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Certificate Program in Marketing & HRM

Introduction to Accounting

Reading material

November 27-28, 2010

Indian Institute of Technology, Bombay

Prepared by:

Dr. Abhijit P. Phadnis


Table of Contents

Financial linkages of business .............................................................................................. 4


Basic business model ......................................................................................................... 4
Key ingredients of a business ........................................................................................... 4
Why is financial dimension important............................................................................ 5
Role of Finance function.................................................................................................... 5
Limited liability companies .............................................................................................. 6
Financial Statements & key financial terms........................................................................ 8
Financial statements........................................................................................................... 8
Assets ................................................................................................................................... 8
Fixed Assets......................................................................................................................... 9
Current Assets .................................................................................................................... 9
Working capital .................................................................................................................. 9
Liabilities ........................................................................................................................... 10
Capital ................................................................................................................................ 10
Reserves ............................................................................................................................. 11
Net Worth.......................................................................................................................... 11
Long Term Liabilities....................................................................................................... 11
Capital Employed............................................................................................................. 12
Current Liabilities ............................................................................................................ 12
Depreciation ...................................................................................................................... 12
Profit................................................................................................................................... 15
Finance cost ....................................................................................................................... 15
Balance Sheet..................................................................................................................... 16
Fundamental accounting equality ................................................................................. 16
Income Statement (Profit & Loss Statement or Account)........................................... 16
Cash Flow Statement ....................................................................................................... 17
Process & principles behind preparation of financial statements................................. 17
Overview of Accounting Process................................................................................... 18
Accounting Convention, Concepts & Standards ......................................................... 19
Disclosure of Accounting Policies.................................................................................. 20
Ratio Analysis ....................................................................................................................... 21
Liquidity Ratios ................................................................................................................ 22
Turnover Ratios ................................................................................................................ 23
Profitability Ratios............................................................................................................ 25
Leverage / Capital Structure Ratios.............................................................................. 26
Earnings Ratios ................................................................................................................. 27
Return on Investments .................................................................................................... 27
Cash & Working Capital Management ............................................................................. 28
Cash .................................................................................................................................... 28
Marketable Securities....................................................................................................... 28
Cash Management............................................................................................................ 29
Working Capital Management ....................................................................................... 29
Inventory Management ................................................................................................... 31
Receivable Management.................................................................................................. 33
Payable Management....................................................................................................... 34
Cost, cost classification & cost management .................................................................... 34
Cost..................................................................................................................................... 34
Cost & Management Accounting................................................................................... 35
Critical role of Cost & Management Accountants....................................................... 35
Cost Classification ............................................................................................................ 36
Cost Management ............................................................................................................ 39
Marginal Cost.................................................................................................................... 39
Contribution...................................................................................................................... 40
Break-even Point analysis ............................................................................................... 40
Financial linkages of business

Welcome to this program which introduces you to the world of finance. You are all business
managers with expertise in you respective disciplines. Yet, you have arrived to learn
something about finance. Perhaps, the reason is obvious. Finance is core to any business.
Your company is no exception. Let us, therefore, begin with a very basic model of any
business.

Basic business model

Every business has its origin in a dream or some idea perceived by an entrepreneur. The
idea needs to be backed by an astute understanding of the environment around and an
action plan to implement the idea. One of the key ingredients of implementation is capital.
This capital is required to acquire various resources for the smooth functioning of the
organization.

This capital is partly provided by an entrepreneur and partly by friends and relatives.
However, often that is not sufficient as the business grows. Then, the public at large may be
willing to contribute to the business, if they perceive it to be a profitable opportunity. These
are the people who are taking the risk of the business. In addition, lenders may come in with
their kitty with an expectation of a pre-determined return.

As the business takes roots and stabilizes, efficiency of the cycle of money becomes
extremely important. In a way, there are two simultaneous and overlapping cycles running
any business. One cycle may be called as ‘value addition’ cycle the beneficiary of which is
the customer. In fact, if this cycle does not add value, the very existence of the business is
shaken. The customer, therefore, comes first. At the same time, the entrepreneur did not
establish the business for a charitable purpose. Neither did other contributors contribute
their share for charity. They expect a return and therefore, one needs to watch the mirror-
image of the ‘value addition cycle’ which let us call as ‘money cycle’. The money cycle
should ensure that while the customer gets value added product or service, the firm should
realize a reasonable return.

Key ingredients of a business

An organization needs to acquire several resources to function. For instance, a firm must
create a certain minimum infrastructure required for smooth functioning of a business.
Examples of infrastructure include office premises, equipment, computers, telephone
connections, and furniture and so on. This, however, is of no use unless the business
engages the right type of people. Infrastructure and people are two critical resources, which
facilitate churning of the day to day business. The purpose of any business is to add value to
the resources acquired from suppliers and to the way they are delivered to the consumers.
Some of the resources retain their form for a long time such as equipment, office premises
etc. There are some other resources that keep changing their forms such as materials, work
in process, finished stock, etc.

The most basic resource is money. Money is used to buy other resources like infrastructure
and also those required for the day to day business like materials, spares, consumables,
other services etc. Capital and borrowings facilitate acquisition of all the resources.

The resources of the type which change their form as a part of the value addition process of
the organization mentioned above need to be bought and with value addition they are sold
to ultimate customers. The resources which remain with the organization such as
infrastructure components can be acquired either by buying them or by hiring them. People
resources need to be hired.

Having acquired these resources, it is highly critical that the same are used properly. If they
are not utilized properly, the organization’s profitability gets affected.

Why is financial dimension important

The purpose of any organization is to create wealth for its shareholders. Shareholders are
the people who have risked their capital and have shown preparedness to let it get wiped
out in case of business failure. However, the reason why they contributed was to earn
profits sustainable in the long term. Hence, the purpose of the organization could be better
stated as ‘Wealth Creation’ than ‘Profit Maximization’ since the latter may be viewed more
from a short term point of view, sacrificing the sense of sustainability over a long term.

Money has become a vehicle to facilitate wealth creation. In the absence of money, collective
utilization of capital and savings would be nearly impossible. Money has also become a
measure of performance and value creation. It provides a common language for business
and channels efficient resource allocation! Money chases profits & wealth!! Finance deals
with this money dimension all the time and hence has become an important function in the
corporate world.

Role of Finance function

Managing the flow of funds efficiently is the purview of finance. Finance function thus deals
with methods to plan, raise and use funds in an efficient manner to achieve corporate
objectives. Finance function has to deal with three major decisions: The investment decision,
the financing decision and the dividend policy decision.

Investment decision

This relates to selection of assets in which funds will be invested by the firm. Assets are
nothing else but the resources which are essential for the functioning of a business. These
assets can fall into two broad groups: Long-term assets & Short- term or current assets.
Methods relating to selection of Long Term Assets are called as capital budgeting. The
aspect of financial decision making with reference to current assets or short-term assets is
popularly termed as working capital management
Financing decision

While initially it is the seed capital of the entrepreneur that gives birth to the organization,
as the organization grows and stabilizes, it has various options of seeking finance.
Financing decision deals with selecting sources which will form part of the Capital Structure
based on their cost effectiveness. The decision also deals with deciding proportion of
various sources in the Capital Structure.

Dividend Policy Decision

Dividends can be distributed only out of profits. However, how much to distribute and how
much to retain depends on a number of factors. Profits of an organization belong to their
owners. In the context of a Limited Company (to be discussed more in detail later), they
belong to the Shareholders. However, Board of Directors are entrusted the task of managing
the business on behalf of the shareholders. They are the ones who are responsible for
formulating business plan of the organization and implementing the same.

Board of Directors may, on the advice of the Chief Financial Officer (CFO) decide to retain
the profits within the business instead of distributing them, if they feel that the money can
be put to use more fruitfully by the company than it will be done by the shareholders. In
turn, that money has the potential to maximize the wealth of the shareholders. On the other
hand, if they feel that there are no great opportunities for the company to use that money,
the Directors may choose to distribute the same to the shareholders.

There are a number of factors which influence the dividend decision:

• Opportunities to invest in new projects


• Level of existing borrowings and availability of credit lines
• Taxation rates on dividend
• Opportunities for the shareholders to invest the money fruitfully

Limited liability companies

First an entrepreneur starts his or her small enterprise. S/he is the only owner of it. As the
business grows and requires more funds, s/he starts looking for partners who will support
in this venture. It may grow into a partnership concern but still its size is quite small and
manageable. The entrepreneurs and their partners’ individual lives are quite intertwined
with the business enterprise. The success of the enterprise is their success; its failure directly
affects them. This works fine when all the people who have staked their capital and life
know each other and the need for financing the business is also quite limited. A stage may
come when the business starts expanding with lot of opportunities waiting to be exploited.
At this stage, there is clearly a need for larger capital base which may be beyond the
capability of the proprietor or individual partners.

