaries account are expenses. Purchases account is an expense because the entire
goods have been sold out in the accounting period itself and hence they become cost of
goods sold out. This aspect would become more clear when the reader proceeds to the
chapter on Profit and Loss account. The closing entries would appear as follows:
(1) Profit and Loss a/c (Dr) 2,210
Salaries a/c (Cr) 210
Purchases a/c (Cr) 2,000
(2) Sales a/c (Dr) 2,500
Profit and Loss a/c (Cr) 2,500
(3) Interest a/c (Dr) 50
Profit and Loss a/c (Cr) 50
Now Profit and Loss a/c, Retained Earnings a/c and Balance Sheet can be prepared
which would appear as follows:
Dr Profit and Loss Account Cr
Purchases a/c
Salaries a/c
Retained Earnings a/c
2,000
210
340
Sales a/c
Interest a/c
2,500
50
2,550 2,550
Dr Retained Earnings a/c Cr
Balance 340 Profit and Loss a/c 340
340 340
Dr Balance Sheet Cr
Cash 3,340 Capital
Retained Earnings
3,000
340
3,340 3,340
4.8 ADJUSTMENT ENTRIES
Because of the adoption of accrual accounting, after the preparation of Trial Balance,
adjustments relating to the accounting period have to be made in order to make the
financial statements complete. These adjustments are needed for transactions which
have not been recorded but which affect the financial position and operating results of
the business. They may be divided into four kinds: two in relation to revenues and the
other two in relation to expenses.
The two in relation to revenues are:
(i) Unrecorded revenues: i.e. income earned for the period but not received in cash.
For example, interest for the last quarter of the accounting period is yet to be received
though fallen due. The adjustments entry to be passed is:
Accrued interest a/c (Dr)
Interest a/c (Cr)
(ii) Revenues received in advance: i.e. income relating to the next period received
in the current accounting period, e.g. rent received in advance. The adjustment entry is:
Rent a/c (Dr)
Rent received in advance a/c (Cr)
The two relating to expenses are:
(i) Unrecorded expenses: i.e. expenses were incurred during the period but no
record of them as yet has been made. e.g. Rs.500 wages earned by an employee during
the period remain to be paid. The adjustment entry would be:
Wages a/c (Dr)
Accrued wages a/c (Cr)
(ii) Prepaid expenses: i.e., expenses relating to the subsequent period paid in
advance in the current accounting period. An example which is frequently cited is
insurance paid in advance. The adjustment entry would be:
Prepaid Insurance a/c (Dr)
Insurance a/c (Cr)
In the above four cases, unrecorded revenues and prepaid expenses are 'assets' and
hence debited (as debit may signify increase in assets), and revenues received in
advance and unrecorded expenses are 'liabilities' and hence credited (as credit may
signify increase in liabilities).
Besides the above four adjustments, some more are to be done before preparing the
financial statements. They are:
1. Inventory at the end.
2. Provision for Depreciation.
3. Provision for Bad Debts.
4. Provision for Discount on receivables and payables.
5. Interest on Capital and Drawings.
4.9 PREPARATION OF FINANCIAL STATEMENTS
Now everything is set ready for the preparation of financial statements for the
accounting period and as on the last day of the accounting period. GAAP require that
three such reports be prepared:
(i) A Balance Sheet
(ii) A Profit and Loss Account (or) Income Statement
(iii) A Fund Flow Statement
4.10 INTERPRETATION OF FINANCIAL STATEMENTS
Financial statements as such do not convey the requisite information. They must be
suitably analysed and interpreted so as to elicit quality information for managerial
decision-making. A detailed discussion on these three financial statements including
their interpretation follows in the succeeding chapters.
4.11 SUMMARY
The following steps are involved in the accounting cycle:
1. The first and most important part of the accounting process is the analysis of the
transactions to decide which account is to be debited and which account is to be
credited.
2. Next comes journalising the transactions i.e. recording the transactions in the
journal.
3. The journal entries are posted into respective accounts in the ledger and the
ledger accounts are balanced.
4. At the end of the accounting period, a Trial Balance is prepared to ensure equality
of debits and credits.
5. Adjustment and closing entries are made to enable the preparation of financial
statements.
6. As a last step financial statements are prepared.
These six steps taken sequentially complete the accounting process during an
accounting period and are repeated in each subsequent period.
4.12 KEY WORDS
Account: It is a statement wherein information relating to an item or a group of similar
items is accumulated.
Debit: Debit signifies increase in asset accounts, decrease in liability accounts and
decrease in owners' equity accounts.
Credit: Credit signifies decrease in asset accounts, increase in liability accounts and
increase in owners' equity accounts.
Double Entry System: In this system which is universally followed for each
transaction the debit amount must equal the credit amount.
Ledger: A ledger is a set of accounts of a specific business enterprise.
Journal: Journal is a book in which the first record of business transactions is done in
a chronological order.
Trial Balance: The Trial Balance is simply a list of the balances of accounts as of a
given moment of time with debit balances in one column and credit balances in another
column.
Closing Entries: These are the entries which are passed for transferring the revenue
accounts to Profit and Loss account.
Adjustment Entries: These are the entries which are passed for transactions which
have been recorded but which affect the financial position and operating results of the
business.
4.13 EXERCISES
1. Explain the following:
a. A journal
b. An Account
c. A Ledger
2. Bring out relationship between a journal and a ledger.
3. Explain the significance of Trial Balance.
4. Why adjustments entries are necessary?
5. Narrate the rules of debit and credit.
6. Distinguish nominal accounts from real accounts.
7. Explain the mechanism of balancing an account.
8. How and why closing entries are made?
9. The following transactions relate to a business concern for the month of March 1994.
Journalize them, post into ledger accounts, balance and prepare the Trial Balance.
March 1 - Started business with a capital of Rs.9000
March 2 - Purchased furniture Rs.300
March 3 - Purchased goods Rs.6000
March 11 - Received order for half of goods from 'C'
March 15 - Delivered goods, C' invoiced Rs.4000
March 17 - Received order for the remaining half of goods
March 21 - Delivered goods, cash received Rs.3800
March 31 - Paid wages Rs.300
10. Enter the following transactions in Journal post them into ledger accounts, balance
the ledger accounts and prepare the Trial Balance:
1994 July 1 - Saravanan commenced his business with following assets:
June 1 Plant and Machinery 2,50,000
2 65,000 90,000
3 Stock 65,000
4 Cash 5,000
July 2 Sold goods to K C Rao 40,000
3 Bought goods from N Rao 65,000
4 K C Rao paid cash 25,000
5 Returned damaged goods to N Rao 1,800
10 Paid N Rao on account 28,200
15 Bought goods from Annamalai 54 ,000
17 Sold goods to D Rajagopal 75,000
20 D Rajagopal returned damaged goods 2,000
20 Received cash from D Rajagopal in full settlement 72,500
26 Bought Typewriter 6,000
27 Paid Annamalai 36,000
31 Received commission 1,000
31 Paid Salaries 7,500
31 Paid rent 2,500
31 Deposited into UC Bank 5,000
1. R.L. Gupta and M Radhaswamy: 'Advanced Accounts', Vol.I, Sultan Chand &
Sons, New Delhi.
2. M.C. Shukla & T.S. Grewal: 'Advanced Accounts', S.Chand & Company, New Delhi.
- End of Chapter -
LESSON - 5
FINANCIAL STATEMENTS - I: BALANCE SHEET
Objectives
After reading this lesson, you would be able to:
understand the conceptual basis of a balance sheet
comprehend the form and method of presentation of a balance sheet
classify the different assets and liabilities
prepare a balance sheet from the given balances of accounts of a business
enterprise
Structure
5.1 Introduction
5.2 Conceptual basis of a balance sheet
5.3 Form and presentation of balance sheet
5.4 Accounting concepts underlying the balance sheet
5.5 Classification of items in the balance sheet
5.6 Summary
5.7 Key words
5.8 Exercises
5.10 Case study
5.1 INTRODUCTION
The basic objective of accounting is to convey information. This is achieved by different
financial statements prepared by a business enterprise. One of the most important
financial statements is the Balance Sheet. A balance sheet shows the financial position of
a business enterprise as of a specified moment of time. That is why it is very often called
a statement of financial position. It contains a list of the assets & liabilities, and capital
of a business entity as of a specified date, usually at the close of the last day of a month
or a year.
5.2 CONCEPTUAL BASIS OF A BALANCE SHEET
The balance sheet is basically a historical report showing the cumulative effect of past
transactions. It is often described as a detailed expression of the following fundamental
accounting equation which has already been explained in detail in an earlier chapter:
Assets = Liabilities + Owners Equity (Capital)
Assets are costs which represent expected future economic benefits to the business
enterprise. However, the rights to assets have been acquired by the enterprise as a result
of past transactions. Liabilities also result from past transactions; they represent
obligations which require settlement in the future either by conveying assets or by
performing services. Implicit in these concepts of the nature of assets and liabilities is
the meaning of owner's equity as the residual interest in the assets of the enterprise.
5.3 FORM AND PRESENTATION OF A BALANCE SHEET
Two objectives are dominant in presenting information in a balance sheet. One is clarity
and readability, the other is disclosure of significant facts within the framework of the
basic assumptions of accounting. Balance sheet classification, terminology and the
general form of presentation should be studied with these objectives in mind.
It is proposed to explain the various aspects of the balance sheet with the help of the
following typical summarised balance sheet of an imaginary partnership firm:
Illustration 5.3.1
SAU & Sons
Balance Sheet as at 31st December 1993
(Rupees in '000s)
Assets Liabilities & Capital
Current Assets: Current Liabilities:
Cash 100 Bills payable 700
Bank 200 Creditors 700
Marketable Securities 300 Outstanding expenses 700
Bills Receivables 300 Income received in advance 100
Debtors 1000 Provision for Income Tax 1000
Total current liabilities 3200
Less Provision for
Doubtful Debts
100 900
Long-term Liabilities:
Inventory 1200 Mortgage loan 2000
Prepaid Expenses 300
Total current assets 3300 Owners equity:
Investments: S's capital 1000
Long term securities at
cost
300 A's capital 1500
Fixed Assets: U's capital 2000
Furniture and Fixtures 100 General Reserve 1000
Less Accumulated
depreciation
10 90
Plant and Machinery 2000
Less Accumulated
depreciation
200 1800
Land 2000
Buildings 2000
Intangible Assets:
Patents 210
Trade Marks 100
Goodwill 900
Total assets 10,700
Total liabilities & owners
equity 10,700
5.3.2 Conventions of Preparing the Balance Sheet:
There are two conventions of preparing the balance sheet the American and the
English. According to the American convention, assets are shown on the left hand side
and the liabilities and the owners' equity on the right hand side. Under the English
convention just the opposite is followed i.e. assets are shown on the right hand side and
the liabilities and owners' equity are shown on the left hand side. In the illustration 5.3.1
the American convention has been followed.
5.3.3 Forms of Presenting the Balance Sheet:
There are two forms of presenting the balance sheet - account form and report form.
When the assets are listed on the left hand side of liabilities and owners equity on the
right hand side, we get the 'account' form of balance sheet. It is so called because it is
similar to an account. An alternative practice is the 'report' form of balance sheet where
the assets are listed at the top of the page and the liabilities and owners equity are listed
beneath them. In illustration 5.3.1 we have followed the account form of balance sheet.
When the above balance sheet is prepared in report form it will appear as follows:
Assets
CURRENT ASSETS: (in Rs.)
Cash 100
Bank 200
Marketable Securities 300
Bills Receivables 300
Debtors 1000
LESS PROVISIONS:
For Doubtful Debts 100 900
Inventory 1200
Prepaid Expenses 300
Total current assets 3300
INVESTMENTS:
Long term securities at cost 300
FIXED ASSETS:
Furniture and Fixtures 100
Less accumulated depreciation 10 90
Plant and Machinery 2000
Less accumulated depreciation 200 1800
Land 2000
Buildings 2000
INTANGIBLE ASSETS:
Patents 210
Trade Marks 100
Goodwill 900
Total assets 10,700
Liabilities & Capital
CURRENT LIABILITIES:
Bills Payable 700
Creditors 700
Outstanding expenses 700
Income received in advance 100
Provision for Income tax 1000
Total current liabilities 3200
LONG TERM LIABLITIES:
Mortgage loan 2000
OWNERS EQUITY:
S's capital 1000
A's capital 1500
U's capital 2000
General Reserve 1000
Total liabilities owners' equity 10700
5.3.4 Listing of Items on the Balance Sheet:
Assets in balance sheet are generally listed in two ways -
i) in the order of liquidity or according to time i.e. in the order of the degree of ease
with which they can be converted into cash, or
ii) in the order of permanence or according to purpose i.e., in the order of the
desire to keep them in use.
Some assets cannot be easily classified. For example, investments can be easily sold but
the desire may be to keep them. Investments may therefore be both liquid and semi-
permanent. That is why they are shown as a separate item in the balance sheet.
Liabilities can also be grouped in two ways either in the order of urgency of payment or
in the reverse order.
The various assets and liabilities grouped in the two orders will appear as follows:
i) Order of liquidity
Assets Liabilities
Cash Bills payable
Bank Creditors
Marketing securities Outstanding expenses
Bills receivable Income received in
advance
Debtors Provsion for Income-Tax
Inventory Mortgage loan
Prepaid Expenses Debentures
Investments Owner's equity
Owner's equity
Furniture and Fixtures
Plant and Machinery
Land and Buildings
Patents
Trade marks
Goodwill
ii) Order of Permanence
Assets Liabilities
Goodwill Owners equity
Trade Marks Debentures
Patents Mortgage loan
Land and Buildings Provision for Income-tax
Plant and Machinery Income received in advance
Furniture and Fixtures Outstanding expenses
Investments Creditors
Prepaid expenses Bills payable
Inventory
Debtors
Bills receivable
Marketable Securities
Bank
Cash
Whatever is the order, it is always better to follow the same order for both assets and
liabilities. In the illustration the order of liquidity has been followed.
5.4 ACCOUNTING CONCEPTS UNDERLYING THE BALANCE SHEET
In the balance sheet of SAU & Sons under illustration, the amounts are expressed in
money and reflect only those matters that can be measured in monetary terms. The
entity involved is SAU & Sons, and the balance sheet pertains to that entity rather than
to any of the individuals associated with it. The statement assumes that SAU and Sons is
a growing concern. The asset amounts stated are governed by cost concept. The
dual aspect concept is evident from the fact that the assets listed on the left hand side
of this balance sheet are equal in total to the liabilities and owners equity listed on the
right hand side. Thus in the balance sheet the following flve accounting concepts are
involved: a) business entity concept, b) money measurement concept, c) going concern
concept, d) cost concept and e) dual-aspect concept.
5.5 CLASSIFICATION OF ITEMS IN THE BALANCE SHEET
Although each individual asset or liability can be listed separately on the balance sheet,
it is more practicable and more informative to summarise and group related items into
categories called as account classifications. The classifications or group headings will
vary considerably depending on the size of the business, the form of ownership, the
nature of its operations, and the users of the financial statements. For example, while
listing assets, the order of liquidity is generally used by sole traders, partnership firms
and banks, whereas joint stock companies by law follow the order of permanence. As a
generalisation, which is subject to many exceptions, the following classification of
balance sheet items is suggested as representative:
Assets
Current Assets
Investments
Fixed Assets
Intangible Assets
Other Assets
Liabilities
Current Liabilities
Long term Liabilities
Owners equity
Capital
Retained Earnings
5.5.1 Classification of Assets
1. Current Assets: Current assets are those which are reasonably expected to be
realised in cash or sold or consumed during the normal operating cycle of the business
enterprise or within one year, whichever is longer. By operating cycle we mean the
average period of time between the purchase of goods or raw materials and the
realisation of cash from the sale of goods or the sale of products produced from the raw
materials. Current assets generally consist of:
a) Cash: Cash consists of funds that are readily available for disbursement. It
includes cash kept in the cash chest/box/safe of the enterprise, as also cash
deposited on call or current accounts with banks.
b) Marketable Securities: These consist of investments that are both readily
marketable and are expected to be converted into cash within a year. These
investments are made with a view to earn some return on cash that otherwise
would be temporarily idle.
c) Accounts Receivables: Accounts receivables consist of amounts owed to the
enterprise by its consumers. This represents amounts usually arising out of normal
commercial transactions. These amounts are listed on the balance sheet at the
amount due less a provision for the portion that may not be collected. This
provision is called as provision for doubtful debts.
Amounts due to the enterprise by someone other than a customer would appear
under the heading 'other receivables' rather than accounts receivables. If the
amounts due are evidenced by written promises to pay, they are listed as 'bills
receivables'. Accounts receivables are expected to be realised in cash.
d) Inventory: Inventory consists of i) goods that are held in stock for sale in the
ordinary course of business, ii) work-in-progress that are consumed in the
production of goods or services to be available for sale. Inventory is expected to be
sold to customers either for cash or on credit to be converted into cash. It may be
noted in this connection that inventory relates to goods that will be sold in the
ordinary course of business. A van offered for sale by a van dealer is inventory. A
van used by the dealer to make service calls is not inventory; it is an item or
equipment which is a fixed asset.
e) Prepaid Expenses: These items represent expenses which are usually paid in
advance such as rent, taxes, subscriptions, and insurance. For example, if rent for
three months for the building is paid in advance then the business acquires a right
to occupy the building for three months. This right to occupy is an 'asset'. Since
this right will expire within a fairly short period of time it is a 'current asset'.
2. Long Term Investments: The distinction between a marketable security shown
under current asset and as an investment is entirely based on time factor. Investments
in shares, debentures, bonds etc. that will be retained for more than a year or one
operating cycle will appear under this classification.
3. Fixed Assets: Tangible assets used in the business that are of a permanent or
relatively fixed nature are called plant assets or fixed assets. Fixed assets include
furniture, equipment, machinery, building and land. Although there is no standard
criterion as to the minimum length of life necessary for classification as fixed assets,
they must be capable of repeated use and are ordinarily expected to last more than a
year. However the asset need not actually be used continuously or even frequently.
Items of spare equipment held for use in the event of breakdown of regular equipment
or for use only during peak periods of activity are included in fixed assets.
With the passage of time, all fixed assets with the exception of land lose their capacity to
render services. Accordingly the cost of such assets should be transferred to the related
expense amounts in a systematic manner during their expected useful life. This periodic
cost expiration is called 'depreciation'. While showing the fixed assets in the balance
sheet, the accumulated depreciation as on the date of balance sheet is deducted from the
respective assets.
4. Intangible Assets: While tangible assets are concrete items which have physical
existence such as buildings, machinery etc. , intangible assets are those which have no
physical existence. They cannot be touched and felt. They derive their value from the
right conferred upon their owner by possession. Examples are: goodwill, patents,
copyrights and trademarks.
5. Fictitious Assets: These items are not at all assets. Still they appear in the asset
side simply because of a debit balance in a particular account not yet written off. For
example, debit balance in current account of partners, Profit and Loss account etc.
5.5.2 Classifications of Liabilities
1. Current liabilities: When the liabilities of a business enterprise are due within an
accounting period or the operating cycle of the business, they are classified as current
liabilities. Most of current liabilities are incurred in the acquisition of materials or
services forming part of the current assets. These liabilities are expected to be satisfied
either by the use of current assets or by the creation of other current liabilities. The one
year time interval or current operating cycle criterion applies to classifying current
liabilities also. Current liabilities generally consist of bills payable, creditors,
outstanding expenses, income-received in advance, provision for income-tax etc.
a) Accounts Payables: These amounts represent the claims of suppliers related
to goods supplied or services rendered by them to the business enterprise for
which they have not yet been paid. Usually these claims are unsecured and are not
evidenced by any formal written acceptance or promise to pay. When the
enterprise gives a written promise to pay money to a creditor for the purchase of
goods or services used in the business or the money borrowed, then the written
promise is called as 'bills payable' or accounts payable. Amounts due to financial
institutions which are suppliers of funds, rather than of goods or services are
termed as 'short-term loans' or some other name that describes the nature of the
debt instrument, rather than accounts payable.
b) Outstanding Expenses: These are expenses or obligations incurred in the
previous accounting period but the payment for which will be made in the next
accounting period. A typical example is wages or rent for the last month of the
accounting period remaining unpaid. It is usually paid in the first month of the
next accounting period and hence it is an outstanding expense.
c) Income Received in Advance: These amounts relate to the next accounting
period but received in the previous accounting period. This item of liability is
frequently found in the balance sheet of enterprises dealing in the publication of
newspapers and magazines.
d) Provision for Taxes: This is the amount owed by the business enterprise to
the Government for taxes. It is shown separate from other current liabilities both
because of the size and because the amount owed may not be known exactly as on
the date of balance sheet. The only thing known is the existence of liability and not
the amount.
2. Long term Liabilities: All liabilities which do not become due for payment in one
year and which do not require current assets for their payment are classified as long-
term liabilities or 'fixed liabilities'. Long term liabilities may be classified as secured
loans or unsecured loans. When the long-term loans are obtained against the security of
fixed assets owned by the enterprise they are called as secured or mortgage loans.
When any asset is not attached to these loans they are called as unsecured loans.
Usually long-term liabilities include debentures and bonds, borrowings from
financial institutions and banks, public debts, etc. Interest accrued on a particular
secured long term loan, should be shown under the appropriate sub-heading.
3. Contingent Liabilities: Contingent liabilities are those liabilities which may or
may not result in liability. They become liabilities only on the happening of a certain
event. Until then both the amount and the liability are uncertain. If the event happens
there is a liability; otherwise there is no liability at all. A very good example for
contingent liability is a legal suit pending against the business enterprise for
compensation. If the case is decided against the enterprise the liability arises and in the
case of favourable decision there is no liability at all. Contingent liabilities are not taken
into account for the purpose of totaling of balance sheet.
5.5.3 Capital or Owners' Equity:
As mentioned earlier in this chapter owners' equity is the residual interest in the assets
of the enterprise. Therefore the owners equity section of the balance sheet shows the
amount the owners have invested in the entity. However, the terminology "owners'
equity" varies with different forms of organisations depending upon whether the
enterprise is a joint stock company or sole proprietorship / partnership concern.
1. Sole Proprietorship / Partnership Concern: The ownership equity in a sole
proprietorship or partnership is usually reported on the balance sheet as a single
amount for each owner rather than distinction between the owner's initial investment
and the accumulated earnings retained in the business. For example, in a sole-
proprietors balance sheet for the year 1993, the capital account of the owner may
appear as follows.
Rs.
Owners capital as on 1/1/1993 50,000
Add 1993-Profit 30,000
80,000
Less 1993-Drawing 5,000
Owners capital as on 31/12/1993 75,000
2. Joint Stock Companies: In the case of joint stock companies, according to the
legal requirements, owners' equity is divided into two main categories.
a) The first category called share capital or contributed capital is the amount the
owners have invested directly in the business. Share capital is the capital stock pre-
determined by the company at the time of registration. It may consist of ordinary share
capital or preference share capital or both. The capital stock is divided into units called
as shares and that is why the capital is called as share capital. The entire predetermined
share capital called as authorised capital need not be raised at a time. That portion of
authorised capital which has been issued for subscription as of a date is referred to as
'issued capital'.
b) The second category of owners' equity is called retained earnings. 'Retained
earnings' is the difference between the total earning to date and the amount of dividends
paid out to the shareholders to date. That is, the difference represents that part of the
total earnings that have been retained for use in the business. It may be noted that the
amount of retained earnings on a given date is the accumulated amount that has been
retained in the business from the beginning of the company's existence up to that date.
The owners' equity increases through retained earnings and decreases when retained
earnings are paid out in the form of dividends.
5.6 SUMMARY
Balance Sheet is one of the most important financial statements which shows the
financial position of a business enterprise as of a particular date. It lists as on a
particular date, usually at the close of the accounting period, the assets and liabilities
and capital of the enterprise. An analysis of balance sheet together with profit and loss
account will give vital information about the financial position and operations of the
enterprise. The analysis becomes all the more useful and effective when a series of
balance sheets and profit and loss accounts are studied.
5.7 KEYWORDS
Asset: Costs which represent expected future economic benefits to the business
enterprise.
Liabilities: Represent obligations which require settlement in the future.
Current Assets: Assets which are reasonably expected to be realised in cash or sold or
consumed during the normal operating cycle of the business enterprise or within one
year, whichever is longer.
Operating cycle: The average period of time between the purchase of goods or raw
materials and the realisation of cash from the sale of final products.
Fixed Assets: Tangible assets used in the business that are of a permanent or relatively
fixed nature.
Intangible Assets: Those assets which have no physical existence.
Fictitious Assets: Not assets, but appear in the asset side simply because of a debit
balance in a particular account not yet written off.
Current Liabilities: Liabilities due within an accounting period or the operating cycle
of the business.
Long Term Liabilities: Liabilities that become due for payment after one year.
Contingent Liabilities: Items which become a liability only on the happening of a
certain event.
Capital or Owners' Equity: This is the residual interest in the assets of the
enterprise.
5.8 EXERCISES
1. Explain the following
o Assets
o Liabilities
o Fictitious Assets
o Income received in advance
o Marketable Securities
2. What are the accounting concepts involved in a balance sheet?
3. Explain the conceptual basis of a balance sheet.
4. What are the two forms of presenting a balance sheet?
5. Why do the joint stock companies follow the order or permanence while listing
the assets and liabilities on the balance sheet?
6. What is meant by operating cycle?
7. What is a contingent liability? Why is it not to be included in the total of the
balance sheet?
8. Why are investments neither shown under current assets nor under fixed assets?
9. Explain owners' equity. How is it to be presented on the Balance Sheet of a
concern?
10. Distinguish with suitable examples the following:
a. Fixed Assets and Current Assets
b. Contingent Liabilities and Current Assets.
11. From the following balances relating to Rolta India Limited prepare the Balance
Sheet as at 30th June 1993.
1. Equity capital 36,42,58,510
2. Reserves & surplus 23,58,26,861
3. Debentures 1,03,36,000
4. Secured Loans 21,27,57,441
5. Fixed assets 37,07,93,048
6. Investments 5,94,80,459
7. Inventories 20,78,28,095
8. Sundry Debtors 10,21,66,468
9. Cash & Bank balances 1,49,87,264
10. Other current assets 57,75,568
11. Loans and advances 12,49,59,370
12. Current Liabilities 4,71,71,358
13. Provisions 4,64,19,410
14. Miscellaneous Expenditure 3,07,79,308
The balance sheet may be prepared in account form and report form.
1. R.L. Gupta and M Radhaswamy: 'Advanced Accounts', Vol.I, Sultan Chand &
Sons, New Delhi.
2. M.C. Shukla & T.S. Grewal: 'Advanced Accounts', S.Chand and Company, New
Delhi.
5.10 CASESTUDY
Given here is the Balance Sheet as at 31-3-1993 of a leading South Indian textile mill -
The Vijayakumar Mills Limited. This Palani based textile mill is part of the famous
Kongarar Group. The Balance Sheet is presented in the report form. As you go through
the Balance Sheet, you would notice that there is an additional column which gives the
corresponding figure for every item for the previous year also. This is mandatory for
Joint Stock Companies as per the Companies Act. Further against each item in the
Balance Sheet a Schedule number is given. If one goes through the respective schedules,
necessary detailed information pertaining to the concerned item may be obtained. This
information is very much useful for the analysis and interpretation of financial
statements. Balance Sheet of The Vijayakumar Mills Limited is given here:
As at
31.03.93
As at
31.03.92
Particulars Schedule (Rs. in lakhs)
SOURCES OF
FUNDS:
SHARE HOLDERS
FUNDS:
a. Share Capital I 156.00 78.00
b. Reserves and
Surplus
II 575.87 626.79
731.87 704.79
LOAN FUNDS:
a. Secured Loans III 1275.50 1255.53
b. Deferred Credits IV 1.61
c. Unsecured Loans V 1577.64 200.11
2853.14 1457.25
TOTAL FUNDS
EMPLOYED
3585.01 2162.04
APPLICATION OF
FUNDS:
FIXED ASSETS VI
Gross Block 2148.02 1904.13
Less: 997.08 1150.94 844.47 1059.66
DEPRECIATION
INVESTMENTS VII 14.43 14.15
CURRENT ASSETS,
LOANS & ADVANCES
VIII
a. Inventories 1519.48 1119.69
b. Sundry Debtors 525.03 386.54
c. Cash & Bank
Balances
105.35 63.94
d. Loans &
advances
766.87 369.73
2916.73 1939.90
LESS:
CURRENT
LIABILITIES &
PROVISIONS
IX 510.79 2405.94 871.78 1068.12
MISCELLANEOUS
EXPENDITURE
X 13.70 20.11
TOTAL FUNDS
APPLIED
3585.01 2162.04
- End of Chapter -
LESSON - 6
FINANCIAL STATEMENTS - II: PROFIT AND LOSS ACCOUNT
Objectives
After reading this lesson, you will be able to:
understand the meaning of income and expense
prepare a Profit and Loss account
appreciate the linkage between Profit and Loss account and Balance Sheet
understand the various methods of inventory valuation
develop an understanding of the various methods of depreciation
Structure
6.1 Introduction
6.2 Basic ideas about income and expense
6.3 Form and presentation of Profit and Loss account / Income Statement
6.4 Explanation of items on the Income Statement
6.5 Statement of Retained Earnings
6.6 Relationship between Balance Sheet and Income Statement
6.7 Concepts underlying Profit and loss Account
6.8 Methods of Inventory Valuation
6.9 Depreciation of Fixed Assets
6.10 Summary
6.11 Key words
6.12 Exercises
6.13 Case study
6.1 INTRODUCTION
Ascertainment of the periodic income of a business enterprise is perhaps the foremost
objective of the accounting process. This objective is achieved by the preparation of
profit and loss account or the income statement. Profit and Loss account is generally
considered to be of greatest interest and importance to end-users of accounting
information. Whereas the balance sheet enables them to know the financial position of
the business enterprise as of a particular date, the profit and loss account enables them
to find out whether the business operations have been profitable or not during a
particular period. The important distinctions which one needs to make between the
balance sheet and the income statement is that the balance sheet is on a particular date,
while the profit and loss account is for a particular period. It is for this reason that the
balance sheet is categorised as a status report (as on a particular date) while the profit
and loss account as a flow report (for a particular period). Usually the profit and loss
account is accompanied by the balance sheet as on the last date of the accounting period
for which the profit and loss account is prepared.
6.2 BASIC IDEAS ABOUT INCOME AND EXPENSE
Income statement (or) profit and loss account consists of two elements: One reports the
inflows that result from the sale of goods and services to customers which are called as
'revenues'. The other reports the outflows that were made in order to generate these
revenues; these are called as 'expenses'. Income is the amount by which revenues exceed
expenses. The term "net income" is used to indicate the excess of all the revenues over
all the expenses. The basic equation is:
Revenues - Expenses = Net Income
6.2.1 Relation Between Income and Owners' Equity: The net income of an
accounting period increases owners' equity because it belongs to the owner. This was
already explained in lesson 3 under "dual aspect concept". To quote the same example,
goods costing Rs. 10,000 are sold on credit for Rs. 12,000. The result is that stock is
reduced by Rs. 10,000; a new asset namely 'debtor' is created for Rs.12,000, and the
total assets increased by the difference which is Rs.2,000. Because of the dual aspect
concept we know that the equity side of the balance sheet would also increase by
Rs.2,000 and the increase would be in owners' equity because the profit on sale of goods
belongs to the owner. It is clear from the above example that income increases the
owners' equity.
6.2.2 Income is not the same as Receipt: Income of a period increases the owners'
equity but it need not result in an increase in cash balance. Loss of a period decreases
owners' equity but it need not result in decrease in cash balance. Similarly increase in
cash balance need not result in increased income and hence increased owners' equity,
and decrease in cash balance need not denote loss and hence a decrease in owners
equity. All these are due to the fact that income is not the same as cash receipt. The
following examples make clear the above point:
i) When goods costing Rs. 10,000 are sold on credit for Rs. 12,000 it results in an
income of Rs.2,000 but the cash balance does not increase because it was sold on credit,
not for cash.
ii) When goods costing Rs.9,000 are sold on credit for Rs.7,000 there is a loss of
Rs.2,000 but there is no- corresponding decrease in cash, because it was sold on credit,
not for cash.
iii) When Rs.3,000 is borrowed (loan is taken) , the cash balance increases but there is
no impact on income.
iv) When a loan of Rs.3,000 is repaid, it decreases only the cash balance, not the
income.
6.2.3 Expenses: An expense is an item of cost applicable to an accounting period. It
represents economic resources consumed during the rent period. When an expenditure
is incurred, the cost involved is either an asset or an expense. If the benefits of the
expenditure relate to future periods, it is an asset. If not, it is an expense of the current
period. Over the entire life of an enterprise, most expenditure becomes expenses. But
according to accounting period concept, accounts are prepared for each accounting
period. Hence we get the following four types of transactions relating to expenditure and
expenses:
1. Expenditures that are also expenses: This is the simplest and most
common type of transaction to account for. If an item is acquired during the year
it is expenditure. If the item is consumed in the same year then the expenditure
becomes expense. E.g. raw materials purchased are converted into saleable goods
and are sold in the same year.
2. Assets that become expenses: When expenditures incurred resut in benefits
for the future period they become assets. When such assets are used in
subsequent years they become expenses of the year in which they are used. For
e.g. inventory of finished goods are assets at the end of a particular accounting
year. When they are sold in the next accounting year they become expenses.
3. Expenditures that are not expenses: As already pointed out, when the
benefits of the expenditure relate to future periods they become assets, not
expenses. This applies not only to fixed assets but also to inventories which
remain unsold at the end of the accounting year. E.g., the expenditure incurred
on inventory that has remained unsold is asset until it is sold out.
4. Expenses not yet paid: Some expenses would have been incurred in the
accounting year but payment for the same would not have been made within the
same accounting year. These are called as 'accrued expenses' and are shown as
liabilities at the year end.
6.3 FORM AND PRESENTATION OF PROFIT AND LOSS ACCOUNT /
INCOME STATEMENT
In practice, there is considerable variety in the formats and degree of detail used in
income statements. The profit and loss account is usually prepared in 'T' shape. The
following (Illustration 6-A) is the summarised profit and loss account of a distillery.
Illustration 6-A
Pondicherry Distilleries Ltd.
Profit and Loss Account for the year ended 31st March.
Dr.
(in Rs.
'000s)
Cr.
(in Rs.
'000s)
Cost of goods sold 47,42 Sales (Schedule XIII)
159,22
Establishment Expenses
(Schedule IX)
34,14 Interest (Schedule XV) 2,13
Maintenance Expenses
(Schedule X)
17,97
Miscellaneous Receipts
(Schedule XVI)
1,86
Administrative and Other
Expenses (Schedule XI)
3,17 Profit on sale of assets 31
Depreciation 15,45
Provision for Taxation 21,09
Net Profit 24,28
1,63,52 1,63,52
In the 'T' shaped profit and loss account, expenses are shown on the left hand side i.e.,
the debit side and revenues are shown on the right hand side - the credit side. Net profit
or loss is the balancing figure.
The profit and loss account can also be presented in the form of a statement when it is
called as income statement. There are two widely used forms of income statement:
single-step form and multiple-step form.
The single-step form of income statement derives its name from the fact that the total
of all expenses is deducted from the total of all revenues. Illustration 6-A can be
presented in the single-step form as given in Illustration 6-B.
Illustration 6-B
Income statement for the year ended 31st March
(Rs. in '000)
Revenues
Net Sales (Schedule XIII) 1,59,22
Interest (Schedule XV) 2,13
Miscellaneous Receipts (Schedule XVI) 1,86
Profit on Sale of assets 31 1,63,52
Expenses
Cost of goods sold 47,42
Establishment Expenses (Schedule IX) 34,14
Maintenance Expenses (Schedule X) 17,97
Administrative and other Expenses
(Schedule XI)
3,17
Depreciation 15,45
Provision for Taxation 21,09 1,39,24
Net Income 24,28
The single-step form has the advantage of simplicity but it is inadequate for analytical
purpose.
The multi-step form income statement is so called because of its numerous sections,
sub-sections and intermediate balances. Illustrations 6-C is a typical proforma of multi-
step income statement.
Illustration 6-C
Proforma of a Multiple-step Income Statement
Rs.
Gross sales XXX
Less Sales returns XXX
Net sales XXX
Less Cost of goods sold, Raw material
Cost
Opening Stock of Raw Material XXX
Add Purchase of Raw Material XXX
Freight XXX
Raw material available XXX
Less Closing stock of raw material XXX
Raw material consumed XXX
Direct Labour Cost XXX
Manufacturing Expenses XXX
Total Production Cost XXX
Add Opening work-in-progress XXX
Total XXX
Less Closing work-in-progress XXX
Cost of goods manufacturing goods XXX
Add Opening Finished goods XXX
Cost of goods available for sale XXX
Less Closing Finished Goods XXX
Cost of Goods sold XXX
Gross Profit XXX
Less Operating Expenses
Administrative Expenses XXX
Selling and Distribution expenses XXX XXX
Operating profit XXX
Add Non-operating Income
(Such as dividends, interest received etc.) XXX
XXX
Less Non-Operating Expenses
(Such as discount on issue of shares
written-off, loss on sale of assets etc.)
XXX
Profit(or) Earnings Before Interest and
Tax (EBIT)
XXX
Less Interest XXX
Profit (or) Earnings Before Tax (EBT) XXX
Less Provision for Income Tax XXX
Net Profit (or) Earnings After Tax (EBT) XXX
Earnings Per share of Common Stock XXX
The multiple-step form of illustration 6-C would be as given under illustration 6-D
Illustration 6-D
Income Statement for the Year ended 31st March...
(Rs. in '000)
Net Sales (Schedule XIII) 1,59,22
Less Cost of goods sold 47,42
Gross Profit 1,11,80
Less Operating Expenses
Establishment Expenses (Schedule IX) 34,14
Maintenance Expenses (Schedule X) 17,97
Administrative and Other Expenses
(Schedule XI)
3,17
Depreciation 15,45 70,73
41,07
Operating Profit
Add Non-Operating Income
Interest (Schedule XV) 2,13
Miscellaneous receipts (Schedule XVI) 1,86
Profit on sale of assets 31 4,30
Profit or Earnings Before Tax (EBT) 45,37
Less Provision for Income-Tax 21,09
Net Profit or Earnings After Tax (EAT) 24,28
The advantage of multiple-step form of income statement over single-step form and the
"T" shaped profit and loss account is that there are a number of significant sub totals on
the road to net income which lend themselves for significant analysis.
Income statements prepared for use by the managers of an enterprise usually contains
more detailed information than that shown in the above illustrations.
6.4 EXPLANATION OF ITEMS ON THE INCOME STATEMENT
The heading of the income statement must show:
i) the business enterprise to which it relates (Pondicherry Distilleries Ltd.)
ii) the name of the statement (income statement)
iii) the time period covered (year ended 31st March of the relevant year)
The balance sheet and income statement are generally followed by various schedules
that give detailed account of the items, listed on them. Information about these
schedules is given against each item on the financial statements. The statement is to
disclose the major source of revenue and to separate it from miscellaneous sources. For
most companies the major source of revenue is the sale of goods and services.
6.4.1 Sales Revenue: An income statement often reports several separate items in the
sales revenue section, the net of which is the net sales figure. For example, the
Pondicherry Distilleries income statement might have shown:
Gross Sales
Less: Sales Returns
Rs. 1,59,21,806
XXX
Rs. 1,59,21,806
Since there are no sales returns, gross sales and net sales are one and the same.
6.4.2 Gross Sales: 'Gross sales' is the total invoice price of the goods sold or services
rendered during the period. It should not include sales taxes or excise duties that may
be charged to the customers. Such taxes are not revenues but rather represent
collections that the business makes on behalf of the government and are liabilities to the
government until paid. To illustrate Pondicherry Distilleries sales shows as follows:
Schedule XII - Sales
In the income statement, sales is shown at Rs. 1,59,21,806 only i.e., after deduction of
excise duty. Similarly, postage, freight or other items billed to the customers at cost are
not revenues. These items do not appear in the sales figure but instead are an offset to
the costs the company incurs for them.
6.4.3 Sales Returns and Allowances: These items represent the sales values of
goods that were returned by customers or allowance made to customers because the
goods were defective. The amount can be subtracted from the sales figure directly
without showing it as a separate item on the income statement. But it is always better to
show them separately.
6.4.4 Sales Discounts: Sometimes called as 'cash discounts', sales discount are the
amount of discounts allowed to customers for prompt payment. For example, if a
business offers a 3% discount to customers who pay within 7 days from the date of the
Total Turnover
Less: Excise duty
Sales (Gross)
Rs. 4,10,76,127
Rs. 2,51,54,321
Rs. 1,59,21,806
invoice and it sells Rs.20,000 of goods to a customer who takes advantage of this
discount, the business receives only Rs.19,400 in cash and records the balance Rs. 600
as sales discount. There is another kind of discount called as 'trade discount', which is
given by the wholesaler or manufacturer to the retailers to enable them to sell at
catalogue price and make a profit. For example List, less 40 percent. Trade discount
does not appear in the accounting records at all.
6.4.5 Miscellaneous or Secondary Sources of Revenues: These are revenues
earned from activities not associated with the sale of the enterprise's goods and services.
Interest or dividends earned on marketable securities, royalties, rents and gains on
disposal of assets are examples of this type of revenues. For example, in the case of
Pondicherry Distilleries, one of the miscellaneous receipts is rent from staff quarters
amounting to Rs. 14,592 out of the total of Rs. 1,86,359. These revenues are called as
'non-operating income'.
6.4.6 Cost of Goods Sold: When income is increased by the sale value of goods or
services sold, it is also decreased by the cost of these goods or services. The cost of goods
or services sold is called the 'cost of sales'. In manufacturing firms and retailing
business, it is often called the cost of goods sold. The complexity of calculation of cost of
goods sold varies depending upon the nature of the business. In the case of a trading
concern that deals in commodities, it is very simple to calculate the cost of goods sold
and it is done as follows:
Opening Stock XXX
Add: Purchases XXX
Freight XXX
Goods available for sale XXX
Less: Closing stock XXX
Cost of goods sold XXX
...when a number of products are manufactured because it involves the calculation of
the work-in-progress and valuation of inventory. The methods of valuation of inventory
are explained separately at the end of this chapter. The cost of goods sold as shown in
the income statement of the Pondicherry Distilleries would have been calculated as
follows:
Illustration 6-E
Cost of goods sold
(Rs. in '000s)
Raw Materials Cost:
Opening stock 4,49
Add Purchase 24,12
28,61
Less Closing Stock 8,06
Raw material consumed 20,55
Power Fuel 39,05
59,60
Add: Opening work-in-progress 9
59,69
Less: Closing work-in-progress 17
Cost of goods manufactured 59,52
Add: Opening Furnished Goods 6,08
Cost of goods available for Sale 65,60
Less: Closing Furnished goods 18,18
Cost of goods sold 47,42
6.4.7 Gross Profit: The excess of sales revenue over cost of goods sold is the 'gross
margin' or gross profit. In the case of multiple-step income statement it is shown as a
separate item. Significant managerial decisions can be taken by calculating the
percentage of gross profit on sale. This percentage indicates the average mark-up
obtained on products sold. The percentage varies widely among industries, but healthy
companies in the same industry tend to have similar gross profit percentages.
6.4.8 Operating Expenses: Expenses which are incurred for running the business
and which are not directly related to the company's production or trading are
collectively called as operating expenses. Usually operating expenses include
administration expenses, finance expenses, depreciation and selling and distribution
expenses. Administration expenses generally include personnel expenses also.
However sometimes personnel expenses may be shown separately under the heading
'Establishment Expenses' as is done in the case of Pondicherry Distilleries under
Schedule IX.
Schedule IX: Establishment Expenses
(Rs. in 'OOOs)
Salaries and Wages 24,27
Bonus and Incentive 4,67
PF Contribution 1,46
Gratuity 1,48
Pension 51
Employees Welfare Expenses 1,75
34,14
The important methods of providing depreciation are given in a separate section at the
end of this chapter.
Until recently most companies included 'expenses on research and development' as part
of general and administrative expenses. But nowadays the FASB requires that this
amount should be shown separately. This is so because the expenditure on research and
development could provide an important clue as to how cautious the company is in
keeping its products and services up-to-date.
6.4.9 Operating Profit:
Operating profit is obtained when operating expenses are deducted from gross profit.
1. Non-operating Expenses: These are expenses which are not related to the
activities of the business e.g. loss on sale of asset, discount on shares written-off
etc. These expenses are deducted from the income obtained after adding other
incomes to the operating profit. Other incomes or miscellaneous receipts have
already been explained. The resultant profit is called as profit (or) earnings
before interest and tax (EBIT)
2. Interest Expenses: Interest expense arises when part of the expenses are met
from borrowed funds. The FASB requires separate disclosure of interest expense.
This item of expense is deducted from income or earnings before interest and tax.
The resultant figure is profit (or) earnings before tax (EBT)
3. Income Tax: The provision for tax is estimated based on the quantum of profit
before tax. As per the corporate tax laws, the amount of tax payable is determined
not on the basis of reported net profit but the net profit arrived at has to be
recomputed and adjusted for determining the tax liability. That is why the
liability is always shown as a provision.
4. Net Profit: This is the amount of profit finally available to the enterprise for
appropriation. Net profit is reported not only in total but also per share of stock.
This per share amount is obtained by dividing the total amount of net profit by
the number of shares outstanding. The net profit is usually referred to as profit or
earnings after tax. This profit could either be distributed as dividends to
shareholders or retained in the business. Just like gross profit percentage, net
profit percentage on sales can also be calculated which will be of great use to
managerial analysis.
6.5 STATEMENT OF RETAINED EARNINGS
The term 'retained earnings' means the accumulated excess of earnings over losses and
dividends. The statement of retained earnings is generally included with almost any set
of financial statements although it is not considered to be one of the major financial
statements. A typical statement of retained earnings starts with the opening balance of
retained earnings, the net income for the period as an addition, the dividends as a
deduction, and ends with the closing balance of retained earnings. The statement may
be prepared and shown on a separate sheet or included at the bottom of the income
statement. The balance shown by the income statement is transferred to the balance
sheet through the statement of retained earnings after making necessary appropriations.
This statement thus links the income statement to the retained earning item on the
balance sheet. This statement can be prepared in 'T' shape also when it is called as
Profit and Loss Appropriation Account. Illustration 6-F gives the statement of
retained earnings of Pondicherry Distilleries.
Illustration 6-F
Pondicherry Distilleries Ltd
Statement of Retained Earnings For the Year Ended 31st March....
(Rs. in '000)
Retained earnings at the beginning of the
year
84,03
Add: Net Income 24,28
1,08,31
Less: Dividends
4,50
Retained earnings at the end of the year 1,03,81
6.6 RELATIONSHIP BETWEEN BALANCE SHEET AND INCOME
STATEMENT
The amount of net income reported on the income statement together with the amount
of dividends, explains the change in retained earnings between the two balance sheets
prepared as of the beginning and end of the accounting period. For example, in the
balance sheet of Pondicherry Distilleries, the retained earnings as on 1st April stood at
Rs.84,03,260 whereas it amounted to Rs. 1,03,81,683 in the balance sheet as on 31st
March. The reason for this increase is explained in the statement of retained earnings
which is a part of income statement. Thus it can be stated that there exists a definite and
close relationship between balance sheet and income statement.
6.7 CONCEPTS UNDERLYING PROFIT AND LOSS ACCOUNT
As in the case of balance sheet, many concepts are involved in the preparation of income
statement also. For example, the income statement is prepared for a particular
accounting period. Here the concept involved is accounting period concept.
Similarly revenues are recognised in the period in which goods were sold to customers
or in which services were rendered. This is in accordance with realisation concept.
Another concept which has to be followed is the concept of conservatism. It is
because of this concept that provision for bad and doubtful debts, provisions for
fluctuation in investments etc. are created. It is in accordance with the concept of
consistency that material issues are priced on the basis of the same method year by
year and so is the case with depreciation methods. The simple equation which is
followed to ascertain income is Revenues- Expenses = Income and this equation is in
accordance with yet another important concept known as concept of periodic
matching of costs and revenues.
6.8 METHODS OF INVENTORY VALUATION
Valuation of inventory is a difficult exercise both for manufacturing concerns and
trading concerns. In the case of manufacturing concerns, raw materials required for
production are purchased at different times and at different prices. They are issued for
production as and when required. It is very difficult to fnd out from which specifc
purchase the issues are made. Hence the valuation of materials issued and closing stock
of materials becomes difficult. Similarly, trading concerns buy stock at different prices
and at different times. They go on adding their purchases to their current stock while at
the same time selling them. It would be impossible to identify the cost price of the
commodities sold by pointing out the time of their purchases and the corresponding
purchase price. As a step towards solving this problem, many methods of inventory
valuation are developed. The important among them are :
i) First-in-First-out Method (FIFO)
ii) Last-in-First-out Method (LIFO)
iii) Weighted Average Method
6.8.1 First-in-First-Out Method (FIFO): This method is based on the assumption
that costs should be charged against revenue in the order in which they were incurred.
This method assumes that materials issued or goods sold are those which represent the
earliest purchases. This would mean that the materials or goods which remain in stock
after the issues or sales are those which represent the most recent purchases.
Illustration 6-G explains the mechanism of this method.
Illustration 6-G
Rs.
January 1 Opening Inventory 200 units@Rs.10 2,000
March 31 Purchases 400 units@Rs.11 4,400
June 1 Purchases 500 units@Rs.12 6,000
Sepember 30 Purchases 300 units@Rs.13 3,900
The physical verification on December 31 shows that 250 units are in stock. In
accordance with the assumption that the inventory is composed of the most recent
costs, the cost of 250 units is determined as:
Deduction
of the
inventory
of
Rs.3450 from Rs. 19,100 worth of materials/goods available for issues/sales gives Rs.
15,650 as the cost of goods sold.
6.8.2 Last-In-First-Out Method (LIFO): The LIFO method is based on the
assumption that the most recent costs incurred should be charged against revenue i.e.,
this method assumes that the materials issued or goods sold are those which are most
recently purchased. It would follow, therefore, that the goods held in stock represent
December 1 Purchases 200 unit@Rs.14 2,800
1600 units 19,100
Most recent costs December 1 200
units @
Rs.14
2,800
Next most recent
costs
September 30 50
units @
Rs.13
650
250 units 3,450
earlier purchase. Based on data presented in Illustration 6-G, the cost of the closing
inventory is determined as:
Deducti
on of
the
closing
inventory of Rs.2,550 from the Rs.19,100 worth of materials/goods available for
issues/sales gives Rs. 16,550 as the cost of goods sold.
6.8.3 Weighted Average Method: This method is based on the assumption that
costs should be charged against revenue in accordance with the weighted average unit
costs of the materials issued or goods sold. The weighted average unit cost is
determined by dividing the total cost of the materials or goods by the number of units.
Continuing the data given in Illustration 6-G the weighted average cost of 1600 units
and the cost of the inventory are determined in the following manner:
Deduction of the closing inventory of Rs.2,984 from the Rs.19,100 worth of
materials/goods available for issues/sales gives Rs. 16,116 as cost of goods sold which
represents the average of the costs incurred.
The FIFO method and the weighted average method are perhaps the most extensively
used methods. The main argument for FIFO method is that the cost of the goods issued
or sold closely reflects the price trend in the markets. Weighted average method is
preferred because of the smoothing of purchase costs achieved by this method which
enables to even out the wide fluctuations in the purchase prices. The LIFO method is
Earliest Costs January 1 200
units @ Rs.
10
2,000
Next earliest costs March 31 50
units @ Rs.
11
550
250 units 2,550
followed by a relatively small number of companies as the application of this method is
not liked by corporation laws in various countries. Yet many companies use LIFO
method for the purpose of internal reporting.
6.9 DEPRECIATION ON FIXED ASSETS
With the passage of time, all fixed assets lose their capacity to render services, the only
exception being land. Accordingly a fraction of the cost of the asset is chargeable as an
expense in each of the accounting periods in which the asset renders services. The
accounting process for this gradual conversion of capitalised cost of fixed assets into
expense is called 'depreciation'. Two factors contribute to the decline in the usefulness of
fixed assets: One is deterioration, the other is obsolescence. Deterioration is the
physical process wearing out whereas obsolescence refers to loss of usefulness due to
the development of improved equipment or processes, changes in style or other causes
not related to the physical condition of the asset.
The International Accounting Standards Committee defines depreciation as follows:
"Depreciation is the allocation of the depreciable amount of an asset over the estimated
useful life".
The useful life in turn is defined as "the period over which a depreciable asset is
expected to be used by the enterprise."
The depreciable amount of a depreciable asset is defined as "its historical cost in the
financial statements, less the estimated residual value."
Residual value or salvage value is "the expected recovery or sales value of the asset at the
end of its useful life".
6.9.1 Methods of Depreciation: The amount of depreciation of a fixed asset is
determined taking into account the following three factors: its original cost, its
recoverable cost at the time it is reused from service, and the length of its life. Out of
these three factors, the only factor which is accurately known is the original cost of the
asset. The other two factors cannot be accurately determined until the asset is reused.
They must be estimated at the timne the asset is placed in service. The excess of cost
over the estimated residual value is the amount that is to be recorded as depreciation
expense during the assets lifetime. There are no hard and fast rules for estimating either
the period of usefulness of an asset or its residual value at the end of such period. Hence
these two factors which are inter-related are affected to a considerable extent by
management policies.
Let us consider the following example: A machine is purchased for Rs. 11,000 with an
estimated life of five years and estimated residual value of zero. The objective of
depreciation accounting is to charge this net cost of Rs. 10,000 (Original cost - residual
value) as an expense over the 5 year period. How much should be charged as an expense
each year? To help us in this regard we are having the following four frequently used
methods of computing depreciation.
i) Straight line method.
ii) Units of production method.
iii) Diminishing balance method.
iv) Sum-of-the-years-digits method.
It is not necessary that an enterprise employs a single method of calculating
depreciation for all classes of its depreciable assets. But in accordance with the
convention of consistency, once a method of depreciation is selected the same method
should be followed throughout.
6.9.2 Straight Line Method: Straight line method assumes that the level of service
provided by a fixed asset is even in all the years of its life. Hence this method provides
for equal annual charges to expense over the estimated life of the asset. To illustrate let
us assume that the cost of a machine is Rs. 11,000. Its estimated residual value is Rs.
1,000 and its estimated life is 5 years. The annual depreciation is calculated as follows.
The annual depreciation can also be calculated as a percentage on net cost (cost -
residual value). The annual percentage is obtained by dividing 100 by the number of
years of life. To continue our illustration the percentage would be 100/5 = 20 and
applying this percentage on the net cost we get annual depreciation as 1000 x 20/100 =
Rs.2000.
This method is a fairly simple method and provides a uniform allocation of costs to
periodic revenue. Hence it is widely used.
6.9.3 Units-of-Production Method: In this method depreciation calculations are
done based on the estimated productive capacity of the asset concerned. Depreciation is
first calculated in terms of an appropriate unit of production, such as hours, kilometers
or number of operations. Then annual depreciation is computed by multiplication of the
unit depreciation by the number of units used during the period. To continue with the
same example, if the machine is expected to have an estimated life of 10,000 hours the
depreciation for one hour is calculated as follows:
If during a particular year the machine was used for 3000 hours, the depreciation
charge for that year would be 3000 x Re. 1 = Rs.3000.
6.9.4 Diminishing Balance Method: This method results in a diminishing periodic
depreciation charge over the estimated life of the asset. Under this method each year's
depreciation is found by applying a rate to the net book value of the asset, as at the
beginning of that year. Next book value at a particular point of time is the original cost
less total depreciation accumulated upto that point of time. The rate to be applied to the
net book value is usually double the straight line depreciation rate. To continue with our
example, the straight line rate we got is 20% and, therefore, the diminishing balance
rate would be its double i.e., 40%. This 40% is applied to the original cost of the asset for
the first year and thereafter to the net book value over the estimated life of the asset. The
asset's estimated residual value, if any, is not taken into account for the calculation of
net book value. However, care should be taken to ensure that the asset is not
depreciated below its residual value in the last year. Table 6-1 illustrates this method of
depreciation.
Table 6-I
Year
Book value at
the beginning of
the year (Rs.)
Rate
Depreciation
for the year
(Rs.)
Book value at
the end of the
year (Rs.)
1. 11,000 40% 4,400 6,600
2. 6,600 40% 2,640 3,960
3. 3,960 40% 1,584 2,376
4. 2,376 40% 950 1,426
5. 1,426 40% 426* 1,000
10,000
* In the last year the actual depreciation is Rs. 570 i.e. 40% of Rs. 1,426 and the book
value, therefore, at the 3 year end would have been Rs.856. But since in the last year,
the asset should not be depreciated below its residual value, the depreciation for the
last year should be Rs.426 which is calculated as follows: Rs. 1426 (book value at the
beginning of the year) minus Rs.1000 (estimated residual value).
6.9.5 Sum-of-the-years-Digits Method: Under this method depreciation for each
year is computed by applying a fraction to the net cost of the asset. The denominator of
the fraction remains constant and it is the sum of the digits representing the year of life.
To continue our example, the estimated life is 5 years and hence the denominator
would be 5+4+3+2+1 = 15. The numerator of the fraction is the number of remaining
years of life and it changes every year. In our example the fraction to be applied on the
net cost of Rs. 10,000 would be 5/15 in the first year, 4/15 in the second year, 3/15 in
the third year, 2/15 in the fourth year, and 1/15 in the last year. The depreciation
schedule under this method for our example would appear as in Table 6-II
Table 6- II
Year Net Cost Rate
Depreciation for
the year
1. 10,000 5/15 3,333
2. 10,000 4/15 2,667
3. 10,000 3/15 2,000
4. 10,000 2/15 1,333
5. 10,000 1/15 667
10,000
Both the diminishing balance and the sum-of-the-years-digits methods provide for a
higher depreciation charge in the first year of the use of the asset and a gradually
declining periodic change thereafter. Hence they are frequently referred to as
'accelerated method of depreciation'.
Chart 6.1 shows the comparative amounts of annual depreciation charges under
straight-line method, diminishing balance method, and sum-of-the-years-digits
method.
6.9.6 Impact of Depreciation Method on Profit Measurement:
Just now we have seen that depending on the method used, we have a different amount
of charge for annual depreciation. It may also be noted that over the entire life of the
asset the total amount of depreciation charge cannot be different.
The difference is only in the annual depreciation charge. The impact of annual
depreciation charge on profit measurement under various methods of depreciation
assuming an annual profit of Rs. 30,000 each year is shown in Table 6-III.
Table 6-III
Depreciation Profits after Depreciation
Year
Profit before
Depreciation
(A)
Straight Line
Method
(SL)
Diminishing
Balance
Method (DB)
Sum-of-
the-
years-
digits
Method
(SD)
Straight
Line
Method
(A-SL)
Diminishing
Balance
Method (A-
DB)
Sum-of-
the-
years-
digits
Method
(A-SD)
1. 30,000 2,000 4,400 3,333 28,000 25,600 26,667
2. 30,000 2,000 2,640 2,667 28,000 27,360 27,333
3. 30,000 2,000 1,584 2,000 28,000 28,416 28,000
4. 30,000 2,000 950 1,333 28,000 29,050 28,667
5. 30,000 2,000 426 667 28,000 29,574 29,333
150,000 10,000 10,000 10,000 140,000 140,00 140,000
It may be seen from the Table that over the life of the asset there is no difference in the
total profit after depreciation. Only there is difference in the annual profits after
depreciation. If the enterprise wants to show higher profits in the initial years it is better
that the straight line method of depreciation is followed.
6.10 SUMMARY
The profit and loss account or income statement summarises the revenues and expenses
of a business enterprise for an accounting period. The information on the income
statement is regarded by many to be more important than information on the balance
sheet because the income statement reports the results of operations and enables to
analyse reasons for the enterprises' profitability or lack thereof. A close relationship
exists between income statement and balance sheet; the statement of retained earnings
which is a concomitant of income statement explains the change in retained earnings
between the balance sheets prepared at the beginning and the end of the period.
6.11 KEYWORDS
Status Report: Position on a particular date.
Flow Report: Financial position for a particular period.
Income: Revenues - Expenses.
Expense: Item of cost applicable to an accounting period
Cost of goods sold: Opening stock + Purchase + Freight Closing stock
Gross Profit: Excess of sales revenue over cost of goods sold
Operating Expenses: Expenses incurred for running the business
Operating profit: Gross profit - Operating expenses
Non operating expenses: Expenses which are not related to the activities of the
business.
Net Profit: Amount of profit finally available to the enterprise for appropriation.
Retained Earnings: Accumulated excess of earnings over losses and dividends.
Depreciation: The allocation of the depreciable amount of an asset over the estimated
useful life.
6.12 EXERCISES
1. What is expenditure? When it becomes an expense?
2. What is income? Can we say that an increase in owners' equity is always due to
generation of income?
3. Does a substantial balance in retained earnings indicate the presence of a large cash
balance? Explain.
4. Explain the important methods of depreciation.
5. Explain the concepts underlying the preparation of Profit and Loss account.
6. Distinguish the following:
(1) Gross Profit
(2) Operating Profit
(3) Earnings Before Interest
(4) Earnings After Tax
7. 'Depreciation is a process of valuation of fixed assets' - Do you agree with this
statement? Discuss.
8. Bring out the relationship between the following:
(1) Owners' equity and income.
(2) Profit and Loss account and Balance Sheet.
9. Distinguish between cash discount and trade discount.
10. Bring out a distinction between:
(1) Straight line method and Diminishing value methods of depreciation.
(2) FIFO and LIFO methods of inventory valuation.
1. R.L.Gupta and M.Radhaswamy: "Advanced Accounts", Vol I, Sultan Chand & Sons,
New Delhi.
2. M.C.Shukla & T.S.Grewal: "Advanced Accounts", S.Chand and Company, New Delhi.
- End of Chapter -
LESSON 7
FINANCIAL STATEMENT ANALYSIS - A MANAGERIAL APPROACH
OBJECTIVES
After reading this lesson you will be able to:
Understand the implications of Financial Statements as performance records of
an enterprise
Identify the users of Financial Statements as members external to the enterprise
and internal managers
Appreciate the methods to carryout Financial Statement Analysis
Learn the procedure to prepare Comparative Financial Statements, Trend
Percentages and Common Size Statements
STRUCTURE
7.1 Introduction
7.2 Users of Financial Statements
A. External users
B. Internal users
7.3 Methods of Financial Statement Analysis
7.4 Comparative Financial Statement
C. Comparative Balance Sheet
D. Comparative Profit and Loss Account
7.5 Trend Percentages
7.6 Common-size Statements
E. Common size Income Statement
F. Common size Balance Sheet
7.7 Summary
7.8 Keywords
7.9 Exercises
7.1 INTRODUCTION
By now we are clear about the important financial statements of a business, viz., the
Balance Sheet or Statement of Financial Position reflecting the assets, liabilities and
capital as on a particular date; and the Profit and Loss Account or the Income
Statement, showing the operating results during a specific period. These two statements
convey a lot of information to both the inside managers as well as to the outside
interested parties on the working of the enterprise. Further, a careful examination of the
data across various heads for years do express the direction of operations of the
enterprise.
7.2 USERS OF FINANCIAL STATEMENTS
The Financial Statement information used by different decision makers differs based on
the decision that they make. The major users of the said information are:
A. External Users - These primarily include the investors, creditors or short term and
long term lenders.
A potential investor is basically interested in his returns in the form of cash dividends
as well as the capital gains that he can realise from eventually selling the stock. These
returns depend upon how profitable the company currently is and how profitable it will
be in future. Therefore, a potential shareholder is interested in the relationships within
the company that indicate the present and future profitability of the enterprise and how
such profitability could be translated into cash dividend.
A creditor, who supplies goods on credit, is interested in the recovery of the cash
during the short period. His interest is on events that will occur during an operating
period, how much cash will be available and how many claims there will be to that cash.
The long term creditors, such as debenture holders, are interested in getting the coupon
rate of interest in the short run and recovery of their investment in the long run.
Therefore, they are interested in some of the indicators of current and potential
profitability and good asset management. Further they are interested in the size of their
claim on company assets.
The other interested parties on the company's performance include the tax
authorities, government agencies, trade unions, and competitors. These
parties show interest in different aspects of the working of the company based on their
particular interest.
B. Internal Users - The internal management gets sizable information on the
company from Financial Statements. Their interest comes from two sources. First,
decisions made by external users of financial statements significantly affect the firm in
different ways. Investors' decisions speak on the availability of funds for future
diversification. Creditors' expectations affect the assets available for use by the
management of the company and flexibilities of the manager in using certain assets.
Secondly, some relationships within the Financial Statements provide benchmarks
against which one can compare performance.
7.3 METHODS OF FINANCIAL STATEMENT ANALYSIS
It is now clear that analyses of financial statements provide necessary insights towards
establishing relationships and trends to determine whether or not the financial position,
length of operations, and financial progress of the company are satisfactory or not.
Some of the analytical methods used to analyse Financial Statement are:
a. Comparative Financial Statements
b. Trend Percentages
c. Common size Financial Statements
d. Ratio Analysis
e. Funds Flow Analysis
Ration Analysis and Funds Flow Analysis will be elaborated in subsequent chapters.
7.4 COMPARATIVE FINANCIAL STATEMENTS
The two Financial Statements traditionally prepared are Profit and Loss Account and
the Balance Sheet. These two column (T-form) statements are generally converted into a
single column statement (vertical) to provide meaningful information in an easily
understandable form. This process of rearrangement of the traditional statements is a
pre-requisite to carry out any analysis of the Financial Statements. Therefore, let's spend
some time looking into the said new proforma before getting into the work of preparing
a comparative financial statement.
TABLE - 7.1
PROFORMA POSITION STATEMENT (OR BALANCE SHEET) AS ON.
Particulars Current Year figures (Rs.)
Previous Year
figures (Rs.)
I. Liquid Assets
Cash at bank ____ ____
Cash in hand ____ ____
Bills receivable ____ ____
Marketable securities ____ ____
Total (1)
------
------
------
------
II. Inventories
Raw materials ____ ____
Finished goods ____ ____
Total (2)
------
------
------
------
III. Total Current Assets (1)+(2) = (3)
------
------
------
------
IV. Current Liabilities
Bills payable ____ ____
Creditors ____ ____
Bank overdraft ____ ____
Outstanding ______ ____
Total (4)
------
------
------
------
V. Provisions
Provision for taxation ____ _____
Proposed Dividends ____ _____
Other Provisions ____ ____
Total (5)
------
------
------
------
VI. Total Current Liabilities and
provisions (4) + (5) = (6)
------
------
------
------
VIII. Net Working Capital
(6) - (3) = (7)
------
------
------
------
VIII. Net Block
Land and Buildings ____ ____
Plant and Machinery ____ ____
Furniture and Fixtures ____ ____
Equipment and Tools ____ ____
Total (8)
------
------
------
------
Total Capital Employed (7) + (8) = (9)
------
------
------
------
IX. Capital employed as represented by
Equity
Equity share capital ____ ____
Reserves and Profit & Loss
account balance
____ ____
Less Balance ____ ____
Total (10)
------
------
------
------
X. Capital employed as represented by
Bonds and Debentures
Debentures ____ ____
LT Loans ____ ____
Other secured loans ____ ____
TABLE 7.2
PROFORMA OF INCOME STATEMENT (PROFIT & LOSS A/C) AS ON...
Particulars
Current Year
figures (Rs.)
Previous Year
figures (Rs.)
Sales ____ ____
Less
Cost of goods sold (cost of materials consumed +
direct wages + other direct expenses)
____ ____
Gross Profit
------
------
------
------
Less Overhead Expenses ____ ____
Admn. overhead expenses Distribution overhead
expenses
____ ____
Selling overhead expenses ______ ____
Financial overhead expenses ____ ____
Net Profit
------
------
------
------
Having seen the new proformas for two Financial Statements, let us carry out the
Comparative Financial Statement analysis.
Comparative Financial Statements are prepared by arranging a company's two or three
year Financial Statements in a comparative order to arrive at meaningful insights into
the company's performance over the years. Often, the comparative presentation of data
is followed by the presentation of increase or decrease in 'absolute' financial data either
in percentage form or in ratio form.
C. Comparative Balance Sheet - Concurrent changes in Assets, Liabilities,
Proprietor's Funds due to the conduct of business operations can be observed by
preparing a Comparative Balance Sheet. Such a comparison throws sufficient light on
the direction and progress of the enterprise over years. To illustrate a Comparative
Balance Sheet, let us consider the Financial Statements recently brought out by Modi
Rubber Limited, as on 31st March 1991.
TABLE - 7.3
COMPARATIVE BALANCE SHEET OF M/S. MODI RUBBER LTD AS ON
31.3.91
Description
As at
31.3.90
As at
31.3.91
Absolute
difference
Percentage
change
SOURCES OF FUNDS:
1. Shareholder's Funds
(a) Share capital 1038.00 1038.00
(b) Reserves & surpluses 5598.82 6023.54 424.72 7.58
6636.82 7061.54 424.72 6.40
2. Loan Funds
(a) Secured loans 4732.39 4378.99 -353.40 -7.47
(b) Unsecured loans Total 2233.83 3321.39 1087.56 48.69
6966.22 7700.38 734.16 10.54
Total 13603.04 14802.11 1199.07 8.82
APPLICATION OF FUNDS:
3. Fixed Assets
(a) Gross Block 16681.84 17320.29 638.45 3.83
(b) Less: Depreciation 10017.68 10842.84 825.16 8.24
Net Block (Gross Block less Depreciation) 6664.16 6477.45 -186.71 -2.80
(c) Capital W-I-P 164.94 89.61 -75.33 -45.67
Total 6829.10 6567.06 -262.04 3.84
4. Investments 2710.38 2750.42 40.04 1.48
5. Current Assets, Loans & Advances
(a) Inventories 6253.50 6612.36 358.86 5.74
(b) S. Debtors 3013.71 3262.57 248.86 8.26
(c) Cash & bank balances 2717.79 2842.05 124.26 4.57
(d) Loans & advances 6695.54 8877.10 2181.56 32.58
Total 18680.54 21594.08 2913.54 15.64
LESS: CURRENT LIABILITIES AND PROVISION
(a) Liabilities 9780.69 10427.48 640.79 6.55
(b) Provision 4830.29 5681.97 851.68 17.63
Total 14610.98 16109.45 1492.47 10.21
NET CURRENT ASSETS 4063.56 5484.63 1421.07 34.97
13603.04 14802.11 1199.07 8.81
The analysis and interpretation of the above Comparative Balance Sheet gives the
following conclusions:
1. Although the firm's share capital has not changed during the said years of
analysis, the additional internal resources in the form of Reserves and Surpluses
have added about Rs.425 lakhs to the equity base. These additions have totally
made the Reserves to constitute 5.8 times of Equity Capital.
2. Among the Long Term Loans that the company mobilised possibly to reap the
advantages of leverage, the unsecured loans have gone up by almost 50 percent to
the previous year balance. On the other hand, the secured loans are found to have
been retired to the extent of Rs.350 lakhs. The shift from secured loans to
unsecured loans would bring flexibility in using the funds.
3. From the additional resources mobilized both internally and externally, about 55
percent have been utilized in creating additional Fixed Assets amounting to Rs.
638 lakhs.
4. While the Gross Current Assets fairly indicate the size of working capital in the
organisation, the rising net current assets indicate the diversion of long term
funds for current uses. Funds mobilised from long term external sources
naturally require necessary servicing, almost commensurate to the market rate.
Therefore, the rising net current asset balances signal the unproductive
deployment of such funds in non- income earning assets. M/s. Modi Rubber has
clearly fallen in the trap of additional working capital of as much as Rs.1421 lakhs
amounting to 34 percent of previous year balance.
Thus the comparative balance sheets show that the company's performance in managing
a good Capital Structure is commendable the deployment of such costly funds lost the
sight of profit requirements.
D. Comparative Profit & Loss Account - A Comparative Profit and Loss account or
Income Statement provides the information on respective changes in revenues and costs
during the study period. While it is profitable to the company when the percentage
change in revenue is larger than the percentage change in expenses, the vice versa
indicates the poor management of costs. Firms trying for competitive advantage
naturally keep their costs under control as well as try to get cost-leadership.
In order to illustrate a Comparative Income Statement, let us consider the latest Income
Statements of Bharti Telecom Limited, the India's No. 1 'Push Button' Telephone
manufacturer.
TABLE - 7.4
COMPARATIVE INCOME STATEMENT OF BHARTI TELECOM LIMITED
Particulars
As on 31.3.92
(Rs.)
As on 31.3.93
(Rs.)
