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ANNAMALAI UNIVERSITY
DIRECTORATE OF DISTANCE EDUCATION
M.Sc.PLANT AND MACHINERY VALUATION
First Year
FINANCIAL AND BUSINESS MANAGEMENT
LESSONS : 1 - 15
Copyright Reserved
(For Private Circulation Only)
886E180
1 - 15
M.Sc. PLANT AND MACHINERY VALUATION
FIRST YEAR
FINANCIAL AND BUSINESS MANAGEMENT
Editorial Board
Members
Dr. C. Antony Jeyasehar
Dean Faculty of Engineering & Technology
Annamalai University Annamalainagar
Dr. G. Ganesan
Professor and Head
Manufacturing Engineering Faculty of Engineering & Technology
Annamalai University
Annamalainagar
Dr. A. Prabaghar
Associate Professor & Wing Head
Engineering Wing, DDE Annamalai University
Annamalainagar
Internals
Mr. S. Natarajan
Assistant Professor Manufacturing Engineering
Engineering Wing, DDE Annamalai University
Annamalainagar
Mr. B. Neelakandan
Assistant Professor Manufacturing Engineering
Engineering Wing, DDE Annamalai University
Annamalainagar
Externals
Dr. K. Kumar
Associate Professor Department of Commerce
National College
Trichy
Dr. N. Arumugam
Assistant Professor Department of Commerce
Government Arts College
Kumbakonam
Lesson Writer
Dr. M. G. Jayaprakash
Assistant Professor
Department of Business Administration Wing, DDE Annamalai University
Annamalainagar
ii
M.Sc. PLANT AND MACHINERY VALUATION
FIRST YEAR
FINANCIAL AND BUSINESS MANAGEMENT
SYLLABUS
Chapter-1
Goals and functions of finance, financial control– planning and budgeting,
Project Report, Techno Economic Viability Report.
Chapter-2
Financial analysis for management decisions - ratio analysis – fund flow, cash
flow analysis, Capital expenditure – recognition & accounting - assessment,
Working capital – definitions, management – assessment.
Chapter-3
Investment decision – decision rule, discounted cash flow - NPV & IRR,
marginal costing, life cycle costing.
Chapter-4
Mergers and acquisitions for corporate restructuring – Enterprise Value, Risk
assessment – External / Internal threats –SWOT analysis.
Chapter-5
Management of Business Enterprises.
References:
1. Prasanna Chandra, Financial Management – Theory and Practice, Tata
McGraw Hill
2. Charles J. Corrado, Investment Valuation and Management, McGraw Hill
iii
M.Sc. PLANT AND MACHINERY VALUATION
FIRST YEAR
FINANCIAL AND BUSINESS MANAGEMENT
CONTENT
Lesson
No. Title Page No.
1 Finance Function 1
2 Financial Forecasting 14
3 Introduction to Budget 19
4 Types of Budgets 23
5 Reporting to Management 54
6 Financial Analysis 61
7 Ratio Analysis 70
8 Fund Flow analysis 106
9 Cash Flow Analysis 120
10 Working Capital Management 131
11 Working Capital Forecasting Techniques and Financing Policy 147
12 Importance of Capital Budgeting 164
13 Methods of Evaluating Capital Investment Proposal 169
14 Marginal Costing and Break –Even Analysis 197
15 Mergers and Acquisitions, and Swot Analysis 223
1
LESSON – 1
FINANCE FUNCTION
1.1 INTRODUCTION
Finance is regarded as the life blood of business enterprise. It is one of the
basic foundations of all kinds of economic activities. A firm’s success depends upon
how efficiently it is able to generate funds as and when needed. Finance holds the
key to all activities. Productive utilisation of money is essential for the profitability
of the organisation.
The word ‘finance’ has been interpreted differently by different authorities.
More significantly, the concept of finance has changed markedly from time to time.
For the convenience of analysis different viewpoints on finance have been
categorised into three major groups.
Finance means cash only: starting from the early part of the present century,
finance was described to mean cash only. The emphasis under this approach is
only on liquidity and financing of the firm. Since nearly every business transaction
involves cash, directly, finance is concerned with everything that takes places in the
conduct of the business. However, it must be noted that this meaning of finance is
too broad to be meaningful.
1.2 OBJECTIVES
The students can understand meaning and definition of finance, objectives and
functions of business finance by studying this lesson.
1.3 CONTENT
1.3.1 Objectives of business function
1.3.2 Scope of finance function
1.3.3 Finance function
1.3.4 Functions of finance controller
1.3.5 Duties of financial manager
1.3.1 OBJECTIVES OF BUSINESS FUNCTION
(a) Profit Maximization: Traditionally, the business has been considered as
an economic institution and profit has come to be accepted as a rationally valid
criterion of measuring efficiency. As a goal, however, profit maximization suffers
from certain basic weaknesses: (1) it is vague, (2) it is a short-run point of view, (3) it
ignores risk, and (4) it ignores the timing of returns.
An unambiguous meaning of the profit maximization objective is neither
available nor possible. It is rather very difficult to know about the following: Does it
mean short-term profits or long-term profits? Does it refer to profit before or after
tax? Does it refer to total profits or profit per share? Besides it is being ambiguous,
the profit maximization objective takes a short-run point of view. Prof. Drucker and
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Prof.Galbraith contradict the theory of profit maximization and observe that exclusive
attention on profit maximization misdirects managers to the point where they may
endanger the survival of the business. Prof.Galbraith gives the following points to
argue his line of reasoning: (1) it undermines the future for today's profit; (2) it
short changes research promotion and other investments; (3) it may shy away from
any capital expenditure that may increase the invested capital base against which
profits are based, and the result is dangerous obsolescence of equipment. In other
words, the managers are directed into the worst practices of management. Risk and
timing factors are also ignored by this objective. The streams of benefits may
possess different degrees of certainty and uncertainty. Two firms may have same
total expected earnings, but if the earnings of one firm fluctuate considerably as
compared to the other, it will be more risky. Also, it does not make a difference
between returns received in different time periods i.e., it gives no consideration to
the time value of money and value benefits received today and benefits after six
months or one year.
For the reasons given above the profit maximization objective cannot be taken
as the objective of financial management.
(b) Wealth Maximization: The maximization of wealth is a more viable
objective of financial management. The same objective, if expressed in other terms,
would convey the idea of net present worth maximization. Any financial action which
creates wealth or which has a net present worth is a desirable one and should be
undertaken. Wealth of the firm is reflected in the maximization of the present value
of the firm i.e., the present worth of the firm. This value may be readily measured if
the company has shares that are held by the public, because the market price of
the share is indicative of the value of the company. And to a shareholder, the term
'wealth* is reflected in the amount of his current dividends and the market price of
share.
Ezra Solomon has defined wealth maximization objective in the following
manner: "The gross present worth of a course of action is equal to the capitalized
value of the flow of future expected benefits, discounted (or capitali zed)at a rate
which reflects the certainty or uncertainty. Wealth or net present worth is the
difference between gross present worth and the amount of capital investment
required to achieve the benefits."
From the above clarification, one thing is certain that the wealth maximi zation
is a long-term strategy that emphasises raising the present value of the owner's
investment in a company and the implementation of projects that will increase
the; market value of the firm's securities. This criterion, if applied, meets the
objections raised against earlier criterion of profit maximization. The financial
manager also deals with the problem of uncertainty by taking into account the trade-
off between the various returns and associated levels of risks. It also takes into
account the payment of dividends to shareholders. All these ingredients of the
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wealth maximization objective are the result of the investment, financing and
dividend decisions of the firm.
1.3.2 SCOPE OF FINANCE FUNCTION
The question of 'scope of finance function' determines the decisions or
functions to be carried out by the financial manager in pursuit of achieving the
objective of wealth maximization. The various functions of the financial manager
relate to the estimation of financial requirements, investment of funds in long-term
and short-term assets, determining the appropriate capital structure, identification
of the various sources of finance, decision regarding retention of earnings and
distribution of dividend, and administering proper financial controls. In the following
discussion, these decisions have been categorized into two broad groupings:
(1) Long-term financial decisions:
(i) Investment decision (capital allocation for fixed and current assets),
(ii) financing decision (capital sourcing), and (iii) dividend decision
(2) Short-term financial decisions: (Working capital management):
(i) Cash, (ii) Investments (marketable securities),
(iii) Receivables, and (iv) Inventory.
A brief description of these financial decisions is given below.
1. Long-Term Financial Decisions: The long term financial decisions
pursued by the financial manager Lave significant long term effects on the value of
the firm. The results of these decisions are not confined to a few months but extend
over several years and these decisions are mostly irreversible. It is, therefore,
necessary that before committing the scarce resources of the firm a careful
exercise is done with regard to the likely costs and benefits of the various decisions.
(i) Investment Decisions: Investment decisions are also known as Capital-
budgeting decisions. It is concerned with the allocation of given amount of capital
to fixed assets of the business. The important characteristic of fixed assets is that
their benefits are realized in the future (generally after one year). Thus, capital-
budgeting decision adds to the total fixed assets of the concern by selecting and
investing in new investments. It must be properly understood at this stage that
because the future benefits are not known with certainty, investment proposals
necessarily involve risk. Consequently, they must be evaluated in relation to their
expected income and risk they add to the firm as a whole. Obviously, the
management will select investments adding something to the value of the firm. The
criteria of judging the profitability of projects is the difference between the cost of the
investment proposals and its expected earnings. The important methods employed to
judge the profitability of the investment proposals and its expected earnings. The
important methods employed to judge the profitability of the investment proposals
are: (a) Pay back method, (b) Average rate of return method, (c) Internal-rate of
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return method, and (d) Net present value method. A careful employment of these
methods helps in determining the contribution of investment projects to owners'
wealth.
(ii) Financing Decisions: Financing Decisions (also known as Capital
Structure decisions) is intimately tied with the investment decisions. To undertake
investment decision the firm needs proper finance. The solution to the question of
raising finance is solved by financing decision. There are number of sources from
which funds can be raised. The most important sources of financing are equity
capital and debt capital. The central tasks before the financial manager is to
determine the proportion of equity capital and debt capital. He must endeavour to
obtain that financing mix or optimal capital structure for the firm where overall cost
of capital is the minimum or the value of the-firm is Maximum. In taking this
decision, the financial manager must bear in -mind the likely effects on
shareholders and the firm. The use of debt capital, for instance, affects the return
and risk of the shareholders. The return on equity will not only increase, but also the
risk. A proper balance will have to be struck between return and risk. When the
shareholder's return is maximized with minimum risk, the market value per share
will be maximized and firm's capital structure would be optimum. Once the
financial manager is able to determine the best combination of debt and equity, he
must raise the appropriate amount through best available sources.
Fig. 1.1 Decisions, Return, Risk, and Market Value
(iii) Dividend Decisions: The next crucial financial decision is the dividend
decision. This decision is the basis of dividends payment policy, reserves policy, etc.
The dividends are generally paid as some percentage of earnings on the paid-up
capital. However, the policy pursued by management concerning dividends
payment is generally stable in character. Stable dividends policy implies the
payment of same earnings percentage with only small variations depending upon the
pattern of earnings. The stable dividends policy among other things increases the
market value of the share. The amount of undistributed profits is called 'retained
earnings'. In other words, dividends payout ratio determines the amount of earnings
retained in the firm. The amount of earnings or profit to be kept undistributed with
the firm must be evaluated in the light of the objective of maximizing shareholders'
wealth.
(2) Short-Term Financial Decisions: The job of the financial manager is not
just limited to the long-term financial decisions, but also extends to the short-term
Capital Budgeting
Decisions
Capital Structure Decisions
Dividend Decisions
Working Capital
Decisions
Market Value
of the firm
Return
Risk
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financial decisions aiming at safeguarding the firm against illiquidity or insolvency. Surveys indicate that the largest portion of a financial manager's time is devoted to the day to day internal operations of the firm; this may be appropriately subsumed
under the heading Working Capital management.
Working capital management requires the understanding and proper
appreciation of its two concepts-gross and net working capital. Gross working
capital refers to the firm's investment in current assets such as cash, short-term
securities, debtors, bills receivable and inventories. Current assets have the
distinctive characteristics of being convertible into cash within an accounting year.
Net working capital refers to the difference between current assets and current
liabilities. Current liabilities are those claims of outsiders which are expected to
mature for payment within an accounting year and include trade creditors, bills
payable, bank overdraft and outstanding expenses. For the financial manager both
these concepts of gross and net working capital are relevant.
Investment in current assets affects firm's profitability, liquidity and solvency. In
order to ensure the neither insufficient nor unnecessary funds are invested in
current assets, the financial manager should develop sound techniques of
managing current assets. He should estimate firm's working capital needs and
make sure that funds .would be made available when needed.
The cost of capital acts as the core in the framework for financial management
decision-making. In has a two-way effect on the investment, financing and
dividend decisions. It influences and is in turn influenced by them. The cost of
capital leads to the acceptance or rejection of projects, as it is the cut-off criterion
in investment decisions. In turn, the profitability of projects raises or lowers
the cost of capi tal . The financing decisions affect the cost of capital because it is
the weighted average of the cost of different sources of capital. The need to raise or
lower the cost of capital, in turn, influences the financing decisions. The
dividend decisions try to meet the expectations of the investors raise or lower the
cost of capital. The following figure explains the components of finance functions
and their interrelation.
INVESTMENT DECISION
Allocation & Rationing the Resources
Risk vs Return 1. Framing (Fixed & Current)
Assets Management Policies
Risk vs Return
External Financing
Debt/Equity Ratios
2. Forecasting and controlling
cash flows, requirements etc.
Internal financing Debt/Equity Ratios
Financing Decisions Dividend Decisions
Planning for a Balanced Capital Structure
Determination of the Quantum & Timing of
Dividend Payment
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1. Deciding upon
requirements and
sources of new external financing
1. Determining the allocation of net profits
2. Carrying on negotiations of new outside financing etc.
2. Checking the financial performance etc.
Debt / Equity Ratios Cost of Capital Payout Ratios
Core in Framework of Financial Management
Decision Making
1. Financing Decisions
2. Investment Decisions
3. Dividend Decisions Fig. 1.2 Relationship between Finance Functions
1.3.3 FINANCE FUNCTIONS
FINANCE FUNCTIONS
Executive Function
a. Financial forecasting
b. Investment policy
c. Dividend policy
d. Cash flows& requirements
e. Deciding upon borrowing policy
f. Negotiations for new outside
financing
g. Checking upon financial
performance
Incidental Function
a. Cash receipts and payments
b. Custody of valuable papers
c. Keeping mechanical details of
financing
d. Record keeping & reporting
e. Cash planning
f. Credit management
Financial Controls: The long-term and short-term decisions, together,
determine the value of the firm to its shareholders. In order to maximize this value,
7
the firm should strive for optimal combination of these decisions. In an endeavour
to make optimal decisions, the financial manager makes use of certain tools in the
analysis, planning and control activities of the firm. Some of such important tools are
a. Financial Accounting Statements
b. Analysis of financial ratios
c. Funds Flow Analysis and Cash Flow Analysis
d. Financial forecasting
e. Analysis or operating and financial Leverage
f. Capital Expenditure Budgeting.
g. Operating Budgeting and Budgetary control
h. Costing and Cost Control Statement
i. Variance Analysis Reports
j. Cost – Volume – profit Analysis
k. Profitability Index
l. Financial Reports
Organisation for Finance Function: Almost anything in the financial realm
falls within such a committees realm, including questions of financing, budgets,
expenditures, dividend policy, and future planning. Such is the power of financial
committee that in most cases their recommendations are approved as a matter of
course by the full board of directors. On the operational level, the financial
management team may be headed up by a financial Vice-President. This is a
recent development, the financial Vice-President answers directly to the president.
Serving under him are a treasurer and a controller. An Illustrative organisation
chart of finance function of management in a large organisation is given below:
Fig. 1.3. Organization Chart of Finance Functions of Management
Vice-President
Marketing
Vice-President
Production
Board of Directors
President
Vice-President
Finance
Vice-President
Personnel
Vice-President
Purchase
Controller Controller
8
The above chart shows that the Vice-President (Finance) exercises his
functions through his two deputies known as : 1. Controller - concerned with
internal matters, 2. Treasurer - basically handles external financial matters.
Fig. 1.4 Functions of Controller and Treasurer
The controller is concerned with the management and control of the firm's
assets. His duties include providing information for formulating the accounting
and financial policies, preparation of financial reports, direction of internal
auditing, budgeting, inventory control, taxes, etc. While the treasurer is mainly
concerned with management of the firm's funds, his duties include the following:
Forecasting the financial needs; administering the flow of cash; managing
credit; floating securities; maintaining relations with financial institutions and
protecting funds and securities.
A brief description of the functions of the Controller and the Treasurer, as
given by the Controllers Institute of America, is given below.