The partners then find it useful to convert their business into a ‘corporate’ vehicle. To create
a corporate vehicle is a legal process. One has to go through a registration process in
accordance with the law of the land. A company is now born. This company now acts as a
vehicle to fulfill the vision of the entrepreneur. The question arises what is the need for a
corporate vehicle.. why a large partnership can’t be formed. Usually, managing a large
partnership is cumbersome since each partner may look for a role to play due to his/ her
monetary stake involved. Even with possibility of sleeping partners, partnership with
unlimited liability of partners may not be a very attractive option. Also, usually law of the
land restricts the number of partners that could be inducted. A limited company implies a
‘limited liability’ company which implies that the liability of the shareholders is limited to
the amount that they have agreed to subscribe in terms of ‘shares’ of the company. A ‘share’
is a portion or unit of the equity capital of the company. A company could be incorporated,
under Indian law, either as a private limited company or as a public limited company. The
minimum number of shareholders required in case of former are 2 and in case of latter 7. A
private limited company, however, restricts its shareholders only to fifty, announces its
intention to refrain from offering the shares to public. Thus, a private limited company is a
natural transition from a partnership with an advantage of ‘limited liability’ protection
unless the ‘corporate veil’ is lifted for some extraordinary reasons. A private limited
company opens an opportunity to more people who share the vision of the entrepreneur/s.
However, a stage may come when an enterprise may have to grow beyond the private
limited umbrella and break open into the public domain. This need arises when even larger
doses of capital are required for the business enterprise. You must have come across ‘Public
Issues’ of shares. They are nothing but an open offer to subscribe to the shares of the
company. People who have trust in the vision of the entrepreneur and are convinced about
the venture would be willing to risk their money, of course with the expectation of a
handsome return. The company law provides protection of ‘limited liability’ whereby the
shareholder does not become accountable for liabilities & debts raised by the company. As
said earlier, the liability is restricted only to the commitment given by the shareholder when
subscribing to the shares.

The key principle involved is that of separation of management and ownership. The
directors collectively called as the Board of Directors, act as the management agent on behalf
of the shareholders. The agency principle requires that the agent acts in the best interest of
the shareholders. However, sometimes a conflict of interest can arise. For instance, some
directors who work in an executive capacity may draw some salaries. They also may be
shareholders like others. In the capacity of a shareholder they are entitled to a
proportionate share in profit. However, in the capacity of an executive they alone draw
remuneration. An increase in remuneration benefits one shareholder at the cost of all other
shareholders and therefore, usually company law requires disclosure of this sensitive
information.

A limited liability company, once incorporated gets certain key rights under the law. The
rights include right to own property in its own name. When say a property is bought on
behalf of the company, the property is required to be registered. The property is registered
in the name of the company and not in the name of promoter directors or any one else.
When vehicles are purchased in the name of the company, the Registration Book of the
vehicle issued by the Regional Transport Office is issued in the name of the company and
not in any other name. Same thing applies in case of bank accounts or financial
investments. Further, a company is allowed to borrow in its own name. Thus, the
borrowings are the liability of the company and not its shareholders.

Financial Statements & key financial terms

There are a number of stakeholders in any business. In the context of a limited liability
corporation, the shareholders are the key stakeholders. In addition, there are lenders,
suppliers, employees, trade unions, tax authorities, government departments, analysts,
prospective investors who are interested in understanding how business is doing. The
management of the enterprise is itself keen to find out how the business is doing on an
ongoing basis since they have the prime task of navigating the ship of the enterprise.
Financial statements are mirrors of company’s actual operations and they summarize the
financial status and financial performance of the firm. What are the key pieces of
information that people would be interested in knowing?

a. What are the resources currently at the disposal of the organization


b. Which are the various entities who have financed the enterprise
c. How is the overall financial stability of the enterprise
d. How has been the profitability of the business
e. What are the sources from which cash is coming in and which are the end-uses
which are taking away cash resources
f. Is there a cash surplus or cash deficit

Financial statements

If you read any company’s annual report, you will find three financial statements as a part
of the same. They are Balance Sheet, Profit & Loss Account and Cash Flow statement. These
financial statements are expected to provide an insight into what is happening in the
organization and how is its financial health. These statements provide answers to the above
questions.

Before we get into details of financial statements, let us first get familiar with various terms
which are often used in the context of these statements.

Assets

We had seen earlier that for a business to come into being and grow, an investment is
required in various resources. These resources are the assets of the organization. By
creating an asset base, an organization creates a framework for being able to provide useful
services to its customers & clients. It creates a foundation which its people can utilize. Assets
can be physical assets or monetary assets. Physical assets are those which can be tangibly
seen. They include machinery & equipment, computers, raw and packaging material
inventory, buildings etc. Monetary assets involve legal claims on third parties. They include
cash balance (claim on the central bank / government), bank balances (claim on a
commercial bank), deposits (with various regulatory authorities or utilities), advances (to
suppliers), receivables (from customers). Sometimes, a firm may invest in another firm. Such
asset is also monetary in nature.

Fixed Assets

Fixed Assets represent the organizational infrastructure. They are the backbone of the
business. Without their availability it becomes very difficult to offer any products or
services to a customer. Of course, there are some organizations that get everything
manufactured outside and only focus on marketing. Even then, certain fixed assets such
office, office equipment, furniture, computers become necessary. It is very difficult to
perceive a business enterprise which has outsourced all its function and therefore, does not
have any infrastructure of its own. These assets are called as ‘fixed’ since they remain with
the organization for a long time. They are disposed off only when their utility dwindles &
they have to be phased out. They are acquired with a view to use them in the business and
not to sell them soon. Some of the fixed assets could be moveable and some others could be
immoveable.

Current Assets

The current assets temporarily exist within the organization, change their form and go away
as soon as handed over to the client. For example, raw material is procured, it is processed,
packed using packing material, dispatched to customers in a finished form and eventually
the amount due from the customer is collected. This process is continuously going on.
Depending on the nature of each business, the time taken to complete the cycle will differ.
Much before one cycle is completed, another begins.

Examples of Current Assets

Raw & Packing Material Inventory


Spares Inventory
Accounts Receivable
Advances to suppliers
Bank Balance

Working capital

The term ‘Gross Working Capital’ is synonymous with current assets. The reason why
current assets are called as working capital is because it stands for an investment in day to
day running of business. This investment or asset base is very dynamic in nature,
continuously changing its form. While infrastructure assets (Fixed Assets) remain with the
company, working capital components keep on changing taking different forms and
eventually converting into cash which in turn again gets invested in buying various current
assets. This cycle goes on. There is another term in the context of working capital: ‘net
working capital’ which is also often focused upon. Net Working Capital is the difference
between Current Assets (Gross Working Capital) and Current Liabilities. The term current
liability has been discussed later, but it may suffice to state here that Net Working Capital
indicates the net investment of business enterprise in day to day running of the business.
The word ‘Working Capital’ should not be confused with the word ‘Capital.’

Liabilities

Liabilities are the source of funds for the organizations. Funds can be provided by a third
party to the organization in monetary form as well as in material / equipment form. For
example, supplier of raw material may grant your organization certain period of credit. Till
the bill is paid for, the purchase amount is a liability for the organization and would appear
on the balance sheet of the firm. A liability can arise on account of borrowing money as
well. It will continue to be recognized as a liability till the amount is paid back. First and
foremost liability of the organization is the share capital itself since without it the
organization will not come into being at all. In a way, it is a permanent liability of the firm
since capital continues to exist till the demise of the firm. To certain extent, this liability
could diminish of there is a share buy back in accordance with the rules of the land.
Following are examples of liabilities:

• Loan taken from a bank which yet outstanding


• Unpaid dues to suppliers
• Unpaid salaries
• Share Capital
• Tax liability

Capital

Capital is the amount of fund provided by a set of people who have taken the prime risk
arising from the business enterprise. In the context of the corporate world, the capital could
be contributed by way of equity capital or by way of preference capital. In case of equity
capital which is also called as risk capital, return is not guaranteed or even indicated.
Equity capital is called Risk Capital since the providers of these funds, the shareholders
have claim on residual profits of the organization and are also required to bear losses.
However, bearing losses does not mean that shareholders have to make up these losses
since by law their liability is limited to the share subscription they have agreed to pay at the
time of allotment of shares. Equity Capital is like a permanent liability. Once a company
raises equity capital by offering shares to public, this money is not repaid unless the
company goes in liquidation or is wound up. Now, a company is allowed to buy some of its
equity back even while it continues to exist and grow. The other type of capital is called as
preference capital. The word preference indicates preference over equity shareholders (and
no one else) in respect of payment of dividend and repayment of capital. In case of
preference shareholders also no dividend or return is guaranteed. However, if the company
chooses to declare dividend to equity shareholders, dividend has to be paid to preference
shareholders first.

There are several determinants of the size of capital required.


 Business Model: One organization may decide to get into own manufacturing activity.
Another may decide to focus only on marketing by outsourcing all the activities.
Naturally, the former would require a larger commitment of capital.

 Distribution Channels: An organization may decide to set-up a chain of retail shops


itself to reach consumers. Another organization, on the other hand, may use distributor-
retailer chain for distributing its own products. A third organization may get into a
franchisee arrangement. The first organization would require the highest amount of
capital towards distribution channels.

 Competitive Pressure: if the market is highly competitive, customer is the king. In a


situation like this, an organization is required to hold a higher level of inventory and be
liberal in granting credit to its customers than what it would prefer to do normally. This
increases the requirement of capital.

 Infrastructure Requirements: Depending on the complexity of manufacture,


organizations are required to create suitable infrastructure. More complex the
manufacture, higher would be the need to invest in a variety of facilities. This means a
larger sum of money is required to be invested.

 Customer Demands: Organizations are required to provide after sales service to


customers. Appropriate infrastructure is required to be created for this purpose. Again,
organizations may cater to industrial customers or they may cater to individual
consumers. In either case, customers are demanding and organization needs to ensure
that it satisfies their requirements.

Reserves

As the company makes profits, it may find it desirable to retain a certain part of the same to
finance the future resource needs of the organization. A part of the profits are distributed as
dividend and the balance accumulate into reserves of the corporation. They also appear on
the liability side of the balance sheet since they reflect dues of the organization to the
shareholders of the company. The level of reserves indicates the financial health of the
company and represents the past profits of the organization to the extent not distributed by
way of dividend.