Percentage
change
Income:
a) Sales/services rendered 14,02,88,948 26,89,48,410 92%
b) Interest 87,26,186 29,18,658 -66.5%
c) Other income 1,06,92,426 1,03,55,072 3.2%
15,97,07,560 28,22,22,140 76.7%
Expenditure:
a) Cost of materials consumed 8,98,85,653 17,99,61,928 100.2%
b) Manufacturing expenses 2,24,27,324 4,19,51,547 87.1%
c) Salaries, wages and other employee
benefits
95,34,806 1,45,87,925 62.9%
d) Managerial remuneration 2,08,881 2,19,695 5.2%
e) Depreciation 39,74,955 66,88,931 53.2%
f) Auditor's remuneration 86,014 1,92,230 123.5%
g) Selling and other expenses 1,51,14,877 2,33,27,621 54.3%
h) Interest 97,30,902 1,00,37,148 3.2%
15,09,63,412 27,68,67,025 83.1%
Profit Before Tax 87,44,148 53,55,115 33.1%
The possible interpretation from the analysis of Comparative Income Statements of
Bharti Telecom Limited could be as follows:
1. Company's revenues have grown up almost double the size of its proceeds during
1992. It is rather clear that the sales rose from Rs.14 Crores to Rs. 27 Crores
during the two years of study. However, the receipts from interest declined
possibly due to reduction in investments made. The other income has marginally
declined by 3 lakhs.
2. On the expenditure side, the prime cost of material cost and manufacturing
expenses jointly rose by 97.6 percent. If one compares the rise in the expenditure
with the size of sales generated, the percentage changes in direct costs are more
than percentage change in sales (92% only). To that extent the profit margin
clearly falls inspite of the increased sales.
3. The overhead expenses of salaries, managerial remuneration, depreciation,
auditor's fee have increased by 57 percent during the two year period. Some of
these overheads are expected to be 'fixed' in nature in the short run and are not
supposed to rise with the volume of production. If one takes general inflation rate
of 10 to 15 percent, these overheads rose by an additional amount of 40 percent.
This rise definitely cuts into the profit margins.
4. The selling and distribution overhead is expected to vary with the increased levels
of production and turnover. However the rise in this respect, which is only 54
percent, can be appreciated as being under control.
5. Interest expenses, the financial overhead also seems to have not exhibited much
change indicating greater control on such expenses.
6. The more than proportionate rise in direct expenses and uncontrolled overhead
expenses have resulted in leaving the net profits to rise only by 33 percent inspite
of the fact that the turnover of the company recorded 92 percent increase during
the two year comparison period.
7.5 TREND PERCENTAGES
Trend Percentage Analysis is carried out to analyse a series of Financial Statements to
draw inferences on possible trends in various aspects of a company. The trend
percentages are calculated considering one of the years as the base year. The trend
percentages, relative to the year, emphasize changes in the financial operations of the
enterprises over the years.
If the size of operations, assets and other expenses are on the rise, the subsequent year
shows figures higher than 100. Similarly, if there is a reduction in the said expenditure,
the trend value works out to be lower than 100. Trend ratios are generally not computed
to all the items in the statements as the fundamental objective is to make comparisons
between items having some logical relationship to one another. To illustrate the
computation of trend percentages, let us consider the four year Financial Statements of
Anglo-French Textiles of Pondicherry.
TABLE 7.5
ANGLO FRENCH TEXTILES LTD.
COMPARATIVE TREND PERCENTAGE OF 4-YEAR BALANCE SHEETS
DURING 1900-1993
As on
31.12.90
As on
31.12.91
As on
31.12.92
As on
31.3.93
Trend Movements
Particulars (Rs.) (Rs.) (Rs.) (Rs.)
31.12.91
(base
year)
31.12.91 31.12.9231.3.93
SOURCES OF FUNDS
1. Shareholders' Funds:
Capital 128,494,456 153,494,456 178,494,456 203,494,456 100 119.46 138.91 158.37
Reserves & Surplus 209,921,036 247,543,724 251,592,135 450,674,274 100 117.92 119.85 214.69
Total (a) 338,416,292 401,038,180 430,086,591 654,168,730 100 118.50 127.01 193.30
2. Loan Funds:
Secured loans 170,671,789 172,091,911 195,993,987 233,761,373 100 108.83 114.84 172.12
Unsecured loans 34,748,753 51,854,685 89,466,532 65,898,913 100 149.23 257.47 189. 64
Total (b) 205,420,542 223,946,596 285,460,519 359,680,292 100 109.02 138. 96 175.08
(a) + (b) 543,836,834 624,984,776 715,547,110 1,013,829,022 100 114.92 131. 57 186.42
APPICATION OF FUNDS
1. Fixed Assets:
Gross block 236,163,053 275,462,668 2,92,287,981 591,085,823 100 116.64 124.19 250.29
Less Depreciation 40,050,580 69,917,486 97,382,578 124,045,575 100 174.57 243.15 309.73
Net block 191,112,473 205,545,252 195,905,403 407,040,248 100 107.55 102.51 244.38
Capital 14,013,644 6,185,277 10,252,468 2,489,528 100 44.14 73.16 1777
Total 205,126,117 211,730,539 206,157,871 469,529,776 100 103.22 100.50 228.90
2. Investments: 30,000 30,000 30,000 30,000 100 100.00 100.00 100.00
3. Current Assets Loans & Advances:
Inventories 310,950,329 382,605,785 495,952,853 514,948,480 100 123.04 159.50 165 60
Sundry debtors 39,633,516 71,025,356 73,004,369 99,342,186 100 179.21 184.20 250.65
Cash and bank balance 26,517,030 20,273,847 18,180,734 40,218,139 100 76.46 68.56 151.67
Other current assets 18,731,340 14,833,381 1,265,191 861,722 100 79.19 6.75 4.60
Loans and Advances 29,688,309 49,239,189 53,750,314 64,287,233 100 165.89 181.09 216.58
Total 425,520,524 537,977,558 642,153,461 719,657,769 100 126.43 150.91 169.12
Less: Current Liabilities and provisions
Current Liabilities 83,653,601 120,854,545 130,734,830 191,754,900 100 144.05 156.28 229.23
Provisions 3,197,654 3,908,316 2,067,024 3,500,627 100 122.22 64.64 109.47
Net current assets 338,669,269 413,214,697 509,351,607 524,402,242 100 122.01 150.40 154.84
4. Miscellaneous expenditure (to
the extent not written off or adjusted)
11,448 9,540 7,632 5,247 100 83.33 66.67 45.83
Profit & Loss Account - - - 19,861,757 100 - - -
543,836,834 624,984,776 715,547,110 1,103,829,022 100 114.92 131.57 186.42
Table 7.6
ANGLO FRENCH, TEXTILES LIMITED
TREND PERCENTAGES IN INCOME STATEMENTS DURING 1990 - 1993
Particulars
As on
31.12.90
(Rs.)
As on
31.12.91
(Rs.)
As on
31.12.92
(Rs.)
As on
31.3.93
(Rs.)
Trend Movements
31.12.91
(base
year)
31.12.91 31.12.9231.12.93
INCOME
Sales 728,626,198 736,534,925 809,489,089 1,092,570,317 100 101.10 111.10 149.95
Export
Incentives
28,779,613 19,495,406 - - 100 67.74 - -
Premium on
Exim scrips
- 6,359,975 5,835,200 - 100 - - -
Other Income 6,781,711 12,061,876 10,073,845 15,616,825 100 177.86 148.5 250.3
764,186,528 774,652,182 825,258,134 1,108,187,142 100 101.37 107.90 144.9
Net Increase/
Decrease in
finished and
process stock
46,247,327 58,957,001 128,185,888 22,090,253 100 127.48 277.2 477.5
Total (A) 810,443,855 833,609,183 953,584,022 1,086,096,889 100 102.86 147.66 134.0
EXPENDITURE
Manufacturing
and other
expenses
706,644,194 726,798,985 861,289,352 1,067,132,410 100 102 .85 121. 68 181.00
Interest 45,225,649 43,077,017 59,856,666 74,297,774 100 95.25 132.35 164 30
Depreciation 24,358,867 24,932,034 27,626,290 34,164,963 100 102.35 113.41 140.03
Total 776,228,710 794,808,036 948,772,308 1,175,595,147 100 102.39 122.30 151.45
Profit/Loss for 3,42,15,145 38,811, 147 4,811,714 189,498,258 100 113.45 14. 10 261.65
the year
The possible inferences that can be drawn from the four year performance of Anglo-
French Textiles Limited is as follows:
1. The size of internal capital constitutes 60 percent of total capital employed and it
has risen gradually by about 2 times during the 4 year period. The rise in internal
resources is more pronounced through the reserves and surpluses which
accounted for 2.15 times to the base year.
2. Of the two external sources of debt capital the rise is more or less equal and
together working out to 1.86 times during the 4 year period. A cursory glance at
the debt/equity relationship shows, that the size of debt works out to 1/3 of the
total capital employed in the business.
3. Among various items in which the funds have been deployed, a large chunk goes
to fixed assets. The size of fixed assets has grown by 2.5 times. The long term
investments record no change all through the 4 year period.
4. Among the current assets, the inventory and debtors report a sizable rise of 1.6
times to 2.5 times respectively giving doubts on the efficient management of
current assets in the organization. Further the rising balances of loans and
advances at the rate of 2.2 times demand an enquiry into the impact of such large
advances on the profitability of the enterprise as well as the recovery
performance.
5. The current liabilities and provisions rose to an extent of 2.28 and 1.1 times
leaving a rise in net working capital to the extent of 1.54 times. This rise in net
working capital is justifiable only when the overall performance of the Enterprise
reports positive result.
6. The income statements show that the sales is very slow, growing slowly over the
years and record 1.5 times by 4th year. The non-operating income reports a
satisfactory rise to 2.3 times.
7. The direct as well as the overhead costs seem to report marginally high
percentage growth compared to sales. The manufacturing expenses record 1.51
times rise, interest expenditure by 1.64 times and the depreciation by 1.4 times.
8. The slow growth in sales and more than proportionate rise in expenditure
coupled with poor working capital management report a negative profit by the
fourth year end.
7.6 COMMON SIZE STATEMENTS
The above said two methods of analysing Financial Statements broadly provide the
direction of change but do not provide required interrelationship between various items
within each Financial Statement. For example, if expenses are expressed to a common
'Base' value of sales figure it would convey the size of expenses as a proportion of Rs.
100 sales figure over the years. Similarly if Total Assets are considered as 'Base' to
examine the trend in changes in working capital, one can easily notice the direction of
working capital balance in an organization. Therefore, an additional dimension is
needed for more in-depth analysis of Financial Statements. It is done through the
'Common Size Statements'. The Common Size Statements are often called as
'Component Percentage', '100 Percent' Statements since each individual item is
expressed as a percentage to total of 100.
The computation of common size statements requires us to identify the possible 'Bases'
to begin with. For purposes of Income Statement 'sales turnover' could become the
'Base' to express the direct expenses, overheads, as well as profit in terms of sales.
Similarly, the total liabilities and capital or total assets could be considered as 'Base' for
comparing the annual Balance Sheets of a company for possible year-wise trends to
examine.
For example, if the overhead (administrative) expenses in a company are working out to
Rs.90,000 when the sales value of the said company is Rs.600,000, then
Common Size value of the overhead expenditure = (Overhead Expenses /
Sales) x 100
= (90,000 / 600,000) x 100 = 15%
This means that the administration expenses are working out to Rs. 15 for every Rs. 100
sales done by the enterprise.
A comparison of this figure over the years tells us about the level of control on the said
expenditure. Further, a possible comparison of this figure with the competitive
enterprises or the industry average provides more meaningful information on the stage
of the company with respect to its cost control and management of affairs of business.
E. Common Size Income Statements - To illustrate the features of a Common Size
Income Statement, let us consider the income particulars of M/s. DCL Polyesters
Limited for the years ending 31st March 1991 and 1992.
TABLE - 7.7
DCL POLYESTERS LIMITED
COMMONSIZE INCOME STATEMENTS FOR THE YEARS ENDING 31-3-91
AND 31-3-92
Particulars
As on
31.3.91
(Rs.)
Percentage
of Sales
As on
31.3.92
(Rs.)
Percentage
of Sales
INCOME
Sales 11668.17 100.00 36493.71 100.00
Other Income 60.60 0.52 211.43 0.58
11728.77 100.52 36705.14 100.58
EXPENDITURE
Payments to
employees
111.58 0.95 208.38 0.57
Manufacturing
expenses
3399.12 29.13 11690.49 32.00
Excise duty 5504.22 47.17 18043.11 49.44
Administration,
selling and other
expenses
633.10 5.43 1809.94 5.00
Interest 932.87 7.99 2507.36 6.87
Depreciation 993.45 8.51 1678.50 4.60
Miscellaneous
expenses
24.77 0.21 24.75 0.07
1599.11 99.41 35962.553 98.55
Profit for the year 129.66 1.11 742.69 2.03
A closer look at the Common Size Income Statements of M/s. DCL Polyesters Limited
reveals the following:
1. Over the two-year period under study the sales turnover rose by more than 3
times from Rs.116 crores to Rs.365 crores. The profits during the corresponding
period rose from Rs. 1.3 crores to Rs. 7.4 crores recording a rise of 5.7 times.
2. When different items of Income Statement are recast in terms of sales the profit
margin works out to be a meager figure of Rs. 1.11 to Rs. 2.03 for every hundred
rupees sales carried out in the company.
3. If one glances at the size of expenditure being incurred by the company, it is clear
that the manufacturing expenses and excise duties constitute three-fourths of the
total revenue generated. Further, the proportion of these items is on the rise from
76.3 to 8.44 per cent during the said years of analysis.
4. A large majority of the remaining overhead expenses like the payments to
employees and administration expenses. Selling and other expenses, interest,
depreciation, although sizeable in absolute terms during the current year, seem to
be declining when expressed in terms of sales revenue.
F. Common Size Balance Sheet - It is not customary not to use the enter Balance
sheet for constructing Size Statements. If one is interested in examining the movement
of current assets and current liabilities with a view to keeping track of the changes in
Working Capital Balance, only that part of the Balance sheet is considered for Common
size Analysis.
Let us consider a Financing Company which deviates from a traditional manufacturing
company with respect to the type and nature of items in their list of current assets and
current liabilities. To illustrate as an example for the construction of Common Size
Statements, the case of M/s. Sakthi Finance Limited is given below:
TABLE - 7.8
M/S SAKTHI FINANCE LTD
COMMON SIZE DETAILS OF CHANGES IN CURRENT ASSETS AND
CURRENT LIABILITIES
As on 31.3.93 As on 31.3.94 % of Current Assets
Rs. Rs. 1993 1994
Current Assets, Loans and Advances
a) Stocks in hire 8165.90 12162.32 68.16 74.02
b) Stock of stationery stamps,
etc.
18.35 9.81 0.15 0.06
c) Cash and bank balance 927.32 981.52 7.74 5.97
d) Income receivable 1015.17 843.92 8.47 5.14
e) Loans and advances 1853.67 2433.23 15.47 14.80
Total current assets 11980.41 16430.80 99.99 99.99
Less: Current Liabilities and Provisions
a) Current liabilities 1706.68 2238.77 14.25 13.63
b) Provisions 77.20 140.88 0.64 0.85
Total Current Liabilities 1783.88 2379.65 14.89 14.48
Net Current Assets 10196.53 14051.15 85.11 85.52
The analysis on the Common size statements made on Current Asset balance of Sakthi
Finance Limited is as below:
1. The total size of Current Assets is assets in any business enterprises. Further, the
case of financing companies is largely different from manufacturing companies.
In case of a manufacturing company, the current finances works to a relatively
smaller size when compared to fixed assets. In case of a financing company, it is
the opposite. The size of current assets over the past year has increased by about
37 percent in the case of the given company.
2. Among various Current Assets, the Stock in Hire Purchase Agreements
constitutes approximately 3/4th of the Total Current Asset Balances. While it is
68 percent in 1993, the same works out to 74 percent in 1994. Among the
remaining assets the stock of Stationery, Stamps, and Income Receivables
decrease both in absolute terms as well as in percentage terms, indicating the
reduction in locking up of capital in the said assets.
3. The size of loans and advances as well as cash and bank balance seems to grow
with the operations of the enterprise. However, their proportion seems to decline
during the current year.
4. Current Liabilities are expected to finance a part of Current Assets. In case of
Sakthi Finance Ltd., it is observed that the proportion of current liabilities to
current assets seems to maintain at 15 percent, leaving about 85 per cent of
current assets to be financed by long terms funds. Although there is a very
marginal decline in respect of these accounts it is not seriously recording any
improvement in reducing the net working capital balance during the study
period.
Thus this chapter provides the preliminary methods of analysing the Financial
Statements. The more advanced aspects of constructing ratios, and examining the flow
of funds position can be seen in future lessons.
7.7 SUMMARY
Financial Statements convey a lot of information to both the external as well as internal
users. Meaningful comparison can be drawn from a systematic analysis of the Financial
Statements by carrying out the Comparative Analysis, Trend Percentages as well as
constructing Common Size Statements. The construction of Comparative Statements
explores the periodic changes in various items listed in both Balance Sheet as well as in
Profit and Loss Account. These periodic changes could be analysed either in absolute
values or in terms of percentage changes. The Trend Percentage method tries to explore
into the possible trends in the operating performance of the enterprise through the
construction of Trend Percentages keeping one of the years' performance as the 'Base'.
Therefore, this method examines more number of years of information compared to the
earlier one. The Common Size Statement Analysis tries to provide an in-depth
examination of each of the Financial Statements by developing inter-relationship
between various items with one base figure. In case of Income Statement, the annual
Sales figure acts as the Base to find the proportionate changes in different costs and
the profit margins annually. Thus, these analysed figures of Financial Statements are
more meaningful for decision making.
7.8 KEY WORDS
Financial Statement Analysis: It is the study of relationships among various
financial factors as disclosed in two financial Statements with a view to draw trends and
inferences about the operating performance of the enterprise.
Comparative Financial Statement: Statement of Financial position of a business is
so designed to provide the time perspective.
Trend Percentages: Percentage relationship of an item in a Financial Statement with
that of the same item in a 'Base' year.
Common-size Statements: A statement in which each item of information is
expressed as a percentage to a specific 'target' items value.
7.9 EXERCISES
1. Bring out the importance of Financial Statement Analysis for different decision
makers in an organisation.
2. Compare and contrast the three different Financial Statement Analysis methods and
examine the relative merits of each method.
3. The Balance Sheet of Rolta India Limited for the years ending 30th June 1993 and
30th June 1992 are given below. Prepare a comparative Balance Sheet and comment.
BALANCE SHEET
30th June '93 30th
June '94
(Rs. Lakhs) (Rs.
Lakhs)
I. SOURCES OF FUNDS
1. Shareholders' funds
a) Equity capital 36,42,58,510 25,87,75,620
b) Reserves & Surplus
i) General Reserves 57,93,460 27,30,852
ii) Share Premium 18,30,76,220 -
iii) Surplus in Profit & Loss account 4,69,57,181 3,51,87,049
--------------------- ---------------------
60,00,85,371 29,66,93,521
--------------------- ---------------------
2. Loan funds
a) Debentures 1,03,36,000 6,90,00,000
b) Secured loans (other than debentures) 21,27,57,441 20,26,46,926
--------------------- ---------------------
22,30,93,441 27,16,46,926
--------------------- ---------------------
Total 1 and 2 82,31,78,812 56,83,40,447
II. APPLICATION OF FUNDS
1. Fixed Assets
a) Net block (original cost less dep.) 36,96,52,868 35,56,06,728
b) Capital work in progress 11,40,180 4,19,180
--------------------- ---------------------
37,07,93,048 35,60,25,908
--------------------- ---------------------
-
2. Investment in subsidiary companies
a) Quoted - -
b) Unquoted 4,56,85,056 -
Others
a) Quoted 1,23,55,803 1,04,47,580
b) Unquoted 14,39,600 14,39,600
------------------ ---------------------
5,94,80,459 1,18,87,180
------------------ ---------------------
3. (i) Current Assets, Loans & Advances
a) Inventories 20,78,28,095 13,51,56,124
b) Sunday debtors 10,21,66,468 6,11,30,707
c) Cash & Bank balance 1,49,87,264 2,28,64,793
d) Other Cr. assets 57,75,568 48,34,500
e) Loans & advance 12,49,59,370 3,24,92,946
------------------ --------------------
45,57,16,765 25,64,79
,070
------------------ --------------------
ii) Current Liabilities & Provisions
a) Liabilities 4,71,71,358 3,71,39,573
b) Provisions 4,64,19,410 3,88,31,681
------------------ ----------------------
9,35,90,768 7,59,71,254
------------------ -----------------------
Net Current Assets (i) + (ii) 36,21,25,997 18,05,07,816
4. Miscellaneous Expenditure 3,07,79,308 1,99,19,544
------------------ -----------------------
Total of 1 to 4 82,31,78,812 56,83,40,448
------------------ -----------------------
4. From the following accounting statements of the Great Eastern Shipping Company
Limited for the year ended 31st March, 94, carry out common size analysis.
BALANCE SHEET
31st March '94 31st
March '93
SOURCES OF FUNDS
Shareholder's Funds:
Capital 2,083,808,111 1,749,046,
803
Reserves &
Surplus 6,249,722,819 2,412,056,956
------------------ --------------------
-----
8,333,530,930 4,161,103,7
59
------------------ --------------------
------
Loan Funds
Secured
Loans 3,235,506,882 1,601,974,666
Unsecured
Loans 60,143,510 2,941,658
------------------ --------------------
-------
3,295,650,392 1,604,916,
324
------------------ --------------------
-------
Due to a foreign ship builder under
deferred payments
agreement _____ 134,343,958
------------------ --------------------
------
11,629,181,851 5,900,364,
021
------------------ --------------------
-------
APPLICATION OF FUNDS
Fixed Assets:
Less from block
depreciation 9,654,639,759 6,947,303,323
Net
Block 3,519,091,916 2,864,473,128
------------------ --------------------
-----
6,135,547,843 4,082,830,
197
Ship under acquisition/capital
WIP 437,269,202 6,067,280
------------------ --------------------
------
6,572,817,045 4,088,897,4
77
------------------ --------------------
------
Investment: 3,173,906,987 52,028,
898
Current Assets, Loans & Advances:
Inventories 332,657,612 291,159,2
24
Sundry debtors 1,007,786
669 388,686,264
Cash & Bank
balance 446,179,214 770,771,427
Other current
assets 126,322,823 50,081,738
Loans &
Advances 1,451,616,854 1,298,900,655
Incomplete
voyages 27,052,497 37,198,435
--------------------- ---------------------
------
33,916,157,669 2,836,797,7
43
--------------------- ---------------------
------
Less Current Liabilities & Provisions:
Current
liabilities 1,103,162,681 627,087,902
Provision 472,108,670 375,885,
057
Incomplete
voyage 70,382,513 91,237,868
--------------------- ---------------------
------
1,645,653,864 1,094,210,8
27
--------------------- ---------------------
------
Net current
assets 1,745,961,805 1,742,586,916
Misc. exp (to the extent not written
off) 136,495,485 16,850,730
exp. on issue of shares
--------------------- ---------------------
----
11,629,181,322 5,900,364,0
21
--------------------- ---------------------
-----
PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDING MARCH 1994
31st March '94 31st
March '93
(Rs.) (Rs.
)
Income
Operating
earnings 4,093,960,402 3,431,821,687
Turnover - Real estate
development 337,606,504 17,979,787
Turnover - Commodities
trading 366,827,173 78,544,044
Profit on sale of
ships 222,863,190 385,659,981
Other
income 383,104,348 594,256,775
--------------------- ---------------------
------
5,304,361,617 4,508,262,2
74
--------------------- ---------------------
------
Expenditure
Operating
expenses 2,237,885,637 2,360,969,573
Cost of sales - Real estate
development 159,327,749 3,964,734
Cost of sales - commodities
trading 260,520,106 78,434,301
Administration & other
expenses 230,412,599 166,048,346
Interest & guarantee
charges 233,550,307 192,944,637
Depreciation 814,844,917 200,718,
432
--------------------- ---------------------
-------
3,936,541,315 3,416,488,0
76
--------------------- ---------------------
-------
Profit before
tax 1,367,820,302 1,091,744,198
Less provision for wealthtax ----
2,009,000
Profit after
tax 1367,820,302 1089,735,198
Add year
adjustments 3,567,771 5,924,885
--------------------- ---------------------
----
1,371,388,073 1,095,660,0
83
--------------------- ---------------------
------
- End of Chapter -
LESSON - 8
CAPITAL BUDGETING I: INVESTMENT PROJECT AND CASHFLOW
FORECASTING
OBJECTIVES
After reading this lesson, you will be able to
Understand the importance of Capital Expenditure Decisions in an Enterprise
Identify the Capital Budgeting Projects and their basic Characteristics
Determine the Cash Flows which will be used in Evaluation of projects
Use Incremental and Differential analysis in estimating Cashflows.
STRUCTURE
8.1 Introduction
8.2 Resource Allocation: A basic function of a firm
8.3 Capital Budgeting: A long term planning decision
8.4 Examples of Capital Investment Projects
8.5 Capital Budgeting Process
8.6 Cashflow Estimation
8.7 Cashflow Forecasting
8.7.1 Incremental Analysis
8.7.2 Differential Analysis
8.7.3 Cash Savings
8.7.4 Estimation of cashflows: Additional Aspects
1. Taxes and cashflows
2. Depreciation shield and cashflow
8.8 Conclusion
8.9 Summary
8.10 Key words
8.11 Exercises
8.1 INTRODUCTION
There are three essential and fundamental decisions that an industrial enterprise must
continuously make if it is to survive. The first is to decide upon the 'objectives' of the
firm - what products and services to be produced, what changes in product lines to be
contemplated for strategic reasons, and how basically the firm has to go about doing
them. The second is concerned with whom to hire, retain which projects, to which
portfolios, in what amounts. All the other decisions are said to be derivatives based on
the above three, which generally determine the 'Success' and 'Survival'. Although one
can recognise the interrelation between all the above decisions, the third one of resource
allocation, generally 'sets' the thrust of the organisation. In this lesson we are going to
enquire into the wide range of issues associated with Capital Expenditure Decision.
8.2 RESOURCE ALLOCATION: BASIC FUNCTION OF A FIRM
Again there are three fundamental activities in which a firm engages in dealing with the
very important resource i.e., capital. These activities range from those by which a firm
secures the capital it needs (financing), those by which it employs its available capital
(investing) and those by which it generates financial returns of its invested funds
(producing). We have illustrated these activities in Figure 8.1.
Securing capital from investors and servicing these resources is called 'Financing'
function of a firm. While the funds mobilised from equity shareholders need payments
in the form of Cash Dividends, Bonus Shares, Preferential Rights to purchase additional
shares at below-market price, the capital secured from lenders needs payment of
'interest'.
Figure 8.1
The investment and production function of a firm covers a whole series of activities
associated with the identification of opportunities and which generate a return on
contemplated investment and appropriate deployment of funds. This function involves
decisions relating to issues like...
What plants to build?
Where should these be located?
What process to use?
How to equip the plants?
What products to make?
What capacity should the process carry?
What new product lines to venture into?
How to carry out diversification?
Typically all these activities require a firm to examine the proposed investment in terms
of 'required investment initially' and subsequently, its anticipated 'cashflows'.
8.3 CAPITAL BUDGETING: A LONG TERM PLANNING DECISION
Selection of profitable investment project is the most important long term planning
decision of a Finance Manager. The long term investments in different fixed assets and
investment proposals involve capital outlays which are expected to generate returns to
the firm over several years. Investments into long term assets like plant facilities,
computers, transportation vehicles and such, are expected to improve the productive
capacities and consequently the future survival of the enterprise. Firm's decision to
commit funds into various long term investments, therefore, draws considerable
significance since such decisions influence the future profitability of the firm,
shareholders' wealth and the direction of growth of the enterprise. Since the
investments involving acquisition of capital assets are very large as well as irreversible,
the firm should carry out long range planning, considering the 'business risks' and
'financial risks' involved in the process. All such long term plans regarding selection and
determination of profitable investment projects in which the firm intends to invest, is
aptly called 'Capital Budgeting'.
8.4 A FEW EXAMPLES FOR CAPITAL INVESTMENT PROJECTS
As managers take part in the planning process, they identify potential areas for further
investment. If, for example, the company management forecasts an increase in the
expected demand for their products, this will probably require expanded production. If
company's existing facilities are not enough to support such expansion, the increased
production calls for additional plant, equipment and facilities. Similarly if a firm
identifies a threat of product obsolescence because of newer technological developments
elsewhere, it may have to altogether abandon the present facilities and plan for totally
different product, involving larger outlays of investment on newer equipment, processes
and distribution channels. Further, the strategic considerations requiring the firm to
gain competitive advantage over rivals may require additional investments either in
expanding the product-line, or entering into tie-up agreements with ancillary units for
possible synergy benefits, or even pre-empting capacities with implicit cost-leadership
considerations.
Various types of investment projects that the firms undertake would attract specified
procedures of analysing them with careful cashflow estimation, evaluation and
implementation. Therefore let us illustrate the nature of a few project proposals.
1. Purchase of New Machinery: A company intends to acquire a new machinery to
equip its production process which is being manually processed so far. The new machine
is supposed to cost Rs. 100,000 and expected to save the current operating expenses to
the extent of Rs. 15,000 per annum over 10 years of its life. It is natural to analyse the
cost / benefit from this project before going for a final decision. Similar analysis is
needed whenever the firm intends to acquire real estates, patent rights etc.
2. Expansion of Product Lines: To increase the output of existing products or to
expand product lines or to expand distribution outlets or to strengthen distribution
facilities in markets now being served - all of these would involve capital expenditure.
For introduction of a new product, the company has to invest heavily on R & D followed
by heavy investments in manufacturing the same. The introduction of a new product
may require an initial outlay of Rs. 1,00,000 towards investment in new plant and
machinery and it is estimated that the introduction of this new line would fetch an
additional revenue of Rs.25,000 per annum. It is quite evidently known that a new
product would be new only for a few years irrespective of the capacity of the new plant
installed. In such a case, the decision of whether the product be introduced or not needs
evaluation.
3. Replacement of Existing Assets: Expenditure is necessary to replace worn-out
or less productive equipment with latest equipment needs evaluation. Similarly
selection of an alternative machine to perform certain process either on semi-automatic
way or on a fully automatic way requires comparison of outlays and benefits. Suppose
the company is considering to replace the existing plant with a new plant costing Rs.
1,00,000. The existing worn out plant is expected to give a scrap value of Rs. 20,000.
Then the new plant with a net value of Rs. 80,000 (1,00,000-20,000) is expected to
save operating expense to the tune of Rs. 10,000 compared to the earlier process. If the
new plant is having a life of 10 years the profitability of this investment is to be verified
for possible selection.
4. Lease versus Buy Analysis: A lease is a contract under which a company is
entitled to use an asset for a specified period. In consideration the user is required to
make periodic payments to the owner of the asset. If the company chooses to buy an
asset, it has to raise necessary capital resources either from within or from external
sources for which a periodic cost is to be made. But the potential advantages associated
with leasing, like easy acquisition of assets and off-balance sheet financing, make leasing
more attractive as compared to buying a capital asset.
5. Merger - Acquisition: Enlarging or improving production and distribution of
existing products or developing new products can be done either internally or externally.
Although internal expansion offers certain advantages, such as greater assurance of
technological compatibility, it requires a longer implementation period and
uncertainties in developing new products and new markets. External acquisition, on the
other hand, helps to acquire facilities or products desired at cheap price. However, each
move is to be weighed appropriately.
All the above issues illustrate different kinds of decisions which are covered under
investment decision making. Therefore, the proposals involving mechanisation,
replacement of assets, and introduction of new products require comparison of different
courses of action. The capital budgeting is a complex process that involves several
activities of searching for new profitable investments, marketing and production
analysis to determine the economic attractiveness.
8.5 CAPITAL BUDGETING PROCESS: KEY ISSUES
Capital budgeting decisions exert considerable influence on the profitability of a
company and on the stockholders' wealth. Companies undertake new investment
proposals to gain profitability in addition to many other considerations like strategic
and tactical, financial and operational aspects. The basic process of capital budgeting is
multidimensional, one which includes the formulation and articulation of firms' long
term goals - searching for profitable investment proposals, estimation of cashflows from
projects, determination of optimal project life, economic evaluation of alternative
projects, and monitoring of the post-implementation performance of projects.
1. Formulation of Long Term Goals: Capital investment decisions presuppose the
formulation of a set of long term goals of an organisation, which would serve as guide
posts for managerial decisions. Regardless of the projects being considered, the firm's
ultimate objective is to strive to secure the largest net return on investment on capital
employed in them so as to maximise the stock prices and, consequently, the
shareholder's wealth. However, many investment projects cannot be evaluated
completely in terms of monetary costs and benefits, for example, construction of
townships, and environment improvement equipment. Even in these cases, a systematic
evaluation of intangible benefits of them being consistent with the firm's long term goals
and costs of alternative investments would provide benchmark for evaluation projects.
2. Generating Investment Proposals: Identification of potential investment
proposals is a prerequisite for systematic capital budgeting. Proposals can originate in a
variety of ways. Search for investment opportunities may encompass the acquisition or
additions to existing production and marketing facilities. Therefore, much of the ideas
can be generated from executives involved, production managers, marketing analysts.
Large companies sometimes maintain project analysis divisions which actively search
for new ideas, projects and ventures. However, not all the proposals could be considered
to be prospective investment projects. For example, if a soft drink company
manufacturing a cola drinks plans to introduce a new orange drink (a proposal). It
would become a potential proposal only if the company can attract additional cashflows,
without affecting cashflows of other existing products. Incidently identifying and
generating investment proposals differ from industry to industry.
3. Cashflow Estimation: Estimating cashflows from an investment project is most
important and most difficult aspect of evaluating capital budgeting decisions. The
benefits generated in a project are its net cashflows which include all cash inflows and
cash outflows of the project, including the initial outlay of the project. The estimation of
cashflows from a project differs from concept of 'accounting profit', as the latter includes
certain non-cash expenditure items like depreciation. Cashflows are said to be
theoretically better measures, since investment analysis is concerned with finding out
whether future economic inflows are sufficiently large to warrant the initial investment.
8.6 CASHFLOW ESTIMATION
As noted earlier, an investment project is usually evaluated on the basis of cashflow
generated by the project over its life time. However, estimation of cashflows is most
difficult step as it requires the whole gamut of the steps involved in forecasting the
future demand for the product being produced, the revenues associated with it, which in
turn depend on forecasts of unit sales, sale prices, price elasticity, advertising effects,
state of the economy, competitors' movements, trends in consumer tastes, changes in
technology and innovation, and improved substitutes. Therefore, a major role for a
Finance Manager in capital budgeting is to forecast the cashflows that will occur during
the life of the project. Further, the cashflows are to be estimated for each alternative
considered in a decision. The cashflow estimation should also include cash outflows
resulting from each type of expenditure that will be made if an alternative is selected
and the cash inflows resulting from each type of receipt that will occur if the project is
undertaken.
For example, 'Investment Week', a supplement to Financial Express Daily, reports the
cost differentials associated with different manufacturing processes relating to man-
made textile units. Basically there are two alternatives involved in 'poly condensation'
process of conversion from polymer to chips to yarn. The one being the 'batch
processing' where the yarn is done in batches and the other is the 'direct melt spinning
process' which facilitates continuous processing of yam without interruption. The cost
saved through the second alternative is said to be around Rs.3 per Kg. Only three
companies in India, viz, Reliance Industries, DCL Polyesters and Sanghi Polyesters use
this process in manufacturing. This example examines the importance of evaluating the
differentials in cost (savings) among alternative investment projects.
Identification Cashflows: As in the above example, there are certain cashflows
within the firm over alternative processes which should be identified in addition to the
externally observable cash inflows in the form of additional revenues. This necessitates
one to make separate efforts for identifying relevant cashflows rather than incomes
reported in Accounting Statements. For instance, in accounting statements, profits are
arrived at by deducting both cash and non-cash expenses, while cash expenses like,
labour cost, rent and taxes, etc., neatly indicate the cash outflow. Certain expenses like
depreciation do not involve any cash outflow. Since we are interested in comparing the
gross benefits generated by an investment proposal with its initial outlay to validate the
profitability of such a project, deduction of a part of the outlay in the form of
depreciation from revenues subject to cost-benefit comparison spoils the purpose.
Therefore, the estimation of relevant cashflows needs a careful analysis of costs with
suitable modification to accounting profits.
The estimates of cashflows thus may be made by adding back all non-cash expenses to
accounting net profit. Since, depreciation is the only major non-cash expense, the cash
inflows during a period 't' (CFt) could be denoted as...
CFt = Accounting Income + Depreciation
Accounting income for any project is to be calculated similar to the procedure followed
in preparation of Financial Statements of a firm, by deducting all relevant costs
associated with the operation of the said project. However, the interest expense should
not be deducted in obtaining the projects' net income. The said logic can be shown as
follows:
Let SR be Sales Revenue; OC be Operating Costs paid out in cash; Dp be Depreciation, a
non-cash cost; T be Tax rate; and PNI be Projects' Net Income. Then,
Sales Revenue SR
Less Operating Costs OC
Less Depreciation Dp
_________________
Net operating income SR-OC-Dp
Less Corporate Tax T
__________________
Projects Net Income PNI
__________________
The term when rearranged, gives PNI = [SR - OC - Dp] [1 -T] ...(8.1)
or
PNI = [SR - OC] [1 -T] - Dp[1 - T]
PNI = [SR - OC] [1 -T] - Dp + TDp
PNI + Dp = [SR - OC] [1 -T] + TDp
Since PNI + Dp = CFt,
CFt = [SR - OC] [1 - T] + TDp ...(8.2)
Thus the cash flows during a specific period, (CFt) consists of (a) After Tax Net
Operating Revenue, plus (b) Tax Rate times Annual Depreciation. Equation 8.2 focuses
on an additional dimension to the size of cashflows with TDp term. The tax bracket in
which the firm is presently operating at and the depreciation policy adopted by the firm
seem to play their role on the size of cashflows. This aspect needs further examination.
8.7 CASHFLOW FORECASTING
Capital budgeting with investments into various long term projects generally involve
comparison of current and near future capital outlays with that of flow of benefits in
future. Therefore, cashflow forecasting necessarily becomes a must. The essential
aspects involved in cashflow forecasting are as follows:
Incremental Analysis
Differential Analysis
Cash Savings
8.7.1 Incremental Analysis: Many a times, an investment project is likely to add to
the costs and benefits of the existing operations. Manufacturing business unit is likely to
add additional plants to its operations. Trading and retailing stores may likely decide on
opening another chain store. A transport services corporation is likely to decide on
purchasing another transportation vehicle or loading or an unloading equipment. In
each of these decisions, the investment projects are likely to add to the operations. In
such cases projects are evaluated based on those aspects which will change the costs and
revenues if the investment is made. Such an evaluation is called incremental analysis.
8.7.2 Differential Analysis: Sometimes, a finance manager is likely to decide on
mutually exclusive project proposals. For example, in case of a manufacturing business,
management may have to decide on which of the two machines they should purchase. In
such a case two cashflows are to be estimated for each machine for possible comparison.
The differential analysis states that the net cashflows from one alternative are to be
subtracted from the net cashflows of the second alternative and then the differential
cashflows are used in project evaluation process.
8.7.3 Cash Savings: In many cases acquisition of additional capital assets are likely to
result in cash savings due to reduction in certain existing cash outflows. The new
equipment is likely to allow the firm to produce the product at a lower operating cost
either by replacing huge wage bill with a smaller one or by substantial cut in power and
fuel expenses or a few other cash costs. An efficient equipment is sometimes likely to
produce more and bring down the unit cost of operating expense and thus the relative
size of cost of production. In such cases the projects are evaluated based on cash savings
generated.
In estimating the cashflows, the following aspects are to be given due care:
* Inclusion of Incidentals - Investment projects, sometimes, are likely to
enhance or detract the profitability of some existing activities, because of their
complementary effects. Therefore, these incidental aspects are also to be
considered along with Direct cashflows.
* Sunk costs are to be ignored - Sunk costs refer to the outlays that have
already been committed. Suppose a departmental store has acquired land in a
possible market corner, say a decade back, keeping the future business expansion
and growth possibilities in mind. The acquisition cost would become the sunk cost
for present analysis if the firm is planning to start a branch office in the given site.
The incremental analysis of estimating cashflows should ignore the land
acquisition cost in evaluating the present proposal.
* Opportunity costs are to be included - If an investment project employs
some of the resources available within the firm, the cost of such useful resources
are to be computed and included in examining the operating revenues of the
project. For example, if the new proposal is likely to use some spare capacity in
manufacturing a new product, the cost of gainful alternative use of even spare
capacity is to be taken into consideration.
An example of cashflow forecast
Medicaps management has discovered that they can replace a machine currently used in
their production process with a new machine that will require lower expenditure for
electricity and maintenance than the current one. The currently used machine is
expected to be useful for next five years and the proposed new machine is also expected
to work for 5 years.
Under incremental analysis, cashflows of using the new machine indicate only the cost
savings in electricity, usage and maintenance costs. The other operating costs need not
be considered since the new machine is not likely to bring about any difference in usage
of materials, labour or other cash expenses.
Suppose the Medicaps management has observed that the current expenditure on
electricity and maintenance of the existing machinery is Rs.25,000 per year. If the
replacement machine is acquired, these expenses are expected to be around Rs. 17,000
per year. The capital outlay required for the new machine is Rs.32,000. The old machine
if sold today is likely to fetch Rs.7,000 (it is effected only in case the new machine is
acquired). On assuming that there is no salvage value in case of both the machines, the
incremental cashflows of the two alternatives could be shown as in Table 8.1. The cash
outlays at the time of acquisition are generally shown in year zero. In case of the
alternative machine, the outlay of Rs.32,000 is adjusted for the possible cash inflow of
Rs.7,000 which will be received if the old machine is sold.
TABLE 8.1
INCREMENTAL ANALYSIS FOR TWO ALTERNATIVE PROPOSALS IN
MEDICAPS LTD
Year
Continue with old
machine
Replacing with new
machine
0 0 (25,000)
1 25,000 17,000
2 25,000 17,000
3 25,000 17,000
4 25,000 17,000
5 25,000 17,000
Although these incremental figures could help in evaluating the two alternatives,
differential analysis is likely to reduce these figures by subtracting all incremental
cashflows of the first alternative from those of the second alternative. In differential
analysis the net change in cash flows are considered if the company considers replacing
old machine with new machine. Table 8.2 shows the differential cashflows.
TABLE 8.2
DIFFERENTIAL CASHFLOWS FOR MACHINE REPLACMENT DECISION IN
MEDICAPS LTD
Year Differential cashflow
0 (25000)
1 8,000
2 8,000
3 8,000
4 8,000
5 8,000
The above differential cashflows also indicate the cash savings from alternative project.
The cashflows shown in the above table, however, do not represent the cash inflows,
since no one will pay the company Rs.8,000 per annum. These figures indicate the
reduction in cash operating expenditure.
8.7.4 Estimation of Cashflow: Additional Aspects: Now that we are clear on
identifying the cashflows from an investment project, let us look into the additional
factors which are likely to influence the size of cashflow in a real world of taxes and
inflation.
i) Taxes and cashflows - It is well known that the corporate taxes are real cash
outflows which must necessarily be taken into account while evaluating a project's
desirability. Although the corporate tax rate T differs among firms, the incremental
cashflows are likely to be affected by the Tax Savings that result from project's
depreciation shield.
In order to determine the after-tax net cashflows from the operations of an enterprise,
let us look into rates of income tax that are applicable in Indian conditions. As per
Indian Income Tax Act (1969), a company is liable to pay income tax on its total income
at a flat rate except on incomes for which special rates have been prescribed.
Rates of Income Tax Applicable for the Assessment Year
1993-94
I. In case of a Domestic Company: Rate
a) Widely held company 45%
b) Closely held company 50%
(If total income exceeds Rs. 75,000, a surcharge of 15% of Income Tax
to be paid)
II. In case of other than Domestic Company: Rate
a) On Royalty income 50%
b) On Technical Service Fees 50%
c) On Balance Income 65%
However, these tax rates are subject to change, from year to year based on the provision
of Finance Bills of Government of India.
The after tax cashflows from operations can easily be estimated by multiplying the net
cashflows by (1 minus the marginal tax rate). This is equal to the
After tax cashflow = CF x (1 - T)
Tax rate is multiplied by cashflow from operations for the project and the result of this
multiplication is subtracted from the cashflows to arrive at after-tax cashflows. For
example, consider a Project X requiring an initial outlay of Rs.1,00,000 with a life of 8
years. And if the firm is in a tax flat rate of 50 per cent, the following cashflows are to be
adjusted with a factor of (1- 50) to arrive at after-tax cash flows from the project.
TABLE 8.3
BEFORE TAX CASHFLOWS OF PROJECT X
Year Net Cashflow Description
0
1-5
6
7-8
(1,00,000)
35,000
20,000
15,000
Initial outlay
Net operating saving
Major / overhaul work to plant
Net operating cash flows after overhaul of
plant
TABLE 8.4
AFTER OPERATING CASHFLOWS OF PROJECT X
1-5
6
7-8
35,000 x (1 - 0.50) = 17,500
20,000 x (1 - 0.50) = 10,000
15,000 x (1 - 0.50) = 7,500
Net operating saving
Tax operating savings
Cash flows after repair
Generally we do not compute after-tax cash flows for initial outlays of a project because
it is adjusted for taxes through annual depreciation. However, a major overhaul or
repair expenditure leading to substantial additional doses of capital flow into the project
is adjusted for tax since such expenditure is not capitalised as well as repair expenses
are tax deductable.
ii) Depreciation shield and cashflow - Depreciation is subtracted as an eligible
expenditure purposes. As mentioned earlier depreciation is actually not a cash outflow
but provides a tax shield through reduced tax burden. You may recall that the after tax
cashflows are by adding back the deprecation to after-tax operating profits.
CFt= (SR - DC - Dp) (1 -T) + Dp ...(8.3)
Alternatively the post tax cashflows are also shown as
CFt = (SR - OC) (1 - T) + TDp ...(8.4)
The TDp term indicates the tax shelter. A firm in a high tax bracket as well as with an
optimal depreciation policy can magnify this term.
In India, although the Companies Act 1956 is silent on the size of depreciation that the
companies can show annually over the years, Section 205 positively makes it clear that
the dividends should not be declared without providing for depreciation on various
Fixed Assets. Of the popular methods of depreciation, the well recognized ones are
'straight line method' and 'reducing balance method'. Section 32 of Income Tax Act,
however, has a list of eligible assets to claim depreciation as well as the rates of
depreciation applicable.
Further the rates of depreciation marginally differs across different 'blocks' of assets
(from the Assessment Year 1992-93) categorised by the Act. In many cases the 'declining
balance method' is in vogue and the rate of depreciation is to be calculated on Written
Down value (WDV) basis. The rates of depreciation, in force at present are as under.
RATE OF DEPRECIATION UNDER IT ACT
Block of Assets Item Rates
I Building
a) Used for residential
b) Other than residential
c) Hotels
d) Temporary erection
5% of WDV
10%of WDV
20% of WDV
100% of WDV
II Furniture & Fittings
a) General rate
b) Special rate for hotels
cinema houses marriage halls
10% of WDV
III Machinery and plant a) General rate
25% of WDV
(33% until recently)
b) Special rates for transport
vehicles used in business
40% of WDV
c) Energy saving device 100% of WDV
V Ships a) Ocean going 20% of WDV
b) Inland waterways 10% of WDV
The tax savings from depreciation shield continues in each year in which depreciation is
deducted from the project. The depreciation shield thus provides cash in addition to net
operating savings. For example, if the Project X referred to in earlier section is likely to
attract an annual depreciation of 25 per cent as Written Down Value (WDV) on
Declining Balance method for '8' years, the after tax cashflows from the Project can be
shown as follows:
TABLE 8.5
AFTER TAX CASHFLOWS OF PROJECT X
0 (1,00,000) Initial outlay
1-5 35,000 x (1 - 0.50) = 17,500 Net operating savings
6 (20,000) x (1 - 0.50) = (10,000) Major Repairs /overhaul work
7-8 15,000 x (1 - 0.50) = 7,500 Operating savings after repair work
1-8*
25,000 x (1 - 0.50) = 12,500
18,750 x (1 - 0.50) = 9,375
14,060 x (1 - 0.50) = 7,030
10,550 x (1 - 0.50) = 5,215
7900 x (1-0.50) = 3,950
5,959 x (1 - 0.50) = 2,975
4,450 x (1 - 0.50) = 2,225
3,340 x (1 - 0.50) = 1,670
Depreciation Tax shield
8 10,010 WDV of the Project (Salvage Value)
*The calculation of depreciation is on declining balance method. Let WDV be the
amount of declining balance after 't' years, IO be the initial outlay of the project, and Dt
the depreciation charged to the Profit and Loss account during the t
th
year; then 'rd'
rate of depreciation eligible as per taxation laws is determined as follows:
WDV1 = IO - IO x rd = IO (1 - rd)
WDV2 = WDV1 - WDV1 x rd = WDV1 (1 - rd) = IO (1 - rd)
2
WDVt = WDVt-1 - WDVt-1 x rd = WDVt-1 (1 - rd) = IO (1 - rd)
n
... (8.5)
and
Dt = WDVt-1 rd = IO rd (1-rd)
t-1
... (8.6)
Example on estimating cashflows
In order to provide additional care and longevity to the quality of milk and other dairy
products, M/s Dempo Dairy - a subsidiary of Glaxo India - plans to purchase a magnetic
scanner. Management has narrowed down the decision to two suppliers.
Standard Electric Company will provide a machine that requires a cash operating cost of
Rs. 1,20,000 per year. The initial cash outlay for this machine is Rs. 6,10,000 with an
expected life of 6 years. At the end of 6 years the technological advances are likely to
make the machine obsolete so that the salvage value will be Rs.40,000.
The other supplier, Spectra Innovation Incorporation offers a machine that will require
cash operating expenses of Rs. 1,00,000 per annum. This machine requires an initial
cash outlay of Rs.6,50,000. The Dempo Dairy management also expects that this
machine will obsolete at the end of 6 years. It is expected to bring Rs.50,000 at the end
of its life.
M/s Dempo Dairy is at present in 40 percent tax bracket and expecting that its turnover
would rise to Rs.2,50,000 per annum subsequent to the installation of the scanner.
Assuming a straight line depreciation on the machine, prepare an estimate of the
differential cashflow if the Dairy is planning to favour the Spectra Innovations.
STEP I: Tabulate the given information
Standard Electric
Company's Scanner
Spectra Innovation
Corporation's Scanner
Initial Outlay 6,10,000 6,50,000
Terminal value 40,000 50,000
Expected life 6 years 6 years
Cash operating costs over its life 1,20,000 p.a. 1,00,000 p.a.
Expected increase in annual
turnover
2,50,000 p.a. 2,50,000 p.a.
Assuming straight line depreciation and a tax rate of 50%, the relevant cashflows are to
be computed.
STEP II: Calculate differential cashflows
The given projects being mutually exclusive and the management preferring the Spectra
Innovation's Scanner, the differential cashflows are as follows:
Initial outlay (Rs.)
Standard Electric Company's
Scanner
6,10,000
Spectra Innovation
Corporation's Scanner
6,50,000
Additional Cashflow 40,000
STEP III: Cashflows estimation
TABLE 8.6 (Cash inflows estimated)
Year
Cash operating expenses saved
in machine supplied by Spectra
Innovations over standard
Electric Co.
Tax liability
on expenses
saved
Benefits
after tax (2)
- (3)
Difference in
depreciation
charges
Tax deductibility of
such additional
depreciation
Total cash benefits of
Spectra Innovation
machine over Standard
Electric (4) + (6)
(1) (2) (3) (4) (5) (6) (7)
1 20000 10000 10000 5000 2500 12500
2 20000 10000 10000 5000 2500 12500
3 20000 10000 10000 5000 2500 12500
4 20000 10000 10000 5000 2500 12500
5 20000 10000 10000 5000 2500 12500
6 20000 10000 10000 5000 2500 12500
TABLE 8.7 (Differences in cash flows - alternative way)
Particulars
Spectra
Innovation
Scanner
Standard
Electric
Scanner
1st Year: Rs. Rs.
Sales 2,50,000 2,50,000
Cash operating expenses 1,00,000 1,20,000
Depreciation* 1,00,000 95,000
Taxable income 50,000 35,000
Tax 50% 25,000 17,500
Net income after tax 25,000 17,500
Add depreciation 1,00,000 95,000
Cashflow 1,25,000 1,12,500
Differential cashflows 12,500 p.a.
* Depreciation for Spectra Innovation Machine is calculated as 1/6 of (6,50,000 -
50,000) = 1,00,000
and depreciation for Standard Electric Machine is calculated as 1/6 of (6,10,000 -
40,000) = 95,000
8.8 SUMMARY
It is clear from the above discussion that capital budgeting is an important long term
decision in any organisation. Identification of investment projects, and evaluating their
viability and implementation, constitutes the basic steps in Capital Budgeting process.
The estimation of cash inflow upon investing a sizable outlay in an investment project
occupies an important dimension. Cash inflows differ from the size of additional profits
generated. Cashflow forecasts are generally done by Incremental Analysis or Differential
Analysis. Since depreciation is a non-cash cost, it incidentally provides a tax shield in
arriving at the after-tax cashflows.
8.9 KEY WORDS
Capital budgeting: A budgeting decision whether or not to undertake a capital project
or which of the several investment projects should be initiated.
Incremental Analysis: An approach to support the managerial decision-making
which requires that only cashflows are expected to be different among the alternatives
considered.
Differential Analysis: An approach to compare two investment projects in which the
cashflows from one project are subtracted from the other.
Depreciation shield: The possible reduction in taxable income due to depreciation.
8.10 EXERCISES
1. Define 'Capital Budgeting' and illustrate some of the investment projects that these
organisations could consider: a) a manufacturing firm, b) a departmental store, and c) a
hotel chain.
2. What is the difference between Incremental Analysis and Differential Analysis? For
what types of capital budgeting decisions would you use a) Incremental analysis b)
Differential analysis?
3. Explain how cash savings, in terms of after tax are to be affected by 'Depreciation Tax
shield'.
4. M/s Blowplast has Rs.2,00,000 to spend on one of the two capital projects. They
intend to undertake one of the projects. The first one is to purchase a new piece of
equipment for Rs.2,00,000 that will allow them to produce more units and increase
sales. This machine is expected to have an 8-year life. Units produced using new
equipment will increase Blowplast's annual turnover by Rs. 1,75,000. The cash
operating expenses will increase by Rs. 1,15,000 if the new equipment is purchased and
used. The second project is to replace one of Blowplast's existing machines. The
replacement is also expected to cost Rs.2,00,000. Both the existing and the replacement
machines are expected to be operative for 8 more years. Cash operating expenses
associated with the existing machine is Rs.96,000 which are likely to come down on
replacement to Rs.52,000.
Determine the estimated cashflows for each of these projects.
5. GEC Alstom is very environment conscious. The management is looking at the
possibility of buying a machine that would permit them to recycle their raw material
scraps and hence reduce the amount of material discarded as garbage. Recycling raw
material will save Rs.23 per tonne of raw material processed. To purchase this machine
will require an initial outlay of Rs.80,000. Annual Salary for an employee to operate the
machine will be Rs.20,000. Electricity and other variable costs are expected to be Rs.3
per tonne of raw material processed. The company estimates that they can process
2,00,000 tonnes per year for 4 years to come. The machine is eligible for straight line
depreciation over its life and presently the company is in 40% tax bracket.
Determine the estimated cashflow for each year over the capital project's life.
- End of chapter -
LESSON 9
CAPITAL BUDGETING II: TIME VALUE OF MONEY AND COST OF
CAPITAL ESTIMATION
OBJECTIVES
After reading this lesson, you will be able to:
Understand the implications of Time Value of Money
Learn the procedure to find the future values and present values of cashflows
Make use of PV tables for evaluating the cashflows of a project
Appreciate the component costs involved in estimated cost of capital
Estimate overall weighted average cost of funds used for investment projects
STRUCTURE
9.1 Introduction
9.2 Interest, Interest Factors and Time Value of Money
9.2.1 Interest rate and Compound Amount Factors
9.2.2 Present Value Factors
9.2.3 Annuities and Compounding
9.2.4 Present Value of Annuity Factors
9.3 Present Value Tables: How to use them?
9.4 Discounting Rate and Cost of Capital
9.4.1 Cost of Capital for Specific Sources
a. Cost of Debt Capital
b. Cost of Preference Shares
c. Cost of Equity Capital
d. Cost of Retained Earnings
9.4.2 Overall Cost of Capital
9.5 Summary
9.6 Keywords
9.7 Exercises
Appendix: Present Value Tables
9.1. INTRODUCTION
The economic analysis of a 'project' involves the study of economic data and deciding on
whether the given 'project' is acceptable to the firm. In other words, the management
needs to decide whether a 'project' should be executed by the firm to become a part of
productive assets of the firm or should it be rejected for lack of viability. All this requires
a stipulation of a decision rule for accepting or rejecting 'Investment Projects'.
Usually, the elementary ideas that revolve in the minds of those who are having little
knowledge of basic economics is the evaluation of an investment project in terms of its
earning capacity over and above the rate of investment that one should repay on the use
of funds borrowed for financing the investment outlay. Although the interest rates in an
economy are generally determined by market conditions, the knowledge of its
measurement would owe to appreciate the Time Value of Money. Further, a large
project is not always financed from one source of borrowing, therefore, the
measurement of costs involved in servicing various sources of finance, nevertheless,
adds a new dimension to the process of examining the project's viability.
In this lesson let us concentrate on the measurement of the interest rate being a factor
for adjusting the cashflows of an investment project as well as the issues involved in
estimating the overall cost of capital of funds used for financing the projects.
9.2. INTEREST, INTERST FACTORS & TIME VALUE OF MONEY
It is well known that most financial decisions associated with acquisition of investment
projects would affect the cashflows over different time periods. A capital investment
decision involves the comparison of present outlays with future benefits, therefore, the
problem relating to the timing of receipts always lies at the very centre of Capital
Budgeting decision. While weighing the desirability of an investment proposal, the
timing of cashflows in addition to the magnitude of relevant cashflows would draw due
consideration. How could the Time Value of Money play a prominent role? How to
measure and adjust it? To clear this issue let us consider an example.
Suppose a project requires an initial outlay of Rs. 1,00,000 which would generate
Rs.1,10,000 by the end of its 1-year life. Is it a worthwhile project? Will the project be
able to attract an investment of Rs. 1,00,000 against its return of Rs. 1,10,000 after a
year? To find the answers, one can consider an alternative use of Rs. 1,00,000. Suppose
we could earn an interest of 12 percent by depositing in a commercial bank, the return
from such an investment could be around Rs. 1,20,000 after a year. In such a case, the
proposed investment outlay in the project is not worthy compared to a bank deposit.
A rupee of today is not equivalent to a rupee to be received in future as long as there
exists an alternative of earning a positive return on the rupee during the interim period.
A theoretical base for the Time Value of Money has been embodied in traditional
interest theory developed by Irving Fisher and extended by J. Hirshleifer against a
backdrop of a set of assumptions like perfectly competitive financial markets with no
transaction costs and instant information. Fisher identifies that the interest rates are
being established by capital market for valuing the inter temporal transfer of funds. As
an example, one may consider a trade-off in the following way -- An individual can forgo
spending Rs. 100 of this year's income in exchange for spending Rs. 110 next year. Here,
the exchange can be thought of as lending present consumption of Rs. 100 in an inter
temporal capital market in order to receive an increased income of Rs.110. Alternatively
one can think of foregoing Rs.110 of next years income in order to increase present
consumption through borrowing.
9.2.1 Interest Rate and Compound Amount Factors
It is now clear that the interest rate is simply the market price for intertemporal
exchange of funds. In such a case a project evaluation involving a time horizon needs the
use of interest factor while estimating the present value of its future cash flows.
Suppose the relevant alternative return, say the market rate of return from a project as a
businessman looks at it, or the market price for inter temporal exchange of funds as
suggested by an economist, is denoted as 'i', then we can show the future value of a sum
to be
Pn = P0 (1 + i)
n
... (9.1)
where, Pn is the future value of sum after 'n' years, P0 is the sum value at present, and i is
the market rate of interest.
This formula is similar to compound interest rate formula that we have studied at our
high school level.
Well, let us consider a simple bank loan example to recollect back the calculation of
'compound interest sum'. Suppose you have borrowed Rs. 10,000 from a commercial
bank at an interest rate of 10% per annum compounded annually. Po is the present
amount borrowed (received), i is the rate of interest, Pn is the amount to be repaid
(inclusive of interest) at the end of period t1. Then,
P1 = Po + Po x i (Total interest = Principle x Interest rate)
or
P1 = Po (1 + i)
In the example, the amount to be paid by the end of 1st year is:
P1 = 10,000 + (10,000 x 10%) = 11,000
Similarly,
P2 = P1 + P1 x i (Since interest is to be calculated an outstanding balance)
or
P2 = P1 (1 + i), but P1 = P0(1 + i), so
P2 = Po (1 + i) (1 + i)
P2 = Po (l + i)
2
TABLE 9.1
STEPS INVOLVED IN CALCULATING COMPOUND AMOUNT
End of
Period
Amount at the beginning of
period
Interest during the
period
Compound amount at the end of
period
1 P0 i x P0 P1= Po + Poi = Po(1 + i)
2 Po(1 + i) i x Po(1 + i) P2 = P1(1 + i) = Po(1 + i)
2
3 Po(1 + i)
2
i x Po(1 + i)
2
P3 = P2(1 + i) = Po(1 + i)
2
(1 + i)
= P0(1 + i)
3
-
-
-
n Po(1 + i)
n-1
i x Po(1 + i)
n-1
Pn = Po(1 + i)
n
The generalized relationship of Pn = Po(1 + i)
n
indicates that the future amount after n
number of years would be equal to the principal amount Po times (1 + i) raised to the
power of 'n' number of years. The term (1 + i) is commonly called as 'Future Value
Factor'.
Illustration 9.1
The fixed deposit scheme of Indian Bank offers the following interest rates.
Period of Deposit Rate per Annum
46 days to 180 days 8.0%
180 days to 1 year 10.5%
1 year and above 11.0%
Solution
Suppose an individual has invested Rs. 10,000 for 3 years, what would be total amount
he gets at the time of maturity of the fixed deposit?
Rate of interest for deposit period more than 1 year (i) = 11.0%
Principal amount (P0) = Rs. 10,000
Pn or Future Value = P0 (1 + i)
n
P3 = 10,000 (1 + 11%)
3
= 10,000 x (1.11)
3
= 13,676
Maturity value of the deposit at the end of 3rd year = Rs. 13,676.
Illustration 9.2
South Indian Bank offers a Cash Certificates Scheme, wherein deposits are accepted for
periods ranging from 6 months to 10 years. Interest, however, is added quarterly. The
rate of interest ranges from 8% for all deposits made for less than 1 year, 9% for deposits
made fort one year to two years, and 10% for deposits made for longer than 2 years. An
individual has deposited Rs. 10,000 for two years.
What will be the total sum at the end? Suppose an individual has invested Rs. 10,000 for
3 years, what would be total amount he gets at the time of maturity of the fixed deposit?
Solution
Since the interest is calculated quarterly, the future value formula is to be adjusted to
accommodate this policy.
Let m = number of times interest is calculated in a year.
Then,
FV = P0(1 + 1/m)
mn
= 10000(1 + 1/4)
4x2
(since the interest is added quarterly, it means the interest is
calculated 4 times in a year)
= 10000(1 + 0.025)
8
= 10000 (1.025)8 = 10000 x 1.2184 = Rs. 12184
So, the future value of Rs.10000 in this scheme after 2 years is Rs.12184
9.2.2. Present Value Factor
Having recalled the knowledge of High School mathematics especially the 'compound
interest formula' let us see its predominant implication on project evaluation. With a
slight modification to the said generalised compounding formula, one can arrive at a
present value of a future sum. It is popularly called 'discounting formula'. Evaluation of
an investment proposal requires comparison of cash outflows with a stream of cash
inflows. Unless the outflows and inflows (likely to accrue) at different time points are
made comparable by bringing them to a common platform of 'present values' against a
time preference discounting rate, such comparison would not be meaningful. Then, the
present value of a future sum could be found out with the help of following formulae:
Po = Pn [1 /(1 + i)
n
] ... (9.2)
or
Po = Pn (1 + i)
-n
(1 + i)
-n
is known as 'present value factor' or 'discounting factor' and 'i' is called 'discount
rate'.
An example of the use of this 'factor' to find the present value of a future sum of Rs.
16100 that occurs at the end of 5th year at an interest rate of 10% could be...
Po = 16100 [1/(1 + 0.10)
5
] = 16100 [1 / (1.1)
5
] = 16100 / 1.61051 = Rs.9997 ~ Rs. 10000.
The present values of a future stream of benefits that one can receive from a project
proposal would allow one to compare cash flows of different points of time. In order to
facilitate the calculations, readymade present value tables are available for different
time periods and at different discounting rates. A sample of such a PV table is given
below:
Table 9.2
PRESENT VALUE FACTORS FOR Re [1 /(1 + i)
n
]
Years
Discount Rate (i)
1% 5% 10% 15% 20%
1 0.990 0.952 0.909 0.870 0.833
2 0.980 0.907 0.826 0.756 0.694
3 0.971 0.864 0.754 0.658 0.579
4 0.961 0.823 0.683 0.572 0.482
5 0.951 0.784 0.621 0.497 0.402
The above listed present value factors could be better understood if one can carefully
observe the Figure 9.1 wherein the present values of a future rupee has been worked out
at 10% discount rate.
FIGURE 9.1
PRESENT VALUES OF A FUTURE Re 1/- AT 10 PERCENT DISCOUNT RATE
Present Value (P0)
Future Values (Pn) at
t1 t2 t3 t4 t5
Re 1 Re 1 Re 1 Re 1 Re 1
1 / (1 + 0.10)
1
= 0.909 <----| | | | |
1 / (1 + 0.10)
2
= 0.826 <----- ----| | | |
1 / (1 + 0.10)
3
= 0.751 <----- ----- ----| | |
1 / (1 + 0.10)
4
= 0.683 <----- ----- ----- ----| |
1 / (1 + 0.10)
5
= 0.621 <----- ----- ----- ----- ----|
A commonly used present value table with lengthier period for different discounting
rates has been provided at the end of this lesson.
9.2.3 Annuities and Compounding
In case of certain project estimates, a series of uniform amounts could have been
estimated at the end of each period for several consequent periods. Such a uniform
series of flows are often called as 'Annuities'. The calculation of 'future values' and
'present values' for such annuities could be carried out in a simpler way as given below
compared to an uneven stream.
When a flow of Rs. A occurs at the end of each period t= 1 to t=n, the future value of the
total stream, FVn at the end of n
th
period could be obtained by summing the future
values of each of the 'n' flows of amounts of A each time.
FIGURE 9.2
FUTURE VALUES OF ASTREAM OF ANNUITIES
Yearly Annuities Future Values
A1 A2 A3 An-2 An-1 An - A(1 + i)
0
= A = An or
FVn
An-1(1 + i)
1
= FVn-1
An-2(1 + i)
2
= FVn-2
A3(1 + i)
n-3
= FV3
A2(1 + i)
n-2
= FV2
A1(1 + i)
n-1
= FV1
In the above set of calculation, the sizes of annuities are similar. Hence, the equation for
a sum of these annuities at a future date is:
FVn = A[(1 + i)
0
+ (1 + i)
1
+ (1 + i)
2
+ ... ... ... + (1 + i)
n-1
] ... (9.3)
The value within the brackets of the above equation looks like a geometric series with a
variable of (1 + i). Multiplying both sides by (1 + i) term, the equation could be extended
to n
th
term and then sum of first n terms of this kind of equation could easily be found
accordingly.
FVn (1+i) = A[(1 + i) + (1 + i)
2
+ ... ... ...+ (1+i)
n
] ... (9.4)
On subtracting 9.3 from 9.4, we get
FVn (1 + i) - FVn = A[(1 + i)
n
- (1 + i)
0
] = A[(1 + i)
n
- 1]
Solving for FVn, we get
FVn = A [ (1 + i)
n-1
- 1 ] ... (9.5)
i
The equation 9.5 could help us in finding a Future Sum of an Annuity. The terms in
bracket are called Annuity Interest Factor.
Illustration 9.3
Under postal recurring deposit scheme, a fixed sum could be deposited every month on
or before a specified due date for any period of 12 to 120 months. The deposit attracts a
rate of interest of 9% per annum if it is for two years and 10% beyond that. However the
interest is calculated quarterly. The depositor is expected to remit the fixed sum before
the due date, failing which the said quarter's interest will not be added to the sum.
An individual, in order to meet a lumpsum obligation by the end of next year, has
started depositing Rs.500 p.m. Calculate the sum available to him by the end of 12
months.
Solution
Monthly recurring deposit = Rs.500 p.m.
Rate of interest applicable = 9% (compounded quarterly)
Let us calculate monthly interest rate after adjusting for quarterly compounding effect:
Monthly interest rate = 0.0931 / 12 = 0.78%
Since deposits represent annuities, using equation 9.5,
= 500 x 12.53 = Rs.6,625
Therefore, one gets Rs.265 towards interest on his deposit of Rs.500 x 12 = Rs. 6000
9.2.4 Present Value of Annuity Factors
Certain investments are likely to yield fixed periodical returns. For example, the UTI's
Monthly Income Scheme provides fixed returns for its subscribers. Similarly if a Mutual
Fund invests its resources either in the form of debentures or convertibles, the rate of
return from such an investment is almost fixed over time. In the same way, if a 'project'
is expected to generate a fixed sum of returns, the present value of such a uniform series
of annuities could be of importance to the investor to find the worthiness of the
investment. An appropriate present value factor or a discounting factor in case of such
annuities could be found as follows:
As per equation 9.1 we know the Future Value formula as Pn = Po(l + i)
n
and similarly, in
case of annuities, the formula, as per equation 9.5 is
= Po(1 + i)
n
So,
The equation 9.6 provides the present value factor for an annuity series.
An example to apply this present value factor would be to find the present value of
getting Rs.1000 annually for 5 years at an interest rate of 10% compounded annually, as
below:
= 3791
In order to quicken the calculation work, annuity present value factor tables are
available in which the values for the term [(1 + i)
n-1
/ i (1 + i)
n
] are given for different
interest rates 'i' and for different periods of time 'n'. A proforma of such Table is given
below.
Table 9.3
PRESENT VALUE OF AN ANNUITY OF Re 1 AT THE END OF 'n' TIME
PERIODS
Years
Discount Rate (i)
1% 5% 10% 15% 20%
1 0.9901 0.9524 0.9091 0.8698 0.8333
2 1.9704 1.8594 1.7355 1.6257 1.5278
3 2.9410 2.7232 2.4864 2.2832 2.1065
4 3.9020 3.5460 3.1694 2.8550 2.5887
5 4.6534 4.3295 3.7908 3.3522 2.9906
A clear meaning of these present value annuity factors could be seen in the Figure 9.3.
FIGURE 9.3
PRESENT VALUE OF FUTURE ANNUITIES OF Re 1 EACH AT 10%
DISCOUNT RATE
Future annuities at the end Present Value sum
t1 = 1 t1 = 2 t1 = 1 t1 = 1 t1 = 1
t2 = 1 t2 = 2 t2 = 1 t2 = 1 |
t3 = 1 t3 = 1 t3 = 1 | |
t4 = 1 t4 = 1 | | |
t5 = 1 | | | |
0.0901
1.7355
2.4869
3.1699
3.7908
An exhaustive Table for these Annuity Factors is provided in Appendix to this Lesson.
9.3 PRESENT VALUE TABLES: HOW TO USE THEM?
Illustration 9.4
Hindustan Electro Graphites at Madhya Pradesh is considering a plan to use the hot
gases of 900
o
C from its two furnaces by capturing these gases to produce steam. It is
estimated that such a project would produce 10 MW of power at nil cost except for a
capital investment of Rs.20 crores. This is likely to reduce its costs and expected to add
to its bottomline. The expected reduction in costs over a period of five year are Rs.10 Cr,
Rs.8 Cr, Rs.12 Cr, Rs.10 Cr, and Rs.7 Cr. Find the present value of future cashflows (cost
savings) in order to take a decision on venturing into the said project.
Solution
Let us find the present value of the stream of cashflows at a time preference market rate
of 10 percent.
TABLE 9.4
CALCULATION OF PRESENT VALUES FOR CASHFLOWS USING TABLE
VALUE
Year
Cashflow (in Rs.