1.3.4 FUNCTIONS OF FINANCE CONTROLLER
1. Planning and Control : To establish, coordinate and administer, as part of
management, apian for the control of operations. This plan would provide to
the extent required in the business, profit planning, programmes for capital
investing and for financing, sales forecasts and expense budgets.
2. Reporting and Interpreting : To compare actual performance wi th
operating plans and standards, and to report and interpret the results of
operations to all levels of management and to the owners of business.
To consul t wi th the management about the financial implications of its
actions.
Controller
Vice-President Finance
Treasure
1. Planning and Control
2. Reporting and Interpreting
3. Tax Administration
4. Government Reporting
5. Protection of Assets
6. Economic Appraisal
1. Provision of Finance
2. Investor Relations
3. Short-term Financing
4. Banking and Custody
5. Credit and Collections
6. Investments
7. Insurance
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3. Tax Administration: To establish and administer tax policies and
procedures.
4. Government Reporting: To supervise or co-ordinate the preparation of
report to government agencies.
5. Protection of Assets: To ensure protection of business assets through
internal control, internal auditing and assuring proper insurance coverage.
6. Economic Appraisal : To appraise economic and social forces and
government influences and interpret their effect upon business.
Functions of Treasurer
1. Provision of Finance: To establish and execute programmes for
the provision of the finance required by the business, including
negotiating its procurement and maintaining the required financial
arrangements.
2. Investor Relations: To establish and maintain adequate market for
the company's securities and to maintain adequate contact wi th
the investment community.
3. Short-term Financing: To maintain adequate sources for the
company's current borrowings from the money market.
4. Banking and Custody: To maintain banking arrangements, to receive,
have custody of and disburse the company's moneys and securities and
to be responsible for the financial assets of real estate transactions.
5. Credit and Collections: To direct the granting of credit and the
collection of accounts receivables of the company.
6. Investments: To invest the company's funds as required and to
establish and coordinate policies for investment in pension and other
similar trusts.
7. Insurance: To provide insurance coverage as may be required.
Another way of looking at these functions is this : The controller
function generally concentrates on the asset side* of the balance sheet,
while the treasurer function concentrates on the claims side i.e.,
identifying the best sources of finance to utilize in the business and
timing the acquisition of funds.
Controller's and Treasurer's Functions in the Indian Context
The terms 'controller' and 'treasurer' are essentially used in U.S.A. However,
this pattern is not popular in India. Some companies do use the term 'Controller'
for the official who performs the functions of the chief accountant or the
management accountant. However, in most cases, in case of Indian companies,
the term 'General Manager (Finance) or Chief Finance Manager is more popular.
Some of the functions of the Controller and the Treasurer such as government
10
reporting, insurance coverage, etc., are taken care of by the Secretary of the
company. The function of the treasurer of maintaining relations with its investors
is also not much relevant in the Indian context since by and large Indian
investors/shareholders are indifferent towards attending the general meetings.
The finance manager in Indian companies is mainly concerned with the
management of the firm's financial resources. His duties are not compounded with
other duties generally in large companies. It is a healthy sign since the management
of finances is an important business activity requiring extraordinary, skill and
attention. He has to ensure that the scarce financial resources are put to the-^
optimum use keeping in view various constraints. It is, therefore, necessary that
the: finance manager devotes his full time attention and energies only in
raising and utilizing the financial resources of the firm.
1.3.5 ROUTINE DUTIES OF FINANCIAL MANAGER
Apart from the three broad functions of financial management mentioned ;
above, the financial manager has to perform certain routine or recurring functions.
These are stated below:
(i) Keeping track of actual and projected cash outflows and making adequate
provision in time for any shortfall that may arise.
(ii) Managing of cash centrally and supplying the needs of various divisions
and departments without keeping idle cash at many points.
(iii) Negotiations and relations with banks and other financial institutions,
(iv) Investment of funds available and free for a short period.
(v) Keeping track of stock exchange prices in general and prices of the
company's shares in particular,
(vi) Maintenance of liaison with production and sales departments for seeing
that working capital position is not upset because of inventories, book debts, etc.
(vii) Keeping management informed of the financial implication of various
developments in and around the company.
Non-Routine Duties; The non-recurring duties of the financial executive may
involve preparation of financial plan at. The time of company promotion, expansion
diversification, readjustments in times of liquidity crisis, valuation of the enterprise at
the time of acquisition and merger thereof, etc.
Today’s financial manager has to deal with a variety of developments that affect
the firm's liquidity and profitability, including:
(a) High financial cost identified with risk-bearing investments in a capital-
intensive environment;
(b)Diversification by firms in to differing businesses, markets, and product
lines;
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(c) High rates of inflation that significantly affect planning and forecasting the firms operations;
(d) Emphasis on growth, with its requirements for new sources of funds and improved uses of existing funds;
(e) High rates of change in technology, wi th an accompanying need for expenditures on research and development;
(f) Speedy dissemination of information, employing high speed computers and
nationwide and worldwide networks for transmitting financial and operating data.
Social Responsibility of Financial Manager
Another point that deserves consideration is social responsibility: should
businesses operate strictly in the stockholders' best interest, or are firms also partly
responsible for the welfare of society at large? In tackling this question, consider first
the firms whose rates of return on investment are close to normal, that is, close to
the average for all firms. If such companies attempt to be socially responsible,
thereby increasing their costs over what they otherwise would have been, and if the
other business in the industry do not follow suit, then the socially oriented firms
will probably be forced to abandon their efforts. Thus, any socially responsible acts
that raise costs will be difficult, if not impossible, in industries subject to keen
competition.
What about firms with profits above normal levels - can they not devote
resources to social projects? Undoubtedly they can many large, successful firms do
engage in community projects, employee benefit programmes, and the like to a greater
degree than would appear to be called for by pare profit or wealth maximization. Still,
publicly owned firms are constrained in such actions by capital market factors.
Suppose a saver who has funds to invest is considering two alternative firms. One
firm devotes a substantial part of its resources to social actions, while the other
concentrates on profits and stock prices. Most investors are likely to shun the socially
oriented firm, which will put if to a disadvantage in the capital market. After all,
why should the stockholders of one corporation subsidise society to a greater extent
than stockholders of other businesses? Thus, even highly profitable firms (unless
they are closely held rather than publicly owned) are generally constrained against
taking unilateral cost-increasing social action.
Does all this mean that firms should not exercise social responsibility? Not at
all - it simply means that most cost-increasing actions may have to be put on a
mandatory rather than a voluntary basis, at least initially, to insure that the burden
of such action fails uniformly across all businesses. Thus, fair hiring practices,
minority training programmes, product safety, pollution abatement, antitrust
actions, and are more likely to be effective if realistic rules are established initially
and enforced by government agencies. It is critical that industry and government
cooperate in establishing the rules of corporate behaviour and that firms follow the
spirit as well as the letter of the law in their actions. Thus, the rules of the game
become constraints, and firms should strive to maximize stock prices subject to
these constraints.
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1.4 REVISION POINTS
Financing is the process of organizing the flow of funds so that a business
firm can carry out its objectives in the efficient manner and meet its obligation as
they fall due.
Function of finance – guide and regulate investment decisions- to determine the
proportion of equity and debenture in the capital structure.- to determine the
portion of dividend- Estimating the financial needs.
Objectives of the business finance–profit maximation and maximization of
wealth.
1.5 INTEXT QUESTION
1. "Finance is the oil of wheel, marrow of bones and spirit of trade, commerce
and industry'-Elucidate.
2. Discuss the role and significance of financial management in the functional
areas of modern management.
3. Some of the early concerns of financial management are related to
preservation of capital, maintenance of liquidity and reorganization .Do you
think these topics are still important in our current unpredictable
economic environment?
4. Who discharges the finance function and what are his specific
responsibilities?
5. Contrast profit maximization and value maximization as criteria for
financial management decisions in practice,
6. Why is it inappropriate to seek profit maximization as the goals of
financial decision making? How do you justify the adoption of present value
maximization as an apt substitute for it?
7. "The operative objective of financial management is to maximize wealth or
net present worth"-Ezra Solomon. Explain the statement and explain the
finance function performed by a Finance Manager to achieve this goal.
8. Explain the scope of finance function and suggest an organisational
structure that you consider suitable for an effective financial control of a
large manufacturing concern.
9. Discuss the respective roles of Treasurer' and 'Controller' in the financial
set-up of a large corporation. Out of these two finance officers who is more
important in the modern contest and why?
10. As a Financial Manager of a company, how would you reconcile between
financial goals and social objectives of the concern?
1.6 SUMMARY
This lesson covers the functions and objectives of business finance, various
approaches in business fines are explained in this lesson. The objectives of
business finance have been now diversified according to the nature of the firm.
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1.7 TERMINAL EXERCISES
1. Reporting and interpreting is a
(a) Finance Functions (b) Functions of Controller (c) Administration Function.
2. Investments (marketable securities) is a
(a) Long – term decision (b) medium term decision (c) Short – term decision.
1.8 SUPPLEMENTARY MATERIAL
Business India, Economics Times of India
1.9 ASSIGNMENT
Read various magazines and journals. Collect published audit report, profit &
loss account and balance sheet of various reputed firms. Prepare an essay on the various function of finance.
1.10 SUGGESTED READINGS / REFERENCE BOOKS
• Fundamentals of Financial Management, New Delhi, Tata McGraw Hill Co.
Financial Decision Making, New Delhi, Prentice Hall of India.
• Financial Management, I.M. pandey., New Delhi , Vikas Publishing House
• Financial Management and Policy, New Delhi, Prentice Hall of India
1.11 LEARNING ACTIVITIES
1. Visit various firms and collect information regarding the capital information regarding the capital structure.
2. Visit the financial institutions and know the lending process.
3. Meet the share brokers or their agents or staffs to get more information about the capital market.
1.12 KEY WORDS
Cut off rate – vague – financial decisions – profit maximization and wealth maximization.
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LESSON – 2
FINANCIAL FORECASTING
2.1 INTRODUCTION
Financial forecasting involves systematic projection of expected actions of
management in the form of financial statements, budgets etc., The process of
financial forecasting involves use of past records, funds flow behaviour, financial
ratios and expected economic conditions in industry as well as in the firm. It is a
sort of working plan formulated for a specified period by arranging future activities.
It is a tool for appraising the real worth of a growing concern. It provides an insight
into two important areas of management- return on investment and soundness of
the company’s financial problems. The financial analysis is the process of
determining the significant financial characteristics of a firm. It may be internal or
external. The internal analysis is performed by the various department of a firm.
The external analysis is performed by creditors, stockholders and investment
analysis.
2.2 OBJECTIVES
Financial forecasting is the core function of financial management students
can know the meaning of the financial forecasting and various techniques
used in financial forecasting from this lesson.
2.3 CONTENT
2.3.1 Advantages
2.3.2 Disadvantages
2.3.3 Tools for financial forecasting
2.3.4 Forecasting future income and expenditure
2.3.5 Long term financial planning
2.3.1 ADVANTAGES
Financial manager derives several benefits out of financial forecasting. Some of
them are as follows.
1. Financial forecasting forms the basis of coordinated thinking for optimum utilization of funds and thus excess cash can be invested profitably.
2. It is useful to fix standards for measuring performance and evaluating results.
3. It is useful to anticipate the financial needs and effects of new policies and
reduce emergency decisions.
4. It serves as a basis for estimating funds requirements within the company.
5. It helps the corporate managers for negotiating confidently with the
suppliers of funds.
6. It is used to protect the financial feasibility of various programmes.
15
2.3.2 DISADVANTAGES
There is no technique by which the future can be fore told. Single
attempt to forecast the future is very hard. A forecast is based on certain
assumptions, which it is difficult to state clearly. Since future is always uncertain,
no constant technique is used to estimate the funds requirements of future.
2.3.3 TOOLS FOR FINANCIAL FORECASTING
Forecasting profit
The following are the stages in profit planning
1. Forecasting sales. This forecasting, whether long term or short term is
concerned with sales. It relates to:
(a) Growth polices (b) Man power planning (c) Policy for research and
development and (d) Financial policy providing for cash flows.
2. Forecasting production
a. Pricing
b. Profits from products and from the business as a whole.
Forecasting variations
It is concerned with asking why the targeted profit has not been achieved and
taking action to prevent further deterioration. All the functions which affect profit
should be part of the system which detects deviation from standard. It makes a
diagnosis of how these deviations have occurred, and which ensures that steps are
taken to correct the situation.
Effective financial Forecasting
Many firms operate in an atmosphere of change and uncertainty and they are
sometimes highly vulnerable, to sharp fluctuations in sales, which are dependent
on the vagaries of weather. They face difficulties in forecasting. They are required to
pay attention to the following.
1. Management should recognize the likely margin of errors inherent in its
forecasts.
2. Financial executives should prepare few sets of projected financial
statements and cash budgets under different key figures like sales,
inventory, debtors etc. It is undesirable to prepare one set.
3. Forecasts should be flexible as the firm is working in changing
environment.
4. Firms should maintain more cash balances to minimize the risk.
5. Key assumptions of forecast i.e., on what basis forecasts are made should
be mentioned for better understanding.
6. One should not forecast in greater details than what situation permits.
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7. Forecasting for a longer period is undesirable in the days of uncertainly as
they are going to be not useful much in times of change.
2.3.4 FORECASTING FUTURE INCOME AND EXPENDITURES
Budgets are estimates of future income and expenses arising out of and
incurred on, the activities of an enterprise. The actual performance is measured in
terms of budget expectation; budgetary control involves an overall supervision of
activities. It directs the way for securing the desired ends. There are many kinds of
budgets;
Sales Budgets: it contains a forecast of sales
Production Budget: it indicates the quality of production and the time limit by
which production may be completed to meet the sales targets.
Revenue and expense Budget: this is prepared by the top management to
determine the profitability of a budgetary programme.
Capital Expenditure Budget: this budget contains a programme for the
acquisition of fixed assets in the years to come. This budget points out the future
cash inflows in respect of particular capital expenditure.
2.3.5 LONG TERM FINANCIAL PLANNING
It examines the effect of the proposed capital investment and is known as
capital budgeting or investment appraisal. It refers to the decision-making
procedure in a firm and concerned with the allocation of capital among competing
investment opportunities. The followings are very important in evaluating the any
investment proposal,
1. To examine the total investment period.
2. To decide the time of capital expenditure.
3. To estimate the life of the project.
4. To determine future realizable receipts.
The following procedure may be adopted to estimate future cash flows of the long term investment.
1. Forecasting long term cash flows.
2. Estimating the cast of a proposal.
3. Evaluating investment proposal.
The following are considered in a long-range Financial planning.
1. The total investment: it covers not only the financial costs (total price of the
investments), but also the installation expenses and working capital
requirements.
2. Timing of capital expenditure: the entire cost of the investment is payable at
different point of time.
3. Estimated life of project: the period of life for which a project is likely to
exist.
17
4. Economic life of the assets: the management should attempt to evaluate the
period of time in which the proposed project would operate efficiently and
economically. The technological obsolescence, market trend, availability of
materials and operating and maintenance cost etc., are to be considered.
The management experience, while evaluating these items.
2.4 REVISION POINTS
Advantages of financial forecasting—optimum utilization of funds – Evaluating
the results and financial performance – Anticipate the financial needs and effects of
new policies -- Tools of financial forecasting – forecasting profit – long term financial
planning.
2.5 INTEXT QUESTIONS
1. Explain the advantages of financial forecasting.
2. What are the factors to be considered while long term financial planning?
3. Point out the essentials of a good financial fore casting.
4. Explain the importance of financial forecasting.
5. How would you forecast the profits?
6. What are the steps in long term financial planning?
2.6 SUMMARY
In this lesson financial forecasting is clearly defined. It is an estimation of
future funds requirements. Advantages of financial forecasting are explained.
Various tools of financial forecasting are- (1) forecasting future incomes and
expenditures (2) Long term financial planning. Various factors to be considered
while estimating the financial requirements.
2.7 TERMINAL EXERCISES
1.Sales budget refers
2 To forecast the profit (b) to forecast the sales (c) to forecast the sales expenses (d) to forecast the cost of sales
3. Long term financial planning is related with
4. Capital profit (b) Capital structure (c) capital budgeting (d) issues of shares.
2.8 SUPPLEMENTARY MATERIALS
http://dosen.narotama.ac.id/
http://www.osbornebooksshop.co.uk/
http://www.fao.org/
2.9 ASSIGNMENT
Refer the suggested materials and collect the information of various methods of
financial forecasting. Do, some home work of preparation of financial forecasting
with the help of suggested reference books. Prepare an essay on long term financial
planning and point out its features.