Net Worth

Net worth implies the total dues to the shareholders. Net worth is thus the total of equity
capital and reserves. When there is preference capital in the capital structure, the same also
needs to be added. Higher the net worth the better is the organizational health.

Long Term Liabilities

Borrowings from Banks & Financial Institutions are for short, medium or long term. The
medium to long term borrowings may range from 3 to 10 years or even more. Even longer
term borrowings may be possible from multilateral financial institutions. Some companies
also raise long term liabilities by issuing debentures. The debentures could be privately
placed or could be offered to public at large. The debentures could be non-convertible or
convertible. They could be redeemed in one bullet payment or they could be redeemed in
installments. The long term liabilities involve payment of interest. Interest could be ‘fixed’
or pre-determined or alternatively interest could be floating which implies that it is reset
periodically for a short period such as six months.

Capital Employed

Capital employed is the quantum of assets invested in running a business financed by long
term sources of funds. The long term sources of funds can be in the form of equity &
preference capital and in the form of long term borrowings. The capital employed is a sum
total of Equity Capital + Reserves of the company + Long Term Borrowings. The same
number can be derived by adding to the Fixed Assets, investments and net working capital
of the company.

Current Liabilities

Current Liabilities are those liabilities which are to be discharged in the near future.
Typically, those liabilities which fall due within a period of one year are called as current
liabilities. The examples of current liabilities include credit received from suppliers, short-
term bank finance, advances received from customers. For that matter, employees also offer
short-term credit to their employer. On an average of 15 days!!! Till the salary is paid, they
form part of current liabilities.

Depreciation

A fixed asset is procured with a view to use it over a long-term. Its life cuts across many
financial years, many projects, and many jobs. The expenditure on acquiring the asset is,
therefore, spread over its useful life instead of just treating it as a cost or an expense of one
year. This prorate charge is called as Depreciation and it is a notional charge since no
cheque is issued to anyone towards depreciation. This is because the payment to the
supplier of equipment is already made at the time of its procurement or at the end of the
credit period.

Depreciation on one hand recognizes the cost of using the equipment and on the other
denotes a reduction in value of the equipment due to wear and tear or even simply passage
of time. Depreciation is calculated with reference to the landed cost of the equipment.
Thus, in addition to the cost charged by the supplier for the equipment, the incidental costs
such as transportation to the place of use, insurance in transit, customs, octroi, sales tax and
such other duties, costs of loading & unloading, cost of installation are all added up together
and are ‘capitalized.’ Sometimes, after acquiring an asset, further expenditure may be
incurred on making additions to the assets or making such modifications that can either
lengthen the life of the asset or increase its capacity. Such cost is also capitalized. From this
entire capitalized cost, the estimated salvage value at the end of the economic period is
reduced. The reason for doing this is to arrive at the net cost of the equipment. Salvage
value stands for the value that can be realized by selling the equipment or the piece of fixed
asset to a third party. In case of some equipment and assets there could be a second hand
equipment market in which case a relatively better value could be realized for the fixed
asset. In may cases, however, the same may not exist in which case salvage value would
simply by the scrap value of the equipment. One of the limitations of accounting is that it
ignores time value concept. Thus, expenditure incurred at one point of time in acquiring the
asset is reduced with the scrap value of the equipment which is going to be realized at a
totally different period of time. Let us now discuss the concept of economic life. Economic
life indicates the productive life of an asset during which an asset can be used at a high level
of efficiency without incurring significant costs for overhaul or major repairs. Physical life
on the other hand implies such period when asset can be used without regard to the amount
of expenditure that may have to be incurred to maintain the asset. From business point of
view, it is the economic life that is critical than the physical life since business always
searches for efficient way of operations.

There are different methods of providing for depreciation, two most common being:
Straight Line Method & Written Down Value Method. Let us discuss these methods below.

Under straight line method of depreciation, the net cost of an asset i.e. the cost incurred
initially as reduced by the estimated salvage value is spread equally over the economic life
of the asset. The reason it is called as straight line method is because if one graphs the
depreciation amount for each of the years during the economic life of the equipment, the
graph (with years on x axis and amount of depreciation on y axis) would be a straight line
parallel to x axis. This method is simple to administer and is suitable where the wear and
tear of the equipment and its efficiency level remains uniform through out the life of the
equipment. Arithmetically, the rate of depreciation under this method can be derived as
follows:
Original cost of the equipment less Estimated Salvage Value
Rate of depreciation = ______________________________________________________ X 100
Original cost of the equipment X Economic life

This rate of depreciation derived above is required to be applied to the original cost of the
equipment.

Under written down value method of depreciation, the calculation is little more complex.
Under this method, the principle that the total depreciation amount to be charged on an
asset should be equal to the original cost of the equipment as reduced by the estimated
scrap value is adhered to. However, the amount of depreciation charged each year on
account of an asset declines with every passing year. Under this method the rate of
depreciation is applied not on the original cost of the equipment ‘capitalized’ on purchase
but rather on written down value of the asset. The written down value is simply the original
cost as reduced by the depreciation charged or recognized on the asset thus far. In the first
year of deprecation recognition, the written down value is equal to the original cost of the
asset. In later years, the written down value becomes smaller and smaller. The rate of
depreciation is worked out in such a way that by keeping the rate constant, the amount of
depreciation is calculated with reference to the written down value and the total
depreciation under this method equals the net depreciable value i.e. original cost less
estimated salvage value. It is but natural that initially the amount of depreciation charged is
high and it reduces as years pass by. The graph of such depreciation amounts declines to the
right. This rate of depreciation can be derived using log function. While, it is relatively more
complex to calculate, it is often favoured by manufacturing enterprises since the usual
experience is that as years pass by the repairs cost does go up. The graph of the repairs cost
is usually rising to the right. Thus, managers in favour of this method argue that a falling
depreciation is compensated by rising repairs cost with the result that the overall cost of
using the equipment i.e. depreciation + repairs remains within a narrow range.

Following table shows, the comparative rates of depreciation under the two methods. These
rates have been calculated assuming 4% as the salvage value.

No. of years Straight Line Written Down


Rate % Value Rate %
3 32.00% 65.80%
4 24.00% 55.28%
5 19.20% 47.47%
6 16.00% 41.52%
7 13.71% 36.86%
8 12.00% 33.13%
9 10.67% 30.07%

Companies Act, 1956 which governs the companies incorporated in India allows flexibility
to companies to use either of the two methods. It also provides a schedule of depreciation
rates to be followed by companies for different asset classes. These are the minimum rates
and if the company realizes that assets depreciate faster than the years assumed for
calculating the deprecation rates, it must provide for depreciation accordingly. The Income
Tax act on the other hand allows only standard depreciation rates prescribed under it and
the depreciation is required to be provided on reducing balance or written down value
method.

Both these methods discussed above are most suitable where efflux of time is the critical
determinant of depreciation. In certain cases, however, the actual time of use or the quantity
extracted becomes the measures of depreciation. An example of the former is an LCD
projector whose bulk of the cost is on account of the bulb which is very expensive. The time
actually the bulb is put on becomes the measure of depreciation rather than just months &
years passing by. The second case is applicable to extractive industries such as mineral or
oil extracting industries where the value to the land is attributable to the specific minerals
which are hidden underneath. Though, usually no depreciation is charged for land since it
is a resource which will not get exhausted, in case of industries which pay for a special
quality of the land (viz. the mineral reserves) the cost attributable to this special quality is
spread over the possible quantity that could be extracted.
Profit

Profit is calculated by reducing from revenue earned by the firm, the costs associated with
the revenue earning activities. It is very critical to ensure that revenue and cost should be
comparable. Let us illustrate with an example. A trading firm buys 10,000 pieces of certain
equipment in a year. Each costs Rs. 1,500. It had to incur Rs. 100 on transportation & various
duties. Out of these it sold 8,000 units for Rs. 1,800 each. While calculating profit for the
firm, we need to take into account the revenue on sale of 8,000 units and also costs
pertaining to the same volume. It will be a mistake to take into account the revenue of 8,000
units and costs pertaining to 10,000 units.

Profit can be defined in various ways. Net profit implies the profit recognized after taking
into account all the costs including interest, depreciation and taxes. Profit before tax implies
all costs have been taken into account but for tax expenditure. Operating Profit takes into
account profit arising only from core activities of the organization. Thus, operating profit
would exclude the profit that has arisen on sale of surplus property which was acquired
sometime ago. Gross profit is calculated by reducing from the revenue only those costs
which are incurred on manufacturing operations.

Profit is the prime motive of an organization soon after customer satisfaction. Profit is a key
measure of overall efficacy of the organization. Profit calculation is done on completion of
the sale transaction irrespective of whether the collection of the customer dues has
happened or not. Similarly costs are recognized irrespective of whether the costs have been
paid for or not already.

At the same time, just ‘earning’ profit is not enough, ‘realizing’ the profit is. Just because a
business segment is profitable may not automatically mean that it would result in cash
surplus or availability. Quite often money is locked in inventories and receivables which
mean strain on cash resources. Sometimes, profitable organizations can become technically
insolvent because they are not able to meet the obligations to their creditors due to non-
availability of cash. It is therefore, important that money locked in inventories and
receivables should be released as early as possible.

Finance cost

Finance cost arises on account of the amounts borrowed by the organization from various
external financiers such as banks, financial institutions, debenture holders and even
customers. These financiers have to be compensated by way of interest which may either be
fixed or floating. Finance cost depends on the interest rate, the quantum of borrowings and
the duration of the borrowings.