Crores)
Present Value
Factor @10%
Present Value of
cashflows (Rs. Crores)
1 10 0.909 9.090
2 8 0.826 6.608
3 12 0.751 9.012
4 10 0.683 6.850
5 7 0.621 4.347
Total 35.907
Po = 35.907 Cr.
The present value of future stream of cash flows from the proposed project is Rs.35.9
Crores.
Illustration 9.5
M/s Seshasayee Papers Ltd. of Tamil Nadu has made a breakthrough in the use of
'Lignite' instead of 'Coal' as fuel during recent past. However, the change in fuel is
warranting the company to bring a change in its technology by switching over to the
Fludised Bed (FB) technology. It is estimated that this change would cost Rs.7 crores
(inclusive of installation costs). With this contemplated change in fuel and with new
technology, it is expected that there would be a substantial reduction in fuel costs to the
tune of Rs.300 per ton of lignite used. The company is presently using 1 lakh tonnes of
lignite and it is estimated that similar consumption would prevail for next 5 years.
You are required to express the company's savings in terms of their present worth in
order to facilitate the design on proposed change in technology used at the company. As
per the illustration, M/s Seshasayee is likely to generate cashflows equivalent to Rs.300
x 1,00,000 tonne of lignite used, i.e. Rs.3 Crores cash savings annually for 5 years to
come. Considering a discounting rate of 15 percent per annum, the present value of full
stream of annual benefit of Rs.3 crores for five years would be...
= A [ (1+0.15)
5
- 1] / 0.15(1+0.15)
5
Using Present Value Annuity Tables, we can solve it as follows...
= Rs. 3 Cr x 3.3522 (Present Value Annuity Factor @ 15% for 5 years)
= Rs. 10.06 Crores
Thus the present value of fuel 'cost savings' due to the use of new technology in M/s
Seshasayee Papers Ltd. would be Rs. 10.06 Crores.
9.4 DISCOUNTING RATE AND COST OF CAPITAL
Investment appraisal through the use of discounted cashflow method requires a time
preference rate to be employed in finding out the present value of cashflows. The time
preference rate used to discount the future expected cashflows is called as 'discount rate'
or 'market rate of return' on alternative investments. But the question regarding
considering an appropriate discount rate is quite complicated issue. Could it be
determined arbitrarily? Should it be the rate at which the firm can borrow to invest in a
project? Should it be the current rate of return on capital employed? These are some of
the issues which require close observation.
A firm may naturally set a 'target rate of return' in appraising the investment proposals
which ordinarily will be not less than the cost of funds invested in a project. In addition,
it is prudent to believe that such a rate of return should be at least equal to the
opportunity cost? What can be earned if the funds were invested elsewhere with similar
risk? Higher the risk of the project being undertaken, it is logical to expect higher rate of
return to compensate the additional risk. Then the target rate of return or the required
rate of return from a project could be the sum of risk-free rate of return plus a 'risk
premium'. Therefore, investment projects are to be evaluated against a minimum
required rate of return which would mostly be equal to the average cost of funds.
The cost of funds or 'cost of capital' is the cost that the company has to pay to the market
for different sources of finance. Such cost would simply be the interest rate in case of
borrowed funds (LT debt, Debentures, Loans or Bonds); specific rate of dividend in case
of preference share capital; expected 'cash dividend' during current year and growth in
dividends plus a 'capital gain' in future to the tune of expectations of shareholders in
case of equity capital; and an opportunity cost in terms of average earnings that
shareholders could earn in case the firm pays cash dividend instead of ploughing back of
profits in the cost of retained earnings or reserves. Although the determination of cost of
capital in case of borrowed funds and preference share capital is easy. The estimation of
cost of equity and retained funds is quite difficult as the latter depends on the relative
changes in market prices of shares.
As most projects are financed through varied sources of funds mobilised by the firm, the
cost of capital required to be used as a discounting rate is not the source-wise cost. It
should be equal to the weighted average of cost of all sources, the weights being the
proportion of each source in the total capital structure of the firm. However, in order to
measure the firm's overall cost of capital, it is necessary to consider the costs of specific
methods of obtaining capital to begin with.
9.4.1 Costs of Capital for Specific Sources
The specific sources from which a firm principally derives funds include debt,
preference, equity and retained earnings. Although no firm employs a specific source of
financing for one project and another specific source for another project, the calculation
of overall cost of capital presupposes the calculation of cost of specific sources of funds.
Cost of capital of any source of financing is to be viewed as the interest rate that a lender
expects for his investment. In such a case the explicit cost of any source is the discount
rate which equates the present value of funds received by the firm (net of flotation costs)
to the present value of future outflow of funds. Such cashflows may be in the form of
interest, repayment of principal, dividends or redemption at premium. Then cost of
capital of any source can be found out by solving the following equation for r.
... (9.7)
where, Sc = Amount of funds received from specific sources
Fc = Flotation costs of underwriting, brokerage etc.
CFt = Cash outflows in the form of service cost t = 0,1 n.
RMc = Redemption value of funds from specific source, if any.
r = Explicit cost of capital for the given source.
Further, the estimation of incremental cost of capital in addition to historical average
cost is of prime importance to a firm which is planning to raise new capital for financing
all new ventures.
a) Cost of Debt Capital
Use of borrowed capital in addition to the funds mobilised from equity holders has had a
strategic importance in Financial Management. Use of fixed interest bearing or less
costly sources of funds in the capital structure of a firm is likely to magnify the earnings
of the firm through leverage benefits. Firms borrow from varied sources. While short
term loans are often obtained from commercial banks either in the form of Open Lines
of Credit or Overdraft or from Money Market from short term instruments like
'Commercial Paper'; the long term loans are raised from public through different forms
of debentures or from Financial Institutions like IFCI, SFCs, IDBI, etc. The major cost
that a firm incurs to this source of financing its investment projects is the 'interest'
expenditure. However the 'interest' cost is an eligible business expenditure for income
tax purposes. Then the major outflows associated in estimating 'Cost of Debt Capital'
(Kd) include the after tax cashflow of interest payments, plus the 'Principle' repayment
at the end of the life of the instrument. The net proceeds of the loan, however, are to be
adjusted for flotation and underwriting costs, if any. Incorporating these inflows and
outflow in equation (9.7) and solving for 'r' yields the required cost of borrowed capital.
In more general terms, the Cost of Debt Capital (Kd) can be arrived at from following
equation, where
i = Compound rate of interest,
m = number of compounding periods per year,
Kd = after tax cost of debt capital,
T = tax rate
Kd = [(1 + i/m)
m
- 1 ] (1 - T) ... (9.8)
Illustration 9.6
Velvette International Pharma Products Ltd., the third largest shampoo manufacturer
has mobilised funds from debentures at a coupon rate of 12 percent per annum, and
interest to be paid quarterly over seven-year life of the investment. If the company is in a
tax bracket of 45 percent what is the effective after-tax cost of such debentures for VIPP
Ltd.
Solution
From equation 9.8,
Kd = [(1 + 0.12/4)
4
- 1] (1 - 0.45)
= (0.1255) (1 - 0.45)
= 0.069
= 7.0%
The debt instruments often have fixed maturity period. Bonds are sometimes issued
either at premium or at discount or redeemed either at par value or at a premium. The
issues relating to these aspects are generally made clear at the instance of the very issue
of the redeemable debentures or convertible debentures (debenture holders are given
offer to convert their loan to the company into equity shares after a specific time at a
specific exchange price in case of convertible debentures). When the future redemption
value (F) of a debt instrument differs with the issue price (P), then the discount or
premium components are eligible for annual amortisation at a uniform rate of 1/N over
the life of the instrument. Then net cash outflow including interest becomes
COF= [I + 1/N (F-P)] (1 - T) ... (9.9)
The approximate after-tax cost of debt capital would be
... (9.9A)
where, (F + P)/2 is the average amount of debt outstanding.
b) Cost of Preference Shares
Until recently many Indian companies used to raise capital by issuing preference shares.
Preference shareholders are generally assured of a pre-fixed preferred dividend,
whenever the company makes a profit. Although the prominence of the use of
preference capital has reduced substantially, few companies still carry preference capital
in their capital structure. Two important issues involved in measuring the cost that the
firm incurs to service preferred stock is the preferred dividend and it is not tax
deductible as interest expenditure. Further, many a time, preference shares are issued
without a stated maturity date. In such a case the cost of funds mobilised from this
source is just the rate of pre-fixed preference dividend.
Although it is not mandatory to pay preference dividend, firms prefer to pay it promptly
to maintain the informational value and consequent market rating.
The cost of preference capital (Kp) thus becomes the rate of preferred dividend (Dp)
paid over the net proceeds of capital mobilised after adjusting for flotation costs (f).
... (9.10)
For example, if a firm raises 12% preference capital (Rs. 100 par value and could realise
net proceeds of Rs.96 per share, net of flotation costs, then the cost of preference shares
would be Kp = 12/96 = 0.125
The Kp is not to be adjusted for taxes, unlike Kd, as preference dividends are not tax
deductible.
c) Cost of Equity Capital
Firms finance a major part of their capital requirements through equity capital. Equity
constitutes the owners' stake. Unlike interest payment on debt capital, the firm has no
fixed or legal obligation to pay dividends to equity holders. However, shareholders
invest in a company with an expectation to receive dividends either in cash or in stock.
The rate of expected dividend may vary between industries as well as with different
market swings. Further, the expected return on their investment decides the market
price for equity at market place. Therefore, the cost of equity would be the required rate
of return which would equate the present value of the expected dividends with the
market value of each share. Many a time, the expected stream of dividends may not be a
constant sum but may include a growth component. Incorporating these expected
dividends there are few theoretical models to construct the cost of equity capital.
(i) Simple Dividend Valuation Model
If one believes that equity shareholder is willing to invest to the extent of the
intrinsic worth of the investment, the presently traded price (value) of a share (PJ)
should be equivalent to a stream of future dividends (Di), i.e.,
... (9.11)
... (9.11A)
or
Ke = D / P0 ... (9.11B)
Thus, the cost of equity capital approximates to dividend - price ratio.
(ii) Growth in Dividend Models:
No company pays the entire earnings in the form of dividends. A specific
proportion of earnings are generally retained for future growth and expansion
without resorting to outside borrowings. Even the policy of retention of earnings is
expected to increase the earnings of the shareholders in future years. If a firm
retains a constant proportion of its earnings (say 'b') and hopefully reinvests at an
rate (r) internally, the future dividends could be expected to grow (g) at a rate
equivalent to the product of the percentage of retention and internal rate of return
i.e. g = rb.
More specifically, the future dividend is expected to grow at a rate i.e., D1 = Do (1
+ g). If the rates of retention and reinvestment rates are assumed constant over a
period of time, the equation (9.11) can be rewritten as
... (9.12)
... (9.12A)
Multiplying both sides of the above equation with (1+Ke) / (1+g), we get...
... (9.12B)
When equation 9.12A is subtracted from equation 9.12B, we get...
When the Ke > g, and n --> infinity, the terms in brackets on the RHS of the above
equation tens to 1....
The cost of equity under the expectations of growth in dividend, thus simply
contains an additional term of 'g' to equation 9.11 B. This explanation has been
developed by Garden and Shapiro as well as Solomon in their research.
d) Cost of Retained Earnings
As noted earlier, every firm retains a portion of its annual profits for future
expansion and growth. The retained funds could freely be used for financing,
rebuilding of existing assets, or for undertaking newer projects. At the outset,
these funds are totally free of cost to the firm, since the retained earnings are
internally generated. However, if one carefully looks, these funds do carry an
implicit cost in the form of opportunity benefit that the shareholders have lost for
having allowed the firm to retain the earnings which otherwise belong to them.
In the absence of corporate and individual taxation and brokerage costs, the cost
of retained earnings is the cost of equity capital itself i.e., Ke, since in the absence
of internal funds, a firm is made to obtain the necessary funds either through
rights issue or new public issue of equity. In such a sense, the firm is expected to
generate returns equivalent to the opportunity benefits that the shareholders could
have presumably found in stocks of other companies with the retained part of their
earnings. However, although the said argument sounds theoretically well, the
presence of personal taxation on cash dividend income and brokerage costs
involved in acquiring new share capital leave lower investible income in the hands
of shareholders for alternative courses to retention by the firm. Then the cost of
retained earnings (in terms of alternative benefits) would definitely be lower than
the 'Ke'. But in the absence of any closely measurable taxation effects and
opportunity rates of return, cost of retained earnings is almost regarded as
equivalent to 'Ke'.
9.4.2 Overall Cost of Capital (Ke)
As noted earlier the ultimate cost of capital for use in capital budgeting is not the
individual source-wise 'cost' but the overall cost of capital for the firm. Such overall cost
of capital is generally arrived at by combining individual sources by weighing each
source to their respective proportion in the total capital structure.
Ko = Wd Kd + Wp Kp + We Ke + Wr Kr ... (9.14)
where Ko = overall cost of capital, Wi = Weightage of the individual sources of capital
(weights being their relative proportions in the total capital structure)
Illustration 9.6
The following is the capital structure of M/s Hindustan Polymers Ltd. as on March 1994.
The estimated costs for different sources computed based on a scientific way are given
here under. Calculate the weighted average cost of capital.
Solution
Source Amount After tax cost
Debentures Rs.15,00,000 6.00%
Preferred stock Rs.15,00,000 12.00%
Equity share capital Rs.60,00,000 16.00%
Earnings retained Rs.10,00,000 16.00%
The historical cost of capital of the firm using weighted average method, weights being
relative proportions of each source in total capital could be calculated as follows:
TABLE - 9.5
CALCULATION OF WEIGHTED AVERAGE COST OF CAPITAL (Ko) IN
HINDUSTAN POLYMERS LTD
Source Amount Proportion Explicit cost Weighted cost
Debentures 15,00,000 0.15 0.0600 0.009
Preferred stock 15,00,000 0.15 0.1200 0.018
Equity share capital 60,00,000 0.60 0.1600 0.096
Retained earnings 10,00,000 0.10 0.1600 0.016
Overall cost of capital (Ko) = 0.139 = 14%
The above method of computing combined cost of capital helps in arriving at the
historical cost of raising capital. However, in capital budgeting decisions, Finance
Manager is much concerned about the cost of new funds to be raised to finance newer
projects. In such a case, the average cost arrived, based on historical book values, may
not really provide an answer. Hence, it is desirable to estimate the incremental or
marginal cost of capital as and when the firm intends to raise additional investments.
The calculations of marginal cost of capital can be show with the help of following
illustration.
Illustration 9.7
Usha Martin Industries Ltd. of Calcutta, a manufacturer of Carbon Alloy Steel billets has
the following capital structure as on 1990.
Source Amount
Equity capital (50 lakh shares @ 10/- each
Preference capital (12% Pref shares of Rs. 100 each)
Reserves and Surpluses
12% Debentures
Long term loans from Financial Institutions (@18%)
500
60
1000
1200
240
Total 3000
The EPS = 6 and share price is around Rs.50. The company is planning to raise Rs.2000
lakhs to finance its expansion programme. Now that Rs. 1000 lakhs of reserves are
available with the firm, the company is proposing to raise the remaining capital
requirements from preference and debenture holders equally. Assuming the component
costs are not likely to change, estimate the average (historical) cost of capital.
Solution
TABLE - 9C
COMPUTATION OF AVERAGE AND INCREMENTAL COSTS OF CAPITAL IN
USHA MARTIN INDUSTRIES LTD
Source
Amount Proportion After
tax cost
Weighted
cost (Rs. Lakhs)
Equity capital 500 0.17 0.12* 0.0204
Pref. capital 60 0.02 0.12 0.0024
Reserves and Surplus 1000 0.33 0.12 0.0396
12% Debentures 1200 0.40 0.06 0.0240
LT loans 240 0.08 0.09 0.0072
3000 1.00 K0
=
0.0936
Incremental cost
Equity/reserve 1000 0.50 0.12 0.060
Pref. capital 500 0.25 0.12 0.030
Debenture 500 0.25 0.06 0.015
2000 1.00 Ko = 0.105
*Cost of equity is calculated as EPS/MPS = 6/50 = 0.12
Thus the estimated marginal cost of capital is relatively higher than the average cost of
capital. A firm can use its marginal cost of capital as the minimum required rate of
return while evaluating the investment proposals.
9.5 SUMMARY
In this chapter, we have understood the simple concepts of Time Value of Money. The
concept of Future Value and the Present Value basically depends on compound interest
rate computation procedure. Estimation of present value of future stream of benefits
would be helpful in project evaluation as projects involve generation of a stream of
cashflows over their life at different time periods. The discounting rate that one has to
use in bringing down the future cashflows to their present value is called the 'cost of
capital'. Since a project's viability is to be judged against a minimum cost that the
company has to pay for the sources from which project is financed, estimation of
individual source-wise cost as well as combined cost needs close observation. The cost of
debt is simply the explicit interest rate. Cost of preferred stock is the coupon rate of
dividend; cost of equity, however, is the expected dividend as well as the growth in it to
commensurate with the market going rate. The overall cost is the combined cost of each
of these sources in the capital structure and the averaging is done based on their relative
proportions. Further, the estimation of incremental cost of capital is likely to provide
more meaning in project evaluation exercise.
9.6 KEY TERMS
Time value of Money: The future value of any present sum when invested at current
market rate of interest. It is also called Time Preference rate.
Discounting factor: The interest factor which equates the present value of a sum with
a future sum.
Annuity: A series with similar sized cashflows over a specific life of an investment.
Cost of Capital: A minimum required rate of return that the funds used in an
investment earn in order to justify the use of such funds in the said investment proposal.
Coupon rate: Fixed explicit rate of servicing cost on a specific source of finance agreed
on the face of the instrument itself.
9.7 EXERCISES
1. Bring out the importance of Time Value adjustment of future stream of cashflows in
project evaluation exercise.
2. What is cost of capital? Explain its importance in capital budgeting decision making.
3. Ms. Padmini wants to invest Rs.25,000 in either of the two plans available. Plan A
offers 14% rate of interest calculated semi-annually for a period of 3 years while plan B
offers to double the amount invested by the end of year 5. Calculate the effective annual
rates of interest implicit in plans A and B.
4. HCL has the following capital structure, which it considers optimal:
Bonds 7% Rs.3,00,000
Pref. stock (Rs.500 each ) Rs.2,40,000
Common Stock Rs.3,60,000
Retained Earnings Rs.3,00,000
Dividends on common stock are currently at Rs.3 per share and are expected to grow at
a constant rate of 6%. Market price per share of common stock is Rs.40 and the
preferred stock is selling at Rs.50. Flotation costs on new issues of common stock is at
10 percent. The interest on Bonds is paid annually. The company's tax rate is 40 percent.
Calculate the weighted average cost of capital.
5. Zed Enterprises has the following capital structure:
Debt (Term Loan @ 14%) Rs. 5 lakhs
Equity Rs. 2 lakhs
Retained Earnings Rs. 1 lakh
The market value of equity as on 31.3.94 is Rs.5 lakhs. The dividend declared in 1993
was Rs.2 per share. The growth rate of dividend is 5% and this growth rate is expected to
continue. The market price per share as on 31-3-94 is Rs.40. The cost of issuing external
equity is 2%. The tax rate of the company is 50 percent. Calculate the weighted average
cost of capital using Book Value and Market Value proportions.
APPENDIX I
Values of the Standard Normal Distribution Function
z 00 01 02 03 04 05 06 07 08 09
0.0 0000 0040 0080 0120 0160 0199 0239 0279 0319 0359
0.1 0398 0438 04 78 0517 0557 0596 0636 0675 0714 0753
0.2 0793 0832 0871 0910 0948 0987 1026 1064 1103 1141
0.3 1179 1217 1255 1293 1331 1368 1406 1443 1480 1517
0.4 1554 1591 1628 1664 1700 1736 1772 1808 1844 1879
0.5 1915 1950 1985 2019 2054 2088 2123 2157 2190 2224
0.6 2257 2291 2324 2357 2389 2422 2454 2486 2517 2549
0.7 2580 2611 2642 2673 2704 2734 2764 2794 2823 2852
0.8 2881 2910 2939 2967 2995 3023 3051 3078 3106 3133
0.9 3159 3186 3212 3238 3264 3289 3315 3340 3365 3389
1.0 3413 3438 3461 3485 3508 3531 3554 3577 3599 3621
1.1 3643 3665 3686 3708 3729 3749 3770 3790 3810 3830
1.2 3849 3869 3888 3907 3925 3944 3962 3960 3997 4015
1.3 4032 4049 4066 4082 4099 4115 4131 4147 4162 4177
1.4 4192 4207 4222 4236 4251 4265 4279 4292 4306 4319
1.5 4332 4345 4357 4370 4382 4394 4406 4418 4429 4441
1.6 4452 4463 4474 4434 4495 4505 4515 4525 4535 4545
1.7 4554 4564 4573 4582 4591 4599 4608 4616 4625 4633
1.8 4641 4649 4656 4664 4671 4678 4G86 4693 4R99 4 706
1.9 4713 4719 4 726 4732 4738 4744 4750 4 756 4 761 4767
2.0 4772 4778 4783 4788 4793 4 798 4803 4808 4812 4817
2.1 4821 4826 4830 4834 4838 .4842 4846 4850 4854 4857
2.2 4861 4864 4868 4871 4875 4878 4881 4884 4887 4890
2.3 4893 4896 4898 4901 4904 4906 4909 4911 4913 4916
2.4 4918 4920 4922 4925 4927 4929 4931 4932 4934 4936
2.5 4933 4940 4941 4943 4945 4946 4948 4949 4951 4952
2.6 4953 4955 4956 4957 4959 4960 4961 4962 4963 4964
2.7 4965 4966 4967 4968 4969 4970 4971 4972 4973 4974
2.8 4974 4975 4976 4977 4977 4978 4979 4979 4980 4981
2.9 4981 4962 4982 4982 4964 4984 4985 4985 4986 4986
3.0 4987 4987 4987 4988 4988 4989 4989 4989 4990 4990
APPENDIX II
Present Value of one Rupee
Periods
until
Payment
1% 2% 2.5% 3% 4% 5% 6% 8% 10% 12%
1
2
3
4
5
0.990
0.980
0.971
0.961
0.951
0.980
0.961
0.942
0.924
0.906
0.976
0.952
0.929
0.906
0.884
0.971
0.943
0.915
0.888
0.863
0.962
0.925
0.889
0.835
0.822
0.952
0.907
0.864
0.823
0.784
0.943
0.890
0.840
0.792
0.747
0.926
0.857
0.794
0.735
0.681
0.909
0.826
0.751
0.683
0.621
0.893
0.797
0.712
0.636
0.567
6
7
8
9
10
0.942
0.933
0.923
0.914
0.905
0.888
0.881
0.853
0.837
0.820
0.862
0.841
0.821
0.801
0.781
0.837
0.813
0.789
0.766
0.744
0.790
0.760
0.731
0.703
0.676
0.746
0.711
0.677
0.645
0.614
0.705
0.665
0.627
0.592
0.558
0.630
0.583
0.540
0.500
0.463
0.564
0.513
0.467
0.424
0.386
0.507
0.452
0.404
0.361
0.322
11
12
13
14
15
0.896
0.887
0.879
0.870
0.861
0.804
0.788
0.773
0.758
0.743
0.762
0.744
0.725
0.708
0.690
0.722
o.7o1
0.681
0.661
0.642
0.650
0.625
0.601
0.577
0.555
0.585
0.557
0.520
0.505
0.481
0.527
0.497
0.469
0.442
0.417
0.429
0.397
0.268
0.340
0.315
0.350
0.319
0.290
0.263
0.239
0.287
0.257
0.229
0.205
0.183
16
17
18
19
20
0.853
0.844
0.736
0.828
0.820
0.728
0.714
0.700
0.686
0.670
0.674
0.657
0.641
0.626
0.610
0.623
0.605
0.587
0.570
0.554
0.534
0.513
0.494
0.475
0.456
0.458
0.436
0.416
0.396
0.377
0.394
0.371
0.350
0.331
0.312
0.292
0.270
0.250
0.232
0.215
0.218
0.198
0.180
0.164
0.149
0.104
0.146
0.130
0.116
0.104
21
22
23
24
0.811
0.803
0.795
0.788
0.660
0.648
0.634
0.622
0.595
0.581
0.567
0.553
0.528
0.522
0.507
0.492
0.439
0.422
0.406
0.390
0.359
0.342
0.326
0.310
0.294
0.278
0.262
0.247
0.199
0.184
0.170
0.158
0.135
0.323
0.112
0.102
0.093
0.083
0.074
0.066
25 0.780 0.610 0.539 0.478 0.375 0.295 0.233 0.146 0.092 0.059
26
27
28
29
30
0.772
0.764
0.757
0.749
0.742
0.598
0.586
0.574
0.563
0.552
0.526
0.513
0.501
0.489
0.477
0.464
0.450
0.437
0.424
0.412
0.361
0.347
0.333
0.221
0.308
0.281
0.268
0.255
0.243
0.231
0.220
0.207
0.196
0.185
0.174
0.135
0.125
0.116
0.107
0.099
0.084
0.076
0.069
0.063
0.057
0.053
0.047
0.042
0.037
0.033
40
50
0.672
0.608
0.453
0.291
0.372
0.228
0.307
0.228
0.205
0.141
0.097
0.054
0.046
0.021
0.022
0.009
0.011
0.003
Periods
until
Payment
14% 15% 16% 18% 20% 22% 24% 25% 26% 30% 40% 50%
1
2
3
4
5
0.877
0.769
0.675
0.592
0.519
0.870
0.756
0.658
0.752
0.497
0.862
0.743
0.641
0.552
0.476
0.847
0.718
0.609
0.516
0.437
0.833
0.694
0.579
0.482
0.402
0.820
0.672
0.551
0.451
0.370
0.806
0.650
0.524
0.423
0.341
0.800
0.640
0.512
0.410
0.328
0.794
0.630
0.500
0.397
0.315
0.769
0.592
0.455
0.350
0.269
0.714
0.510
0.364
0.260
0.186
0.667
0.444
0.296
0.198
0.132
6
7
8
9
10
0.455
0.400
0.351
0.308
0.270
0.432
0.376
0.327
0.284
0.247
0.410
0.354
0.005
0.263
0.227
0.370
0.314
0.266
0.225
0.191
0.335
0.279
0.233
0.194
0.162
0.303
0.249
0.204
0.167
0.137
0.275
0.222
0.179
0.144
0.116
0.262
0.210
0.168
0.134
0.107
0.250
0.198
0.157
0.125
0.099
0.207
0.159
0.123
0.094
0.073
0.123
0.095
0.068
0.048
0.035
0.088
0.059
0.039
0.026
0.017
11
12
13
14
15
0.237
0.208
0.182
0.160
0.140
0.215
0.187
0.163
0.141
0.123
0.195
0.168
0.145
0.125
0.108
0.162
0.137
0.116
0.099
0.084
0.135
0.112
0.093
0.078
0.065
0.112
0.092
0.075
0.062
0.051
0.094
0.076
0.061
0.049
0.040
0.086
0.069
0.055
0.044
0.035
0.079
0.062
0.050
0.039
0.031
0.056
0.043
0.033
0.025
0.020
0.025
0.038
0.013
0.009
0.006
0.012
0.008
0.005
0.003
0.002
16
17
18
19
20
0.122
0.108
0.095
0.083
0.073
0.107
0.093
0.081
0.070
0.061
0.093
0.080
0.069
0.060
0.051
0.071
0.060
0.051
0.043
0.037
0.054
0.045
0.038
0.031
0.026
0.042
0.034
0.028
0.023
0.019
0.032
0.026
0.021
0.017
0.014
0.028
0.023
0.018
0.014
0.012
0.025
0.020
0.016
0.012
0.010
0.015
0.012
0.009
0.007
0.005
0.005
0.003
0.002
0.002
0.001
0.002
0.001
0.001
21
22
23
24
25
0.064
0.056
0.049
0.043
0.038
0.053
0.046
0.040
0.035
0.030
0.044
0.038
0.023
0.028
0.024
0.031
0.026
0.022
0.019
0.016
0.022
0.018
0.015
0.013
0.010
0.015
0.013
0.010
0.008
0.007
0.011
0.009
0.007
0.006
0.005
0.009
0.007
0.006
0.005
0.004
0.008
0.006
0.005
0.004
0.003
0.004
0.003
0.002
0.002
0.001
0.001
0.001
26
27
28
29
30
0.033
0.029
0.026
0.022
0.020
0.026
0.023
0.020
0.017
0.015
0.021
0.018
0.016
0.010
0.012
0.014
0.011
0.010
0.008
0.007
0.009
0.007
0.006
0.005
0.004
0.006
0.005
0.004
0.003
0.002
0.004
0.003
0.002
0.002
0.002
0.003
0.002
0.002
0.002
0.001
0.002
0.002
0.002
0.001
0.001
0.001
0.001
0.001
40 0.005 0.004 0.003 0.001 0.001
50 0.001 0.001 0.001
APPENDIX III
Present of value of an Annuity of Re One
Periods
until
Payment
1% 2% 2.5% 3% 4% 5% 6% 8% 10% 12%
1
2
3
4
5
0.990
1.970
2.941
3.902
4.853
0.980
1.942
2.884
3.808
4.713
0.976
1.927
2.856
3.762
4.946
0.971
1.914
2.829
2.717
4.580
0.962
1.886
2.775
3.630
4.452
0.952
1.859
2.723
3.546
4.330
0.943
1.833
2.673
3.465
4.212
0.926
1.783
2.577
3.312
3.993
0.909
1.736
2.487
3.170
3.791
0.893
1.690
2.402
3.037
3.605
6
7
8
9
10
5.795
6.728
7.652
8.566
9.471
5.601
6.472
7.325
8.162
8.893
5.508
6.349
7.170
7.971
8.752
5.417
6.230
7.020
7.786
8.530
5.242
6.002
6.733
7.435
8.111
5.076
5.786
6.463
7.108
7.722
4.917
5.582
6.210
6.802
7.360
4.623
5.206
5.747
6.247
6.710
4.357
4.868
5.335
5.759
6.145
4.111
4.564
4.468
5.328
5.650
11
12
13
14
15
10.368
11.255
12.134
13.004
13.865
9.787
10.575
11.348
12.105
12.849
9.514
10.258
10.983
11.691
12.381
9.253
9.953
10.635
11.296
11.938
8.760
9.385
9.986
10.563
11.118
8.306
8.863
9.394
9.899
10.380
7.887
8.384
8.853
9.295
9.712
7.139
7.536
7.904
8.244
8.559
6.495
6.814
7.103
7.367
7.606
5.938
6.194
6.424
6.628
6.711
16
17
18
19
20
14.718
15.562
16.398
17.226
18.046
13.578
14.292
14.992
15.678
16.351
13.055
13.712
14.353
14.979
15.589
12.561
13.166
13.754
14.324
14.877
11.652
12.166
12.659
13.134
13.590
10.838
11.274
11.690
12.085
12.462
10.106
10.477
10.828
11.158
11.470
8.851
9.122
9.372
9.604
9.818
7.824
8.022
8.201
8.365
8.514
6.974
7.120
7.250
7.366
7.469
21
22
23
24
25
18.857
19.660
20.456
21.243
22.023
17.011
17.658
18.292
18.914
19.523
16.185
16.765
17.332
17.885
18.424
15.415
15.937
16.044
16.936
17.413
14.024
14.451
14.857
15.247
15.622
12.821
13.163
13.489
13.799
14.094
11.764
12.042
12.303
12.550
12.783
10.017
10.201
10.371
10.529
10.675
8.649
8.772
8.883
8.985
9.077
7.562
7.645
7.718
7.784
7.843
26
27
28
29
30
22.795
23.560
24.316
25.066
25.808
20.121
20.707
21.281
21.844
22.396
18.951
19.464
19.965
20.454
20.930
17.877
18.327
18.764
19.188
19.604
15.983
16.330
16.663
16.984
17.292
14.375
14.643
14.898
15.141
15.444
13.003
13.211
13.406
13.591
13.765
10.310
10.935
11.051
11.158
11.258
9.161
9.237
9.307
9.370
9.427
7.896
7.943
7.984
8.022
8.055
40
50
32.835
39.196
27.355
31.424
25.103
28.362
23.115
25.730
19.793
21.482
00.259
00.256
15.046
15.762
11.925
12.233
9.779
9.915
8.244
8.304
14% 15% 16% 18% 20% 22% 24% 25% 26% 30% 40% 50%
0.877
1.647
2.322
2.914
3.433
3.889
4.288
4.639
4.946
5.216
5.453
5.660
5.842
6.002
6.142
6.265
6.373
6.467
6.550
6.623
0.870
1.626
2.283
2.855
3.352
3.784
4.160
4.447
4.768
5.019
5.234
5.421
5.583
5.724
5.847
5.954
6.047
6.128
6.198
6.259
0.862
1.605
2.246
2.798
3.274
3.685
4.039
4.344
4.607
4.833
5.029
5.197
5.342
5.468
5.576
5.668
5.749
5.818
5.878
5.929
0.847
1.566
2.174
2.640
2.127
3.498
3.812
4.078
4.303
4.494
4.656
4.793
4.910
5.008
5.092
5.162
5.222
5.273
5.316
5.353
0.833
1.528
2.106
2.589
2.991
3.326
3.605
3.837
4.031
4.192
4.327
4.439
4.533
4.611
4.676
4.730
4.775
4.812
4.844
4.870
0.820
1.492
2.042
2.494
2.864
3.167
3.416
3.619
3.786
3.923
4.035
4.127
4.203
4.265
4.315
4.357
4.391
4.419
4.442
4.460
0.806
1.457
1.981
2.404
2.745
3.020
3.242
3.421
3.566
3.682
3.776
3.851
3.912
3.962
4.000
4.033
4.059
4.080
4.097
4.110
0.800
1.440
1.952
2.362
2.689
2.951
3.161
3.429
3.463
3.571
3.656
3.725
3.780
3.824
3.859
3.887
3.910
3.928
3.942
3.954
0.795
1.424
1.923
2.320
2.635
2.885
3.083
3.241
3.366
3.465
3.544
3.006
3.656
3.695
3.726
3.751
3.771
3.786
3.799
3.808
0.769
1.361
1.816
2.166
2.436
2.643
2.802
2.925
3.019
3.092
3.147
3.190
3.223
3.249
3.268
3.283
3.295
3.304
3.311
3.316
0.714
1.224
1.589
1.849
2.035
2.168
2.263
2.331
2.379
2.414
2.434
2.456
2.468
2.478
2.484
2.488
2.492
2.494
2.496
2.497
0.667
1.111
1.407
1.605
1.737
1.824
1.883
1.922
1.948
1.965
1.977
1.985
1.990
1.993
1.995
1.967
1.998
1.999
1.999
1.999
6.687
6.743
6.792
6.835
6.873
6.906
6.935
6.961
6.983
7.003
7.105
7.133
6.312
6.359
6.399
6.434
6.464
6.491
6.514
6.534
6.651
6.566
6.642
6.660
5.773
6.011
6.044
6.073
6.097
6.118
6.136
6.152
6.166
6.177
6.234
6.246
5.384
5.310
5.432
5.451
5.467
5.480
5.492
5.502
5.510
5.517
5.548
5.554
4.891
4.909
4.924
4.937
4.948
4.956
4.964
4.970
4.975
4.979
4.997
4.998
4.476
4.488
4.499
4.507
4.514
4.520
4.524
4.528
4.530
4.534
4.544
4.545
4.121
4.130
4.137
4.143
4.147
4.151
4.154
4.157
4.159
4.160
4.166
4.167
3.963
3.970
3.976
3.981
3.985
3.988
3.990
3.992
3.994
3.996
3.999
4.000
3.816
3.822
3.827
3.831
3.834
3.837
3.839
3.840
3.841
3.842
3.846
3.846
3.520
3.323
3.335
3.327
3.329
3.350
3.331
3.331
3.332
3.332
3.333
3.333
2.498
2.498
2.499
2.499
2.499
2.500
2.500
2.500
2.500
2.500
2.500
2.500
2.000
2.000
2.000
2.000
2.000
2.000
2.000
2.000
2.000
2.000
2.000
2.000
- End of Chapter -
LESSON 10
CAPITAL BUDGETING III: TECHNIQUES OF PROJECT EVALUATION
UNDER CERTAINTY
OBJECTIVES
After reading this chapter, you will be able to:
Understand the methods of Evaluating Capital Budgeting Projects.
Workout a ranking procedure for all evaluated projects.
Appreciate the controversy associated with the use of NPV and IRR methods.
Examine the issues relating to Capital Rationing Procedure.
STRUCTURE
Introduction
Methods for Evaluating Investment Projects
Few Additional Illustrations
Net Present Value vs. Internal Rate of Return
Capital Rationing
Linear Programming Model for Capital Rationing
Summary
Keywords
Exercises
Case Illustration
INTRODUCTION
Since the primary goal of a firm is shareholders' wealth maximisation, an appropriate
goal for a capital budgeting decision is the identification of investment projects which
maximize the future value of the company. Any economic analysis has to start with
appropriate measurement criterion on costs and benefit flows in addition to the implicit
constraints, if any, existing on the final selection and inclusion of such a project into the
productive assets of the company. Final selection and execution constraints broadly
relates to the issue of evaluating projects either as independent candidates or mutually
exclusive units. While the projects under first category need only determination of
economic desirability isolation, the second set demands for incremental analysis among
competing alternative projects. Further, the evaluating techniques do differ under a set
of essential assumptions of certainty about investment outcomes, stability in risk
perception and equilibrium in interest rates, calling for perfect capital market to exist.
This chapter presents the popular capital budgeting techniques and highlights the issues
involved in evaluating investment projects essentially under conditions of capital
rationing. While the primary focus of each of the techniques is to arrive at an acceptance
criterion, the ultimate selection of the project generally depends on consideration of
strategic importance.
METHODS FOR EVALUATING INVESTMENT PROJECTS
The methods of appraising capital expenditure proposals can be classified as:
Traditional Techniques
1. Payback Method
2. Accounting Rate of Return Method
Discounted Cashflow Techniques
1. Net Present Value Method
2. Internal Rate of Return Method
3. Profitability Index Method
Payback Method
Payback method is a simple and an easy project evaluation technique. This method
concentrates on the time taken by the project to recover back the capital invested in it.
Under this method, project is evaluated and compared by working out the payback
period of the cashflows expected from the project.
Payback Period = Initial Outlay / Cashflows = IO / CF ...(10.1)
For example, if an investment project of Rs.10,000 is expected to generate cashflows of
the size of Rs.2,500 per year for seven years, then the payback period is IO/CF =
10,000/2,500 = 4 years
Suppose, some other project costing Rs.12,000 is able to generate annual cash flows of
the size of Rs.4,000 per annum, the payback period of such project is 3 years. These
payback periods would signify the number of years that the projects would take to repay
themselves.
However, the above said formula is not suitable for projects whose cashflows are
uneven. In such a case the payback period could be worked out by observation in most
of the cases or by accumulating cashflows over time. The payback period would be the
number of years when cumulative cashflows become equal to the original initial outlay.
To illustrate this method, let us consider the investment proposal as given in Table 10.1.
TABLE 10.1
CALCULATION OF PAYBACK PERIODS THROUGH CUMULATIVE
CASHFLOW
Annual Cashflows Cumulative Cashflows
Year Project A Project B Project A Project B
0 -15,000 -10,000 - -
1 5,000 2,500 5,000 2,500
2 8,000 3,500 13,000 6,000
3 6,000 3,000 19,000 9,000
4 5,000 2,000 24,000 11,000
5 3,000 1,000 27,000 12,000
It can be observed that in case of project A, the Payback (PB) period would lie at two
years plus few months and in case of project B it is after three years. More specifically,
Payback (PB) period of project A is calculated as this:
Initial Outlay of Project A is Rs.15,000
At the end of year 1, returns are Rs.5,000
At the end of year 2, returns are Rs.5,000 + Rs.8,000 = Rs.13,000
To recover the remaining Rs.2,000 the little more time is required, which is 2000/6000
= 1/3 of a year = 4 months
Hence, the net time required for the project's initial outlay to be recovered is 2 years and
4 months.
Payback (PB) period of project B is calculated as this:
Initial Outlay of Project A is Rs.10,000
At the end of year 1, returns are Rs.2,500
At the end of year 2, returns are Rs.2,500 + Rs.3,500 = Rs.6,000
At the end of year 3, returns are Rs.2,500 + Rs.3,500 + Rs.3,000 = Rs.9,000
To recover the remaining Rs.1,000 the little more time is required, which is 1000/2000
= 1/2 of a year = 6 months
Hence, the net time required for the project's initial outlay to be recovered is 3 years and
6 months.
Evaluation
As payback period indicates time taken to recover the initial outlay, the projects with
lowest payback would be considered. Sometimes, the management sets a 'standard
payback' period to be maintained on all investment projects. Then the decision on
project selection would be
PB of specific project < Standard PB: Accept the specific project
PB of specific project > Standard PB: Reject the specific project
Sometimes individual projects could be ranked based on the payback periods for
necessary consideration.
Illustration 10.1
A company is considering the following projects requiring a cash outlay of Rs.15,000
each. Suggest your evaluation decision if standard payback period is 3 years.
Cashflows
Year Project A Project B Project C Project D
1 5,000 3,500 2,500 8,000
2 5,000 4,000 2,500 6,000
3 5,000 4,500 2,500 6,000
4 5,000 6,000 2,500 5,000
5 5,000 6,000 2,500 5,000
Solution:
Calculation of Payback Periods
Payback period for Project A = 15,000/5,000 = 3 years (= IO/CF, since the
cashflows are even)
Payback period for Project B = 3 years + [3,000/6,000] x 12 months = 3 years 6
months
{In 3 years, money recovered is Rs.12,000; the remaining 3,000 is to be still
recovered, which will be recovered in part of the 4th year}
Payback period for Project C = 15,000/2,500 = 6 years
Payback period for Project D = 2 years + [1,000/6,000] x 12 months = 2 years 2
months
{In 2 years, money recovered is Rs.14,000; the remaining 1,000 is to be still
recovered, which will be recovered in part of the 3rd year}
Selection of Projects
Payback period of Project A, 3 years = Standard Payback Period, 3 years : Accept
Project A
Payback period of Project B, 3 years 6 months > Standard Payback Period, 3
years : Reject Project B
Payback period of Project C, 6 years = Standard Payback Period, 3 years : Reject
Project C
Payback period of Project D, 2 years 2 months < Standard Payback Period, 3
years : Accept Project D
Implications of Payback
Payback method is in wide usage in spite of new sophisticated methods, due to the
following advantages:
1. Calculation of payback period is simple and easy to understand; it is simply a
measure of time required for a project to return the investment;
2. Payback period reflects the liquidity of a project and thereby an element of risk
associated with covering the investment made in a project. As this method
suggests for selection of a project with lower payback period, it ensures that the
projects with good liquidity are selected, and thereby the risk is the least.
However, this method suffers for following serious limitations:
1. It fails to consider the cashflows earned by the projects subsequent to the
recovery of the investment. Therefore, it ignores the profits of the projects.
2. It ignores the time value of money. The initial outlay and the cashflows generated
over different years are considered at the same rupee value, which is hardly
comparable in true sense due to inflation and falling rupee value in the economy.
3. It is difficult to evaluate the pattern, size and magnitude of cashflows generated
in different years during the payback. For example, suppose there are two
projects as below:
Project A Project B
Initial Outlay 10,000 10,000
Cashflows: 1 7,000 1,000
2 2,000 2,000
3 1,000 7,000
The payback period of the both the projects is 3 years, but the pattern of cashflows
differs. Although both the projects are considered equally preferrable by payback
method, it is by observation that project A is superior to project B, as A recovers
sizable portion of capital very early.
4. This method is further endowed with difficulty in determining the standard
payback period for comparison of projects. Since the method of evaluating
projects ignores the cost of capital and profitability, this method is not consistent
with the objectives of maximising the market value of a firm's shares.
In spite of these limitations this payback method is very popular in usage due to its
simplicity. The reasons for its popularity are:
1. As payback method considers projects with high liquidity, it ensures quick
turnover of capital resources which can be employed in new projects without
resorting to raising new finances.
2. Selection of projects with high liquidity reduces the risk of recovering capital,
especially when the future is uncertain, economy is inflationary, government is
unstable, and business risks are high.
3. As the payback method is also helpful to evaluate the projects by using
sophisticated techniques like internal rate of return, the payback period acts as a
good approximation to the reciprocal of internal rate of return of projects.
Accounting Rate of Return Method
Under this method, projects are evaluated following the principles and practices
commonly used in accounting by estimating a rate of return. There are two types of
measures, one is the original investment measure and the other, average investment
measure.
Under the original investment measure, the accounting rate of return is found by
dividing the average income by the original investment. This is simply a ratio of
earnings to investment.
Accounting Rate of Return, ARR = (Annual Income / Original Initial Outlay)
x 100 ... (10.2)
However under the average investment measure, average investment is considered in
place of original initial outlay. The average investment is the initial outlay plus salvage
value (if any) divided by two. Sometimes the average investment is also calculated by
dividing the book value of the project by its life period. The basic assumption of using
'average investment' is the regular recovery of capital over the life of the project.
Illustration 10.2
Determine the average rate of return for the following projects:
Project A Project B
Initial Outlay 50,000 50,000
Life 5 years 5 years
Salvage value 3,000 3,000
Annual Income after Depreciation and Income Tax
I year 3,000 12,000
II year 5,000 9,000
III year 7,000 7,000
IV year 9,000 5,000
V year 12,000 3,000
Then,
Average income of each project = Total Income / No. of years = Rs. 36,000 / 5 =
Rs.7,200
Average investment of each project = (Salvage Value + Initial Outlay)/2 =
(3,000+50,000)/2 = Rs.26,500
ARR = Average Income / Average Investment = 7200/26500 = 0.2717 = 27.17%
Average rate of return in case of both the projects would be 27.2%. A variation of this
ARR method by using average income divided by original outlay would yield a more
consistent result of 7,200/50,000 which is generally considered to be an approximation
to be internal rate of return earned by a project.
Selection Criterion: Projects are selected based on the size of ARR in case of
mutually exclusive projects. However, the selection of independent project be done if the
ARR of a project is higher than the minimum rate of return expected by management
from all its investment projects.
If ARR > Predetermined or minimum rate of return : Accept the project
If ARR < Predetermined or minimum rate of return : Reject the project
Alternative proposals could be ranked based on the magnitude of ARR from each of the
proposals.
Implications of ARR Method: The ARR as an evaluation measure of selecting
investment proposals could be appreciated against the backdrop of the followings pros
and cons:
1. It is very easy to calculate and the data from accounting records could be
sufficient to estimate the rate of return from a project.
2. ARR considers all the cashflows generated by a project and due weightage is
given to the recovery of initial outlay through the depreciation cover.
However, this method suffers from the following drawbacks:
1. ARR method considers accounting profits in place of cashflow. Generally
accounting profits ignore the reinvestment potential of project's income flows
while cashflows take into account those additional cashflows and consequently
total benefits from a project.
2. ARR criterion does not differentiate projects based on their lives, sizes of
investments, and patterns of cashflows.
3. It ignores the time value of money. Both cashflows generated over years and cash
outflows are not strictly on comparable rupee value.
Thus, the two traditional techniques suffer with specific limitations.
DISCOUNTED CASHFLOW (DCF) METHODS
Three popular methods of project evaluation, which would consider the discounted
cashflows are:
1. Net present value (NPV) method
2. Internal Rate of Return (IRR) method
3. Profitability Index (PI) method.
Net Present Value (NPV) Method
Net Present Value method evaluates the investment projects by deducting the initial
outlay (IO) from out of discounted stream of cash inflows i.e., Present Value of stream of
Cash Flows (PVCF). In other words, it makes a comparison of cost-benefits, benefits
being the sum of present value of future stream of cashflows expected from a project.
The investment appraisal procedure consists of:
i. estimation of present value of each cash inflow, discounted at an appropriate cost
of capital.
ii. adding the discounted cashflows and deducting the initial outlay, to determine
the Net Present Value (NPV).
iii. if the NPV is a positive figure the project would be accepted, and if the NPV is
negative, the project is rejected. If projects are mutually exclusive type, the
project with higher positive NPV could be accepted.
Therefore, the NPV method involves calculations of present values of cashflows of an
investment proposal using the cost of capital as the discounting rate, and determining
the net present value by subtracting the initial outlays from the sum of present value of
cash inflows Symbolically,
... (10.3)
where,
CF = Cashflows over the life of the project
IO = Initial outlay
i = Discounting rate of cost of capital
n = Life of the project in years
Illustration 10.3:
A company is considering to invest in two mutually exclusive projects, each one of which
would cost an initial outlay of Rs.25,000. The expected cashflows over their lives are as
follows:
Project A Project B
CF1 Rs. 10,000 CF1 7,000
CF2 Rs. 10,000 CF2 10,000
CF3 Rs. 10,000 CF3 12,000
CF4 Rs. 10,000 CF4 15,000
CF5 10,000
Life = 4 years Life = 5 years
Evaluate the projects if the required rate of return is 10%. The net present values of the
two projects would be calculated as per the following formula:
TABLE 10.2
CALCULATION OF NPV IN CASE OF TWO PROJECTS
Year
Project A Project B
Cashflows
expected
PV
factor
@10%
PV of
cashflows
Cashflows
expected
PV
factor
@10%
PV of
cashflows
CF1 10,000 0.909 9,090 7,000 0.909 6,363
CF2 10,000 0.826 8,260 10,000 0.826 8,260
CF3 10,000 0.751 7,510 12,000 0.751 9,012
CF4 10,000 0.683 6,830 15,000 0.683 10,245
CF5 - - - 10,000 0.621 6,210
PVCF 31,690 PVCF 40,090
IO -25,000 IO -25,000
NPVA 6,690 NPVB 15,090
Selection Criterion:
Projects would be selected based on the size and sign of NPV that they generate. In case
of a single project, it would be accepted only if the NPV is positive. In case of mutually
exclusive projects, projects are compared basing on the absolute values of NPV.
NPV > 0 : Accept the project
NPV < 0 : Reject the project
Further, the independent projects could be ranked based on the absolute size of NPV
generated by each.
Implications of NPV Method:
The size of NPV represents the present value of the benefit that the firm could realise if
it accepts the said project, provided the expected cashflows are materialised. Therefore,
the NPV is something like 'unrealised capital gain' from a project. Further, the NPV
method examines the project from the point view of (i) Repayment of original
investment in the project; (ii) Interest on funds invested towards the original
investment; and (iii) Interest on the surplus being generated. This point could be
illustrated as follows:
In case of project A, suppose the firm has borrowed Rs.31,690 (Rs.25,000 towards cost
of the project & Rs.6,690 towards the present value of surplus being generated by the
project) at an interest rate of 10% from a financial institution. The following table shows
how the firm's cashflows would help in repaying the entire amount:
TABLE 10.3
PATTERN OF UTILISATION OF CASHFLOWS FROM PROJECT A
Years
Loan at
beginning
Interest
@ 10%
Total
outstanding
Repayment
through
cashflow
Balance
outstanding
1 31,690 3,169 34,859 10,000 24,859
2 24,859 2,486 27,345 10,000 17,345
3 17,345 1,735 19,080 10,000 9,080
4 9,080 908 9,988 10,000 (12)*
*Rounding off error
Illustration 10.4
The management of a company desires to invest surplus funds of Rs.25,000. They are
having three projects before them. You are required to rank the three projects under
NPV method at a market rate of 10%.
Nature of
Investment
Cost Form of return
Annual
cash
inflow
Duration in
years
i.
Automatic
Equipment
6,000 Savings in labour cost 2,000 5
ii.
Purchase of small
machine shop to add
18,000 Profits after tax 6,000 6
iii. New boiler 10,000
Cost savings, fuel
consumption and
maintenance
3,000 5
i. Automatic Equipment
IO = Rs. 6,000
CFt = Rs. 2,000
Life = 5 years
NPV
= [2000/(1+0.10)] + [2000/(1+0.10)
2
] + [2000/(1+0.10)
3
] + [2000/(1+0.10)
4
] +
[2000/(1+0.10)
5
] - 6,000
TABLE 10.4
CALCULATION OF NPV OF AN AUTOMATIC EQUIPMENT PROJECT
Year Cashflow PV factor @ 10% PV of cashflow
1 2,000 0.909 1818
2 2,000 0.826 1652
3 2,000 0.751 1502
4 2,000 0.683 1366
5 2,000 0.621 1242
PVCF = 7580
(-) IO = 6000
NPV = 1580
ii. Small Machine Shops
IO = Rs. 18,000
CFt = Rs. 6,000
Life = 6 years
NPV
= [6000/(1+0.10)] + [6000/(1+0.10)
2
] + [6000/(1+0.10)
3
] + [6000/(1+0.10)
4
] +
[6000/(1+0.10)
5
] + [6000/(1+0.10)
6
] - 18,000
TABLE 10.5
CALCULATION OF NPV FOR SMALL MACHINE SHOP PROJECT
1 6,000 0.909 5454
2 6,000 0.826 4956
3 6,000 0.751 4506
4 6,000 0.683 4098
5 6,000 0.621 3726
6 6,000 0.564 3384
PVCF = 26124
(-) IO = 18000
NPV = 8124
iii. New Boiler
IO = Rs. 10,000
CFt = Rs. 3,000
Life = 5 years
NPV
= [3000/(1+0.10)] + [3000/(1+0.10)
2
] + [3000/(1+0.10)
3
] + [3000/(1+0.10)
4
] +
[3000/(1+0.10)
5
] - 10,000
TABLE 10.6
CALCULATION OF NPV FOR NEW BOILER PROJECT
1 3,000 0.909 2727
2 3,000 0.826 2478
3 3,000 0.751 2253
4 3,000 0.683 2049
5 3,000 0.621 1863
PVCF = 11370
(-) IO = 10000
NPV = 1370
Ranking of Projects based on size on NPV:
i. Automatic Equipment NPV = 1580 Rank II
ii. Small Machine Shop NPV = 8124 Rank I
iii. New Boiler NPV = 1370 Rank III
Implications:
1. One significant advantage of NPV method is the recognition of time value of money.
Evaluation of projects under NPV method ensures greater comparison of benefits and
costs at current rupee and the cost of capital mobilised to finance the project is well
taken care off.
2. NPV considers all the cashflows generated by the project. In addition, the pattern of
cashflows is recognised. Suppose two projects are similar except for the pattern of
cashflows, the NPV method ultimately selects that project which could generate sizable
cashflows in the initial years. Selection of such a project ensures liquidity in addition to
early profitability.
3. NPV method helps in selecting the projects which would be profitable, as the accept-
rejection criterion indicates to select projects with NPV > 0. Therefore, the NPV method
facilitates in achieving the objectives of Financial Management in maximising the
shareholders' wealth.
However, NPV has certain limitations. Some of them are:
1. Compared to the traditional methods like Payback and Accounting Rate of Return, the
calculation of NPV is endowed with difficult calculations.
2. Determination of appropriate discount rate in project evaluation is certainly a
complex issue. Whether to consider firm's overall cost of capital or cost of project
finance is an issue. Further, ascertaining the cost of capital is a separate aspect making
the entire method complex.
3. Comparison of different projects with varying degrees of life, initial outlay, pattern of
cashflows, and risk composition poses a clear problem on the adaptability of NPV
method for project appraisal and ranking of projects.
Internal Rate of Return (IRR) Method
The NPV method evaluates projects by computing the net present surplus of a project.
Mostly this amount would be expressed in absolute terms which may not be able to
convey any sizeable information to investor with respect to the 'rate' of profitability of
the project. But it is well known. A common businessman or an investor wishes to
express the return on investment as 'rate', rather than in absolute figures without
referring to the size of investment made. Therefore, a need arose to ascertain the
profitability of a project in specific way as 'rate'. The calculation of Internal Rate of
Return (IRR) of a project has become another popular capital budgeting technique
using the DCF methodology. This rate of return of a project is also known as 'yield on
investment', 'marginal efficiency of capital', 'time adjusted rate of return' and so on.
The IRR could be called as that discount rate which equates the present value of cash
inflows with that of initial outlay. The rationale lies in the fact that the NPV decreases
from a project if one goes on increasing the 'discounting rate'. At a particular discount
rate, the entire NPV of a project would become 'zero'. In other words, the surplus
expected from a project is fairly converted into a discount rate at that point. Therefore,
such discount rate is called as 'Internal Rate of Return'. It can be determined by solving
an equation all most similar to that of NPV excepting solving it for the discount rate.
or
- IO = Zero ... (10.4)
where,
r = Internal rate of return
IO = Initial outlay
CF = Cashflows over the life of the project
n = Life of the project
In case of NPV method, the discount rate 'i' represents the cost of capital, mostly the
minimum required rate of return of interest on the funds utilised for funding the
project, whereas in IRR method, the discount rate 'r' represents the return from a
project in terms of a 'rate'.
The calculation of IRR involves a tedious process. Mostly, it should be worked out by
trial and error approach. One generally starts the process of finding out that discount
rate which makes the NPV of a project 'zero'. By assuming a certain discount rate is
positive, the trial is to be done with increased discount rate. The process should
continue until NPV becomes zero, and ultimately the said discount rate which yielded
zero NPV would become the IRR of a project. Let us consider an illustration to work out
the IRR.
Illustration 10.5
A project costs Rs.19,828 and is expected to generate cashflows for five years as Rs.5000
in first year, Rs.6000 in second year, Rs.7000 in third year, Rs.8000 in fourth year, and
Rs.9000 in fifth year. Find the IRR.
Solution
Let us select a discount rate of 10% to start with and proceed on...
TABLE - 10.7
CALCULATION OF NPV AT AN ASSUMED DISCOUNT RATE OF 10%
1 5,000 0.909 4545
2 6,000 0.826 4956
3 7,000 0.751 5257
4 8,000 0.683 5464
5 9,000 0.621 5589
PVCF = 25811
(-) IO = 19828
NPV = 5983
TABLE - 10.8
CALCULATION OF NPV AT A DISCOUNT RATE OF 15%
1 5,000 0.897 4530
2 6,000 0.756 4536
3 7,000 0.658 4606
4 8,000 0.572 4576
5 9,000 0.497 5473
PVCF = 23541
(-) IO = 19828
NPV = 3713
TABLE - 10.9
CALCULATION OF NPV AT A DICOUNT RATE OF 20%
1 5,000 0.833 4165
2 6,000 0.694 4164
3 7,000 0.579 4025
4 8,000 0.482 3856
5 9,000 0.402 3618
PVCF = 19828
(-) IO = 19828
NPV = 0
Therefore, IRR = 20 percent
Illustration 10.6
A project costs Rs.20,500 and is expected to generate cashflows of Rs.5,000 annually for
5 years. Let us calculate the internal rate of return.
Solution
TABLE - 10.10
CALCULATION OF IRR AT A DICOUNT RATE OF 10%
1 5,000 0.909 4545
2 5,000 0.826 4130
3 5,000 0.751 3755
4 5,000 0.683 3415
5 5,000 0.621 3105
PVCF = 18950
(-) IO = 20500
NPV = -1550
TABLE - 10.11
CALCULATION OF IRR AT A DICOUNT RATE OF 8%
1 5,000 0.926 4630
2 5,000 0.857 4285
3 5,000 0.794 3970
4 5,000 0.735 3675
5 5,000 0.681 3405
PVCF = 19965
(-) IO = 20500
NPV = -535
TABLE - 10.12
CALCULATION OF IRR AT DISCOUNT RATE OF 7%
1 5,000 0.935 4675
2 5,000 0.873 4365
3 5,000 0.816 4080
4 5,000 0.763 3815
5 5,000 0.713 3565
PVCF = 20500
(-) IO = 20500
NPV = 0
Therefore, IRR = 7 percent
The above two illustrations show that the determination of IRR is a repetitive process
and may not be able to find the exact IRR from a project when the rate lies in between
two whole numbers. Say, suppose the calculated NPV value from a project lies:
At discount rate NPV
17% +843.00
18% -572.00
Then the actual IRR must be slightly higher than 17% but less than 18%. To find out the
value, the following interpolation formula is in wide usage.
where,
iL = Lower Discount Rate
NPVL = NPV of the profit at lower discount rate
^PVCF = Difference in calculated present values of cashflows (in absolute sums of NPV)
^i = Difference in discount rates
In the above case,
= 17.59
Selection Criterion: Since IRR method gives the profitability of a project in terms of a
'rate', projects with higher rate of return compared to the cost of capital could be
accepted. The cost of capital 'k' may be the minimum required rate of return that a firm
is expected to generate from its investment projects. Therefore 'k' becomes the cut-off
rate or target rate in project appraisal. Then the acceptance rejection criterion would be
If IRR > k = Accept the project
If IRR < k = Reject the project
It is generally known that the projects with returns higher than the cost of capital, if
accepted, would raise the market value of a firm.
Implications of IRR method: IRR method helps in examining the profitability of a
project in terms of generating necessary cashflows to repay the loan and the interest on
it, if project is financed through borrowed capital. Further, IRR > k indicates the rate of
return in terms of its present value. In other words, the IRR is the maximum interest
rate that the firm can generate, in case the entire project is to be financed by borrowed
funds. Consider the following example to understand the full implications of IRR:
Illustration 10.7
Suppose the cost of the project is Rs.28,550 (fully borrowed at 15%) with the cashflows
of Rs. 10,000 for four years yields on IRR of 15% then verify whether project could be
able to repay the cost of the project.
Solution
Some specific advantages of IRR over NPV are:
i) Project profitability is more easily understood in case of IRR than the absolute size of
NPV.
ii) Determination of cost of capital is not required in case of IRR for project appraisal, as
is needed in case of NPV.
iii) Comparison of projects is easier done in case of IRR, irrespective of the sizes of
initial outlays.
However, the following are some serious limitations of this method:
i) Calculation of IRR is difficult and it involves tedious exercise of finding the exact
discount rate which equates cashflows of initial outlay.
ii) IRR method yields absolutely different results compared to NPV method when
projects differ in respect of initial outlays, pattern of cashflows, and project lives.
iii) IRR method assumes that the intermittent cashflows are reinvested at the same rate
as the internal rate of return generated by the project. It would always be on higher side
as the funds in circulation may not be that profitable as that of the investment.
A Practical Approach to Find IRR: As the trial and error method of finding IRR is a
tedious process, there is a practical approach to ascertain IRR easily by using the
reciprocal of payback period. Such reciprocal value is observed to be a good
approximation of the IRR mostly when the cashflows of a project are even. However,
even in case of uneven cashflows, this method is used after ascertaining annual average
cashflows.
Under this method, present value of annuity tables (given in Annexure 9B) is used to
find the approximate IRR of the project.
The steps involved in determining the IRR value under the payback reciprocal approach
start with the calculation of PB period for the project. The calculated PB period becomes
the PV factor for the given life of the project. In the annuity table, one has to then look
for a PV factor which is close to the calculated PB value for the said years of life of the
project. Roughly the closest rate of discount which yields similar PV factor to that of PB
period is the IRR.
Suppose, the life of a project is 5 years and its payback value is 3 years then, we have to
search for a factor closest to 3.000 in 'present value of annuity' table for 5 years. The
factor closest to 3.000 is 2.991 in the table. This occurs where the rate of interest is 20%.
Next nearer figure is 3.058, it is at 19%. Hence, the project's IRR would be in between
19% and 20%. By observation, we can consider 20% as the approximate IRR. However,
for exact IRR an interpolation similar to the one adopted earlier would be helpful.
PV factor Deviation from 3.000
At 19% 3.058 0.058
At 20 % 2.991 0.009
--------------
0.067
--------------
Exact IRR = 19% + (0.058 / 0.067) = 19 + 0.8656 = 19.8656%
Illustration 10.8
The management of a company has two alternative projects under consideration.
Project A requires a capital outlay of Rs. 1,20,000 but Project B needs Rs. 1,80,000.
Both are estimated to provide cashflows for five years: A - Rs.40, 000 per year and B -
Rs.58,000 per year. Show which of the two projects are preferable using IRR method.
Solution
Project A
PB period = IO/CF = 1,20,000/40,000 = 3 years
PV annuity factors nearer to 3.000 for 5 years are 3.058 at 19% and 2.991 at 20%.
By interpolation, exact IRR = 19% + 0.058/(0.058+0.009) = 19.8656%
Project B
PB period = IO/CF = 1,80,000/58,000 = 3.1034 years
PV annuity factors nearer to 3.1034 for 5 years are 3.127 at 18% and 3.058 at 19%.
By interpolation, exact IRR = 18% + 0.0236/(0.0236+0.0454) = 18.3420%
Since IRR of Project A is greater than IRR of Project B, Project A is preferrable.
Profitability Index Method
Profitability Index (PI) Method is the third popular project evaluation method which
uses DCF methodology. PI method is almost similar to NPV method. In case of NPV, the
net present value of cashflows from a project are ascertained by deducting the initial
outlay (IO) from the sum of PVs of all cashflows expected to be generated.
- IO ... (10.5)
Ultimately the NPV would be an absolute figure which may not be able to permit the
comparison of different projects with varying initial outlays. Therefore, the profitability
index provides us a solution by constructing a ratio to express the relative profitability of
each project to the size of initial outlay. PI is worked out by dividing the present value of
all cash inflows expected, by the initial outlay. Symbolically.
... (10.6)
or
[PV of future stream of benefits / Initial Cost of the project]
Illustration 10.9
A project costs Rs. 1,00,000 and is expected to generate cashflows for five years as
Rs.20000, Rs.30000, Rs.40000, Rs.30000, and Rs.20000. Calculate profitability
index.
Solution
TABLE 10.14
CALCULATION OF PROFITABILITY INDEX ASSUMING A DISCOUNT
RATE OF 10 PERCENT
Year Cashflows Discounting factor
Present Value
(Cashflows x Discounting factor)
1 20,000 0.909 18,180
2 30,000 0.826 24,780
3 40,000 0.751 30,040
4 30,000 0.683 20,490
5 20,000 0.621 12,420
PVCF = 105,910
Profitability Index (PI) = PVCF / IO = 105910 / 100000 = 1.06
Selection Criterion:
Since PI method provides a ratio of benefit-to-cost, the project could be profitable only
when the benefit is higher than the cost of the project. In such a case the calculated PI
should be greater than 1. It follows the similar logic as that of NPV. As long as the
present values of cash inflows are larger than the IO, the NPV would be positive.
Therefore, whenever the NPV of a project is positive, it is certain that PI results more
than one. Therefore, the selection of a project would be done as follows:
If PI > 1 : Accept the project
If PI < 1: Reject the project
Implications of PI:
The PI method although depends on similar methodology of that of the NPV, is more
suited for comparison of projects especially under conditions of capital rationing.
FEW ADDITIONAL ILLUSTRATIONS
Illustration 10.10
An oil company proposes to install a pipeline for the transport of crude from wells to
refinery. Investments and operating costs of the pipeline vary for different sizes of pipes
(diameter). The following details have been collected:
Pipeline diameter 3" 4" 5" 6" 7"
Investment required (in Rs.
Lakhs)
16 24 36 64 150
Gross annual savings in operating
costs before depreciation
5 8 15 30 50
Estimated life of the installation is 10 years. Tax rate is 50%. If the company desires a
15% after tax return, indicate the proposal that is viable.
Solution
TABLE 10.15
DETERMINATION OF CASHFLOWS
(Rs. in lakhs)
Pipeline diameter
3" 4" 5" 6" 7"
Savings before Depreciation
Tax
5 8 15 30 50
Less: Depreciation (@10% on 1.6 2.4 3.6 6.4 15
investment)
3.4 5.6 11.4 23.6 35
Less: Tax @50% 1.7 2.8 5.7 11.8 17.5
Net savings after Tax and
Depreciation 1.7 2.8 5.7 11.8 17.5
Annual cashflow (Tax +
Depreciation)
3.3 5.2 9.3 18.2 32.5
Payback period = Initial
Outlay / Annual cashflow
16/3.3 24/5.2 36/9.3 64/18.2 150/32.5
= 4.85 = 4.61 = 3.87 = 3.52 = 4.62
6" pipelines have the lowest payback period.
TABLE 10.16
DETERMINATION OF NPV WHEN COMPANY'S REQUIRED RATE OF
RETURN IS 15%
(Rs. in lakhs)
Diameter of Pipeline
3" 4" 5" 6" 7"
Annual cashflows expected 3.3 5.2 9.3 18.2 32.5
Life Years 10 10 10 10 10
PV factor for annuity at 15% discount
rate
5.019 5.019 5.019 5.019 5.019
PVCF(Rs. in lakhs) 16.56 26.10 46.68 91.35 163.12
Initial outlays 16.00 24.00 36.00 64.00 150.00
NPV 0.56 2.10 10.61 27.55 23.12
6" Pipelines gives highest NPV.
Illustration 10.11: A company is thinking of installing a computer. It has to decide
whether the computer is to be hired or bought outright. The following data are available.
Purchase of Computer :
Purchase price : Rs. 40,00,000
Annual maintenance : Rs. 50,000 (to be paid in advance every year)
Life of the computer : 10 years
Depreciation : 15% per annum on the reducing
balance method
Residual value is written
Off / salvage value after
10 years : Rs. 4,00,000
Hiring of computer
Initial one-time cost : Rs.40,000
Annual hire-charges : Rs.7,00,000 (to be paid in advance every year)
Rate of discounting : 10 %
Ignore Tax
You are required to advise the company as to whether it should purchase the computer
or hire it.
Since the projects are mutually exclusive, let us try to find differential NPV. To ascertain
such a value we have to find differential initial outlay and differential cashflows.
i) Differential Initial outlay:
Computers cost price = Rs. 40, 00,000
Hire charge (Initial cost) = 40,000
_______________
ii) Differential Annual cashflow :
Hire charges = Rs. 7,00,000
Annual maintenance if
purchased 50,000
__________________
6,50,000 (for ten years)
____________________
iii) Salvage value (10th year) = Rs. 4,00,000
TABLE 10.17
CALCULATION OF NET PRESENT VALUE
Therefore, purchasing the computer is advisable.
Depreciation and Taxation are ignored.
Illustration 10.12: A job which is presently done entirely by manual methods has a
labour cost of Rs.46, 000 a year. It is proposed to install a machine to do the job, which
involves an investment of Rs.80, 000 and an annual operating cost of Rs. 10,000.
Assume the machine can be written off in 5 years on straight line depreciation basis for
tax purposes. Salvage value at the end of its economic life is zero. The tax rate is 55%.
Analyse the economic implications of the proposal by the Internal Rate of Return
Method.
Since the new machine is likely to replace the entire manual method, it saves the labour
cost of Rs.46, 000. However, the machine maintenance operating cost is expected be Rs.
10,000 per annum.
Net savings of machine = 36,000
Tax on the savings (55%) = 19,800
___________
Therefore, purchasing the computer is advisable.
Depreciation and Taxation are ignored.
Illustration 10.12: A job which is presently done entirely by manual methods has a
labour cost of Rs.46, 000 a year. It is proposed to install a machine to do the job, which
involves an investment of Rs.80, 000 and an annual operating cost of Rs. 10,000.
Assume the machine can be written off in 5 years on straight line depreciation basis for
tax purposes. Salvage value at the end of its economic life is zero. The tax rate is 55%.
Analyse the economic implications of the proposal by the Internal Rate of Return
Method.
Since the new machine is likely to replace the entire manual method, it saves the labour
cost of Rs.46, 000. However, the machine maintenance operating cost is expected be Rs.
10,000 per annum.
If the firms cost of capital is lower than the IRR the project is acceptable
10.5 NET PRESENT VALUE Vs INTERNAL RATE OF RETURN
The Net Present Value (NPV) and Internal Rate of Return (IRR) are two S1milar
methods in evaluating Capital Investment proposals Both these methods use the similar
procedure of discounting the future cash flows, with almost similar Mathematical
formulae. Under NPV method a project is acceptable when it possess positive NPV
(NPV>0) and in case of IRR method all projects with internal rate of return higher than
the required rates of return (r>k) are acceptable. In case of economically independent
projects if a project which adjudged as acceptable under NPV criterion is automatically
founds acceptable under IRR criterion as well. It is basically true due to the fact that any
project which can generate positive NPV when future cashflow are discounted at a
minimum required rate of return or cost of capital (k) is likely to possess a higher IRR
(r>k).
Let us recall the formulae for NPV and IRR for possible equivalence between them
The discounted value of cashflows on the left handside of equation 10.4 which equals to
IO must be smaller than the left- hand side of inequality in equation 10.3 which is
greater than IO. Since CFS are identical, 'r' must be greater than 'k'. Further the said
equivalance can be shown as in Figure 10.1
FIGURE - 10.1
NPV PROFILE AT DIFFERENT DISCOUNTING RATES
The figure indicates that the size of NPV is positive when the project is evaluated at the
rate of 'k'. For the same said project the IRR or V which is defined to be the discount rate
which makes NPV = 0, is greater than 'k'.