18
2.10 SUGGESTED READINGS /REFERENCE BOOKS
1. Cost and Management Accounting ---- V K Saxena
2. Financial Management ----- Kulkarni
3. Financial Management --- Krishna Reddy.
2.11 LEARNING ACTIVITIES
Students may collectively have some discussion on financial forecasting with
the help of suggested books and examine the relevant methods financial
forecasting. The techniques used in financial forecasting may be changed according
to the nature of the firm. Students may analyse the various methods of financial
forecasting and suggest new ideas for effective financial forecasting
2.12 KEY WORDS
Forecasting – fore see prediction
Uncertain – not sure
Standard – an accepted measure of quantity
Vulnerably – capable of being wounded
Vagaries – change.
19
LESSON 3
INTRODUCTION TO BUDGET
3.1 INTRODUCTION
To achieve the organizational objectives, an enterprise should be managed
effectively and efficiently. It is facilitated by chalking out the course of action in
advance. Planning, the primary function of management helps to chalk out the
course of actions in advance. But planning has to be followed by continuous
comparison of the actual performance with the planned performance, i. e.,
controlling. One systematic approach in effective follow up process is budgeting.
Different budgets are prepared by the enterprise for different purposes. Thus,
budgeting is an integral part of management.
In the business world, a budget is a statement showing the expected income
and expenditure for a specific future period. Thus, budgeting is required
everywhere in national, domestic and business affairs.
3.2 OBJECTIVES
After completing this Lesson you should be able to Know
What is Budget
Meaning of budgeting
Important elements of Budgeting
3.3 CONTENT
3.3.1 Definition of Budget
3.3.2 Elements of Budgets
3.3.3 Characteristics of a Budget
3.3.4 Budgeting
3.3.5 Elements of Budgeting
3.3.1 DEFINITION OF BUDGET
Budget is a systematic plan for utilization of all types of resources, at its
command. It acts as a barometer of a business as it measures the success from
time to time, against the standard set for achievement.
‘A budget is a comprehensive and coordinated plan, expressed in financial
terms, for the operations and resources of an enterprise for some specific period in
the future’. (Fremgen, James M – Accounting for Managerial Analysis)
‘A budget is a predetermined detailed plan of action developed and distributed
as a guide to current operations and as a partial basis for the subsequent
evaluation of performance’. (Gordon and Shillinglaw)
‘A budget is a financial and/or quantitative statement, prepared prior to a
defined period of time, of the policy to be pursued during the period for the purpose
of attaining a given objective’. (The Chartered Institute of Management
Accountants, London)
20
3.3.2 ELEMENTS OF BUDGET
The basic elements of a budget are as follows:-
1. It is a comprehensive and coordinated plan of action.
2. It is a plan for the firm’s operations and resources.
3. It is based on objectives to be attained.
4. It is related to specific future period.
5. It is expressed in financial and/or physical units.
3.3.3 CHARACTERISTICS OF A BUDGET
The main characteristics of a budget are:
A Comprehensive Business Plan showing what the enterprise wants to
achieve.
Prepared in Advance.
For a Definite Period of Time.
Expressed in quantitative form, physical or monetary terms, or both.
For achieving a given objective.
A proper system of Accounting is essential.
System of Proper Fixation of Authority and Responsibility has to be in
place.
Need of Budget
A budget is prepared to have effective utilization of resources and for the
realization of objectives, as efficiently as possible.
3.3.4 BUDGETING
Budgeting is the process of preparing and using budgets to achieve
management objectives. It is the systematic approach for accomplishing the
planning, coordination, and control responsibilities of management by optimally
utilizing the given resources. In other words Budgeting is a technique of
formulating budgets.
Budgeting is the whole process of designing, implementing and operating
budgets. The main emphasis in this is short – term budgeting process involving the
provision of Resources to support plans which are being implemented.
‘The entire process of preparing the budgets is known as Budgeting’(J. Batty)
‘Budgeting may be said to be the act of building budgets’ (Rowland&Harr)
3.3.5 ELEMENTS OF BUDGETING
1. A good budgeting should state clearly the firm’s expectations and
facilitate their attainability.
2. A good budgeting system should utilize various persons at different
levels while preparing the budgets.
3. The authority and responsibility should be properly fixed.
4. Realistic targets are to be fixed.
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5. A good system of accounting is also essential.
6. Wholehearted support of the top management is necessary.
7. Budgeting education is to be imparted among the employees.
8. Proper reporting system should be introduced.
9. Availability of working capital is to be ensured.
3.4 REVISION POINTS
1. 1. Budget is a Pre-determined Statement of Management Policy During a
Given Period Which provide a standard for comparison with the results
Actually achieved
2. Budgeting is a technique of formulating budgets.
3. Elements of Budget It is a comprehensive plan for the firm resources,
It is related Specific future period and expressed in financial or physical
unit
4. Characteristic of a budget It is prepared in advance for a definite period of
time
5. Elements of Budgeting Should express the firms expectation, realistic
target are fixed, good accounting system is essential, top management
support is necessary, working capital is to be ensured
3.5 INTEXT QUESTIONS
1. Define Budget
2. What do you mean by Budgeting?
3. What are the Basic elements of budgets
3.6 SUMMARY
Budget is a systematic plan for utilization of all types of resources, at its
command. It acts as a barometer of a business as it measures the success from
time to time, against the standard set for achievement. A budget is prepared to
have effective utilization of resources and for the realization of objectives, as
efficiently as possible. Budgeting is the process of preparing and using budgets to
achieve management objectives. It is the systematic approach for accomplishing the
planning, coordination, and control responsibilities of management by optimally
utilizing the given resources. In other words Budgeting is a technique of
formulating budgets. Elements of Budget It is a comprehensive plan for the firm
resources, It is related Specific future period and expressed in financial or physical
unit. Elements of Budgeting Should express the firms expectation, realistic target
are fixed, good accounting system is essential, top management support is
necessary, working capital is to be ensured.
3.7 TERMINAL EXERCISE
1 ………………………..is a detailed plan of operations for specific future period.
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2. …………………………is a technique of formulating budgets.
3. The entire process of preparing the budgets is known as…………………
3.8 SUPPLEMENTARY MATERIAL
Pillai.R.S.N, Bagavathi Management Accounting S. Chand & company LTD
Antony Robert.N and Reece, James.S
Management Accounting Principles Tata McGraw Hill
3.9 ASSIGNMENTS
1. What are the important points to be considered for a good budget?
2. Narrate the characteristics of a budget
3. Explain the Elements of a budgeting.
3.10 SUGGESTED READINGS / REFERENCE BOOKS
http://dosen.narotama.ac.id/
http://www.osbornebooksshop.co.uk/
http://www.fao.org/
http://www.icaiknowledgegateway.org/
3.11 LEARNING ACTIVITIES
Go to the nearby organization and observe how budgets are Prepared?
3.12 KEYWORDS
Budget, Budgeting, Budgetary Control
23
LESSON 4
TYPES OF BUDGETS
4.1 INTRODUCTION
The budgets are classified according to their nature. The budgets may be
classified according to function, flexibility, time. Functional budget is one which
relates to a function of the business. Flexible budget is one which is designed to
change in relation to the level of activity attained. On the basis of time, the budget
can be classified as Long term budget, Short term budget ,Current budget ,Rolling
budget .
4.2 OBJECTIVES
After completing this Lesson you should be able to know
Classification of Budgets According to Function, Flexibility and Time
How to prepare different types of Budgets
Advantages and Disadvantages of Budgetary Control
4.3 CONTENT
4.3.1 Types/Classification of Budget
4.3.2 Classification according to Function
4.3.3 Classification according to Flexibility
4.3.4 Classification according to Time
4.3.5 Advantages of Budgetary Control
4.3.6 Limitations of Budgetary Control
4.3.7 Preparation of Budgets
4.3.1 TYPES/CLASSIFICATION OF BUDGETS
Budget can be classified into three categories from different points of view.
They are:
1. According to Function
2. According to Flexibility
3. According to Time
4.3.2 CLASSIFICATION ACCORDING TO FUNCTION
a.Sales Budget
The budget which estimates total sales in terms of items, quantity, value,
periods, areas, etc is called Sales Budget.
b.Production Budget
It estimates quantity of production in terms of items, periods, areas, etc. It is
prepared on the basis of Sales Budget.
c.Cost of Production Budget
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This budget forecasts the cost of production. Separate budgets may also be
prepared for each element of costs such as direct materials budgets, direct labour
budget, factory materials budgets, office overheads budget, selling and distribution
overheads budget, etc.
d.Purchase Budget
This budget forecasts the quantity and value of purchase required for
production. It gives quantity wise, money wise and period wise particulars about
the materials to be purchased.
e.Personnel Budget
The budget that anticipates the quantity of personnel required during a
period for production activity is known as Personnel Budget
f.Research Budget
This budget relates to the research work to be done for improvement in
quality of the products or research for new products.
g.Capital Expenditure Budget
This budget provides a guidance regarding the amount of capital that may
be required for procurement of capital assets during the budget period.
h.Cash Budget
This budget is a forecast of the cash position by time period for a specific
duration of time. It states the estimated amount of cash receipts and estimation of
cash payments and the likely balance of cash in hand at the end of different
periods.
i.Master Budget
It is a summary budget incorporating all functional budgets in a capsule
form. It interprets different functional budgets and covers within its range the
preparation of projected income statement and projected balance sheet.
4.3.3 CLASSIFICATION ACCORDING TO FLEXIBILITY
On the basis of flexibility, budgets can be divided into two categories. They are:
1. Fixed Budget
2. Flexible Budget
1.Fixed Budget
Fixed Budget is one which is prepared on the basis of a standard or a fixed
level of activity. It does not change with the change in the level of activity.
2. Flexible Budget
A budget prepared to give the budgeted cost of any level of activity is
termed as a flexible budget. According to CIMA, London, a Flexible Budget is, ‘a
budget designed to change in accordance with level of activity attained’. It is
prepared by taking into account the fixed and variable elements of cost.
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4.3.4 CLASSIFICATION ACCORDING TO TIME
On the basis of time, the budget can be classified as follows:
1. Long term budget
2. Short term budget
3. Current budget
4. Rolling budget
1.Long-Term Budget
A budget prepared for considerably long period of time, viz., 5 to 10 years is
called Long-term Budget. It is concerned with the planning of operations of the
firm. It is generally prepared in terms of physical quantities.
2.Short-Term Budget
A budget prepared generally for a period not exceeding 5 years is called Short-
term Budget. It is generally prepared in terms of physical quantities and in monetary units.
3.Current Budget
It is a budget for a very short period, say, a month or a quarter. It is adjusted to
current conditions. Therefore, it is called current budget.
4.Rolling Budget
It is also known as Progressive Budget. Under this method, a budget for a year
in advance is prepared. A new budget is prepared after the end of each
month/quarter for a full year ahead. The figures for the month/quarter which has
rolled down are dropped and the figures for the next month/quarter are added.
This practice continues whenever a month/quarter ends and a new month/quarter
begins.
4.3.5 ADVANTAGES OF BUDGETARY CONTROL
The following are the advantages of budgetary control system.
1.Profit Maximization
The resources are put to best possible use, eliminating wastage. Proper control
is exercised both on revenue and capital expenditure. To achieve this, proper
planning and co-ordination of various functions is undertaken. So, the system
helps in reducing losses and increasing profits.
2.Co-ordination
Co-ordination between the plans, policy and control is established.
The budgets of various departments have a bearing with each other, as
activities are interrelated. As the size of operations increases, co-ordination
amongst the different departments for achieving a common goal assumes more
importance. This is possible through budgetary control system.
As all the personnel in the management team are involved and coordinated,
there is bound to be maximum profits.
26
Budgetary control system acts as a friend, philosopher and guide to the
management.
1.Communication
A budget serves as a means of communicating information throughout the
organisation. A sales manager for a district knows what is expected of his
performance. Similarly, production manager knows the amount of material, labour
and other expenses that can be incurred by him to achieve the goal set to him. So,
every department knows the performance expectation and authority for achieving
the same.
1.Tool for Measuring Performance
Budgetary control system provides a tool for measuring the performance of various departments. The performance of each department is reported to the top
management.
The system helps the management to set the goals. The current performance is compared with the pre-planned performance to ascertain deviations so that corrective measures are taken, well at the right time.
It helps the management to economise costs and maximise profits.
1.Economy
Planning at each level brings efficiency and economy in the working of the
business enterprise. Resources are put to optimum use. All this leads to
elimination of wastage and achievement of overall efficiency.
2.Determining Weaknesses
Actual performance is compared with the planned performance, periodically,
and deviations are found out. This shows the variances highlighting the
weaknesses, where concentration for action is needed.
3.Consciousness
Budgets are prepared in advance. So, every employee knows what is expected
of him and they are made aware of their responsibility. So, they do their job
uninterrupted for achieving, what is set to him to do.
4.Timely Corrective Action
The deviations are reported to the attention of the top management as well as
functional heads for suitable corrective action, in time. In the absence of budgetary
control, deviations would be known only at the end of the period. There is no time
and opportunity for necessary corrective action.
5.Motivation
Success is measured by comparing the actual performance with the planned
performance. Suitable recognition and reward system can be introduced to motivate
the employees, at all levels, provided the budgets are prepared with adequate
planning and foresight.
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6. Management by Exception
The management is required to exercise action only when there are
deviations. So long as the plans are achieved, management need not be alerted.
This system enables the introduction of ‘Management by Exception’ for effective
delegation and control.
6.Overall Efficiency
Everyone in the management is associated with the preparation of budget.
There is involvement from the top functionaries and each one knows how the target
fixed can be achieved. Budgets once, finally, approved by the Budget Committee, it
represents the collective decision of the organisation. With the implementation of
budgetary control, there would be over all alertness and improved working in all the
departments, with better coordination.
Budgetary Control acts like an impersonal policeman to bring all round
efficiency in performance.
7.Optimum Utilisation of Resources
As there is effective control over production, the resources of the
organisation would be put to optimum utilisation.
4.3.6 LIMITATIONS OF BUDGETARY CONTROL
Budgetary control is a sound technique of control but is not a perfect tool.
Despite many good points, it suffers from the following limitations:
1.Uncertainty of Future
Budgets are prepared for the future periods. So, budgets are prepared, with
certain assumptions. There is no certainty that all the assumptions prevail in
future. With the change in assumptions, the situation, in future, changes. Due to
this, the utility of budgetary control reduces.
2.Problem of Co-ordination
The success of budgetary control, largely, depends upon effective co-
ordination. The performance of one department depends on the performance of the
other department. To ensure necessary co-ordination, organisation appoints a
budget officer. All organisations cannot afford the additional expenditure involved
with the appointment of a budget officer, separately. In case, budget officer is not
appointed, lack of co-ordination results in poor performance.
3.Not a Substitute for Management
Budgetary control helps in decision-making, but is not a substitute for
management. A budgetary programme can be successful, if there is proper
administration and supervision.
4.Discourages Efficiency
Every person is given a target to achieve. So, everyone is concerned only
achieving the target of his own. This is the common tendency. Even capable and
competent people too would concentrate just to achieve their individual targets. So,
28
budgets may become managerial constraints, unless suitable award or incentive
system is introduced. In the absence of award system to recognise efficiency and
exceptional talents, budgets may dampen the people, with initiative and
enthusiasm.
5.Timely Revision Required
Budgets are prepared on certain assumptions. When those conditions do not
prevail, it becomes inevitable to revise the budget. Such frequent revision of
budgets reduces reliability and value. Revision of budgets involves additional
expenditure too.
6.Conflict among Different Departments
For the success of budgetary control, co-ordination of the different departments
is essential. Every department is concerned with the achievement of the individual
department’s goal, not concerned with the final goal of the enterprise. In this
process, each department tries to secure maximum fund allocation and this creates
conflict among the different departments.
7.Depends upon Support of Top management
The success of budgetary control depends upon the support of top
management. If the top management is not enthusiastic for its success, the
budgetary control collapses. So, the wholehearted interest of top management is
highly essential for its implementation, in its true spirit, to make it workable and
succeed.
4.3.7 PREPARATION OF BUDGETS
I. Sales Budget
Sales budget is the basis for the preparation of other budgets. It is the forecast
of sales to be achieved in a budget period. The sales manager is directly responsible
for the preparation of this budget. The following factors are taken into
consideration:
a. Past sales figures and trend
b. Salesmen’s estimates
c. Plant capacity
d. General trade position
e. Orders in hand
f. Proposed expansion
g. Seasonal fluctuations
h. Market demand
i. Availability of raw materials and other supplies
j. Financial position
k. Nature of competition
l. Cost of distribution
m. Government controls and regulations
29
n. Political situation.