It may be mistakenly believed that Finance Cost is under the control of the Chief Financial
Officer (CFO). In fact, there is only a certain portion of it that CFO can influence. CFO can
influence the rate at which the funds are borrowed. However, it is the business managers
who influence the ‘size’ of funds required. Please remember all of you are business
managers and it is you who can influence the finance cost. The biggest influencer of the
finance cost is the size of borrowing which in turn gets influenced by the size of assets. If
assets are the engine of the enterprise, liabilities are simply a bogey that follows. Higher the
size of assets, higher is the size of liabilities. Higher the size of liabilities, higher the finance
cost. Higher the finance cost lower the profitability.

There are a number of factors which have a bearing on the size of assets. By creating excess
capacity, the size of assets would be larger than with the asset base with optimum capacity.
Also, if there is a mismatch between capacities of various processes, this would result in
underutilization of capacity of some process and also piling of inventory wherever there is a
bottleneck. The other thing to watch is the amount of time it takes for completing the cycle
of money which begins with procurement of resources and ends with realization of sale
proceeds from customer. Key thing to remember here is that longer the time it takes to
convert money back to money through business operations, higher is the investment of
money and higher the liabilities and higher the finance cost.

Balance Sheet

Balance sheet provides a snapshot of financial position of business as on a particular date.


Balance Sheet reports the balance of the resources (assets) available at the disposal of the
firm at the time of preparing the balance sheet and the balances of sources (liabilities) which
have financed these resources.

Conventionally, the assets with a longer life are listed first followed by assets which have a
shorter life span. Thus, current assets appear at the bottom. Similarly, the liabilities which
are permanent (capital) is listed first followed by liabilities which are long term in nature.
Current liabilities appear at the bottom.

Fundamental accounting equality

A corporate umbrella is created essentially to serve a growing business need and need for
larger doses of capital. The company form is thus simply a ‘vehicle’ for fulfilling human
needs. Thus, it has to be that all the resources owned by the enterprise have to eventually
belong to those who have financed the enterprise. This results into a fundamental
accounting equality which implies that the assets of an enterprise are equal to the liabilities
of the enterprise.

Income Statement (Profit & Loss Statement or Account)

Profit and Loss Account provides details about revenue and expenses (costs) of the
company. There are a number of heads under which expenses are incurred and revenue is
earned. The published statements that you see, therefore, would provide all the details of
these expenses and revenues in neatly classified schedules. It should be noted that unlike
the balance sheet, the profit & loss account is prepared for a period, usually a financial year.
It is important to note that the profit & loss account provides a reconciliation of the reserves
position of the business enterprise between the dates of the balance sheet at the beginning
and end of the year or at the end of two years.
Every profit earned bolsters the reserves position of the enterprise. However, it is important
to understand in details all the causes (revenues & costs) which are impacting the
profitability of the organization and therefore, the profit & loss account is prepared in
adequate detail so that one can understand all the reasons that have impacted the
profitability and even be able to compare the same from year to year or across firms.

Cash Flow Statement

Cash flow statement provides details of the sources of cash inflow for the organization and
the destinations where cash has been utilized. Cash flow statement has three components
arising from three different avenues for cash flows.

Operating Cash Flow portion deals with cash generated from business operations. An
efficient business indicates a very healthy operating cash flow position the net result of
which should be ‘positive’. A highly profitable business with collection inefficiencies or
disorganized inventory management or sloppy collection effort may mean a ‘negative’ net
operating cash flow since profits are earned but only on paper and are not realized.

Financing cash flows indicate all the activity happened during the year in raising money
from fresh sources as well as in repaying the debt previously raised or money paid in
servicing the capital whether in the form of interest or dividend payments.

Investing cash flows indicate the cash paid out for acquiring long term assets like Plant &
Machinery, Buildings and even for making investments in other companies. Cash realized
by selling similar assets in which money was previously invested is also shown in this part
of the statement.

These three types of cash flows could individually be positive or negative. This leads to
number of different combinations each providing a different interpretation of the health of
the business. For instance, a positive operating cash flow coupled with a negative (excess of
outflow over inflow) investing cash flow and a negative financing cash flow indicate that
the firm is generating so much of operating cash flow that it has adequate cash to invest in
growth of the business and further the cash that is left over is used for repayment to the
lenders.

Like the profit & loss statement, cash flow statement is also prepared for a period of time
and it provides reconciliation between the cash resources available at the beginning of the
period and the cash resources available at the end of the period. Cash implies cash in
currency form, bank balance and securities which have been temporarily held for earning
return from surplus funds.

Process & principles behind preparation of financial statements

We have seen above the need for various financial statements, some details of various
financial statements and certain key accounting and financial terms. In this section, we
would deal with the process and key principles which form the back bone of accounting
process.

Overview of Accounting Process

Accounting is based on the fundamental business reality: there is no free lunch. In other
words, there is always a ‘give’ and ‘take’ in every business transaction. On one hand
something is given and on the other something is received. Accounting recognizes this two
way flow. It is therefore called as a ‘Double entry’ book-keeping system. Each entry stands
for one ‘leg’ of the transaction. These two legs are called as ‘Debit’ and ‘Credit’ legs and
they have the same monetary value. One caution here. Please remove any connotation that
you may have in mind about these words. Often in general usage, ‘debit’ has a negative
connotation and ‘credit’ has a positive connotation. Since our interest is not so much in
understanding the book-keeping process but rather its interpretation, let’s not get into too
much of details of these two words. However, the following paragraph and the small table
below that will provide to you some glimpse of the process.

For recording a variety of business transactions, account heads are created. These account
heads broadly have the following categories: Assets, Liabilities, Revenue & Expenses. Under
each category there could be numerous account heads. Account heads assist in grouping
similar transactions together and therefore, they are defined in sufficient detail to capture
the differences across transactions or end use of funds.

In every business transaction, at least two account-heads are involved. It is not unusual to
have three or more account heads getting involved. Even then, the key thing remains, the
total of debit legs and the total of credit legs of the transaction is the same. As transactions
get recorded, account heads start accumulating balances.

Debit Credit
Assets An asset acquired An asset surrendered or sold
Liabilities A liability repaid An amount borrowed
Expenses An expense incurred Normally none, unless the supplier
subsequently agrees to give a rebate.
Revenue Normally none, unless we A revenue earned
agree to give a rebate to the
customer subsequent to the
business transaction.

As an example, when material is bought from a supplier on credit, the transaction is


recorded as:

Debit: Material Inventory


Credit: Supplier

When payment is made to the supplier, the transaction is recorded as follows:

Debit: Supplier
Credit: Bank Account (since in a way the bank balance to the extent of the transaction
amount is being surrendered to the supplier)

Assets & liabilities have a longer life than Revenue & Expenses. Assets & Liability account
heads continue to show balances till the time the asset is disposed off or the liability is
repaid. The obvious reason for this is that every business would like to track what it owns
and what it owes. An individual can afford to keep all that in his mind but a corporation’s
mind is reflected in its books of accounts. Since the usual financial period is one year, the
Revenue & Expenses account heads accumulate balances only for one year.

A statement which shows all such balances is called as ‘Trial Balance’. Because of a
methodical process followed in recording each transaction with equal debit and credit legs,
the balances of all accounts with debit balances will match with the balances of all accounts
with credit legs. The trial balance thus matches. In the manual record-keeping of
yesteryears, this was an important step in vetting the accuracy of the book-keeping process.

From the trial balance, first the profit & loss statement is prepared. When this is done at the
end of the financial year, the balances in revenue & expenses account heads are reset to zero.
The process of resetting to zero is achieved by transferring their balances to “Profit & Loss
Account” which is a summary account. As discussed earlier, the balance in Profit & Loss
Account now becomes a part of the Liability to shareholders since the business is being run
on their behalf and whatever the business earns is naturally on their behalf. If profit is
earned during the year, the liability to shareholders increases. On the other hand, if loss is
incurred during the year, the liability to shareholders diminishes. Thus, liability to
shareholders on account of profits called as ‘Reserves’ of business is a ‘highly desirable’
liability since in a way it reflects the savings of the business organization.

After transferring all the revenue & expense accounts to profit & loss statement, if a trial
balance is prepared again, it will only be left with asset & liability accounts which include
the balance in the profit & loss account for the reason mentioned above.

Accounting Convention, Concepts & Standards

As we have seen earlier, financial statements provide very vital information to their users.
Often the financial information of one organization is compared with other organizations
also. For comparability of financial statements across firms, it is required to ensure that they
are prepared on certain generally accepted norms which are valid across the accounting
community. In this context, we would discuss key accounting concepts, conventions and
fundamental accounting assumptions.

Accounting concepts:

• Entity: Business enterprise is independent of its owners. Therefore, capital & reserves
are shown as a liability in the corporate balance sheet. The same applies even to the
balance sheet of a partnership or even a proprietary concern.
• Money Measurement: Only such transactions which can be measured in money are
accounted for.
• Cost: Transaction is recorded at its underlying monetary value and not at a notional
value.
• Dual Aspect: Each transaction has two aspects and both have to be recorded.
• Realization: Revenue should be recorded only on conclusion of the transaction i.e. when
a monetary claim is established. Revenue cannot be recognized from unsold inventory.
• Matching: Revenue & cost have to be comparable before arriving at profit. Apples &
oranges cannot be compared.
• Materiality: Heads which are of material value will be disclosed separately.