Against the above said proof, the project selection is likely to be similar under NPV and
IRR method. If a project is found acceptable under NPV, it automatically gets selection
under IRR. However, this equivalence ends in confrontation when projects are mutually
exclusive type.
Conflicting Ranking by NPV and IRR:
The NPV and IRR methods are expected to rank all independent projects similarly.
However, this dictum is found to have been contradicted at times especially when
projects are dependent type. A business enterprise is often to decide upon one of the
alternatives among two or three mutually exclusive investment projects. For example, a
firm has to decide on one of the two alternatives like (a) Installing a conveyor belt or (b)
Purchasing a fleet of trucks inorder to transport mineral ore to furnace. Similarly most
make or buy decisions involve mutually exclusive alternatives. In case of such projects
NPV and IRR are likely to differ in selecting the profitable project. To illustrate, consider
the following products
Projects
Initial
outlay
Annual
cashflows
Life of the
project
NPV@15% IRR
I 14,000 2745 20 3181 19%
J 19,000 3550 20 3210 18%
If I and J are independent, both are acceptable due to positive NPV as well as IRR being
greater than K in both the cases. But in case these projects are dependent on one
another clear cut decision can be taken on acceptability of anyone of them being
superior to the other. The NPV and IRR methods rank them differently. If one follows
NPV method project J is acceptable based on larger Net Present Value. But the size of
IRR is found larger in case of project I. Thus a conflicting ranking is evident under both
the methods.
The conflicting ranking is attributed to some of the following situations.
1. When projects involve different cash outlays.
2. When projects under comparison are with different lives.
3. When the patterns of expected cashflow differ among the projects.
i. Different Project Sizes
The NPV and IRR criterion are likely to provide conflicting ranking of projects when the
size of outlay differs among the said mutually exclusive projects. Consider the following
illustrations:
Illustration 10.13: Tantex Knitware Ltd. is considering two equally efficient spinning
machines. Lakshmi Machine Tools (LMT) machine is expected to cost Rs.48, 700. It is
supposed to work for 5 years with Rs. 17,000 annual cash savings compared to the
present practice of buying the ready-made output from suppliers. The machine being
sold by HMT on the other hand expected to last Rs.31, 600 and cash savings are
estimated to be around Rs. 12,000 per annum for 5 years to come. The flow of cashflows
from both alternatives is as follows
Years t0 t1 t2 t3 t4 t5
LMT Machine 48700 17000 17000 17000 17000 17000
HMT Machine 31600 12000 12000 12000 12000 12000
Calculate the NPV and IRR
TABLE 10.18
CALCULATION OF NPV AND IRR FOR THE SAID MACHINE
Machine NPV @ 10% IRR
LMT 15747 22%
HMT 13892 26%
If one goes by NPV criterion LMTs machine is acceptable compared to HMTs spinning
Machine. On the other hand, if one uses IRR method the HMTs machine is found to
earn higher IRR and hence acceptable. Thus the methods rank the projects conflictingly.
ii Different Lives Of Project
IRR and NPV method are likely to rank the projects differently when project with
different life spans are compared. Some investment projects are likely to generate
cashflows from the very next year of its implementation while other exhibits an initial
gestation period and subsequently sizable returns. A comparison between such projects
poses the problem of conflictory ranking by NPV and IRR.
Illustration 10.14
A tree plantation company has acquired the rights of collecting Timber from the
Standing Casurina trees from a social-forestery development agency. The plantation
company has two alternatives: first alternative is immediate cutting of the timber and
make a cashflow of Rs.6.25 lakhs by the end of the year against a deal price of Rs.5
lakhs, second alternative is delay the logging for Rs.5 more years, and the larger plants
would produce Rs. 10.37 lakhs at the end of 5th year for the same deal price of Rs.5
lakhs.
To present the details
If one looks at the calculated NPV @ 10% discount rate, the size of NPV is large with
second alternative. But IRR shows that the project A records higher IRR of 25% against
just 16% in case of alternative B. Thus, NPV and IRR found conflicting in evaluating
projects with different lives.
iii) Timing of Cashflows
Certain projects are likely to generate sizable cashflows in the initial years while others
are likely to record larger cashflows in the later years. Such projects are said to differ in
their timing of cashflows. The NPV and IRR methods are likely to conflict in ranking the
projects with such differences in timing of cashflows.
To illustrate, two projects requiring same cash outlay are having the following pattern
of cashflows:
to t1 t2 t3
Project A (16,800) 14000 7000 1400
Project B (16,800) 1400 8400 15,100
TABLE 10.19
THE NET PRESENT VALUE OF THESE TWO PROJECTS AT
RATES ARE AS FOLLOWS:
Discounting Rate (k) NPV
Project A Project B
0% 5600 8100
5% 4090 5200
10% 2760 2760
15% 1590 700
20% 530 (1060)
25% (400) (2570)
30% (1250) (3880)
The size of net present value of both the projects is similar at 10 percent discount rate,
indicating that any one of the projects is acceptable. However, an estimation of IRR for
the said projects by plotting the sizes of NPV at discounting rates reveals that (See
Figure 10.2) the IRR of project A is 23% and IR of project B is 17% (IRR being the
discount rate where NPV became zero). Thus the IRR criterion conflicts with NPV and
attaches superiority to project A over Project B. The difference in projects' profitability
can be attribute to the pattern of cashflows over their lives.
Reasons for conflicting Ranking:
The NPV and IRR methods are basically relied on same principle of comparing the time-
value adjusted cashflows. However, they found, differ in ranking the projects especially
when projects differ with respect to their lives, size of outlays and patterns of generating
cashflows. One common explanation put forth in 'Finance literature' towards their
conflicting ranking by the two DCF methods is the assumption on Reinvestment Rates.
The NPV method implicitly assumes reinvestment of the intermediate proceeds at the
rate equal to the cost of capital. However, the IRR method is expected to assume that
the reinvestment at projects' internal rate of return. The reinvestment assumption made
under NPV fairly explains that interim cashflows are expected to generate minimum
opportunity rate elsewhere. This implicit assumption looks logical. Expecting a rate of
return equivalent to the projects' IRR from the intermediate cashfows under IRR
method, is really on higher side. Definitely the liquid form cashflows may not be in a
position to earn such high rate. Thus the assumption has no economic basis. The
alternative use of intermediate cashflows cannot earn IRR. Then the NPV method could
be ranked as fairly dependable in providing an optimal solution to capital budgeting.
10.6 CAPITAL RATIONING
So far the capital budgeting problem has been addressed only to the extent of evaluation
of profitability of individual projects without much consideration to the size of capital
availability. The DCF techniques establishes that all those projects which could generate
cashflows larger than the marginal cost of capital 'k' are acceptable when necessary
funds are available to finance them. However, no firm, in reality, manages to control,
unlimited amounts of capital to undertake all available projects. In such a situation, the
capital budgeting problem addresses to a new dimension of involving the allocation of
scarce capital resources among competing economically desirable projects as not all of
them could be carried out due to capital constraints. This problem is referred to as
'Capital Rationing'.
If a firm plans to adopt IRR method, its optimal investment policy suggests the
acceptance of all projects till the point that the internal rate of return is equal to the
marginal cost of capital of the firm. However, the firms cannot raise unlimited amounts
of capital at a constant cost. Rather the cost of capital (k) is likely to raise after a specific
level of borrowing from the capital market. The raising marginal cost of capital supply
curve provides newer implications on the selection of project are with marginally higher
internal rates of return. Certain marginal projects with IRR close to the increased cost of
capital will no longer be acceptable When projects are arranged in terms of decreasing
IRR, one can arrive at the marginal rate of returns from different individual projects. An
illustration of this situation is shown in Figure 10.3.
FIGURE - 10.3
CAPITAL RATIONING WITH IRR AND K
The intersection of incremental rates of return (IRR) curve with the marginal cost of
capital (k) curve determines the optimum allocation of capital as well as the amount of
capital that a firm can raise to finance all profitable projects in order to maximise its
wealth.
Selection of Investment Projects under Capital Rationing:
Under conditions of capital budgetary constraints, a firm cannot accept all profitable
projects. The only optimal decision consistent with the economic principle is equating
the marginal benefits to marginal costs. The 'marginal' concept requires calculation of
incremental rates of returns between projects. Further, when a firm is considering
certain dependences in projects, the incremental rates of return are also to be calculated
in between bundles of projects. The bundle providing the last incremental rate of return
greater than the firm's cost of capital could be considered as optimal subset of projects.
Illustration 10.15: Let us consider three projects with investments and cashflows as
follows (Illustration adopted from Lynn & Bussey, The Economic Analysing Industrial
Projects, PHI 1978, p.p.269)
Project Investment
Net cashflow per
year
Life
A - 12,000 +4281 5
B - 10,000 +4184 5
C - 17,000 +5802 10
If the firms' minimum required rate of return is 10 per cent and all the three projects are
economically independent of each other, let us examine what projects are to be selected
at different budget ceilings?
First, let us list all possible combinations of the above said projects where each
combination is economically mutually exclusive bundle:
Combination
number
Projects
Total
investment
outlay
Total cashflows expected
from the combined projects
1 A 12000 4281 - 5 yrs
2 B 10000 4184 - 5 yrs
3 C 17000 5802 - 10 yrs
4 AB 22000 8465 - 5 yrs
5 AC 29000
10083 - 5 yrs
5802 - 6-10 yrs
6 BC 27000
9986 - 5 yrs
5802 - 6-10 yrs
7 ABC 39000
14267 - 5 yrs
5892 - 6-10 yrs
In order to calculate the incremental returns let us arrange all these
projects in the order of their sizes of investments.
In order to calculate the incremental returns let us arrange all these projects in the order
of their sizes of investments.
Combination
number
Projects
Total
investment
outlay
Total cashflows expected
from the combined projecs
2 B 10000 4184 - 5 yrs
1 A 12000 4281 - 5 yrs
3 C 17000 5802 - 10 yrs
4 AB 22000 8465 - 5 yrs
6 BC 27000
9986 - 5 yrs
5802 - 6 -10 yrs
5 AC 29000
10083 - 5 yrs
5802 - 6-10 yrs
7 ABC 39000
14267 - 5 yrs
5802 - 6-10 yrs
The next step is the calculation of incremental rates of return between corresponding
combinations of projects. For example, between first two combination of projects, the
incremental added investment is (12000 - 10000) = 2000. And incremental annual
cashflows are Rs.97 for 5 years. The IRR and NPV of these incremental flows are as
follows:
(At K = 15%)
NPV = 97 (3,352) -2000 = -1675
IRR = = -34.06%
Then second combination is not viable to accept when compared to its incremental
profitability continuing this logic the incremental returns for different projects are as
follows
Based on the above incremental returns, we can decide on accepting those combinations
of projects at different budget levels. For example, if budget is 30,000, B and C
combination of projects are acceptable. Similarly at Rs.25,000 budget level only project
C (combination 3) is profitable. Thus the incremental analysis fairly provides a solution
for considering different combinations of projects within the budgetary constraints.
10.7 Linear Programming Model for Capital Rationing
Linear programming model, more specifically, the integer programming model could be
used to allocate capital to different projects under conditions of capital rationing.
Considering an objective function to maximise net present value of different
combinations of projects, the Linear Programmes model can be constructed. The
considerations relating to Budgeting constraint (B), mutually exclusive alternatives for
projects and such other constraints can be accommodated through suitable formulation
in addition to project indivisibility constraint of either accepting the project in to or not
selecting it altogether. A structural formulation could be shown as follows:
CFtj = Cashflows of j
th
project at t
th
period
d = number of projects under consideration
n = life of the project
k = Firm's marginal cost of capital
Xj =Decision variable taking a value of 0 or 1
IOtj =Initial outlay of j
th
project
Bt = Total budgeted resources
The solution to this type of mathematical programming ensures an optimal allocation of
capital resources among competing investment projects.
10.8 SUMMARY
In this chapter detailed accounts of different capital budgetary techniques have been
analysed. The traditional project evaluation techniques like 'payback' and 'ARR'
methods provide simpler procedures to examine the project viability. However, the
limitation of these traditional techniques, especially in terms of non-consideration to
changing time value of money necessitated the prominent use of Discounted Cash Flow'
based techniques. While NPV method tries to arrive at the project's profitability after
discounting the future cashflows ,at a minimum required rate of return, the IRR method
directly works out it projects internal rate of return for a possible comparison with the
cost of capital for acceptance of a project. The profitability index method provides a
ratio of benefit-to-cost in a project. The NPV and IRR methods are likely to exhibit
conflicting ranking when projects under comparison differ in respect of scale, life and
cashflow pattern. The popular explanation for such contradiction is the underlying
different assumption on 'reinvestment rates of return'. The limited availability of capital
resources in any firm posits a capital rationing problem in capital budgeting. The
calculation of incremental rates of return likely to help in finding suitable combination
of projects at different budget levels. Integer programming types of mathematical
programmes are quite handy to solve the capital rationing problem especially when a
firm faces allocation of resources between a variety of projects.
10.8 KEY TERMS
1.Capital Budgeting: The decision whether or not to undertake a capital project or
which of several capital projects to initiate.
2. Payback period: The number of years until cashflows arising from a capital project
are enough to payback the initial cash outflow required by the project.
3. Accounting Rate of Return: A capital project evaluation tool computed by
dividing the incremental net income from the project by investment required for the
project.
4. Present Value Analysis: The capital budgeting tool that uses the concept of time
value of money to enable one to compare the cashflows that would occur in different
years.
5. Discounting Rate: The capitalisation rate, equivalent to the cost of capital (for
example, interest rate) that is used in adjusting the future cashflows to arrive at their
present values.
6. Internal Rate of Return: The discounting rate at which the present values of a
project's net cashflows are zero.
7. Capital rationing: A situation that occur when the re-selection of a combination of
viable projects is to be taken up for want of capital budgetary constraints.
10.10 EXERCISES
1. What is capital budgeting? Explain its importance in Financial Management.
2. Discuss the characteristics and relative merits and demerits of different methods
of appraising capital investment proposals.
3. What do you mean by time by time value of money? Bring out the superiority of
capital budgeting methods which adjusts their cashflows to changes in time value
of money.
4. 'Despite its weaknesses, the payback method is popular in practice'. What are the
reasons for its popularity?
5. The management of a company has two alternative projects under consideration.
Project A requires a capital outlay of Rs. 1,20,000 but project B needs Rs.
1,80,000. Both are estimated to provide a cashflow for five years A Rs.40,000 per
annum and B Rs.58,000 per annum. The cost of capital is 10%. Show which of
the two projects is preferable from the point of view of (i) Net present value and
(ii) Internal rate of return.
[NPV: 31640, 39878; IRR; 19.8, 18.5]
6. The following is a summary of financial data in respect of five investment projects.
Initial outlay Net annual cashflow
Life in
year
A 60,000 18,000 15
B 88,000 15,000 25
C 2,150 1,000 5
D 20,500 3,000 10
E 4,25,000 1,50,000 20
Rank these projects according to
(i) Payback period.
(ii) Accounting Rate to Return.
(iii) Net present value at a cost of capital of 10%
[C, E, A, B, D]
7. A company is considering the purchase of a Delivery Van and is evaluating the
following two choices:
a. The company can buy a second-hand van for Rs.80,000 and after five years sell
the same for Rs.20,000 and replace it with another second-hand van which is
expected to cost Rs. 1,20,000 and last 5 years with a terminating value of
Rs.20,000.
b. The company can buy a new van for Rs.2,40,000. The projected life of the van is
10 years and has an expected salvage value of Rs.30,000 at the end of ten years.
When the services provided by the vans under both the choices are the same.
Assuming that the cost of capital 10% which choice is preferable.
[Alternative A]
8. The Philips Corporation which has a 50% tax rate and a 10% after tax cost of capital is
evaluating a project which will cost Rs. 1,00,000 and will require an increase in the level
of inventories and receivables of Rs.50,000 over its effective life. The project will
generate additional sales of Rs. 1, 00,000 and will require cash expenses of Rs.30,000 in
each year of its 5 year life. It will be depreciated on straight line basis. What are the net
present value and IRR of the project?
[NPV=51650 IRR 21%]
9. A firm needs a component in an assembly operation. If it wants to do the
manufacturing itself, it would need to buy a machine for Rs.4 lakhs which would last for
4 years with no salvage value. Manufacturing costs in each of the four years would be
Rs.6 lakhs, Rs.7 lakhs, Rs.8 lakhs and Rs. 10 lakhs respectively. If the firm had to buy
the components from a supplier the component would cost Rs.9 lakhs, Rs. 10 lakhs, Rs.
11 lakhs and Rs. 14 lakhs respectively, in each of the four years. However, the machine
would occupy floor space which could have been used for another machine. This better
machine could be hired at no cost to manufacture an item, the sale of which would
produce net cashflows in each of the four years of Rs.2 lakhs, it is impossible to And
room for both the machines. Should the firm make component or buy from outside?
[Buy-beneficial]
CASE 10.1
After returning from a seminar, the President of M/s.My Fair Lady Cosmetics Limited
posed the following question to his managers. "We have traditionally evaluated new
products for our company using the payback method and a maximum acceptable
payback of 2 years. At the seminar, I attended; they said that the present value analysis
is better way to evaluate capital projects. Now, we have been in business for 15 years and
are pretty successful. Obviously, the evaluation of capital projects is important to our
business. If we have been using the wrong method all these years, why have not we
failed?"
The managers are now requested to answer the President "whether the present value
analysis would have leaded the company to select a different set of products?" To answer
this question a detailed list of products accepted or rejected during the life of the
company has been compiled. It is discovered that most of the products launched by the
company had an average life of 4 years. Most products required an initial outlay of Rs. 1,
00,000 to Rs.2, 00,000. Further most products resulted in the same amount of
cashflows during their life. These observations found true for all the products either
accepted or rejected.
Required:
a) Determine the approximate discounting rate for use in present value analysis which
would cause the company to accept and reject the same projects that they have accepted
or rejected under currently practiced payback method. Illustrate with examples.
- End Of Chapter -
LESSON 11
CAPITAL BUDGETING IV: TECHNIQUES UNDER RISK AND
UNCERTAINTY
Objectives
After reading this lesson you will be able to...
Understand the concept of Risk and its Measurement
Evaluate the role of risk as a new dimension in Capital Budgeting Problem
Appreciate different Capital Budgeting Techniques to tackle Risk and Uncertainty
Make use of 'Normal Distribution' theory in business decision making
Structure
Introduction
Risk in Capital Budgeting Context
How to measure Risk?
Capital Budgeting Techniques under Risk
- Certainty Techniques Adjusted under Risk
- Methods Based on Statistical Techniques
- Probability Distribution Methods
- Other Methods
Summary
Keywords
Exercises
Appendix - area under normal curve
INTRODUCTION
The discussion on capital budgeting process and evaluation techniques have been so far
centered on various estimates that a firm has to make out on cashflows relating to the
future. However, making a perfect forecast on the future events is impossible for any
decision maker. It leads to uncertainty about the cashflows expected since they depend
upon future state of economic conditions. The uncertainty associated with the
anticipation of occurrences of possible events likely to make the prediction of cashflow -
sequence difficult. It results in variability in expected stream of returns - which is
formally termed as 'Risk'.
Not all the projects possess similar 'variability' in their expected returns. The projects
which record greater variability of expected returns are said to be riskier projects. For
example, the investments made in Government Bonds or Treasury Bills at fixed yield,
likely give 'certain' returns. It is believed that the government will not fail and the
payment of interest would be regular. On the other hand, the investments made in
shares of different companies are likely to possess a degree of uncertainty in realising
the expected returns. Such uncertainty is often referred to as 'Risk' associated with those
investments. Similarly the degree of risk varies with different investment projects.
Investments in many traditional lines of business arc likely to carry normally a
moderate amount of risk. On the other hand, the investments in commercialising a new
product or investments in oil exploration business possess high degree of risk, since the
returns from such projects are unpredictable.
RISK IN CAPITAL BUDGETING CONTEXT
Risk analysis under capital budgeting exercises has certain implications. It is well known
that the capital budgeting decision involves evaluation of benefits from different
investment projects. These benefits are measured as cashflows either in terms of
incremental flows or differential flows. However, the estimation of these cashflows
depend upon the assumptions of variety of factors like market acceptability of the
product, sales volume, cost of production, general changes in prices, competition, and so
on. These estimates are in turn largely influenced by general changes in an economy,
inflation, political environment, etc. However, the accurate estimation of all the factors
and consequent influence of them on expected returns will not work out to the actuals.
In other words, the actual realised returns definitely vary from estimates.
On the other hand, the project evaluation under capital budgeting exercise assumes that
the initial outlay is one-shot expenditure and that the life of the project can be estimated
in certain number of years. Based on such assumptions various evaluating techniques
estimate the incremental returns in terms of after-tax cashflows. But in reality, projects
do require subsequent outflows on the eve of either due incidence of a major 'repair' to
the plant and machinery or due to a contemplated change in the manufacturing process
for meeting the market requirements. In such a case, the dynamically changing cash
outlays as well as the expected returns from such projects are likely to vary. Further,
early product obsolescence, entry of competitive products, new technological
developments are likely to bring down the life of the projects much earlier than the
technically certified life of the plant and machinery under use. In such a case, the
estimations made on 'depreciation' would go wrong and consequently the expected
future cashflows as well. This in turn, makes the actual and expected returns from a
project to vary.
Thus, the risk in the context of a capital budgeting decision results from the variations
between the estimated and actual returns. Then variations are either due to the
variability in expected cash in-flows, or variability in the cash outlay and project
obsolescence. Greater the variability in the expected returns, the riskier the project is
said to be. Hence risk adds a new dimension in the evaluation of capital investment
projects.
HOW TO MEASURE RISK?
In the earlier paragraphs, risk has been defined as the variability in expected returns
that one ultimately realises from an investment. In statistical terms risk refers to
'probability' that some unfavourable event is likely to happen. Suppose an asset
manager has a choice of selecting one of the three alternatives as shown below:
Alternative I : Investing an amount of Rs. 1,00,000 in Government Bonds yielding 14%
rate of return for 5 years;
Alternative II : A Blue Chip company's debenture with a coupon rate of 17% p.a
Alternative III : An investment project which costs Rs. 1,00,000 and yields an internal
rate of return as specified in Table 11.1, depending upon the state of the economy.
TABLE - 11.1
PROBABILITY DISTRIBUTION OF EXPECTED RETURNS
State of the
economy
Probability of
it's happening
Expected returns
Govt.
Bonds
Company
Debenture
Investment
Project
Extreme recession 0.05 0.14 0.22 -0.07
Slight decline
compared to
present
0.20 0.14 0.20 0.10
Similar to present
phase
0.50 0.14 0.17 0.24
Slight betterment
compared to the
present
0.20 0.14 0.15 0.28
Extreme boom 0.05 0.14 0.12 0.36
1.00
The rate of return on a corporate debenture has been estimated based on likely changes
in interest rates which depend upon the state of the economy. Further, the changing
interest rates exhibit an inverse relationship with the bond prices. A prosperous
economy leads the interest rates to rise and consequently the prices for corporate bonds
would decline. Hence the capital gain component falls in the interest rate estimation.
The expected returns across different events for given possible states of economy exhibit
the probability distribution of returns, wherein the possible 'probability' is attached to
each of the possible outcomes. The table 11.1 clearly shows that the possible outcomes
are not known with certainty for the alternatives, except the Government Bonds, which
yield a certain return irrespective of the state of the economy. Thus the alternatives II
and III are said to be risky.
In order to arrive at a comparable rate of return from the above alternatives, a statistical
summary could be obtained for the above probability distributions. The 'expected' rate
of return for each of these alternatives could be arrived at by multiplying each possible
outcome by its probability of occurrence and then summing up these products. It is
simply the weighted average of expected returns, weights being the probabilities.
... (11.1)
where, ri = i
th
possible rate of return, and pi = probability of i
th
event
We will be learning about the remaining part of risk measurement in later part of this
lesson.
CAPITAL BUDGETING TECHNIQUES UNDER RISK
Now that, you appreciate the association of risk in all most all investment projects,
project appraisal has to necessarily consider additional parameters in order to examine
the viability of each risky project. Further, as it is also well known that the degrees of
risk between projects certainly vary, and decision rules are to be drawn for accepting
projects with higher degree of risk. It is prudent to believe that high risky projects are
naturally acceptable if the expected returns from them are proportionately larger. Some
of the project evaluation techniques which would incorporate the 'risk' are:
1. Certainty techniques adjusted for risk
i) Adjusted payback method
ii) Risk-adjusted NPV method
iii) Certainty-equivalents method
2. Statistical techniques
i) Expected monetary value method
ii) Standard deviation method
3. Probability distribution based methods
i) Normal distribution method for projects with Independent cashflows
ii) Normal distribution method for projects with dependent cashflows
4. Other methods
i) Sensitivity analysis
ii) Decision tree approach
iii) Preference - ordering approach
1. CERTAINTY TECHNIQUES ADJUSTED FOR RISK
The project evaluation techniques under this category accommodate necessary
adjustments for the techniques already examined in the previous lesson. The techniques
of project evaluation under certainty have assumed certain cashflows from a project
which do not vary from that of the estimated ones. However, under 'uncertainty' these
cashflows are to be adjusted to represent their readability.
(i) Adjusted Payback Method : Payback period, as discussed in earlier lesson,
focuses on the time required for the recovery of the capital invested in a given project.
Under this method projects with shorter payback are preferred over ones with longer
payback periods. Such a decision rule automatically keeps away all riskier projects.
Further, if the cashflows are adjusted for time value of money before determining the
payback period, the traditional payback method is likely to accommodate the additional
benefits of present value analysis. Considering the in-built risk-avoidance, the adjusted
payback method has become popular in business circles.
Illustration 11.1
Compute time-adjusted payback for a project with an initial outlay of Rs.10000 and was
expected to generate Rs.3000 net cash inflows per year over its five years life. Let us
assume that the company is using a 14% discounting rate.
Normal Payback period
= Initial outlay / Cashflow = 10000/3000 = 3.33 years
Adjusted payback period
Step I: Discount the cashflows for finding their present value
Table 11.2
CALCULATION OF PRESENT VALUES
Year Cashflow PV factor @ 14% Present values
1 3000 0.877 2637
2 3000 0.769 2307
3 3000 0.675 2025
4 3000 0.592 1776
5 3000 0.519 1557
Step II. Computation of Time adjusted payback for the project
Initial outlay = 10000
Present value of 1st year cashflow = 2631
------------
To be paid back after 1 year = 7369
PV of 2nd year cashflow = 2307
------------
To be paid back after 2 years = 5062
PV of 3rd year cashflow = 2025
------------
To be paid back after 3 years = 3037
PV of 4th year cashflow = 1776
------------
To be paid back after 4th year = 1261 <--- Payback period comes here
PV of 5th year cashflow = 1557
------------
Surplus = 296
------------
Step III. Calculation of exact fraction.
1261 / 1557 = 0.81 years
Adjusted payback period = 4.81 years
Time adjusted payback period helps in evaluating the uncertainty about the project's
life. If the capital asset wears out before the end of the project's expected life, the firm
fails to recover the total investment in the said project. In such a case the project fails in
earning the rate of return expected to be generated from it. The project examined in the
above illustration takes 4.81 years, almost equal to the project life. If management feels
that there is a good chance of the capital asset wearing out before the end of its expected
life, they would choose to undertake this project.
Thus, the adjusted payback method draws a superior evaluation on the project under
consideration.
(ii) Risk Adjusted NPV Method : It has been argued in Finance Literature that risky
projects are acceptable if they can generate additional returns over and above what
riskless projects could earn. In other words, the investments in risky projects are
expected to earn a premium commensurate with the degree of risk they possess.
Accordingly, the greater the uncertainty in expected cashflows from a project, the
greater the risk and the larger the premium required from such projects. The risk-
adjusted NPV method tries to incorporate this argument in capital budgeting process, if
one considers a 'certain' return on an investment as 'risk-free' rate. For example,
investment in Government Bonds gives a certain return. An investor's expected return
that could satisfy him for bearing the additional risk in a risky project could be treated
as 'risk premium'. The sum of the 'risk free' rate and the 'risk premium' could be used to
adjust the discounting rate in NPV method to examine the viability of the risky projects.
It can be done as...
... (11.2)
where, i* = risk adjusted discount rate = RF + = Risk free rate + risk premium
Suppose the risk free rate is 10% and expected risk premium is 5%, the cashflows of a
risky project are now to be discounted at a higher discount rate of 15%. Naturally, when
discount rate increases, the present values of the said cashflows decreases, thereby the
size of NPV decreases giving way for reconsidering the decision on projects viability.
Illustration 11.2
NEPC industries are considering different investment alternatives of building a Lignite-
based power plant or a Wind power based power plant. The management believes that
Lignite-based plant is of average risk in its character and the wind-power based plant is
of high risk due to the problem of high tidal winds in coastal region. Further, the average
cost of capital on a moderately risky project is 10 percent and for high risk investment it
is 15 percent. The cash outlay for the construction of each plant is expected to be almost
similar and the revenues do work-out to same excepting at initial stages.
Year
Cashflows in alternative plans (Rs. Lakhs)
Lignite based power
plant
Wind power based
power plant
0 (4000) (4100)
1 - 400
2 500 600
3 1000 1000
4 1200 1200
5 1500 1500
6 1500 1500
7 1500 1500
Since, the projects are conceived to be different with respect of their riskiness in
generating cashflows, they are exerted to be subjected at different discounting rates. The
Lignite-based project is to be evaluated by using normal cost of capital in its NPV
formula and risk-adjusted with discounting rate for wind-power plant.
Accordingly, the NPV of both the projects are:
Lignite-based power plant's NPV =
TABLE 11.3
NPV CALCULATE USING RISK FREE RATE FOR NORMAL LIGNTE
PROJECT
Year CF PV factor @ 10% PVCF
2 500 X 0.826 413.00
3 1000 X 0.731 751.00
4 1200 X 0.683 819.00
5 1500 X 0.621 931.50
6 1500 X 0.565 847.50
7 1500 X 0.513 769.50
4532.10
Less IO 4000.00
NPV 532.10
Adjusted NPV for wind-power project =
Table - 11.4
ADJUSTED NPV CALCULATION USING 15% DISCOUNTING RATE FOR
WIND-POWER BASED PLANT
Year CF PV factor @ 15% PVCF
1 400 x 0.864 347.60
2 600 x 0.756 453.60
3 1000 x 0.656 656.00
4 1200 x 0.572 686.40
5 1500 x 0.497 745.50
6 1500 x 0.432 648.00
7 1500 x 0.376 564.00
4101.10
Less IO 4100.00
NPV 1.10
Thus, we observe that the viability of wind power based project is lower, when the
cashflows are adjusted for risk. It is true in spite of the fact that the said project even
generated larger cashflows initially compared to the Lignite based project.
If one uses the IRR method instead of NPV for evaluating the projects, the internal rates
of return of the projects should be compared with the risk-adjusted minimum required
rate of return, i.e. i*, to evaluate the project's acceptability in the light of larger perceived
risk.
(iii) Certainty Equivalents Method : Under the certainty equivalents approach, the
projects cashflows are directly adjusted to 'risk' by considering certain conservative
estimates. While under risk-adjusted NPV method the denominator is adjusted, the
certainty equivalents method attempts to alter the numerator of the present value
equation. Certainty equivalent cashflow is the 'best estimate' of the cashflow from a
given project that one can expect under riskier conditions. However, such an estimate
depends on the subjective risk-aversion utility functions of individuals.
A certainty equivalent coefficient (t) is generally arrived at to adjust the future expected
cashflows. The coefficient can be determined as a ratio of certain cashflows to the
uncertain future cashflow.
Certainty Equivalent Coefficient (t) = Certain cashflow / Uncertain
cashflow ... (11.3)
For example, suppose a risk-averse investor is indifferent to the various combinations of
risk and return (as can be seen in Figure 11.1). At point 'M' if an investment is perceived
to have a risk of M, with an expected return of Rs. 10,000 by an individual and the said
individual, however, is indifferent to an almost certain alternative of Rs.6,000 at point
'N'; an expected return of Rs. 15,000 at point 'O' with risk O, then his indifference curve
can be shown as in Figure 11.1.
FIGURE - 11.1
RISK-RETURN TRADE FOR A RISK AVERAGE INVESTOR
Then, the certainty equivalent factor at risk level of 'M' is
M = 6000 / 10000 = 0.6
and that of 'O' is
O = 6000 / 15000 = 0.4
Thus the certainty equivalent coefficient '1' assumes a value between 0 and 1. A
coefficient of = 1 indicates complete certainty and anything lower than it represent the
size of risk. Depending on decision makers' subjective confidence on obtaining the
cashflows over the years, the coefficient could be arrived at.
Illustration 11.3
Bharti Telecom Limited of Gurgaon was considering a project to launch 'Speaker Phone'.
BTL used certainty equivalents approach to capital budgetary decisions. The expected
cashflows and certainty equivalent coefficients for each of the future cashflows are as
follows:
Year Expected Certainty equivalent
cashflows coefficient
0 (72,00,000) 1.0
1 15,00,000 0.9
2 37,00,000 0.9
3 50,00,000 0.7
4 50,00,000 0.7
The cost of new machine is known with certainty, since the manufacturer has given the
fixed quotation price for 90 days. If BTL's cost of capital is 12 percent, should the project
be accepted? Assume that the risk-free rate of return is 10 percent.
Table - 11.5
CALCULATION FOR PROJECT'S CERTAINTY EQUIVALENT CASHFLOWS
Year
Expected
cashflows
Adjustment
factor
Certainty equivalent
cashflow
0 (72,00,000) 1.0 (72,00,000)
1 15,00,000 0.9 13,50,000
2 37,00,000 0.9 33,30,000
3 50,00,000 0.7 35,00,000
4 50,00,000 0.7 35,00,000
In order to examine the viability of the project, one has to calculate the NPV based on
adjusted expected cashflows. Since these cashflows are adjusted to the size of risk, the
discounting is carried out at risk-free cost of capital.
... (11.4)
where,
CFt = Certainty equivalent cashflows during t
th
period
RF = Risk-free discount rate
IO = Initial outlay with a certainty equivalent factor of = 1
n = life of the project
NPV for the BTL's project could be calculated as follows:
NPV = 13,50,000/(1+0.1)
1
+ 13,50,000/(1+0.1)
2
+ 13,50,000/(1+0.1)
3
+
13,50,000/(1+0.1)
4
= 72,00,000
TABLE 11.6
CALCULATION OF NPV BASED ON CERTAINTY EQUIVALENT
CASHFLOWS FOR BTI'S PROJECT
Thus, the certainty equivalent method recognises the risk and adjusts the cashflows
directly compared to the use of adjusted discounting rate. Further the certainty
equivalent coefficients can be changed over different points of time to accommodate, the
'uncertainty' during different time horizons. However, this method of risk-adjustment
suffers due to forecasting problems and estimation bias.
2. METHODS BASED ON STATISTICAL TECHNIQUES
The three methods of adjusted payback, risk-adjusted discounting rate, certainty
equivalent methods have enabled us to handle the risk in evaluating a risky project.
However, all the three methods depended on evaluator's perception on the degree of
risk to design an appropriate adjustment coefficient. However, the advancements in
Statistics now help one to adopt a more scientific and objective estimation of 'most
likely' forecasts. A statistical measure instead of depending on a single forecast value,
considers all surrounding values through the concept of 'Probability Distribution'. A
probability of an event could be thought of as chance percentage of a certain outcome.
For example, if it is determined that a particular outcome has a probability of 0.3, it is
expected that the given outcome will occur in three out of ten times. Hence, the
Statistical Techniques consider the whole possible range of cashflows along with their
probability of occurrence to represent the degree of risk as well as the percentage chance
of occurrence. Two basic methods under this category are:
(i) Expected Monetary Value (EMV) Method : Expected monetary value is simply
the average expected cashflows of the project over different possible likelihoods, when
the full range of cashflows is estimated along with their probability assignment. EMV
can be calculated as weightage average of various outcomes,
... (11.5)
where, CFt = Expected cashflow for period t
CFij = Cashflow of the i
th
period for jth event
Pjt = Probability of the j
th
event for period t
The calculation of EMV provides an indicative estimate of the likely returns of the
project, but it may never be realised regardless of whether the attached probabilities are
estimated objectively or subjectively. The EMV provides a scientific basis of estimating
most likely cashflows over different possible events.
Illustration 11.4
M/s Harrisons Universal Flowers Ltd. are considering a floriculture project with an
initial outlay of Rs. 10 lakhs. The expected returns from such a project would work for
three years at the most. The size of cashflows that one can realise depends on the
climate, as well as the demand at domestic and international markets. The estimated
cashflows across different estimates about the market are as follows:
Event
Business
condition
1 year 2 year 3 year
Cashflow Probability Cashflow Probability Cashflow Probability
A Deep recession 1,00,000 0.10 2,00,000 0.10 1,00,000 0.10
B Mild recession 2,00,000 0.15 4,00,000 0.15 2,00,000 0.20
C Normal 3,00,000 0.50 6,00,000 0.40 3,00,000 0.30
D Above normal 4,00,000 0.20 8,00,000 0.20 4,00,000 0.30
E Prosperous boom 5,00,000 0.05 10,00,000 0.15 5,00,000 0.10
In order to examine the project's viability, let us calculate the expected monetary values
of each year's cashflows, as given under:
TABLE 11.6
CALCULATION OF EXPECTED MONETARY VALUES FOR FLORICULTURE
PROJECT:
Event
1 year 2 year 3 year
Cashflow Probability
Expected
Value
Expected
Value
Expected
Value
A 1,00,000 0.10 10,000 2,00,000 0.10 20,000 1,00,000 0.10 10,000
B 2,00,000 0.15 30,000 4,00,000 0.15 60,000 2,00,000 0.20 40,000
C 3,00,000 0.50 15,000 6,00,000 0.40 2,40,000 3,00,000 0.30 90,000
D 4,00,000 0.20 80,000 8,00,000 0.20 1,60,000 4,00,000 0.30 1,20,000
E 5,00,000 0.05 25,000 10,00,000 0.15 1,50,000 5,00,000 0.10 50,000
EMV1 = 2,95,000 EMV2 = 6,30,000 EMV3 = 3,10,000
The Net Present Value of the project (at 10% discounting rate) is:
1 Year: 2,95,000 x 0.909 = 2,68,155
2 Year: 6,30,000 x 0.826 = 5,20,320
3 Year: 3,10,000 x 0.751 = 2,32,810
10,21,345
Less: Initial Outlay 10,00,000
NPV = __ 21,345
(ii) Standard Deviation Method : The earlier method of EMV considers the possible
cashflows along with their probabilities to explicitly reflect the risk involved in future
cashflows of a project. However, the averaging (weighted with the size of probabilities)
has simplified the cashflows to a single figure and enabled us to find the viability by NPV
method. If one closely observes the whole list of all possible cashflows and the single
value of EMV, another dimension of risk can be identified. As individual cashflows differ
from the average EMV, such variance indicates the probable degree of uncertainty in
reliability of EMV. Such dispersion can be captured through a statistical a measure
called "standard deviation". Standard deviation (denoted as ) is the measure of average
variance or deviation of possible cash flows from the expected cashflow.
In order to examine the importance of standard deviation as a measure of risk, let us
consider the following illustration.
Illustration 11.5
Pentafour Software Industries Ltd. is considering investing in developing two software
packages called GLXPT and SLXPT. In the light of widespread uncontrollable piracy in
the country, the management expects that the maximum life to their product is just one
year. The development of both the softwares requires an outlay of Rs. 10,000 towards
systems specialist's compensation. The real market depends on how well the consumers
look at this product superior to that of the competitors' versatility of the software,
compatibility and so on. Based on some of these required features, the following are the
likely cashflows across different business events during the next one year:
Software GLXPT Software SLXPT
Initial
outlay
Rs.10,000 Rs.10,000
Event
Expected
cashflows
Probability
Expected
cashflows
Probability
A 8,000 0.10 10,000 0.10
B 12,000 0.15 12,000 0.15
C 15,000 0.50 15,000 0.50
D 22,000 0.20 22,000 0.20
E 25,000 0.05 25,000 0.05
Examine the profitability of the venture.
Solution
Step I: Let us calculate the expected monetary values.
The calculations are shown in Tables 11.7 and 11.8.
TABLE 11.7
CALCULATION OF EMV OF CASHFLOWS AND THE STANDARD
DEVIATION FOR SOFTWARE GLXPT PROJECT OF PENTAFOUR LTD:
Event Possible cashflow (CFjt) Probability (Pj) Expected cashflows (CFjt.Pj) CFjt - CFt (CFjt - CFt)
2
.Pj
A 8,000 0.10 800 -7,950 63,20,250
B 12,000 0.15 1,800 -3,950 23,40,375
C 15,000 0.50 7,500 -950 4,51,250
D 23,000 0.20 4,600 7,050 99,40,500
E 25,000 0.05 1,250 9,050 40,95,125
EMV: CFt = 15,950 2,31,47,500
TABLE 11.8
CALCULATION OF EMV OF CASHFLOWS AND THE STANDARD
DEVIATION FOR SOFTWARE SLXPT PROJECT OF PENTAFOUR LTD:
Event Possible cashflow (CFjt) Probability (Pj) Expected cashflows (CFjt.Pj) CFjt - CFt (CFjt - CFt)
2
.Pj
A 10,000 0.10 1,000 5,950 35,40,250
B 12,000 0.15 1,800 3,950 23,40,275
C 15,000 0.50 7,500 950 4,51,250
D 22,000 0.20 4,400 -6,050 73,20,500
E 25,000 0.05 1,250 -9,050 40,95,125
EMV: CFt = 15,950 1,77,47,400
Step II: Find the standard deviation.
For GLXPT case, SD = Square Root of 2,31,47,500 = 4,811.18
For SLXPT case, SD = Square Root of 1,77,47,400 = 4,212.78
One can observe that both the projects are equally profitable as both of them are
realising an EMV of 15950 during their one-year life. However, the standard deviations
calculated based on the full stream of possible cashflows work out differently for the two
proposals, indicating that the first proposal is relatively riskier than the second one. The
standard deviation as a measure of 'average deviation of possible cashflows from the
expected cashflow' works out to...
SD / CFt = 4811.18 / 15950 = 30.16% in case of proposal I
(This ratio is also called as Co-efficient of Variation in Statistics) and
SD / CFt = 4212.78 / 15950 = 26.4% in case of Proposal II.
Thus the Standard Deviation provides an absolute measure of risk in quantifiable terms.
3. PROBABILITY DISTRIBUTION METHODS
Having seen the use of simple statistical techniques in handling the risk in capital
investment projects, let us now try to see the benefits of further advanced statistical
tools. On such concept is the use of 'probability distribution' parameters. Kindly recall
from the earlier illustration where one wishes to consider all possible cashflows against
different business likelihoods uses the entire probability distribution of return. A
probability distribution may be defined as a series of all possible outcomes, with a
probability of occurrence attached to each outcome. So far we have seen only few
possible business events like deep recession, mild recession, average economy, mild
boom and strong boom, so and so forth. But in reality the state of economy in a year
may be same even in between. Thus an infinite number of possibilities could be thought
of along with their probabilities. Such a situation provides a continuous picture of the
state of economy instead of few 'discrete' distinctive phases. Thus the reality works to
continuous 'normal distribution' pattern whose characteristics could be gauged through
two important statistical parameters - mean and standard deviation.
A normal distribution is a common distribution which depicts the sizes of occurrences of
events along with their probabilities. It is symmetric about the expected value, meaning
that equal number of observations could be recorded less than and more than the mean
value. The average deviation of all possible outcomes could be measured as distance
from their expected value. Here the measure of standard deviation helps. In a normally
distributed data, approximately 68.3 percent of total observations lie within 1 standard
deviations from the mean; 95.5 percent lie within 2 standard deviations from the
mean; and 99.7 percent lie within 3 standard deviations from the mean. The coverage
is of much use to find the appropriate probability of realising a specific range of
cashflows from a given project.
Graphically a normal distribution for the following ranges of rates of return can be
worked out as follows:
This distribution of rates of return can be shown graphically by considering the range of
rates of return on X-axis and the size of probability on Y-axis. It can either be shown as
histogram or as a smooth curve as given in Figure 11.2.
FIGURE-11.2
NORMAL DISRIBUTION OF RATES OF RETURNS
The smooth bell-shaped curve is popularly called as 'Normal Distribution' curve. One
can easily calculate the area beneath the normal curve for any range of values. To find
the probability of occurrence of a range of area under normal curve are readily
calculated for a Standard Normal Distribution (called z-distribution with mean '0' and
standard deviation 'i'). Those probabilities are given in Annexure 11.1. For example, if an
investor is interested in finding the probability of earning a rate of return ranging from
2.85 to 17.15 per cent. We must calculate the area beneath the curve in between the said
points i.e., the shaded area in Figure 11.3. The probability of rate of return in between
the said range is 0.68 (the said range denotes mean 1 standard deviations level). The
area under the curve is found by transforming the actual range in terms of a Standard
Normal Distribution (Z-Distribution).
FIGURE 11.3
CALCULATING PROBABILITY OF A GIVEN RANGE OF RATES OF RETURN
BY USING NORMAL DISTRIBUTION CURVE
Z = -3 Z = -2 Z = -1 Z = 0 Z = 1 Z = 2 Z = -3
Therefore, probability of returns within a range of 2.85 to 17.15 is 0.6800
... (11.7)
where 'z' refers to the distance between the given X value and its mean (x) expressed in
terms of number of standard deviations (). For different Z values, probabilities are
given in 'Area under Normal Curve' table. Such a table looks as this...
TABLE 11.9
AREA UNDER NORMAL CURVE FOR DIFFERENT Z- VALUES
Suppose you are interested in finding the probability of the returns in earlier
distribution to be in the range from 2.83 to 20.73 percent, then corresponding Z values
are
The area associated with the given range of -1 to +1.5 is from 0.3413 to 0.4332. It can be
seen from the Figure 11.4 that the total shaded area to this given range is 0.7745. Thus
the probability of rate of return to be in the range of 2.85% to 20.73% is 0.7745.
FIGURE - 11.4
CALCULATION OF PROBABILITY FOR RATES OF RETURN FOR THE
RANGE 2.85 TO 20.73
Thus the normal distribution method provides a superior technique of finding the
probability of projects profitability. The application of normal distribution in capital
budgeting problems is attempted under the following heads:
(i) Normal distribution method for projects with independent cashflows.
When a project's future cashflows are not influenced by the past cashflows such projects
are said to have independent cashflows. In other words, there is no causative
relationship between cashflows from period to period.
... (11.8)
where,
EMV - CFt = expected value of cashflows during the period 't'
k = discounting rate
n = number of periods over which cashflows are expected.
The Standard Deviation of probability distribution of net present value is...
... (11.9)
To arrive at the present value of standard deviations of the project, we discount the
periodic standard deviation of cashflows (i.e. t) at a discounting rate (k). To examine
the estimation of the above said values let us consider the following illustration.
Illustration 11.6
Balaji Distilleries Ltd. of Madras is planning to invest in a new project with an estimated
life of three years. There is no dependence in the demand pattern in between years. The
cost of the project is Rs. 10 lakhs and the possible cash flows for the three periods are:
Assuming a discounting rate of 10 percent, calculate the expected monetary value and
standard deviation of the probability distribution of possible Net Present Value.
Assuming a normal distribution, what is the probability of the project providing a net
present value of zero or less? of Rs. 1,00,000 or more? of Rs.3 lakhs or more?
Solution
To determine the characteristics required for normal distribution of cashflows, let us
calculate the EMV and standard deviations as follows:
TABLE 11.10
CALCULATION OF EMV AND SD OF POSSIBLE RETURNS
Period 1 Period 2 Period 3
Expected
cashflow
Expected
cashflow
Expected
cashflow
0 0.10 0 1,00,000 0.15 15,000 0 0.15 0
2,00,000 0.20 40,000 4,00,000 0.20 80,000 1,50,000 0.20 30,000
4,00,000 0.40 1,60,000 7,00,000 0.30 2,10,000 3,00,000 0.30 90,000
6,00,000 0.20 1,20,000 10,00,000 0.20 2,00,000 4,50,000 0.20 90,000
8,00,000 0.10 80,000 13,00,000 0.15 1,95,000 6,00,000 0.15 90,000
CF1 = EMV = 4,00,000 CF2 = EMV = 7,00,000 CF3 = EMV = 3,00,000
SD = 2,19,089 SD = 3,79,473 SD = 1,89,737
NPV = [CF1/(1+k)
1
+ CF2/(1+k)
2
+ CF3/(1+k)
3
] - IO
= 4,00,000/(1+0.10)
1
+ 7,00,000/(1+0.1)
2
+ 3,00,000/(1+0.1)
3
- 10,00,000
Standard Deviation PV Factor @10% PV of Standard Deviation
--------------------------------------------------------------------------------
2190892 x 0.8264
379493 x 0.6870 397,921
1897572 x 0.9645
--------------------------------------------------------------------------------
Two characteristics of the probability distribution of possible net present value:
NPV = 167000
SD = 397921
a) Probability of the project earnings net present value of zero or less
Total shaded area = 0.5000
Minus area from z=0 to z=0.4197 = 0.1628
0.3372
Therefore, probability of NPV <= 0 is 0.3372
b) Probability of NPV greater than Rs. 1,00,000
Plus area from z=0 to z=0.1683 = 0.0675
0.5675
Therefore, probability of NPV >= 1,00,000 is 0.5675
c) Probability of NPV equal to or greater than Rs. 3,00,000
Plus area from z=0 to z=0.3342 = 0.1293
0.3707
Therefore, probability of NPV >= 3,00,000 is 0.3707
Thus the normal distribution method provides a superior methodology to find the
probability with which different ranges of returns could be arrived at from an
investment project.
(ii) Normal distribution method for projects with dependent cashflows.
Sometimes the future performance of a project depends on its initial years performance.
In such a case cashflows are said to be dependent. When cash flows are dependent, the
size of risk as measured by standard deviation is likely to rise, although the expected
value of net present value is likely to be the same as in the case of independent
cashflows. When cashflows are dependent, the probabilities of later period cashflows are
to be restated as conditional probabilities.
For example, a project's cashflow depends upon the demand for the product being
manufactured. for example, in the first period demand may be good (probability 0.6) or
poor (probability 0.4). In the second period, demand is again likely to be either good
(probability 0.5) or poor (probability 0.5). In such a case the expected cashflow of the
second period is to be estimated by using the joint probability of the successive events (if
good demand is followed by good demand, then probability is 0.6 x 0.5 = 0.30)
Illustration 11.7
A publisher is planning to undertake the publication of a book on the current economic
environment and policy. As is well known, such titles could be published for not more
than two prints. The publisher estimates the following possibilities of demand for the
said edition over two periods.
If the publisher is likely to incur Rs. 10000 towards printing and distribution, calculate
the NPV.
Solution
TABLE 11.11
CALCULATION OF NPV FOR DEPENDENT CASHFLOWS OVER TIME
For calculating the standard deviation in case of dependent cashflows the following
formula is of use:
where, NPVe is the net present value of the project for event; NPV is the expected value
of Net Present Value of the project, and Pe is the probability of occurrence of the said
event.
4. OTHER METHODS
Among the other methods widely in use for handling risk in capital budgeting the
following are worth knowing:
a. Decision tree approach
b. Simulation approach
A detailed discussion on these methods is provided in second year subject entitled
'Financial Management'.
SUMMARY
In this chapter, we have understood the importance of 'risk' as an additional variable in
capital budgeting and project evaluation. The measurement of variation in expected
returns could be carried out scientifically with statistical procedures, like, EMV,
standard deviation. A new set of capital budgeting techniques has emerged to handle the
project evaluation work. These new techniques range from the techniques studied in
earlier chapter with a risk co-efficient to advanced statistical procedures of using
Normal Distribution Method.
KEYWORDS
1. Risk-adjusted discount rate is adjusted discounting rate in proportion to size
of risk perceived in an investment project.
2. Certainty equivalents: Approximate 'certain' element in an expected future
cashflow. It may be equivalent to the conservative estimate of future cashflow
from a project.
3. Probability distribution is distribution of a variable across a range of values
along with the probability of its occurrence.
4. Normal distribution is a theoretical probability distribution which represents
the data distribution with random range of values.
5. Conditional probability: Probability of occurrence of an event subsequent to
the happening of a specific prior value.
EXERCISES
1.. M/s Aditya Spinners Ltd. has an average cost of capital of 10 percent. The company is
choosing between two mutually exclusive projects. Project 'B' is of average risk, and has
a cost of Rs.20,000. It has expected cash flows of Rs.5,880.50 per year for five years.
Project 'A' is of above average risk and management estimates that its cost of capital is
12 percent. A also costs Rs. 20,000 and it is expected to provide cashflows of Rs.
3,752.21 per year for 10 years.
a. Calculate risk adjusted NPVs for the two projects and use these NPVs to choose
between them.
b. Explain how you would find a risk-adjusted discount rate for project 'A' that
would make its risk adjusted NPV equal to NPVB when 'B' is evaluated at a 10
percent cost of capital.
2. Garware Plastics and Polyster Ltd. is evaluating a capital project that will require a
current outlay of Rs.5,00,000. The cash flows from the project will begin one year later
and is stated below. The riskless rate is 12 percent, and the risk adjusted discount rate
on the investments is 18 percent. The company has also estimated the certainty
equivalent factors for each year, which are indicated below:
a. Verify that the net present value is the same for this investment whether the firm
uses the risk adjusted discount rate of 18 percent or uses the certainty equivalent
approach.
b. Is the above set of certainty equivalent factors equivalent to the 18 percent risk
adjusted discount rate? To answer this question, for each year (years 1 to 4)
separately compute the risk-adjusted discount rate that would be appropriate for
discounting that year's expected cashflow. To compute the risk adjusted discount
rate, use the certainty equivalent factors (at) shown above and the riskless rate.
c. Consider the alternatives of certainty equivalent factors (at) shown below and
determine the risk adjusted discount rate that would be appropriate for
discounting each year's expected cash flow. (This is done as in 'b' above)
Year
Expected cashflow
(Rs.)
Alternative set of ertainty equivalent
factors (at)
1 1,00,000 0.949
2 1,00,000 0.901
3 2,00,000 0.855
4 4,00,000 0.811
What can you conclude from the results of 'a' 'b' and 'c' above?
3. The A Fields Corp. of Bargah is considering three projects with the following expected
outcomes and distributions:
Project A Project B Project C
Probability Outcome Probability Outcome Probability Outcome
0.10 1,000 0.10 1,000 0.10 4,000
0.20 6,000 0.40 7,000 0.40 5,000
0.50 8,000 0.40 9,000 0.30 10,000
0.20 10,000 0.10 15,000 0.15 15,000
0.05 22,000
Given this information,
a. Calculate their Expected Values.
b. Calculate their Standard Deviations.
c. Is the Standard Deviation a meaningful statistic for the distribution associated
with Project C? Why or why not?
4. ABC Corporation is ordering a special purpose piece of machinery costing $9,000
with a life of 2 years, after which there is no expected salvage value. The possible
incremental net cash flows are:
Year 1 Year 2
Cashflow ($) Probability Cashflow ($) Probability
6,000 0.3 2,000 0.3
3,000 0.5
4,000 0.2
7,000 0.4 4,000 0.3
5,000 0.4
6,000 0.3
8,000 0.3 6,000 0.2
7,000 0.5
8,000 0.3
The company's required rate of return for this investment is 8 percent.
a. Calculate the Expected Value and Standard Deviation of the probability
distribution of possible Net Present Values.
b. Suppose now that the possibility of abandonment exists and that the
abandonment value of the project at the end of year 1 is $4,500. Calculate the
new Expected Value and Standard Deviation, assuming the company abandons
the project if it is worthwhile to do so. Compare your calculations with those in
Part 'a'. What are the implications?
5. The Halo Shampoo Company is considering an investment in a project that requires
an initial investment of $6,000, with a projected after-tax cashflow generated over the
next 3 years as follows:
Period I Period II Period III
Cashflow
($)
Probability
Cashflow
($)
Probability
Cashflow
($)
Probability
1,000 0.10 1,000 0.20 1,000 0.30
2,000 0.30 2,000 0.40 2,000 0.40
3,000 0.20 3,000 0.30 3,000 0.10
4,000 0.40 4,000 0.10 4,000 0.20
Assume that probability distributions are independent and the after-tax risk-free rate of
return is 6 percent. Calculate,
a. the expected NPV of the project.
b. the standard deviation of the expected NPV.
c. the probability that the NPV will be zero or less (assume that the probability
distribution is normal and continuous).
d. the probability that the NPV will be greater than zero, and
e. the probability that the NPV will be greater than the expected value.
- End of Chapter -
LESSON - 12
CAPITAL BUDGETING V: PROJECT SELECTION UNDER CAPM
OBJECTIVES
After reading this lesson, you will be able to...
Understand the preliminary ideas of portfolios,
Examine the portfolio return and portfolio risk,
Appreciate the implications of diversification,
Differentiate the 'Systematic' and 'Unsystematic' risks, and
Learn about the implications of CAPM.
Structure
Introduction
Basis of Portfolio Approach
Portfolio Theory
Expected Return on a Portfolio
Portfolio Risk
Diversification of Risk
Risk and Return on a Portfolio: Efficient Combinations
Capital Asset Pricing Model
Capital Market Line (CML)
Security Market Line (SML)
Using CAPM to Capital Budgeting
Summary
Keywords
Exercises
INTRODUCTION
So far we have considered two fundamental approaches to project selection exercise.
The first approach assumes certainty in expected future cashflows and known discount
rates to evaluate the net present values of the projects. The second approach has given
explicit recognition to possible uncertainty in future expected cashflows and examined
the project's profitability in terms of recognisable 'variability' in project's cashflows. The
first approach depends upon an unrealistic assumption of 'certainty' of all future events
and existence of a known discounting rate in evaluating the projects. Similarly the cost
of capital for the firm, in the second approach, which contain an implicit allowance for
risk in addition to simple time value of money, attracts serious objection due to
compounding of risk factors.
Against such restrictive assumptions and criticism, a third approach has emerged, viz.,
the Capital Asset Pricing Methodology (CAPM). This approach to do project selection
incorporates capital market theory. The capital asset pricing theory basically provides a
market-based cost of capital to effectively evaluate the investment projects. By
expressing the explicit risk involved in making an investment through a relative
'volatility' measure, the CAPM provides a necessary condition for undertaking or
rejecting a project while holding the equivalent risk position of the firm unchanged.
BASIS OF PORTFOLIO APPROACH
The basic ideology of CAPM approach posits for the combination of projects. The
concept of 'portfolios' and the portfolio returns, which are being affected by 'co-variance'
among individual projects, becomes a major dimension of CAPM approach. The efficient
portfolio or the capital market line provides the theoretical logic in identifying the parity
between risk and return. The project selection is ultimately done based on reward-to-
volatility criterion.
PORTFOLIO THEORY
In order to examine the fuller implications of CAPM, the portfolio theory considers a
risky investment proposal like investment into equity shares by an individual investor.
One can draw parallels between a capital budget investment project and individual's
investment in a security. Both involve an initial outlay followed by a stream of
cashflows. The cashflows (return) in case of an individual security are the dividend
incomes plus the change in security's price from time to time. While the former
represents current income, the latter provides capital gain, considering that a financial
asset, unlike investments in physical assets, provides a facility of divisibility. One cannot
think two-thirds of plant and machinery but can invest in a one-million
th
of a share in
Reliance. Thus financial investments help in overcoming the scale problems. Further,
the investments in capital goods involve long-term commitment of funds over a fixed
number of years, but financial assets are reversible. Thus financial investments provide
easy way for ranking without the problem of scale, duration, limitation of mutually
exclusiveness as well as no separate individual discounting rates.
(i) Expected Return on a Portfolio
When one considers the financial investments in securities, the rate of return is simply
the change in securitys price during the holding period. The benefits like Cash
Dividend, Bonus Shares, Rights Benefits from equity investments are treated as if they
are reinvested or ignored, being very marginal when compared to the size of the
investment. In a portfolio context (a portfolio consisting of 'n' number of securities), the
expected rate of return is simply the weighted average of rates of return from individual
investments. The weightage are the relative size of investments in each security.
Illustration 12.1
An investor has invested his small savings of Rs. 100,000 in selected scrips belonging to
different family groups in the following proportions:
Estimate the portfolio return:
20% investment made in ACC indicates that out of the investor's total investment of Rs.
100,000, an amount of Rs.20,000 has been invested in ACC shares. The quarterly
return indicates the rise in equity share price over the purchase price. The mean return
of the said portfolio can be worked out as follows:
TABLE 12.1
CALCULATION OF PORTFOLIO RATE OF RETURN ON SELECTED SCRIPS
= 0.1702
(ii) Portfolio Risk
Individual investments exhibit the risk through the variability in expected returns
during the holding period. The portfolio approach of combining a number of securities
into portfolios expects some degree of income stabilisation possibly due to non-
synchronies price movements among all the securities. The business opportunities to
different lines of activity differ. Consequently, the returns from different industries vary
in different directions. In a specific year, the climatic conditions might have favoured an
agro-based industry to do well, but during the same period, the climate might not have
permitted the construction industry to do even the normal business. In such a case the
variations in rates of return from the investments made in different industries are likely
to vary in the opposite direction, putting the combined deviation to 'zero' without
impairing the expected returns. The existence of such co-movements, the riskiness of a
portfolio (Rp) is generally not the weighted average of standard deviations of individual
investments.
The variance of the rates of return for a portfolio (originally developed by Markowitz)
incorporates the additional term of pair-wise Covariance.
... (12.2)
In simple words, the portfolio risk is the weighted average of standard deviations of
individual investments plus weighted co-movement between them. To illustrate this fact
consider two investments with a positive co-movement (statistically measurable in
terms of co-variance) likely to show a marginal decrease in risk, when combined as
portfolios. Look at the Table 12.2.
TABLE 12.2
ILLUSTRATIVE PRESENTATION OF CALCULATED EXPECTED RETURN
AND RISKS ON INDIVIDUAL ASSETS AS WELL AS ON PORTFOLIO
(TWO-ASSET CASE)
The above illustration shows that a part of the risk in individual investments can be
diversified away (reduced away) when they are held in portfolios. It is principally due to
more stable returns from a portfolio compared to widely fluctuating returns in case of
individual assets. The portfolio risk (p) can also be estimated with the following
formula in two-asset case:
... (12.3)
where,
Wx, Wy = Proportion of investment made in each asset (weightages) and Wx + Wy = 1
x
2
, y
2
= Variances of rates or return on individual assets
Cov(xy) = Covariance between the two assets.
Covariance vs. Correlation:
Covariance and Correlation are two statistical concepts used to measure the general
movement relationship between two variables. For example, if due to general changes in
an economy, the price of a scrip X positively changes by 10 percent during a specific
quarter, another scrip W also reports a change due to similar changes in the economy.
But, the respective change in W is more or less than that of X or even there may not be
any sizeable change at all. Suppose, one is interested in observing the relationship
between X and W in terms of their respective changes in price movements (the rate of
price change denotes the rate of return during the period), such a relationship could be
established through statistical measure called 'Covariance'.
... (12.4)
The RHS of the equation denotes the product of pair-wise deviations of individual
scrip's quarterly returns (Rx) from their respective average return (Ri). Here 'n' denotes
the number of pairs of observations considered to establish the expected relationship
between two assets.
To illustrate the calculation of covariance for any two assets let us consider the data
given in Table 12.2
Cov (x,y) =
5
(Rxi-Rx) (Ryi-Ry)
= (40.0 - 13.4) (36.0 - 13.4) + (-25.0 - 13.4) (20.00 - 13.4) + (39.0 - 13.4) (20.0 - 13.4) +
(18.0 - 13.4) (-25.0 - 13.4) + (-5.0 - 13.4) (16.0 - 13.4)
= 58.44
The sign of the covariance indicates the direction of co-movement between the scrips.
The co-movement, thus calculated, based on the above measure is often called as
'absolute' measure. For possible future comparison between another pair of assets,
another statistical measure is in wide use, called 'Correlation Coefficient'. The
Correlation Coefficient,
... (12.5)
The correlation coefficient () is simply the restatement of the covariance Cov(AB) in
terms of their respective standard deviations (A, B). Then,
Based on the available values of Cov(x,y), x, y, the correlation between two scrips
considered in the Table 12.2 is as follows:
The calculated correlation value of ( = 0.11) gives the degree of relationship between
the returns of two scrips. Generally the value ranges between +1 and -1. A correlation
value of +1 indicates a strong positive relationship between the movements of prices of
two assets under consideration, while the value -1 denotes strong negative relationship.
A value of 'zero' indicates that there is no relationship between the two variables.
Making use of correlation coefficient (), the equation of portfolio risk can be restated
(equation 12.3) as follows:
p = (Wx
2
x
2
+ Wy
2
y
2
+ 2Wx Wy xy x y) ... (12.6)
Based on equation 12.6, let us calculate the portfolio risk and verify the answer with the
worked out example.
Portfolio Risk in two-asset case:
1) Based on covariance (equal weightage)
p = (0.50
2
x 25.29
2
+ 0.50
2
x 20.30
2
+ 2 x 0.5 x 58.44) = 17.12
2) Based on correlation (equal weightage)
p = (0.50
2
x 25.29
2
+ 0.50
2
x 20.30
2
+ 2 x 0.5 x 0.1133 x 25.29 x 20.39) = 17.12
In case of more than two assets, the calculation of portfolio risk becomes cumbersome.
One has to calculate pair-wise correlation to estimate the portfolio risk. A convenient
way for a large number of assets is the construction of 'variance- covariance' matrix,
which looks as follows.
TABLE 12.3
VARIANCE - COVARIANCE MATRIX
If the proportions of investments (weights) are known, the portfolio risk can be
calculated by adding the products of each entry in the matrix multiplied by the portfolio
weights on either side.
As an example, the following variance-covariance matrix of equity returns of TVS group
companies, i.e., Sundaram Fasteners Ltd, TVS-Suzuki Ltd. and Srichakra Tyres Ltd.
DIVERSIFICATION OF RISK
The rigorous exercise on the computation of portfolio risk reveals that:
a) Portfolio risk (p) is lower than the risk (i) of individual assets.
b) Portfolio risk (p) varies with the size of correlation.
= +1 : no risk reduction;
= 0 : weightage average of the individual asset's risk;
= -1 : possibility of complete reduction in risk.
Thus, on one extreme (=-1.0) risk can be completely eliminated while on the other
extreme case ( = +1.0) diversification does no good whatsoever. Since the reality may
not be of the two extremes, any portfolio with assets having varying degrees of
correlation is likely to exhibit best portfolio risk but does not eliminate the risk inherent
in the individual stocks.
Against such an observation it is of interest to anyone on what is going to happen if we
add more and more assets to a given portfolio? It is natural to believe that the risk level
of a portfolio has to reduce as the number of stocks in a portfolio increases. Different
empirical studies have shown that adding additional number of assets in a portfolio,
after a particular size, is not likely to reduce the portfolio risk beyond a certain level.
When once the inclusion of additional asset to the existing portfolio reports a positive
correlation of 1.0 or even slightly lower than it, not all the risk of such an additional
asset can be diversified.
Then, finding always the negatively correlated assets becomes impossible as most assets
are likely to be affected by similar economic conditions. Then a portfolio of n-assets are
likely to be left with certain degree of risk, which is inevitable and is called 'un-
diversifiable risk' or 'systematic risk'. The Figure 12.1 indicates the said logic.
FIGURE -12.1
EFFECT OF PORTFOLIO SIZE ON PORTFOLIO RISK
RISK AND RETURN ON A PORTFOLIO: EFFICIENT COMBINATIOS
Portfolio theory posits for efficient portfolios of those combinations of assets which
provide for the highest expected return for any degree of risk, or the lowest degree of
risk for any expected return. Combination of assets can be attempted in different
proportions. Each combination exhibits different portfolio returns and portfolio risks.
Attainable combinations in terms of positive risk-return framework can be identified by
plotting the values of E (Rp) and (p) for different portfolios. To illustrate let us consider
two assets with following characteristics:
ASSETS
A B
E(Ri) 0.10 0.04
i 0.05 0.10
To begin with, let us assume that the correlation between the two assets = 0
When WA = 0.50
WB = 0.50
E(Rp) = 0.50 x 0.10 + 0.50 x 0.04 = 0.070
p = [(0.50
2
x 0.5
2
+ 0.50
2
x 0.10
2
)]
= 0.056
The E(Rp) and p at different weightage are as given in the table 12.4
TABLE - 12.4
RELATIONSHIP BETWEEN PORTFOLIO RISK AND PORTFOLIO RETURN
( =0)
A weightage of 1.50 to A indicates selling of Asset B and investing the proceeds in Asset
A. Similarly -0.50 denotes short-selling A shares and buying B shares. The relationship
between expected return and risks of the five portfolios can be shown as in Figure 12.2.
FIGURE 12.2
RELATIONSHIP BETWEEN PORTFOLIO RISK AND PORTFOLIO RETURNS
( = 0)
Portfolios beyond 'P' are said to be efficient since they maintain positive risk return
parity.
In case of perfect positive or perfect negative correlation between the two-asset return,
the possible portfolios their expected rates of returns and portfolio risks are as follows:
TABLE 12.5
RELATIONSHIP BETWEEN PORTFOLIO RISK AND PORTFOLIO RETURNS
( = +1, = -1 )
The computed values indicate that with perfect negative correlation, one can create a
riskless portfolio. On the other hand, the risk associated with short position on either
stock is likely to be more when assets are negatively correlated. To find the risk-return
parity for the given portfolios the data given in table is shown Figure 12.3.
FIGURE -12.3
RISKRETURN RELATIONSHIP LINES FOR DIFFERENT TWO-ASSET
PORTFOLIOS WHEN ASSETS ARE EITHER POSTIVELY, NEGATIVELY OR
UNCORRELATED
With only two assets, the feasible set of portfolios is a line of curve as shown in the
Figure 12.3. Leaving the extreme correlation possibilities, if number of assets increases
possible alternative increases. Suppose an individual has three assets to invest in, the
possible portfolios can be shown as in Figure 12.4
FIGURE - 12.4
RISK-RETURN RELATIONSHIP LINES IN CASE OF 3-ASSET PORTFOLIO
Here curve I represents the combinations of Assets A and B, curve II and III represent
the respective portfolios which include B and C, as well as AC. The curve IV represents
all possible three-security combinations.
With increased number of securities in a well-diversified portfolio, full set of feasible
portfolios can be shown as the shaded area in Figure 12.5. From among all these feasible
portfolios from 'n' number of assets, the portfolio which maximizes the expected return
for a given standard deviation is said to be efficient.
FIGURE - 12.5
FEASIBLE AND EFFICIENT SET OF PORTFOLIOS
Since individual investors differ with respect to their attitudes towards risk, an optimal
portfolio can be selected by super-imposing the set of investors' indifference curves on
the above shown feasible set. The tangency point marks the high level of satisfaction at
an investor can attain.
CAPITAL ASSET PRICING METHODOLOGY
Since it is clear now that holding assets in portfolios instead of individual securities
reduces the riskiness of any investment, it is reasonable to consider the riskiness of a
security in terms of its contribution to the riskiness of the portfolio. In such a situation a
natural question is how much should be the expected return at different levels of
portfolio risk? This issue is addressed in a celebrated theoretical model - the Capital
Asset Pricing Methodology (CAPM). CAPM develops a simple but elegant equilibrium
relationship between risk and required rates of return on assets when they are held in
well-diversified portfolios. The model has been generally attributed to the seminal work
of William Sharpe, but similar independent derivations are made by John Lintner
and John Mossin almost at a time. Therefore, it is often referred to as Sharpe-inter-
Mossin Capital Asset Pricing Methodology.
Two important constituents of the CAPM model are
i) Capital market line
ii) Security market line
CAPITAL MARKET LINE
A capital market line is a theoretical justification for proportionate relationship between
the expected return and risk in a perfect capital market when assets are held in
portfolios.
Figure 12.5 presents the efficient portfolios and possible relationship between expected
return and risk an efficient frontier. To the given set of multiple assets, if we include a
risk free asset with (RF) rate of return and with zero risk, the expected returns from such
a portfolio becomes:
The equations 12.7 and 12.8 indicate that when a risk free (RF) asset is added to risky
asset (M), both the expected return E(Rp) as well as portfolio risk (p) works out to be
linear. The investment opportunities may be even extended by considering the
possibilities of borrowing and lending. For simplicity, if we assume that an investor can
borrow or lend at a specific risk free rate of (RF), the newer portfolios with risk free asset
(examined in above equation) gets accommodated in establishing a Capital Market Line
(CML). The CML represents the equilibrium relationship between the expected returns
on risk-free plus risky investment portfolios and the portfolio risk. It can be shown as in
Figure 12.6
FIGURE - 12.6
CAPITAL MARKET LINE
The Capital Market Line (CML) can be specified mathematically as
SECURITY MARKET LINE (SML)
The discussion so far is on the equilibrium relationship that an efficient capital market
tries to establish between the expected return on portfolios (returns are nothing but the
relative changes in asset prices) and such portfolio's standard deviation of returns.