Example
1. The Royal Industries has prepared its annual sales forecast, expecting to
achieve sales of 30,00,000 next years. The Controller is uncertain about the pattern
of sales to be expected by month and asks you to prepare a monthly budget of
sales. The following is the sales data pertained to the year, which is considered to
be representative of a normal year:
Month Sales Month Sales
January 1,10,000 July 2,60,000
February 1,15,000 August 3,30,000
March 1,00,000 September 3,40,000
April 1,40,000 October 3,50,000
May 1,80,000 November 2,00,000
June 2,25,000 December 1,50,000
Prepare a monthly sales budget for the coming year on the basis of the above data.
Answer
Sales Budget
Month Sales(given)
Sales estimation
based on cash sales ratio given
January 1,10,000 (1,10,000/25,00,000) x 30,00,000 = 1,32,000
February 1,15,000 (1,15,000/25,00,000) x 30,00,000 = 1,38,000
March 1,00,000 (1,00,000/25,00,000) x 30,00,000 = 1,20,000
April 1,40,000 (1,40,000/25,00,000) x 30,00,000 = 1,68,000
May 1,80,000 (1,80,000/25,00,000) x 30,00,000 = 2,16,000
June 2,25,000 (2,25,000/25,00,000) x 30,00,000 = 2,70,000
July 2,60,000 (2,60,000/25,00,000) x 30,00,000 = 3,12,000
August 3,30,000 (3,30,000/25,00,000) x 30,00,000 = 3,96,000
September 3,40,000 (3,40,000/25,00,000) x 30,00,000 = 4,08,000
October 3,50,000 (3,50,000/25,00,000) x 30,00,000 = 4,20,000
November 2,00,000 (2,00,000/25,00,000) x 30,00,000 = 2,40,000
December 1,50,000 (1,50,000/25,00,000) x 30,00,000 = 1,80,000
Total 25,00,000 30,00,000
Note: Sales budget is prepared based on last year’s month-wise sales ratio.
30
2. M/s. Alpha Manufacturing Company produces two types of products, viz.,
Raja and Rani and sells them in Chennai and Mumbai markets. The following
information is made available for the current year:
Market Product Budgeted Sales Actual Sales
Chennai Raja 400 units @ 9 each 500 units @ 9 each
Rani 300 units @ 21 each 200 units @ 21 each
Mumbai Raja 600 units @ 9 each 700 units @ 9 each
Rani 500 units @ 21 each 400 units @ 21 each
Market studies reveal that Raja is popular as it is under priced. It is observed
that if its price is increased by1 it will find a readymade market. On the other hand,
Rani is overpriced and market could absorb more sales if its price is reduced to ̀
20. The management has agreed to give effect to the above price changes.
On the above basis, the following estimates have been prepared by Sales
Manager:
Product
% increase in sales over current budget
Chennai Mumbai
Raja +10% + 5%
Rain + 20% + 10%
With the help of an intensive advertisement campaign, the following additional
sales above the estimated sales of sales manager are possible:
Product Chennai Mumbai
Raja 60 units 70 units
Rani 40 units 50 units
You are required to prepare a budget for sales incorporating the above estimates.
31
Answer:
Sales Budget
Area Product
Budget for
current year Actual sales
Budget for
future period
Units Price Value Units Price Value Units Price Value
Chennai
Raja 400 9 3600 500 9 4500 500 10 5000
Rani 300 21 6300 200 21 4200 400 20 8000
Total 700 9900 700 8700 900 13000
Mumbai
Raja 600 9 5400 700 9 6300 700 10 7000
Rani 500 21 10500 400 21 8400 600 20 12000
Total 1100 15900 1100 14700 1300 19000
Total
Raja 1000 9 9000 1200 9 10800 1200 10 12000
Rani 800 21 16800 600 21 12600 1000 20 20000
Total
Sales 1800 25800 1800 23400 2200 32000
Workings
1. Budgeted sales for Chennai
All in Units Raja Rani
Budgeted Sales 400 300
Add: Increase
(10%)
40 (20%) 60
440 360
Increase due to advertisement 60 40
Total 500 400
2. Budgeted sales for Mumbai
All in Units Raja Rani
Budgeted Sales 600 500
Add: Increase (5%) 30 (10%) 50
630 550
Increase due to advertisement 70 50
Total 700 600
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II. Production Budget
The production budget is an estimate of the quantity of goods that must be
produced during the budget period. The aim of the production function will
presumably be to supply finished goods of a specified quality to meet marketing
demands. The sum of sales requirements plus changes in stock levels of finished
goods gives the production requirements for the period being budgeted. In order to
construct the production budget we need the level of sales expected and the desired
levels of stock of finished goods. The following formula is used for calculation of
units to be produced.
Production = Sales + Closing stock – Opening stock
Production budget should be developed keeping in view the optimal balance
between sales, inventories and production so as to result in minimum cost. Once
the production level is determined, it becomes the starting point for the direct
materials, direct labour and manufacturing overhead budgets.
Production = Sales + Closing Stock – Opening Stock
Example
3 The sales of a concern for the next year is estimated at 50,000 units. Each
unit of the product requires 2 units of Material ‘A’ and 3 units of Material ‘B’. The
estimated opening balances at the commencement of the next year are:
Finished Product : 10,000 units
Raw Material ‘A’ : 12,000 units
Raw Material ‘B’ : 15,000 units
The desirable closing balances at the end of the next year are:
Finished Product : 14,000 units
Raw Material ‘A’ : 13,000 units
Raw Material ‘B’ : 16,000 units
Prepare the materials purchase budget for the next year.
Answer
Production Budget (All in Units)
Estimated Sales 50,000
Add: Estimated Closing Finished Goods 14,000
64,000
Less: Estimated Opening Finished Goods 10,000
Production 54,000
Materials Purchase Budget
33
Material ‘A’ Material ‘B’
(all in Units)
Material Consumption 1,08,000 1,62,000
Add: Closing stock of materials 13,000 16,000
1,21,000 1,78,000
Less: Opening stock of materials 12,000 15,000
Materials to be purchased 1,09,000 1,63,000
Workings
Materials consumption: Material ‘A’ Material ‘B’
Material required per unit of production 2 units 3 units
For production of 54,000 units 1,08,000 1,62,000
III. Cash Budget
It is an estimate of cash receipts and disbursements during a future period
of time. “The Cash Budget is an analysis of flow of cash in a business over a future,
short or long period of time. It is a forecast of expected cash intake and outlay”
(Soleman, Ezra – Handbook of Business administration)
Procedure for Preparation of Cash Budget
1. First take into account the opening cash balance, if any, for the beginning
of the period for which the cash budget is to be prepared.
2. Then Cash receipts from various sources are estimated. It may be from
cash sales, cash collections from debtors/bills receivables, dividends,
interest on investments, sale of assets, etc.
3. The Cash payments for various disbursements are also estimated. It may
be for cash purchases, payment to creditors/bills payables, payment to
revenue and capital expenditure, creditors for expenses, etc.
4. The estimated cash receipts are added to the opening cash balance, if any.
5. The estimated cash payments are deducted from the above proceeds.
6. The balance, if any, is the closing cash balance of the month concerned.
7. The closing cash balance is taken as the opening cash balance of the following month.
8. Then the process is repeatedly performed.
9. If the closing balance of any month is negative i.e the estimated cash
payments exceed estimated cash receipts, then overdraft facility may also
be arranged suitably.
34
Example:
From the following budgeted figures prepare a Cash Budget in respect of
three months to June 30, 2006.
Additional Information
1. Expected Cash balance on 1st April, 2006 – 20,000
2. Materials and overheads are to be paid during the month following the
month of supply.
3. Wages are to be paid during the month in which they are incurred.
4. All sales are on credit basis.
5. The terms of credits are payment by the end of the month following the
month of sales: Half of credit sales are paid when due the other half to
be paid within the month following actual sales.
6. 5% sales commission is to be paid within in the month following sales
7. Preference Dividends for30,000 is to be paid on 1st May.
8. Share calls money of 25,000 is due on 1st April and 1st June.
9. Plant and machinery worth10,000 is to be installed in the month of
January and the payment is to be made in the month of June.
Answer:
Cash Budget for three months from April to June, 2006
Particulars April Rs.
May Rs.
June Rs.
Opening Cash Balance 20,000 32,600 (-) 5,600
Add: Estimated Cash Receipts:
Sales Collection from debtors 60,000 72,000 82,000
Share call money 25,000 25,000
TOTAL ------- A 1,05,000 1,04,600 1,01,400
Month Sales Materials Wages Overheads
January 60,000 40,000 11,000 6,200
February 56,000 48,000 11,600 6,600
March 64,000 50,000 12,000 6,800
April 80,000 56,000 12,400 7,200
May 84,000 62,000 13,000 8,600
June 76,000 50,000 14,000 8,000
35
Less: Estimated Cash
Payments:
Materials 50,000 56,000 62,000
Wages 12,400 13,000 14,000
Overheads 6,800 7,200 8,600
Sales Commission 3,200 4,000 4,200
Preference Dividend --- 30,000
Plant and Machinery --- --- 10,000
TOTAL ------- B 72,400 1,10,200 98,800
Closing Cash Balance (A-B) 32,600 (-) 5,600 2,600
WORKINGS:
1. Sales Collection: Payment is due at the month following the sales. Half is
paid on due and other half is paid during the next month. Therefore, February sales ` 50,000 is due at the end of March. Half is given at the end of March and other half
is given in the next month i.e., in the month of April. Hence, the sales collection for the month of April will be as follows:
For April – Half of February sales (56,000 x ½)= 28,000 Plus
Half of March Sales (64,000 x ½)= 32,000
Total Collection for April= 60,000
Similarly, the sales collection for the months of May and June may be
calculated
2. Materials and Overheads: These are paid in the following month. That is
March is paid in April, April is paid in May and May is paid in June
3. Sales Commission: It is paid in the following month. Therefore
For April – 5% of March Sales (64,000 x 5 /100) = 3,200
For May – 5% of March Sales (80,000 x 5 /100) = 4,000
For April – 5% of March Sales (84,000 x 5 /100) = 4,200
IV. Flexible Budget
A flexible budget consists of a series of budgets for different level of activity.
Therefore, it varies with the level of activity attained. According to CIMA, London, A
Flexible Budget is, ‘a budget designed to change in accordance with level of activity
attained’. It is prepared by taking into account the fixed and variable elements of
cost. This budget is more suitable when the forecasting of demand is uncertain.
Points to be remembered while preparing a flexible budget
1. Cost has to be classified into fixed and variable cost.
2. Total fixed cost remains constant at any level of activity.
36
3. Total Variable cost varies in the same proportion at which the level of activity varies.
4. Fixed and variable portion of Semi-variable cost is to be segregated.
Example
5. The following information at 50% capacity is given. Prepare a flexible budget
and forecast the profit or loss at 60%, 70% and 90% capacity.
Particulars Expenses at 50% capacity
Fixed expenses: Rs.
Salaries 5,000
Rent and taxes 4,000
Depreciation 6,000
Administrative expenses 7,000
Variable expenses:
Materials 20,000
Labour 25,000
Others 4,000
Semi-variable expenses:
Repairs 10,000
Indirect Labour 15,000
Others 9,000
It is estimated that fixed expenses will remain constant at all capacities.
Semi-variable expenses will not change between 45% and 60% capacity, will rise by
10% between 60% and 75% capacity, a further increase of 5% when capacity
crosses 75%.Estimated sales at various levels of capacity viz.,60%. 70% and 90%
respectively of Rs.1,10,000 1,30,000 and Rs.1,50,000.
Answer
Flexible Budget (Showing Profit & Loss at various capacities)
Particulars
Capacities
50% 60% 70% 90%
Fixed Expenses: Rs. Rs. Rs. Rs.
Salaries 5,000 5,000 5,000 5,000
Rent and taxes 4,000 4,000 4,000 4,000
Depreciation 6,000 6,000 6,000 6,000
Administrative expenses 7,000 7,000 7,000 7,000
Variable expenses:
Materials 20,000 24,000 28,000 36,000
Labour 25,000 30,000 35,000 45,000
Others 4,000 4,800 5,600 7,200
37
Semi-variable expenses:
Repairs 10,000 10,000 11,000 11,500
Indirect Labour 15,000 15,000 16,500 17,250
Others 9,000 9,000 9,900 10,350
Total Cost 1,05,000 1,14,800 1,28,000 1,49,300
Profit (+) or Loss (-) (-) 4,800 (+) 2,000 (+) 700
Estimated Sales 1,10,000 1,30,000 1,50,000
Example
6. The following information relates to a flexible budget at 60% capacity. Find
out the overhead costs at 50% and 70% capacity and also determine the overhead
rates:
Particulars Expenses at60% capacity
Variable overheads:
Indirect Labour 10,500
Indirect Materials 8,400
Semi-variable overheads:
Repair and Maintenance(70% fixed; 30% variable) 7,000
Electricity(50% fixed; 50% variable) 25,200
Fixed overheads:
Office expenses including salaries 70,000
Insurance 4,000
Depreciation 20,000
Estimated direct labour hours 1,20,000 hours
Answer Flexible Budget
50 % 60% 70%
Capacity Capacity Capacity
Variable overheads:
Indirect Labour 8,750 10,500 12,250
Indirect Materials 7,000 8,400 9,800
Semi-variable overheads:
Repair and Maintenance (1) 6,650 7,000 7,350
Electricity(2) 23,100 25,200 27,300
Fixed overheads:
Office expenses including salaries 70,000 70,000 70,000
Insurance 4,000 4,000 4,000
38
Depreciation 20,000 20,000 20,000
Total overheads 1,39,500 1,45,100 1,50,700
Estimated direct labour hours 1,00,000 1,20,000 1,50,000
Overhead rate per hour 1.395 1.21 1.077
Workings:
The amount of Repairs and maintenance at 60% Capacity is 7,000. Out of
this, 70% (i.e4,900) is fixed and remaining 30% (i.e2,100) is variable. The fixed
portion remains constant at all levels of capacities. Only the variable portion will
change according to change in the level of activity. Therefore, the total amount of
repairs and maintenance for 50% and 70% capacities are calculated as follows:
Repairs and maintenance 50% 60% 70%
Fixed (70%) 4,900 4,900 4,900
Variable (30%) 1,750 2,100 2,450
Total 6,650 7,000 7,350
2. Similarly, electricity expenses at different levels of capacity are calculated as
follows:
Electricity 50% 60% 70%
Fixed (50%) 12,600 12,600 12,600
Variable (50%) 10,500 12,600 14,700
Total 23,100 25,200 27,300
Exercise
1. With the following data for a 60% activity, prepare a budget for production at
80%
and 100% capacity
Production at 60% activity 600 units
Material Rs. 100 per unit
Labour Rs. 40 per unit
Expenses Rs. 10 per unit
Factory Expenses Rs. 40,000 (40% fixed)
Administration Expenses Rs. 30,000 (60% fixed)
39
{ Ans: Total Variable Cost at 60% Rs.1,68,000 at 70% Rs.2,10,000 and Fixed
cost Rs.34,000}
2. The expenses for the production of 5,000 units in a factory are given as follows:
Per Unit Rs.
Materials 50
Labour 20
Variable Overhead 15
Fixed Overhead (Rs. 50,000) 10
Administrative Expenses (5% Variable) 10
Selling Expenses (20% fixed) 6
Distribution Expenses (10% fixed) 5
Total Cost of Sales per Unit 116
You are required to prepare a budget for the production of 7,000 units and
9,000 units.
{ Ans: Total Variable Cost for 7,000 Units Rs.6,63,600 for 9,000 units
Rs.8,53,200 and Fixed cost Rs.1,06,000}
Note: 1.
In the problem, expenses per unit are calculated on the production level of
5,000 units. So, administrative expenses were Rs. 10 per unit, when the production
level was 5,000 units. So, total administrative expenses were Rs. 50,000. Out of
which, 5% was variable cost (Rs. 0.50 per unit) and balance 95% was fixed cost,
which works out to Rs. 47,500. Fixed costs Rs. 47,500 are constant, whatever be
the level of activity.
Note 2:
Total Selling Expenses are Rs. 30,000. Out of which, 20% were fixed costs,
which works out Rs. 6,000. Balance amount was variable cost Rs. 24,000, which
works out to Rs. 4.80 per unit.
Note 3:
Total Distribution costs were Rs. 25,000. Out of which 10% were fixed costs,
which works out to Rs. 2,500. Balance amount was variable cost Rs. 22,500, which
works out to Rs. 4.50 per unit.
3. Prepare a Production Budget for each month and summarized Production Budget
for the six months period ending 31st Dec., 1989 from the following of product X.
40
(i) The units to be sold for different months are as follows:
July-1989 1,100
August 1,100
September 1,700
October 1,900
November 2,500
Dec-1989 2,300
Jan-1990 2,200
(ii) There will be no work in progress at the end of any month.
(iii) Finished units equal to half the sales for the next month will be in stock at
the end of each month (including June 1989).