Fundamental Accounting Assumptions

• Going Concern: Financial Statements, particularly balance sheet is prepared on a going


concern assumption. This implies that a business is supposed to exist for an indefinitely
long time. If the assumption is not valid, the assets may have to be valued on the basis of
their realizable value which could be much lower than the book value.
• Substance over Form: While recording transactions or business events, the true nature of
the transaction rather than the garb given to it will be taken into account.
• Accrual: Transactions are to be recorded on their legal completion and need not wait for
their cash settlement.

Accounting conventions

• Consistency in accounting practices: For comparability of financial numbers from year to


year, it is critical that accounting policies and practices are consistently followed.
• Disclosure of significant information: All material information which has a bearing on
the interpretation of financial statements has to be separately disclosed.
• Conservatism: Unfavorable events are recorded quickly assuming the worst could
happen and favorable events are recorded only when there is a reasonable certainty that
it is likely to happen.

Disclosure of Accounting Policies

Accounting Standard 1 deals with the disclosure of significant accounting policies followed
in preparing and presenting financial statements. To ensure proper understanding of
financial statements, it is necessary that all significant accounting policies adopted in the
preparation and presentation of financial statements should be disclosed. They should be
disclosed together rather than scattering them over schedules and notes. Accounting
policies refer to the specific accounting principles and the methods of applying those
principles adopted by the enterprise in the preparation and presentation of the financial
statements. It is not possible to put differing circumstances and the policies applicable in a
straight-jacketed manner. Considerable judgment by the management of the company is
required in determining the policies that are best suitable in the given circumstances. Also, if
any policies undergo change from year to year, specific disclosure is required. The standard
states that the following are the fundamental accounting assumptions. These are expected to
be the founding principles underlying accounting policies and thus presentation of any
financial statements and thus, if they are not followed, a specific disclosure is required:
Going Concern, Consistency & accrual. The standard further states that while selecting
appropriate policies, following considerations are required to be factored: Prudence,
Substance over form and Materiality.

Ratio Analysis

There are various stakeholders in a business enterprise. All these stakeholders keenly follow
financial performance of a firm since expectations about financial performance have a
bearing on the valuation of the firm, its ability to repay debt in the long term or in the short
term, its ability to compensate suppliers of various types, etc. The various stakeholders and
their key concerns, for which they analyze financial statements, are as follows:

 Shareholders & Potential shareholders


 Present and future earnings
 Valuation of the company
 Lenders
 Ability to service debt
 Creditors
 Liquidity
 Government regulators
 Overall financial stability
 Management
 Profitability
 Liquidity
 Efficiency
 Employees & unions
 Financial stability
 Profitability

The three financial statements: Balance Sheet, Profit & Loss Account and Cash Flow
Statement mirror the financial performance of the organization from three different angles.
Balance Sheet reflects the value & type of assets the organization currently holds and the
amount & type of liabilities that have been used to finance these assets. Profit & Loss
Account reflects the amount & sources of revenue for the organization and the amount and
the types of costs incurred during the last financial year. Cash Flow statement classifies the
cash flows into operational, investment & financing cash flows and reflects various
purposes to which cash has been put to use and the way financing has been done during the
last financial year.

The technique often used for understanding the above aspects or concerns is the technique
of Ratio analysis. As the name suggests, it involves calculation of a ratio that establishes a
meaningful relationship between two identities or items. The ratio could be calculated using
a Profit & Loss Account identity and / or a Balance sheet identity or two identities from the
same financial statement. Thus, money circulation efficiency or infrastructure utilization are
calculated using a Profit & Loss Account item in the numerator and a Balance Sheet Asset
item in the denominator and such a ratio often indicates the number of times the particular
asset class is ‘turned over’ during the financial year. Financing strategies are revealed by
calculating a ratio with a liability in the numerator with another liability in the denominator.
The profitability ratios are calculated with a Profit measure in the numerator. The profit
measure in the numerator can be compared with revenue or with capital employed in the
denominator. Ratio needs to provide some meaningful insight into company operations. It
is important for us to understand this relationship between the two numbers, factors
influencing them and the significance of any change in them. For interpretation of the
computed ratio, it is important to have some benchmark to compare with.

This ratio calculation is done based on the numbers pertaining to a given financial period or
in case of balance sheet at the end of it. Ratio analysis can be further extended to cover
multi-periods. The ratios calculated need to be benchmarked with reference to the ratios of
another period or those of competing organizations or industry averages. The various ways
in which it can be done is as follows:

 Comparing with normative ratios: Comparison can be with normative ratios which are
universally considered as thumb rules. Each industry and each company though could
have its own set of ratios, but this provides a general idea regarding the position of the
industry or company.

 Comparison of present ratio with past ratio: Comparison could be with prior periods. A
shift in the ratio will indicate either an improvement or a deterioration of the operating
efficiency of the company. Understanding the underlying reasons of change is a very
important part in the analysis.

 Comparison across companies / industry averages: Comparison with industry averages


or competitors could also throw a lot of light on how a company is performing vis-à-vis
the industry and its competition. The company can then identify the areas for its
improvement.

Ratios can be expressed in the form of

 Percentage : ‘Net profit is 25% of sales’


 Fraction: ‘The fixed asset turnover is 5.4’
 A stated comparison between two numbers: ‘Current ratio is 2.3 : 1’

Ratios can be broadly classified as:

 Liquidity Ratios
 Asset Utilization or Turnover Ratios
 Profitability or Operating Performance
 Capital Structure and Long Term solvency
 Return on Investments

Liquidity Ratios

Liquidity ratio measures short term ability of a company to meet its short term obligations.
It indicates current assets available for meeting current liabilities.
Current Ratio

Current Assets Cash & Cash Equivalents + Debtors + Inventory + Prepaid


________________ = __________________________________________________________
Current Liabilities Current Liabilities

Higher the current ratio more is the company's ability to meet current liabilities and greater
is the safety for short term creditors. Higher assets are required to meet uneven flow of cash,
possible shrinkage of assets values, etc. Current ratio indicates the available buffer.
Conventionally current ratio of 2:1 is considered adequate. A very high ratio will also not be
considered good as it may be on account of inefficiency in working capital management.
Currently, many firms have been consciously pushing this ratio down to 1: 1 level to ensure
that their investment in working capital is negligible or is directly financed by suppliers in
the form of current liabilities. Thus, the interests of different stakeholders (suppliers &
shareholders) may conflict.

There are a few limitations of this ratio:

1. Does not take into account the composition of the current assets.
2. Liquidity depends on future cash flows and to less extent on cash and cash equivalents
or near cash.

Liquid Ratio

Liquid Assets Cash & Cash Equivalents + Debtors


________________ = ________________________________
Current Liabilities Current Liabilities

The rule of thumb for this ratio is 1: 1 i.e. the liquid assets should be adequate to meet the
current liabilities.

Cash Ratio

Cash Assets Cash & Cash Equivalents


________________ = ______________________
Current Liabilities Current Liabilities

Turnover Ratios

Turnover ratios indicate the ability of a firm to utilize the assets in the best possible manner
as indicated by the revenue in relationship with the amount of investments made. These
ratios can be calculated with reference to the aggregate asset base or with reference to
individual asset components. In relation to the various components forming part of the
working capital cycle, it indicates the number of times that asset class completes the cycle in
a year.
Basic Turnover Ratio:

Sales
________________
Total Assets

Fixed Assets Turnover Ratio:

Sales
______________
Fixed Assets

The receivable turnover ratio:

Net sales on credit


__________________________
Average Accounts Receivable

Receivable Turnover Ratio measures how rapidly debts are collected. A high ratio indicates
a small gap between sale and actual cash collection. A low ratio indicates that the company
gives lot of credit to its customers, debts are not collected fast or bad debts are forming a big
chunk of the debtors and need to be provided for. Another way of measuring the efficiency
is the ‘collection period:’ Debt Collection Period indicates the average credit period enjoyed
by the customers.

Collection period for Accounts Receivable (a corollary of the previous ratio)

360 X Average Accounts Receivable


_______________________________
Net Sales on Credit

Similar ratios can be calculated for creditors indicating how fast the creditors are paid for by
the firm.

Inventory Turnover Ratio:

Cost of goods sold


__________________
Average Inventory

Inventory Turnover Ratio indicates how fast inventory is sold. A high ratio is good from the
point of view of liquidity. A low ratio will indicate that the inventory does not sell fast and
either takes a lot of time to reach the market or stays on the shelf for a long time. Another
way of looking at this is the ‘Inventory holding’ measure:

Days to sell inventory or inventory holding:


Ending inventory
______________________
Cost of average day’s sales

Profitability Ratios

Operating Profit ratio

Operating Profit
____________________
Net Sales

Operating Profit = Net Sales – (Cost of goods sold + other operating expenses)

Net Income Ratio

Net Income
________________
Total Revenue

Gross Profit (or Margin) Ratio

Gross Profit
______________
Net Sales

Gross Profit = Net Sales less Cost of Sales

Various expenses as a % of sales

Employee Costs
Repairs and Maintenance
Administrative Expenses
Sales and Distribution Expenses
Advertising Expenses
Research and Development Expenses

Certain expenses could also be expressed with reference to the relevant asset base, such as:

Depreciation
________________________
Assets subject to depreciation
Bad Debts
____________________
Accounts Receivable

Interest Expenses
________________________________
Average Indebtedness subject to interest

Repairs and Maintenance


________________________________________________________________
Property, Plant and Equipment (other than land) net of accumulated depreciation

Leverage / Capital Structure Ratios

Ratio of total debt to total equity capital or Debt Equity ratio

Total Debt
_____________________
Total shareholders’ equity

Debt Equity ratio is the relationship between borrowed funds and owners’ capital
(shareholders’ equity) and measures long term financial solvency of a firm. This can be
calculated as a ratio of long term debt to equity (as below) or sometimes even total debt
(including current liabilities) to equity (as above). The ratio indicates the relative
contribution of creditors and owners in its financing. A high ratio shows a large
contribution by the creditors. It is a danger signal for the creditors. If things were to go
wrong, the creditors would lose heavily. Also with a small stake the owners may behave
irresponsibly and indulge in risky or speculative activities. From the company's point of
view, a high debt equity ratio will lead to inflexibility in operations, interference and
pressure from the creditors, restricted ability to borrow further and a high interest burden.