However, the discussion ignores the determination of individual assets prices in terms
of their expected returns. This aspect is focused in Security Market Line (SML), also
called as Capital Asset Pricing Model (CAPM). As discussed earlier, each individual
asset's risk (variance in expected returns) consists of two components. It is clearer when
an asset is held in portfolio that the asset's total risk reduces but does not become zero.
That part of risk, which each asset loses in the context of portfolio combination, can
easily be attributed to its unique nature or nature of the line of business activity that the
asset belongs to. The other part of the risk which cannot be diversified away due to
reasons like general economic trends, common political factors, etc are likely to have
influence on expected returns of almost all securities, called 'systematic risk'. Therefore,
an asset's total risk becomes irrelevant for establishing its relationship with the expected
return in an efficient capital market having diversification possibilities. What is relevant
is that the 'systematic risk' component which cannot be diversified away, needs to be
compensated with proportionate additional returns. This is the total logic of Security
Market Line which tries to establish an equilibrium relationship between the expected
returns in individual assets and their systematic risk components.
Total risk of an individual asset = Variance = Systematic risk + Diversifiable
risk
Since it is argued that the systematic risk arises because of common influences in a
given market, this risk is also often called 'market risk'. Considering this aspect
William Sharpe has developed a small statistical method to calculate the 'Systematic
risk' of an individual asset, by conducting a simple linear regression relationship
between each individual asset's returns and the returns on an average market portfolio.
As average portfolio is unobservable, any stock market index (viz. Bombay SENSEX, ET
Index, FE Index, National Index, RBI Index) broadly provides the overall stock price
movements during a given period. The said regression relationship is:
Rj = aj + j Rm + e ... (12.10)
where,
Rj = Return on j
th
asset
Rm = Return on a market Index
aj = intercept
j = Regression coefficient = Beta
e = error terms
The regression coefficient '' (beta coefficient) measures the relative volatility of a given
asset (j) with the market fluctuations, thus constitutes the market sensitivity index. An
individual stock's movement with the market constitutes a risk that cannot be
diversified away. Thus the beta fairly measures an individual asset's 'systematic risk'.
SML establishes a relationship between an asset's systematic risk with its expected
returns as follows:
SML = E(Ri)= Rf + bi [E (Rm - Rf)] ... (12.11)
Since,
SML in terms of Covariance is:
... (12.12)
where,
Rf = Risk free rate of return
Cov(Ri Rm) = i
th
asset's covariance of returns with the market
E(Ri) = expected return on i
th
asset
Thus the SML suggests that an asset's expected rate of return is made up of two
components:
i) The risk-free rate representing the price for time,
ii) The market price for risk as measured by the slope coefficient
The equilibrium Security Market Line can be shown as in Figure 12.7
FIGURE 12.7
SECURITY MARKET LINE
USING CAPM FOR CAPITAL BUDGETING
The CAPM suggests that the required rates of return on any risky asset consist of a risk-
free rate and a risk premium commensurate to the size of 'systematic' risk that the asset
possesses. It is well known that the capital budgeting techniques tries to evaluate the
profitability of a project in terms of the surplus generated by the project on discounting
the full stream of future cashflows at a specific required rate of return. Such discounting
process could now be improved by substituting the required rate of return parameter of
SML equation as follows:
Since R = Rf + (RM- RF),
... (12.13)
But, the CAPM provides the estimation procedure for a single period. The changing
'beta' values over the life of the project and risk-free rates of return are approximately
accommodated to discount to the full stream of benefits.
However, the CAPM has become the basis to construct 'reward-to-variability' ratios of
different projects to determine their possibility of selection and rejection. The use of this
criterion requires one to estimate the current rate of return Ro at current risk level. The
project selection can be done with expected rate of return (Ri) from the project to
Current return (Ro). If,
Accept, otherwise reject.
Thus the CAPM provides a newer look to the problem of determining the 'cost of capital'
dynamically in different market environments, enabling the project evaluation more
realistic and dependable. However, the entire CAPM is designed for single period
equilibrium exercises.
A project evaluation for different time horizons requires the knowledge of advancements
on the CAPM theory in a multi-period context. A detailed discussion on these aspects
would be provided in the second year subjects.
12.8 SUMMARY
In this chapter, you are exposed to the modern thinking in the area of project
evaluation. Projects when considered as combinations are called portfolios. The
portfolio return and risk differs, based on the proportion of different individual assets in
each portfolio. Portfolio risk is relatively smaller than the individual assets' risk, due to
the fact that a part of the risk could be diversified while constructing portfolios. An
efficient capital market is expected to maintain parity between the asset prices, and their
risks in expected returns. This concept is examined under the modern portfolio theory.
Two important equations provide the basis of risk-return parity. While CML describes
the equilibrium relationship between the portfolio risk and returns, the CAPM enlists
the possible linear relationship between an assets' 'systematic' risk (beta risk) and its
expected return.
KEY WORDS
Portfolio: A portfolio is a combination of different risky assets.
Systematic risk: Systematic risk is that part of an asset's variability in expected
returns due to common market fluctuations.
CAPM: The Capital Asset Pricing Methodology is an equilibrium capital market theory
which tries to explain the linear relationship between expected returns and risks in the
context of pricing risky assets.
EXERCISES
1. Define 'Systematic' and 'Unsystematic' risks in the context of portfolio theory.
2. Consider the data given below:
Scrip Return SD
Century 10% 15%
Escorts 8% 10%
Hoechst 18% 30%
Correlation:
Century and Escorts = 0.2
Century and Hoechst =0.6
Escorts and Hoechst = 0.4
Construct a portfolio with equal weightage.
3. The table below provides the annual rates of return on General Motors, American
Motors Corporation and S & P Five Hundred Index, which is approximately a proxy to
Market portfolio. Assuming riskless interest rate of 3% answer the following questions:
Year GM AMC Market
1 14.4 121.2 11.9
2 -22.2 -33.9 0.4
3 47.5 3.7 26.9
4 7.7 3.1 -8.6
5 42.8 17.2 22.8
6 30.7 -16.9 16.5
7 14.11 -32 12.5
8 32.5 -30.4 -10.6
9 30.5 114.0 23.9
10 1.8 -3.7 11.1
11 -6.2 -33.0 -8.5
12 22.3 33.2 3.9
13 4.3 21.6 14.3
14 6.5 17.8 19.1
15 -37.8 7.8 -14.7
16 -26.6 -62.3 -26.5
17 97.1 -65.4 37.4
18 45.85 -28.08 2.8
19 -11.25 -6.33 -7.15
20 -4.7 26.67 12.16
i) Calculated the Systematic Risk and Nonsystematic risk for both the scrips
ii) For a risk free rate of 3% draw a CML and illustrate graphically the decomposition of
risk into two components.
iii) Draw SML and show the location of two scrips.
iv) Use the systematic risk to calculate the equilibrium risk premium of GM and AMC.
What was the actual estimate of the risk premium during the last twenty years? How do
you explain the difference in the expected risk premium?
DR. K. CHANDRASEKHARA RAO,
Reader in Commerce,
Pondicherry University,
Pondicherry
- End of Chapter -
LESSON - 13
RATIO ANALYSIS - I
A financial statement is an organized collection of data according to logical and
consistent accounting procedures. Its purpose is to convey an understanding of some
financial activities of a business firm. It may show a position of the business at a
moment of time as in the case of a balance sheet, or may reveal a series of activities over
a given period of time as in the case of an income statement.
Thus the term 'financial statements' generally refers to two basic statements: (i) the
Income Statement and (ii) the Balance Sheet. Of course, business may also prepare a
Statement of Retained Earnings and a Statement of Changes in Financial Position in
addition to the above two statements.
All these statements provide some extremely useful information. For instance the
Balance Sheet is a mirror of the financial position of a firm. It reveals the assets the
firm owns, the liabilities it has to pay to the outsiders and the amount of internal
liabilities in terms of the capital supplied by the owners to finance the business at a
particular point of time. The Income Statement shows the results of trading and non-
trading operations during a certain period of the time, usually a year. It presents the
summary of the income obtained and the costs incurred by the firm during one year
period.
The Statement of Retained Earnings which is also called the "Profit and Loss
Appropriation Account" in case of companies is a connecting link between the
balance sheet and the income statement. It is fundamentally a display of things that
have caused the beginning-of-the-period retained earnings balance to change into the
one shown in the end-of-the-period balance sheet. The Statement of Changes in
Financial Position identifies the movement of working capital or cash in and out of
the business.
Thus, the financial statements provide a summarised view of the operations of a firm.
These statements may be more fruitfully used if they are analysed and interpreted to
have an insight into the strengths and weaknesses of the firm. The success of the
company's financial plans is based on the financial analysis which is the starting point
for making plans before using any sophisticated forecasting and budgeting procedures.
Various tools are employed by the interested parties in analysing the financial
information contained in these statements and Ratio Analysis is one of them. The
present chapter is concerned with a detailed account of ratio analysis as a tool of
analysis for financial management.
RATIO ANALYSIS - MEANING AND RATIONALE
Ratio analysis is the process of determining and presenting in arithmetical terms the
relationship between figures and groups of figures drawn from the financial statements.
"Ratio" is the basis of such analyses.
A ratio is calculated by dividing one item of the relationship with the other, i.e., one
number expressed in terms of the other. A ratio may be defined as 'the indicated
quotient of two mathematical expressions', and 'the relationship between two or more
things'. Ratio may be expressed in any of the three ways.
i. Rate, which is the ratio between the two numerical facts over a period of time.
ii. Pure ratio or proportion, which is arrived at by simple division of one number by
another.
iii. Percentage, which is the relationship expressed per hundred. It is arrived at by
multiplying the quotient by 100.
For instance, the net profit of a firm amount to Rs.50,000 while its sales aggregate to
Rs.2,00,000. The relationship between sales and net profit can be stated in the
following terms:
i. net profit is one fourth of sales
ii. relationship between sales and profit is 4:1
iii. net profit is 25% of sales
Each of the three measures of expressing related variables describes the relationship
between net profit and sales of the firm. It should be noted that computing the ratios
does not add any information not already inherent in the above figures of profits and
sales.
Why study Ratios?
What the ratio does is "reveal" the relationship in a more meaningful way so as to enable
us to draw conclusions from the information. The rationale of ratio analysis lies in the
fact that it makes related information comparable. A single figure by itself has no
meaning but when expressed in terms of a related figure it yields significant inferences.
For instance, the fact that the net profits of a firm amount to say Rs. 10 lakhs throws no
light on its adequacy or otherwise. The figure of net profit has to be considered in
relation to other variables. How does it stand in relation to sales? What does it represent
by way of return on total assets used or total capital employed? If, therefore, the net
profit is shown in terms of its relationship with items such as sales, assets, capital
employed and so on, a meaningful conclusion can be drawn regarding its adequacy.
To carry the above example further, assuming that the capital employed is Rs.50 lakhs
and Rs. 100 lakhs, the net profits are 20% and 10% respectively. The ratio analysis
converts figures into meaningful comparable forms and removes the difficulty of
drawing inferences on the basic of absolute figures. As a quantitative tool it enables
analysts to draw quantitative answers to questions such as: Are the net profits adequate?
Are the assets being used efficiently? Is the firm solvent? Can the firm meet its current
obligations? and so on.
A more meaningful financial analysis involves ratios and their comparison relating to a
business concern
- over a period of years;
- against another unit;
- against the industry as a whole;
- against predetermined standards;
- for one department or division against another department or division of the same
unit.
INTERPRETATION OF RATIOS
Importance of ratios as a tool of analysis lies in its proper interpretation by the financial
analyst. There are four different methods applied for interpretation of ratios:
(1) An individual ratio by itself may convey a significant meaning of the related
items. For instance, if the Current Ratio consistently falls below one, it may reveal
the impending financial solvency of the concern, which only means that the
current assets of the units are not even sufficient to meet current liabilities. It is
very rare with regard to a business concern under normal circumstances, and one
cannot jump to hasty conclusions after studying ratios in isolation. Moreover, a
single ratio at times may fail to reveal the exact financial position of the firm.
(2) Interpretation of ratios can be effected by taking into analysis a group of
related ratios in sufficient numbers. By compilation and analysis of group of inter-
related ratios, the significance of ratios can be fully understood, as the same
cannot be achieved in isolation. For instance, the value of Net Profit Ratio is
increased by taking the ratio disclosing the number of times the proprietor's
statement is turned over in sales every year.
(3) Interpretation of ratios involves comparison of ratios of one business concern
with those of others which is often referred to as "inter firm comparison". This
comparison provides valuable information, as in most cases, members of the same
industry face similar problems - internal as well as external. These comparisons
are often facilitated by the use of Tables summarising the ratios of units in the
particular industry. These Tables are usually prepared by trade associations and
credit agencies.
(4) Interpretation of ratios involves making comparison of ratios of the unit over a
period of years. By this, the same ratio or a group of related ratios of a business
concern are compiled and evaluated over a period of years. This study highlights
significant trends showing the rise, fall, or stability achieved by the unit. The
average value of a particular ratio for a number of years can serve as a standard
against which the future performance can also be compared.
To sum up, any detailed investigation of the financial position and progress of a
business concern involves analysis and interpretation of ratios, either individually for
any intrinsic meaning that it may convey, or with a group of inter-related ratios of the
same unit, or comparison of similar ratios of other units in the industry, or comparison
of the ratios of the unit over a period of time.
CLASSIFICATION OF RATIOS
Ratios can be classified into different categories. Depending upon the basis of
classification, the traditional classification has been on the basis of the financial
statement to which the determinants of the ratio belong. On this basis, the ratios could
be classified as:
1. Profit and Loss Account Ratios, i.e. ratios calculated on the basis of items of
the Profit and Loss account only. For example, Gross Profit Ratio and Stock
Turnover Ratio.
2. Balance Sheet Ratios, i.e. ratios calculated on the basis of figures of the
Balance Sheet only. For example, Current Ratio and Debt Equity Ratio.
3. Composite Ratios or Inter-statement Ratios, i.e. ratios based on figures of
Profit and Loss account as well as the Balance Sheet. For example, Fixed Assets
Turnover Ratio and Overall Profitability ratio.
However, the above basis of classification has been found to be crude and unsuitable
because analysis of Balance Sheet and Income Statement cannot be done in isolation.
They have to be studied together in order to determine the profitability and solvency of
the business. In order that ratios serve as a tool for financial analysis, they are now
functionally classified as:
1. Profitability Ratios
2. Coverage Ratios
3. Turnover Ratios
4. Financial Ratios
a. Liquidity Ratios
b. Stability Ratios
The above classification of ratios can be depicted by means of the following chart.
Accounting Ratios
|
-----------------------------------------
| |
Traditional Functional
| |
Profit & Loss Account Ratios ---------| Profitability Ratios----|
Balance Sheet Ratios -----------------| Coverage Ratios ------|
Composite or Inter-statement Ratios -| Turnover Ratios -----|
Financial Ratios -----|
|
-------------------
| |
Liquidity Ratios Stability Ratios
PROFITABILITY RATIOS
What is profitability?
Apart from the creditors of the firm, other parties interested in the financial soundness
of the firm are the owners / shareholders and the management. The management is
eager to measure the operating efficiency of the concern to show how best it has
managed the financial resources of the concern. On the other hand, shareholders who
invest their funds in the company also expect a fair return on their investments. Thus
both these groups are interested in the higher profitability of the concern. Profitability is
an indication of the efficiency with which the operations of the business are carried on.
Poor operational performance may indicate poor sales and hence poor profits. A lower
profitability may arise due to the lack of control over expenses.
Measuring profitability
The profitability of a firm can be measured by its profitability ratios. In other words,
profitability ratios are designed to provide answers to questions such as:
Is the profit earned by the firm adequate?
What rate of return does it represent?
What is the rate of profit for various divisions and segments of the firm?
What is the earnings per share?
What amount was paid as dividends?
What is the rate of return to equity holders? and so on.
Types of Profitability Ratios
Profitability ratios can be determined on the basis of either SALES or INVESTMENTS.
A. Profitability Ratios Related to Sales
These ratios are calculated on sales and are based on the premise that the firm should
earn sufficient profits on its sales, otherwise it may face difficulty in meeting the
operating expenses, and shareholders would also get no returns. These ratios consist of:
(i) Profit Margins or Profit Ratios
Profit Margin as a profitability ratio measures the relationship between 'profits' and
'sales'. As the profits may be gross or net, there are two types of profit margins - Gross
Profit Margin and Net Profit Margin.
a. Gross Profit Margin (also known as Gross Profit Ratio) - This ratio
establishes relationship of profit with sales to measure the operating efficiency of
the firm and to reflect its pricing policy. This ratio is calculated by dividing the
gross profit by sales. Thus, expressed as a %
Gross Profit Margin or Gross Profit Ratio = [Gross Profit / Net Sales] x
100
Illustration:
Calculate the Gross Profit Ratio from the following figures:
Sales = Rs. 1,00,000
Sales returns = Rs. 10,000
Purchases = Rs. 60,000
Purchase returns = Rs. 15,000
Opening stock = Rs. 20,000
Closing stock = Rs. 5,000
Solution:
Gross Profit Ratio = [Gross Profit / Net Sales] x 100
= [{Net sales - Cost of goods sold} / Net sales] x 100
= [{(Sales - Sales returns) - (Opening Stock + Purchases - Purchase
returns - Closing stock)} / Net sales] x 100
= [{(1,00,000 - 10,000) - (20,000 + 60,000 - 15,000 - 5,000)} / Net sales]
x 100
= [{90,000 - 60,000} / Net sales] x 100
= [30,000/90,000] x 100 = 33.33%
Significance of Gross Profit Ratio
A high ratio of gross profit to sales is a sign of good management, as it implies that
the cost of production is relatively low. It may also be indicative of a higher sales
price without a corresponding increase in the cost of goods sold. It is also likely
that cost of sales might have declined without a corresponding increase in sales
price. Nevertheless, a very high and rising gross margin may also be the result of
unsatisfactory basis of stock valuation, which means, over-valuation of closing
stock and/or under-valuation of opening stock. A thorough investigation of the
factors contributing to a high gross margin is called for.
A relatively low gross margin is definitely a danger signal, warranting a careful and
detailed analysis of the factors responsible for it. The important contributory
factors may be - high cost of production reflecting acquisition of raw materials and
other inputs on unfavourable terms, inefficient utilisation of current as well as
fixed assets etc., or low selling price resulting from severe competition, inferior
quality of the product, lack of demand etc.
b. Net Profit Margin (also known as Net Profit Ratio) - This measures the
relationship between net profit and sales of a firm. Depending upon the concept of net
profit employed, this ratio can be computed in three ways:
One, Net Profit Ratio = [Net Profit after Taxes before Interest / Net Sales] x 100
Two, Net Profit Ratio = [Net Profit before Interest and Taxes / Net Sales] x 100
Three, Net Profit Ratio = [Net Profit after Taxes and Interest / Net Sales] x 100
Illustration:
From the following information of a firm, determine the Net Profit Margin:
Sales = Rs. 2,00,000
Cost of goods sold = Rs. 1,00,000
Other operating expenses = Rs. 50,000
Solution:
Net Profit Ratio = [Net Profit / Net Sales] x 100
= [(Net Sales - Cost of goods sold - Other operating expenses) / Net Sales ] x 100
= [(2,00,000 - 1,00,000 - 50,000) / 2,00,000] x 100
= [50,000/2,00,000] x 100 = 25%
Significance of Net Profit Ratio
This ratio helps in determining the efficiency with which affairs of the business are
being managed. An increase in the ratio over the previous period indicates
improvement in the operational efficiency of the business, provided the gross
profit ratio is constant. The ratio is thus an effective measure to check the
profitability of business.
An investor has to judge the adequacy or otherwise of this ratio by taking into
account the cost of capital, return in the industry as a whole, and market
conditions such as boom or depression period. No norms can be laid down.
However, constant increase in this ratio year after year is a definite indication of
improving conditions of the business.
(ii) Expenses Ratio
Another profitability ratio related to sales is the Expenses Ratio. It is computed by
dividing 'expenses' by 'sales'. The team 'expenses' refers to the operating expenses of a
firm exclusive of financial expenses (like interest, taxes, and dividends) and
extraordinary losses due to theft of goods, goods destroyed by fire and so on. There are
different concepts of operating expenses:
a. Total Operating Expenses consisting of costs of goods sold, and selling, general, and
distributive expenses and so on;
b. Cost of goods sold; and
c. Specific operating expenses.
Accordingly, the expenses ratio can be computed in three ways. That is,
One, Expense Ratio = [Cost of Goods Sold + Other operating Expenses] / Sales
Two, Expense Ratio = Cost of Goods Sold / Sales
Three, Expense Ratio = Specific Operating Expenses / Sales
Interpretation of Expenses Ratio:
The expenses ratio is, in a way, reciprocal of the profit margin, gross as well as net. For
instance, if the Profit Margin (or Profit Ratio) is deducted from 100%, the resultant is
Expenses Ratio. Alternatively, when the Expenses Ratio is subtracted from 100%, we get
the Profit Ratio.
If the sales and total operating expenses of a firm are Rs. 40,00,000 and Rs. 32,00,000
respectively, the operating ratio would be 32,00,000 divided by 40,00,000, which is
80%. It implies that total operating expenses consume 80% of the sales receipts of the
firm and 20% is left for paying interest, tax and dividend liabilities, and for retaining
profits for future expansion. The Cost of Goods Sold Ratio shows the percentage
share of sales that is consumed by the cost of goods sold and, conversely, the proportion
that is available for meeting expenses such as selling and general distribution, as well as
financial expenses like taxes, interest, dividends and so on.
The Expenses Ratio is, therefore, very important for analysing the profitability of a firm.
It should be compared over a period of time with the industry average, as well as with
firms of similar type. As a working proposition, a low ratio is favorable while a high one
is unfavorable. The implication of a high Expenses Ratio is that only a relatively small
percentage share of sales is available for meeting financial liabilities like interest, tax
and dividends, etc. An analysis of the factors responsible for a low ratio may reveal
changes in the selling price or the operating expenses. It is likely that individual items
may behave differently. While some operating expenses may show a rising trend, others
may record a fall. The specific expenses ratio for each of the items of operating cost may
be calculated. These ratios would identify the specific cause. To illustrate, an increase in
selling expenses may be due to a number of reasons:
General rise in selling expenses,
Inefficiency of the marketing department leading to uncontrolled promotional
and other expenses,
Growing competition,
Unnecessary advertising,
Inefficient utilisation of resources, and so on.
A low operation ratio is, by and large, a test of operational efficiency. In case of firms
whose major source of income and expenses are non-operating, the operating ratio,
however, cannot be used as a yardstick of profitability.
To conclude, the profitability ratios based on sales are an important indicator of the
operational efficiency of a manufacturing enterprise. However, these ratios suffer from a
serious limitation in that they are not useful from the viewpoint of the owners of the
firm. From the owners' point of view, rate of return on investments is a better measure
of testing the profitability of a firm. This is taken up subsequently.
B. Profitability Ratios Related to Investments
There are three different concepts of investments recognized in the financial parlance -
assets, capital employed and shareholders equity. Based on each of them, there are three
broad categories of Return on Investment (ROI). They are
(i) Return on Assets (ROA) Ratio
The profitability ratio is calculated in terms of the relationship between 'net profits' and
'assets'. This ratio is also known as Profit-to-Assets Ratio. As there are various
definitions of net profit and assets, depending upon the purpose and intent with which
the computation is made, there are different variations of ROA:
The concept of net profit may refer to:
(a) net profit after taxes, or
(b) net profit after taxes plus interest, or
(c) net profit after taxes plus interest minus tax savings.
Similarly, the term assets may refer to:
(a) total assets, or
(b) fixed assets, or
(c) tangible assets.
Accordingly, the different calculations of return on assets are given below:
The Return on Assets Ratio measures the profitability of the total funds invested in a
firm but does not reflect the profitability of the different sources of all the funds. This
ratio should be compared with the ratios of other similar companies or for the industry
as a whole, to determine whether the rate of return is attractive. This ratio provides a
valid basis for inter-industry comparison.
Illustration:
Calculate and comment on the rate of return on total assets from the following data of
two companies:
Go Slow Co. Go Fast Co.
Total assets 42,50,000 42,12,500
Net profit in sales 6% 4%
Turnover of assets 6 times 6 times
Gross margin 20,68,000 12%
Sales
42,50,000 x 6 =
2,55,00,000
42,12,500 x 6 =
2,52,75,000
Net profit
6% of 2,55,00,000 =
15,30,000
4% of 2,52,75,000 =
10,11,000
Rate of Return on Total Assets = Net
Profit / Total Assets x 100%
[1530000/4250000] x 100
= 36%
[1011000/4212500] x 100
= 24%
Comment:
The rate of Return on Total Assets in respect of Go Fast Co. is less than that of Go Slow
Co., as the total assets are of same amount (approx) in both the cases. Net Profit in Sales
in Go Fast Co. is 2/3 of that in Go Slow Co. (4% vs. 6%) and similar is the case with the
rate of Return on Total Assets (24% vs. 36%).
(ii) Return on Capital Employed (ROCE) Ratio
It is a truism to say that proprietors invest money in a business to obtain a satisfactory
return on their capital. The nature of this return will be influenced by factors such as
type of industry, risk involved, risk of inflation, comparative rate of return on gilt-edged
securities, and fluctuations in external economic conditions. For this purpose, the
shareholder can measure the success of a company in terms of 'profit' related to 'capital
employed'. The return on capital employed can be used to show the efficiency of the
business as a whole.
The term "Capital Employed" has been given different meanings by different
accountants. Some of the popular meanings are as follows:
a. Sum total of all assets, whether fixed or current;
b. Sum total of fixed assets;
c. Sum total of long-term funds employed in business, i.e. share capital + reserves &
surplus + Loan term loans + non-business assets + fictitious assets. In management
accounting, the term capital employed is generally used in this meaning.
The term "Operating Profit" means profit before interest and tax. The term "Interest"
means interest on long-term borrowings. Interest on short-term borrowings is deducted
for computing the operating profit. Non-trading incomes such as interest on
government securities or non-trading losses or expenses such as loss on account of fire,
etc., is also excluded.
ROCE can be computed in different ways, using different concepts of profit and capital
employed. Thus,
Significance:
The concept of 'Return on Capital Employed' has been given much attention in recent
years, particularly in the field of financial management, where it is used to determine
whether a certain goal has been achieved or whether an alternative use of capital is
justified. Further, it is also used as a basis for various managerial decisions.
In fact, the starting point of business budgeting should be the determination of a
minimum rate of profit on capital investment, which is then worked backwards for
planning the detail of business operations. This is the minimum return expected on
capital employed and, in order to attract capital to a particular business, a fair return
has to be paid. Then, the laying down of a minimum return is also essential from the
point of view of making a correct choice of investments so that, if adequate return is not
forthcoming in a particular line, the same may be discarded in favour of a more lucrative
alternative. There is hardly any criterion for determining the minimum return with
reference to which return on capital investment may be judged.
ROCE is the only measure which can be said to show satisfactorily the overall
performance of an undertaking from the standpoint of profitability- the benefits
obtained in the form of share of income in return for the capital invested. It enables the
management to show whether the funds entrusted to the business have been properly
used or not. Thus, it can become an integral part of the budgetary control system in
order that the management may be able to follow the progress being made and to take
corrective action, if necessary.
(iii) Return on Shareholders' Equity (ROSE) Ratio
This profitability ratio carries the relationship of 'return' to the 'sources of funds' to yet
another step further. While the ROCE expresses the profitability of a firm in relation to
the funds supplied by the creditors and owners taken together, the return on
shareholders' equity measures the return on the owner's funds.
The shareholders of a firm fall into two broad groups: preference shareholders and
equity shareholders. The holders of preference shares enjoy a preference over equity
holders in respect of receiving dividends. In other words, from the net profits available
to the shareholders, the preference dividend is paid first and whatever remains belongs
to the ordinary shareholders. The profitability ratios based on shareholder's equity are
termed as Return on Shareholders' Equity. There are several measures to calculate the
return to shareholders:
a. Rate of return on total shareholders' equity
b. Rate of return on ordinary shareholders' equity
c. Earnings per share
d. Dividends per share
e. Dividend payout ratio
f. Dividend and earnings yield
g. Price-earnings ratio
a. Return on Total Shareholders' Equity
The profitability, according to this ratio, is calculated by dividing the 'net profits
after taxes' by the 'total shareholders' equity', which is preference share capital +
ordinary share capital + share premium + reserves & surplus - accumulated losses.
The Shareholders' Equity is also known as Net Worth. Thus,
Return on Total Shareholders' Equity = Net Profit (after taxes) / Total
shareholders' equity
This ratio shows how the owner's funds have been used by the firm and may be
used in comparison with profitability of similar firms.
Illustration:
Excerpts of Balance Sheet (liabilities side)
(in Rs.)
Share Capital Authorised:
15,000 7% Cumulative Preference Shares of Rs.10 each 1,50,000
20,000 Equity Shares of Rs.10 each 2,00,000 3,50,000
Issued and Subscribed:
15,000 7% Cumulative Preference Shares of Rs.10 each fully paid 1,50,000
5,000 equity shares of Rs. 10 each Rs. 5 per share called up 25,000 1,75,000
Reserves & Surplus:
Capital Reserve 10,000
General Reserve 52,000
Reserve for Contingencies 22,000
Profit and Loss Account 40,000 1,24,000
Shareholders' Fund 3,02,000
Net Profit for the year 84,000
Return on shareholders' investment = 84,000 / 3,02,000 = 0.278
This means that the return on shareholders' funds is 28 paise per rupee, or 28%.
This ratio reveals how profitably the owner's funds have been utilized by the firm.
A comparison of this ratio with that of similar firms, as also with the industry
average, will throw light on the relative performance and strength of the firm.
b. Return on Ordinary Shareholders' Equity
The profitability from the point of view of the equity shareholders is judged after
taking into account the amount of dividend payable to the preference
shareholders.
Return on Equity Shareholders' Funds
= [Net Profit after Interest, Tax, and Preference Dividend / Equity
shareholders' fund] x 100
Illustration:
In the example taken for the rate of return on shareholders' investments,
Return on Equity Capital = [(84,000 - 10,500) / 25,000] x 100 = [73,500 /
25,000] x 100 = 294%
Earnings per Equity Share = 73,500 / 5,000 = Rs. 14.70
It reveals whether the firm has earned a reasonable profit for its equity
shareholders by comparing it with its own past records, inter-firm comparison,
and comparison with the overall industry average.
c. Earnings Per Share (EPS)
This ratio indicates the availability of total profits per share. The following formula
may be employed to determine EPS (Earnings per Share).
EPS = Net profits available to equity shareholders / No. of equity share
outstanding
Illustration:
Calculate the earnings per share (EPS) from the following data:
Net profit before Tax = Rs. 1,00,000
Taxation is at 50% of Net Profit
10% Preference Share Capital (Rs. 10 each) = Rs. 1,00,000
Equity Share Capital (Rs. 10 share) = Rs. 1,00,000
Solution:
EPS = Net profits available to equity shareholders / No. of equity share
outstanding
= [Rs. 1,00,000 - (50% of Rs. 1,00,000) - (10% of Rs. 1,00,000)] / [Rs. 1,00,000 /
Rs. 10]
= Rs. 40,000 / Rs. 10,000 = Rs. 4
EPS is a widely used ratio. Its usefulness lies in analysing the effect of a change in
net operating earnings for the ordinary shareholders. Yet, EPS as a measure of
profitability of a firm from the owner's point of view should be used cautiously, as
it does not recognize the effect of increase in equity capital because of retention of
earnings. In other words, if EPS has increased over the years, it does not
necessarily follow that the firm's profitability has improved. This is because the
increased profits may be the effect of an enlarged equity capital resulting from
profit retentions, though the number of ordinary shares outstanding may have
remained constant. Another limitation of EPS is that it does not reveal how much
is paid to the owners as dividends and how much of the earnings is retained in the
business. It only shows how much 'theoretically' belongs to the ordinary
shareholders.
As a profitability ratio, the EPS can be used to draw inferences on the basis of its
trend over a period of time, in comparison with the EPS of other firms, and in
comparison with the industry average.
d. Dividend Per Share (DPS)
The EPS represents what the owners are theoretically entitled to receive from the
firm. A part of the net profits belonging to them is retained in the business and the
balance is paid to them as dividends. The dividends paid to the shareholders on
per share basis are the DPS. In other words, DPS is the net distributed profit
belonging to the shareholders divided by the number of ordinary shares
outstanding.
DPS = Net profit after interest and dividend paid to ordinary
shareholders / No. of ordinary shares outstanding
The shareholders have a definite preference for dividends relative to retention of
earnings. The DPS is a better indicator than EPS, as it shows what exactly is
received by the owners. Like EPS, DPS also should not be taken at its face value, as
an increased DPS may not be a reliable measure of profitability, since the equity
base may have increased due to increased retention without any change in the
number of outstanding shares.
e. Dividend Payout Ratios
This ratio indicates what proportion of earning per share has been used for paying
dividends. The ratio can be calculated as follows:
Payout Ratio = Dividend per equity share / Earning per equity share
A complementary of this ratio is the Retained Earnings Ratio. It is calculated as
follows:
Retained Earnings Ratio = Retained Earnings per Equity Share /
Earnings per Equity Share
The payout ratio and the retained earnings ratio are indicators of the amount of
earnings that have been ploughed back into the business. The lower the payout
ratio, the higher the amount of earnings ploughed back into the business and vice-
versa. Similarly, the lower the retained earnings ratio, the lower the amount of
earnings ploughed back into the business, and vice-versa.
f. Earnings and Dividend Yield Ratio
Another profitability ratio from ordinary shareholders point of view is earning and
dividend yield ratio. This ratio is based on market value instead of book value of
shares. The earning yield can be determined by dividing EPS by market value per
share. This ratio reveals the real worth of the firm.
Dividend yield ratio is calculated by dividing dividend per share by the market
value per share. It is important to prospective investors. Thus,
Earnings Yield = EPS / Market Value per Share
Dividend Yield = DPS (in cash) / Market Value per Share
g. Earnings Yield / Price Earnings Ratio (PER)
The P/E ratio is closely related to the earning yield/earnings price ratio. It is
actually the reciprocal of the latter. This ratio is computed by dividing the market
price of the shares by the EPS. Thus,
PER = Market Price per Equity Share / Earning per Equity Share
For example, if the market price of a share is Rs. 30 and EPS is Rs. 5, the PER
would be 30 / 5 = 6. It means that market value of every one rupee of earning is six
times. The ratio is useful in financial forecasting. It also helps in knowing whether
the shares of a company are under- or over-valued. For example, if the EPS of AB
Limited is Rs.20, its market price is Rs. 140, and PER of similar companies is 8, it
means that the market price of a share of AB Limited should be Rs.160 (8 x Rs.
20). The share of AB Limited is, therefore, undervalued in the market by Rs. 20.
(Rs.160 - Rs.140). In case the PER of similar companies was only 6, then we can
say that value of share of AB Limited should have been Rs.120 (6 x Rs. 20). Thus
the share would have been overvalued by Rs. 20 (Rs.140 - Rs.120).
COVERAGE RATIOS
For a normal firm, in the ordinary course of business, the claims of creditors are not met
out of the sale proceeds of the permanent assets of the firm. The obligations of a firm are
normally met out of the earnings or operating profits. These claims consist of interest on
loans, preference dividends, and amortization of principal or repayment installment of
loans or redemption of preference capital on maturity.
The soundness of a firm from this ability is indicated by the Coverage Ratios. The
Coverage Ratios measure the relationship between what is normally available from
operations of the firms and the claims of the outsiders. The important coverage ratios
are:
A. Interest Coverage Ratio (ICR)
The ratio is very important from the lenders' point of view. It indicates whether the
business would earn sufficient profits to pay periodically the interest charges. The
higher the ratio, the more secure the lender is in respect of his periodical interest
income. It is calculated as follows:
Interest Coverage Ratio = Income before Interest and Tax / Interest charges
The standard for this ratio for an industrial company is that the interest charges should
be covered six to seven times.
Illustration:
If the net income of an enterprise is Rs. 1,62,400, its fixed interest charges on mortgage
debentures amounts to Rs.2,700, and income tax paid by it is Rs. 1,62,400, then
calculate the Interest Coverage Ratio.
Interest Coverage Ratio = (1,62,400 + 1,62,400 + 2,700) / 2,700 = 121 times
approximately
Interest coverage of 121 times may be considered very much more than adequate.
Note: Usually, in the case of corporate enterprises, the rate of income tax is 50% of
profits.
Significance:
The ratio gives an idea of the extent to which a firm's earning may contract before it is
unable to meet interest payments out of current earnings. It is used in external financial
analysis and is watched more closely, by external analysis, than any other ratio. The
standard for this ratio for an industrial company is that its fixed interest charges should
be covered six to seven times. The weakness of the ' ratio would make the financial
manager experience difficulty in raising additional funds from debt sources.
The assumption underlying this relationship is that the average historical performance
of the firm under review will be its average performance in future, which may or may
not be true but, in the absence of evidence to the contrary, historical data will be used by
suppliers of capital to make such judgments regarding the future.
B. Dividend Coverage Ratio (DCR)
It measures the ability of a firm to pay dividend on preference shares which carry a
stated rate of return. This ratio is the ratio (expressed as x number of times) of 'earnigs
after taxes' (EAT) and the 'amount of preference dividends'. Thus,
Dividend Coverage Ratio = EAT / Preference Dividend
It can be seen that although preference dividend is a fixed obligation but the earnings
taken into account are after taxes. This is because, unlike debt on which interest is a
charge on the profits of the firm, the preference dividend is treated as an appropriation
of profit. The ratio, like the interest coverage ratio, reveals the safety margin available to
the preference shareholders. As a rule, the higher the coverage ratio, the better it is from
their point of view.
Illustration:
The operating profit of a company after taxes is Rs. 10,000. The amount of interest is
Rs. 2,000 and the provision for tax has been made for Rs. 4,000. The amount of
preference dividend payable is Rs. 1,000. Compute the Dividend Coverage Ratio.
Solution:
Dividend Coverage Ratio = EAT / Preference Dividend
= 10,000 / 1,000 = 10 times
C. Debt Service Coverage Ratio (DSCR)
This is an ideal ratio for measuring the capability of an enterprise to meet its long term
liabilities. This ratio shows the number of times the enterprise's funds from operations
cover the repayment of instalment and interest of term loans on an annual basis. This is
computed as follows:
DSCR = Cash generated / (Instalment of term loan+ Interest on term loan)
For the purpose of computation of the amount of cash generated, generally the analysis
starts from the concept of profit after tax (PAT) although the same can be computed on
the basis of profit before tax (PBT) also. Since PAT has been arrived at after charging
depreciation in the P & L account, which is in fact a non-cash charge, the amount of the
same is added back to PAT to arrive at the actual amount of cash generated. Similar
treatment is also given to interest on term-loans, which has also been debited to P & L
account. Therefore, DSCR can be calculated as under:
DSCR = Net profit before interest and taxes / [Interest + Principle payment
instalment/(1-tax rate)]
This ratio is calculated on yearly basis over the entire payment period and then the
average thereof is calculated. Ideal DSCR should be minimum 21 on average basis so
that there is sufficient cover and the unit may not face problem in meeting the long-term
liabilities in time.
Illustration:
Net profit before interest and tax = Rs. 50,000
10% debentures (payable in 10 years in equal installments) = Rs. 1,00,000
Tax rate = 50%
Calculate the debt service coverage ratio.
Solution
DSCR = Net profit before interest and taxes / [Interest + Principle payment
instalment/(1-tax rate)]
= 50,000 / [10% of 1,00,000 + 10,000*/(1-50%)]
= 50,000 / [10,000 + 10,000/0.5]
= 50,000 / [10,000 + 20,000] = 50,000/30,000 = 1.67 times
* Since the principle of Rs.1,00,000 is to be paid in 10 equal instalments, the principle
payment instalment = 1,00,000 divided by 10 = Rs.10,000
The ratio of 1.67 means that the net profit before interest and tax covers adequately both
interest and principal repayment installment.
MODEL QUESTIONS
1. Discuss the role of ratio analysis in the analysis and interpretation of financial
statements.
2. How would you analysis the financial position of a company from the point of
view of (a) an investor (b) a creditor and (c) a financial executive of the company?
3. "Return on Investments" is a single comprehensive measure that contains
everything happening within the organization". Explain the statement and
illustrate its computations with imaginary figures.
4. Define and distinguish between PER and EPS.
5. Examine the limitations of Ratio Analysis.
- End of Chapter -
LESSON - 14
RATIO ANALYSIS - II
TURNOVER RATIOS
The turnover ratios indicate the efficiency with which the capital employed is rotated in
the business. The overall profitability of the business depends on two factors:
(i) the rate of return on capital employed, and
(ii) the turnover, i.e., the speed at which the capital employed in the business rotates.
Higher the rate of rotation, the greater will be the profitability.
Thus, the overall profitability ratio can be classified into Net Profit Ratio and Turnover
Ratio.
As already explained, the Net Profit Ratio is calculated as (Net Operating Profit / Sales)
x 100.
Turnover Ratio is calculated as (Sales / Capital Employed) x 100
Turnover Ratio indicates the number of times the capital has been rotated in the process
of doing business. If these two ratios are put together, we get...
Overall Profitability Ratio = Net Profit Ratio x Turnover Ratio
= (Net Operating Profit / Sales) x (Sales / Capital
Employed)
Overall Profitability Ratio = (Net Operating Profit / Capital Employed) x
100 (expressed as %)
Illustration:
Determine which company is more profitable, from the data given below.
Company A Company B
Net profit ratio 5% 8%
Turnover ratio 6 times 3 times
Solution:
In the above case if only Net Profit Ratio is seen, Company B seems to be more
profitable, but if we see the Turnover Ratio, Company A seems more profitable. If we
look at the Overall Profitability Ratio, for Company A it is 5 x 6 = 30%, while for
Company B it is 8 x 3 = 24%. hence Company A is more profitable overall.
In order to find out which part of capital is efficiently employed and which part is not,
different Turnover Ratios are calculated. These ratios are:
A. Fixed Assets Turnover Ratio
This ratio expresses the relationship between 'sales' and 'fixed assets'. Since investment
in fixed assets is made for the ultimate purpose of effecting sales, this ratio is used to
measure the fulfillment of that objective. This ratio is computed by dividing the 'net
sales' by the 'fixed assets'. Hence,
Fixed Assets Turnover Ratio = Net Sales / Fixed Assets
If the ratio is too high, it reflects that the firm is overtrading on its assets. On the other
hand, if the ratio is too low, it represents that the firm has made excessive investments
in fixed assets.
As volume of sales is dependent on a variety of factors such as price, quality of goods,
nature of salesmanship, marketing strategies, channels of distribution, etc. it is argued
that no direct relationship can be established between sales and fixed assets.
Accordingly, it is not recommended for general use.
Illustration:
The following details have been given to you for M/s Reckless Ltd. for two years. You are
required to find out the Fixed Assets Turnover Ratios for both and comment on it.
1987 1988
(Rs.) (Rs.)
Fixed assets at written-down value 1,50,000 3,00,000
Sales less Sales returns 6,00,000 8,00,000
Solution:
Fixed Assets Turnover Ratio = Net Sales / Fixed Assets
6,00,000 / 1,50,000 8,00,000 /
3,00,000
= 4 times = 2.67
times
Comments: There has been a decline in the Fixed Assets Turnover Ratio from 1987 to
1988, though absolute figures of sales have gone up. It means that the increase in the
investment in fixed assets has not brought about commensurate gains. However, the
results for next two or three years must also be seen before commenting on
judiciousness or otherwise of increasing investments in fixed assets.
B. Working Capital Turnover Ratio
This ratio is used to measure efficiency with which the working capital has been utilized
in a business. This measures the relationship between net sales and networking capital.
This ratio is computed by dividing the 'net sales' by 'net working capital'. Thus,
Working Capital Turnover Ratio = Net sales / Networking Capital
The higher the working capital turnover Ratio, the more favourable it is for the firm,
unless sales constitute more of credit sales. A higher ratio may at times reflect
inadequacy of networking capital. But still a low turnover of net working capital may
also be due to excessive working capital combined with slow turnover of inventories and
receivables. While interpreting the Working Capital Turnover Ratio, one should exercise
more care and caution, since this represents a composite of interrelationships each one
of which requires a closer scrutiny.
Working Capital Turnover Ratio may take different forms for different purposes. Some
of them are:
(i) Debtors Turnover Ratio (DTR)
Also called Receivables Turnover Ratio, this ratio matches 'net credit sales' of a firm to
'recorded trade debtors', thereby indicating the rate at which cash is generated by
turnover of receivables or debtors. However, this is not immediately apparent from this
ratio and therefore it has to be supplemented by Average Collection Period (ACP).
Analysing DT Ratio together with ACP involves the following steps:
a. Calculation of daily sales - This is obtained by dividing 'number of working days
during a year' by 'net credit sales for the year'.
b. Calculation of average collection period - This is done by dividing 'sales per day' (as
arrived at in step No.1) by the 'amount of trade debtors'. The quotient represents the
number of days sales is tied up in receivables.
DT Ratio shows the relationship between sales and debtors for a firm. It can be
calculated in two ways. One way is...
DTR = Credit Sales / Average Debtors
This approach requires two types of data. First, credit sales, which may not be readily
available to the analyst. Similarly, the computation of the figure of average debtors
involves practical difficulties. In theory, the average debtors should be measured, as in
case of average inventory, on the basis of the monthly average of debtors. Since this type
of information is not likely to be available to the analyst, the alternative is to use the
average of the opening and closing balances of debtors.
'Average debtors' in the above equation refers to the average of the opening and closing
balances of debtors, i.e., (Opening balance + Closing balance) / 2.
To solve the difficulty arising out of the non-availability of the information on credit
sales and average debtors, an alternative method is used to calculate the ratio - in terms
of relationship between 'total sales' and 'closing balance of debtors'. Thus, the second
way is...
DTR = Total Sales / Debtors (closing balance)
It should be noted that the first approach to the computation of the DT Ratio is superior
in that the question of the speed of conversion of sales into cash arises only in case of
credit sales. The effect of adopting the second approach would be able to inflate the
receivables turnover ratio.
Another way of measuring the liquidity of a firm's debtors is the Average Collection
Period Ratio. This ratio is, in fact, inter-related with, and dependent upon, the
Receivables Turnover Ratio. It is calculated by dividing the 'months or days in a year' by
the 'debtors turnover'. Thus,
ACPR = Months in a year / Debtors Turnover
or
ACPR = (Debtors x Months in a year) / Credit Sales
Illustration:
Credit Sales for the year = Rs. 12,000
Bills receivables = Rs. 1,000
Debtors = Rs. 1,000
Calculate the Debtors Turnover Ratio and Debt Collection Period (same as Average
Collection Period).
Solution:
DT Ratio = Credit Sales / Debtors = 12,000 / (1,000 + 1,000) = 6 times
Note: Receivables are also 'debtors'
Debt Collection Period = Average age of receivables = Months in a year / Debtors
turnover = 12/6 = 2 months
Alternately,
Debt Collection Period = (Debtors x Months in a year)/Credit Sales in a year = (2,000 x
12)/12,000 = 2 months
Alternately,
Debt Collection Period = Debtors / Credit Sales in a month = 2,000 / 1,000 = 2 months
In fact, the two ratios are interrelated. DT Ratio can be obtained by dividing number of
months (or days) in a year by the average collection period (i.e., 12 / 2 = 6). Similarly,
where the number of months (or days) in a year are divided by the DT Ratio, average
collection period is obtained (i.e., 12 / 6 = 2 months).
Significance:
The amount of trade debtors and bills receivables depend upon the sales volume credit
extension practice and the effectiveness of the collection policy. Since debtors constitute
a major element of current assets, the credit and collection policies of the business must
be under continuous watch. The amount of trade debtors at the end of total accounting
period should not exceed a reasonable proportion of 'net sales', and the Debtors
Turnover Ratio is an enabling device to find out as to how many days average sales is
tied up in the value of amount owed by debtors according to the Balance Sheet. It is also
an excellent supplementary check to judge the adequacy of Current Ratio.
(ii) Creditors Turnover Ratio (CTR)
This ratio indicates the number of days of credit enjoyed by the unit for purchase of its
raw materials. It is calculated as...
CT Ratio = Sundry Creditors (trade) / Purchases per day,
where Purchases per day = Total purchase (credit) / 360
Hence,
CT Ratio = [Sundry Creditors (trade) / Total purchase (credit)] x 360
If the ratio is high, it means that the unit is enjoying good reputation in the market and
is able to get more credit for purchase of raw materials. But, if the ratio is too high
compared to other units in the liquidity position, the unit may become unstable.
Similarly if the ratio is too low, it may be interpreted that the unit is not getting any
credit in the market for its purchases. Here, the trends are important as to which
direction the unit is moving.
(iii) Inventory Turnover Ratio (ITR)
Also known as Stock Turnover Ratio in the traditional language, this ratio usually
establishes relationship between the 'cost of goods sold during a given period' and the
'average amount of inventory outstanding during that period'.
ITR can be looked at from another point of view also. While it helps in determining the
liquidity of a firm in as much as it gives the rate at which inventories are converted into
sales and then into cash, it assists the financial manager in evaluating inventory policy -
finding out the reasonableness of such a policy at a given level to avoid any danger of
overstocking as a prelude to the effective utilization of resources of the firm. The ratio
can be computed in two ways:
a. By dividing the 'cost of goods' by 'average inventory'
ITR = Cost of goods sold / Average Inventory
where,
Cost of goods sold = Opening stock + Manufacturing cost + Purchases Closing
stock of inventory
Average Inventory = (Opening Stock + Closing Stock) / 2
b. Sometimes, the analyst may find it difficult to get information regarding
inventory levels or cost of goods. In that case, the second approach is followed, i.e.,
by dividing 'total sales' by 'closing inventory'. Thus,
ITR = Total Sales / Closing Stock of Inventory
In theory, the second approach is not logical as the two variables (sales and inventory)
are not strictly comparable.
Illustration:
A firm has sold goods worth Rs. 3,00,000 with a gross profit margin of 20%. The stock
at the beginning and the end of the year was Rs. 35,000 and Rs. 45,000 respectively.
What is the Inventory Turnover Ratio?
Solution:
ITR = Cost of goods sold / Average Inventory
= [(Selling Price - Profit] / [(Opening stock + Closing stock)/2]
= [3,00,000 - 20% of 3,00,000] / [(35,000 + 45,000)/2]
= 2,40,000 /40,000 = 6 (times per year)
Significance:
Inventory Turnover Ratio is an indication of the velocity with which merchandise moves
through the business. ITR standing by itself means absolutely nothing, because there is
no fixed norm for inventory turnover, which depends greatly on the nature of the
industry and on the sale policies followed by the firm. Therefore, to state that the
turnover of a particular firm is, say 5, reveals nothing about the wisdom or otherwise of
the firm's inventory management policy. To give meaning to a turnover figure, one must
compare it with other such figures so that a comparative analysis with industry or a
comparative analysis for the firm over time. Suppose, a firm's turnover ratio in the year
just ended is 5, whereas in the preceding year it was 5.5, and in the year before it was 6,
this gives a strong evidence of growing deficiency in inventory management, although
not conclusive by any means. It furnishes sufficient ground to warrant a thorough
analysis of the situation. Likewise, say, a firm's turnover ratio in the year just ended is 5,
while those of its principal competitors are 6, 6.5, and 7, it appears to be a record of poor
performance of the firm; but an investigation of its causes would surely be required.
Precautions:
While using the ITR, care must be taken regarding the following factors:
Seasonal conditions:
If the Balance Sheet is prepared at the time of a slack season, the average
inventory will be much less (if calculated on the basis of inventory at the beginning
and close of the accounting period). This may give a very high turnover ratio.
Supply conditions:
In case of conditions of scarcity, inventory may have to be kept high for meeting
the future requirements.
Price trends:
In case of the possibility of a rise in prices, a larger inventory may be kept by the
business. Reverse will be the case if there is a possibility of a fall in prices.
Trend of volume of business:
In case there is a trend of sales being sufficiently higher than sales in the past, a
higher amount of inventory may be kept.
FINANCIAL RATIOS
Financial Ratios indicate about the financial position of the company. A company is
deemed to be financially sound if it is in a position to carry on its business smoothly and
meet its obligations, both short-term as well as long-term, without strain. It is a sound
principle of finance that the short-term requirements of funds should not be met out of
long-term funds. For example, if the payment for raw material purchases is made
through issue of debentures, it will create a permanent interest burden on the
enterprise. Similarly, if fixed assets are purchased out of funds provided by bank
overdraft, the firm will come to grief because such assets cannot be sold away when
payment is demanded by the bank.
Financial ratios can be divided into two broad categories:
A. Liquidity Ratios
B. Stability Ratios
A. Liquidity Ratios
Liquidity ratios measure the firm's ability to meet its current obligations i.e., ability to
pay its obligations as and when they become due. They show whether the firm can pay
its short term obligations out of short-term resources or not. A low liquidity may result
in the failure of meeting firm's short-term liabilities, which may carry a bad name to the
firm, loss of creditor's confidence, and unnecessary law suits. A very high degree of
liquidity is also bad because the funds are unnecessarily tied up in current assets which
earn nothing. A striking balance, therefore, is necessary.
The important liquidity ratios are as follows:
(i) Current Ratio
The Current Ratio is the ratio of 'total current assets' to 'total current liabilities'. It is
calculated by dividing the current assets by current liabilities:
Current Ratio = Current Assets : Current Liabilities
Current assets of a firm represent those assets which can be, in the ordinary course of
business, converted into cash within a short period of time, normally not exceeding one
year. Current assets include cash and bank balances, marketable securities, inventory of
raw materials, semi-finished (work-in-progress) and finished goods, debtors after
provision for bad and doubtful debts, bills receivables, and prepaid expenses.
Current liabilities are the liabilities which are short-term maturing obligations to be
met, as originally contemplated, within a-year. Current liabilities consist of trade
creditors, bills payables, bank credit, provision for taxation, dividends payables, and
outstanding expenses.
Current Ratio, also called the Working Capital Ratio, is related to the working capital of
the firm. The term Current Ratio is, however, a better term to use, as it is free from the
ambiguity associated with the term Working Capital Ratio.
Illustration:
Current Ratio = 90,000 : 30,000 = 3:1
This means that for every Re. 1 worth of current liabilities, there are current assets
worth Rs.3. It also means that the firm will be able to pay off its current liabilities in full,
even if it liquidates its current assets at 33% of the then book value, while there is every
probability of their realizing more.
Precautions:
In determining the Current Ratio, it is important that all current assets and current
liabilities are properly valued. To the extent that values of current assets are not
correctly estimated in the Balance Sheet, the Current Ratio may be unduly inflated or
unnecessarily reduced. Therefore, reserves and other accounts related to the valuation
of current assets are deducted from the total current assets.
Moreover, contingent liabilities by way of discounted bills receivables should be given
proper consideration in the study of Current Ratio. Consequently, though it is not the
most common practice, all bills receivables, whether discounted or not, are treated as
current assets. At the same time, discounted bills receivables are treated as current
liabilities. In so far as a business is contingently liable in the event of a default on
discounted bills on maturity, such a procedure gives realistic and accurate idea of the
current financial position.
Significance:
The Current Ratio is an index of the concern's financial stability since it shows the
extent of the working capital, which is the amount by which the current assets exceed
the current liabilities. As stated earlier, higher current ratio would indicate inadequate
employment of funds, while poor current ratio is a danger signal to the management as
it shows that business is trading beyond its resources.
Change in the Current Ratio:
The relationship between current assets and current liabilities is disturbed on account of
a number of factors, some of which are:
i. Seasonal changes in the balance: Certain concerns purchase their raw materials
at the harvest time and manufacture goods having a seasonable market in
advance.
ii. Over-trading: Accumulation of stocks and mounting up of debtor's and creditor's
balances.
iii. Repayment of a long-term liability.
iv. A change made in the terms of trade, e.g. goods are being sold on one month's
credit instead of selling them for cash or on hire-purchase basis.
(ii) Acid Test Ratio or Quick Ratio
This ratio is very akin to the Current Ratio. The only difference is that it compares the
very 'liquid assets' with 'current liabilities'. The figures of inventory are excluded from
the current assets to arrive at the value of liquid assets. This is done on the assumption
that the stocks of inventory may not be converted into cash at the time of difficulty.
Thus, quick ratio is calculated as:
Acid Test Ratio = (Cash + Realizable Securities + Receivables) : Current
Liabilities
= Quick Assets : Current Liabilities
This ratio, in fact, measures the ability of the enterprise to pay off its impending current
obligations immediately. If the quick ratio is less, but the current ratio is high, it may
mean that the unit is holding high level of inventory and it is not able to sell its finished
products.
Illustration:
Current Ratio = 16,000 : 8,000 = 2 : 1
Acid Test Ratio = 4,000 : 8,000 = 0.5 : 1
Significance:
In so far as it eliminates inventories as a part of current assets in the calculation of ratio,
Acid Test Ratio is a more rigorous test of liquidity than the Current Ratio and, when
used in conjunction with Current Ratio, it gives a better picture of the firm's ability to
meet its short-term debts out of short-term assets. Rule of the thumb is 1:1 for the acid-
test ratio so that, if a business has Quick Ratio of at least 100 percent, it is considered to
be in a fairly good current financial position.
However, care must be exercised in placing too much reliance on the acid-test ratio
without further investigation. This is so because the interpretation of the acid test ratio,
like any other ratio, depends much on circumstances - a seasonal business which seeks
to stabilize production will tend to have a weak acid-test ratio during its period of slack
sales, but probably a powerful one in its period of heavy selling. So, the earlier weak
position would have to be judged in relation to the market production for the firm's
products in the later period.
Further, while deriving conclusions from this ratio, it must be remembered that, though
technically inventories are not available to meet liquid liabilities, they can be used to a
measurable extent to meet current liabilities, because of their normal conversion into
cash and bills receivables as well as due to their conversion at a profit in the ordinary
course yielding a larger amount of cash.
Apart from these, the interpretation of the acid-test ratio is hedged in by the same
factors and conditions as the current ratio.
(iii) Defensive Interval Ratios
The liquidity ratios of a firm outlined in the preceding discussions throw light on the
ability of a firm to pay its current liabilities. Apart from paying current liabilities, the
liquidity position of a firm should also be examined in terms of its ability to meet
projected daily expenditure from operations. The Defensive Interval Ratio provides such
a measure of liquidity. It is a ratio between the 'quick assets' and the 'projected daily
cash requirements' and is calculated as follows:
Defensive Interval Ratio = Quick Assets / Projected daily cash requirement
where,
> Projected daily cash requirement = Projected cash operating expenditure / No. of days
in a year (365)
> Projected cash operating expenditure = Cost of goods sold + selling, administrative,
and other ordinary expenses
The projected cash operating expenditure is based on past expenditures and future
plans. Alternatively, a very rough estimate of cash operating expenses can be obtained
this way:
> Projected cash operating expenditure = Total expenses - noncash expenses like
depreciation and amortisation.
> Quick assets = Current assets - Inventory - Prepaid expenses
The Defensive Interval Ratio measures the time-span a firm can operate with present
liquid assets (comprising cash and marketable securities and cash collected from
debtors) without resorting to next year's income.
Illustration:
The Projected Cash Operating Expenses of a firm for the year 1991 are estimated at Rs.
7,30,000. The firm has current assets amounting to Rs.80,000. Calculate the Defensive
Interval Ratio.
Solution:
Defensive Interval Ratio = Quick Assets / Projected daily cash requirement
Projected daily cash requirement = Projected Cash Operating Expenses / 365 =
730,000/365 = 2,000
So, Defensive Interval Ratio = 80,000 / 2,000 = 40 days
A Defensive Interval Ratio of 40 days means that the firm can meet its operating cash
requirements for 40 days without resorting to next year's income.
B. Stability Ratios
These ratios help in ascertaining the long-term solvency of a firm which depends
basically on three factors:
i. Whether the firm has adequate resources to meet its long-term funds requirements.
ii. Whether the firm has used an appropriate debt-equity mix to raise long-term funds.
iii. Whether the firm earns enough to pay interest and installment of long-term loans in
time.
The capacity of the firm to meet the last requirement can be ascertained by computing
the various Coverage Ratios. For the first two factors, the ratios to be seen are:
(i) Fixed Assets Ratio
This ratio indicates how much the assets of an enterprise cover the amount of secured
long term loans. Long term loans are secured by mortgage on fixed assets. In case the
project fails, the sale proceeds of the fixed assets should suffice to repay the obligations
under term-loan. The ratio is computed as:
Fixed Asset Ratio = Net Fixed Assets / Long-term Debts
Ideally speaking, minimum acceptable ratio should be 2:1. However, the ratio has its
own limitations in as much as that the same can easily be inflated by revaluation of fixed
assets. Further, in case of failure of a project, the value of assets in liquidation is likely to
be very low.
Illustration:
From the information given here, compute the Fixed Asset Ratio.
Solution:
Fixed Asset Ratio = Fixed Assets / Long-term Funds
= (Plant & Machinery + Land & Building + Furtniture) / (Share Capital + Debentures +
Trade Creditors)
= 2,25,000 / 2,50,000 = 0.9
(ii) Capital Structure Ratios
These ratios explain how the capital structure of a firm is made up or what debt-equity
mix has been adopted by the firm. The following ratios fall under this category:
a. Capital Gearing Ratio
This ratio determines the relationship between the debts of the company and
shareholders' funds in a different manner. If a company has much more debt
compared to own equity, it is said to be highly geared - a position which may yield
some benefits to the shareholders.
Illustration:
This means, return on equity is much more in respect of the company 'A'
compared to that of the company 'B', though in absolute terms, the profit figures of
the latter are larger. This is mainly because the profits of the company 'B' are to be
distributed over a much larger equity base and consequently ROI is less.
A big advantage of the borrowed capital is that the interest charged on the same is
a permissible deduction from profit before income tax is computed.
However, at the same time, a very high capital gearing ratio is always risky because
the interest burden on the borrowed capital is a constant liability and the same has
to be paid whether the unit makes a profit or not. Further, a highly geared capital
ratio means that the company is very heavily dependent on the borrowed capital,
and, therefore, the assets of the same are charged to the creditors. In case of
liquidation, the sale proceeds of the assets would go towards repayment of the
dues of the secured creditors while the shareholders may not be left with anything.
b. Debt Equity Ratio (D/E Ratio)
Debt to Equity Ratio relates all recorded creditors' claims on assets to the owners'
recorded claims in order to measure the firm's obligations to creditors in relation
to funds provided by the owners. It is also known as 'External-Internal Equity
Ratio'.
The creditor category includes all debts, whether long-term or short-term or in the
form of mortgages, bills or debentures, while the claims of owners consist of
preference shares, equity shares, capital reserve, retained earnings and any
reserves representing earmarked surplus, like reserve for contingencies, reserve
for plant expansion, etc.
In some financial circles, this ratio is also computed with preference shares classed
as creditors rather than as ownership claims, because preference shares are
ownership commitments only in the eyes of law and usually do not exhibit the
characteristics of an ownership security. Thus, there are differences of opinion
regarding the treatment of preference shares as a creditor or ownership claim
which depends upon the nature of preference shares and the purpose of financial
analysis.
Debt to Equity Ratio = External Equities / Internal Equities
or
Debt to Equity Ratio = Outsiders Funds / Shareholders' Funds
Illustration:
On the basis of figures given in the Balance Sheet above, it is clear that liabilities to
third parties are Rs. 45,000 (Current liabilities + Long-term liabilities) and
liabilities to the proprietors (Reserves & Surplus + Capital) are Rs. 1,05,000.
Debt Equity Ratio = 45,000 : 1,05,000 = 3 : 7
This means that the value of assets could shrink by 57 percent (4/7) before
creditors' prospects of repayment would in any way be impaired.
Significance:
The D/E Ratio is an important tool of financial analysis to appraise the financial
structure of a firm. It has important implications from the view point of the
creditors, owners and the firm itself. The ratio reflects the relative contribution of
creditors and owners of business in its financing. A high ratio shows a large share
of financing by the creditors relatively to the owners and, therefore, a larger claim
against the assets of the firm. A low ratio implies a smaller claim of creditors. The
D/E Ratio indicates the margin of safety to the creditors. If, for instance, the D/E
ratio is 1:2, it implies that for every rupee of outside liability, the firm has two
rupees of owner's capital. In other words, the outside liability is half (50%) of the
owner's funds. Another way of saying this is that the shareholder's stake in the
firm is double that of creditors or the stake of creditors is only half of the owner's.
There is, therefore, a safety margin of 50% available to the creditors of the firm.
If the D/E ratio is high, the owners are putting up relatively less money of their
own. It is a danger signal for the creditors. If the project should fall financially, the
creditors would lose heavily. Moreover, with a small financial stake in the firm, the
owners may behave irresponsibly and indulge in speculative activity. If they are
heavily involved financially, they will strain every nerve to make the enterprise a
success. In brief, the greater the D/E ratio, the greater the risk to the creditors.
A Debt to Equity Ratio has equally serious implications from the firm's point of
view also. A high proportion of debt in the capital structure would lead to
inflexibility in the operations of the firm as creditors would exercise pressure and
interfere in management. Secondly, such a firm would be able to borrow only
under very restrictive terms and conditions. Further, it would have to face a heavy
burden of interest payments, particularly in adverse circumstances when profits
decline. Finally, the firm will have to encounter serious difficulties in raising funds
in future.
c. Proprietary Ratio
It is a variant of debt to equity ratio. It establishes relationship between the
'proprietor's funds' and the 'total tangible assets'. It may be expressed as:
Proprietary Ratio = Shareholders Funds / Total Tangible Assets
Illustration:
From the following, calculate the Proprietary Ratio:
Solution:
Proprietary Ratio = Shareholders' Funds / Total Tangible Assets
= 3,00,000 (Preference and Equity Share Capital) / 4,50,000 (Fixed Assets +
Current Assets + Investments)
= 0.67 = 67%
Significance:
This ratio focuses the attention on the general financial strength of the business
enterprise. The ratio is of particular importance to the creditors who can find out
the proportion of shareholders' funds in the total assets employed in the business.
A high proprietary ratio indicates relatively lesser danger to the creditors, etc., in
the event of forced reorganisation or winding up of the company. A low
proprietary ratio indicates greater risk to the creditors since, in the event of losses
a part of their money may be lost besides loss to the proprietors of the business.
The higher the ratio, the better it is. A ratio below 50% may be alarming for the
creditors since they may have to lose heavily in the event of company's liquidation
on account of heavy losses.
ADVANTAGES OF RATIO ANALYSIS
Following are some of the advantages of ratio analysis:
1. Simplifies financial statements: Ratio analysis simplifies the comprehension of
financial statements. Ratios tell the whole story of changes in the financial condition of
the business.
2. Facilitates inter-firm comparison: Ratio analysis provides data for inter-firm
comparison. Ratios highlight the factors associated with successful and unsuccessful
firms. They also reveal strong firms and weak firms, overvalued and undervalued firms.
3. Makes intra-firm comparison possible: Ratio analysis also makes possible
comparison of the performance of the different divisions of the firm. The ratios are
helpful in deciding about their efficiency or otherwise in the past and likely performance
in the future.
4. Helps in planning: Ratio analysis helps in planning and forecasting. Over a period
of time a firm or industry develops certain norms that may indicate future success or
failure. If relationship changes in firm's data over different time periods, the ratios may
provide clues on trends and future problems. Thus, ratios can assist management in its
basic function of forecasting, planning, coordination, control and communication.
LIMITATIONS OF RATIO ANALYSIS
Ratio analysis is, as already mentioned, a widely-used tool of financial analysis. Yet, it
suffers from various limitations. The operational implication of this is that while using
ratios, the conclusions should not be taken on face value. Some of the limitations which
characterise ratio analysis are:
1. Difficulty in Comparison:
One serious limitation of ratio analysis arises out of the difficulty associated with their
comparison to draw inferences from inter-firm comparison. But such comparisons are
vitiated by different procedures adopted by various firms. The differences may relate to:
i. differences in the basis of inventory valuation (e.g. last-in-first-out, first-in-first-out,
average cost, and cost);
ii. different depreciation methods (i.e. straight lines vs. accelerated basis);
iii. estimated working life of assets, particularly of plant and equipment;
iv. amortisation of intangible assets like goodwill, patents and so on;
v. amortisation of deferred revenue expenditure such as preliminary expenditure and
discount on issue of shares;
vi. capitalisation of lease;
vii. treatment of extraordinary items of income and expenditure;
...and so on.
Apart, from different accounting procedures, companies may have different accounting
periods, implying difference in the composition of the assets, particularly current assets.
For these reasons the ratios of two firms may not be strictly comparable.
Another basis of comparison is the industry average. This presupposes the availability
on a comprehensive scale of various ratios for each industry group over a period of time.
If, however, as is likely, such information is not compiled and available, the utility of
ratio analysis would be limited.
2. Impact of Inflation:
The second major limitation of the ratio analysis as a tool of financial analysis is
associated with price level changes. This in fact is a weakness of the traditional financial
statements which are based on historical costs. The one implication of this feature of the
financial statements as regards to ratio analysis is that assets acquired at different
periods are in effect. Shown at different prices in the balance sheet, they are not
adjusted for changes in the price level. As a result, ratio analysis does not yield strictly
comparable and, therefore, dependable results.
3. Conceptual Diversity:
Yet another factor which affects the usefulness of ratios is that there is difference of
opinions regarding the various concepts used to compute the ratios. As shown already,
there is scope for diversity of opinions as to what constitutes shareholders' equity, debt,
assets, profits and so on. Different firms may use these terms in different senses or the
same firm may use them to mean different things at different times.
4. Interim periods not revealed:
Finally, ratios are only a post-mortem of what has happened between two balance sheet
dates. For one thing, the position in the interim period is not revealed by the ratio
analysis. Moreover, they give no clue to the future.
In brief, ratio analysis suffers from serious limitations. The analyst should not be carried
away by its oversimplified nature, easy computation, and high degree of precision. The
reliability and significance attached to ratios would largely depend upon the quality of
data on which they are based. They are as good as the data itself. Nevertheless, they are
an important tool of financial analysis.
MODEL QUESTIONS
1. What are turnover ratios? Discuss their significance in financial analysis.
2. Explain the significance of Debt to Equity Ratio in determining the cost of capital of a
business.
3. Explain the features of different types of solvency ratios.
4. Elaborate the implications of a high stock turnover ratio.
5. Write a note on each:
i) Capital Gearing Ratio
ii) Quick Ratio
iii) Debtors Turnover Ratio
iv) Debt Service Coverage Ratio
- End of Chapter -
LESSON - 15
FUNDS FLOW ANALYSIS
BACKGROUND
It has been the salient features of the evolution of accounting theory and practice that
the preparation and presentation of final accounts and statement is undertaken with the
objective of providing as much information as possible for public gaze. From this point
of view, the 'traditional package' of final accounts and statements, consisting of the
Balance Sheet and Income Statement (or P&L A/c), fulfils this objective very well. The
Balance Sheet portrays the financial position of the undertaking, the assets side showing
the development of resources in various types of properties and the liabilities side
indicating the manner in which these resources were obtained. The income statement
measures the change in the owner's equity as a result of period's productive and
commercial activities. Though these are highly significant functions, especially in terms
of the principal goals of the enterprise, there are certain other fruitful relationships
between the Balance Sheets at the commencement and end of the accounting period on
which these two statements of financial position fail to throw any light.
Owing to these limitations of financial statements, a need was felt for designing
additional financial statements which could provide information on the major financing
and investing activities of the firm during the period. Such a statement is called the
Statement of Changes in Financial Position. It summaries the sources from which funds
have been obtained and uses which they have been applied. This statement, it may be
noted, is not intended to be a substitute for the Profit and Loss account or the Balance
Sheet; it is prepared to show additional useful information not covered by the
traditional statements.