(iv) Budgeted production and production cost for the year ending 31st
December, 1989 are as follows:
Production Units 22,000
Direct Materials Per Unit Rs. 10
Direct Wages Per Unit Rs. 4
Total Factory Overheads Apportioned to Product Rs. 88,000
Answer:
July Aug Sep Oct Nov Dec
Opening Stock 550 550 850 950 1250 1150
Closing Stock 550 850 950 1250 1150 1100
Production 1100 1400 1800 2200 2400 2250
4. Following are the budget estimates of a repairs and maintenance department,
which are to be used to construct a flexible budget for the ensuing year.
Details of Cost
Planned at 6,000
Direct Hours
Planned at 9,000
Direct Hours
All in Rs.
Employees salaries 28,000 28,000
indirect Repair Material 42,000 63,000
Miscellaneous Cost 16,000 20,500 i. Prepare a flexible budget for the department up to activity level of
10,000 direct repair hours using increment of 1,000 hours.
ii. What would be the budget allowance for 9,500 direct repair hours?
41
Ans: Note 1: Indirect Repair Material is a Variable Overhead, so absorbed @ of Rs.7 per Direct Hours
Note 2: Miscellaneous cost is a semi-variable cost, containing fixed cost and
variable cost components. Fixed cost is Rs. 16,000. Balance amount Rs. 4,500
(20,500 – 16,000) is variable cost component, which works out to Rs. 1.50 per hour
(4,500/3,000).
Note 3: At 9,500 hours, for the incremental increase of 500 hours, the cost increases by Rs. 4,250 due to the following:
Variable Cost
Indirect Repair Material (@ Rs. 7 per hour) = 500 × 7 = 3,500
Semi-fixed cost miscellaneous cost
(@ Rs. 1.50 per hour Variable cost component) = 500 × 1.50 = 750
Total incremental cost= 4,250
Direct Hours 6000 7000 8000 9000 9500 10000
Total cost 86000 94500 103000 111500 115750 120000
5. Prepare a Cash-Budget of a company for April, May and June 2015 in a
columnar
form using the following information:
(All in Rs.)
Month, 2015 Sales Purchases Wages Expenses
January (Actual) 80,000 45,000 20,000 5,000
February (Actual) 80,000 40,000 18,000 6,000
March (Actual) 75,000 42,000 22,000 6,000
April (Budgeted) 90,000 50,000 24,000 7,000
May (Budgeted) 85,000 45,000 20,000 8,000
June (Budgeted) 80,000 35,000 18,000 6,000 You are further informed that:
(a) 10% of the purchases and 20% of the sales are for cash;
(b) The average collection period of the company ½ month and the credit
purchases are paid off regularly after one month;
(c) Wages are paid half monthly, and the rent of Rs. 500 included in expenses
is paid monthly;
(d) Cash and Bank Balance as on April, was Rs. 15,000 and the company wants to keep it at the end of every month approximately this figure, the excess
cash being put in fixed deposits in the bank.
6. From the following forecast of income and expenditure, prepare a cash budget for
the months January to April 2016.
42
(All in Rs.)
Months Sales
(Credit)
Purchases
(Credit)
Wages Manufacturing
Expenses
Administrative
Expenses
Selling
Expenses Nov-15 30,000 15,000 3,000 1,150 1,060 500 Dec-15 35,000 20,000 3,200 1,225 1,040 550
Jan-16 25,000 15,000 2,500 990 1,100 600 Feb 30,000 20,000 3,000 1,050 1,150 620
March 35,000 22,500 2,400 1,100 1,220 570 April 40,000 25,000 2,600 1,200 1,180 710
Additional information is as follows:
1. The customers are allowed a credit period of 2 months.
2. A dividend of Rs. 10,000 is payable in April.
3. Capital expenditure to be incurred: Plant ‘purchased on 15th January for
Rs. 5,000, a Building has been purchased on 1st March and the payments
are to be made in monthly installments’ of Rs. 2,000 each.
4. The creditors are allowing a credit of 2 months.
5. Wages are paid on the 1st on the next month.
6. Lag in payment of other expenses is one month.
7. Balance of cash in hand on 1st January, 2016 is Rs. 15,000
Other Exercise for practice
1. M.K. Exports Ltd. wishes to arrange overdraft facilities with its bankers
during the period April-June 2006 when it will be manufacturing mostly for stocks.
Prepare a cash budget for this period from the following data, indicating the extent
of the bank facilities the company will require at the end of each month.
Period (2006) Sales (Rs.) Purchases (Rs.) Wages (Rs.)
February 180000 124000 12000
March 192000 144000 14000
April 108000 243000 11000
May 174000 246060 10000
June 126000 268000 15000
50% of the sales are realised in the following the sales and the remaining 50%
in the second month following. Creditors are paid in the month following the month
of purchase. Cash at bank on 1st April 2006 is Rs.25000.
2. Prepare a flexible budget for production at 80% and 100% activity on the
basis of the following information:
Production at 50% capacity 5000 Units
Raw Materials Rs.80 per unit
43
Direct Labour Rs.50 per unit
Direct Expenses Rs.15 per unit
Factory Expenses Rs.50000 (50% fixed)
Administration Expenses Rs.60000 (60% variable)
3. Draw up a flexible budget for overhead expenses on the basis of the following
data and determine the overhead rates at 70%, 80% and 90% plant capacity.
At 80% Capacity
Rs. Variable Overheads:
Indirect labour 12,000
Stores including spares 4,000
Semi-variable Overheads:
Power (30% fixed, 70% variable) 20,000
Repairs and maintenance (60% fixed, 40% Variable) 2,000
Fixed Variable:
Depreciation 11,000
Insurance 3,000
Salaries 10,000
Total Overheads 62,000
Estimated direct labour hours 1,24,000 hrs.
4. The expenses budgeted for production of 10000 units in a factory are
furnished below:
Rs. per Unit
Material 70
Labour 25
Variable Overheads 20
Fixed overheads (Rs.100000) 10
Variable expenses (direct) 5
Selling expenses (10% direct) 13
Distribution expenses (20% fixed) 7
Administration Expenses (Rs.50000) 5
Total 155
Prepare a budget for the purpose of (a)8000 units and (b)6000 units.
Assume that administration expenses are rigid for all levels of production.
44
5. From the following data, prepare a flexible budget for production of 40000
units and 75000 units, distinctly showing variable cost and fixed cost as well as
total cost. Also indicate element-wise cost per unit. Budgeted output is 100000
units and budgeted cost per unit is as follows:
Rs.
Direct Material 95
Direct Labour 50
Production overhead (variable) 40
Production overhead (fixed) 5
Administration overhead (fixed) 5
Selling overhead (10% fixed) 10
Distribution overhead (20% fixed) 15
6. Z limited has prepared the budget for the production of 100000 units from a
costing period as under:
Per Unit (Rs.)
Raw Materials 10.08
Direct Labour 3.00
Direct Expenses 0.40
Works overhead (60% fixed) 10.00
Administration overhead (80% fixed) 1.60
Sales overhead (50% fixed) 0.80
Actual production in the period was only 60000 units. Prepare budgets for the
original and revised levels of output.
7. A department of AXY company attains sales of Rs.600000 at 80% of its
normal capacity. Its expenses are given below:
Rs.
Office salaries 90,000
General expenses 2% of sales
Depreciation 7,500
Rent and rates 8,750
Selling Costs:
Salaries 8% of sales
Travelling expenses 2% of sales
Sales office 1% of sales
45
General expenses 1% of sales
Distribution Costs:
Wages 15,000
Rent 1% of sales
Other expenses 4% of sales
Draw up Flexible Administration, Selling and Distribution Costs Budget,
operating at 90%, 100% & 110% of normal capacity.
8. A company is expecting to have Rs.25000 cash in hand on 1st April 2006 and
it requires you to prepare cash budget for the three months. April to June 2006.
The following information is supplied to you.
Period (2006) Sales (Rs.) Purchases (Rs.) Wages (Rs.) Expenses (Rs.)
February 70000 40000 8000 6000
March 80000 50000 8000 7000
April 92000 52000 9000 7000
May 100000 60000 10000 8000
June 120000 55000 12000 9000
Other Information:
a) Period of credit allowed by suppliers is two months:
b) 25% of sale is for cash and the period of credit allowed to customers for
credit sale is one month;
c) Delay in payment of wages and expenses one month
d) Income tax Rs.25000 is to be paid din June 2006.
9.The following data relate to bookshop Ltd: The financial manager has made
the following sales forecasts for the first five months of the coming year,
commencing from 1st April, 2006:
Month Sales (Rs.)
April 40,000
May 45,000
June 55,000
July 60,000
August 50,000
Other data:
i. Debtor’s and Creditor’s balance at the beginning of the year are
Rs.30000 & Rs.14000 respectively. The balance of other relevant assets
and liabilities are:
46
ii. Cash Balance(Rs). 7,500; StockRs.51,000; Accrued Sales Commission
Rs. 3,500
iii. 40% sales are on cash basis. Credit sales are collected in the month
following the sale .
iv. Cost of sales is 60% on sales
v. The only other variable cost is a 5% commission to sales agents. The
Sales commission is paid in a month after it is earned.
vi. Inventory(stock) is kept equal to sales requirements for the next two
months budgeted sales.
vii. Trade creditors are paid in the following month after purchases.
viii. Fixed costs are Rs.5000 per month including Rs.2000 depreciation.
You are required to prepare a Cash Budget for the months of April, May and
June,2006 respectively.
10.Prepare a Clash Budget for the three months ending 30 th June 2006 from
the information given below:
Period
(2006)
Sales
(Rs.)
Materials
(Rs.)
Wages
(Rs.)
Overheads
(Rs.)
February 14000 9600 3000 1700
March 15000 9000 3000 1900
April 16000 9200 3200 2000
May 17000 10000 3600 2200
June 18000 10400 4000 2300
(b). Credit terms are: sales and debtors – 10% sales are on cash, 50% of the
credit sales are collected next month and the balance in the following month.
Creditors – Materials 2 Months
Wages ¼ month
Overheads ½ month
(c). Cash and bank on 1st April, 2006 is expected to be Rs.6000
(d). Other relevant information are:
i. Plant and machinery will be installed in February 2006 at a cost of
Rs.96000. The monthly instalment of Rs.2000 is payable from April
onwards.
ii. Dividend @ 5% on Preference Share capital of Rs.200000 will be paid
on 1st June.
47
iii. Advance to be received for sale of vehicles Rs.9000 in June.
iv. Dividends from investments amounting to Rs.1000 are expected to be
received in June.
v. Income tax (advance) to be paid in June is Rs.2000
11. The following information relates to Rs. ‘000
Month Wages incurred Materials
Purchased
Overhead Sales
February 6 20 10 30
March 8 30 12 40
April 10 25 16 60
May 9 35 14 50
June 12 30 18 70
July 10 25 16 60
August 9 25 14 50
September 9 30 14 50
1. It is expected that cash balance on 31st May will be Rs.22000
2. The wages may be assumed to be paid within the month they are incurred
3. It is the company’s policy to pay creditors for materials three months after
receipt.
4. Debtors are expected to pay creditors for materials three months after
receipt
5. Included in the overhead figure is Rs.2000 per month which represents
depreciation on two cars and one delivery van.
6. There is a one month delay in paying the overhead expenses.
7. 10% of the monthly sales are for cash and 90% are sold on credit.
8. A commission of 5% is paid to agents on all the sales on credit but, this is
not paid until the month following the sales to which it relates; this
expense is not included in the overhead figure shown.
9. It is intended to repay a loan of Rs.25000 on 30 th June.
10. Delivery is expected in July of a new machine costing Rs.45000 of which
Rs.15000 will be paid on delivery and Rs.15000 in each of the following
months.
11. Assume that overdraft facilities are available, if required.
You are required to prepare a cash budget for the three months of June, July
and August.
48
12. With the following data at 60% activity, prepare a budget at 80% and 100%
activity.
Production at 60% capacity 600units
Materials Rs.120 per unit
Labour Rs.50 per unit
Expenses Rs.20 per unit
Factory Expenses Rs.60000 (40% fixed)
Administration Expenses Rs.40000 (60% fixed)
13. For production of 10000 Electrical Irons, the following are budgeted
expenses:
Per Unit Rs.
Direct materials 60
Direct labour 30
Variable overhead 25
Fixed overhead (Rs.150000) 15
Variable expenses (direct) 5
Selling expenses (10% fixed) 15
Administration expenses (Rs.50000
rigid of all levels of production) 5
Distribution expenses (20% fixed) 5
Total cost of sales per unit 160
Prepare a budget for production of 6000, 7000 & 8000 irons, showing distinctly
marginal cost and total cost.
14. A company produces a standard product. The estimated costs per unit are
as follows:
Raw materials Rs.4; Wages Rs.2; Variable overhead Rs.5
The semi-variable costs are:
Indirect materials Rs.235; Indirect labour Rs.156; Repairs Rs.570
The variable costs per unit included in semi-variable are:
Indirect materials Re.0.05; Labour Re.0.08 and Repaire.0.10.
The fixed costs are Factory Rs.2000; Administration Rs.3000; Selling Rs.2500.
The above cost are 70% of normal capacity production i.e. 700units. The selling
price is Rs.30 per unit. Prepare Flexible Budget for 80% and 100% normal
capacities from the above information.
49
15. The following data are available in a manufacturing company for a yearly
period:
Fixed Expenses:
Rs. Lakhs
Wages & salaries 9.5
Rent, rates & taxes 6.6
Depreciation 7.4
Sundry administration expenses 6.5
Semi-variable expenses (At 50% of capacity):
Maintenance and repairs 3.5
Indirect labour 7.9
Sales department salaries, etc 3.8
Sundry administration salaries 2.8
Variable expenses (At 50% of capacity):
Materials 21.7
Labour 20.4
Other expenses 7.9
Total Cost 98.0
Assume that the fixed expenses remain constant for all levels of production;
semi-variable expenses remain constant between 45% and 65% of capacity,
increasing by 10% between 65% and 80% capacity and by 20% between 80% and
100% capacity.
Sales at various level are:
50% capacity Rs. Lakhs 100 75% capacity Rs. Lakhs 150
60% capacity Rs. Lakhs 120 90% capacity Rs. Lakhs 180
100% capacity Rs. Lakhs 200
Prepare a flexible budget for the year and forecast the profit at 60%, 75%,
90% and 100% of capacity.
16. A company expects to have Rs.37500 cash in hand on 1 st April, and
requires you to prepare an estimate of cash position during the three months, April,
May & June. The following information is supplied to you:
50
Sales
(Rs.)
Purchases
(Rs.)
Wages
(Rs.)
Factory
expenses
(Rs.)
Office
expenses
(Rs.)
Selling
expenses
(Rs.)
February 75000 45000 9000 7500 6000 4500
March 84000 48000 9750 8250 6000 4500
April 90000 52000 10500 9000 6000 5250
May 120000 60000 13500 11250 6000 6570
June 135000 60000 14250 14000 7000 7000
Other Information:
1. Period of credit allowed by suppliers – 2 months
2. 20% of sales is for cash and period of credit allowed to customers for
credit is one month.
3. Delay in payment of all expenses – 1 month
4. Income tax of Rs.57500 is due to be paid on June 15 th.
5. The company is to pay dividends to shareholders and bonus to workers
of Rs.15000 and Rs.22500 respectively in the month of April.
6. Plant has been ordered to be received and paid in May. It will cost
Rs.120000.
4.4 REVISION POINTS
1. Sales Budget The budget which estimates total sales in terms of items,
quantity, value, periods, areas, etc is called Sales Budget.
2. Production Budget It estimates quantity of production in terms of items,
periods, areas, etc. It is prepared on the basis of Sales Budget.
3. Cost of Production Budget This budget forecasts the cost of
production
4. Purchase Budget This budget forecasts the quantity and value of purchase
required for production.
5. Personnel Budget The budget that anticipates the quantity of personnel
required during a period for production activity is known as Personnel
Budget
6. Research Budget This budget relates to the research work to be done for
improvement in quality of the products or research for new products.
7. Capital Expenditure Budget This budget provides a guidance regarding the
amount of capital that may be required for procurement of capital assets
during the budget period.
8. Cash Budget This budget is a forecast of the cash position by time period for
a specific duration of time..
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9. Master Budget It is a summary budget incorporating all functional budgets
in a capsule form.
10. Fixed Budget Fixed Budget is one which is prepared on the basis of a
standard or a fixed level of activity.
11. Flexible Budget A budget prepared to give the budgeted cost of any level
of activity is termed as a flexible budget.
12. Long-Term Budget A budget prepared for considerably long period of time,
viz., 5 to 10 years is called Long-term Budget.