Ratio of long term debt to total equity capital

Long Term Debt


_____________________
Total shareholders’ equity

Measures of earnings coverage

Earnings available to meet fixed financial charges


________________________________________
Fixed financial Charges
Fixed Charges include interest expenses, interest capitalized in asset values, implicit interest
in finance leases, preference shares dividend (duly adjusted for tax effect), and principal
repayment requirements. This ratio measures the capacity of the company to service its debt
as far as fixed interest on long term loan is concerned. It indicates the extent to which a fall
in PBIT is tolerable so as not to affect debt servicing. A high ratio indicates larger cover to
the creditors. Too high a ratio will imply that the company has not sufficiently tapped its
debt potential.

Earnings Ratios

Earnings per share (EPS)

Net Profit available for Equity Shareholders


________________________________________
Number of Equity Shares

EPS is a widely used ratio. It measures the profit available per share to equity shareholders.
But it does not indicate how much of the available profits were actually distributed to the
shareholders.

Dividend per share (DPS)

DPS corrects the above and actually shows how much dividend has been distributed. This is
defined as:

Dividend distributed
_______________________
Number of Equity Shares

Dividend payout ratio

Dividend Payout Ratio shows the relationship between earnings and dividend distributed.

Dividend distributed
______________________________________
Earnings available for Equity Shareholders

The P/E ratio reflects the price paid by the market for each rupee of reported EPS. In other
words it measures investors’ expectations and market appraisal of the performance of the
company

Return on Investments

This measure can be defined in several ways. There is a saying that it can be defined in as
varied as 324 ways. It is important that the ratio once defined is used consistently. It is
important to ensure that the numerator and denominator are strictly comparable.
Otherwise, it may yield erroneous results. Some of the definitions are as follows:

Return on total assets (post-tax)

Net Income + Interest Expenses X (1 – tax rate)


_____________________________________________
(Average Total Assets) / 2

Return on capital employed (post-tax)

Net Income + Interest Expenses X (1 – tax rate)


___________________________________________________
Average (long-term liabilities + equity capital + reserves)

Cash & Working Capital Management

Significant resources of the organization are blocked in financing its day to day operations.
The level of this investment has a direct bearing on the level of borrowings of the
organization. The level of investment also reflects the process and operational efficiencies of
the organization. A lot of attention has to be provided to cash and working capital
management of the organization.

Cash

The word cash has to be looked at in a broader way in the context of today’s business. It
includes cash on hand as well as the bank balances. Availability of cash is important to
ensure liquidity of the organization i.e. its ability to meet its obligations. If an organization,
howsoever profitable it may be, fails to meet its obligations could be technically declared
insolvent. The most apt analogy for cash in a business organization is that of blood in
human body. Just like blood reaches nook & corner of human body, cash needs to do the
same in a business organization. Shortage of cash can create instability in an organization
and Surplus can create tardiness.

Marketable Securities

Running bank balances more than required is not prudent since it implies that resources to
that extent are getting underutilized and there is a loss in the form of interest cost which is
incurred on borrowings. Surplus cash is therefore quickly invested by corporate treasures in
instruments which can be liquidated quickly whenever required and in the meantime can
earn a reasonable return. Marketable securities are also called as cash equivalents and
therefore, for all practical purposes included along with cash for measuring the liquidity
position. Treasury bills, money market mutual funds, certificates of deposits are examples of
marketable securities.
Cash Management

Liquidity is critical to every organization as we have seen during our discussion above. At
the same time excessive liquidity means resources with opportunity loss. Cash management
deals with ensuring that cash is available at all the operating units of the organization may
they be manufacturing locations, sales depots or administrative offices. At the same time,
excess cash balances at any place are to be avoided. Cash does not necessarily mean only
currency. The balances held in bank accounts which are not interest bearing viz. current
accounts are also treated as cash for all practical purposes. Excess cash balances make
bankers happy but bleed the organization holding those balances. If we assume a rate of
interest of 12%, the opportunity loss on idle funds held in a bank account amounting to Rs.
1,00,00,000 works out to Rs. 3,300 per day.

Quite often organizations have customers spread all over the country. As all of us know, the
time taken for realization of upcountry cheques can be very long; as long as 15 days. Thus,
one could imagine the opportunity loss if an amount of Rs. 1,00,00,000 remains to be
realized for a long time of 15 days. Organizations therefore go for ‘cash management’
products offered by a number of banks. Organization may generate temporary surpluses.
These temporary surpluses are required to be invested in a way that they could mature in a
time frame when the funds would be needed again. Corporate Treasurers use various
avenues for investing these surpluses as seen above. With extensive automation of banks
and real time gross settlement (RTGS) unveiled by Reserve Bank of India, cash management
is no longer as complicated as it used to be in the past. Further, there are two ways of
defining liquidity. Liquidity arises partly because of surplus funds available at the banking
accounts. The other way of defining liquidity is the amount of unutilized credit within the
banking system. This can be drawn any time. Companies often find it quite convenient to
manage liquidity in this form rather than trying to manage bank surpluses.

Working Capital Management

Working Capital Management is a very important aspect of managing organizational


resources. It is important both from operational and financial point of view. Operational,
because it directly impacts the ability of the organization to meet customer expectations.
Financial, because large sums of money are often blocked in working capital.

As a part of this discussion, we will identify the key ingredients of working capital
management. We will also discuss the tools for managing these ingredients and also the
policy variables which have an impact on the levels of working capital.

Working capital represents assets which quickly change their form. Life of each component
of working capital is fairly short.

There is always a trade-off in the size of working capital. By holding larger working capital,
the risk of loss of customer is less on the other hand profitability may suffer.
Working Capital requirement varies from industry to industry and company to company.
Manufacturing / trading concerns would typically need more investment in working capital
than a service industry where there will not be any inventory.

Production Cycle is the entire time taken from the raw material stage for conversion to a
finished product. Longer the production cycle larger will be the need of working capital.
Nature of industry will also have an impact. For example, in case of a distillery ageing
process is critical and therefore, there will be a higher inventory. On the contrary, a bakery
will carry much less inventory since the turnover is quick.

Within an industry, the technology used by different companies impacts the investment in
inventories. At times especially in companies manufacturing heavy machinery and
equipment, they obtain advance from customer to reduce their own risk and investment.
Following factors also play an important role:

 Ups and downs are all part of a business cycle. Each phase of the cycle leads a different
level of working capital requirement. In the recession phase, there will be a time-gap
between cash commitment for buying material and the cash realization from sales. This
would result in increase in working capital investment in the form of increased
inventory (of raw materials, finished goods) and increased debtors.

 The point mentioned above can be further expanded by saying that an industry in
growth phase needs to have more investment in working capital. It is difficult to
establish a correlation between working capital and sales. But it is important for the
concerned company to project the need and be prepared.

 Production policy especially in seasonal industries plays an important role in


determining working capital requirement. The management can follow any of the
alternative policies.

 If the policy is to produce throughout the year it will ensure that all resources are
well utilized and that stocks are available in the peak season. But this will mean
large inventory build up leading to risk of change in demand pattern over previous
year. This is also not possible for products with low shelf life.

 The second policy could be to produce only during the season. Here there is no
inventory build up and the production can be planned based on the changing
requirements. But this would also mean underutilization of resources during the
slack period and the possibility of loss of sale.

 The third and the most practical policy would be to diversify - engage the resources
in some other activity. But this could lead to loss of sales of the seasonal product if
production in the peak season cannot match demand for the product.

 If a company uses raw materials which are seasonal or the supply of which is unreliable,
the inventory build up tends to be quite high. For seasonal raw materials the company
has to buy during the season and stock it for the rest of the year. If the raw material is a
perishable one, then processing capacity has to be large enough to take care of peak
availability and then hold the semi finished stock or the finished product over the year.
If the company does not do this, it may have to pay higher rates at the time of
consumption.

 Availability of raw materials could also be uncertain if there are few sources that have
formed a cartel or a material which is controlled by the government to ensure equitable
distribution or imports where the lead time could be long and uncertain.

 Credit policy of the company and its suppliers will directly have an impact on the level
of debtors and creditors.

 Efficiency of operations accelerates the pace of the operating cycle and improves the
working capital turnover

Inventory Management

Control of inventories which is often the biggest constituent of working capital, is the most
important problem of working capital management, particularly in manufacturing
environment. Inventories include raw and packing materials, spares, work-in-progress or
in-process inventory & finished goods. Inventory management crosses functional
boundaries across the entire value chain. The responsibilities span across the
manufacturing, purchases, material handling, sales and distribution functions.