Initially, the statement began from a simple analysis called the "Where-Got and Where
Gone Statement". It was merely concerned with listing of increases or decreases in
various items of the company Balance Sheet. After some years, the title of the statement
was changed to "The Funds Statement". In 1691, the American Institute of Certified
Public Accounts (AICPA) recognizing the overwhelming significance of this statment,
sponsored research in the area. On the basis of the recommendations of their study in
1963, the Accounting Principles Board (APB) Opinion No.3 was issued. It recommended
that the name be changed to "Statement of Source and Application of Funds" and such a
statement should be including as supplementary information in corporate annual
reports. The inclusion of such a report however was not made mandatory, but was kept
optional. The recommendation was well received by the business community. In 1969,
the Securities and Exchange Commission began requiring firms to include audited funds
statements in periods reports filed with it. Then in 1971, APB Opinion No. 19 made it
mandatory to include such a statement as an integral part of the financial statements to
be presented in the companys annual reports and recommended that it be given the
new title of "Statement of Changes in Financial Position".
The Statement of Changes in Financial Position is a statement of flows, i.e. it measures
the changes that have taken place in the financial position of a firm between two balance
sheet dates. The changes in financial position could be related to several different
concepts of "funds". The two most common usages of the term "funds" are cash and
working capital. Working capital is the difference between current assets and current
liabilities. Viewed in this sense, Statement of Changes in Financial Position explains the
changes in cash or working capital. Accordingly, we have two statements, i.e., Statement
of Changes in Cash, popularly called Cash Flow Statement, and Statement of
Changes in Working Capital, popularly known as Sources and Uses Statement or Funds
Flow Statement. This lesson deals with the Funds Flow Statement.
MEANING OF FUNDS FLOW STATEMENT
It will be appropriate to explain the meaning of the term 'Funds' and the term 'Flow of
Funds' before explaining the meaning of the term 'Funds Flow Statement'.
- Meaning of Funds
The term 'funds' has a variety of meanings. There are people who take it synonymous to
cash; to them there is no difference between a Funds Flow Statement and Cash Flow
Statement. While others include marketable securities besides cash in the definition of
the term 'funds'. The International Accounting Standard No. 7 on "Statement of
Changes in Financial Position" also recognises the absence of single generally accepted
definition of the term. According to the Standard, the term "fund" generally refers to
cash, or cash and cash equivalents, or working capital. Of these, the last definition of the
term is by far the most common definition of "fund".
There are also two concepts of working capital - Gross concept and Net concept. Gross
working capital refers to the firm's investment in current assets, while Net working
capital means excess of current assets over current liabilities. It is in the latter sense in
which the term 'funds' is generally used.
The terms 'current assets', 'current liability', 'non-current assets' and 'non-current
liability' are explained below for better clarity.
Current Assets are assets which are expected to be realised in cash or sold or
consumed or turned over within one operating cycle of the unit, normally not exceeding
12 months. Current Assets can be of two types - Chargeable Current Assets and Other
Current Assets.
Chargeable Current Assets are those assets that appear as security against
bank finance, such as inventory, spares, receivables etc. Inventory shall include
stocks of raw-materials and consumable stores, stock-in-process and finished
goods.
Other Current Assets include:
- Cash and bank balances;
- Investment by way of government and trustee securities other than for long term
purposes e.g., sinking fund, gratuity fund etc.
- Fixed deposits with banks;
- Advance payment for tax;
- Prepaid expenses;
- Advances for purchase of raw materials, components and spares etc.
Current Liabilities denote liabilities which are payable or expected to be turned over
within one year from the date of balance sheet. These include:
Short term borrowings (including bills purchased and discounted) from banks
and other sources;
- Unsecured loans;
- Public deposits maturing within one year;
- Sundry creditors (trade) for raw materials and consumable stores and spares;
- Interest and other charges accrued but not due for payment;
- Advance/progress payments from customers;
- Installments of term loans, debentures, redeemable preference shares, and long
term deposits payable within a year;
- All statutory liabilities like PF provision for taxation, sales-tax, excise etc.
Miscellaneous current liabilities like dividends, liabilities for expenses, gratuity
payable within one year, other provisions, other payments due within 12 months
etc.
Non-current Assets are assets other than current assets, such as goodwill, land,
building, machinery, furniture, long investments, patent rights, trade marks, debit
balance of the Profit and Loss count discount on issue of shares and debentures,
preliminary expenses, etc.
Non-current Liabilities are liabilities other than current liabilities, like share capital,
long-term loans, debentures, share premium, credit balance in the Profit and Loss
Account, revenue and capital reserves (e.g., general reserve, dividend equalization fund,
debentures sinking fund, capital redemption reserve etc.
- Concept of Flow
The 'flow' of funds refers to transfer of economic values from one asset to another, from
one equity to another, from an asset to an equity or vice versa or a combination of any of
these. According to working capital concept of funds, the 'flow' of funds refers to
movements of funds described in terms of the flow in and out of the working capital
area. This occurs when changes occuring in non-current accounts (e.g., fixed assets,
fictious assets, long-term liabilities, internal reserves, etc.) are off-set by corresponding
changes in current accounts (current assets or current liabilities) and vice versa. For
example, when a cash purchase of machinery is effected, debentures are redeemed by
payment in cash, creditors are paid by raising long-term loan, cash dividend is
distributed among shareholders, or permutations and combinations of any of these.
In other words, in business, several transactions take place. Some of these transactions
increase the funds, while others decrease the funds. Some may not make any change in
the funds position. In case a transaction results in increase of funds, it will be termed as
a "source of funds". For example, if the funds are Rs. 10,000 and on account of a
business transaction, say, issue of shares, they become Rs. 15,000, "Issue of Shares" will
be taken as a source of funds. In case a transaction results in decrease of funds it will be
taken as an "application or use of funds". For example, if the funds are Rs. 10,000 and
on account of, say, purchase of furniture for Rs. 5,000, the funds stand reduced by
Rs.5,000, the purchase of furniture will be taken as an "application of funds". In case a
transaction does not make any change in the funds position that existed just before the
happening of the transaction, it is considered a "non-fund transaction". For example, if
the funds are Rs. 10,000 and a fixed asset of Rs. 5,000 is purchased by issuing shares of
Rs. 5,000, the funds position will not change, and therefore, this transaction will be
taken as a non-fund transaction.
- Funds Flow Statement
The funds-flow-statement is a report on financial operations, changes, flows or
movements of funds taken place between two accounting periods. It is a statement
which shows the sources and application of funds or how the activities of a business
were financed during a particular period. In other words, such a statement shows how
the financial resources have been used during a particular period of time. It is, thus, a
historical statement showing sources and application of funds between the two dates
designed especially to analyse the changes in the financial conditions of an enterprise.
In the words of Foulke...
"A statement of Sources and Application of Funds is a technical device designed to
analyse the changes in the financial condition of a business enterprise between two
dates"
Funds Flow Statement is not an Income Statement. Income statement shows the items
of income and expenditure of a particular period, but the funds flow statement is an
operating statement as it summarises the financial activities for a period of time. It
covers all movements that involve an actual exchange of assets.
Funds Flow Statement is also not a Supporting Schedule to the Final Accounts of the
concern to be submitted to the shareholders, although technically, it is based upon the
same accounting data. It is, instead, a complementary statement showing the analysis of
sources and uses of funds which cannot be obtained from the other financial statements.
Various titles are used for this statement such as 'Statement of Source and Application
of Funds', 'Summary of Financial Operations', 'Changes in Financial Position', 'Funds
Received and Disbursed', 'Funds Generated and Expended', 'Changes in Working
Capital', 'Statement of Fund', etc. The title of Funds Flow Statement has been modified
from time to time. It is very difficult to find a short title for such statement which carries
much to the readers regarding its contents and functions.
Thus the basic purpose of preparing Funds Flow Statement is to account for the changes
in working capital during the period covered by the statement.
GENERAL RULES
Let us formulate some general rules to ascertain which transactions give rise to a
'source' or 'use' of working capital and which not. This exercise is useful in the
preparation of the funds flow statement. The changes in the individual components of
working capital are separately shown in a statement called 'The Statement of Changes in
Working Capital'. Symbolically,
WC = CA - CL
where,
WC = Working capital
CA = Current Assets
CL = Current Liabilities
From the above equation the following RULES may be deduced:
Transactions affecting WC are...
i) An increase in CA causes an increase in WC.
For example, issue of equity shares causes an increase in cash (CA) and increase in non-
current liability (NCL)
ii) A decrease in CA causes a decrease in WC.
For example, purchase of non-current asset (NCA) causes decrease in cash (CA) and
increase in (NCA)
iii) An increase in CL causes a decrease in WC.
For example, bank overdraft to repay long-term loans causes an increase in CL and
decrease in NCL
iv) A decrease in CL causes an increase in WC.
For example, bank overdraft paid by issue of debentures causes a decrease in bank
overdraft (CL) and an increase in NCL
Transactions not affecting WC are...
v) An increase in CA and increase in CL does not affect WC.
For example, purchase of inventories on credit causes an increase in inventory (CA) and
an increase in creditors (CL)
vi) A decrease in CA and decrease in CL does not affect WC.
For example, payment to creditors causes a decrease in cash (CA) and a decrease in
creditors (CL)
A close examination of the above rules and illustrations shows that a transaction that
gives rise to a "source" or "use" of working capital should affect current account (CA and
CL) and non-current account (NCA or NCL) simultaneously.
However, if a transaction occurs where current accounts (as shown in rules v and vi) are
affected, working capital is not changed and the transaction does not appear on the
funds statement. Likewise, if both non-current accounts are affected as a result of the
transaction, it does not bring about any change in the working capital. For instance, a
conversion of debentures in to equity increases one component of NCL (equity) and
decreases another component of NCL (debentures). The fact that such a transaction
does not appear on the funds statement does not make the transaction unimportant. On
the contrary, the knowledge of large amount of debt conversion into equity would be
very useful for management as well as outside investors. Though the definition of funds
excludes such a transaction keeping in view the importance of such items, they would be
shown in our statement of changes in financial position (on both sides).
MANAGERIAL USES OF FUNDS FLOW ANALYSIS
The statement of sources and application of funds is a useful tool in the financial
managers analytical kit because from it emerges a better as well as more detailed
analysis and understanding of changes in the distribution of resources between balance
sheet dates. The uses of fund statement are:
(1) The basic purpose of preparing the statement is to have a rich insight into the
financial operations of the concern. It analyses how the funds were obtained and used in
the past. In this sense it is a valuable tool for the finance manager for analysis of the past
and future plans of the firm and their impact on the firm's liquidity. He can deduce the
reasons for the imbalances in uses of funds in the past and take necessary corrective
actions. In analysing the financial position of the firm, the Funds Flow Statement
answers such questions as:
1. Why were the net current assets of the firm down, though the net income was up
or vice versa?
2. How was it possible to distribute dividends in absence of or in excess of current
income for the period?
3. How was the expansion in plants and equipment financed?
4. How was the sale proceeds of plant and machinery used?
5. How were the debts retired?
6. What became of the proceeds of share or debenture issue?
7. How was the increase in working capital financed?
8. Where did the profits go?
Though it is not an easy job to find definite answers to such questions because funds
derived from a particular source are rarely used for one purpose. However, certain
useful assumptions can often be made and reasonable conclusions are usually not
difficult to arrive at.
(2) It acts as an instrument for the allocation of resources. In modem large scale
business, as the need for resources is always more than their availability, productive
enterprises have to evolve an order of priorities for putting through their expansion
programmes, which are phased accordingly and funds have to be arranged, as different
phases of the programmes get into their stride. The amount of funds to be available
from current business operations for meeting the needs of such programmes is
estimated by the financial manager through the projection of funds flow analysis.
Frequently forward projected funds flow statements are tied into the capital budget by
indicating the estimated amounts of funds available for this purpose. This prevents the
business from becoming a helpless victim of unplanned action and enables management
to acquire control over the destiny of an enterprise.
(3) It is a test as to how effective or otherwise the use of working capital has been. Funds
flow statement is a test of effective use of working capital by the management during a
particular period. The adequacy or inadequacy of working capital will tell the financial
analyst about the possible steps that the management should take for effective use of
surplus working capital or make arrangements in case of inadequacy of working capital.
(4) Funds Flow Statement helps in gathering the financial states of business. It gives an
insight into the evaluation of the present financial position and finds answers to
questions like "where have our resources been moving?". It enables the readers to obtain
necessary information on the methods used, dividend policies followed, and
contribution of funds to the growth of the company. In the present world of credit
financing, it provides a useful information to bankers, creditors, financial institutions,
and government etc. regarding the amount of loan required, its purpose, terms of
repayment, and sources of repayment of loan etc. The financial manager gains a
confidence born out of a study of Funds Flow Statement. In fact, it carries information
regarding the firm's financial policies to the outside world. In India, financial
institutions such as IFCI, IDBI, ICICI, etc. require funds flow statement to be submitted
to them along with application for loan and other relevant papers.
(5) Funds flow statement also evaluates the urgency of operational issues. Problems
faced by a business do not arise all of a sudden. They take time to assume serious
proportions, invariably implying a financial commitment to which the management has
to measure itself. While the problem is thus developing, it is affected by a number of
factors. The real contribution of the funds flow analysis is in bringing all these factors in
a delicate balance for determining the time limit within which the problem would reach
a critical stage. This is done by projecting the funds flow statement which then provides
a perspective for proper consideration of the financial implications of evolving issues
and enables suitable action to be initiated to reverse an unfavorable trend. All this
provides an insight into the intricate of the managerial job.
PREPARATION OF FUNDS FLOW STATEMENT
In order to prepare a Funds Flow Statement, it is necessary to find out the "sources" and
"applications" of funds.
A. Sources of Funds
The sources of funds can be both internal as well as external.
1. Internal Sources
Funds from operations is the only internal source of funds.
The profit or loss figure, as shown in the Profit and Loss account of the firm, does not
indicate the quantum of working capital provided by business operations because the
revenue and expenses shown do not run parallel to the inflow of working capital. The
Profit and Loss account contains a variety of write-offs and other adjustments which do
not involve any corresponding movement of funds. The reason for this discrepancy is
found in the fact that while funds movements are related to current decisions,
accounting statements are the combined results of past and current decisions.
Therefore, appropriate adjustments are to be made to the profit disclosed by the P & L
account to arrive at the funds from business operations. For this purpose:
(i) All expenses that have been deducted from revenue but do not reduce working
capital, are to be added back,
(ii) Items that have been added to revenue but do not contribute to the working capital
are to be subtracted, and
(iii) All revenues that are not directly caused by business operations should be deducted
and shown separately in the statement.
Thus the following adjustments will be required in the figure of Net Profit for finding
out real funds from operations:
Add the following items as they do not result in outflow of funds:
+ Depreciation on fixed assets
+ Preliminary expenses or goodwill, etc. written off
+ Contribution to debenture redemption fund, transfer to general reserve, etc., if they
have been deducted before arriving at the figure of net profit.
+ Provisions for taxation and proposed dividends are usually taken as appropriations of
profits only and not as current liabilities for the purposes of Funds Flow Statement.
Taxes or dividends actually paid are taken as application of funds. Similarly, interim
dividend paid is shown as an application of funds. All these items are to be added back
to net profit, if already deducted, to find funds from operations vs. loss on sale of fixed
assets.
Deduct the following items as they do not increase funds:
- Profit on sale of fixed assets, since the full sale proceeds are taken as a separate source
of funds and inclusion here will result in duplication.
- Profit on revaluation of fixed assets.
- Non-operating incomes such as dividend received or accrued dividend, refund of income tax,
rent received or accrued rent. These items increase funds but they are non-operating incomes.
They will be shown as other sources of funds as a separate head in the Funds Flow Statement.
In case the Profit and Loss Account shows 'Net Loss', this should be taken as an item
which decreases the funds.
Illustration:
Following are the extracts from the Balance Sheets of a company as on 31st December
1992 and 31st December 1993. Calculate the funds from operations.
As on 31 December
1992 1993
Profit & Loss Appropriation Account 30,000 40,000
General Reserve 20,000 25,000
Goodwill 10,000 5,000
Preliminary Expenses 6,000 4,000
Provision for Depreciation on Machinery 10,000 12,000
Solution:
Funds from Operations
Rs.
Profit & Loss Appropriation Account balance as on 31.12.1993 40,000
Add: Items which do not decrease funds
Transfer to General Reserve 5,000
Goodwill written-off 5,000
Preliminary expenses written-off 2,000
Provision for Depreciation on Machinery 2,000
54,000
Less: Profit and Loss appropriation account balance as on 31.12.1992 30,000
Funds from Operations 24,000
The funds from operations can also be calculated by preparing an adjusted Profit & Loss
Account:
Adjusted Profit & Loss Account
(Rs.) (Rs.)
To Transfer to General Reserve 5,000 By Balance B/F 30,000
To Goodwill written-off 5,000
By funds from operation (balance
figure)
24,000
To Preliminary expenses
written-off
2,000
To Provision for Depreciation 2,000
To Balance C/d 40,000
Total 54,000 Total 54,000
2. External Sources
These sources include:
a. Long-term financing
Either in the form of issuing debentures or preference shares or equity shares, it
constitutes another major source of working capital. For example, a company
issues Rs. 2,00,000 equity shares at a premium of 10%, then Rs. 2,20,000
constitutes a source of working capital as it increases cash (CA) and increases
NCL. It is important to remember here that the face value of the security is
immaterial; it is net amount received (increase in CA) from the transaction that
constitutes the source.
b. Sale of non-current assets
It is not unusual for a business firm to sell one or more of its non-current assets
particularly in the case of plants and equipment, either because they have become
useless or more efficient plant and machinery equipment have appeared in the
market. If the sale is made for cash or a receivable, current assets increase.
Therefore, the sale proceeds from disposal of non-current assets is a source of
funds. Whether the non-current asset is sold at a profit or at a loss is irrelevant for
the purpose. The amount received or receivable in the near future constitutes the
source. For instance, a plant and equipment having a net book value of Rs. 30,000
has been sold for Rs. 20.000, then Rs. 20,000 would constitute the source of
funds, and the loss of Rs. 10,000 would be transferred to the Profit and Loss
account. If it is sold for Rs. 40,000, then Rs. 40,000 would constitute the source of
funds and Rs. 10,000 being profit will be transferred to the Profit and Loss
account.
c. Funds from increase in share capital
Issue of shares for cash or for any other current asset results in increase in
working capital and hence will be taken as a source of funds.
B. Application of Funds
The uses to which funds are put are called 'applications of funds'. Following are some of
the purposes for which funds may be used:
1. Redemption of Preference Shares and/or Debentures
Retirement of long-term liabilities such as payment to preference shareholders and
debenture holders involves the use of cash (CA). There is a corresponding decrease in
long-term liabilities. It should be borne in mind that it is not the face value of the
security redeemed that is important; the important thing is to know the actual payment
made to retire such securities.
2. Recurring Payments to Investors
Dividends and interest constitute the recurring payments to investors. In most cases,
these kinds of transactions decrease the NCL, and decrease the cash (CA) or increase in
CL (dividends payable or interest payable). Clearly, recurring payments to investors
represent another use of funds.
3. Purchase of Fixed Assets
Purchase of fixed assets such as land, building, plant, machinery, long-term investment,
etc., results in decrease of current assets without any decrease in current liabilities.
Hence, there will be a flow of funds. But in case shares or debentures are issued for
acquisition of fixed assets, there will be no flow of funds.
4. Payments of Tax Liability
Provision for taxation is generally taken as an appropriation of profits and not as an
application of funds. But if the tax has been paid, it will be taken as an application of
funds.
TECHNIQUE OF PREPARING A FUNDS FLOW STATEMENT
Preparation of statement of sources and applications of funds is a time consuming task.
Depending upon the object of analysis, it may range from casual observation of the
changes in the various items summarised in the beginning and ending balance sheets to
the elaborate worksheet reconstruction of fund transactions. In any case, adequate
information can be extracted from an approximate analysis without going through the
long, arduous, and cumbersome exercise involved in adjustments necessary for refining
the analysis. The financial manager may find it adequate and very convenient to make a
'rough and ready analysis' from time to time, to be able to appraise the trends of
developments relating to some aspects of the financial conditions of his own unit. A
comprehensive funds statement may, however, be prepared by the staff of the financial
manager as and when needed. Thus, there is no prescribed format for the funds flow
statement. The only important point to be borne in mind is that the items should be
arranged and described in such a way as to exhibit clearly the important financial events
of the period.
PROFORMA OF A FUNDS FLOW STATEMENT
STATEMENT OF SOURCES AND APPLICATIONS OF FUNDS
(Rs.)
Sources:
(a) Issue of Share Capital
(b) Issue of Debentures
(c) Institutional Loans
(d) Sale of Investments and other Fixed Assets
(e) Trading Profit or Funds from Operations
(f) Non-trading income (e.g., interest received)
Total
Applications:
(a) Payment of Share Capital (redeemable)
(b) Repayment of Institutional Loans
(c) Redemption of Debentures
(d) Purchase of Investments and other Fixed
Assets
(e) Non-trading payments (e.g., dividends paid)
Total
Increase / Decrease in Working Capital as per the statement of changes in Working
Capital -
AN ALTERNATIVE PROFORMA
STATEMENT OF SOURCES AND APPLICATIONS OF FUNDS
(Rs.) (Rs.)
Sources: Applications:
(a) Issue of Share Capital
(a) Redemption of redeemable
Preference Share Capital
(b) Issue of Debentures (b) Redemption of Debentures
(c) Institutional Loans
(c) Repayment of Institutional
Loans
(d) Sale of Investments and
other Fixed Assets
(d) Purchase of Investments
and other Fixed Assets
(e) Trading Profit or Funds
from Operations
(e) Payment of Dividends (for
last year and interim period)
(f) Non-trading income (f) Non-trading expenses
Total Total
Decrease in Working Capital
as per statement of changes in
working capital
Increase in Working Capital as
per statement of changes in
working capital
Total Total
Variation in Working Capital
In the funds statement the usual practice is to show the difference between the total
sources of funds and total applications of funds as either increase or decrease in working
capital or funds over the period covered by the statement. This variation in working
capital should be verified by calculating the working capital separately also. Working
capital represents the excess of current assets over current liabilities. Since several items
i.e., all current assets and current liabilities are the components of working capital, it is
necessary to ascertain the working capital or 'fund' at the beginning and at end of the
period, and to measure the increase or decrease therein, and prepare what may be called
a 'Statement or Schedule of Changes in Working Capital'.
A proforma is given below:
STATEMENT OF CHANGES IN WORKING CAPITAL
Previous year
(Rs.)
Current year
(Rs.)
Effect on Working Capital
Increase (Rs.) Decrease (Rs.)
Current
Assets:
Stock
Debtors
Cash
Bank
B/R
Prepaid
expenses
Total (a)
Current
Liabilities:
Creditors
B/P
Outstanding
expenses
Total (b)
Working
Capital:
Increase /
decrease in
working capital
Total (a) - (b)
While preparing a schedule of changes in working capital it should be noted that:
(a) An increase in current assets increases the working capital (CA WC)
(b) A decrease in current assets decreases working capital (CA WC)
(c) An increase in current liabilities decreases working capital (CL WC)
(d) A decrease in current liabilities increases working capital (CL WC)
Treatment of Provisions for Taxes and Proposed Dividends
Provision for Tax
While preparing a Funds Flow Statement, there are two options available:
(i) Provision for tax may be taken as a current liability. When provision for tax is made,
the transaction involves Profit & Loss Appropriation Account (a fixed liability) and
Provision for Tax Account (a current liability). It will thus decrease the working capital.
On payment of tax there will be no change in working capital because it will involve
Provision for Tax Account (a current liability), and Bank or Cash Account balance (a
current asset).
(ii) Provision for tax may be taken only as an appropriation of profit, meaning, there will
be no change in working capital position, since it will involve two fixed liabilities - Profit
and Loss Appropriation Account and Provision for Tax Account. However, when tax is
paid, it will be taken as application of funds, because it will then involve Provision for
Tax Account (a fixed liability) and Bank Account (a current asset).
Provision for Proposed Dividends
Whatever has been said about the provision for taxes is also applicable to provision for
proposed dividends. Proposed dividends can also be deal with in two ways:
(i) Proposed dividends may be taken as a current liability since declaration of dividends
by the shareholders is simply a formality. Once the dividends are declared in the general
meeting, they will have to be paid within 42 days of their declaration. In case proposed
dividend is taken as a current liability, it will appear as one of the items decreasing the
working capital in the "Schedule of Changes in Working Capital". When dividend is paid
later on, it will not be shown as an application of funds.
(ii) Proposed dividends may simply be taken as an appropriation of profits. Proposed
dividend for the current year will be added back to current year's profits in order to find
out funds from operations, if the dividend has already been charged to profits. Payment
of dividend will be shown as an "application of funds".
COMPREHENSIVE FUNDS FLOW STATEMENT
Illustration:
From the following Balance Sheets as at 31st December 1992 and 1993, and additional
information relating to Precision Tools Ltd., prepare the following:
1. Statement showing the changes in the Working Capital, and
2. Statement of Sources and Applications of funds for the year ended 31st December
1993
Liabilities
1992
(Rs. '000s)
1993
(Rs. '000s)
Assets
1992
(Rs. '000s)
1993
(Rs. '000s)
Sundry Creditors 1,000 1,030 Cash 1,600 1,776
Bills Payables 200 250 Sundry Debtors 400 740
Debentures 880 880 Stock of Raw Materials 220 248
Depreciation Fund 200 112 Stock of Finished Goods 280 240
Reserves & Surplus 600 780 Stock of Work-in-Progress 100 200
Share Capital 1,400 1,740 Land 100 160
Buildings 860 640
Plant & Machinery 600 680
Debenture discount 80 72
Patents 40 36
4,280 4,792 4,280 4,792
Additional Information:
Net profit reported = Rs. 4,00,000
Dividend paid = Rs. 80,000
Depreciation charged to profits = Rs. 32,000
Issued equity shares for Rs. 2,00,000 and bonus shares for Rs. 1,40,000
Sold a building for Rs. 56,000, the cost and book value being Rs. 1,60,000 and Rs.
40,000 respectively
Solution:
Sources and Applications of Funds during the year ending 31st December
1993
Sources Rs. '000s Applications Rs. '000s
Profit from Operation 428 Additions to Plant 80
Sale of Building 56 Dividend paid 80
Issue of Shares 200 Increase in working capital 524
684 684
Workings
Statement of Changes in the Working Capital
(Rupees in thousands)
1992
(Rs. '000s)
1993
(Rs. '000s)
Increase in WC
(Rs. '000s)
Decrease in WC
(Rs. '000s)
Cash 1,600 1,776 176 -
Sundry Debtors 400 740 340 -
Stock of Raw Materials 220 248 28 -
Stock of Finished Goods 280 240 - 40
Stock of Work-in-Progress 100 200 100 -
Total (A) 2,600 3,204
Sundry Creditors 1,000 1,030 - 30
Bills Payables 200 250 - 50
Total (B) 1,200 1,280
Working Capital (A) - (B) 1,400 1,924 644 120
Net Increase in Working Capital 524 - - 524
1,924 1,924 644 644
Adjusted Profit & Loss Account
To Depreciation 32 By Balance 600
To Dividend 80 By Profit on Sale of Building 16
To Patent 4 By Profit from Opoerations 428
To Bonus Shares 140
To Debenture Discount 8
To Balance 780
1,044 1,044
Building Account
To Balance 800 By Cash 56
To Profit & Loss 16 By Depreciation Fund 120
To Patent 4 By Balance 640
816 816
Depreciation Fund Account
To Building 120 By Balance 200
To Balance 112 By Depreciation 32
232 232
MODEL QUESTIONS
1. What is a Funds Flow Statement? Examine its managerial uses.
2. "A funds flow statement is a better substitute for an income statement" - Discuss.
3. Explain the various concepts of funds in the context of funds flow statement.
4. Explain the main sources of flow of funds in a business.
5. Is depreciation a source of fund? Explain.
- End of Chapter -
LESSON - 16
CASH FLOW ANALYSIS
Cash flow analysis is another important technique of financial analysis. It involves
preparation of Cash Flow Statement for identifying sources and applications of cash.
Cash flow statement may be prepared on the basis of actual or estimated data. In the
latter case, it is termed as 'Projected Cash flow Statement', which is synonymous with
the term 'Cash Budget'. In this chapter, preparation of cash flow statement, utility and
limitations of cash flow analysis are explained in detail.
In essence, cash flow statements are statements of changes in financial position
prepared on the basis of funds defined as cash or cash-equivalents. In short, cash flow
statements summarize sources of cash inflows and uses of cash outflows of the firm
during a particular period of time. Generally, cash flow statements are prepared for a
period of less than one year. Projected statements of cash flows are designated as cash
budget. Such a statement can be prepared on the basis of information required for the
preparation of funds statement, i.e. comparative Balance Sheets, Profit and Loss
accounts and additional information regarding adjustments.
PREPARATION OF CASH FLOW STATEMENT
The principal difference between a statement of changes in financial position and the
cash flow statement lies in the amount shown as 'resources' provided by business
operations. Most of the other items reported in the funds statements generally involve
cash receipts or payments, for example, issue of equity shares or preference shares, sale
or purchase of non-current assets like equipments, building and so on. These items also
appear in a cash flow statement. The major area where the two statements differ is the
flow from business operations, therefore, from the point of preparing a cash flow
statement, funds from operations are to be adjusted so as to obtain cash from
operations.
CASH FROM OPERATIONS
Cash from operations is the main internal source. The Net Profit shown by the Profit
and Loss Account will have to be adjusted for non-cash items for finding out cash from
operations. Some of these items are as follows:
(i) Depreciation: Depreciation does not result in outflow of cash and therefore, net
profit will have to be increased by the amount of depreciation or development rebate
charged, in order to find out the real cash generated from operations.
(ii) Amortization of intangible assets: Goodwill, preliminary expenses etc., when
written-off against profits, reduce the net profits without affecting the cash balance. The
amounts written-off should, therefore, be added back to profits to find out the cash from
operations.
(iii) Loss on sale of fixed assets: It does not result in outflow of cash and, therefore,
should be added back to profits.
(iv) Gains from sale of fixed assets: Since sale of fixed assets is taken as a separate
source of cash, it should be deducted from net profits.
(v) Creation of reserves: If profit for the year has been arrived at after charging
transfers to reserves, such transfers should be added back to profits. In case operations
show a net loss, such net loss, after making adjustments for non-cash items is to be
shown as an application of cash.
Thus, cash from operations is computed on the pattern of computation of 'funds' from
operations. However, to find out real cash from operations, adjustments will have to be
made for 'changes' in current assets and current liabilities arising on account of
operations, viz., trade debtors, trade creditors, bills receivable, bills payable etc.
For the sake of convenience computation of cash from operations can be studied by
taking two different situations:
When all transactions are cash transactions: The computation of cash
from operations is very simple in this case. The net profit as shown by the Profit
and Loss Account is taken as the amount of cash from operations.
When not all transactions are cash transactions: Businesses may sell
goods on credit, and may purchase goods on credit. This means, certain incomes
are not immediately realized, and some expenses may show as outstanding.
Under such circumstances, the net profit made by the firm cannot generate
equivalent amount of cash. The computation of cash from operations in such a
situation can be done conveniently if it is done in two stages:
i. Computation of funds (i.e., working capital) from operations.
ii. Adjustments in the funds so calculated for changes in the current assets (excluding
cash) and current liabilities.
In this case, the rules for relating the changes in current assets and current
liabilities to P & L account for computation of cash flow from operations are
summarized below:
(i) All the increases in current assets except cash, and decreases in current
liabilities, both of which increase working capital, result in a decrease in cash. The
explanation for current liabilities is obvious. The decrease in current liabilities
takes place when they are paid in cash. For instance, decrease in creditors, bank
overdrafts, bills payables, and dividends payable will occur due to their payments.
A word of explanation is necessary to show the negative impact of increase in
current assets on cash. For instance, an increase in sundry debtors takes place
because sales are greater than cash collections from them, inventories increase
when the cost of goods purchased is more than the cost of goods sold. Increase in
prepaid expenses certainly involves payment of more cash than is required for
their current services.
(ii) From the first rule follows the second rule: all decrease in current assets other
than cash, and increase in current liabilities, both of which causes decrease in
working capital, result in an increase in cash. Debtors would decrease because
cash collections are more than current sales; inventories would decrease because
cost of goods sold is more than cost of goods purchased; decrease in prepaid
expenses reflects that the firm has paid less for services that they have used or
currently using.
Thus,
Cash from operations = Net Profit + Decrease in Debtors
+ Decrease in Stock
+ Decrease in Prepaid Expenses
+ Decrease in Accrued Income
+ Decrease in Creditors
+ Decrease in Outstanding Expenses
- Increase in Debtors
- Increase in Stock
- Increase in Prepaid Expenses
- Increase in Accrued Income
- Increase in Creditors
- Increase in Outstanding Expenses
The above formula may be summarized in the form of following general rules:
Increase in a Current Asset
Decrease in a Current Liability
results in
Decrease in Cash
&
Decrease in a Current Asset
Increase in a Current Liability
results in
Increase in Cash
FORMAT OF A CASH FLOW STATEMENT
A cash flow statement can be prepared in the following form:
CASH FLOW STATEMENT
for the year ending on ....
--------------------------------------------------------------------------------------------------------
---
Balance as on 1.1.91
Cash Balance ____________
Bank Balance ____________
Add: Sources of Cash
Issue of
shares ____________
Raising of long-term
loans ____________
Sale of fixed
assets ____________
Short-term
borrowings ____________
Cash from operations:
Profit as per Profit and Loss Account ____________
Add/Less Adjustment for non-Cash items:
Add: Increase in current liabilities ____________
Decrease in current assets ____________
Less: Increase in current assets ____________
Decrease in current liabilities ____________
Total cash available
(1) ____________
Less Applications of Cash:
Redemption of redeemable preference
shares ____________
Redemption of long-term
loans ____________
Purchase of fixed
assets ____________
Decrease in deferred payment
liabilities ____________
Cash outflow on account of
operations ____________
Tax
paid ____________
Dividend
paid ____________
Decrease in unsecured loans, deposits etc., ____________
Total cash available
(2) ____________
Closing Balance*
Cash
Balance ____________
Bank
Balance ____________
*This total should tally with the balance as shown by (1) - (2)
DIFFERENCE BETWEEN CASH FLOW ANALYSIS AND FUNDS FLOW
ANALYSIS
(1) A Cash Flow Statement is concerned only with the change in cash position while a
Funds Flow Analysis is concerned with change in working capital position between two
balance sheet dates; cash is only one of the constituents of working capital besides
several other constitutions such as inventories, accounts receivable, prepaid expenses.
(2) A Cash Flow Statement is merely record of cash receipts and disbursements. Of
course, it is valuable in its own way but it fails to bring to light many important changes
involving the disposition of resources. While studying the short-term solvency of a
business one is interested not only in cash balance but also in the assets that are easily
convertible into cash.
(3) Cash Flow Analysis is more useful to the management as a tool of financial analysis
in short period as compared to Funds Flow Analysis. It has been said that shorter the
period covered by the analysis, greater the importance of cash flow analysis. For
example, if it is to be found out whether the business can meet its obligations maturing
after 10 years from now, a good estimate can be made about firm's capacity to meet its
long-term obligations if changes in working capital position on account of operations are
observed. However, if the firm's capacity to meet a liability maturing after one month is
to be seen, the realistic approach would be to consider the projected change in the cash
position rather than an expected change in the working capital position.
(4) Cash is part of working capital and, therefore, an improvement in cash position
results in improvement in the funds position but the reverse is not true. In other words,
"inflow of cash" results in inflow of funds but inflow of funds may not necessarily mean
ther has been an inflow of cash. Thus, a sound funds position does not necessarily mean
a sound cash position but a sound cash position generally means a sound funds position.
(5) Another distinction between a cash flow analysis and flow analysis can be made on
the basis of the techniques of their preparation. An increase in current liability or
decrease in current asset results in decrease in working capital and vice versa. While an
increase in a current liability or decrease in a current asset (other than cash) results in
increase in cash and vice versa.
USES / ADVANTAGES OF CASH FLOW ANALYSIS
The chief advantages of the Cash Flow Statement are the following:
1. Although the two concepts of fund (concepts of financial resources and working
capital) discussed earlier are more commonly used, the cash concept is useful in
evaluating financial policies and current cash position. Since cash is the basis for
carrying on operations, the cash flow statement prepared on an estimated basis for the
next accounting period enables the company management to plan and coordinate the
financial operations properly. The management would know how much funds are
needed, how much can be generated internally, and how much needs to be arranged
from external sources. Thus, it is especially useful for management in preparing cash
budgets.
2. Cash Flow Statement is also a control device for the management. A comparison of
cash flow statement of previous year with the budget for that year would indicate the
extent by which the resources of the enterprise were raised and applied according to the
plan. Thus a comparison of original forecast with actual results may highlight trends of
movement that might otherwise go undetected.
3. Since it gives the amount of cash inflow from operations, (and not income inflow from
operations), it may be useful to internal financial management in considering the
possibility of retiring long-term debt in planning replacement of plant facilities and in
formulating dividend policies.
4. It enables the management to account for situation when business has earned huge
profits yet run without money or when it has suffered a loss and still has plenty of
money at the bank.
5. Cash Flow Statement helps the management in taking short term financial decisions.
Suppose the firm wants to know its state of solvency after one month from today, it is
possible only from Cash Flow Analysis and not from Fund Flow Statement. Shorter the
period, greater is the importance of Cash Flow Statement.
LIMITATIONS OF CASH FLOW ANALYSIS
Though the statement of cash flow serves a number of objectives of financial
management, it is necessary to take certain precautions while making use of this
analytical tool. Misleading implications can result from isolated reports of 'cash flow'
which are not placed in proper perspective to the net income figures and a complete
analysis of sources and applications of funds. Some of the noteworthy limitations on the
usefulness of cash flow statement as a tool of financial analysis are:
(a) As the enterprise shifts from strictly cash basis to credit transactions as well, and
takes into account prepaid and accrued items, the net income would generally represent
an increase in working capital. Yet equating net income to cash flow for such enterprise
would be inaccurate and misleading since a number of 'non-cash' items would affect the
net income of the enterprise.
(b) Most of the business has, in addition to current assets, a number of fixed assets.
These assets involve cash payments in years past and charges against operating income
of current years via depreciation entries. Thus, net income moves even further away
from being a net cash flow. In fact there is little, if any, relationship between them.
(c) The cash balance is too easily influenced by postponing purchases and other
payments.
The foregoing discussion makes it clear that cash flow is a part of funds (working capital
concept) flow while income flow is one of the various sources of funds flow. The cash
flow statement cannot replace the financial statements of account, viz., Balance Sheet
and Income Statement, but it is certainly very useful supplementary statement. The
volume of cash flowing in any part of the system and the speed at which it flows
determine the amount of capital tied up in any segment of the business at any given
time. In its turn, the magnitude of capital tied up and the rate at which it is turned over
have a direct bearing on the return obtained on the investment. Thus, any change in the
speed at which cash is flowing through the different parts of the business may have an
important bearing on the profitability of the business. Cash Flow Analysis, used in
conjunction with Ratio Analysis, provides a barometer for measuring the aforesaid
change and makes 'financing' problems of the business much more manageable.
COMPREHENSIVE CASH FLOW STATEMENTS
Illustration
Balance Sheets of A and B as on 1.1.1993 and 31.12.1993 are as follows:
Liabilities
1.1.93
(Rs.)
31.12.93
(Rs.)
Assets
1.1.93
(Rs.)
31.12.93
(Rs.)
Creditors 40,000 44,000 Cash 10,000 7,000
M/S A's Loans 25,000 - Debtors 30,000 50,000
Loan from Bank 40,000 50,000 Stock 35,000 25,000
Capital 1,25,000 1,53,000 Machinery 80,000 55,000
Land 40,000 50,000
Building 35,000 60,000
2,30,000 2,47,000 2,30,000 2,47,000
During the year a machine costing Rs. 10,000 (accumulated depreciation Rs. 3,000)
was sold for Rs. 5,000. The provisions for depreciation against Machinery as on 1.1.93
was Rs. 25,000 and on 31.12.1993 was Rs.40,000. Net profit for the year 1993 amounted
to Rs. 45,000. You are required to prepare the Cash Flow Statement.
CASH FLOW STATEMENT
Rs.
Cash Balance as on 1.1.1993 10,000
Add: Sources:
Cash from operations 59,000
Loan from bank 10,000
Sale of machinery 5,000 74,000
84,000
Less: Applications:
Purchase of land 10,000
Purchase of building 25,000
M/s A's Loan repaid 25,000
Drawings 17,000 77,000
Cash balance as on December 31,1993 7,000
Working Notes:
CASH FROM OPERATIONS
Rs.
Profit made during the year 45,000
Add: Depreciation on machinery 18,000
Loss on sale of machinery 2,000
Decrease in stock 10,000
Increase in creditors 4,000 + 34,000
79,000
Less: Increase in debtors -20,000
Cash from operations 59,000
MACHINERY ACCOUNT (AT COST)
To balance B/d (80,000
+ 25,000)
1,05,000 By Bank 5,000
By Loss on sale of
machinery
2,000
By Provision for
depreciation
3,000
By Balance C/d (55,000
+ 40,000)
95,000
1,05,000 1,05,000
PROVISION FOR DEPRECIATION
To Machinery A/C 3,000 By Balance B/d 25,000
To Balance C/d 40,000
By P&L A/C
(depreciation charged balancing figure)
18,000
43,000 43,000
Capital as on 1.1.93 = 1,25,000
Add: Net Profit = 45,000
1,70,000
Capital as on 31.12.93 = 1,53,000
Drawings = 17,000
MODEL QUESTIONS
1. What is a Cash Flow Statement? How is it prepared?
2. Distinguish between cash flow and funds flow statements.
3. What are the uses of cash flow and funds flow statements?
4. Explain the technique of preparing a cash flow statement with imaginary figures.
5. What are the limitations of cash flow analysis?
- End of Chapter -
LESSON - 17
MARGINAL COSTING
PRELUDE
Materials, labour and other expenses constitute the different elements of cost. These
elements of cost can broadly be put into two categories: Fixed costs and Variable costs.
Fixed costs are those costs which do not vary but remain constant within a given
period of time and range of activity in spite of fluctuations in production. Just contrary
to this are variable costs which may increase or decrease in proportion to increase or
decrease in output. The cost of a product or process can be ascertained using the
different elements of cost by any of the following two techniques:
1. Absorption Costing
2. Marginal Costing
Absorption costing technique is also termed as Traditional or Full Cost Method.
According to this method, the cost of a product is determined after considering both
fixed and variable costs. The variable costs, such as those of direct materials, direct
labour etc., are directly charged to the products, while the fixed costs are apportioned on
a suitable basis over different products manufactured during the period. Thus in case of
absorption costing, all costs are identified with the manufactured products.
Under the marginal costing technique, only variable costs are taken into account for
purposes of product costing, inventory valuation and other important management
decisions, and no attempt is made to find suitable bases apportionment of fixed costs.
Marginal costing is also known as Direct Costing or Variable Costing. It is the most
useful technique which guides the management in pricing, decision-making and
assessment of profitability.
CONCEPT OF MARGINAL COST
'Marginal Cost' derived from the word 'Margin' is a well-known concept of economic
theory. Thus, quite in tune with the economic connotation of the term, it is described in
simple words as "the cost which arises from the production of additional increments of
output". Hence, it does not arise if no additional increments are produced.
The Institute of Cost and Works Accountants, London, in the publication "A Report on
Marginal Costing" defines marginal cost as "the amount at any given volume of output
by which the aggregate costs change if the volume of output is increased or decreased by
one unit". For instance, suppose 100 units of a commodity can be produced at a cost of
Rs. 2,000. If we produce 101 units at a total cost of Rs. 2,010, the marginal cost (i.e.
increase in aggregate cost for additional unit) is Rs. 10 (i.e. Rs. 2,010 - Rs. 2,000).
In the above definition, the word 'unit' needs elucidation. Practically it may mean a
single item of a product, a process, an operation, a batch of production, a department or
a stage of production capacity. The costs thatincrease or decrease in response to change
in any of these factors, may be called as its marginal costs.
Marginal cost in the short run is the total variable cost because within the capacity of the
organisation, an increase of one unit in production will cause an increase in variable cost
only. The variable cost consists of direct materials costs, direct labour costs, variable
direct expenses and other variable overheads. It must be noted here that even variable
portion of semi variable costs are included in marginal cost. However, in the long run,
marginal costs will also include fixed costs in planning production activities involving an
increase in the production capacity. Thus, marginal costs are related to change in output
under particular circumstances of a case.
However, where an increase in fixed costs is envisaged in the wake of an addition in the
productive capacity and consequently to the level of activity, fixed costs are dealt with as
a part of 'Differential Costs' so that the usage of the term 'Marginal Cost' is restricted in
actual practice only to cases involving a more effective utilisation of the existing
installed capacity intended for a better recovery of fixed costs per unit of output.
CONCEPT OF MARGINAL COSTING
As already pointed out, 'marginal costing' is a technique where only the variable costs
are considered while computing the cost of a product. The fixed costs are met from the
total fund arising out of the excess of selling price over total variable cost. This fund is
known as 'Contribution in Marginal Costing'.
According to the Institute of Cost and Works Accountants, London, "Marginal Costing is
the ascertainment by differentiating between fixed costs and variable costs, of marginal
costs, and of the effect on profit or changes in the volume and type of output". According
to the Chartered Institute of Management Accountants, London, "Marginal costing is a
technique where only the variable costs are charged to cost units, the fixed cost
attributable being written off in full against the contribution for that period". This will
be clear with the help of the following illustration.
Illustration
A company is manufacturing three products A, B and C. The costs of their manufacture
are as follows:
Details
Products
A B C
Direct materials per unit (Rs.) 3 4 5
Direct labour per unit (Rs.) 2 3 4
Selling price per unit (Rs.) 10 15 20
Output (units) 1000 1000 1000
The total overheads are Rs. 6,000 out of which Rs. 3,000 is fixed cost and rest is
variable cost. Prepare a statement of cost and profit according to the marginal costing
technique.
Solution:
Statement of Cost and Profit
(under marginal costing technique)
Details Product A Product B Product C
Rs. per
unit
Total
Rs.
Rs. per
unit
Total
Rs.
Rs. per
unit
Total
Rs.
Direct materials 3 3000 4 4000 5 5000
Direct labour 2 2000 3 3000 4 4000
Variable overheads
(6000-3000)/3
1 1000 1 1000 1 1000
Total marginal
contribution
6 6000 8 8000 10 10000
Sales - Variable cost
4 4000 7 7000 10 10000
Selling price 10 10000 15 15000 20 20000
Thus the total contribution from the three products A, B and C amounts to Rs.21,000
(4000 + 7000 + 10000). The profit will now be computed as follows:
Total contribution = Rs. 21000
Fixed costs = Rs. 3000
Rs. 18000
Hence it is clear that marginal costing is not a system of finding cost such as job, process
or operating costing, but it is a special technique concerned particularly with the effect
of fixed overheads on running the business. In other words, it has been designed simply
as an approach to presentation of meaningful accounting information to the
management from the view point of adjudging the profitability of an enterprise by
carefully studying the impact of the entire range of costs according to their respective
nature.
The concept of marginal costing is a formal recognition of ideas underlying flexible
budgets, breakeven analysis and cost volume profit relationship. It is an application of
these relationships which involve a change in the conventional treatment of fixed
overheads in relation to income determination.
CHARACTERISTIC FEATURES OF MARGINAL COSTING
1. It is a technique of analysis and presentation of cost rather than an independent
method of costing. It can be applied with any other method of costing.
2. It is based on the important distinction between product costs and period costs; the
former being related to the volume of output and latter to the period of time.
3. It regards product costs as only those manufacturing costs which have a tendency to
vary directly with the volume of output i.e. it considers only variable costs in its analysis
and fixed costs are excluded from computation though they may be reported separately.
4. It guides pricing and other managerial decisions on the basis of 'Contribution' which
is the difference between sales value and variable, cost of sales. Contribution is also
known as gross margin or marginal income'.
5. The stock of finished goods and work in progress are valued at marginal cost only.
6. The difference between contribution and fixed cost represents either profit or loss.
Excess of contribution over fixed cost is the profit, and deficiency of contribution below
fixed cost is the loss.
MARGINAL COSTING vs. ABSORPTION COSTING
Since marginal costing is an alternative to absorption costing, it is necessary to compare
the two and suggest the technique which is more appropriate in routine costing.
Following are the important points of distinction between absorption costing and
marginal costing:
1. Absorption/Total Cost technique is the practice of charging all costs, both variable
and fixed to operations, processes or products, i.e., both fixed and variable overheads
are charged to production.
In marginal costing, only variable overheads are charged to production, while fixed
overheads are transferred in full to the costs in Profit and Loss account. Thus in
marginal costing there is under recovery of overheads since only variable overheads are
charged to production.
2. In case of absorption costing, stocks of work-in-progress are valued at works cost,
while finished goods are valued at total cost of production. The works cost and cost of
production include the amount of fixed overheads also.
In case of marginal costing, only variable costs are considered for computing the value
of work-in-progress or finished goods. Thus the closing stock in marginal costing is
undervalued as compared to absorption costing.
3. In the case of absorption costing, profit is the difference between sales revenue and
total cost. As such managerial decision making is wholly dependent upon this concept of
profit.
In the case of marginal costing, the excess of sales revenue over marginal cost is known
as 'contribution' and decision-making centres round this concept of profit.
4. In total cost technique, there is the problem of apportionment of fixed costs, since
fixed costs are also treated as product costs.
Marginal costing excludes fixed costs. Therefore there is no question of arbitrary
apportionment.
The above points of difference between absorption costing and marginal costing will be
clear with the help of the following illustration:
Illustration:
A company has a production capacity of 2,00,000 units per year. Normal capacity
utilisation is reckoned as 90%. Standard variable production costs are Rs. 11 per unit.
The fixed costs are Rs. 3,60,000 per year. Variable selling costs are Rs.3 per unit and
fixed selling costs are Rs.2,70,000 per year. The selling price per unit is Rs. 20. In the
year ended on 30th June 1993, the production was 1,60,000 units and sales were
1,50,000 units. The closing inventory on 30.06.1993 was 20,000 units. The actual
variable production costs for the year were Rs. 35,000 higher than the standard.
Calculate the profit for the year...
(a) by the absorption costing method, and
(b) by the marginal costing method.
Also explain the difference in the profits.
Solution:
a) Profit Statement for the year ended 30th June 1993 (under absorption costing
method)
Particulars
Amount
(Rs.)
Amount
(Rs.)
Sales: 1,50,000 units at Rs.20 per unit 30,00,000
Less: Cost of production:
Variable production cost for 1,60,000 units at Rs.11
per unit
17,60,000
Increase in fixed cost 35,000
Fixed costs 3,60,000
21,55,000
Add:
Opening stock:
10,000 units (i.e. Sales 1,50,000 units + Closing
stock 20,000 units - Productio 1,60,000 units) at
Rs.13 (i.e. variable normal capacity utilization)
1,30,000
22,85,000
Less:
Closing stock: 20,000 units values
At current cost (21,55,000 x 20,000 / 1,60,000)
2,69,375 -20,15,625
Gross Profit
9,84,375
Less: Selling expenses:
Variable 4,50,000
Fixed 2,70,000 -7,20,000
Net Profit
2,64,375
b) Profit Statement for the year ended 30th June 1993 (under marginal costing method)
Particulars
Amount
(Rs.)
Amount
(Rs.)
Sales: 1,50,000 units at Rs.20 per unit 30,00,000
Less: Marginal Cost:
Variable production cost for 1,60,000 units at
Rs.11 per unit
17,60,000
Additional variable production cost 35,000
Variable cost of opening stock of finished goods 1,10,000
19,05,000
Less:
Closing stock of finished goods:
20,000 units valued at current variable
production cost (17,95,000 x 20,000 / 1,60,000
2,24,375
Variable production cost of 1,50,000 units
16,80,625
Add:
Variable selling cost of 1,50,000 units
(1,50,000 x 3)
4,50,000 -21,30,625
Contribution
8,69,375
Less: Fixed costs:
Fixed production costs 3,60,000
Fixed selling costs 2,70,000 -6,30,000
Net Profit
2,39,375
The difference in profits as arrived at under absorption and marginal costing methods
(Rs. 2,64,375 - Rs. 2,39,375 = Rs. 25,000) is due to the element of fixed cost included in
the valuation of opening and closing stocks under the absorption costing method.
WHICH TECHNIQUE IS PREFERABLE?
Since absorption costing and marginal costing methods are alternative techniques in the
routine cost accounting system, it is necessary to say a word about their appropriateness
for product costing.
Absorption Costing may be preferred on the following grounds:
1. In modern times fixed costs constitute a substantial portion of total cost. Production is
impossible without incurring fixed costs. As such they are a part of cost of production.
2. Inclusion of fixed costs in inventory valuation becomes absolutely necessary if
building up of stocks is a necessary part of business operations. For instance, in the case
of timbers and fireworks, stocks have to be built up. If fixed costs are excluded from
inventory valuation fictitious losses are shown in earlier years and excessive profits later
when goods are actually sold.
3. Profit fluctuations are lesser when production is constant but sales fluctuate.
4. This technique enables matching of costs and revenues in the period in which revenue
arises and not when costs are incurred.
5. Inclusion of fixed costs does not give room for fixation of price below total cost
although some contribution is generated.
Marginal Costing may be preferred on the following grounds:
1. This technique is simple to understand and easy to operate.
2. Indivisible fixed costs need not be apportioned on an arbitrary basis.
3. It avoids the contingency of over- or under-absorption of overheads.
4. Fixed costs accrue on time basis. Hence they should be written-off in the period of the
accrual.
5. Accounts prepared under this technique more nearly approach the actual cash flow
position.
In the light of the above arguments in favour of each of the techniques it is not possible
to lay down any general rule regarding the use of a particular technique. The cost
accountant would be the right person to decide in favour of either of the two, depending
upon the appropriateness and the particular organisation. While absorption costing is
the basis of financial accounting, it is equally so in the routine cost ascertainment
procedure, since the use of full marginal costing system for product costing is very rare
in modem times. However, for purposes of planning and decision making, marginal
costing is the only technique which is universally recognised.
MARGINAL COSTING - ROLE OF CONTRIBUTION
Contribution is of vital importance for the system of marginal costing. The rationale of
contribution lies in the fact that, where a business manufacturers more than one
product, the profits realised on individual products cannot possibly be calculated due to
the problem of apportioning of fixed costs to different products which is done away with
under marginal costing.
Contribution is the difference between sales and variable cost of sales and is therefore
sometimes referred to as 'gross margin'. It is called as 'contribution' because it enables
to meet fixed costs and contributes to the profit. It is visualised as some sort of a 'fund'
or 'pool' out of which all fixed costs, irrespective of their nature, are to be met and to
which each product has to contribute its share. The difference of amount between
contribution and fixed costs can be either profit or loss.
The concept of contribution is useful in the fixation of selling prices, determination of
breakeven point, selection of product-mix for profit maximization, and ascertainment of
the profitability of products, departments, etc.
FIXED AND VARIABLE COSTS
In marginal costing, in addition to 'contribution', the concepts of 'fixed costs' and
'variable costs' are also important.
Variable cost is defined as "a cost which in the aggregate tends to vary in direct
proportion to changes in the volume of output or turnover" (ICMA Terminology).
The definition of variable cost given here relates variable cost to an activity i.e., any
expense that is expected to change with the volume of production is treated as variable
overhead. All supplies, indirect manufacturing labour, expenses of receiving, storing and
maintenance of plant and machinery are all included under this classification. Thus
variable costs tends to vary with the volume of production or sales. Further the change is
supposed to be in direct proportion to the level of activity. But the 'variable cost per unit'
remains constant.
Fixed cost is defined as "a cost which accrues in relation to the passage of time and
which, within certain output or turnover limits, tends to be unaffected by fluctuations in
volume of output or turnover".
This definition makes it clear that these are time-based and within certain limits, and
these are unaffected by changes in activity. In other words, fixed costs are costs of time.
They accumulate with the passage of time irrespective of the volume of output or
turnover. It is this point that distinguishes variable costs from fixed costs. Conventional
items such as depreciation of plant and machinery, factory insurance, salaries etc.,
represent fixed overheads/costs.
However, to say that fixed costs do not vary would be incorrect. Even fixed costs become
variable beyond a particular point. If production increases substantially, additional
accommodation and additional executive staff cause an increase in rent, insurance,
salaries etc. There are also other factors such as inflation, government policies, and
management decisions which bring about a change in the level of fixed costs. Since fixed
costs do not, in total, respond to changes in the level of activity, an increase in volume
will result in a decrease in the fixed cost per unit.
Semi-variable cost, according to the ICMA Terminology, is "a cost containing both
fixed and variable elements which therefore are partly affected by fluctuations in the
volume of output or turnover". In other words, semi-variable expenses possess both
fixed and variable characteristics. Salaries of foremen and supervisors, electricity
charges, telephone charges etc. fall under this category. Semi-variable cost is also known
as semi-fixed cost. Semi-variable costs may be either mainly variable with a
significant fixed element, or mainly fixed with a significant variable element. Very
rarely, a cost would be wholly fixed or wholly variable. In a large number of cases it
includes both the elements.
TYPES OF SEMI-VARIABLE COSTS
Although, what is variable, fixed or semi-variable cost depends upon the nature of
business, it is usual to distinguish four types of semi variable costs. They are:
(a) Fixed and Variable elements combined
Electricity charges, for instance, contain a fixed charge and a variable element viz. cost
per unit consumed. Similarly telephone charges. The same is true of indirect labour cost
when a minimum force is necessary to operate but is easily supplemented when need
arises.
(b) Cost increasing in steps
Also known as step costs, they remain constant for a particular range of activity. When
activity increases beyond the range, cost increases significantly. A typical example is
supervision cost. If one foreman could supervise the work of eight labourers, any
increase in the number of labourers would be beyond the control of one foreman. In
such a case the labourers should be split into two groups necessitating the appointment
of an additional foreman.
(c) Seasonal Costs
Some items of costs tend to be higher during certain months than during other months
owing to climatic conditions or any other reason unconnected with the volume of
output, like heating and lighting.
d) Costs increasing at a fluctuating rate
Sometimes the cost curve may be curvilinear, i.e, increasing more rapidly at some
volumes of output than others. This happens very often when a particular department
reaches or exceeds its practical capacity. For example, electricity consumption charge
per unit may increase at a fluctuating rate.
SEGREGATION OF SEMI-VARIABLE COSTS
Marginal costing requires segregation of all costs between two parts fixed and variable.
This means that the semi-variable cost will have to be segregated into fixed and variable
elements. This may be done by any one of the following methods:
1. Accounts classification method
An examination of the cost code used by a business facilitates identification of costs as
fixed or variable. To decide whether a cost tends to be wholly fixed or wholly variable
requires exercising one's judgment. One has to decide whether there is a larger variable
or larger fixed element in an item of cost. It is also possible to investigate the make-up of
each item of cost by examining invoices, vouchers and other documents, noting
separately the fixed costs and the variable costs.
This method, though simple, is a time-consuming method. Further, if an account
classification cannot be identified as fixed or variable by inspection, it becomes
necessary to rely upon any of the subsequent methods we have described further.
2. Levels of output compared with levels of expenses method
According to this method, the output at two different levels is compared with
corresponding level of expenses. Since the fixed expenses remain constant, the variable
overheads are arrived at by the ratio of change in expense to change in output.
Illustration:
Year 1992
months
Production (in
units)
Semi-variable expenses
(Rs.)
July 50 250
August 30 132
September 80 200
October 60 170
November 100 230
December 70 190
During the month of January 1993, the production is 40 units only. Calculate the
amount of fixed, variable and total semi-variable expenses for the month.
Solution:
Computation of Fixed and Variable Overheads
(Figures of September and November taken as the base)
Month
Production (in
units)
Semi-variable
expenses (Rs.)
Fixed Variable
September 80 200 80* 120*
November 100 230 80** 150**
Difference 20 30
Therefore, variable element = Change in amount of expense / Change in activity or
quantity
= 30 / 20 = Rs. 1.50 per unit
* Variable overheads for September = 80 x 1.50 = Rs. 120
Fixed overheads for September = 200 - 120 = Rs. 80
** Variable overheads for November = 100 x 1.50 = Rs. 150
Fixed overheads for November = 230 - 150 = Rs. 80
Thus,
Variable overheads for January = 40 x 1.50 = Rs. 60
Fixed overheads for January = Rs. 80
Total semi-variable overheads = Rs. 60 + Rs. 80 = Rs. 140
3. High-Low Points method
This method establishes the relationship between cost and volume on a historical basis.
It involves the examination of previous results. Under this method,
(i) The cost of a particular item of expenditure for a given number of past costing
periods is taken into consideration.
(ii) The level of activity for each of the periods is ascertained. The level of activity may be
expressed in terms of 'number of units produced' or 'number of labour hours worked out
of the number of machine hours'.
(iii) At two extreme levels of activity, the related costs are picked out and the rate of
change between the two points is worked out. This rate of change is assumed to be the
variable cost per unit.
(iv) The total variable cost for one of the points is then calculated by multiplying the
level of activity by the variable cost per unit.
(v) It is then deducted from the total cost for that level of activity. The balance is the
fixed cost.
In selecting the periods and in dealing with costs incurred during such periods, care
should be taken to see that figures are not distorted by any abnormal factors.
This method can be elucidated by the following examples of costs incurred in the
maintenance of plant by a business undertaking:
Illustration:
Activity level in terms of direct labour (hours)
Costs
No. Percentage
High 13,680 100 5552
Low 5,472 40 3500
Range of variation 8,208 60 2052
Variation rate = Variation in costs / Variations in Activity Level = 2052 / 8208 = Rs.
0.25 per direct labour hour.
Solution:
The fixed element of maintenance cost of plant at two points of activity can then be
arrived at as this:
High Low
Total costs 5,552 3,500
Variable costs @ Rs. 0.25 per direct labour hour 3,420 1,368
Fixed cost component 2,132 2,132
Sometimes, this is also expressed by means of a formula:
Variable Cost = (CH - CL) x LH / (LH - LL)
where,
CH = Cost at high level of activity
CL = Cost at low level of activity
LH = High level of activity
LL = Low level of activity
Therefore, in this example,
Variable cost = (5552 - 3500) x 100% / (100% - 40%) = 2052 x 100% / 60% = 2052 x
5/3 = Rs. 3,420
Fixed cost component = Total cost - Variable cost = Rs.5552 - Rs.3420 = Rs. 2,132
Variable rate per hour = Variable cost / No. of hours of High Level activity = 3420 /
13680 = Rs. 0.25
4. Scattergraph method
The steps are:
i. Plot the costs at various levels of output, taking output along the horizontal axis (x-
axis) and costs along the vertical axis (y-axis).
ii. Draw a line which links as the many points as possible and which has as equal
number of points on either side of the line. Ignore the points which indicate abnormal
results. The line thus drawn is known as the 'line of best fit'.
iii. Extend the line to the vertical axis (y-axis). The point at which the line intersects the
vertical axis indicates the fixed cost element.
iv. Draw a line representing the fixed cost parallel to the horizontal axis (x-axis). The gap
between the total cost line and the fixed line indicates the variable cost element for a
particular parallel the horizontal axis.
v. Divide the variable cost for a certain level of activity by the number of units. This gives
the variable cost per unit.
5. Method of least squares
This method, also known as the regression analysis, is based on the mathematical
technique of fitting an equation with the help of a number of observations. The method
makes use of the equation of straight line, Y = a + bx for fitting a straight line trend. The
linear equation, i.e., a straight line equation can be assumed as:
y = a + bx
and the various sub-equations shall be,
y = na + bx
y = ax + bx
2
6. Engineering estimates method
The statistical methods outlined above are of limited use if historical data is not
available or the data is unreliable owing to technological changes. Even if accurate
historical data is available, the relationship between cost and volume will be imperfect if
cost is influenced by a number of factors. In such cases, the assistance of industrial
engineers who, along with the members of the accounting department, determine the
physical inputs necessary to achieve certain levels of output and then convert these into
money costs. Not only do they separate the fixed and variable elements, they also
establish efficiency standards for different levels of activity.
Each of the methods outlined above has its own limitations. As such, none of these is
said to be the best from the point of view of segregation of fixed and variable elements.
In a number of cases, it becomes necessary to use the methods together. When it is
known that there is strong evidence of correlation, the Least Square method is the best.
In the absence of correlation, the least square method, like the Scatter Diagram and
High-and-Low Points methods merely establish an overhead recovery rate consisting of
the fixed and variable elements. In such cases, engineering estimates will be accurate.
MARGINAL COSTING AND DECISION MAKING
Decision making is one of the most important activities of management When faced
with the problem of choosing a particular course of action from amongst a number of
alternative courses, a manager has to predict the possible outcome of each course. All
decisions, thus, relate to the future. Consequently, he needs information regarding
future costs and revenues. Although future cannot be foretold, an understanding of
behaviour of costs is absolutely necessary. He has to fall back upon information
pertaining to past costs, records of performance, future costs and revenues, likely state
of the market etc. It is in this context that the technique of marginal costing assists
management in making predictions about the future in relation to alternative courses of
action. Therefore, it is essential to study as to how the technique of marginal costing is
applied to practical problems.
(i) Fixation of selling prices
Although prices are more controlled by market conditions and other economic factors
than by decisions of management, yet the fixation of selling prices is one of the most
important functions of management. This function is to be performed:
(a) Under normal circumstances
(b) In times of competition
(c) In times of trade depression
(d) In accepting additional orders for utilizing idle capacity, and
(e) In exporting and exploring new markets.
Under normal circumstances, the price fixed must cover total cost, as otherwise
profits cannot be earned. It can also be fixed on the basis of marginal cost by adding a
high margin to it, which may be sufficient to contribute towards fixed expenses and
profits.
But under other circumstances, products may have to be sold at a price below total cost,
if such a step is necessary in situations of competition, trade depression, additional
orders for utilising spare capacity, exploring new markets etc. Thus in special
circumstances, price may be below the total cost and it should be equal to marginal cost
plus a certain amount (if possible).
Pricing in depression:
Prices fall during depression and the product may be sold below the total cost. In case
there is a serious but temporary fall in the demand on account of depression leading to
the need for a drastic reduction in prices temporarily, the minimum selling price should
be equal to the marginal cost. If the selling price at which the goods can be sold is equal
to or more than marginal cost, the product should be continued. Fixed expenses will be
incurred even if the product is discontinued during depression for a short period. If the
product can be sold at a price which is a little more than marginal cost, loss on account
of fixed expenses will reduce because price will be able to recover fixed expenses to some
extent. This can be made clear by giving the following example:
Illustration:
As statement of cost prepared under absorption costing shows the following situation
prevailing in an engineering firm facing depression:
Direct material (2100 units) Rs. 31,500
Direct wages Rs. 14,700
Overheads:
Variable cost Rs. 6,300
Fixed cost Rs. 10,500
Total cost Rs. 16,800
------------------------------------------------------------
Rs. 63,000
Sales of 2,100 units at Rs. 26 per unit Rs. 54,600
------------------------------------------------------------
Loss Rs. 8,400
------------------------------------------------------------
There is no sign of improvement in the situation and the losses have been chronic.
Therefore the management wants to know whether it is desirable to stop production.
Give your views on this matter. What should be the minimum price at which you would
like to suggest shut down?' What would be your suggestion if price falls to Rs. 23 per
unit?
Solution:
Even if the factory is shut down, the fixed expense of Rs. 10,500 will have to be incurred,
and then the loss will be equal to fixed costs (= Rs. 10,500), which is more than the
present loss of Rs.8,400. Therefore it is advisable not to close the factory. The present
loss is lesser, because the price is more than the marginal costs and contributes recovery
of fixed costs.
Costs
Price per unit
(Rs.)
Total sales
(Rs.)
Direct material 15 31,500
Direct labour 7 14,700
Variable expenses 3 6,300
Marginal cost
25 52,500
Sale price of 2100 units at Rs.26
per unit
26 54,600
Contribution (Marginal cost -
Sale price) 1 2,100
Fixed cost Contribution = Loss
10,500 2,100 = Rs. 8,400
Therefore, so long as the price is above marginal cost, the contribution goes to recover
fixed costs, which have to be incurred even when production is stopped.
The price at which production may be discontinued should be at least equal to the
marginal cost (Rs.25). Any price below Rs.25 will not recover even the marginal cost,
and the loss would become more than the fixed cost.
In case the price is reduced to Rs. 23 per unit, stopping the production is recommended,
as stopping production will limit the loss to the fixed cost. Let's see how...
Rs.
Sales price (2100 units x Rs. 23 per unit) = 48,300
Marginal cost (2100 units x Rs. 25 per unit) = 52,500
Loss (52,500 - 48,300) = 4,200
Fixed cost = 10,500
Total Loss (Loss + fixed cost) = 14,700
If production is stopped, loss = fixed cost = Rs.10,500
If sale price is reduced to Rs.23 per unit, loss = Rs. 14,700
Hence, it is better to stop production rather than sell at Rs. 23 per unit.
(ii) Accepting additional orders, exploring additional markets and
exporting
Bulk orders may be received from large scale buyers or foreign dealers asking for a price
which is below the market price. This calls for a decision to accept or reject the order. If
the price is below the total cost, it may be tempting to reject such offer. But marginal
costing takes a different view. It recommends accepting the order provided the quoted
price is more than the marginal costs. The reason being, since the local market price
provides contribution sufficient to recover fixed costs and a margin of profit, any
contribution from the foreign offers would be net addition to the profits. However, if the
quoted price is less than the marginal cost, it is not advisable to accept the order. Care
should be taken to see that low quotations should not have any adverse impact on the
local market.
Illustration:
The cost sheet of a product is given as under:
Rs.
Direct materials 5.00
Direct wages 3.00
Factory Overheads:
Fixed Re. 0.50
Variable Re. 0.50 1.00
Administrative expenses: 0.75
Selling and distribution overheads:
Fixed Re. 0.25
Variable Re. 0.50 0.75
10.50
Selling price per unit is Rs. 12.
The above figures are for an output of 50,000 units; capacity for the firm is 65,000
units. A foreign customer is desirous of buying 15,000 units at a price of Rs. 10 per unit.
Advise the manufacturers whether the order should be accepted. What will be your
advice if the order were from a local merchant?
Solution:
Marginal cost or additional cost for additional 15,000 units
The order from the foreign customer will give an additional contribution of Rs.15,000.
Hence the order should be accepted because the additional contribution of Rs. 15,000
will increase the profit by this amount, since the fixed expenses have already been met
from the internal market.
The order from the local merchant should not be accepted at a price of Rs.10, which is
less than normal price of Rs. 12. This price will affect relationship with other customers
and there will be a general tendency of reduction in the price.
(iii) Profit Planning
Profit planning is the planning of future operations to attain maximum profit or to
maintain a specified level of profit. Marginal costing, through the calculation of
contribution ratio, enables the planning of future operations in such a way as to attain
either minimum profit or to maintain a specified level of profit. Thus it is helpful in
profit planning.
Illustration:
A toy manufacturer earns an average net profit of Rs. 3 per piece at a selling price of Rs.
15 by producing and selling 60,000 pieces at 60% of the potential capacity. Composition
of his cost of sales is:
Direct materials Rs. 4.00
Direct wages Rs. 1.00
Works overhead Rs. 6.00 (50% is fixed cost)
Sales overhead Rs. 1.00 (25% is variable cost)
During the current year, he intends to produce the same number but anticipates that
(a) his fixed charge will go up by 10%
(b) rates or direct labour will increase by 20%
(c) rates or direct material will increase by 5%
(d) selling price cannot be increased
Under these circumstances, he obtains an order for a further 20% of his capacity. What
minimum price will you recommend for accepting the order to ensure the manufacturer
an overall profit of Rs. 1,80,500?
Solution:
Marginal cost statement for Current Year
(Prior to acceptance of 20% excess order)
Per Piece (Rs.) Total amount (Rs.)
Variable cost:
Direct material 4.20
Direct labour 1.20
Works overhead 3.00
Sales overhead 0.25
8.65 5,19,000
Sales value 15.00 9,00,000
6.35 3,81,000
Fixed cost:
Works overhead 1,80,000
Add 10% 18,000 1,98,000
Sale value 45,000
Add 10% 4,500 49,500 2,47,500
Profit 1,35,500
Planned profit = 1,80,500
Increase in profit (1,80,500 - 1,33,500) = 47,000
The minimum price for 20,000 toys (order for 20% of capacity) can be worked out as
under:
Variable cost at Rs. 8.65 = Rs. 1,73,000
Add: Increase in profit = Rs. 47,000
Rs. 2,20,000
Minimum sale price = Rs.11 per unit x 20,000 units = Rs. 2,20,000
iv) Decision to make or buy
The technique of marginal costing enables management to decide whether to make a
particular product / component or buy it from outside. Such decisions become
necessary when unutilized production facilities exist, and the product being produced
has a component which can either be made in the factory itself or purchased from
outside.