13. Short-Term Budget A budget prepared generally for a period not exceeding
5 years is called Short-term Budget.
14. Current Budget It is a budget for a very short period, say, a month or a
quarter. It is adjusted to current conditions.
15. Rolling Budget. Under this method, a budget for a year in advance is
prepared.
4.5 INTEXT QUESTIONS
1. What do you mean by cash Budget?
2. What do you mean by flexible Budget?
3. What do you mean by Performance Budget?
4. What do you mean by capital Expenditure Budget?
5. What do you mean Rolling Budget?
4.6 SUMMARY
Sales Budget which estimates total sales in terms of items, quantity, value,
periods, areas, etc is called Sales Budget. Production Budget estimates quantity of
production in terms of items, periods, areas, etc. It is prepared on the basis of Sales
Budget.
Cost of Production Budget forecasts the cost of production. Separate budgets
may also be prepared for each element of costs such as direct materials budgets,
direct labour budget, factory materials budgets, office overheads budget, selling and
distribution overheads budget, etc.
Purchase Budget forecasts the quantity and value of purchase required for
production. It gives quantity wise, money wise and period wise particulars about
the materials to be purchased.
Personnel Budget that anticipates the quantity of personnel required during a
period for production activity is known as Personnel Budget. Research Budget
relates to the research work to be done for improvement in quality of the products
or research for new products. Capital Expenditure Budget provides a guidance
regarding the amount of capital that may be required for procurement of capital
assets during the budget period. Cash Budget is a forecast of the cash position by
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time period for a specific duration of time. It states the estimated amount of cash
receipts and estimation of cash payments and the likely balance of cash in hand at
the end of different periods. Master Budget is a summary budget incorporating all
functional budgets in a capsule form. It interprets different functional budgets and
covers within its range the preparation of projected income statement and projected
balance sheet. Fixed Budget is one which is prepared on the basis of a standard or
a fixed level of activity. It does not change with the change in the level of activity.
Flexible Budget is prepared to give the budgeted cost of any level of activity is
termed as a flexible budget. According to CIMA, London, a Flexible Budget is, ‘a
budget designed to change in accordance with level of activity attained’. It is
prepared by taking into account the fixed and variable elements of cost. Long-Term
Budget is prepared for considerably long period of time, viz., 5 to 10 years is
called Long-term Budget. It is concerned with the planning of operations of the
firm. It is generally prepared in terms of physical quantities. Short-Term Budget is
prepared generally for a period not exceeding 5 years is called Short-term Budget. It
is generally prepared in terms of physical quantities and in monetary units.
Current Budget is a budget for a very short period, say, a month or a quarter. It
is adjusted to current conditions. Therefore, it is called current budget. Rolling
Budget is also known as Progressive Budget. Under this method, a budget for a
year in advance is prepared. A new budget is prepared after the end of each
month/quarter for a full year ahead. The figures for the month/quarter which has
rolled down are dropped and the figures for the next month/quarter are added.
This practice continues whenever a month/quarter ends and a new
month/quarter begins.
4.7 TERMINAL EXERCISE
1. ……………………. prepared to give the budgeted cost of any level of
activity is termed as a flexible budget.
2. .The budget which estimates total sales in terms of items, quantity,
value, periods, areas, etc is called ……………………………..
3. The budget that anticipates the quantity of personnel required during a
period for production activity is known …………………………….
4. .………………………………., a budget for a year in advance is prepared.
5. …………………..budget relates to the research work to be done for
improvement in quality of the products or research for new products
4.8 SUPPLEMENTARY MATERIALS
https://ocw.mit.edu
http://kesdee.com/
http://simplestudies.com/
http://repository.um.edu.my/
53
http://www.cimaglobal.com/
4.9 ASSIGNMENTS
1. 1.Explain the points to be taken care while preparing the Flexible
Budget.
2. Enumerate the importance of research Budgets
3. Highlight the advantages of cash budgets which is prepared by a
seasonal manufacturing company.
4. Throw a light on production Budget
4.10 SUGGESTED READINGS / REFERENCE BOOKS
1. Oswal, Maheshwari, Modi — Cost accounting. Cost Accounting ( RBD,
Jaipur)
2. Pandey. I. M. — Management Accounting (S. Chand & Sons.)
3. Agrawal, Shah, Mendiratta, Agarwal, Sharma, Tailor — Cost and
Management Accounting (Malik and Co.)
4.11 LEARNING ACTIVITIES
Visit the different types of Manufacturing company and take a note on how
they are preparing the different types of budgets.
4.12 KEYWORDS
Sales Budget, Production Budget, Cost of Production Budget, Purchase Budget,
Personnel Budget, Research Budget, Capital Expenditure Budget, Cash Budget,
Master Budget, Fixed Budget, Flexible Budgets, Long term Budget, Short Term
Budget, Current Budget, Rolling Budget.
54
LESSON –5
REPORTING TO MANAGEMENT
5.1 INTRODUCTION
The success or otherwise of any business undertaking depends primarily on
earning revenue that would generate sufficient resources for sound growth. To
achieve this objective, the management should discharge its functions efficiently
and effectively. The reporting systems are highly useful to the management for
effective planning and control. A regular system of reporting is considered as a
better guidance for prompt decision making. Hence, it is necessary to have a good
management reporting system.
5.2 OBJECTIVES
After completing this Lesson you should be able to know
The meaning of management reporting
Objectives of management reporting
Different types of management reporting
5.3 CONTENT
5.3.1 Definition of Management Reporting
5.3.2 Objectives of Management Reporting
5.3.3 Essentials of Good Reporting System
5.3.4 Classification of Management Report
5.3.1 DEFINITION OF MANAGEMENT REPORTING
According to Kohler reporting refers to "A body of information organized for
presentation or transmission to others. It often includes interpretations,
recommendations and findings with supporting evidence in the form of other
reports."
'Management Reporting' may be defined as "A system of communication,
normally in the written form, of facts which should be brought to the attention of
various levels of management who use them to take suitable action." In other words
the process of providing information to the management is known as Management
Reporting. The word "Information" refers to the data processed or evaluated for a
specific purpose.
Dr. Maheshwari has also defined Management reporting system as "an
organized method of providing each manager with all the data and only those data
which he needs for his decisions, when he needs them and in a form which aids his
understanding and stimulates his action."
5.3.2 OBJECTIVES OF MANAGEMENT REPORTING
1. To obtain the required information relating to the business to discharge
its managerial functions of planning. organizing, controlling. directing,
and decision making etc. efficiently and effectively.
55
2. To ensure the operational efficiency of the concern.
3. To facilitate the maximum utilization of resources.
4. To secure industrial understanding among people who are engaged in
various aspects of work of enterprise.
5. To enable to motivating improving discipline and morale.
6. To help the management for effective decision making.
5.3.3 ESSENTIALS OF GOOD REPORTING SYSTEM
The following are the essentials of a good management reporting system:
Proper Form: A good report should have a comprehensive form with suggestive
title, heading, sub heading and number of paragraphs as and where necessary for
easy and quick reference.
1. Contents: Simplicity is one of the requisites of reporting in relation to the
contents of a report. Further the contents should follow a logical sequence.
Wherever necessary the contents should be represented in the form of
visual aids such as charts and diagrams etc.
2. Promptness: It means that the system should ensure the preparation and
submission of report at the proper time. It facilitates business executives to
make suitable decisions based on quick reports without delay.
3. Accuracy: Information conveyed should be accurate. This means that the
person responsible for reporting should have sufficient care in preparing
the report as correctly as possible within the parameters of possible
accuracy in this regard.
4. Comparability: In order to ensure that the furnished information is useful,
it is essential that reports are also meant for comparison. The report should
provide information about both the actual and the budgeted performance of
the budget period. So that meaningful comparison can be made to find out
the deviations and to initiate appropriate action.
5. Consistency: In order to make a meaningful and useful comparison,
uniform accounting principles and procedures should be followed on
consistent basis over a period of time for collection, classification and
presentation of accounting information.
6. Relevancy: The report should be presented with relevant data to disclose
the fact in unambiguous terms. Because, inclusion of both the relevant and
the irrelevant data in the management reports may result in faulty
decisions. Therefore, the contents expressed therein should reveal the
reporter's greater consciousness of expression with reference to length and
time in particular.
56
7. Simplicity: The report should be as far as possible in simple form. In other
words, the report should avoid technical jargons, duplication of work and
presented in a simple style.
8. Flexibility: The system should be capable of being adjusted according to
the requirement of the users.
9. Cost-Benefit Analysis: Cost-Benefit Analysis should be made and the cost
of reporting should commensurate with the expenditure involved.
10. Principle of Exception: Since the time and effort of managerial personnel
are precious, the principle of management by exception has become the
rule of the day instead of exception. It is necessary therefore to draw the
attention of management, through reports, only towards exceptional
matters.
11. Controllability: It is necessary that every report should be addressed to a
responsibility centre and analysed the factors into controllable and
uncontrollable separately. So that the head of the responsibility centre can
be held responsible only for controllable variance but not for variances
which are beyond his control.
Further, in order to assist the management to imitate remedial measures,
probable reasons for the factors of uncontrollable should also be incorporated in
the reports.
5.3.4 CLASSIFICATION OF MANAGEMENT REPORTING
Basically, there are two ways to report to the management. They are :
Oral Report and
Written Report.
The Written Reports may be classified into number of ways. The following are
the important types:
I. According to Objects:
(A) External Reports
(B) Internal Reports
(1) Reports Meant for Top Management
(2) Reports Meant for Middle Level Management
(3) Reports Meant for Junior Level Management
II. According to Period:
(1) Routine Reports
(2) Special Reports
I. According to Functions:
(A) Operating Reports
(1) Control Reports
(2) Information Reports
57
(3) Venture Measurement Reports
(B) Financial Reports
(1) Static Reports
(2) Dynamic Reports
According to Object or Purposes
(A) External Reports: These reports prepared for persons outside the business
such as Government. shareholders. bankers. investors and financial institutions
etc. External Reports usually represent published annual reports. Annual Reports
of Trading. Profit and Loss Accounts and Balance Sheet of the Indian Companies
are to be prepared in terms of Schedule VI of the Indian Companies Act of 1956.
(B) Internal Reports : Internal Reports are those which are prepared for internal
uses of different level of management. It is also called as Management Reports.
These reports are not meant for disclosure to those who are outsiders to the
business. They do not have to comply with any statutory requirements. From the
managerial point of view the reports can be classified into the following categories :
(1) Report Meant for the Top Level of Management
(2) Report Meant for the Middle Level of Management
(3) Report Meant for the Junior Level of Management
(1) Report Meant for the Top Level of Management
Top Level Management is concerned with the formulating policies planning and
setting goals and objectives. This level of management consisting of the Boa rd of
Directors including Chairman. Managing Directors. General Manager or any other
chief executive as the case may be. The report to this level of management should
be specifically summarized with all aspects of operating performance together with
a comparison of actual with budgeted performance. The usual reports sent to this
level of management are:
(a) Reports on budgeted and actual profit
(b) Reports on sales and production
(c) Capital budget
(d) Master budget
(e) Periodical financial reports
(f) Plant utilization report
(g) Machine and labour utilization report
(h) Reports on research and development activities
(i) Project evaluation report
(j) Report on stock of raw materials, work in progress and finished goods
(k) Overhead cost absorption and efficiency reports
(l) Reports on selling and distribution overhead.
58
(2) Reports Meant for Middle Level Management
The Middle Management is constituted of the heads of all departments such as
production department headed by production manager. marketing department
headed by marketing manager and so on. This level of management is concerned
with the functioning and control of their departments. They act mainly as
coordinating executives to administer policies directly through operating
supervisors and evaluate their performance. Hence, they may require more detailed
information about their departments and at frequent intervals. Generally, the
middle level management should receive the following reports at different intervals:
(a) Purchase Manager:
(1) Reports on material price and usage variance
(2) Reports on material carrying cost, loss of material in the storage etc.
(3) Reports on trends in the pertaining of various items of materials.
(b) Materials Manager
(1) Reports on stock of raw materials, work in progress and finished goods
(2) Reports on material wastage and losses
(3) Reports on stock of materials planning and control
(4) Reports on level of materials stock at the stores
(5) Reports on surplus and deficiency report.
(c) Production Manager
(1) Reports on budgeted and actual production
(2) Reports on overtime work and ideal time
(3) Reports on labour utilization statement
(4) Reports on machine utilization statement
(5) Reports on scrap production cost
(6) Reports on any accident causing dislocation of activity.
(d) Sales Manager
(1) Reports on budgeted and actual sales
(2) Reports on sales efficiency
(3) Reports on orders received and orders executed
(4) Reports on cash sales and credit sales
(5) Reports on stock of finished goods
(6) Reports on market share and market potential
(7) Reports on sales promotion efficiency.
(8) Reports Meant for Junior Level Management
The lower level management is directly responsible for executing various
policies assigned by top management. This level of management is constituted of
Foremen, Supervisors and sectional in charges etc. They are in touch with the day-
to-day performance of their section. The report meant for this level are mainly in
terms of physical units. The usual reports sent to this level are:
59
(1 ) Reports on labour efficiency variance
(2) Reports on ideal time, overtime and machine utilization
(3) Reports on materials usage variance
(4) Reports on credit collections and outstanding
5.4 REVISION POINTS
1. Objectives of Management reporting
2. Essentials of Good reporting system
3. Classification of management Reporting
5.5 INTEXT QUESTIONS
1. What is meant by management reporting?
2. What do you mean by Eternal Reports?
3. What do you mean by Internal Reports?
4. What do you mean by financial Reports?
5. What do you mean by Operating reports
5.6 SUMMARY
Good management reporting system should have the following things proper
form, contents, promptness, accuracy, comparability, consistency, relevancy,
simplicity, flexibility, cost benefit analysis , principle of exception, comfort ability.
Objectives of Management Reporting system are given below; To obtain the
required information relating to the business to discharge its managerial functions
of planning. organizing, controlling. directing, and decision making etc. efficiently
and effectively. To ensure the operational efficiency of the concern. To facilitate the
maximum utilization of resources. To secure industrial understanding among
people who are engaged in various aspects of work of enterprise. To enable to
motivating improving discipline and morale. To help the management for effective
decision making. Basically, there are two ways to report to the management.
They are :Oral Report and Written Report.
The Written Reports may be classified into number of ways. The following are
the important types(A)According to Objects: External Reports ,Internal Reports,
Reports (B) According to Period: Routine Reports, Special Reports(C)According to
Functions: Operating Reports, Financial Reports.
5.7 TERMINAL EXERCISE
1. ………………………reports prepared for persons outside the business
such as Government. shareholders. bankers. investors and financial
institutions etc.
2. ……………………………….Reports are those which are prepared for
internal uses of different level of management.
5.8 SUPPLEMENTARY MATERIALS
http://dosen.narotama.ac.id/wp-content/uploads/2013/02/Chapter-31-
Reporting-to-Management.pdf
60
https://www.treasury.qld.gov.au/publications-resources/financial-
accountability-handbook/5-1-management-reporting.pdf
5.9 ASSIGNMENTS
1. What do you understand by the term reporting to management?. What
matters would you include for reporting to board of directors.
2. What are the points to be kept in mind while preparing the report?.
5.10 SUGGESTED READINGS /REFERENCE BOOKS
1. Agrawal & Agrawal — Management Accounting (RBD. Jaipur)
2. Jain, Khandelwal, Pareek — Cost Accounting (Ajmera Book depot,
Jaipur)
3. Khan, Jain — Management Accounting (S. Chand & Sons.)
4. Oswal, Maheshwari, Modi — Cost accounting. Cost Accounting ( RBD,
Jaipur)
5. Pandey. I. M. — Management Accounting (S. Chand & Sons.)
6. Agrawal, Shah, Mendiratta, Agarwal, Sharma, Tailor — Cost and
Management Accounting ( Malik and Co.)
7. Agrawal, Jain, Sharma, Shah, Mangal — Cost Accounting ( RBD, Jaipur)
8. Agarwal. M.R. — Managerial Accounting (Garima Publications)
9. Agrawal & Agrawal — Management Accounting (RBD. Jaipur)
10. Jain, Khandelwal, Pareek — Cost Accounting (Ajmera Book depot,
Jaipur)
11. Khan, Jain — Management Accounting (S. Chand & Sons.)
12. Oswal, Maheshwari, Modi — Cost accounting. Cost Accounting ( RBD,
Jaipur)
13. Pandey. I. M. — Management Accounting (S. Chand & Sons.)
5.11 LEARNING ACTIVITIES
Choose an organisation of your choice and see how reports are prepared and
identify how it was reporting to the management
5.12 KEYWORDS
Oral Report, Written Report, External Reports, Internal Reports, Routine
Reports, Special Reports, Operating Reports, Financial Reports.