Trade-off

There is a trade-off between ability to serve customers and inventory holding or carrying
cost. Shortage of stock can have several implications of the business and hence to its
profitability. Shortage of raw material would mean that the production team spends far
more time and resources in ensuring that the material reaches the production floor on time.
If this becomes a regular feature the relationship with the supplier will also get affected.
There could also be times when a compromise is made on the quality of the material just to
ensure that production does not stop. If the shortage is of an intermediate or final product,
attempt could be made to speed up the production process. But this may not be possible all
the time. In cases where it can be done, it could lead to additional costs like overtime to
workers, sub-optimal run leading to contamination of the final product or a compromise in
quality. A shortage of the final product would be loss of sales. This loss will create a long
term impact on the company if the customer does not return and this loss is immeasurable.
The reverse is also true. Excessive stock which will ensure that there is no shortage is
equally expensive. Apart from the high capital costs it will lead to higher storage and
handling costs. In industries which need cold storage this cost becomes prohibitive. There is
a possibility that prices of raw materials or finished products may decline due to change in
demand - supply equation, entry of a new supplier or competitor, introduction of a new
product in the market or simply change in habits and tastes of consumers. A high stock in
such circumstances will lead to obsolescence. Storage of goods for a longer duration could
also lead to damage and deterioration.
ABC analysis

Just 15-20% number of items usually account for 80-85% value of the material consumption
and a large % of items account for a very meager % in terms of value. Inventory items thus
can be categorized into A, B & C categories. A category items need particular attention.

Supply chain & safety stocks

Identifying the weak link in terms of supply shortages and addressing the problem is an
important activity. Both excess & shortage of stocks (raw material, work in progress or
finished products) in the supply chain will result in bunching of stocks which is highly
undesirable. Further, safety stocks at appropriate level are required. Excess safety stocks
come with a high cost. Reliable suppliers, smoothing the inflow schedules of raw materials,
improving reliability of the production process, improving the distribution network - all
favorably impact the need for safety stocks. Planning of stocks is done to a large extent on
the production plans. Hence strict adherence is necessary. Any change should be
immediately communicated to all the concerned parties. Perishable materials /pre-printed
packing material need lot of attention in such scenarios where dynamic production plans
exist. Companies with more than one production unit/sales points should have a robust
system which tracks stocks not required at one physical location but needed in another.

Ordering quantities & levels

There are various scientific models that deal with ordering quantity such as the Economic
Order Quantity models. Also, there are models that deal with the re-ordering levels. These
can be used for high value items.

Disposal of old stocks

There should be an efficient system to identify old & obsolete stocks and then to dispose
them off on a timely basis. Accumulation of old stocks can result in fall in their realizable
value as well as can result in costs such as storage costs & insurance.

Business model & inventory

The way the business (manufacturing and distribution) is organized has a bearing on the
inventory levels of the organization. Let us discuss an example of a large FMCG
multinational. The company has several factories manufacturing and sending stocks to
several depots. It is a many– many combination. The entire distribution set up was divided
geographically into North, South, East, and West. Distribution in the company operated on
a truck load basis. It was not known for a factory to send partial loads to the depots. This
was due to sheer cost of under loading. In case of products which were required in
quantities of a truck load, the depots did not have a problem. But in case of those products
with low off take, it disrupted the supply chain. It resulted in mismatch of stocks and sales –

 Huge stocks at some depots


 No stocks at other depots
 Inter depot movement
 Additional handling and storage costs
 Uncertainty regarding arrival of stocks due to long distance movement

To counter the problem of rising stocks at one place and loss of sales at another the
company embarked on the concept of a super depot. Four super depots were set up - one in
each geographical region. The factories now send stocks to these super depots only. The
depots coordinated with the other depots and send mixed loads to them containing material
received from several factories. This ensured –

 Availability of all stocks at all depots


 Lower stock levels
 Higher customer service
 Greater assurance on stocks being delivered

Receivable Management

Like any other asset management exercise, the management of receivables also has
maximization of returns as its objective. The goal is to use the funds as economically as
possible to optimize the level receivables so that there is no loss of profitable sales and there
is no bad debt. The two basic goals in receivables management are to collect receivables
when they become due and to reduce future maturities without resulting in loss of sales.

A credit policy is normally designed keeping in mind the overall corporate objectives and
the culture in mind. In the initial period of a business the objective may be to maximize sales
at whatever costs. This goal will lead to a fairly lenient credit policy. Similarly a
conservative policy may put a cap on the exposure irrespective of the target of maximizing
sales. In a competitive environment a company cannot afford to be left behind. In most
cases it will need to follow aggressive strategies followed by its competitors or risk losing
business. A company where capacity is underutilized may decide to sell at a more relaxed
credit terms to maximize capacity utilization. Conversely, a company operating at full
capacity will select customers with high credit rating.

Once a company formulates its credit policy the factors which influence the actual quantum
of receivables will depend upon the factors stated above. A company should conduct a
study on the customers’ credit worthiness before granting them credit. The company could
collect information from internal sources like its own salesmen etc about the activities of the
prospective customer - Customers plants or stores, its competitors, business organization,
etc. The company can also do its own analysis based on the published accounts of the
prospective customer. It can also use information sources offered by certain companies.

For an important customer who the company is viewing for a long term relationship, it
would be worthwhile to visit and obtain first hand feel about the culture, professionalism,
attitude, etc. Finally a careful study of financial resources of the customer, demonstrated
ability to operate successfully, reputation in terms of fair and honest dealings and possibility
of attaching special conditions especially if the customer is perceived as a “weak” account.
A company could also have a policy of securing bank guarantees or deposits from the
customers.

Payable Management

Most often than not one hears “What is there about Payables Management? Pay the
suppliers when you can”. This is probably the most ‘unhygienic’ way of looking at payables.
Suppliers are an integral part of a business plan. Success cannot be achieved without every
member of the supply chain succeeding.

Partnering with the vendor is the key to minimize the overall cost. Quite often the cost of
purchase is only seen as the price which appears on the purchase order. This in fact is only a
part of the cost.

Organizations incur huge costs on quality checks, follow-up and a lot of expensive
managerial time is spent on this. By partnering with a vendor, it is possible to reduce a lot
of these costs and bring more reliability to organization's production schedules.

At the same time, reasonable credit should be negotiated with the supplier and while
making payment the same should be availed of. Once the credit period is negotiated, it is
better to stick to the same than overextending it since it can become a question of credibility
and the supplier may not provide support in when the firm badly wants it.

In a situation where the supplier’s cost of borrowing is very high due to smallness of size or
any other reason and the firm is running cash surpluses, it may be prudent to make upfront
payment to the supplier and negotiate a discount which creates a win-win situation.

Cost, cost classification & cost management

Understanding of costs, cost drivers, cost behavior is very critical for business managers.
Cost can be a differentiating factor in a fierce market place. Control & reduction of costs is
therefore critical important. Two kinds of organizations have been able to survive & grow in
the long run: Product Differentiators & Cost Differentiators. Even the commodity
businesses like cement of yesteryears have been able to create differentiated products,
though in some industries it could be quite difficult. Cost differentiation, however, is
possible by understanding what drives cost & how costs can be managed so that a win-win
opportunity can be created for the firm and the customers.

Cost

Cost is monetary compensation for consumption of various resources in the process of


producing & delivering goods/services. Since costs are an indicator of resources consumed,
it is essential to monitor the costs systematically. Cost is recognized only on a consumption
of a resource, not its procurement. On procurement, a resource continues to show up as
asset on the balance sheet of the company. There are, however, certain resources which get
consumed simply by passage of time and they cannot be stored. The examples are: human
services, renting of office spaces, depreciation of equipment & machinery.

Cost & Management Accounting

Cost accounting discipline deals with ascertainment of cost pertaining to various cost objects
such as products, processes, distribution channels and customers. Ascertainment of
accurate cost is essential for the purpose of managerial decision making. As opposed to
financial accounting which is focused on historical data, cost accounting is three
dimensional. It takes stock of the past, ascertains historical cost of various cost objects. It
guides management in dealing with the current situation as well as take decisions
pertaining to the future by providing appropriate data and supporting it with detailed
analyses. While financial accounting deals with aggregates, cost accounting deals with
details.

Critical role of Cost & Management Accountants

a. Timeliness of information

Often Cost Accountants are in search of the most accurate cost data but in the process lose
precious time. Data which is 95% accurate but submitted on time is much more valuable
than 100% accurate data with a lot of delay. Cost Accountants need to be conscious of the
‘cost of costing’ or else the process could consume a lot of time & organizational resource
without commensurate benefit.

b. Catalysts for Cost Management

Cost Accountants are in possession of data which can positively impact the competitiveness
of the organization. The data throws up areas which if worked upon, can make a significant
difference to the organization’s ability to ward off competitive pressures. Cost Accountants
can play a lead role & be catalysts for cost management by working closely with the
operating executives.

c. Cost Education

There are several concepts such as break-even point, fixed / variable costs, activity based
costing, target costing (discussed later) which if shared with operating executives can make
a significant difference. Cost Accountants can take the initiative of sharing these ideas with
operating executives. They can encourage & act as catalysts in benchmarking of
performance across units or product variants.

d. Strategic business decisions

There are several strategic business decisions where Cost Accountants can play a key role,
for instance, outsourcing. Often, there is an obsession with outsourcing. However, not many
may bother to work out the break-even of the outsourcing contracts & examine whether,
outsourcing still makes sense or needs to be reverted to in-sourcing. This kind of analysis
can throw up opportunities for re-negotiation. They can also contribute a lot in redefining
the manufacturing (location, capacity) & distribution models of the organization.

e. Supply Chain & Cost Reduction

The Cost Accountants need to be aware about the supply chain of the organization. They
should work closely with business executives to identify cost reduction opportunities along
the chain by closely working with suppliers & customers. Henry Ford said over 80 years
ago, people know what cost is but no one knows what cost should be. That throws up a lot
of creative opportunities for cost reduction which the cost accountants must help in
exploiting.

f. Cost Allocations

In the past, material cost used to be the most significant portion of the product cost. No
longer. With technological developments & complexities of organizations, overheads have
already overtaken them. Often cost accountants look at overhead cost allocation as a ritual
to be completed to tie up the aggregate overhead to the income statement. These allocations,
if not done carefully, can distort the cost estimations totally. They can ruin the future of
some products. Cost Accountants should work closely with the managements to analyze the
cost lumps & their drivers so that allocations are reasonably accurate & non-distorting.

g. Budgeting

Budgeting has become a ritual in many organizations. A financial budget is of no use unless
it is backed up by operational budgets. Industry needs cost accountants’ intervention to
make the process more effective. Else, the budgeting exercise can only suck more costs.

h. System implementation support

Cost Accountants can play a key role in this area particularly for ERP implementation as
well as implementation of Activity Based Costing systems.