It is also possible that a concern manufacturing more products than one, but each
complimentary to the other, may decide to give up the production of one of them on the
ground that it is less profitable, and buy the same from outside. Such a situation may
exist in the case of concerns manufacturing primary packing materials.
While deciding to make or buy, the cost comparison should be between the marginal
cost of manufacturing and the fixed cost because these will be incurred even if the part is
not produced. Thus, additional cost of the part will be as follows:
Materials = Rs. 3.50
Direct labour = Rs. 4.00
Other variable expenses = Re. 1.00
Total = Rs. 8.50
The company should produce the part even if the part is available in the market at Rs.
9.00 because the production of every part will give to the company a contribution of 50
paise (i.e. 9.00 - 8.50).
The company should not manufacture the part if it is available in the market at less than
Rs. 8.50, say, at Rs. 8.00 because, additional cost of producing the part is 50 paise (i.e.,
8.50 - 8.00) more than the price at which it is available in the market.
(v) Problem of Key or Limiting Factor
Under the marginal cost concept, profitability of a product or process is measured with
reference to its contribution. This is based on the assumption that it is possible to
increase the manufacture of the product yielding the highest marginal contribution to
any desired extent and there is no limitation in this regard. In practice, however, this
assumption is not valid and the management is confronted with factors which put a
limit on their efforts to produce as many units of the selected products as they would
like to. Such factor, which is equally important in the determination of profitability, is
called 'Key Factor' or 'Limiting Factor' or 'Governing Factor' or 'Principal
Budget Factor' or 'Scarce Factor'.
A limiting or key factor is defined as "the factor which, over a period, will limit the
volume of output". Usually sales is the limiting factor, but itf may sometimes arise due
to the shortage of one or more of the factors of production such as materials, labour,
capital and plant capacity. When both, contribution and key factors are known, the
relative profitability of different products or processes can be assessed with the help of
the following formula:
Profitability = Contribution / Key Factor
Illustration:
From the following data relating to products X and Y, for which certain materials used
are in shortage, find out which is more profitable from the point of view of economical
use of scarce resources.
Product X Product Y
Materials:
3 units at Rs. 5 per unit 15 ---
5 units at Rs. 5 per unit --- 25
Labour 10 15
Overheads:
Variable 5 5
Fixed 12 20
Total cost 42 65
Selling price 50 75
Profit (selling proce - Total cost) 8 10
Solution:
Product X
(Rs.)
Product Y
(Rs.)
Marginal cost:
Material + Labour + Variable
expenses
30 45
Selling price: 50 75
Contribution:
(Selling price - Marginal cost)
20 30
Contribution per unit:
X = 20 + 3 6.67 ---
Y = 30 + 5 --- 6.00
Since contribution per unit of material in case of X is more than that of Y, the available
material should be used first for X and when its demand is met, Y should be produced.
(vi) Choice of profitable product mix
When a concern manufactures more than one product, a problem is faced by the
management as to which product mix will give maximum profits. The best product mix
is that which yields the maximum contribution. The products which give the maximum
contribution are to be retained and their production should be increased. The products
which give comparatively less contribution should be reduced or closed down
altogether.
Illustration:
The following three alternative plans are being considered for the next account year by a
company:
Plan A: Sell 1000 units of product X and 500 units of product Y.
Plan B: Sell 800 units of product X and 700 units of product Y.
Plan C: Sell 750 units of each product X and Y.
The budget figures are:
Calculate the budgeted profit that would result from each of the three alternatives and
suggest the most profitable alternative. The budgeted fixed costs are Rs. 1500.
Solution:
X (Rs.) Y (Rs.)
Selling price 8.00 7.00
Direct materials 5.50 5.25
Direct wages 2.50 1.75
X (Rs.) Y (Rs.)
Selling price 8.00 7.00
Direct materials 3.00 3.00
Direct wages 2.00 2.00
Variable overhead 0.50 0.25
Plan A: 1000 units of product X and 500 units of product Y.
Contribution:
X: 1000 x 2.50 = 2,500
Y: 500 x 1.75 = 857
Total contribution = 3,375
Less: Fixed cost = 1,500
Net profit = 1,875
Plan B: 800 units of product X and 700 units of product Y.
Contribution:
X: 800 x 2.50 = 2,000
Y: 700 x 1.75 = 1,225
Total contribution = 3,225
Net profit = 1,725
Plan C: 750 units of each of the products X and Y.
Contribution:
X: 750 x 2.50 = 1,875.00
Y: 750 x 1.75 = 1,312.50
Total contribution = 3,187.50
Net profit = 1,687.50
Plan A with 1000 units of product X and 500 units of Product Y is the best mix since the
contribution and the profit are the highest. However before taking the decision,
consideration should be paid to the limiting factor.
vii) Evaluation of alternative methods of products
Marginal costing is helpful in comparing the alternative methods of production i.e
machine work and hand work. The method which gives the greatest contribution is to be
adopted, keeping, of course, the limiting factor view.
Illustration:
Product X can be produced either by machine A or by machine B. Machine A can
produce 100 units of X per hour and machine B can produce 150 units per hour. The
total machine hours available during the year are 2500. Taking into account the
following data, determine the profitable method of manufacturing.
Per unit of Product X
Machine A (Rs.) Machine B (Rs.)
Marginal cost 5 6
Selling price 9 9
Fixed cost 2 2
Solution:
Profitability Statement
Machine A (Rs.) Machine B (Rs.)
Selling price per unit (A) 9 9
Less: Margin cost (B) 5 6
Contribution per unit (C) = (A) - (B)
4 3
Output per hour (D) 100 150
Contribution per hour (E) = (C) x (D) 400 450
Machine hours per year (F) 2,500 2,500
Annual contribution (G) = (E) x (F) 10,00,000 11,25,000
Hence production by Machine B is preferable.
viii) Determination of optimum activity level
One of the very common problems confronting a business is regarding the level of
activity for which it should have plans in hand. Such plans may envisage an expansion
or contraction of productive activities depending upon the qualitative conditions in the
market. The expansion or contraction has to be arranged before the events overtake the
business. In this context, management would like to have an idea of the contribution at
different levels of activities.
Illustration:
Following is the cost structure of an electronics company:
Level of activity
50% 70% 90%
Output (in units) 10,000 14,000 18,000
Cost (in Rs.)
Materials 1,00,000 1,40,000 1,80,000
Labour 30,000 42,0000 54,000
Factory overheads 50,000 60,000 70,000
Factory cost 1,80,000 2,42,000 3,04,000
Solution:
Marginal Cost Statement
(at 100% level of activity with 20,000 units)
Total cost (Rs.) Cost per unit (Rs.)
Materials 2,00,000 10.00
Labour 60,000 3.00
Factory overheads (variable) 50,000 2.50
Marginal factory cost
3,10,000 15.50
Fixed factory overheads ** 25,000 ---
3,35,000
Thus the marginal factory cost per unit is Rs. 15.50 and the total production cost per
unit is Rs. 16.75 (Rs. 3,35,000 / 20,000 units).
Working:
Calculation of variable factory overheads per unit:
(Rs. 60,000 - Rs. 50,000) / 4,000 = Rs. 2.50
**Calculation of fixed factory overheads:
Factory overheads - (No. of units at certain level of activity x Variable factory overheads
per unit)
= 50,000 - (10,000 x 2.50)
= 50,000 - 25,000) = Rs. 25,000
This amount can be verified by making calculation at any other level of activity.
Variable Factory Overheads at 100% level of activity:
= 20,000 x Rs. 2.50 = Rs.50,000
ADVANTAGES OF MARGINAL COSTING
1. It assists in taking decisions such as pricing, accepting foreign orders at low price,
make or buy, profit planning, deciding about profitable product mix etc., as explained
earlier.
2. Elimination of fixed overheads from the cost of production means that finished goods
and work in progress are valued at their original cost and therefore the valuation is more
realistic and uniform as compared to the one when they are valued at their total cost.
There is no problem of arbitrary apportioning of fixed overheads.
3. It enables effective cost control through flexible budgeting by dividing costs into fixed
and variable component.
4. By differentiating fixed and variable costs and by means of breakeven charts, it
depicts convincingly the inter-relationship between cost, volume, and profits, thereby
aiding in optimising the level of activity and helping in profit planning.
5. Marginal costing has a unique approach in reporting cost date to the management.
The reports are based on figures of marginal costs and sales rather than on total cost
and production. So fixed costs and stocks do not vitiate appraisal as well as comparison
of profitability or performance efficiency.
MODEL QUESTIONS:
1. Distinguish marginal costing from absorption costing.
2. "Marginal costing is the administrative tool for the management to achieve
higher profits and efficient operations"- Elaborate.
3. Are there pit falls in the application of marginal costs? Explain.
4. Explain the managerial uses of marginal costing.
5. Explain how semi-variable costs would be split into fixed and variable costs.
- End of Chapter -
LESSON - 18
BREAKEVEN ANALYSIS AND PROFIT PLANNING
Planning is the essence of business management. It is only by planning that
management can realistically view future problems, analyse them, study their impact on
the activities of business and decide on the policy to be followed for achieving the
objective of making profits.
Profit planning is necessarily a part of operations planning. It is the basis of planning
cash, capital expenditure and pricing. It involves the prediction of most aspects of a
firm's operations. While an enterprise usually plans its sales activities and costs, and
then calculates the profit it hopes to make, in the case of profit planning, however, a
target of profit is laid down in advance and then decision is taken regarding sales,
activities and costs required to achieve the targets. Thus "Profit Planning is the planning
of future operations to attain maximum profit or to maintain a specified level of profit".
COST VOLUME PROFIT ANALYSIS
Herman C. Helser, in his book 'Budgeting - Principles and Practice' writes that, "the
most significant single factor in profit planning of the average business is the
relationship between the volume of business, cost and profit". These days in
management accounting, a great deal of importance is being attached to cost-volume-
profit relationship which, as its name implies, is an analysis of three different factors -
costs, volume and profit. In this case, an analysis is made to find out:
What would be the cost of production under different circumstances?
What has to be the volume of production? What profit can be earned?
What is the difference between the selling price and cost of production?
CONCEPT OF COST-VOLUME-PROFIT (CVP) RELATIONSHIP
Most business decisions are an exercise in the selection of alternatives - whether to
accept a certain business at the specified price or not, whether to aggressively push the
sales of one product or another, whether to exploit more intensively one or more of the
territories, and so on. In a scheme of cost-volume-profit analysis, an attempt is made to
measure variations of cost with volume. Cost may depend on volume, which in turn
depends on demand; profits depend on the price that can be obtained for the goods
manufactured and placed in the market less the cost thereof. Moreover, a business must
incur certain minimum expenditure on fixed and semi-variable charges. Such
expenditure must be paid out of marginal profits earned on each unit of production with
the result that a minimum volume of business becomes essential, the direct variable cost
of each article sold being covered by the sale proceeds.
CVP analysis is an extension of marginal costing. It makes use of the principles of
marginal costing and is an important tool of short term planning. It is more relevant
where the proposed changes in the level of activity are relatively small.
USES of CVP ANALYSIS
CVP analysis is useful to the finance manager in the following respects:
1) It helps him in forecasting the profit fairly accurately.
2) It is helpful in setting-up flexible budgets, as on the basis of this relationship, he can
ascertain the cost, sales and profits at different levels of activity.
3) Since costs and profits depend upon volume, the effects of changes in volume should
be considered while reviewing costs and profits achieved. Thus, performance evaluation,
which is necessary for cost control, is tendered possible by a study of the relationship of
these variables. It helps in formulating price policy by projecting the effect which
different price structures will have on cost and profits.
4) It helps in determining the amount of overhead cost to be charged at various levels of
operations, since overhead rates are generally predetermined on the basis of a selected
volume of production. Thus CVP analysis is an important medium through which the
management can have an insight into effects on profit caused by variations in costs
(both fixed and variable) and sales (both volume and value) and take appropriate
decisions. A widely used technique which facilitates the study of CVP relationship is the
Breakeven Analysis.
BREAK-EVEN ANALYSIS
A logical extension of marginal costing is the concept of breakeven analysis. It is based
on the same principle of classifying the operating expenses into fixed and variable.
Nowadays it has become a powerful instrument in the hands of policy-makers for
maximising profits.
The term 'breakeven analysis' is interpreted in the narrow as well as broad sense. Used
in its narrower sense, it is concerned with finding out the breakeven point i.e., the level
of activity where total cost equals total selling price. In other words, breakeven point is
the level of sales volume at which there is neither profit nor loss. Considered, therefore
in its literal sense, the term breakeven analysis seems to be misleading. It implies that
the only concern of management is the level of activity at which no profit is made and no
loss is suffered. Accordingly, the term is considered by some as a misnomer. However,
some feel that the term breakeven analysis is appropriate upto the point at which costs
become equal to the revenue and beyond this point it is the study of the cost volume
profit relationship. In its broader sense, break even analysts means the system of
analysis which determines the probable profit at any level of activity.
{Media#239}
PRESENTATION OF BREAKEVEN ANALYSIS
Usually, breakeven analysis is presented graphically, as this method of visual
presentation is particularly well suited to the needs of business; the manager is able to
appraise the situation at a glance. A visual representation of the relationship between
costs, volume and profit is known as a breakeven chart. Such a chart not only depicts
the level of activity where there will be neither loss nor profit but also shows the profit or
loss amounts at various levels of activity. According to the Chartered Institute of
Management Accountants, London, a breakeven chart means "a chart which shows
profit or loss at various levels of activity, the level at which neither profit nor loss is
shown". This may also take the form of a chart on which the relationship either of 'total
cost of sales' to 'sales' or 'affixed costs' to 'contribution' is plotted. Thus it is a graphical
presentation of cost and revenue data so as to show their inter relationship at different
levels of activity.
Breakeven Charts are frequently used and needed where a business is new or where it is
experiencing trade difficulties. In these cases the chart assists the management in
considering the advantages and disadvantages of marginal sales. However in a highly
profitable enterprise, there is little need of breakeven charts except when studying the
implications of a major expansion scheme involving a heavy increase in fixed charges.
There are three methods of drawing a breakeven chart. These have been explained with
the help of the following illustration:
Illustration:
For the data given below, calculate the Breakeven Point and Profit if the output is
50,000 units, and draw a breakeven chart for it.
Solution:
First Method
On the X-axis of the graph, plot the number of units produced and sold, and on the Y-
axis show costs and sales revenues.
(i) The fixed cost line is drawn parallel to the X-axis. This line indicates that fixed
expenses remain the same with any volume of production.
(ii) The variable costs for different levels of activity are plotted over the fixed cost line at
zero volume of production. This line can also be regarded as the 'Total Cost Line'
because it starts from the point where fixed cost has been incurred and variable cost is
zero.
(iii) Sales values at various levels of output are plotted, joined and the resultant line is
the 'Sales Line'. The sales line would cut the Total Cost Line at a point where the total
costs are equal to the total revenues and this point of intersection of two lines is known
as breakeven point - the point of no profit no loss.
(iv) The number of units to be produced at the breakeven point is determined by
drawing a perpendicular line from the point of intersection on to the X-axis, and
measuring the horizontal distance from the zero point to the point where the
perpendicular line cuts the X-axis.
(v) The sales value at the breakeven point is determined by drawing a perpendicular line
from the point of intersection on to the Y-axis, and measuring the vertical distance from
the zero point to the point at which the perpendicular line cuts the Y-axis.
(vi) Loss and profit are as shown in the chart, which shows that if production is less than
the breakeven point, the business shall be running at a loss, and if the production is
more than the breakeven level, profit shall result.
Second Method
(i) Another method of drawing a breakeven chart is showing the variable cost line first
(ii) Draw the fixed cost line above the variable cost line. The latter line is the 'Total Cost
Line' because it is drawn over the variable cost line and represents the total cost
(variable and fixed) at various levels of output. The difference of this method from the
first method is that the fixed cost line shown above the variable cost line is drawn
parallel to the latter, whereas under the first method, the fixed cost line is parallel to the
X-axis.
(iii) The sales line is drawn as usual and therefore the added advantage of this method is
that 'contributions' at varying levels of output are automatically depicted in the chart.
(iv) The breakeven point is indicated by the intersection of the Total Cost Line and the
Sales Line. The breakeven chart on the basis of the data given in the following
illustration will appear as given below.
Third Method
(i) Under this method, fixed cost line is drawn parallel to the X-axis.
(ii) The contribution line is drawn from the origin and this line goes up with increase in
output.
(iii) The sales line is plotted as usual. The question of interaction of sales line with cost
line does not arise because the total cost line is not drawn in this method. In this
method, breakeven point is that point where the contribution line cuts the fixed cost
line. At this point, contribution is equal to fixed expenses and there is no profit or loss. If
the contribution is more than the fixed expenses, profit shall arise, and if the
contribution is less than the fixed expenses, loss shall arise. The graphical presentation
of the given data according to this method is given in figure 18.3
CASH BREAKEVEN CHART
Though breakeven charts are generally based on profit and loss data, and are used to
estimate earnings most likely to result from a given scale of operations, such charts can
also be made to yield information regarding the effect of changes in the scale of
operations upon the cash situations of a business. However this requires a slight
rearrangement and a few adjustments in the basic approach to the graphical
representation of breakeven analysis.
The following points have to be kept in mind in connection with the construction of cash
breakeven charts:
i. Fixed expenses are to be divided into cash expenses and non-cash expenses, like
depreciation.
ii. In view of the fact that cash breakeven chart is designed to show actual payments, and
not expenses incurred, any lag in the payment of the items of variable cost must be
taken into account.
iii. Consideration has also to be given to the period of credit allowed to debtors for
arriving at cash to be received from them.
Illustration:
From the following data, plot a Cash Breakeven Chart:
Output and Sales 1000 units
Selling price per unit Rs. 15
Fixed costs (including depreciation Rs.1000) Rs.5000
Variable cost per unit Rs. 5
Assume there is no lag in payments.
Solution:
Output (in
units)
Cash Variable
costs (Rs.)
Cash Fixed
costs (Rs.)
Total cash
costs (Rs.)
Sales
(Rs.)
200 1000 4000 5000 3000
400 2000 4000 6000 6000
600 3000 4000 7000 9000
800 4000 4000 8000 12000
1000 5000 4000 9000 15000
Cash Breakeven Point = Cash Fixed cost / Cash Contribution per unit = Rs.4000 / 10 =
400 units
The Cash Breakeven Chart is given below:
ANGLE OF INCIDENCE
This is the angle formed at the breakeven point (at which the sales line cuts the cost
line). This angle indicates the rate at which profits are being made. The larger angle of
incidence, the higher is the rate at which profits are being made. Also, a smaller angle
suggests that the variable costs form a major part of cost of production. A larger angle of
incidence with a high margin of safety indicates the most favourable position of a
business and even the existence of monopoly conditions.
'Margin of safety' represents the amount by which the actual volume of sales exceeds the
volume at the breakeven point. It is important that there is a reasonable margin of
safety; otherwise a reduced level of activity may prove disastrous. A low margin usually
indicates high fixed costs, so the profits are not made until there is high level of activity
to absorb fixed costs.
PROFIT-VOLUME (PV) GRAPH
The Profit-Volume analysis graph discloses the relationship of profit to volume. The PV
graph is also referred to as PV Chart. The utility of PV graph is that it depicts the direct
relationship between sales volume and quantum of profit at different levels of activity. It
is drawn on the basis of information as is required for the construction of breakeven
chart.
The following steps are to be adhered for construction of a PV graph:
i. Profit and the fixed costs are represented on the vertical axis (Y-axis) with appropriate
scale. Total fixed costs are represented below the sales line on the left hand side of the
vertical axis, and the profits are shown on the right hand side above the sales line.
ii. Sales are represented on the horizontal line (X-axis) with appropriate scale. More
precisely, the horizontal line itself forms the sales line. This line is drawn in the middle
of the graph so as to represent losses below this line and profits above this line.
iii. Points are plotted on the PV graph for the required fixed costs and profits at two or
three assumed sales levels. The points should be selected in such a manner that one
point plotted must be below the sales line and the other must be above the sales line.
iv. The origin of the curve (profit line) would be a point of total fixed cost (treating the
entire amount as loss) at zero sales level.
v. By drawing a line connecting the point of origin with two points already plotted (as
per step iii), PV graph is completed.
The PV chart does not project the BEP alone, for it contains a set of points whereby each
point measures the amount of profit or loss in relation to sales volume.
Illustration:
X Ltd reports the following results for one year:
Sales Rs. 2,00,000
Variable costs Rs. 1,20,000
Fixed costs Rs. 50,000
Net profits Rs. 30,000
Draw the PV Graph.
Solution:
ASSUMPTIONS UNDERLYING CVP ANALYSIS / BREAKEVEN CHARTS
1. All costs can be separated into fixed and variable costs.
2. Fixed costs remain constant at every level and they do not increase or decrease with
change in output.
3. Variable costs fluctuate per unit of output. In other words, they vary in the same
proportion in which the volume of output or sales varies.
4. Selling price will remain constant even though there may be competition or change in
volume of production.
5. Cost and revenue depend only on volume and not on any other factor.
6. Production and sales figures are either identical or changes in the inventory at the
beginning and at the end of the accounting period are not significant.
7. There is only one product, and in the case of many products, one (unchanged) product
mix.
ADVANTAGES OF BREAKEVEN CHARTS
1. Breakeven chart provides detailed and clearly understandable information to the
management. Such information can be understood by the management more easily than
that contained in the Profit and Loss account and the cost estimates, because it is a
simple presentation of cost, volume and profit structure of the company. It summarises
a great mass of detailed information in a graph in such a way that its significance may be
grasped even with a cursory glance.
2. Profitability of different products can be known with the help of breakeven charts,
besides the level of no profit / no loss. The problem of managerial decision regarding
temporary or permanent shutdown of business or continuation at a loss can be solved by
breakeven analysis.
3. A break even chart is useful for studying the relationship of cost, volume and profit.
The effect of changes in fixed and variable costs at different levels of production can be
demonstrated by the graph more legibly. Effect of changes in selling price can also be
grasped quickly by the management by having a look at the break even chart. Thus it is
very much useful for quick managerial decisions.
4. A breakeven chart is a tool for cost control because it shows the relative importance of
the fixed cost and the variable cost.
5. A breakeven chart is helpful for forecasting, long-term planning, growth and stability
of the business.
6. The profit potentialities can be best judged from a study of the position of breakeven
point and the angle of incidence in the breakeven chart. The capacity can be utilised to
the fullest extent possible, and the economies of scale and capacity utilisation can be
effected. Comparative plant efficiencies can be studied through the breakeven chart.
LIMITATIONS OF BREAKEVEN CHARTS
1. A breakeven chart is based on a number of assumptions which may not hold
good. Fixed costs vary beyond a certain level of output. Variable costs do not vary
proportionately if the law of diminishing or increasing returns is applicable in the
business. Sales revenue does not vary proportionately with changes in volume of
sales due to reduction in selling price as a result of competition or increased
production.
2. Only a limited amount of information can be presented in a single breakeven
chart. If we have to study the changes of fixed costs, variable costs, and selling
prices, a number of breakeven charts have to be drawn.
3. The effect of various product mixes on profits cannot be studied from a single
breakeven chart.
4. A breakeven chart does not take into consideration the capital employed, which is
a very important factor in taking managerial decisions. Therefore, managerial
decisions on the basis of breakeven chart alone may not be reliable.
ALGEBRAIC METHOD
The algebraic method of making CVP/BEP analysis is by the use of simple formula
developed on the basis of the fundamental marginal costing equation:
Sales - Variable cost = Fixed cost + Profit
S - V = F + P
This is the basic formula which is used to find out any one of the factors when the other
three are known.
Since contribution is the excess of sales revenue over marginal cost, the right hand side
of the equation may be substituted by C. Accordingly, the equation becomes:
Sales - Variable Cost = Contribution
S - V = C
At the breakeven point, profit is nil. Therefore,
S - V = F + 0
We can find out the sales volume required to breakeven by multiplying both sides of the
equation by S. The equation will then become:
S (S - V) = F x S
Hence, Breakeven Sales (S) = (F x S) / (S - V)
Since, S - V = C, the equation can be written as:
S = (F x S) / C
Again, Fixed cost + Profit must be equal to Contribution, the equation can be seen as:
S = (F x S) / (F + P)
The BEP can also be shown by the formula
Fixed Cost
Breakeven Sales, S = -------------------------
Variable Cost
1 - -------------------
Sales
If it is derised to find out the breakeven point in terms of units, the Breakeven Sales may
be divided by the price per unit. Alternately, Breakeven Sales in terms of units can be
found out by the formula:
BEP (units) = Fixed cost / (Sales price per unit - Variable cost per unit)
or BEP (in units) = F /C
Illustration:
From the following particulars, calculate the level of sales to break even
Units sold 5000
Selling price Rs.2 per unit
Variable cost Rs.1.50 per unit
Fixed cost Rs. 2000
Solution:
BEP (units) = 2000 / 0.50 = 4000 units
Sales revenue for 4000 units @ Rs. 2 per unit = Rs. 8000
Less: Variable cost @ Rs. 1.50 per unit = Rs. 6000
Contribution = Rs. 2000
Fixed Cost = Rs. 2000
Profit / Loss = Nil
MODEL QUESTIONS
1. What is meant by breakeven analysis? Explain the important assumptions and
practical significance of breakeven analysis.
2. Draw a breakeven chart with imaginary figures.
3. "Cost-Volume-Profit relationship provides the management with a simplified
framework for an organisation which is thinking on a number of its problems" - Discuss.
4. Discuss the importance of the following in relation to marginal costing.
i) Breakeven point
ii) Margin of Safety
iii) Contribution
iv) Profit Volume Ratio
5. "The effect of a price reduction is always to reduce the PV ratio and to raise the
breakeven point". Explain and illustrate this by a numerical example.
- End of Chapter -
LESSON - 19
BUDGETARY CONTROL
Like marginal costing, which is a technique of managerial decision-making, budgetary
control is also a technique of the managerial functions of planning and control.
Though all managers plan, there are considerable differences in the way they plan -
some managers may do their planning entirely in their heads, others may make notes
and rough estimates on the back of old envelopes, and yet others may express their
plans in quantitative terms and reduce them to black and white in some orderly and
systematic manner. It is this last group of managers that, drawing inspiration from the
principles of modem scientific management, came to the conclusion that methods of
fixing performance standard in advance need not necessarily be restricted to a limited
number of departments but could be applied to the entire field of activity of the
enterprise.
These standards, embracing all activities of the organization, together form a plan of
'campaign' or 'budget' giving the directions and indications for future management, and
providing at the same time the standards by which the actual results can be measured.
Budgetary control has been inducted into the system as a means aimed at the
comparison of the actual outcome with budgeted figures and the analysis of deviations.
CONCEPT OF BUDGETS AND BUDGETARY CONTROL
A budget is a detailed plan of operations 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 a complete programme of activities of the business for the period covered.
According to Gordon and Shilling, law budget may be defined as "pre-determined
detailed plan of action developed and distributed as a guide to current operations and as
a partial basis for the subsequent evaluation of performance". A 'Budget' has been
defined by ICMA London as "a financial and/or quantitative statement, prepared and
approved prior to a defined period of time of the policy to be pursued during that period
for the purpose of attaining a given objective. It may include income, expenditure and
the employment of capital".
According to the above definitions, essentials of a budget are:
1) It is a statement defining objectives to be attained in a future period and the course to
be followed to achieve them.
2) It may express its targets either in rupees or in physical units or both. For example, a
budget may provide for a sale of Rs. 1,00,000 (i.e., monetary units) or for a sale of
10,000 units (i.e., physical units) or for a sale of 10,000 units of Rs. 1,00,000 (i.e.,
both).
3) It is prepared for a definite period well in advance.
Different types of budgets are prepared by an industrial concern for different purposes.
A Sales Budget is prepared for the purpose of forecasting sales for a future period. A
Manufacturing Cost Budget is prepared for forecasting the manufacturing costs. The
Master Budget embodies forecasts for the sales and other expenses, cash and capital
requirements besides forecasting the figure of profit or loss.
The budget system is both a 'plan as well as a control' and therefore, it also includes
within its broad scope 'budgetary control' which has been defined by the International
Management Institute's Conference on Budgetary Control held at Geneva in 1930 as "an
exact and rigorous analysis of the past and the probable and desired future experience
with a view to substituting considered intention for opportunism in management".
According to J.A. Scott, "Budgetary Control is the system of management control and
accounting in which all operations are forecasted and as far as possible, planned ahead,
and the actual results compared with the forecasted and planned ones".
The ICMA, London defines Budgetary Control as "The establishment of budgets relating
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
objective of that policy or to provide a basis for its revision".
The above definition brings out the following features of budgetary control which may
be considered to be the steps involved in it.
STEPS OF BUDGETARY CONTROL
1) Laying down the objectives to be achieved by the business;
2) Formulating the necessary plans to ensure that the desired objectives are achieved;
3) Translating the plans into budgets;
4) Relating the responsibilities of executives to the budgets or particular sections of the
same;
5) Continuous comparison of actual results with the budget and the ascertainment of
deviations;
6) Investigating into the deviations to establish the causes;
7) Presentation of information to management relating the variances to individual
responsibility; and
8) Corrective action of the management to prevent recurrence of variances.
Broadly speaking, it can be said that budget is concerned with policy making, while
budgetary control results from the implementation of the policy. Rowland and W.
H. Harr observe, "Budgets are the individual objectives of a department whereas
Budgeting may be said to be the act of building budgets. Budgetary Control embraces
all this and in addition includes the science of planning the budgets themselves and the
utilisation of such budgets to affect an overall management tool for the business
planning and control". Accordingly, the preparation of a budget is a planning function,
and the administration of the budget is a controlling function. Budgetary Control starts
with Budgeting and ends with Control.
Depaula has given the following beautiful analogy to explain the main idea behind the
budgetary control:
"The position may be likened to the navigation of a ship across the seas. The log is kept
written regarding the happenings and the position of the ship from hour to hour, and
valuable lessons are to be learnt by the captain from a study of the factors which caused
any misadventure in the past. But to navigate the ship safely over the seven seas, the
captain requires his navigating officer to work out the course ahead and constantly
check his ship's position against the pre-determined one. If the ship is off its course, the
navigating officer must report it immediately, so that the captain may take prompt
action to regain his course. Exactly so, it is with the industrial ship; the past records
represent the log and the auditor is responsible for verifying so far as he can, that those
records are correct and reveal a true and fair view of the financial position of the
concern. But what modern management requires for day-to-day operating purposes is
forecasts showing in detail the anticipated course of business for, say, the coming year.
During the course of years, the management requires immediate reports of material
variance from the predetermined course to the other with explanation of reasons for
variations".
It should be noted that a budget or a system of budgetary control is not something rigid
or like a strait-jacket. There is enough flexibility to provide initiative and drive and also
caution against undue recklessness. It is, as a matter of fact, one of the systems through
which dynamism is introduced into the organisation.
NATURE OF BUDGETS AND BUDGETARY CONTROL
A business budget is a plan covering all phases of operations for a definite period in
future. It is a formal expression of policies, plans, objectives, and goals laid down in
advance by top management for the undertaking as a whole and for every subdivision
thereof. Hence there is an overall budget for the unit composed of numerous sub-
budgets in the form of departmental and divisional budgets, which, in turn are generally
broken down to still smaller subdivisions consistent with organizational subdivisions.
The budget expresses revenue goals in the sales budgets and expense limitations in the
expense budgets that must be attained in order to realise the desired net income
objective. Moreover, budget expresses plans relative to such items as inventory levels,
capital additions, cash requirements, financing, production plans, purchasing plans,
labour requirements etc.
Budgetary control is achieved through the carrying out of the operational plan which is
the budget. It is not the mere matching of estimated expenses with probable income; it
also includes checking up the forecast figures by comparing actual results with them and
placing the responsibility for failure to achieve the budget figures. The periodic checking
up of incomes, costs and expenses constitutes the administration of the budget which
results in budgetary control.
While originally the budget constituted a financial document, it is now concerned with
devising a coordinated programme of operation, providing an effective means of
communication among managerial personnel for the purpose of evaluating proposed
plans of action, directing the diverse activities towards the accomplishment of
predetermined goals, and obtaining all requisite approvals. Thus, there is an increasing
trend towards extending the frontiers of business budgets to include planning,
coordinating, and controlling of the entire operations of a business. This has
transformed budgets and budgetary control into a valuable tool of purposeful
management.
Budgets encourage cogent thinking and help in the avoidance of vague generalisations,
as all executives concerned have to quantify plans to examine their feasibility in terms of
profit potential. They place the problem of profit in proper perspective by emphasizing
that the only means of safeguarding the desired margin of profit lies in adapting costs to
proceeds which are beyond the control of an enterprise. Then, by maintaining the
various activities of a concern in proper relation to one another, business budgets bring
a sense of balance and direction in the affairs of an undertaking. Budget is also a
psychological device that obtains results. It makes those responsible for the
implementation of the budget proposals ever conscious of its existence with the
consequence that, though no monetary reward is offered to them, there is stronger
probability of their achieving the budget goals than in the absence of predetermined
targets. To that extent, budget acts as an impersonal policeman that maintains ordered
efforts and brings about efficiency in results.
OBJECTIVES OF BUDGETARY CONTROL
Budgetary Control is planned to assist the management in the allocation of
responsibilities and authority to aid in making estimates and plans for future, to assist
in analysis of variations between estimated and actual results, and to develop the basis
of measurement or standards with which to evaluate the efficiency of operations. The
general objectives of budgetary control are as follows:
1. Planning:
A budget is a plan of the policy to be pursued during the defined period of time to attain
a given objective. The budgetary control will force management at all levels to plan in
time all the activities to be done during the future periods. A budget as a plan of action
achieves the following purposes:
a) Action is guided by well thought-out plan because a budget is prepared after a careful
study and search.
b) The budget serves as a mechanism through which management's objectives and
policies are effected.
c) It is a bridge through which communication is established between the top
management and the operatives who are to implement the policies of the top
management.
d) The most profitable course of action is selected from the various available
alternatives.
e) A budget is a complete formulation of the policy of the undertaking to be pursued for
the purpose of attaining a given objective.
2. Coor di nation:
Coordination is "the orderly arrangement of group effort to provide unity of action in
the pursuit of a common purpose". In other words, it means developing and maintaining
various activities within the concern in proper relationship with one another.
Coordination of the various activities is also achieved by operating the technique of
budgetary control. This is clear from the fact that the budgets are not prepared by the
line and functional managers in isolation. A budget is prepared for the business as a
whole. The sales manager, for instance, has to base his budget on the volume of
production the production manager is capable of doing. Similarly the cash manager
must take into account the amount and the timing of the revenues to be received from
sales. Thus the various departmental budgets are interdependent, and when they are
integrated into the master budget, the targets set are capable of achievement only when
there is cooperation between the executives. In other words, budgetary control forces
the executives to think, and think as a group.
3. Control:
Planning is not the means of control. It generates the need for control. In fact nothing
can be achieved by just laying down the objectives and hoping that the desired
objectives will be accomplished. It is therefore necessary to provide a mechanism
whereby control can be exercised over the activities of the business. This is especially so
in the case of a large concern where it is difficult for the chief executive to supervise
personally the day-to-day operations.
Budgetary control makes control possible by continuous comparison of actual
performance with that of the budget so as to report the variations from the budget to the
management for corrective action. Thus budgeting system integrates key managerial
functions as it links top management's planning function with the control function
performed at all levels in the managerial hierarchy. The need to keep a strict control
over costs is thus impressed upon every manager. Budgetary control makes every
manager becomes cost conscious. Since he is continually supplied with information
which tells him whether he is accomplishing his target, there is an opportunity to take
corrective action before it is too late. Hence proper control can be exercised over
expenditure.
BUDGETARY CONTROL AS A MANAGEMENT TOOL
Budgetary Control has become an essential tool of management for controlling costs and
maximising profits. It may be conceived as one of the supreme examples of rationality in
management. It is a useful management tool for comparing the current performance
with the pre-planned performance with a view to attain equilibrium between ends and
means, output and effort. It corrects the deviations from the pre-planned path through
observation, research planning, control and decision making, and thus helps in the
performance of future activities in an orderly way. It uncovers uneconomies in
operations, weaknesses in the organisation structure, and minimises wasteful spending.
It acts as a friend, philosopher, and guide to the management. Its advantages to
management can be summarised as follows:
1. The establishment of divisional and departmental responsibilities involved in
budgeting prevents buck-passing when the budget figures are not achieved.
2. It coordinates the various divisions of a business - production, marketing,
financial and administrative decisions. This facilitates smoother operation and
less internal friction which results in the achievement of a budget goal.
3. It forces management to give timely and adequate attention to the expected
trend of general business conditions, and stabilises conditions in industries
which are subject to seasonal and cyclical fluctuations.
4. The centralisation of budgetary control over all divisions and departments
helps in carrying out a uniform policy without the disadvantage of an
authoritarian type of business organisations.
5. The use of budget figures as measures of operating performance and financial
position makes possible the adoption of the standard costing principles in
divisions other than the production division.
6. It facilitates management by exception, and timely correction of significant
deviations from the targets set.
7. Advance planning inherent in the budgets is looked upon with favour by credit
agencies as indicative of sound management.
8. Being a means of communication, it enables lower levels of management to
understand the basic objectives and policies of the concern.
9. In the presence of an effective budgetary control system, the purchase of stores
is based upon predetermined requirements for raw materials and this helps to
prevent stock shortages as well as excessive purchases. Work-in-process
inventories are kept to a minimum because of predetermined production
requirements, and finished goods inventories are maintained at a level necessary
to meet the predetermined schedule of sales. Thus, it ensures the availability of
sufficient working capital and diverts capital expenditure into the most profitable
channels.
10. Budgeting guards against undue optimism leading to over-expansion because
the targets are fixed by the executives after careful and cool thought.
11. As goals are set up for being attained and achievements or failures are
revealed only with reference to these goals, results can be viewed objectively with
minimum of personal prejudice.
LIMITATIONS OF BUDGETARY CONTROL
1. The usefulness of budgeting depends upon the extent to which forecasts can be relied
upon. Since forecasting cannot be considered to be an exact science, the accuracy of the
data on which the estimates are based determines the adequacy or otherwise of a
budgetary programme. If forecasts are made on the basis of inadequate and inaccurate
data, the budgeted figures would be far from reality and the targets set would also be
inaccurate.
2. As budgets are prepared by quantifying all relevant data, there is tendency to attach
some sort of finality to budget figure. But as they are meant to deal with business
conditions that are constantly changing, they would lose much of their usefulness if they
acquire rigidity. Therefore it is essential that budgetary programme must be
continuously adapted to changing conditions in and off a business unit.
3. Budgetary Control implies the preparation of budgets and their administration also.
As such, mere preparation of budgets does not mean that their execution is automatic.
Since budgets are related to the executives concerned, their implementation demands
unified effort of all the personnel in the organisation. In other words, budgetary control
demands active cooperation between the different levels of management. But there may
be active and passive resistance to budgetary control, as it points to the efficiency or
inefficiency of individuals. The opposition is also due to the human nature i.e., the
tendency to resist change. Chris Agris has in his study of "Human Problems with
Budget" has pointed out the following reasons for a high degree of negative reaction
against budgeting on the part of front line managers.
a) Budgets are evaluation instruments. They tend to set goals against which the
people are measured and hence they naturally are complained about.
b) Some of the supervisors tend to use budgets as "whipping posts" in order to
release their feelings about many (often totally unrelated) problems.
c) Budgets are thought of as pressure devices. As such, they produce the same kind
of unfavorable reactions as other kinds of pressures do, regardless of origin.
4. Budget is only a management tool. It cannot substitute management. In other words,
a budget is not designed to reduce the managerial function to a formula; it is a
managerial 'tool'.
5. Budgeting necessitates the employment of specialised staff and this involves
expenditure, which small concerns may not attend. Even in the case of big concerns, the
usefulness of budgetary control should be viewed from the point of view of cost. Hence it
is essential that there must be some correlation between the cost of the system and the
benefits obtained from it.
In spite of these limitations, it can be safely said that the technique of budgetary control
is a must for each business enterprise. It leaves sufficient time for the top management
for formulation of overall policy and planning. Much success can be achieved if the top
management devotes attention chiefly to unusual or exceptional items that appear in
daily, weekly and monthly statements and reports. In the words of J.R. Batliboi, "The
success of budgetary control must depend on the adequacy and reliability of records, the
past and the present performances, on the interest of all executives and subordinates in
the purposes of such control, proper departmentalisation and subdivision of factory
activities, a close classification and proper division and analysis of the expenditure, and
the most suitable system of cost and financial accounts."
ORGANISATION FOR BUDGETARY CONTROL
The preparation and implementation of budgets demand a sound and efficient
organisation. The creation of a formal organisation is thus necessary for the installation
of a budgetary control system. An effective organisation for the system of budgetary
control is laid out on the following lines:
(1) Installation of Budget Centres
A budget centre is located within the four corners of the organisation of an enterprise
and is defined as a "Section of the organisation of an undertaking defined for the
purposes of budgetary control". Since preparation of budgets and their implementation
are both entrusted to the same person, it is necessary to establish budget centers so that
a budget may be prepared for each centre by the concerned head. To illustrate,
production manager has to be consulted for the preparation of production budget, and
finance manager for cash budget. Under mechanized accounting system budget centers
are also numbered.
(2) Preparation of Organization Chart
There should be an organization chart for effective budgetary control. It highlights the
functional responsibilities of each member of the management and thereby makes it
possible for him to know his position in the organisation hierarchy as also his
relationship to other members. A specimen of the organisation chart is given below:
The above chart shows that the Chief Executive is the head of the budgetary control
system. He delegates his authority to the Budget Officer who sees that all budgets are
coordinated and drawn in time. The other managers prepare the budgets shown against
them in the chart. Thus budgetary control is a concerted action in which all individuals
take part and there must be coordination in order to have proper link among them.
When there is a clear-cut division of responsibility and authority, no overlapping will be
there. It would create team work and a spirit of cooperation among the staff, ultimately
leading to high degree of budget consciousness.
(3) Establishment of Budget Committees
The responsibility for budgeting and implementation is laid down on (i) Budget
Committee and (ii) Budget Officer
Budget Committee is a permanent standing committee consisting of General Manager
as the Chairman and other departmental executives. The functions of the budget
committee are:
a. To assist departmental managers in the work of forecasting by supplying past
information.
b. To receive instructions concerning the general policy to be followed.
c. To receive and review individual budget estimates relating to different functions.
d. To suggest budget revisions
e. To approve the revised budgets
f. To receive from time to time budget reports comparing actual results with the budgets
g. To allocate responsibilities and recommend corrective action where necessary.
Budget Officer is the head / secretary of the formal budgetary control organisation,
sometimes designated as Budget Director or Budget Controller. He derives authority
from the Chief Executive and is directly responsible to him for the functions assigned to
him. It is the duty of the Budget Officer to coordinate the work connected with the
budget. His chief duties are:
a. To advise the Chief Executive, departmental managers and budget committee on
budgetary' matters.
b. To assume responsibility of budgeting and budgeting organisation.
c. To recommend techniques and procedures of budgeting, provide schedules, forms,
and statements of reports and also the necessary statistical data.
d. To assist in the preparation, and revision of budgets and budget manual.
e. To ensure proper system of communication at all levels of management, and
f. To supervise execution of budgets, analyse variances in performance, and suggest
suitable actions.
(4) Budget Period
It is a period for which a budget is prepared and employed. Since planning, and
therefore budgeting must be related to a specific period of time, it is necessary at the
outset, to specify the length of the period for which the budget is prepared and used.
The factors governing the length of the budget period are:
(a) Nature of the demand for the product.
(b) Length of the trade cycle.
(c) The production cycle.
(d) Functional area covered by the budget.
(e) Need for control of operations.
(f) Time interval necessary for financing production well in advance of actual needs.
(g) The accounting period.
For example in case of seasonal industries (i.e., food or clothing) the budget period
should be a short one and should cover one season. But in case of industries with heavy
capital expenditure like heavy engineering works, the budget period should be long
enough to meet the requirements of the business. From control point of view, the budget
period should be a short one so that the actual results may be compared with the budget
each week end or month end and discussed with the Budget Committee. Long term
budgets should be supplemented by short term budgets to make the budgetary control
successful, as short term budgets help in exercising control over day-to-day operations.
In short, the budget period should not be too long, so that the estimates don't become
unreliable. Similarly, it should also not be to short, so that there is sufficient time before
budget implementation. For most businesses, annual budget is quite common because it
compares with the financial accounting year.
There should be a regular time plan for budget preparation. It may be on the following
lines:
I. Long term budgets for three to five years should be prepared for expansion and
modernisation of the undertaking, introduction of new products or new projects
and undertaking heavy advertisement.
II. Annual budgets coinciding with financial accounting year should be prepared
for operational activities viz., sales, purchase, etc.
III. For control purposes, short term budgets - monthly or even weekly - should
be prepared for watching progress of actual performance against targets. Short-
term budgets are prepared to see that actual performance is proceeding according
to the budgets and early corrective action may be taken if there is any pitfall.
(5) Determination of the Key Factor
The sequence of preparation of budgets is determined by the Key Factor or the
"Principal Budget Factor". The ICMA London defines it as "The factor, the extent of
whose influence must first be assessed in order to ensure that the functional budgets are
reasonably capable of fulfillment". Key Factor represents some powerful influence which
so dominates business operation as to represent obstacles in the achievement of the
ambitions contained in the functional budgets. Therefore, it becomes necessary to assess
its impact right in the beginning of the budgetary process.
Also called 'limiting or governing' factor, the key factor serves as the starting point for
the preparation of the budget. After the determination of the Key Factor, the relevant
budget is first prepared and integrated with other budgets after being reconciled. It is
possible that there may be two or more limiting factors at the same time. Under such
conditions, the budget preparation has to reckon the relative impact of these factors,
which is done with the help of graphs, linear programming, operations research etc.
For example, a concern has the capacity to produce 50,000 units of a particular item per
year. But only 30,000 units can be sold in the market. In this case, low demand for the
product is the limiting factor. Therefore, sales budget should be prepared first and other
functional budgets such as production budget, labour budget etc., should be prepared in
accordance with the sales budget. Suppose another concern has no sales problem and
can sell whatever it produces. In this case, plant capacity is limited. Therefore,
production budget should be prepared first and other budgets should follow the
production budget.
The following are the key factors which can possibly affect budgeting:
i. Materials
(a) Shortage due to non-availability
(b) Shortage due to restrictions imposed by licenses, quotas etc
ii. Labour
(a) General shortage
(b) Shortage of certain grades of labour
iii. Plant
Insufficiency due to
(a) Shortage of supply
(b) Lack of capital
(c) Lack of space
(d) Bottlenecks in certain key processes
iv. Sales
(a) Consumer demand
(b) Insufficient advertising
(c) Shortage of good salesmen
v. Management
(a) Overall paucity of capital
(b) Limited availability of expertise - technical and managerial
(c) Flogging research effort in respect of methods of production, production design, etc
The Key factors should be correctly defined and diagnosed. Budgets will be meaningless
unless key factors are considered in depth. However, the key factors are not of a
permanent nature and they can be overcome by the management in the long run if an
effort is made in this direction by selecting optimum level of production, dealing in
more profitable products, introducing new methods, changing material mix, working
overtime or extra shifts, providing incentives to workers, hiring new machinery etc.
(6) Budget Manual
As the budgetary system gets into stride, it becomes essential to systematize the
procedure for the preparation of various budgets. Generally the practice is to arrange
this by means of a budget manual which has been described by ICMA, London, as "a
document which sets out the responsibilities of persons engaged in the routine of, and
the forms and records required for budgetary control".
Thus a budget manual specifies in detail the procedures to be followed, the forms to be
used, and the responsibilities of those who take part in the budgeting process. The
manual formalises budget procedure and avoids misunderstanding.
The following are some of the important matters covered in a budget manual:
i. A statement regarding the objectives of the organisation and how they can be achieved
through budgetary control.
ii. A statement regarding the functions and responsibilities of each executive by
designation both regarding preparation and execution of budgets.
iii. Procedures to be followed for obtaining the necessary approval of budgets. The
authority of granting approval should be stated in explicit terms.
iv. Time tables for all stages of budgeting.
v. Reports, statements, forms and other documents to be maintained.
vi. Accounts code in use. It is necessary that the framework within which the costs,
revenues and other financial amounts are classified must be identical both in the
account and the budget departments.
(7) Preparation of Budgets
The top management should defend the objectives and policies in clear terms. The goals
set should be realistic and attainable. Then the budget estimates are prepared by the
executives-in-charge of different functions. The budget programme should be
comprehensive, covering all activities of the undertaking.
General sales budget is made by the Sales Manager. If there is any other key factor, the
budget estimate of such factor may be prepared first. Budget Committee discusses these
estimates and gives tentative approval. Thereupon, other executives submit their
estimates relating to production, plant utilisation, material, hour expenses etc. Cash
budget is prepared on the basis of sales and production cost and other budgets. These
are discussed in Budget Committee and with modifications, as necessary, budgets are
drawn up. All budgets are incorporated into a Master Budget which is to be approved by
the top management and put into action. All budgets may be revised from time to time
taking into account the current developments.
ESSENTIALS FOR EFFECTIVE BUDGETING
(a) Support of Top Management
Though a budget programme, in order to be successful, must have the whole-hearted
support of every member of management, the impetus and direction must come from
the top. This requires commitment of top management to the budget idea as well as to
the principles, policies and philosophy underlying it.
(b) A Clearly Defined Organisation
There should be a sound plan of organisation with responsibilities defined. The records
should be clearly departmentalised and established in such a manner as will indicate
definite responsibility on each unit or section of the business. Certain responsible
officers must be given the power to carry out the arranged policies, to administer the
budgets, and to exercise control over the results by authorising them to take up
corrective measure wherever necessary.
(c) Motivational Approach
People resist pressure and therefore budgeting should not be a pressure device.
Motivational approach towards budgeting should be adopted.
(d) Preparation by Responsible Executives
Every executive responsible for the implementation of budgets should be given an
opportunity to take an active part in the preparation of the budgets. In other words,
subject to the control of the Budget Director and the Budget Committee, those who are
responsible for performance should be made responsible for the preparation of their
budgets also.
(e) A Clearly Defined Policy
It is imperative for the management to define, in clear and unambiguous terms, its
policies and instructions relating to production, price and profit, personnel,
advertisement and sales promotion, capital expenditure projects etc. The policies
constitute the foundation upon which the budgets are framed.
(f) Accurate Accounting System
The system of accounting in the business should be such as to hold each part of the
organisation to its responsibilities. The budget fosters coordinated action and wherever
this is broken or interfered with, the responsible factor should be unmistakably
revealed. The accounting system should make it possible to establish such responsibility
beyond doubt.
(g) Logical Sequence in the Budget Preparation
It is essential that proper procedure is evolved for the preparation, submission,
examination, and review of budget figures in logical sequence. Budget preparation often
demands much careful thought and attention on the part of the entire staff of the
business unit engaged in the compilation of various figures.
(h) Flexibility
Budgetary programme should be designed to accommodate unforeseen circumstances
as well as possible changes in future. The question of flexibility is tackled through
'Flexible Budgets'.
(i) Budget Education
It is equally important that everyone in the organisation knows the working of the
budget programme and its benefits. 'Budget Manual' is a very useful guide in imparting
budget education. If budget education is neglected, the possible result would be
compiling figures for the sake of compiling, and framing policies for the sake of policies.
(j) Human Factor
The management should not forget that they are dealing with human beings who have
since ancient times resented and rebelled against domination, whether in the form of
complete slavery or economic and political coercion. The management should therefore
prefer 'control through objectives' rather than 'control through domination'. In other
words, control should not be influenced by the personality of the superior or
subordinate. It should be definite, determinable and verifiable.
(k) Good Reporting System
Budget cannot be successful unless there is a proper feedback system. The reporting
system should be so devised that it not only tells about major variations but also the
persons who are responsible for these variations. For this purpose, periodical
statements comparing the actual performance with the budgeted performance should be
prepared. The cause of variances should be analysed and the management should be
kept informed about major variances working on the principle of management by
exception. Proper, remedial measures should be taken by the management at
appropriate level and at appropriate time.
MODEL QUESTIONS
1) What do you understand by 'Budgetary Control?' Explain its significance.
2) What are the factors influencing the selection of a budget period between two firms
carrying on diverse activities?
3) Explain the objectives of budgetary control.
4) "Budgetary control improves planning, aids in coordination, and helps in having
comprehensive control" - Elucidate.
5) What is a budget manual? What are its contents?
6) Elaborate the main steps involved in budgetary control
7) What is a principal budget factor? Give a list of such factors.
- End of Chapter -
LESSON - 20
CLASSIFICATION OF BUDGETS
Different types of budgets have been developed keeping in view the different purposes
they serve. Budgets can be classified according to:
The coverage they encompass;
The capacity to which they are related;
The conditions on which they are based; and
The periods which they cover
CLASSIFICATION ACCORDING TO COVERAGE
(1) FUNCTIONAL BUDGETS
A functional budget is one which relates to a function of an undertaking. Accordingly a
budget is prepared for every function of the business and these budgets become
subsidiary to the master budget for the business as a whole. The number of functional
budgets depend upon the size and nature of a business. However the following
functional budgets are prepared by a concern operating comprehensive budgetary
control system:
i. Sales budget
ii. Production budget
iii. Production Cost budget
iv. Personnel budget
v. Plant Utilisation budget
vi. Administrative Cost budget
vii. Selling and distribution Cost/Overhead budget
viii. Capital Expenditure budget
ix. Cash budget
x. Research and Development budget
i. Sales Budget
It is a forecast of total sales during a period, expressed in money and/or quantity terms.
It is analysed by products, sales territories and salesmen, periods and types of
customers such as individual or institutional, government or private, home market or
export, wholesale or retail.
In most cases sales budget is not only the most important one, but also the most difficult
to prepare. It forecasts what the business can reasonably expect to sell to its customers
during the budget period. Including within its fold both the sales quantities as well as
sales revenue, sales budgets represent the income side of the planning budget. Every
effort should be made to ensure that its figures are as accurate as possible because this is
usually the starting budget (sales being limiting factor on which all the other budgets are
built up). In preparation of the sales budget, the sales manager should take into
consideration the following factors:
- Historical analysis of sales - The record of previous year's sales is the most
reliable guide as to future sales, as the past performance is related to actual
business conditions. The compiler of the sales budget should be assisted by graphs
recording sales of the previous years and the general sales trend (upward and
downward) should be noticed from the graphs. But in addition to the past sales,
other factors affecting future sales e.g., seasonal fluctuations, growth of market,
trade cycle etc., should be considered in the preparation of the sales budget.
- Salesmen's Estimate - Salesmen, who are men on the spot, may be asked to
make an estimate of the probable sales they could affect in their respective areas
during the budget period. Owing to their intimate contact with the market and the
customers, they are likely to make a realistic estimate of the sales potential.
However the estimates should be used only after testing the conclusions reached at
by the other methods, since the opinion of the salesmen might sometimes be
biased.
- Plant Capacity - It should be the endeavour of the business to ensure proper
utilisation of plant facility and that the sales budget provides for an economic and
balanced production in the factory.
- General Trade and Business Conditions - The demand for a product and
hence its sales are also affected by the general conditions prevailing in the
business world. A change in political or economic conditions is bound to influence
the volume of sales. Besides getting familiar with these changes, it is also
necessary to get information about competing concerns to assess the strength of
competition. Further, information about complementary industries would also be
useful in estimating the assistance to be derived from them.
- Availability of Raw Materials and Other Supplies - Adequate supply of
raw materials and other supplies should be ensured before preparing the sales
estimates, which will then be adjusted according to the availability of raw
materials if in short supply.
- Orders in Hand - In case of industries where production is quite a lengthy
process, orders on hand may have a considerable influence on the amount of sales
projections.
- Seasonal Fluctuations - In preparation of the sales budget, seasonal
fluctuations should be considered because the sales are affected by these
fluctuations. In order to ensure an even flow of production, efforts should be made
to minimise the effects of seasonal fluctuations on sales by giving special
concessions or added inducements during the off-season time.
- Financial Aspect - Expansion of sales usually requires an increase in capital
outlay also; therefore, sales budget must be within the bounds of financial
capacity.
- Adequate Return on Capital Employed - The sales volume budgeted should
produce an adequate return on capital employed.
- Potential Market - Market research must be carried out for ascertaining the
potential market for the company's products. Such an estimate is made on the
basis of expected population growth, purchasing power of consumers and buying
habits of the people.
- Other Factors - Nature and degree of competition within the industry, cost of
distributing goods, government controls, rules and regulations related to the
industry, and political situation - national and international - these factors also
can have an influence on the market.
The Sales Manager, after taking into consideration all these factors, prepares the sales
budget in terms of quantities and money, distinguishing between products, periods and
areas of sales.
Illustration:
A company has four sales divisions. Each division consists of four areas -North, South,
East and West. The company sells two products A and B. The budgeted sales for six
months ended 31st December 1992 in each area of Division I were as follows:
North East
A - 8,000 units at Rs. 6 each A - 12,000 units at Rs. 6 each
B - 5,000 units at Rs. 4 each
South West
B - 10,000 units at Rs. 4 each A - 7,000 units at Rs. 6 each
The actual sales for the same period in Division I were as follows:
North East
A - 9,000 units at Rs. 6 each A - 14,000 units at Rs. 6 each
South West
B - 11,000 units at Rs. 4 each A - 7,500 units at Rs. 6 each
From the salesmen's reports and observations of the area sales managers, it is thought
that sales could be budgeted for six months ended 30th June 1993 as follows:
North
A - Budget increase of 3,000 units on December, 1992 budget
B - Budget increase of 300 units on December, 1992 budget
South
East
A - Budget increase of 2,500 units on December, 1992 budget
West
A - Budget increase of 800 units on December, 1992 budget
Further, at a meeting of the area sales managers with the divisional sales manager, it
was decided to launch an intensive advertising campaign in areas South and East. It was
anticipated that these campaigns will result in additional sales of 4,000 units of A in the
Southern area and 6,000 units of B in the Eastern area.
Prepare for presentation to the budget committee, the sales budget for the six months
ended 30th June, 1993, showing also the budgeted and actual sales for December 31,
1992.
Solution:
Sales Budget
Division No. I (Period: 6 months ended 30th June, 1993)
Area Production
Budget June 30,
1993
Budget Dec 31, 1992 Actual Dec 31, 1992
Qty
Price
(Rs.)
Value
(Rs.)
Qty
Price
(Rs.)
Value
(Rs.)
Qty
Price
(Rs.)
Value
(Rs.)
1 2 3 4 5 6 7 8 9 10 11
North A 11000 6 66000 8000 6 48000 9500 6 57000
B 5300 4 21200 5000 4 20000 6500 4 24000
Total 16300 87200 13000 68000 15500 81000
South A 4000 6 24000 --- 6 --- --- 6 ---
B 10800 4 43200 10000 4 40000 11000 4 44000
Total 14800 67200 10000 40000 11000 44000
East A 14500 6 87000 12000 6 72000 14000 6 84000
B 6000 4 24000 --- 4 --- --- 4 ---
Total 20500 111000 12000 72000 14000 84000
West A 7800 6 46800 7000 6 42000 7500 6 45000
B 3300 4 13200 3000 4 12000 4200 4 16800
Total 11100 60000 10000 54000 11700 61800
All A 37300 6 223800 27000 6 162000 31000 6 186000
B 25400 4 101600 18000 4 72000 21200 4 84800
Total 62700 325400 45000 234000 52200 270800
Sales Forecast and Sales Budget:
A sales forecast may be just a guess of sales without taking into consideration
production capacity and may lack an objective to control the actual performance. On the
other hand, estimate of the sales given in the sales budget is not a mere guess; it is based
on the plant capacity, availability of material, labour and working capital, and many
other considerations. It is capable of being achieved; so it is amenable to control.
ii. Production Budget
It is a forecast of the output for the period analysed according to products,
manufacturing departments, and periods of production (i.e., by month). It is prepared
simultaneously with preliminary sales budget.
The objectives of production budget are:
- To bring to a common focus all the factors necessary to establish policies and to
determine operations.
- To project these established policies into the future by an analysis of past
performances.
- To plan and control the operations being carried out to implement policies
decided upon.
- To make provision for materials at right time and place.
- To plan the sequence of operations required for economical production.
- To coordinate the various aspects of factory operation as to make them a vital
link in the chain of profitable programme.
Production budget is prepared after taking into consideration the estimated opening
stock, the estimated sales and the desired closing finished stock of each product.
Suppose the opening stock of Product X is 2,000 units, the estimated sales is 15,000
units, and the closing stock of the product is 2,500 units, then the estimated production
will be 15,000 + 2,500 - 2,000 (Sales + Closing stock - Opening stock) = 15,500 units.
The works manager is responsible for the departmental production budget.
There are two problems connected with the production budget:
I. Determining the annual production required
II. Pro-rating it throughout the year
The planning of production programme is essential to have sufficient stock for sales, to
keep inventories within reasonable limits, and to manufacture goods most economically.
To achieve it, the following factors should be taken into consideration:
- Inventory policies - Inventory standards should be pre-determined so that
there is neither a shortage nor over-stocking of goods.
- Sales requirements - The quantity of goods to be sold would decide, to a great
extent, how much is to be produced. Therefore this budget depends upon the sales
budget.
- Production stability - For reduction of costs, stability in employment and
better utilization of plant facility, the production should be evenly distributed
throughout the year. In case of seasonal industries, since it is not possible to have
stable levels of production or inventory, an effort should be made to have the
optimum balance between the two.
- Plant capacity - How much can be produced depends upon the available plant
capacity. There must be sufficient capacity to produce the annual requirements
and meet seasonal high demands.
- Availability of materials and labour - Adequate and timely supply of raw
materials and labour force should have an important effect on the planning of
production.
- Time taken in production process - The production should commence well
in time keeping in view hew much time it would take in the factory to convert the
raw materials into finished goods.
Illustration:
Prepare a production budget of Ibcon Limited for 1993-94 from the following
information:
Products
Sales as per Sales
Budget (in units)
Estimated Stock (in
units)
1 July
1993
30 June
1994
P 4,88,000 10,000 12,000
Q 3,75,000 20,000 45,000
R 6,00,000 50,000 25,000
Solution:
IBCON Ltd - Production Budget
P units Q units R units
Estimated sales 4,88,000 3,75,000 6,00,000
Add: Stock to be maintained on 30.06.94 12,000 45,000 25,000
Total 5,00,000 4,20,000 6,25,000
Less: Estimated quantity of opening stock 10,000 20,000 50,000
Estimation of production 4,90,000 4,00,000 5,75,000
iii. Production Cost Budget
After determining the volume of output, the cost of procuring the output must be
obtained by preparing a cost of production budget. This budget is an estimate of cost of
output planned for a budget period and may be classified into material cost budget,
labour cost budget and overheads budget because cost of production includes material,
labour and overheads:
Materials Budget - Materials budget shows the estimated quantity and cost of
materials required for production and maintenance of plant and equipment. It is based
upon production requirements, stock available at the beginning of the budget period,
stocks required to be built up during the budget period, purchase orders already made,
storage space, economic order quantity, lead time, price trends, stock levels, availability
of finance etc. The materials budget generally deals only with the direct materials.
Indirect materials are generally included in overhead budget.
The preparation of the materials budget includes the following activities:
a) Preparation of estimates of raw materials requirements.
b) Scheduling of purchases in required quantities at the required time.
c) Controlling of raw material inventories.
The objectives served by the material budgets are:
i. To give information regarding the stock position.
ii. To help make estimates of the total quantity of all materials required for
production.
iii. To arrive at the costs of the various raw materials.
iv. To provide the purchasing department with data required for formulating
purchase programme.
In preparing the materials budget the following factors are considered:
- Raw materials are required for the budgeted output.
- Percentage of raw materials to total cost of products: It should be calculated on
the basis of previous records. On the basis of this percentage a rough total value of
raw materials required for the budgeted output will be ascertained.
- Company's stocking policy: Figures related to the anticipated raw material stock
to be held at different times should be known.
- Time lag between the placing of order for materials and the receipt of materials
- Seasonal nature of availability of raw material should be considered.
- Price trend in the market.
The materials budget can be classified into two categories:
(i) Materials Requirement budget and
(ii) Materials Procurement or Purchase budget.
The former tells about the total quantity of materials required during the budget period,
while the latter tells about the materials to be acquired from the market during the
budget period.
Illustration:
The sales director of a manufacturing company reports that next year he expects to
sell 50,000 units of a product. The production manager consults the storekeeper
and casts his figures as follows:
Two kinds of raw materials A and B are required for manufacturing the product.
Each unit of the product requires 2 units of A and 3 units of B. The estimated
opening balances at the commencement of the next year are - finished product =
10,000 units; A = 12,000 units; B = 15,000 units. The desirable closing balances at
the end of the next year are - finished product = 14,000 units; A = 13,000 units; B
= 16,000 units.
Draw up a quantitative chart showing the materials purchases budget for the next
year.
Solution:
Production Budget for the year
Particulars Units
Sales during the year 50,000
Add: Desired stock at the end of next year 14,000
64,000
Less: Expected stock at the beginning of the next year 10,000
Estimated production for the next year
54,000
Purchase Budget for the year
Particulars
Material A
units
Material B
units
Consumption during the year:
A = 54,000 x 2 units 1,08,000
B = 54,000 x 3 units 1,62,000
Add: Desired stock at the end of the year 13,000 16,000
1,21,000 1,78,000
Less: Expected stock at the beginning of the
year
12,000 15,000
Quantity of materials to be purchased
1,09,000 1,63,000
Direct Labour Budget - Direct labour budget is a forecast of the requirements of
direct labour essential to meet the production targets.
This budget may be classified into:
(i) Labour Requirement budget, and
(ii) Labour Recruitment budget.
The former is developed on the basis of requirement of the given production
budget and detailed information regarding different classes of labour e.g. fitters,
welders, millers, grinders, drillers etc., required for each department, their scales
of pay and hours to be spent. This budget is prepared to enable the personnel
department to carry out training and transfer programmes, to find out sources of
labour needed so that the difficulties in production due to lack of suitable
personnel can be removed. Labour recruitment budget is prepared after taking
into consideration the available workers in each department, the expected labour
turnover during the budget period. In preparing labour cost budget, 'overtime'
should not be overlooked because workers are entitled to get higher wages if they
work overtime. Regular overtime should be avoided by engagement of additional
workers and extension of plant. Where standard costing system is applied, the
labour cost budget is developed on the basis of standard labour cost per unit
multiplied by the quantity of anticipated production mentioned in production
budget. If standard costing system is not adopted, information on labour costs
may be obtained from the past records or estimated costs.
Illustration:
The direct labour hour requirements of three of the products manufactured in a
factory, each involving more than one labour operation, are estimated as follows:
Direct labour hours per unit (in minutes)
Operation Products
1 2 3
1 18 42 30
2 - 12 24
3 9 6 -
The factory works 8 hours per day, 6 days in a week. The budget quarter is taken
as 13 weeks and during a quarter, lost hours due to leave and holidays and other
causes are estimated to be 124 hours.
The budgeted hourly rates for the workers manning the operation 1, 2 and 3 are
Rs. 2.00, Rs. 2.50 and Rs. 3.00 respectively.
The budgeted sales of the products during the quarter are:
Product
1 9,000 Units
2 15,000 Units
3. 12,000 Units
Prepare a manpower budget for the quarter showing for each operation for (i)
director hours, (ii) direct labour cost, and (iii) the number of workers.
Solution:
Quarterly Manpower Budget
Operation
Hourly
rate
(Rs.)
Product 1 Product 2 Product 3 Total
No. of
workers
D L
(hrs.)
Cost
(Rs.)
D L
(hrs.)
Cost
(Rs.)
D L
(hrs.)
Cost
(Rs.)
D L
(hrs.)
Cost
(Rs.)
I 2.00 3,000 6,000 7,000 14,000 5,000 10,000 15,000 30,000 30
II 2.50 --- --- 2,000 5,000 4,000 10,000 6,000 15,000 12
III 3.00 1,500 4,500 1,000 3,000 --- --- 2,500 7,500 5
Total 4,500 10,500 10,000 22,000 9,000 20,000 23,500 52,500 47
Working Notes:
Production Budget
Product 1 (units) 2 (units) 3 (units)
Sales 9,000 15,000 12,000
Add: Closing stock 1,000 --- 2,000
Less: Opening stock --- 5,000 4,000
Production Budget 10,000 10,000 10,000
Total available hours per man in a quarter
Total hours = 8 x 6 x 13 = 624
Less: Hours lost due to leave etc = 124
Total available hours per man = 500
Calculation of direct labour hours, direct labour cost and number of
men (Illustrated for product I)
Direct labour hours = 18 x 10,000/60 = 3000
Direct labour cost = 3000 hours x Rs.2 = Rs.6000
Number of men required = Direct labour hours required / Total available hours
per man
= 15000/500 = 30 men
Similarly calculations have been made for the other products also, and shown in
the budget table above.
Factory Overheads Budget - This budget represents the forecast of all production
overheads, which are divided into variable expenses, semi-variable expenses and fixed
overheads/expenses. Variable and semi-variable expenses vary with the level of activity;
fixed overheads may also vary e.g., when it is necessary to increase the size of the factory
or the number or size of the machine included therein.
A factory consists of production and service departments. A production department is
one in which actual productive operations are performed. Service departments are those
anciliary to the production departments and are created to facilitate manufacture of
products at the factory. Each item of expense should be individually considered and
charged to the appropriate department in which it arises. The overheads apportioned to
the service departments are totalled and allocated to the production departments on an
agreed basis, which is determined by the production department's use of the services
available. Whether the production departmental charges are allocated to product
operations in the departmental will depend upon the decision of the management.
The cost accountant prepares this budget on the basis of figures available in the
manufacturing overhead budget or the head of the workshop may be asked to give
estimates for the manufacturing expenses. A good method is to combine the estimates of
the cost accountant and shop executives.
Illustration:
From the following average figures of previous quarters, prepare a manufacturing
overhead budget for the quarter ending March 31, 1993. The budgeted output
during this quarter is 4,000 units.
Fixed overheads = Rs. 20,000
Variable overheads = Rs. 10,000 (varying @ Rs. 5 per unit)
Semivariable overheads = Rs. 10,000 (40% fixed, 60% varying @ Rs. 3 per unit)
Solution:
Manufacturing Overheads Budget for the Quarter Ending March 31,
1993
Fixed overheads Rs. 20,000
Variable overheads Rs. 20,000
Semivariable overheads:
Fixed = Rs. 4,000
Variable @ Rs. 3 per Unit = Rs. 12,000 Rs. 16,000
Total Variable cost Rs. 56,000
iv. Personnel Budget
This budget is a forecast of the requirements of direct and indirect labour for various
production and service departments during the budget period. It is based upon
production budget, sales budget, capital expenditure budget, research and development
budgets etc.
Direct and indirect labour requirements are represented by this budget in terms of
money, number, grades of personnel, number of working hours etc. Besides showing the
number of each grade of workers to achieve the budgeted output and the estimated cost
of such labour during the budgeted period, this budget should also make provision for
the period of training necessary for new workers, shifts and overtime work, and the
possibility of new wage agreements.
Uses of personnel budget:
It facilitates efficient labour management;
It reduces labour turnover;
It guides recruitment policy to avoid surplus workforce;
It stabilises the proportion of direct and indirect labour; and
It helps in arranging funds for timely payment of wages.
v. Plant Utilization Budget
This budget represents plant and machinery requirements to meet budgeted production
during the budget period. Plant capacity is expressed in the budget in terms of
convenient units, such as working hours, or weight, or the number of products.
The main purposes of this budget are:
- to determine the machine load on each department.
- to indicate overloaded departments for taking suitable actions such as allowing
overtime, or transferring work to other departments, or getting work done from outside
or expanding plant;
- to adjust sales and production according to plant capacity.
vi. Administrative Overheads / Cost Budget
This budget covers the expenses incurred in framing policies, directing the organisation
and controlling the business operations. In other words, it covers estimated expenditure
of administrative offices and management salaries. Budget is prepared on departmental
basis for ensuring control over expenses by fixing responsibility on persons. The
minimum requirements for the efficient operation of each department can be estimated
on the basis of cost for prior years, and after a study of the plans and responsibilities of
each administrative department for the budget period. The budget for the entire
administrative division is prepared by totalling the separate budgets of all
administrative departments. Since a majority of the items of cost relating to this budget
are fixed, preparation of this budget does not present much difficulty. Although fixed
expenses remain constant and are not related to sales volume in the short run, they are
dependent upon sales in the long run. With a small change in output they do not change,
however, if there is a persistent fall in output, administration expenses will have to be
reduced by discharging the services of some members of the staff and taking other
economy measures. On the other hand, with persistent increase in output or business
activity, administration expenses will increase but they may lag behind business activity.
vii. Selling and Distribution Overheads Budget
This budget is the forecast of all costs to be incurred in selling and distributing the
company's products during the budget period. It is closely linked with the sales budget
in as much as it is mainly based on the volume of sales projected for the period.