61
LESSON - 6
FINANCIAL ANALYSIS
6.1 INTRODUCTION
In any form of organisations the financial analysis is very common. Raw
financial data has no meaning. The data are being interpreted to find out the
conclusions and to know the financial position. These analysis are indifferent
forms. A firm may select the particular method of financial analysis according to
the nature of the firm.
6.2 OBJECTIVES
After reading the lesson students can understand the – Meaning of the
financial analysis- its importance – procedure for financial analysis – objectives of
financial analysis.
6.3 CONTENT
6.3.1Meaning
6.3.2 Users of financial analysis
6.3.3 Information needed and steps in financial analysis
6.3.4 Procedure in financial analysis
6.3.5 Meaning and type of financial statements
6.3.6 Objectives of financial analysis
6.3.7 Types of financial analysis
6.3.8 Tools of financial analysis
6.3.9 Limitations of financial analysis
6.3.1 MEANING
The technique of financial analysis is typically devoted to evaluate the past,
current and projected performance of a business firm. In general business usage,
financial analysis is concerned with the analysis of financial statements such as
balance sheet, profit and loss account, etc., Broadly, the term financial analysis is
applied to almost any kind of detailed inquiry into financial data. A financial
executive has to evaluate the past performance, present financial position, liquidity
situation, enquire into profitability of the firm and to plan for future operations. For
all this, they have to study the relationship among various financial statements.
The analysis of financial statements is an attempt to determine the significance and
meaning of the financial statements data, so that the forecast may be made of the
future prospects for earnings, ability to pay interest and debt maturities(both
current and long term) and profitability.
Financial analysis is very general managerial activity. Financial managers may
attempt to analysis the historical financial records of a firm in order to indentify the
factors which are having a significant influence upon the wealth of shareholders.
(e.g) Debt- Equity ratio. He must analyse both the risk and return aspect of past
and present financial decisions. He must also evaluate the financial decisions i.e.,
62
what has happened to the firm, to control what is happening and to assist what will
happen.
6.3.2 USERS OF FINANCIAL ANALYSIS
Financial analysis is the process of indentifying the financial strengths and
weakness of the firm. It is made by properly establishing relationship between the
items of the balance sheet and profit and loss account. It can be undertaken by the
management of the firm or by the outsiders.
Trade Creditors: are interested in firm’s ability to meet their claims over a very
short period of time. They mainly evaluate the firm’s liquidity position.
Financial institutions: are interested to know the long term profitability of the
concern. They want to know the safety of their loan granted to the firms. Before
granting the loan they analyse the income statement of the applicant firm’s for the
last 5 or 6 years.
Debenture holders: are concerned about the firm’s long – term solvency and
survival. They analyse the firm’s profitability and track record over time. They want
to know, whether the firm is able to repay the principal with agreed interest.
Financial statements are used to analyse the profitability of the firm.
Investors: who have invested their money in the firm’s shares are most
concerned about the firm’s and the risk faced by the firm.
Management of the firm would be interested in every aspect of the financial
analysis. It is their responsibility to see that the resources of the firm are used most
effectively and efficiently.
Purchasers of the business want to know the real worth of the concern, which
they want to buy. He also wants to know the earning capacity of the firm.
6.3.3 INFORMATION NEEDED AND STEPS FOR FINANCIAL ANALYSIS
The balance sheet and income statement information are supreme in financial
analysis. These are readily available for interpretation. A financial analysis assist in
identifying and indicating whether a firm has enough cash to meet obligation. A
reasonable accounts receivable collection period, an efficient inventory management
policy, sufficient plant, property and equipment and an adequate capital structure
all of which are necessary if the firm is to achieve the goal of maximising
shareholder wealth. Financial analysis is also used to determine whether a
satisfactory return is being earned for the risk taken.
Financial analysis follows a series of interrelated steps are (1) to specify the
purpose of analysis (2) identify the measurement base and fix standard (3) to collect
necessary data (4) to classify and process the data (5) to compare the processed
data with a standard (6) to make inferences.
The usefulness of financial information is increased when it can be compared
with related data. Comparison may be internal (within one firm) or external (with
another same category firm). External comparison may be difficult to make in
practice since financial statements of many firms may not be readily comparable
because of the use of different generally acceptable accounting principle.
63
6.3.4 PROCEDURE IN FINANCIAL ANALYSIS
Comparison of financial statement data are frequently expressed as
percentages or ratios. These comparisons may represent (1) percentage increases
and decreases in an item in comparative financial statements (2) percentages
relationship of individual components to an aggregate total in single financial
statement. (3) Ratios of one amount to another in the financial statements.
6.3.5. MEANING AND TYPES OF FINANCIAL STATEMENTS
A financial statement is an organised collection of data according to logical and
consistent accounting procedures. It will convey an understanding of financial
aspects of a business firm. It shows the financial position at a point of time.
The term financial statements generally refers to there basic statements.
i. The Income statement.
ii. The Balance sheet.
iii. Statement of retained earnings
Some times, a business may prepare another forms of statements also namely
statement of changes in Financial position in addition to the above three
statements
The meaning and significance of these statements are explained below.
Income Statement
The Income Statement (also termed as profit and loss Account) is generally
considered to be the most useful of all financial statements. It explains what has
happened to a business as a result of operation between two dates. For this
purpose it matches the revenues and costs incurred during the given period and
also shows the net profit earned or loss suffered.
The nature of the ‘income’ which is the focal item of the income
statement can be well understood from the ‘Inputs’ and ‘outputs’ of business in
the goods and services that the business providing to its customers. The values of
these outputs are the amount paid by the customers for them. Such amounts are
called ‘Revenues’ in accounting. The inputs are the economic resources used by the
business in providing these goods and services. Their values are termed as
‘expenses’ in accounting.
Balance Sheet
It is a statement of financial position of a business at a point of time. It
represents all assets owned by the firm at particular time and the claims (or
equities) of the owners and outsiders against these assets at that time. It is in a way
snapshot of the financial position of the business at that time.
The important distinction between an Income statement and Balance Sheet is
that the Income Statement is for a period while Balance is on a particular date.
Income Statement is therefore, a flow report as contrasted with the Balance Sheet
which is a static report.
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Statement of Retained Earnings
The term retained earnings means the accumulated excess of earnings over
losses and dividends. The balance shown by the income statement is transferred to
the Balance Sheet through this statement, after making necessary appropriations
thus, a connection link between the Balance Sheet and the Income Statement. The
statement is also termed as ‘profit and loss appropriation account’ in case of
companies.
6.3.6 OBJECTIVES OF FINANCIAL ANALYSIS
The following are the main objectives of the analysis of financial statements:
i. To estimate the earning capacity of the firm.
ii. To gauge the financial position and financial performance of the firm,
iii. To determine the long term liquidity of the funds as well as solvency,
iv. To determine the debt capacity of the firm,
v. To decide about the future prospects of the firm, etc.
vi. To know the effect9ve utilisation of resources
vii. To know the comparative advantages of return on investment.
viii. To ascertain the market trends.
ix. To identify the areas which are to be concentrated more i.e. key areas?
As a matter of fact, the objectives of analysis of these statements, depend to a
large extent on the point of the view of the analyst, the degree of interest in the
company and the need for depth of enquire and finally on the amount and quality
of the data available. A trade creditor considering what action to take on a long
overdue account may well focus his inquire on the immediate financial condition of
the firm and its liquidity. In contrast, a security analysis considering a purchase of
equity shares may tend to centre his effort on the measurement of financial
condition and future profitability of the firm, if a thorough analysis is desired and
the full data needed are not available or if the suspicion exists that the firm is
trying to hide or confuse its real position, the financial analyst must be a virtual
detective in order to find out the truth.
6.3.7 TYPES OF FINANCIAL ANALYSIS
External Analysis
This analysis is only made by the outsiders of the firm. External analysis of
financial statement is made by those who do not have access to the detailed
accounting records of the company, i.e., banks, creditors and general public. Those
people depend almost entirely on published financial statements. The main
objective of such analysis varies from party to party. Some agencies are deployed to
perform the functions
Internal Analysis
Such analysis is made by the finance and accounting department to help the
top management. These people have direct approach to the relevant financial
records so they can keep behind the two basic financial statements (Balance Sheet
65
and Income Statement) and narrate the inside story. Such analysis emphasizes on
the performance appraisal and assessing the profitability of different activities.
Short – term Analysis
The short-term analysis of financial statement is mainly concerned with the
working capital analysis. In the short run a company must have ample funds
readily available to meet its current needs and sufficient borrowing capacity to meet
the contingencies. Hence in short – term analysis the current assets and the
current liabilities are analysed and cash position (liquidity) or the concern is
determined.
Long term Analysis
In the long- term analysis the company must earn a minimum amount
sufficient to maintain a suitable rate of return on the investment to provide for the
necessary growth and development of the company and to meet the cost of capital.
Financial planning is also necessary for the continued success of a company.
Thus, in the long – run analysis, the stress is on the stability and earning
potentiality of the concern. In long – term analysis the fixed assets, long – term debt
structure and the ownership’s interest are analysed.
The short – term and long – term both type of analysis are important proper
planning for the future, requires fairly sufficient knowledge of the company’s
current position which may be determined from short – term financial analysis
only. The need of short – term analysis for long – term planning is useful in the
same way as driver, consulting a road map for the best route to his destination,
must know his present location exactly.
1. Horizontal Analysis
When financial statement for a number of years of a company reviewed and
analyzed the analysis is called ‘horizontal analysis’. The preparation of comparative
statement is an example for horizontal analysis. As it is based on data from year to
year, rather than on one date or period to time as a whole, this is also known as
‘Dynamic Analysis’.
2. Vertical Analysis
Vertical analysis is also known as ‘static’ analysis, when ratios are calculated
from the balance sheet of one year, it is called vertical analysis. It is not very useful
for long-term planning as it does not include the trend study for future.
6.3.8 TOOLS OF FINANCIAL ANALYSIS
1.Comparative Analysis
It is a method of training periodic changes in the financial performance of a
company to prepare comparative statements.
The financial data for the current year is compared with the financial data of
the one or more previous years. This is the simplest form of comparative analysis.
The absolute amount of changes of each item in the current financial statements
with the corresponding items in previous years.
66
Seshu Manufacturing Company: comparative Balance Sheet
2002 2003 Change Percentage of Change Capital and Liabilities Rs. Rs. Rs. Rs.
Currently Liabilities 1123.57 1555.74 (+) 432.17
(+) 38.75
Long term Liabilities 361.65 389.14 (+) 27.49 (+) 7.6
Share Capital 225.00 225.00 0 0
Reserves 357.95 447.81 (+) 89.86 (+) 25.1
Total 2068.17 2617.69 (+)549.52 (+) 26.6
Assets
Current Assets 1404.55 1870.92 (+)466.37 (+) 33.2
Net Fixed Assets 647.18 686.11 (+) 38.93 (+) 6.0
Other Assets 16.44 60.72 (+)44.28 (+)269.3
Total 2068.17 2617.74 549.57 26.6
In this example, the information of the year 2013 are treated as the current
year data. These data are compared with the previous year 2012 data. The exact
item wise amount of changes and the percentages of changes are clearly exhibited.
2.Common and Analysis
Every item on a financial statement is expressed as a percentage of single base
amount. State is commonly used as the base for analysis of an income statement.
Figures reported are converted into percentages to some common base. In this
income statement the sales figure is assumed to be 100 and all figures are
expressed as percentages of this total.
Example
Common – Size Income Statement
For the year ended 31 December 2014 and 2015 (Figures in percentage)
From this example cost of goods sold percentage has been increased from 75%
to 80% from the year 2014 to 2015 and gross profit percentage has been decreased
by 5%. The percentage of each item to the total in each period is explained but not
the variation in respective items from period to period. It does not give information
2014 2015
Net sales 100 100
Cost of goods sold 75 80
Gross profit 25 20
Less: Operating expenses
Administration Expenses 2.50 2
Selling Expenses 3.75 2
Total operating Expenses 6.25 4
Operating profit 18.75 16
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about the trend of individual items, but the trend of their relationship to total. This
analysis helps to identify the items which occupy the major portion to the total.
3.Trend Analysis (percentage)
This method is helpful in making a comparative study of the financial
statements for several years. Under this method, the calculation of percentage
relationship that each item bears to the same item in the base year, each item of
base year is taken as 100 and on that basis the percentage for each of the items of
each of the years are calculated. Any year may be taken as base year. The object of
trend analysis is to highlight the relative changes of the major items over the year
as percentage.
4.Cost-Volume Profit Analysis
It is an important tool of profit planning. It studies the relationship between
cost, volume of production, sales and profit. It tells the volume of sales at which the
firm will break even (no profit or no loss), the effect on profit on account of
variations in output, selling price, and cost. It is also helpful to ascertain the
quantity to be produced and sold to reach the target profit level.
5.Ratio Analysis
An accounting ratio shows the relationship in mathematical terms between two
interrelated accounting figures. The figures have to be interrelated (eg) gross profit
and sales, current assets and current liabilities etc. If the ratios and calculated
between the two figures which are not at all related to each other, there will be no
meaning to calculate ratios.
6.Fund Flow Analysis
It reveals the changes in working capital position. It tells about the sources
from which the working capital or found was obtained and the purposes for which
it was used. Fund flow statement focuses on major financial changes. It is a
detailed study about the financial changes between the balance sheets of the two
successive years.
7.Cash Flow Analysis
It is useful for short run planning. A firm needs sufficient cash to pay debt
maturing in the near future, to pay interest and other expenses and to pay dividends to shareholders. It is statement of changes in the financial position on
cash basis. It summarises the cause of changes in cash position between dates of the two balance sheets.
6.3.9 LIMITATIONS OF FINANCIAL ANALYSIS
1. Financial analysis is not a final result ie., it is treated as starting point in
financial decisions. It requires external support for effective
implementation.
2. It ignores the price level changes. It is prepared on the concept of historical
costs.
3. The exact value of the assets or profits may not be available.
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4. Financial statements are prepared on the basis of certain accounting
concepts and convention. On account of this reason the financial position
as disclosed by these statements may not be realistic.
5. Personal judgement of the accountant is influencing in valuation of assets
and liabilities.
6. Financial statements do not depict those facts which cannot be expressed
in terms of money.
6.4 REVISION POINTS
1. Financial analysis is concerned with the analysis of financial statements.
This analysis is made to evaluate the past performance, present financial
position and to plan the future. This analysis is made.
2. User of financial analysis: trade creditors, financial institutions, debenture
holders, investors and management are the users of financial analysis.
3. The balance sheet and income statement information are needed for
financial analysis.
4. Types of financial analysis: External analysis, internal analysis, short term
analysis, long term financial analysis, horizontal analysis and vertical
analysis.
5. Tools of Financial Analysis: Comparative analysis, Common size analysis,
trend analysis, cost-volume profit analysis, ratio analysis, fund flow
analysis, cash flow analysis.
6.5 INTEXT QUESTIONS
1. What is meant financial analysis? Explain its advantages.
2. Who are the users of financial analysis?
3. Elucidate the procedure for financial analysis.
4. Explain the various types of financial statements.
5. Point out the ad vantages of common size statement.
6. What are the various tools used in the financial analysis? Explain
briefly.
7. Explain any four types of financial analysis.
8. Point out the weakness of the financial analysis.
6.6 SUMMARY
The financial executive has to evaluate the performance of the firm in the
particular period, it is a managerial activity. Trade creditors, financial institutions,
debenture holders, investors and management are the beneficiaries of the financial
analysis.
Procedures in financial analysis are using percentages, rations, etc. Income
statement, balance sheet and statement of retained earnings are the financial statements, financial analysis is used in the firm for various objectives.
This lesson covers the various types of financial analysis. Like external analysis for outsiders, internal analysis for the management. Current needs are analyzed
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through short term analysis, long term requirements are analyzed through long term analysis. If the analysis is made for number of years for a single unit it is known as horizontal analysis. When ratios are calculated from the accounts records
of one year it is known as vertical analysis.
This lesson also includes the various tools used in the financial analysis.
6.7 TERMINAL EXERCISES
1. Which one of the following is not a user of Financial Analysis?
a. Sundry debtors (b) Trade creditors (c) Financial institutions (d) Debenture holders.
2. 2.Which one of the following is not a financial statement?
a. The income statement (b) the balance sheet (c) statement of retained earnings (d) cash book.
6.8 SUPPLEMENTARY MATERIALS
http://dosen.narotama.ac.id/
http://www.osbornebooksshop.co.uk/
http://www.fao.org/
6.9 ASSIGNMENTS
1. Collect the various published audited accounts and compare with each other, Students must compare one firm’s account with other firms’
accounts in the same line and critically analyse the performance.
2. Prepare an essay on distinctive features of various tools in financial
analysis collect various published accounting records or statements and use the above tools. Read various unpublished research report about the
financial analysis.