Cost Classification

Costs can be classified in a variety of ways.

By elements

There are various elements of costs. Traditionally, they have been classified into material
costs, labour costs & expenses. Expenses stand for various services availed by the firm.
Material costs include both raw & packing materials.

By directness
Costs can be classified as direct or indirect with reference to a cost object. For instance, in a
manufacturing process, costs incurred on security agency for the firm is an indirect costs
since it does not directly add value to the process. However, it indirectly does. By
combining classification by elements & directness, it may be possible to further classify costs
as:

Direct Material
Direct Labour
Direct Expenses

Indirect Material
Indirect Labour
Indirect Expenses

The group of all indirect costs together is called as overheads. Thus the costs are usually
classified into four heads which are Direct Material, Direct Labour, Direct Expenses &
Overheads.

By cost behavior

Costs are subject to two key drivers which shape the behavior of the aggregate cost pool.
One of them is time and the other is volume or activity. Costs that are driven by time
include those costs which are incurred irrespective of the actual activity that has taken place.
For instance, when an employee is engaged or hired and is committed a certain amount of
salary, the salary cost gets incurred irrespective of whether he is assigned work or not or
whether the project for which s/he is engaged is smoothly running or is at standstill. Other
examples of the time driven costs include interest, depreciation, and administrative costs.
On the other hand, there are costs that in the aggregate are linked to the volume of activity.
For instance the material consumed is clearly driven by the volume of work. The other
examples include fuel, power, and spares. In this classification, we are ignoring the impact
of inflation since that way both the types of costs are subject to change over a period of time.
The costs which change with time are called as Fixed costs and the costs that change with
activity or volume are called as Variable costs. Fixed costs in a way also reflect the costs
being paid for creating or renting different types of capacities viz. Infrastructural or human.

This understanding is necessary to tailor the management response suitably according to


changing business conditions. During recessionary times, it becomes important to ensure
that as many costs as possible are activity related or variable so that they fall in case of
reduction in activity. On the other hand, during times of boom ahead, it pays to have a
higher component of fixed costs which reflects availability of higher capacity. The
advantage in this situation is that even when the activity increases, the fixed costs remain
the same and thus the profitability margin tends to improve with higher capacity utilization.

Variable & Fixed Costs

Variable Cost
Variable costs are those which are linked with the volume of activity of an organization. Per
unit variable cost remains the same but the aggregate increases, as the organizational
activity increases. For example, the required quantity & cost of a raw material per unit of
finished product would remain the same but the total cost of the material would go up as
the volume of concrete increases.

Management of variable costs

In most organizations, a significant portion of the cost is variable. As operating executives,


there are a variety of ways in which you can influence these costs downwards. Following
are the techniques which are often used for management of variable costs

• Negotiating for a lower price


• Substitution of raw materials
• Alternate sourcing of raw materials
• Technological breakthrough
• Improved efficiency in energy utilization
• Change in mix of raw materials without change in quality
• Improvement in input-output ratio
• Realizing higher value for by-products or wastages

Fixed Costs

Fixed Costs are those which are not linked with the volume of activity of an organization.
Therefore, Fixed Costs are incurred irrespective of the size of activity. However, if the
activity is higher, per unit cost comes down since it gets divided over a larger volume. Let
us take an example: Company decides to buy a particular equipment. Let us say it costs Rs.
1,500,000. Buying this equipment is going to make ‘capacity’ available within the
organization. At the same time, once this money is spent, following costs are going to be
incurred. An opportunity loss to the extent of interest cost, say @ 12% equal to Rs. 1,80,000
p.a. Minimum Maintenance costs, say Rs. 1,20,000 p.a. This implies that whether the
equipment is utilized or not a cost of Rs. 3,00,000 p.a. is involved. If this capacity goes
unutilized or remains partly utilized, there is a loss of this or portion of this amount.

Management of Fixed Costs

As mentioned earlier, fixed costs create manufacturing, distribution, transport or human


capacity. It should always be an organizational priority to utilize these resources to the best
of their capacity. This improves profitability and in turn provides an opportunity to the
organization to compensate its people better.

By reversibility

It is important to note that costs are linked with organizational commitments. The
commitments are not only to the suppliers but also to the customers. No wonder then that
many US automobile manufacturers incur huge costs on recall of cars, even if there is a
single defective part found. These are quality commitments. In addition, there are usually
legal or contractual commitments as well. Some of the legal commitments are reversible
quickly. Some take long time to reverse. For instance, setting up a factory under ownership
involves a commitment for a longer time since it may or may not be possible to exit from
that investment quickly. On the other hand, if the factory is leased it may be relatively easier
to exit the investment by even exercising a ‘break-clause’ in the lease deed.

Cost Management

We have discussed above management of fixed and variable costs. In this section, we will
discuss cost management more holistically. One of the first and foremost essentials of cost
management is cost control. Cost control implies ensure that the costs remain within pre-
determined limits and are spent on the targeted uses. This is facilitated by the budgeting
process discussed below. In certain, difficult circumstances, organizations resort to what
may be called as tactical cost slashing. This is the period in which, due to the general
recession in the marketplace, firms prune their expenditures wherever possible. Executives
may be asked to travel by alternate modes of transport than air or are required to travel by a
lower class of travel or are asked to avoid overnight stays. These techniques may be
necessary given certain circumstances. However, they are not sustainable in the long term.
Pressure builds up within the organization for reversing these diktats. Sometimes
organizations, out of very desperate situations, may cut expenditure on people development
initiatives or on research & development. However, in this environment of high turnover of
people and product obsolescence, it may find it very difficult to maintain the momentum in
the long term. All these initiatives have a limited use to serve. However, an organization has
to grow beyond them. The solution is to create a culture which is focused on cost reduction.
Cost reduction is different from cost control since the former deals with a permanent
reduction in the cost without compromising on quality, not just adherence to standards.
Cost reduction comes out of very innovative methods. It is achieved by challenging the
status quo. It is facilitated by involvement of people and generating ideas. Maruti Udyog
implemented suggestion scheme which resulted in a huge number of ideas which resulted
in a significant cost reduction for the company.

Marginal Cost

The concept of marginal cost focuses on cost of producing one extra individual unit of
product or service. It naturally includes only those costs which will go up with production
of one unit. They would include material, labour & expenses which are variable in nature. In
extreme situations, they could give rise to increase in fixed costs but such circumstances are
very rare. The concept of marginal cost cannot be used for pricing of products and services
in the usual circumstances. The reason for the same is that marginal costs exclude a share of
the overheads & fixed costs. However, this concept is extremely useful while applying to
very specific situations, particularly when there is an excess capacity available within the
firm. In such a situation, marginal cost based pricing could be applied. A special order from
a customer, an export order which could open up opportunities for more orders later, are
such examples. The concept of marginal cost along with the concept of contribution
(discussed later) can be used to select product mix of the organization to maximize profit.
Contribution

The classification of fixed and variable costs (marginal cost) furthers help in establishing the
contribution margin each extra unit of productive activity generates. This is done by
reducing from the revenue only variable costs (or marginal costs) thus arriving at what is
called as contribution amount. The contribution amount divided by the revenue provides an
idea about the contribution margin. Thus, 45% contribution margin indicates that on every 1
Re of revenue earned 45 Paise get added to the kitty from which fixed costs are to be paid
for and the remaining amount is available in the form of profit.

In selecting mix of products or services, when there is a capacity constraint, the concept of
contribution could be very useful. A product or service which provides maximum
contribution per unit of the constrained capacity should be first taken up and then the
others in the order of their contribution.

Break-even Point analysis

Break-even point is a very useful tool to bring the relationship of revenues, variable costs
and fixed costs together to understand organizational risks. This is a level of activity at
which the revenue is equal to cost. When the actual activity exceeds break-even level, it
results into profits.

The fixed costs pool when divided by the contribution margin % indicates the break-even
point of the organization reflecting the minimum level of revenue that needs to be achieved
so that the organization moves into a profit zone. For a multi-product company this
contribution margin % has to be calculated for the entire product mix together. Any fall
from this level results into slippage of the organization into a loss zone. At the same time
beyond the break-even point the profitability of the organization surges rapidly. The
difference between the current level of revenue already achieved and the break-even level of
revenue is called as the Margin of safety. This amount divided by the current revenue level
indicates the Margin of safety in % terms which implies that even in case of a fall in revenue
by that %, the company will continue to be in the profit zone.

Fixed Cost
Break-even point = ________________________
Contribution Margin %

Margin of Safety = Current Revenue – Break-even level of revenue

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