However, the fact must be kept in view that expenditure may be contemplated during
the budget period, which will have no effect on sales until a future budget period. For
example an advertising campaign may be launched this year which will have no
immediate effect but should influence sales in future.
The following points should be considered in the preparation of this budget:
The channels of distribution of products
The advertising and sales promotion policy
The market area to be covered
The mode of packing and dispatch of products to customers
The credit and collection policy
Costs are divided into fixed, variable and semi variable categories and estimated on the
basis of past experience. The Sales Manager is normally responsible for the preparation
of the selling and distribution cost budget. Nevertheless, he will cooperate with the sales
office manager, distribution manager and the advertising manager or the advertising
agents. Advertising is gradually becoming an increasingly important and costly item in
selling cost budgets so much so that some companies now prepare an advertising
budget.
Illustration:
You are requested to prepare a Sales Overheads Budget from the estimates given below:
Advertisement = Rs. 2,500
Salaries of the sales department = Rs. 5,000
Expenses of the sales department = Rs. 1,500
Counter salesmen's salaries at 1% on their sales = Rs. 6,000
Travelling salesmen's commission is at 10% of their sales and expenses at 5% of their
sales.
The sales during the period were estimated as follows:
Counter Sales Travelling salesmen's sales
Rs. 80,000 Rs. 10,000
Rs. 1,20,000 Rs. 15,000
Rs. 1,40,000 Rs. 20,000
Solution:
Estimated Sales (Rs.)
90,000 1,35,000 1,60,000
Fixed overheads:
Advertisement 2,500 2,500 2,500
Salaries of sales department 5,000 5,000 5,000
Expenses of sales department 1,500 1,500 1,500
Counter salesmen's salaries and DA 6,000 6,000 6,000
Total fixed overheads 15,000 15,000 15,000
Variable overheads:
Counter salesmen's commission @ 1% on
sales
800 1,200 1,400
Travelling salesmen's commission @ 10%
of sales
1,000 1,500 2,000
Travelling salesmen's expenses @ 5% of
sales
500 750 1,000
Total variable overheads 2,300 3,450 4,400
Total overheads 17,300 18,450 19,400
viii. Capital Expenditure Budget
The capital expenditure budget gives an estimate of the amount of capital that may be
needed for acquiring fixed assets required for fulfilling production requirements as
specified by the production budget. Unlike the other functional budgets, the capital
expenditure budget is based upon a long term forecast covering a period of 5 or 10 years.
It is based on such information as:
Overloading as indicated in the Plant Utilisation Budget.
Future development plans to increase the output by buying new and improved
equipment; and
Requests from production department for new machinery, maintenance and
service departments for new equipments, sales and distribution departments for
new vehicles, accounting department for new accounting machines and, decision
of the board to extend buildings.
Departmental heads submit their estimates of capital assets required by their
departments to the Budget Committee. The Committee discusses the urgency and merits
of each item of assets. After considering funds available, it determines the priority of
capital projects. Items to be replaced are considered first.
While budgeting for new projects, the aspects to be remembered are:
- cost of purchase and installation of the asset,
- annual expenditure on repairs and maintenance,
- expected savings in cost; and
- the pay back period (the period within which the cost of the asset is to be recovered).
This budget has to be coordinated with the cash budget for allocation of funds.
ix. Cash Budget
A cash budget is a summary statement of the firm's expected cash inflows and outflows
over a projected time period. In other words, cash budget involves a projection of future
cash receipts and cash disbursements over various time intervals.
It is prepared for the following purposes:
- To ensure that cash is available in time for carrying out business activities and meeting
financial obligations.
- To maintain working capital position secure by making financial arrangements in
advance to overcome shortage of funds.
- To use cash available in the best possible manner.
- To find out whether surplus funds, are available for outside investment.
Cash budget is based on the following information:
- The amount of budgeted monthly cash sales and credit sales.
- The number of months within which bills in respect of credit sales are realised.
- Selling and distribution expenses to be incurred during the month.
- The amount of budgeted monthly cash purchases and credit purchases.
- Number of months allowed for meeting the bills in respect of credit purchases.
- The amount of salaries and wages to be paid.
- Overhead expenses to be incurred.
- Details of capital expenditure to be incurred, and
- Details of administrative expenses, payment of dividend, debenture interests and
miscellaneous income.
The cash budget usually extends over the same period as the master budget. However
for control purposes, it should be analysed to show monthly or weekly requirements of
cash.
This budget is prepared by the chief accountant for the guidance of management, so that
arrangements may be made with the bank to provide the necessary money to meet the
cash requirements of the organisation.
The importance of preparing a cash budget may be more in some trades than in others,
e.g., in trades where there are wide seasonal fluctuations or where long contracts are
undertaken. The negotiation of a bank loan or overdraft can be easily carried through
because cash requirements are estimated sufficiently in advance and potential financial
strains and crisis are avoided by making timely arrangement with the bank.
Construction of Cash Budget:
Preparation of the cash budget is a relatively simple matter in an undertaking with a
complete system of budgetary control because most of the information needed for its
preparation is contained in budgets that precede its formulation. In case a business is
satisfied to confine its system of budgetary control to cash and fixed asset budgets, the
preparation would become a little more involved because the information usually
contained in various operating budgets under a comprehensive budgetary system will
have to be somehow assembled and this is likely to prove difficult owing to the absence
of detailed budgeting.
There are three methods generally used in preparation of cash budget:
(a) Receipts and Payments Method
(b) Adjusted Profit and Loss Method
(c) Balance Sheet Method
Representing different approaches to the preparation of cash budget, the first method is
found useful over short periods while the other two methods are generally used over
long periods.
(a) Receipts and Payments Method - In this method, the cash receipts from
various sources and cash payments to different agencies are estimated. Both
Receipts and Payments may be Capital or Revenue type.
Capital Receipts include the proceeds of issue of shares or debentures or loans to
be raised, and sale proceeds of long-term investments or fixed assets.
Revenue Receipts include amount receivable on cash sales of goods or services,
amount receivable from customers or clients, and other business receipts like
commission, income from investments, etc.
Capital Payments include redemption of redeemable preference shares, payment
of long-term loans, and purchase of fixed assets.
Revenue Payments include payments for materials supplied, payment of wages,
payment of overheads, payments of interest on loans and income tax etc., and
payment of dividends.
In the opening balance of cash for a period, the estimated cash receipts are added
and the estimated cash payments are deducted to find out the closing balance.
This will become the opening balance of cash for the next period.
Opening balance of cash + Estimated cash receipts - Estimated cash payments =
Closing balance of cash
Illustration:
Prepare a cash budget in respect of 6 months from July to December from the
information given as under:
Month
Sales
(credit)
Materials Wages
Overheads
Prodn Admin Selling Distrib R & D
April 100 40 10.0 4.4 3000 1600 800 1000
May 120 60 11.2 4.8 2900 1700 900 1000
June 80 40 8.0 5.0 3040 1500 700 1200
July 100 60 8.4 4.6 2960 1700 900 1200
August 120 70 9.2 5.2 3020 1900 1100 1400
September 140 80 10.0 5.4 3080 2000 1200 1400
October 160 90 10.4 5.8 3120 2050 1250 1600
November 180 100 10.8 6.0 3140 2150 1350 1600
December 200 110 10.6 6.4 3200 2300 1500 1600
Additional Information:
Cash balance on July 1 was expected to be Rs. 1,50,000
Plant and machinery to be installed in August at a cost of Rs.40,000
payable on September 1
Extension to Research and Development Department amounting to Rs.
10,000 will be completed on August 1
Payable Rs.2,000 per month from completion date.
Under a hire purchase agreement Rs.4,000 is to be paid each month.
Cash sales of Rs.2,000 per month are expected. No commission is payable.
A sales commission of 5 per cent on credit sales is to be paid within the
month following the sales.
o Period of credit allowed by suppliers = 3 months
o Period of credit allowed to customers = 2 months
o Delay in payment of overheads = 1 month
o Delay in payment of wages = 1
st
week of the following
month
Income tax of Rs. 1,00,000 is due to be paid on October 1
Preference share dividend of 10 per cent on Rs.2,00,000 is to be paid on
November 1
10 per cent calls on equity share capital of Rs.4.00,000 is due or July 1 and
September 1
Dividend from investments amounting to Rs. 30,000 is expected on
November 1
Solution:
Cash Budget
Jul (Rs.)
Aug
(Rs.)
Sep
(Rs.)
Oct (Rs.)
Nov
(Rs.)
Dec
(Rs.)
Opening Balance 1,50,000 2,44,560 2,35,800 2,63,980 1,89,900 2,33,680
Receipts:
Cash sales 2,000 2,000 2,000 2,000 2,000 2,000
Cash from debtors (2
month prior credit sale
realized)
1,20,000 80,000 1,00,000 1,20,000 1,40,000 1,60,000
Dividend Income --- --- --- --- 30,000 ---
Call money on equity
shares
40,000 --- 40,000 --- --- ---
Total Receipts 3,12,000 3,26,560 3,77,800 3,85,980 3,61,900 3,95,680
Payments:
Creditors (3 months
prior credit purchases
paid)
40,000 60,000 40,000 60,000 70,000 80,000
Wages (previous
month)
8,000 8,400 9,200 10,000 10,400 10,800
Previous month's credit
sales
4,000 5,000 6,000 7,000 8,000 9,000
Total overheads
(previous month)
11,400 11,360 12,620 13,080 13,820 14,240
Plant & Machinery --- --- 40,000 --- --- ---
Research &
Development
--- 2,000 2,000 2,000 2,000 2,000
Hire & Purchase
Installment
4,000 4,000 4,000 4,000 4,000 4,000
Income tax --- --- --- 1,00,000 --- ---
Preference Dividend --- --- --- --- 20,000 ---
Total Payments 67,440 90,760 1,13,820 1,96,080 1,28,220 1,20,040
Closing Balance 2,44,560 2,35,800 2,63,980 1,89,900 2,33,680 2,75,640
(b) Adjusted Profit and Loss Method - The adjusted profit and loss method,
also sometimes known as the cash flow statement, is especially useful for long-
term forecasting, when management is more interested in getting an overall
picture than the details of incomes and expenses in connection with long-term
planning.
Under this method, profit is considered to be equivalent to cash. Accordingly,
instead of taking into consideration transactions relating to cash receipts and cash
payments, the method considers only non-cash transactions. Profit is adjusted by
adding back depreciation, provisions, stock, work-in-progress, capital receipts,
decrease in debtors, increase in creditors, and by deducting dividends, capital
payments, increase in debtors, increase in stock and decrease in creditors. The
adjusted profit then represents the estimated cash available.
For converting profit and loss account into cash forecast, the following
information becomes necessary:
(a) Expected opening balance,
(b) Net profit for the period,
(c) Changes in current assets and current liabilities,
(d) Capital receipts and capital expenditure, and
(e) Payment of dividend.
Illustration:
The following data is available to you. You are required to prepare a cash budget
according to adjusted profit and loss method.
Balance Sheet as on 31st December 1992
Liabilities Rs. Assets Rs.
Share Capital 1,00,000 Premises 50,000
General Reserve 20,000 Machinery 25,000
P & L Account 10,000 Debtors 40,000
Creditors 50,000 Closing stock 20,000
Bills payable 10,000 Bills receivable 5,000
Outstanding Rent 2,000 Prepaid Commission 1,000
Bank 51,000
Projected Trading and Profit & Loss Account for the Year Ending 31st
December 1993
To Opening Stock 20,000 By Sales 2,00,000
To Purchases 1,50,000 By Closing Stock 15,000
To Octroi 2,000
To Gross Profit c/d 43,000
2,15,000 2,15,000
To Interest 3,000 By Gross Profit b/d 43,000
To Salaries 6,000 By Sundry Receipts 5,000
To Depreciation (10% on
premises and machinery)
7,500
To Rent 6,000
Less: Last year's outstanding 2,000
4,000
Add: Outstanding 1,000 5,000
To Commission 3,000
Add: Last year's prepaid 1,000 4,000
To Office Expenses 2,000
To Advertising Expenses 1,000
To Net Profit c/d 19,500
48,000 48,000
To Dividends 8,000
By Balance of profit
from last year
10,000
To Addition to Reserves 4,000 By Net Profit b/d 19,500
To Balance c/d 17,500
29,500 29,500
Closing balances:
Share Capital = Rs. 1,20,000
10% Debentures = Rs. 30,000
Creditors = Rs. 40,000
Debtors = Rs. 60,000
B/P = Rs. 12,000
B/R = Rs. 4,000
Furniture = Rs. 15,000
Plant = Rs.50,000 (both these assets are to be purchased by the end of the year).
Solution:
Cash Budget
Opening Balance as on 1 Jan 1993 51,000
Add: Net Profit 19,500
Depreciation 7,500
Decrease in 1,000
Increase in B/P 2,000
Issue of Share Capital 20,000
Issue of Debentures 30,000
Decrease in Prepaid Commission 1,000
Decrease of Stocks 5,000 86,000
1,37,000
Less: Purchase of Plant 50,000
Purchase of Furniture 15,000
Increase in Debtors 20,000
Decrease in Creditors 10,000
Decrease in Outstanding Rent 1,000
Dividend paid 8,000 1,04,000
Closing Balance as on 31 Dec 1993
33,000
(c) Balance Sheet Method - According to this method of preparing a cash budget or
cash forecast, a forecast balance sheet is prepared as of the end of the budget period
with all items of assets and liabilities except cash balance, which is then arrived at as a
balancing figure. The magnitude of the two sides of the Balance Sheet excluding cash
balance would determine whether the Bank Account would show a debit or credit
balance, i.e., cash balance at bank or bank overdraft.
Thus, the method very much resembles the Adjusted Profit and Loss Method in
mechanics and broad approach with the only difference that while cash balance is
calculated by preparing a cash flow statement under the adjusted profit and loss
method, the same is compared as a balancing figure under the balance sheet method.
Illustration:
With the figures given in previous illustration, prepare the cash budget using
Balance Sheet Method.
Solution:
Budgeted Balance Sheet as on 31st December 1993
Liabilities
Amount
(Rs.)
Assets
By
Sales
2,00,000
Share Capital 1,20,000 Premises 50,000
10% Debentures 30,000 Less: Depreciation 5,000 45,000
General Reserve 24,000 Machinery 25,000
Profit & Loss
Account
17,500 Less: Depreciation 2,500 22,500
Creditors 40,000 Furniture 15,000
Bills payable 12,000 Debtors 60,000
Outstanding Rent 1,000 Bills Receivable 4,000
Plant 50,000
Closing Stock 15,000
Bank (Balancing
figure)
33,000
2,44,500
2,44,500
x. Research and Development Budget
Research and development may be extremely important, as they are in the aircraft
industry, or they may be quite unimportant, as they are in motor repair work
businesses. It is impossible, therefore, to assess the size of a typical research and
development budget. However, the budget defines in terms of money the permissible
limits within which research and development activities are to be pursued.
While developing research and development budget, it should be clear in mind that
work relating to research and development is different from that relating to the
manufacturing function. Manufacturing function gives quicker results than research and
development which may go on for several years. So, these budgets are established on a
long term basis, say for 5 to 10 years. These budgets can be further subdivided into short
term budgets on annual basis. As a rule, research workers are less cost conscious; so
they are not susceptible to strict controls. A research and development budget is
prepared taking into consideration the research projects in hand and the new research
and development projects to be taken up. Thus this budget provides an estimate of the
expenditure to be incurred on research and development during the budget period.
(2) MASTER BUDGETS
Master budget is a consolidated summary of the various functional budgets. According
to the ICMA Terminology "A master budget is the summary budget incorporating its
component functional budgets and which is finally approved, adopted and employed".
Accordingly it comprises the functional budget summaries in the form of budgeted
Profit and Loss account and budgeted Balance Sheet. It is the summary budget as
approved and accepted by the management.
It has been defined by Rowland and William H. Harr as a "summary of the budget
schedule in a capsule form made for the purpose of presenting in one report, the
highlights of the budget forecast".
Before the summary budget becomes the master budget, it should be considered from
many angles and may be subjected to major or minor amendments according to
circumstances. Eventually, however, when management is satisfied that it is both
realistic and appropriate, it will accept it and call it a master budget.
The master budget projects the activities of a business during the budget period and is
thus a profit plan.
The master budget is prepared by the budget committee on the basis of coordinated
functional budgets, and becomes the target for the company during the budget period
when it is finally approved by the committee. This budget summarises functional
budgets to produce a Budgeted Profit and Loss Account and a Budgeted Balance Sheet
as at the end of the budget period.
Advantages of the Master Budget are:
1) A summary of all functional budgets in capsule form is available in one report.
2) The accuracy of all the functional budgets is checked because the summarised
information of all functional budgets should agree with the information given in the
master budget.
3) It gives an overall estimated profit position of the organization for the budget period.
4) Information relating to forecast balance sheet is available in the master budget.
This budget, is very useful for the top management because it is usually interested in the
summarised meaningful information provided by this budget.
CLASSIFICATION ACCORDING TO CAPACITY
(1) FIXED BUDGETS
Fixed budget is "a budget which is designed to remain unchanged irrespective of the
level of activity actually attained" (ICMA, London). Thus a budget prepared on the basis
of a standard or fixed level of activity is known as a fixed budget. It does not change with
the change, therefore it becomes an unrealistic yardstick in case the level of activity
(volume of production or sales) actually attained is different from what was assumed for
the budgeting purposes. The management will not be in a position to assess the
performance of different heads on the basis of budgets prepared by them because they
can serve as yardsticks only when the actual level of activity corresponds to the budgeted
level of activity. But in practice the level of activity and set conditions would change as a
result of internal limitations and external factors, like changes in demand and prices,
shortage of materials and power, acute competition etc. Fixed budgets are hardly used
as a mechanism of budgetary control because they do not make any distinction between
fixed, variable, and semi variable costs, and do not provides for adjustment in the
budgeted figures as a result of changes in costs due to change in level of activity.
(2) FLEXIBLE BUDGETS
The Institute of Cost and Management Accountants, England, defines a flexible budget
as "a budget designed to change in accordance with the level of activity actually
attained". Thus, a flexible budget gives different budgeted cost for different levels of
activity. A flexible budget is prepared after making an intelligent classification of all
expenses between fixed, semi-variable, and variable expenses, because the usefulness of
such a budget depends upon the accuracy with which the expenses can be classified.
Flexible budgeting is desirable in the following cases:
Where on account of typical nature of the business the sales are unpredictable,
e.g., in luxury trades.
Where the venture is a new one and, therefore, it is almost impossible to foresee
the public demand e.g., novelties in the fashion.
Where the business is subject to the vagaries of nature such as ice-creams, etc.
Where the progress depends on adequate supply of labour and the business is in
an area which is already suffering from shortage of labour.
Advantages of flexible budgeting:
a. It serves as a readymade budget available in advance in relation to the actual volume
of production or sales under varying conditions.
b. It can get adjusted automatically to the actual level of activity, unlike a fixed budget
that remains fixed even after its revision without conforming to the actual level.
c. It is a very useful device for controlling costs and assessing performance.
d. It traces the impact of varying levels of activity on profits.
Preparing a flexible budget:
In a system of flexible budgetary control, a series of fixed budgets is set for each
manufacturing budget centre so that, within limits, whatever the level of output reached,
it can be compared with an appropriate budget. The preparation of flexible budgets
necessitates the analysis of all overheads into fixed, semi-variable and variable costs.
The analysis is not a peculiar feature of flexible budgeting alone, but it is more
important to fully carry out such analysis in flexible budgeting rather than in fixed
budgeting. This is so because varying levels of output have to be considered and they
would have a different impact on each class of overhead.
The fixed expenses tend to remain unaffected by variations in the volume of output or
sales; semi-variable expenses vary, though not proportionately, with changes in output
or sales; variable overheads vary directly with alterations in output or sales.
When a fixed budget is prepared, the amounts of variable and semi-variable expenses
included therein are computed for a single level of activity. A flexible budget requires
precisely the same technique of assessment but for several different levels. It is,
therefore, necessary that the sums included for variable and semi-variable expenses
must be adjusted for each level of activity.
Illustration:
The statement given below gives the flexible budget at 60% capacity. Prepare a tabulated
statement giving the budget figures at 75% capacity and 90% capacity.
When no indication has been given, make your own classification of expenses between
fixed and variable overheads.
Expenses At 60% capacity (Rs.)
Direct materials 1,60,000
Direct labour 40,000
Indirect materials & spares 48,000
Depreciation 60,000
Indirect labour 40,000
Rent 12,000
Electric power 8,000
Repairs & Maintenance (40% variable) 20,000
Insurance on machinery 12,000
Solution:
Fexible Budget
Expenses Basis
Capacity
60% (Rs.) 75% (Rs.) 90% (Rs.)
Variable Cost:
Direct materials 100% variable 1,60,000 2,00,000 2,40,000
Direct labour 100% variable 40,000 50,000 60,000
Indirect materials & spares 100% variable 48,000 60,000 72,000
Indirect labour 100% variable 40,000 50,000 60,000
Semi-Variable Overheads:
Electric power 60% variable 8,000 9,200 10,400
Repairs & maintenance 40% variable 20,000 22,000 24,000
Fixed Overheads:
Depreciation 0% variable 60,000 60,000 60,000
Rent 0% variable 12,000 12,000 12,000
Insurance 0% variable 12,000 12,000 12,000
Total 4,00,000 4,75,000 5,50,400
Note: Semivariable overheads:
Electricity
Fixed portion = 40% of Rs. 8,000 = Rs.3,200
Variable portion at 60% capacity = 8,000 - 3,200 = Rs. 4,800
Variable portion at 75% capacity = (4,800 / 0.60) x 0.75 = Rs. 6,000
Total cost = Fixed cost portion + Variable cost portion
Total electricty cost at 75% capacity = Rs. 3,200 + Rs. 6,000 = Rs. 9,200
Variable portion of electricity at 90% capacity = (4,800 / 0.60) x 0.90 = Rs. 7,200
Total electricity cost at 90% capacity = Rs. 3,200+ Rs. 7,200 = Rs. 10,400
Repairs & Maintenance
Fixed portion of cost = 60% of Rs. 20,000 = Rs. 12,000
Variable portion at 60% capacity = 40% of Rs. 20,000 = Rs. 8,000
Variable portion of cost at 75% capacity = (8,000 / 60%) x 75% = Rs. 10,000
Total maintenance & Repairs at 75% capacity = Rs. 12,000 + Rs. 10,000 = Rs. 22,000
Variable portion of cost at 90% capacity = (8,000 / 60% ) x 90% = Rs. 12,000
Total Repairs & Maintenance Cost at 90% Capacity = Rs. 12,000 + Rs. 12,000 = Rs.
24,000
CLASSIFICATION ACCORDING TO CONDITION
(1) BASIC BUDGETS
A basic budget is a budget prepared for use unaltered over a long period of time. This
does not take into consideration current conditions and can be attainable under
standard conditions.
(2) CURRENT BUDGETS
A current budget is a budget related to the current conditions, and is prepared for use
over a short period of time. This budget is more useful than a basic budget, as the target
it lays down is corrected to current conditions.
CLASSIFICATION ACCORDING TO PERIOD
In terms of time factor, budgets are broadly of the following three types:
(1) LONG TERM BUDGETS
They are concerned with planning the operations of a firm over a prospective period of
five to ten years. They are usually in the form of physical quantities.
(2) SHORT TERM BUDGETS
They are usually for a period of one year or two years and are in the form of production
plan in monetary terms.
(3) ROLLING BUDGETS
Some companies follow the practice of preparing a rolling or progressive budget. In such
companies, there is always a budget prepared for a year in advance. A new budget is
prepared after the end of each month/quarter for a full year ahead. The figures for the
month or quarter which has rolled down are dropped, and the figures for the next
month or quarter are added. For example, if a budget has been prepared for the year
1990, after the expiry of the first quarter ending 30th June 1990, a new budget for the
full year ending 31st March 1991 is prepared by dropping the figures of the quarter
which has rolled down (i.e., quarter ending 30th June 1990) and adding figures for the
new quarter ending 30th September 1991. The figures for the remaining three quarters
ending 31st March 1992 may also be revised if necessary. This practice will continue
whenever a quarter ends and a new quarter begins.
ZERO BASE BUDGETING
The use of zero base budgeting (ZBB) as a managerial tool has become increasingly
popular since the early 1970s. It is steadily gaining acceptance in the business world
because it is proving its utility as a tool in integrating the managerial function of
planning and control. It first came into being when Jimmy Carter, the ex-President of
the United States of America and the then Governor of the State of Georgia, introduced
it as a means of controlling state expenditure.
The technique of zero base budgeting suggests that an organization should not only
make decisions about the proposed new programmes but it should also, from time to
time, review the appropriateness of the existing programmes. Such review should
particularly be done of such responsibility centres where there is relatively high
proportion of discretionary costs.
ZBB (or review) as the term suggests, examines a programme or function or
responsibility from "scratch". The reviewer proceeds on the assumption that nothing is
to be allowed. The manager proposing the activity has, therefore, to prove that the
activity is essential and the various amounts asked for are responsible, taking into
account the volume of activity. Nothing is allowed simply because it was being done or
allowed in the past. Thus, it means writing on a clean slate.
MODEL QUESTIONS
1) Explain the different types of budgets.
2) What is a sales budget? What considerations are necessary in the preparation of such
budgets?
3) What is principal budget factor? Give a list of such factors. Explain how you would
proceed to prepare budgets in the case of a manufacturing company.
4) What is a cash budget? How is it prepared?
5) "Flexibility in a budget is an aid to coordination, while the budgetary control is an
instrument of coordination" - Elaborate.
- End of Chapter -
LESSON - 21
REPORTING TO MANAGEMENT
IMPORTANCE OF REPORTING
Accounting is an information system and attempts to communicate information in the
form of reports, statements, charts and graphs to help the management in taking
appropriate decision. In small units, the necessity of communicating information may
not arise, as the owner is in close contact with all the departments and has an intimate
knowledge of all happenings in the business. But in big concerns, the size of the business
is so large that the owners and top management are not in contact with all the activities
of the business, so, necessity of communication of information arises for taking
appropriate action.
No planning and control procedure is complete without prompt and accurate feedback
of operating result. Management must know how actual profit performance compares
with the objective and the past performance, and to what extent variations from
objective and past performance have been caused by various influencing factors.
Therefore, the development of the system, or system of reporting, is considered as part
of accounting methods and is largely responsible for the change of outlook as well as
approach to accounting methods.
As we know, there are three broad divisions of cost accounting - cost ascertainment, cost
presentation and cost control. Reduction of cost through the technique of cost control
is the ultimate goal of any costing system. It is achieved through cost ascertainment
and cost presentation. For the purpose of cost control, it is essential that there is an
adequate means of reporting the costing data to the various levels of management, so
that they may be guided about what line of action needs to be pursued. Management
needs information for arriving at decisions and for evaluating performance to run the
factory efficiently. The required information can be made available to the management
by means of reports. 'Reports' can be defined as means of communication, usually in the
written form, of facts which should be brought to the attention of the various levels of
management who can use them to take suitable action for the purpose of control. Thus,
presentation of regular reports to help management is the most important task of the
cost accountant.
Like management accounting, reporting in all its ramifications has developed most in
the USA, where, contrary to the general impression, reporting system has been
introduced in quite small businesses, and naturally, the complexity of the reporting
system has grown pari passu (meaning with equal step) with the increase in the scale of
business. Though it is fully recognized that a highly developed team spirit can reduce the
need of wading through voluminous reports relating to the operation of the firm, the
Americans seem to feel that a regular system of reporting is a better guarantee of
efficiency and cooperation than reliance on personal qualities.
It is difficult to list out the reports which will be suitable for all businesses. The
reporting system suitable for a business should be framed according to its individual
requirements. Thus, reporting system will vary in different businesses according to their
different requirements.
OBJECTIVES OF REPORTING
The primary objective of reporting to management is to reach sound judgments on the
basis of operating results. Another objective, which is closely allied to this, and is
important in terms of efficiency, morale and motivation, is to be able to understand and
accept the judgment of people working for the enterprise. However, the latter purpose
lies in the twilight zone between psychology, sociology, semantics, speech, language and
graphic arts, as also newly evolving fields of organization theory, group dynamics and
human relations. Though these disciplines are important for the purpose of reporting,
they can only be touched briefly, wherever necessary, in the consideration of the subject
in management accounting.
REPORTING NEED AT DIFFERENT MANAGEMENT LEVELS
As the system of reporting has to meet the requirements of management at different
levels, the approach to the reporting problem would vary according to the reporting
level. If the reports for top management have to be comprehensive and concise, the
reports to operating supervisors have to be specific and concise because the daily
routine of production and selling requires the supervisor to be a man of action rather
than an analyst.
Generally, the reporting levels, with their reporting needs may be divided into following
three broad categories:
I. TOP MANAGEMENT LEVEL
The function of top management is to evolve proper plans and bring about a sound
organization with successful delegation of responsibility to subordinates, such that the
resources provided through investment are utilized efficiently. Development schemes
are of special significance at the level of top management. Further, though top
management may or may not be interested in making comparisons of actual
performance in physical terms with the standards, it would certainly like to make
comparisons between actual income expenditure and the budgeted figures for the same.
Of particular importance is the projection of past behaviour into future while planning
for future action. Thus the top management needs information to be furnished as the
basis of operational control as well as cost control.
In view of this, reports to top management must show...
- whether plans were sound,
- whether organisation was properly established, and
- whether delegated responsibility has been effectively used.
Consequently, the reporting system must enable management to make comparison, to
review organisation, and to appraise the effectiveness of subordinate executives.
Secondly, departmental reports should be summarised by totals only, so that the
principle of exception can be applied by the top management while reviewing
departmental performances. The, the management will be able to discover weak areas in
a quick review, and study the details of the particular reports instead of having to review
all performances.
Thirdly, in appraising plans for future action, management requires factual information
concerning the matter at hand - marketing a new product, expansion of its foreign
markets, or the construction of a new plant. Therefore, the writer of a planning report
requires information about company's own resources, information about external
conditions, supplemented by imaginative judgment.
II. CO-ORDINATING EXECUTIVES OR MIDDLE MANAGEMENT LEVEL
While the top management is primarily concerned with planning and organisation, the
execution of plans is the function of coordinating executives who administer the policies
and the direct operating supervisors, and appraise their performances.
From this point of view, reports meant for the middle management should be such that
they help them in administering policies and in appraising the performances of
operating supervisors. Owing to the peculiar position of these executives in
organisational hierarchy, these reports are split up into two parts -
- those dealing with expenses incurred through the junior management, and
- those dealing with expenses that are the direct responsibility of middle management.
This is so because management should not be charged or credited with any item of
income or expense over which it has either limited or no control. Thus, at the
intermediate level of responsibility, it is essential that executives receive reports about
proper administration of their duties. Moreover, having a multiplicity of activities under
them, the requirements of middle management cannot simply be met through physical
reports to disclose performance, hence, money values have also to be used.
III. OPERATING SUPERVISORS OR JUNIOR MANAGEMENT LEVEL
This management level consists of foremen, superintendents, etc., who are interested
more in physical performance than anything else. Then, operating supervisors would
like to keep themselves up-to-date about the day-to-day working of the operations under
their charge - products manufactured from the material, labour and facilities under
them.
In the context of their needs, specific and detailed reporting is required at the level of
direct supervision. Operating supervisors should receive reports about effectiveness of
their operation showing planned performance, actual performance and variations from
the plans. It necessary that the reports give specific information about the department,
so that the operating supervisors are able to use the reports for better control of
operations. To illustrate, if a foreman of a manufacturing department is told that his
direct labour cost is above the budgeted figure, or that his labour cost per unit was 20
per cent above the allowable rate, it is not an adequate report, because it throws the
burden of analysis and investigation entirely upon the foreman. Rather, if the reporting
system shows that defective work, rework and added operations caused a 20% increase
in direct labour cost, the report can serve as a medium for investigation. Thus, reported
facts should be supported by records of rework and scrapped material, so that both the
supervising executive and his superior has a factual basis for taking corrective action. It
is immaterial from the point of view of the operating executives whether the reports
have been converted into money values or not. Apart from these, foreman or
superintendent is interested in daily reports, and may even like to know the position
shift by shift.
GENERAL PRINCIPLES OF REPORTING
In order to make a report interesting and easily understandable, certain general
principles are to be followed while reporting. A good report is one that would help the
management in taking expected action for improving the performance of the concern.
The basic principles to be kept in mind while preparing and submitting reports are as
follows:
1. PROMPTNESS : The importance of promptness is reporting cannot be
overstressed. It means that the report must be prepared and issued before it becomes
ancient history. There are cases where promptness in presentation is more important
than any other of the general principles of reporting. As business executives need quick
reports to carry on day-to-day operations, very often the choice is between furnishing
incomplete, and possibly incorrect data, on time, and waiting until the veracity of
information is established. Reliability is sometimes sacrificed for speed in reporting. In
order to achieve promptness, accounting executives can often improve their methods of
collecting data, thereby increasing the speed with which final information becomes
available. Following are some of the ways in which accounting processes might be
accelerated:
a) Establishment of a record-keeping system tailored to the report requirements.
b) Use of mechanical accounting devices to avoid clerical errors and to increase
productivity.
c) Departmentalization of accounting work to prevent bottlenecks in reporting.
d) Training of employees to report extraordinary conditions when they are first
observed.
2. FORM : Every report should have a title suggestive of the subject matter in relation
to which it is prepared and presented. If possible, and necessary, different and
distinctive forms may be designed for different items to be reported. The title should be
brief, and to make the same clear, sub-titles may also be used. Columnar headings and
abbreviations used should also be explained. The report should mention the period
covered by it. As far as possible, the report should be of a standard size printed or typed.
3. COMPARATIVE STATEMENTS : In order to make the information conveyed
useful. It is necessary to supplement the same with comparative data or statements of
past performance, targets to be achieved or the standards set.
4. SIMPLICITY : Another requirement of reporting - simplicity - means presentation
of operating information in a clear manner by elimination of extraneous data, use of
facts rather than quasi-interpretations, and use of graphs instead of statistical arrays
whenever feasible. Presentation of information in a clear manner requires exact and
simple definitions of financial terms, precise use of technical terms, and careful
summarization of operating results. Simplicity of reporting, especially for top
management, can be attained by ruthless elimination of extraneous data through use of
schedules, or through the preparation of separate reports dealing with the extraneous
matters. The use of graphic devices, especially makes it possible to indicate trends or
deviations from established goals in a more striking form than is possible by tabulation
or editorial comments. The use of facts rather than quasi-interpretations assists an
operating executive by supplying him with hard facts based on books of accounts which
can be used as guide to executive action.
There is another dimension to simplicity - readability - which is of paramount
importance. A non-accountant, and sometimes even an accountant, may overlook vital
facts regarding operations if the figures are presented merely in a long column. The
rounding off the figures to a significant point also aids in readability. Therefore, paisas
are irrelevant and can be dropped-off, while, in large companies, even hundreds are
approximated. The length of the report contributes much to readability. The report
must, of course, be long enough to cover all significant points but not so long that it fails
to sustain interest.
5. ACCURACY : Information conveyed should be accurate. Inaccurate information not
only gives a wrong impression of the actual events but also misguides the executives.
Information must be accurate even if timeliness of presentation has to be sacrificed. It is
always better to have timely reports with information which is reasonably accurate.
6. DOVETAILING OF REPORTING AND RESPONSIBILITY : It is necessary
that every report is addressed to a responsibility centre, and must contain a message
about events controllable at that point. A serious problem of reporting lies in tailoring
the content to a responsibility centre, and at the same time giving information related to
one level of responsibility such that it appears as details for a higher level of
responsibility. Reports are prepared periodically from routine procedures, and hence,
the nature of the details must be kept under special summaries, either in the underlying
document containing the evidence of the event recorded (pay roll summaries, sales slips,
etc) or as detailed entries in ledgers, which can be extracted for particular reporting
purposes. To illustrate, total direct labour, direct material and burden costs may be
accumulated in individual ledger accounts and combined for inventory valuation
purposes, control reports for assembly department may reflect only the material, labour
and burden costs controllable by the assembly department foreman.
7. MISCELLANEOUS FACTORS : A report should be periodically reviewed. The
form and contents of a report should not be of permanent nature. They should go on
changing with the change in circumstances, otherwise the recipient will take them as
stale, useless and routine type.
The report should draw management's attention immediately to exceptional matters so
that management by exception may be carried out effectively. Thus, reports should
highlight significant deviations from standards.
Visual reporting through graphs, charts and diagrams should be preferred over
descriptive reports because visual reporting attracts the eye more quickly and leaves a
lasting impression on the mind.
- End of Chapter -
LESSON - 22
FORMS OF PRESENTATION OF INFORMATION
There are three distinct and recognised methods of communication media available in
presenting cost information to management. These are:
a) Narrative or written forms of communication such as formal accounting
statements, tabulated statistics, and narration and exposition using words;
b) Graphic media consisting of charts, diagrams and pictures; and
c) Oral communication through group meetings and conversation with individuals.
Although the narrative form is the most popular, each method having its own relative
merits and drawbacks, a combination of these has become common from the
effectiveness point-of-view. This is so because there are different levels of management
and their ability to grasp information differs from level to level and individual to
individual.
CLASSIFICATION OF REPORTS
Reports can be classified by their forms, contents and frequency as follows:
FORMS OF REPORTING
1. Descriptive Reports: These types of reports are written out in a descriptive style.
These reports usually do not take the help of tables and graphs, but they include tables
and graphs only to lay emphasis on some points in it. The language used is a very
important factor in such reports. The language should be simple and correct, and convey
the idea of the reporter accurately to the management. The report should have suitable
headings and sub-headings, and it should be suitably structured and paragraphed. The
main report should be summarised, so that the recipient of the report is able to know
the exceptional matters and recommendations of the report without going into the
details of the report.
Descriptive reports are considered to be less effective devices as compared to tabular
and graphical reports. Such a report does not attract the eye quickly and forcibly.
2. Tabular Reports: Such reports are presented in the form of comparative
statements. This form of reporting is applied in case of periodical reports covering
production, costs, sales and finance. These reports should use the same standard form
of statements or tables from period to period, so that proper comparison can be seen
between the present and past performance. Examples of this type of reporting are -
statement of cost, statement of profit, statement of materials cost, labour efficiency
report, idle time report etc. These reports are more effective as compared to descriptive
reports because they create more impression on the readers' minds.
3. Graphic Presentations: It is very useful method of presenting information to the
management in a pictorial manner that can attract the eye more quickly and forcibly.
Recently, graphs and diagrams are becoming very popular with the cost accountant
reports because these are the most effective ways for disclosing trends and making
comparisons over fairly long periods within a short space. Graphs and diagrams make
the otherwise dull and confusing figures interesting and attractive. This method of
presenting information can effectively depict production costs, fluctuations in input and
output, position and movement of stocks, variances, components and cost of production
etc. The following types of diagrams and charts are discussed below:
(a) Bar Charts :These charts provide a convenient method of showing comparative
sales, cost per unit, output, labour turnover, percentage of abnormal loss etc. These
charts are known as bar charts because in these, only the length of the bars or lines is
taken into account. Bars can be shown either horizontally or vertically with equal
spacing between them. All these bars should be of uniform width, not too narrow to
make the bar look like a line, and not too wide to make the bar appear as a rectangle.
Bar charts are of four types:
i. Simple Bar Charts : In these charts, one bar represents only one figure and
the number of bars is equal to the number of figures. Such charts are useful in
showing one type of data.
For example, the following information relates to factory
Year Sales (Rs.)
1990 5,50,000
1991 8,25,000
1992 6,75,000
1993 10,00,000
The above information has been presented in simple bar chart given in Fig 22.1
below.
ii. Multiple Bar Charts : As the name indicates multiple bar charts represent
information about more than one inter-related data in one diagram. These charts
are useful for making comparison of the same type of data over a period of time. In
these charts the bars of two or more inter related data are placed side by side to
facilitate comparison.
For example, the following data relate to value of production and sales of a factory
during various years:
Years Cost of production (Rs.) Sales (Rs.)
1990 5.0 lakhs 4.0 lakhs
The above information is presented in a multiple bar chart in Fig 22.2 below.
iii. Sub-divided Bar Charts : These charts are used to present data which is to
be shown in parts or which is the total of various divisions. This type of chart is
constructed by sub-dividing the bars in the ratio of components. These charts are
useful for showing the relationships of parts to one another and to the whole. The
various component parts are distinguished by using different colors, lines or
crosses. In costing, such charts can be successfully used in making the analysis of
cost or sales by their constituent elements.
For example, the following data relates to a factory for the year 1993:
Product A Product B
Sales 8,50,000 5,00,000
Material 3,50,000 2,50,000
Labour 2,00,000 2,00,000
Overheads 1,50,000 1,00,000
iv. Percentage Bar Charts : Bars can be sub-divided on percentage basis. The
information presented in a sub-divided bar chart can be converted into
percentage. All bars are of equal height. Portions corresponding to different
percentages are then cut off from the whole bar representing 100%. These charts
have the added advantage of comparison on a relative basis because bars are sub-
divided on percentage basis.
For example, the following table shows various percentages of the components of
the selling price of a commodity in 1992 and 1993:
1992 1993
Per unit % Per unit %
Material 10.0 50 12.0 48
Labour 5.0 25 5.5 22
Overheads 3.0 15 4.5 18
Profit 2.0 10 3.0 12
Total 20.0 100 25.0 100
Percentage Bar Chart
Fig. 22.4
(b) Pie (or circular) Charts : Subdivided circular charts are like percentage charts;
these charts are presented as segments of a circle instead of as components of bars. The
sum of angles made by all segments at the centre of the circle is 360 (which is
equivalent to 100%).
For example, the following costing information has been taken from the books of a
factory:
Rs. Sectors
Direct Material 2,00,000 144
0
Direct Labour 1,25,000 90
0
Factory overheads 62,500 45
0
Office overheads 62,500 45
0
Selling and Distribution Overheads 50,000 36
0
The above information has been presented in Pie chart in Fig. 22.5 below:
(c) Zee Chart (Z chart) : It is a triple curve chart showing three curves on a single
graph. It is called Z chart because on completion it is similar to the shape of letter Z. The
three curves on Z chart are:
i. The curve of original data
ii. The cumulative curve
iii. The moving annual total curve
When Z chart is applied to labour costs, monthly labour costs are first plotted in the
bottom portion of the chart. After this, cumulative monthly labour costs are plotted, and
then the moving annual total is plotted on the chart. At the end of the year, the moving
annual total curve and the cumulative monthly total curve meet each other because
figures of the moving annual total and the cumulative monthly total are the same at the
end of the year.
(d) Gantt Chart : This chart was been developed by H.L. Gantt. It is a special type of
bar chart in which bars are drawn horizontally. It is a progress chart showing the work
accomplished against planned performance.
(e) Break Even Chart : This chart shows the breakeven point i.e. the point at which
there is no profit and no loss. This chart establishes the relationship between cost, profit
and sales.
(f) Profit Volume Chart : This chart is a variation of the breakeven chart and
establishes the relationship between profit and loss.
INFORMATION TO BE PRESENTED
1. REPORTS TO THE BOARD OF DIRECTORS
As the directors are not interested in the day-to-day management, their primary interest
lies in the overall working of the undertaking as highlighted by the profits. They are,
therefore, interested in the Profit and Loss account as well as the Balance Sheet of the
unit, so much so that a monthly Profit and Loss account and Balance Sheet is usually
given to the Board. Over and above these, the following are also submitted to them for
their perusal:
(i) Statements giving details in respect of the items of Profit and Loss account and
Balance Sheet which are, of course, prepared in the form that clearly brings out
the comparison with the Master Budget as well as with the figures of the
corresponding period in the previous year.
(ii) Statements that supplement the information contained in the Profit and Loss
account and the Balance Sheet in its material particulars. Sometimes, these
statements are quite numerous, with the resut that in such cases, a small booklet
containing a series of statements is prepared for the Board.
(iii) Statement of return on capital employed, which is very crucial for justifying
the rationale of carrying on the business. Calculations are, therefore, made to
disclose these figures. Coupled with this, the Board is also interested in certain
ratios, like Gross Profit Ratio, Ratio of Overheads to Sales etc., which throw light
on the various aspects of the conduct of business. This might, in some cases, be
carried to its farthest limit in the analysis of the individual heads of expense by
placing them in relation to sales.
(iv) Statistics showing the trend of production and sales, as the working of a unit
is dependent primarily on sales, production and raw materials. These would
enable the Board to keep itself well-informed of the position regarding
availability of raw materials, quantum of production, number and value of orders
received as well as sales effected.
(v) Statement showing the general trend of costs, because the Board's interest in
detailed costing is limited. This is done by pointing out the favourable and
unfavourable variances from the budget which is based on predetermined costs.
(vi) Report on expenditures made on R & D, as these are generally undertaken
under the direct responsibility of central management and often the Board of
Directors. Separate report on each item is sent to the Board.
(vii) Short report on the anticipated future results. In case the Board is interested
only in long-term plans, as happens in a number of cases, this report is given a
miss.
A study of a number of cases has revealed that the P&L Account, Balance Sheet, as well
as other statistics furnished to the Board of Directors remain of only academic
importance because when they reach their hands, the period to which they refer to,
would have already passed into history. Consequently, the Board cannot effectively use
them as a basis of any action for reversing an unfavourable trend or for fully exploiting a
favourable trend. In view of this, it is considered expedient to sacrifice accuracy and
precision for the sake of ensuring quick submission. Therefore, a certain element of
estimation is bound to creep in the reports to the Board.
2. REPORTS TO TOP MANAGEMENT
In big companies, where the delegation of responsibility has been pushed to the farthest
possible limits, top management acts as a clearing house between the operating
divisions and Board of Directors. Generally speaking, the reporting at this level is
divided into reports for transmission to the Board of Directors and reports to be
considered by the top management for which no reference to the Board is necessary. As
many persons at the central executive level are simultaneously on the Board, there is
bound to be some overlapping of reporting of the functions of central authority and the
Board of Directors, especially where the Board has more than half of its members from
top executive level.
Being responsible for the performance of their own managerial functions, top executive
managements are interested more in the operational side of the undertaking than in the
purely financial side. They act as supervisors and advisors to all divisional or
departmental heads. Top management lives up to this role by receiving reports of
variances from the budgeted figures and these are very carefully studied and analysed.
The central executive authority is responsible for initiating policy. Thus, it has to advise
the Board about what action should be taken on the reports submitted to it. In all this,
greater emphasis is placed on the future than on the past, so, the report at this level
must emphasise future aspects. Thus budgetary control provides for the periodic
revision of budgets for immediate future on the basis of past performances, so that the
management may be able to exercise a more effective control. Reporting, in such cases,
becomes a judicious blend of comments on past performance and the evaluation of
effect of such performance on future results.
3. REPORTING TO TOP DIVISIONAL MANAGEMENT
The main difference between the top management and the divisional management is
that the latter has to operate within the framework of policy laid down by the company.
In cases where the decentralization of authority is not complete, some of the functions of
divisional management would come under the jurisdiction of central authority and the
procedure of reporting would vary accordingly.
From the point of view of divisional management, operational reports might be divided
into the following four categories:
a. Report on Sales : This report is simple and would show the sales expected, sales
made, the difference between the two, and a comparison with the sales of the
corresponding period of the previous year. Further, the sales may be analysed
geographically. In such analysis, transport would be an important element of cost, which
may require careful consideration. As the primary concern of the business is the net
price received for its products, a report is given on the costs of selling, such as
commission paid, discounts allowed etc.
b. Report on Purchases : Report on purchases is comparatively simple. It must
incorporate the trend of prices of raw materials, which is important from both short and
long-term points of view. However, as purchases are usually made for a period of time,
report on them may be given at longer intervals than other items.
c. Report on Production : This is usually couched in physical terms - the number of
hours tried the plant and equipment have worked, the number of hours labour has
worked, total output, etc. It also includes a study of idle time. Moreover, production
trends are studied and reported upon.
d. Report on Costs : Each product has different elements of costs. These elements are
studied and compared in cost reports. In case of reports on cost of production, a
comprehensive summary is usually prepared giving the labour, material and expense
costs, and the spoilage of material, idle time and usage of machinery. Report may also
make use of standard cost for the purpose of comparison and conclusion.
e. Reports on Financial and Office Management : Reporting on financial and
office management involves reporting on items that do not form part of direct cost of
production. Even if reporting on overhead expenditure is taken as part of production
report and cost report, there would still remain certain types of expenses, like interest,
which it is not possible to include in the normal production cost and, therefore, would
have to be reported separately.
4. REPORTS TO JUNIOR MANAGEMENT LEVEL
Sometimes known as 'Day-to-Day Working Reports', such reports are meant for floor
level workers. The main differences between these and the reports to top management
or middle management are:
i. These reports are most likely in physical terms, although may also be in both physical
and monetary terms.
ii. These reports are prepared normally by the supervisor himself without any expert
advice.
MODEL QUESTIONS
1. What do you understand by the term 'reporting to management'? Discuss briefly the
matters you would deal with while reporting to the Board of Directors.
2. What are the essential characteristics of a good report?
3. 'Reporting is an essential means for cost control' - Elaborate.
4. Write short notes on:
i. Circular pie chart
ii. Gantt Chart
iii. Zee Chart
iv. Bar Chart
- End of Chapter -
LESSONS 23 & 24
WORKING CAPITAL
MEANING OF WORKING CAPITAL
The term working capital refers to the capital required for day-to-day operations of a
business enterprise. It is represented by excess of current assets over current liabilities.
It is necessary for any organisation to run successfully its affairs, to provide for adequate
working capital. Moreover, the management should also pay due attention in exercising
proper control over working capital. It has been correctly observed by Schall and
Haley that managing current assets requires more attention than managing plant and
equipment expenditure. Mismanagement of current assets can prove costly. Too large
an investment in current assets means tying up capital that could have been used
productively elsewhere. On the other hand, too little investment can also be expensive.
For example, insufficient inventory may mean that sales are lost since the goods that a
customer wants to buy are not available. The result is that Financial Manager spends a
large percentage of his time in managing current assets because these assets vary
quickly and a lack of attention paid to them may result in an appreciably lower profit for
the firm.
CONCEPTS/DEFINITIONS OF WORKING CAPITAL
There are two concepts of working capital: Gross and Net.
The term "gross working capital", also referred to as working capital, means the total
current assets.
The term "net working capital" can be defined in two ways:
(i) The most common definition of net working capital (NWC) is the difference between
current assets and current liabilities;
(ii) An alternate definition of NWC is, that portion of a firm's current assets which is
financed with long-term funds.
As already observed, the task of the financial manager in managing working capital
efficiently is to ensure sufficient liquidity in the operations of the enterprise. The
liquidity of a business firm is measured by its ability to satisfy short-term obligations as
they become due. The three basic measures of a firm's overall liquidity are:
Current Ratio
Acid-test Ratio
Net Working Capital
In brief, they are very useful in inter-firm comparisons of liquidity. Net working capital,
as a measure of liquidity, is not very useful for comparing the performance of different
firms, but it is quite useful for internal control. The NWC helps in comparing the
liquidity of the same firm over time. For purposes of working capital management,
therefore, NWC can be said to measure the liquidity of the firm. In other words, the goal
of working capital management is to manage the current assets and liabilities in such a
way that an acceptable level of NWC is maintained.
The two concepts of working capital - gross and net - are not exclusive; rather they have
equal significance from management's viewpoint. The gross working capital concept
focuses attention on two aspects of current assets management:
1. Optimum investment in current assets : The level of investment in current assets
should avoid two danger points - 'excessive' and 'inadequate' investments in current
assets. The investment in current assets should be just adequate, not more not less, to
the needs of the business firm. Excessive investment in current assets should be avoided
because it impairs firm's profitability, as idle investment earns nothing. On the other
hand, inadequate amount of working capital can threaten the solvency of the firm, if it
fails to meet its current obligations. It should be realised that the working capital needs
of the firm may be fluctuating with changing business activity. This may cause excess or
shortage of working capital frequently. The management should be prompt to initiate
action and correct the imbalances.
2. Financing of current assets : Another aspect of the gross working capital points to the
need of arranging funds to finance current assets. Whenever a need for working capital
funds arises due to the increasing level of business activity or for any other reason, the
arrangement should be made quickly. Similarly, if suddenly some surplus funds arise,
they should not be allowed to remain idle, but should be invested in short-term
securities. Thus, the finance manager should have the knowledge of the sources of
working capital funds as well as the investment avenues where the idle funds may be
temporarily invested.
The net working capital, being the difference between current assets and current
liabilities, is a qualitative concept. It...
1. Indicates the liquidity position of the firm : Current assets should be sufficiently in
excess of current liabilities to constitute a margin or buffer for maturing obligations
within the ordinary operating cycle of a business. In order to protect their interests,
short-term creditors always like the company to maintain current assets at a higher level
than current liabilities. It is a conventional rule to maintain the level of current assets
twice of the level of current liabilities. However, the quality of current assets should be
considered in determining the level of current assets vis-a-vis current liabilities. A weak
liquidity position poses a threat to the solvency of the company and makes it unsafe and
unsound. A negative working capital means a negative liquidity, and may prove to be
harmful for the company. Excessive liquidity is also bad. It may be due to
mismanagement of current assets. Therefore, prompt and timely action should be taken
by management to improve and correct the imbalance in the liquidity position of the
firm.
2. Suggests the extent to which working capital needs may be financed by permanent
sources of funds.
The net working capital concept also covers the question of judicious mix of long-term
and short-term funds for financing current assets. For every firm, there is a minimum
amount of net working capital which is permanent. Therefore, a portion of the working
capital should be financed with the permanent sources of funds such as - owner's
capital, debentures, long-term debt, preference capital or retained earnings.
Management must, therefore, decide the extent to which current assets should be
financed with equity capital and/or borrowed capital.
In summary, it may be emphasised that gross and net concepts of working capital are
two important facets of the working capital management. There is no precise way to
determine the exact amount of gross or net working capital for every firm. The data and
problems of each company should be analysed to determine the amount of working
capital. It is not feasible in practice to finance current assets by short-term sources only.
Keeping in view the constraints of the individual company, a judicious mix of long-term
finances should be invested in current assets.
TYPES OF WORKING CAPITAL
Working capital can also be classified into
1. Fixed or Permanent Working Capital : It represents that part of capital which is
permanently locked up in the current assets to carry out the business smoothly. This
investment in current assets is of a permanent nature and increases as the size of
business expands. Example of such investments are - investments required to maintain
the minimum stock of raw materials, work-in-progress goods, finished products, loose
tools and equipment. It also requires minimum cash balance to be kept in reserve for
the payment of wages, salaries and all other current expenditure throughout the year.
The permanent fixed working capital can again be subdivided into
(a) Regular Working Capital - It is the minimum amount of liquid capital needed to keep
up the circulation of the capital from cash to inventories, to receivables, and again to
cash. This would include sufficient minimum bank balance to discount all bills,
maintain adequate supply of raw materials etc.
(b) Reserve Margin or Cushion Working Capital - It is the excess over the needs of
regular working capital that should be kept in reserve for contingencies that may arise at
any time. These contingencies include rising prices, business depression, strikes, special
operations such as experiments with new products etc.
2. Variable Working Capital : It changes with the increase or decrease in the volume
of business. It may also be sub-divided into:
(a) Seasonal Working Capital - It is the working capital required to meet the seasonal
liquidity of the business
(b) Special Working Capital - It is that part of the variable working capital which is
required for financing the special operations such as extensive marketing campaigns,
experiments with products or methods of production, carrying of special job etc.
The distinction between fixed and variable working capital is of great significance
particularly in raising the funds for an enterprise. Fixed working capital should be raised
in the same way as fixed capital is procured. Variable needs can, however, be financed
out o
f
short-term borrowings from the bank or from the public.
There are no set rules or formulae to determine the working capital requirements of the
firms. A large number of factors influence the working capital needs of the firms. All
factors are of different importance. Also, the importance of the factors changes for a
firm over time. Therefore, an analysis of the relevant factors should be made in order to
determine the total investment in working capital. The following is the description of the
factors which generally influence the working capital requirements of the firms.
FACTORS INFLUENCING WORKING CAPITAL REQUIREMENTS
1. General Nature of Business : The working capital requirements of an enterprise
are basically related to the conduct of the business. Enterprises fall into some broad
categories depending on the nature of their business. For instance, public utilities have
certain features which have a bearing on their working capital needs. The two relevant
features are:
a. The cash nature of business, i.e., cash sale
b. Sale of services rather than commodities.
In view of these features they do not maintain big inventories and have, therefore,
probably the least requirement of working capital. At the other extreme are trading and
financial enterprises. The nature of their business is such that they have to maintain a
sufficient amount of cash, inventories and book debts. They have to necessarily invest
proportionately large amounts in working capital. The manufacturing enterprises fall, in
a sense, between these two extremes. The industrial concerns require fairly large
amounts of working capital, though it varies from industry to industry depending on
their asset structure. The proportion of current assets to total assets measures the
relative requirements of working capital of various industries. Available data in respect
of companies in India confirm the wide variations in the use of working capital by
different enterprises. The percentage of current assets to total assets was found to be the
lowest in hotels, restaurants and eating houses - 10 to 20% range, while in electricity
generation and supply, it was in the range of 20-30%. The enterprises in tobacco
business had the highest component of working capital - 80 to 90% range. The other
industrial groups fall between these limits, though there are very wide inter-industry
variations.
2. Production Policies : The production policies pursued by the management have a
significant effect on the requirements of working capital of the business. The production
schedule has a great influence on the level of inventories. Decision of the management
regarding automation etc. will also have its effect on working capital requirements. In
case of labour-intensive industries the working capital requirements will be more, while
in case of a highly automatic plants, the requirements of long-term funds will be more.
3. Business Fluctuations : Most firms experience seasonal and cyclical fluctuations
in the demand for their products and services. These business variations affect the
working capital requirement, specially the temporary working capital requirements of
the firm. When there is an upward swing in the economy, sales increase;
correspondingly, the firm's investment in inventories and book debts also increase.
Under boom, additional investment in fixed assets may be made by some firms to
increase their productive capacity. This act of the firms will require further additions of
working capital. To meet their requirements of funds for fixed assets and current assets
under boom period, firms generally resort to substantial borrowing. On the other hand,
when there is a decline in the economy, sales fall and consequently, levels of inventories
and book debts also fall. Under recessionary conditions, firms try to reduce their short-
term borrowings.
Seasonal fluctuations not only affect working capital requirements but also create
production problems for the firm. During periods of peak demand, increasing
production may be expensive for the firm. Similarly, it will be more expensive during
slack periods when the firm has to sustain its workforce and physical facilities without
adequate production and sales. A firm may, thus, follow a policy of steady production,
irrespective of seasonal changes in order to utilise its resources to the fullest extent.
Such a policy would mean accumulation of inventories during the off-season and their
quick disposal during the peak season.
The increasing level of inventories during the slack season will require increasing funds
to be tied-up in the working capital for some months. Unlike cyclical fluctuations,
seasonal fluctuations generally conform to a steady pattern. Therefore, financial
arrangements for seasonal working capital requirements can be made in advance.
However, the financial plan or arrangement should be flexible enough to take care of
some abrupt seasonal fluctuations.
4. Credit Policy : A company that allows liberal credits to its customers, may have
higher sales but will need more working capital as compared to a company which has an
efficient debt collection machinery and observe strict credit terms. This is because in the
case of the former type of company, a substantial amount of its funds will get tied up in
its sundry debtors. The working capital requirements can also be affected by the credit
facilities enjoyed by the company. A company enjoying liberal credit facilities from its
suppliers will seed lower amount of working capital as compared to a company which
does not enjoy such credit facilities.
5. Growth and Expansion : As a company grows, it is logical to expect that a large
amount of working capital will be required. It is, of course, difficult to determine
precisely the relationship between the growth in the business volume of a company and
the increase in its working capital. The composition of working capital in a growing
company also shifts with economic circumstances and corporate practices. Other things
being equal, growth industries require more working capital than those that are static.
The critical fact, however, is that the need for increased working capital funds does not
follow the growth in business activities but precedes it. Advance planning of working
capital is, therefore, a continuing necessity for a growing concern. Or else, the company
may have substantial earnings but little cash.
6. Fluctuations of Supply : Certain companies have to obtain and maintain large
reserves of raw materials due to their irregular sales and intermittent supply. This is
particularly true in case of companies requiring special kind of raw material available
only from one or two sources. In such a case large quantity of raw materials has to be
kept in store to avoid any possibility of the production process coming to a dead halt.
Thus, the working capital requirements in case of such industries would be large.
7. Profit Margin and Profit Appropriation : Firms differ in their capacity to
generate profits from business operations. Some firms enjoy a dominant position due to
quality product or good marketing management or monopoly power in the market and
earn a high profit margin. Some other firms may have to operate in an environment of
intense competition and may earn low margins of profits. A high net profit margin
contributes towards the working capital pool. In fact, the net profit is a source of
working capital to the extent it has been earned in cash. The profit can be found by
adjusting non-cash items, such as depreciation, outstanding expenses, accumulated
expenses and losses written-off, in the net profit. But in practice, the net cash inflows
from operations cannot be considered as cash available for use at the end of the period.
Even as the company's operations are in progress, cash is used up for augmenting
stocks, book debts or fixed assets. The financial manager must see whether or not the
cash generated has been used for rightful purposes. The application of cash should be
well planned.
Even if the net profits are earned in cash at the end of the period, whole of it is not
available for working capital purposes. The contribution towards working capital would
be affected by the way in which profits are appropriated. The availability of cash
generated from operations, thus, depends upon taxation, dividend and retention policy
and depreciation policy.
Taxes must be paid out of profits. Tax liability is unavoidable and adequate provision
should be made for it in working capital planning. If the tax liability increases, it will
impose an additional strain on working capital. The finance manager must do tax
planning in order to avail the benefits of all sorts of tax concessions and incentives.
The firm's policy to retain or distribute profits also has a bearing on working capital.
Payment of dividend consumes cash resources and, thus, reduces firm's working capital
to that extent. If the profits are retained in the business, the firm's working capital
position will be strengthened. A number of factors should be evaluated by the financial
manager in deciding whether profits will be retained or distributed. A firm may follow
the policy of paying a constant amount of dividend every year. In the years the firm
makes high profits, its liquidity position will become strong; but in the years it does not
earn sufficient profits, the preserved cash resources will be utilised to pay dividends.
Sometimes a company wants to pay dividend but at the same time it does not want to
drain away its cash resources. The alternative in such a case is to declare bonus shares
(stock dividend) out of the past accumulated profits.
The depreciation policy, through its effect on tax liability and retained earnings, has an
influence on working capital. Depreciation is tax deductible. Higher the amount of
depreciation, lower the tax liability and more the cash profit. Similarly, the amount of
net profits will be less if higher depreciation is charged. If the dividend policy is linked
with net profits, the firm can pay less dividend by providing more depreciation. Thus
depreciation is an indirect way of retaining profits and preserving the firm's working
capital position.
8. Operating Efficiency : The operating efficiency of management is also an
important determinant of the level of working capital. Management can contribute to a
sound working capital position through operating efficiency. Although management
cannot control the rise in prices, it can ensure the efficient utilisation of resources by
eliminating waste, improving coordination, and a fuller utilisation of existing resources,
etc. Efficiency of operations accelerates the pace of the cash cycle and improves the
working capital turnover. It releases the pressure on working capital by improving
profitability and improving the internal generation of funds.
ESTIMATION OF DIFFERENT COMPONENTS OF WORKING CAPITAL
Since working capital is the excess of current assets over current liabilities, the forecast
for working capital requirements can be made only after estimating the amount of
different constituents of working capital. The procedure for estimating each of the
constituents- and the information required for the purpose is discussed below:
1. Inventories: The term 'inventories' include stock of raw material, work-in-progress
and finished goods. The estimation of each of them will be made as follows:
(a) Stock of raw materials: The average amount of raw materials to be kept in
stock will depend upon the quantity of raw materials required for production
during a particular period and the average time taken in obtaining a fresh delivery.
Suitable adjustments may have to be made to provide for contingencies and
seasonal factors. For example, if the total quantity of raw materials required in a
year amounts to 1,200 kg and one month is taken in obtaining a fresh delivery, it
means a minimum stock of 100 kg of raw materials must be kept. This may have to
be further increased on the basis of likely delays and other considerations. The
quantity of stock multiplied by the price will give the amount of working capital
required for holding stock of raw materials.
(b) Work-in-progress: The cost of work-in-progress includes raw materials,
wages and overheads. In determining the amount of work-in-progress, the time
period for which the goods will be in the course of production process is most
important. Consider the following example:
Production 12,000 units per annum
Elements of cost:
Direct materials 50%
Direct labour 40%
Overheads 10%
Each unit costs Rs. 8 and will be in process for one month on an average. The
amount of working capital locked up in work-in-progress will be computes as
follows:
Production for one month 1,000 units
Cost of direct materials 1,000 units x Rs. 4 = Rs. 4,000
Cost of direct labour 1,000 units x Rs. 3.20 = Rs. 3,200
Overheads 1,000 units x Rs. 0.80 = Rs. 800
Total = Rs. 8,000
In case the wages and overheads accrue evenly during the time production is in
progress, then the labour and overhead cost will be taken only for half a month
instead of one month taken above.
(c) Finished goods: The period for which the finished goods have to remain in
the warehouse before sales is an important factor for determining the amount
locked up in finished goods. Consider the following example:
Finished goods are to stay in the warehouse for two months on an average before
being sent to the customers.
The working capital requirements for finished goods will be computed as follows:
2. Sundry Debtors: The amount of funds locked up in Sundry Debtors will be
computed on the basis of credit sales and the time-lag in collecting payment. Consider
the following example:
3. Cash and Bank Balance: The amount of money to be kept as cash in hand or cash
at bank can be estimated on the basis of past experience. Every businessman knows the
amount that he will require for meeting his day-to-day payments.
4. Sundry Creditors: The lag in payment to suppliers of raw materials, goods, etc.,
and the likely credit purchases to be made during the period will help in estimating the
amount of creditors. This will be clear with the help of the following example:
Credit purchases per annum : Rs. 24,000
Credit period enjoyed : 1 month
This means on an average Rs.2.000 will remain outstanding on account of creditors.
5. Outstanding Expenses: The time-lag in payment of wages and other expenses will
help in estimating the amount of outstanding expenses. For example, if monthly
payments for wages and expenses are estimated at Rs. 15.000 and a time lag of 15 days
in payment is estimated, the amount of outstanding expenses on an average will amount
to Rs.7,500.
Having determined the amount of various current assets and current liabilities, the
amount of working capital can be calculated by any of the following two methods:
i. By considering the total amount of current assets and current liabilities.
ii. By considering only the cash cost of current assets and current liabilities.
Both these methods have been explained in the following pages with proper
illustrations.
METHODS OF MAKING WORKING CAPITAL FORECASTS
The assessment of working capital requirements for the future can be made according to
any of the following methods:
i. By determining the amount of current assets and current liabilities:
The assessment of working capital requirements can be made on the basis of the current
assets required for the business and the credit facilities available for the acquisition of
such current assets, i.e., current liabilities. The broad categories of the 'current assets'
and the 'current liabilities' have already been explained.
Illustration:
A proforma cost sheet of a company provides the following particulars:
Amount per unit (Rs.)
The following further particulars are available:
Raw materials in stock on average one month; Materials are in process on average half a
month; Finished goods in stock on average one month.
Credit allowed by suppliers is one month; credit allowed to debtors is two months; lag in
payment of wages is 2 weeks; lag in payment of overhead expenses is one month; one-
fourth of the output is sold against cash; cash in hand and bank is expected to be Rs.
25,000.
You are required to prepare a statement showing the working capital needed to finance
a level of activity of 1,04,000 units of production.
You may assume that production is carried on evenly throughout the year, and wages
and overheads accrue similarly.
Solution:
Statement showing Determination of Net Working Capital
= Current assets Current Liabilities
= Rs. 47,45,000- Rs.12,10,000
= Rs. 35,35,000
WORKING NOTES AND ASSUMPTIONS:
i. 26,000 units have been sold for cash. Therefore, credit sales pertain to 78,000 units
only.
ii. Year has 52 weeks.
iii. (a) Profits may or may not be a source of working capital, (b) Profits are to be
adjusted for income-tax and dividend payments. For these reasons, profits have been
ignored.
iv. All overheads are assumed to be variable. Presence of depreciation element in
overheads will lower the working capital requirement. In the absence of such a figure, an
estimate of the amount cannot be made.
ii. By determining the cash costs of current assets and current liabilities:
It has already been stated that the working capital is the difference between current
assets and the current liabilities. In order to estimate the requirements of working
capital one has to forecast the amount of current assets and the current liabilities.
However, in case of certain current assets, the cash costs involved are much less than
the value of the current assets. For example, if the sundry debtors are estimated at Rs.
1,00,000 and the cost of production of the goods with them is only Rs. 75,000, the
amount of funds blocked with them is only Rs. 75,000 and not Rs. 1,00,000. Moreover,
if the cost of production includes a sum of Rs. 5,000 as depreciation, the amount of
actual funds blocked with them is only Rs. 70,000. This is equally true of the cost of
finished goods and work-in-progress which may include the amount of depreciation.
Many experts, therefore, calculate the working capital requirements by taking into
account only the cash cost blocked in sundry debtors, stock of work-in-progress and
finished goods. According to this approach, the debtors are computed not as a
percentage of sales but as a percentage of cash costs. Similarly the finished goods and
work-in-progress are valued according to cash cost.
Illustration:
Raju Brothers Private Ltd., sells goods on a gross profit of 25%. Depreciation is taken
into account as a part of cost of production. The following are the annual figures given to
you:
Solution:
STATEMENT OF WORKING CAPITAL REQUIREMENTS
(Rs.)
MODEL QUESTIONS
1. "The level of Working Capital is a function of trade-off between liquidity and
profitability" - Elaborate.
2. Explain the various determinants of Working Capital of a concern.
3. Define Working Capital. Distinguish between permanent and temporary working
capital.
4. Explain the importance of working capital in attaining the profit objective of an
organisation. Explain how working capital needs are assessed.
5. Write a note on:
i. Gross Working Capital
ii. Net Working Capital
iii. Receivables Management
iv. Operating Cycle
DR. RM. CHIDAMBARAM
Prof. & Head
Dept. of Bank Management
Alagappa University
Karaikudi
ASSIGNMENTS
Financial and Management Accounting
1. Explain how the Management Accounting helps in removing the limitations of
financial accounting in the context of information of beds of different levels of
Management.
2. Explain the role of Management Accountant in setting long range and short range
objectives of a business organization and also in ensuring that such objectives are
achieved.
3. What is a capital expenditure budget? Why is it necessary? What are its essential
features?
4. Discuss briefly the Net Present Value (NPV) vs. Internal Rate of Return (IRR)
methods of evaluation of projects.
5. Explain the importance of proper planning and control of capital expenditure and the
various techniques that are used for comparative evaluation of mutually exclusive
capital expenditure proposals.
6. Explain the different methods of financial statement analysis.
7. Give the format of a single column statement with imaginary figures.
8. How do you analyse and interpret the financial statement of a company for reporting
on the soundness of its capital structure and solvency.
9. "Return on capital is the product of profit margin and capital turnover" - Discuss the
statement and state how this statement is used for managerial purposes.
10. What are the objectives of inter firm comparisons?
11. 'Accounting ratios are mere guides and complete reliance on them in decision
making is suicidal' - Elucidate.
12. Explain the techniques of marginal costing and state its importance in decision
making.
13. What is breakeven analysis? Discuss its assumption and uses.
14. State four different methods of finding out the breakeven point graphically.
15. 'Cost-Volume-Profit relationship provides management with a simplified framework
for an organisation which is thinking on a number of its problems'. Discuss.
16. Define budget and budgetary control. Explain various types of budgets that are
drawn up in manufacturing units.
17. Explain what is meant by flexible budget and its utility.
18. Discuss the difficulties which arise and how they are overcome in forecasting sales
and preparing sales budget.
19. What do you understand by the expression 'Reporting to management'? Explain in
detail the matters that you would deal with while reporting to Board of Directors.
20. What factors would you take into consideration in planning the working capital
requirements of a firm? Explain them in brief.
- End of Chapter -

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LESSON - 1

ACCOUNTING - THE LANGUAGE OF BUSINESS

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