6.10 SUGGESTED READING / REFERENCE BOOKS
1. Management Accounting- S.N.Maheswari
2. Management Accounting – R.S.N. Pillai and Bhavathi.
3. Financial Management – Khan and Jain
6.11 LEARNING ACTIVITIES
Students may read various journals and unpublished research reports and gain some practical knowledge about financial analysis.
Student may organize a group discussion to discuss about the various types of financial analysis and the nature of tools used in the financial analysis.
6.12 KEY WORDS
Market trend
Suspicion
Long term liquidity
Solvency
Focal
Deployed
Dynamic Analysis
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LESSON -7
RATIO ANALYSIS
7.1 INTRODUCTION
Ratio analysis is a powerful tool of financial analysis. It is used as a
benchmark for evaluating the financial position and performance of a firm. It is
known as the relationship between two accounting figures expressed
mathematically. Ratio help to summarise large quantities of financial data and to
make judgement about the firm’s financial performance
7.2 OBJECTIVES
The students can know the uses of the ratio analysis. This lesson also
explains the difficulties in ratio analysis. Students can also know some precautions
before using the ratio analysis techniques. More over in this lesson, students can
know various ratios and their significances.
7.3 CONTENT
7.3.1 Objectives and utility of ratio analysis
7.3.2 Difficulties in ratio analysis
7.3.3 Nature of ratio analysis
7.3.4 Precautions in using ratio analysis
7.3.5 Types of Ratios
7.3.6 Significance of important Ratios
7.3.1 OBJECTIVES AND UTILITY OF RATIO ANALYSIS
Ratio analysis is an important and useful technique to check upon the
efficiency with which working capital is being used in the enterprise. Some ratios
indicate the trend or progress or down fall of the firm. It helps the financial
manager in evaluating the financial position and performance of the firm. The use
of ratio analysis is not confined to the financial manager only. The credit supplier,
bank, lending institution and experienced investor all use ratio analysis as their
initial tool in evaluating the firm as a desirable borrower or as potential investment
outlet. With the help of ratio analysis financial executive can measure whether the
firm is at present financially healthy or not. The following are important managerial
uses of ratio analysis.
1. Aid in financial forecasting: Ratio analysis is very helpful in financial
forecasting. Ratio relating to past sales, profits and financial position are
based for future trend.
2. Aid in Comparison: Ratio analysis can be used for comparison for a
particular firm’s progress and performance.
3. Aid in Cost Control: Ratios are very useful for measuring the performance
and in cost control.
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4. Communication value: different financial ratios communicate the strength and financial standing of the firm to the internal and external parties.
5. Financial ratios are very helpful in the diagnosis of the financial health of a
firm. They highlight the liquidity, solvency, profitability and capital gearing
etc., of the firm. They are useful for analysing financial performance.
6. The ability of the firm to meet its current obligations.
7. The extent to which the firm has used its long term solvency by borrowing
fluids.
8. The efficiency with which the firm is utilising its assets in generative sales
revenue.
9. The overall operating efficiency and performance of the firm are measured
through ratio analysis.
7.3.2 DIFFICULTIES IN RATIO ANALYSIS
1.Decide proper Basis for Comparison
Ratios of a company have meaning only when they are compared with some
standards. It is difficult to find out a proper basis of comparison. Usually it is
recommended that ratios should be compared with the industry averages. But the
industry averages are not easily available. In India, for example, no systematic and
comprehensive industry ratios are compiled.
2.Comparison Becomes Difficult Because of Different Situations:
The situations of two companies are never same. Similarly, the factors
influencing the performance of a company in one year may change in another year.
Thus , the comparison of the ratios of two companies becomes difficult and
meaningless when they are operating in different situations.
i.Ratio analysis becomes meaningless if the data in the financial statements are
window dressed. No fixed standards can be laid down for ideal ratio.
ii. The differences in the definitions of items in the balance sheet and profit and
loss statement makes the interpretation difficult.
iii.Ratio alone are not adequate. They are only indicators. They cannot be taken
as final regarding good or bad financial position of the business. Other factors are
to be considered.
iv.Ratios are only mathematical expression of financial data. Average people
may not understand the facts without explanation.
v.External factors which affect the financial performance of a firm are not
considered in Ratio analysis.
Price change:
The interpretation and comparison of ratios are also rendered invalid by the
changing value of money. The accounting figures, presented in the financial
statements, are expressed in the monetary unit which is assumed to remain
72
constant. In fact, prices change over years and, as a result, assets acquired at
different times will be expressed at different rupees (values) in the balance sheet.
This makes comparison meaningless. For example, two firms maybe similarly in
every respect except the age of plant and machinery. If one firm purchased its plant
and machinery at a time when prices were high, the equal rates of return on
investment of the two firms cannot be interpreted to mean that the firms are
equally profitable. The return of the first firm is over- stated because its plant and
machinery have a low book value.
Definitional Difference:
In practice, differences exist as to the meaning of certain terms. Diversity of
views exists as to what should be included in calculating net worth or shareholder’s
equity, current assets or current liabilities. Whether preference share capital chould
be included in debt or should current liabilities to included in debt in calculating
the debt equity ratios? Should intangible assets be excluded to calculate the rate of
return on investment? If intangible assets have to be included how will they be.
Similarly, profit means different things to different people.
Short term changes:
The ratios do not have much use, if they are not analysed over years. The
balance sheets prepared at different points of time, are static in nature. They do not
reveal the changes which have taken place between dates of two balance sheets.
The statements of changes in financial positions reveal this information, but these
statements are not available to outside analysis.
No Indicators of Future
The basis of calculated ratios are financial statements. The financial analyst is
more interested in what happens in future, while the ratios indicate what happened
in the past. Management of the company has information about the company’s
future plans and policies and, therefore, is able to predict future happenings to a
certain extent. But the outside analyst has to rely o the past ratios, which may not
necessarily reflect the firm’s financial position and performance in future.
7.3.3 NATURE OF RATIO ANALYSIS
Time series analysis
The easiest way to evaluate the performance of a firm direction of firm is to
compare its present ratio with the past ratio. It gives an indication of the direction
of change and reflects whether the firm’s financial of performance has improved or
deteriorated.
Cross sectional Analysis:
The ratio of one firm is compared with some selected firms in the same industry
at the same point of few carefully selected competitors, who have similar
operations. This type of comparison indicates the relative financial position and
performance of the firm.
73
Industry Analysis
To determine the financial condition and performance of a firm its ratio may be
compared with average ratios of the industry of which the firm is member.
Pro – forma Analysis:
Sometimes future ratios are used as the standard of comparison. Future ratios
can be developed from the projected financial statements. The comparison of
current or past ratios with future ratios with future ratios shows the firm relative
strengths and weakness in the future.
7.3.4 PRECAUTIONS IN USING RATIO ANALYSIS
The ratio analysis is widely used technique to evaluate the financial position
and performance of a business. But there are certain considerations to be
considered while using the ratios.
It is difficult to decide on the proper basis of comparison. If there is no proper
comparison, the ratio analysis became meaningless. Generally rations should be
compared with industry averages.
Situation of two companies are never same. Similarly, the factors influencing
the performance of a company in one year may change in another year. So separate
norms may be used for each year comparison since the influenced factors are
changed from year to year.
The price level changes should be considered in the ratio analysis. The
accounting figures presented in the financial statements which are used in the ratio
analysis, are expressed in the monetary unit. The price level changes over years,
affects the real worth of earnings.
In practice, differences exist as to meaning of certain terms. Different views
exist as to what should be included in Net Worth, current assets or current
liabilities, similarly how to treat intangible assets.
The ratio does not have much use if they are not analysed over years. The
ratio at a moment of time may suffer from temporary changes. The trends of ratios
over years is more helpful to solve this problem.
The sources of information for ratio analysis are from historical records of
financial accounts. Such scattered information in the financial records be properly
consolidated or adjusted or modified before using in ratio analysis.
The assets and liabilities should be properly valued before applying the ratio
analysis for which a common norm should be followed. (Eg.) whether to include the
fictitious assets in the value of total assets.
Some organisations are having huge amounts of sundry debtors without
adequate provision for doubtful debts and write off of bad debts. Similarly showing
the fixed assets in the balance sheet without adequate provisions for depreciation.
These are the cause for window dressing.
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7.3.5 TYPES OF RATIOS
Various ratio, calculated from the accounting data, can be grouped into various
classes according to financial activity or function to the evaluated. Short term
creditors are main interest in the liquidity position or the short – term solvency of
the firm. Long term creditors on the other hand are more interested in the long
term solvency and profitability and finance condition.
Various types of ratios are
Liquidity Ratios
(a) Current Ratio
(b) Liquid Ratio
(c) Absolute Liquid Ratio
(d) Over-due Liability Ratio
Profitability Ratios
(a)
(a)
Gross Profit Ratio.
(b) Operating Profit Ratio.
(c) Net Profit Ratio,
(d) Earning Power,
(e) Return on Investment
(f) Return on the Total Assets
(g) Return on the Total Equity
(h) Return on Common Equity "
(i) Earnings per Share
(j) Dividends per share
(k) Dividend-Pay out ratio
(l) Price-Earning ratio.
(m) Dividend yield ratio.
(n) Earnings yield ratio.
(o) Net profit to Net Worth
Leverage Ratios
(a) Debt-Equity Ratio
(b) Total Debt-Equity Ratio
(c) Debt to total capital ratio
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(d) Equity Ratio
(e) Fixed Assets to Net Worth Ratio
(f) Current Assets to Net Worth Ratio
(g) Long-term Debt to Net Working Capital Ratio
(h) Current liabilities to net Worth
(i) Total Liabilities to Net Worth
(j) Capital gearing ratio
(k) Fixed Assets to Long-term funds.
(1)
n
terest
coverage
ratio
Interest coverage ratio
(m) Preference Dividend Coverage Ratio
Operating Rations
i. Operating Ratio
ii. Expenses Ratio
iii. Net sales to Fixed Assets
iv . Net sales to current Assets
v . Net sales to Net Worth
vi. Net sales to Net profit
Turn over Ratios
a) Inventory Turnover Ratio
b) Debtors Turn over Ratio
c) Creditors Turn over Ratio
d) Fixed Assets Turn over
e) Total Assets Turn over
f) Working Capital to Inventory
g ) Working Capital to Inventory
h) Working Capital to Total Assets
i ) Cash Turn Over Ratio
j) Current Assets Turn over
k) Inventory to working capital
l) Debtors to working capital
m) Cash to Working capital
n) Capital out-put ratio
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Distinguish Current Ratio and Liquidity Ratio
Current Ratio (CR)
Donald Miller describes the current ratio as one which is generally recognised
as the patriarch among ratios. He states at that one time, it commanded such
widespread respect that many businessmen regarded it as being endowed with the
infallibility of nature's laws - it was a law of gravity applied to the Balance Sheet. By
using the current ratio, a credit manager or lending officer can lay aside his
"flipping coin" and arrive at decisions based on some figures of logic and accuracy.
Formula
Current Ratio = Current Assets
Current Liabilities
The ratio should be 2:1. But depending on each industry's own peculiar
problems, the ratio may vary between 1.5 : 1 to 3 : 1. If cash and marketable
securities constitute 10% of total current assets, even a current ratio of 1.5 : 1
will be satisfactory.
Liquid Ratio (LR)
Christy and Roden define the liquidity of an asset as moneyness. A firm's
liquidity may vary over the business cycle. Liquidity Radio indicates the firm's
ability to pay its current liabilities.
Current ratio is a liberal test of liquidity where as liquid ratio is a more
stringent test of a firm's ability to meet its current liabilities. It is also called as Acid
Test Ratio (ATR) or Quick Ratio (QR). As the conversion of inventory into cash will
take time, it i s excluded from current assets in order to arrive at' the amount of
liquid assets. Prepaid expenses are also excluded as these are already spent.
Formula
𝐿𝑖𝑞𝑢𝑖𝑑 𝑟𝑎𝑡𝑖𝑜 = 𝐿𝑖𝑞𝑢𝑖𝑑 𝐴𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝐿𝑖𝑞𝑢𝑖𝑑 𝑟𝑎𝑡𝑖𝑜 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − (𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 + 𝑝𝑟𝑒𝑝𝑎𝑖𝑑 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠)
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
The ratio should be 1:1. If current ratio is more than 2:1 but liquid
ratio is less than 1:1, it indicates excessive inventory.
As the bank overdraft is a permanent arrangements with the banker it may
be excluded to find out the liquid ratio.- In such case, the formula will be as
follows:
𝐿𝑖𝑞𝑢𝑖𝑑 𝑟𝑎𝑡𝑖𝑜 = 𝐿𝑖𝑞𝑢𝑖𝑑 𝐴𝑠𝑠𝑒𝑡𝑠
𝐿𝑖𝑞𝑢𝑖𝑑 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
i.e.
.
77
Absolute Liquid Ratio (ALR)
It is still stringent test of liquidity. It may not be possible to realise amounts
from all the debtors and hence the amount of debtors also is treated non -liquid
assets.
Absolute Liquid Ratio (ALR)
It is still stringent test of liquidity. It may not be possible to realise amounts
from all the debtors and hence the amount of debtors also is treated non-liquid
assets.
𝐴𝑏𝑠𝑜𝑙𝑢𝑡𝑒 𝐿𝑖𝑞𝑢𝑖𝑑 𝑟𝑎𝑡𝑖𝑜 = 𝑐𝑎𝑠ℎ + 𝑀𝑎𝑟𝑘𝑒𝑡𝑎𝑏𝑙𝑒 𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠
𝑞𝑢𝑖𝑐𝑘 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
The ratio should be 0.5 : 1.
Overdue Liability Ratio (OLR)
The ratio should be 1.5 : 1. If OLR is lower but current ratio is good, it
indicates excessive debtors and delay in realization of cash from debtors..
Profitability Ratios
Christy and Roden state that profit is the figure at the bottom of the income
statement - what is left for shareholders after all the changes have been paid.
Profit is an absolute figures and profitability is a ratio.
Gross profit ratio = Gross profit
Sales× 100 or Gross profit ratio =
EBIT
Sales× 100
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑟𝑎𝑡𝑖𝑜 = 𝑁𝑒𝑇 𝑝𝑟𝑜𝑓𝑖𝑡 𝑜𝑟 𝑃𝑟𝑜𝑓𝑖𝑡 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥
𝑆𝑎𝑙𝑒𝑠× 100
𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑝𝑜𝑤𝑒𝑟 = 𝐸𝐵𝐼𝑇
𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠× 100
EBIT= Earning, before interest tax.
Return on the Investment (ROI)
𝑅𝑂𝐼 = 𝑝𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑇𝑎𝑥
𝐶𝑎𝑝𝑡𝑖𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑 × 100
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 = 𝑝𝑟𝑜𝑓𝑖𝑡 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠× 100
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑡𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑃𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
𝑡𝑜𝑡𝑎𝑙 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 𝑒𝑞𝑢𝑖𝑡𝑦× 100
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐶𝑜𝑚𝑚𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑙𝑒𝑠𝑠 𝑝𝑒𝑟𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝐶𝑜𝑚𝑚𝑜𝑛 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝐸𝑞𝑢𝑖𝑡𝑦𝑆𝑎𝑙𝑒𝑠× 100
𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 (𝐸𝑃𝑆) = 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑙𝑒𝑠𝑠 𝑝𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒𝑠
Current Assets- (Inventory + Prepaid expenses)
Current Liabilities - Bank Overdraft
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𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑦 𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜 = 𝐷𝑃𝑆
𝐸𝑃𝑆× 100
𝑃𝑟𝑖𝑐𝑒 𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑅𝑎𝑡𝑖𝑜(𝑃𝐸𝑅) = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝐸𝑃𝑆
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑌𝑖𝑒𝑙𝑑 𝑟𝑎𝑡𝑖𝑜(𝐸𝑌𝑅) = 𝐷𝑃𝑆
𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑡𝑜 𝑛𝑒𝑡 𝑤𝑜𝑟𝑡ℎ = 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑙𝑒𝑠𝑠 𝑝𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝐸𝑢𝑖𝑡𝑦 𝐶𝑎𝑝𝑖𝑡𝑎𝑙+𝑅𝑒𝑠𝑒𝑟𝑣𝑒𝑠× 100
Leverage Ratios
Liquidity ratios are calculated to know the current financial position of the
firm. In order to know the long-term financial position, leverage ratios are
calculated. These are also called "capital structure ratios" and "Solvency Ratios".
These ratios will indicate the proportion of debt and equity in the capital
structure of an organisation. These are also calculated to know the extent to
which operating profits are sufficient to cover the fixed interest charge.
Debt Equity Ratio =long trem debt
share holder Equity=
loan funds
Own funds
This ratio is generally 1 : 1 in Public Sector and 2 : 1 in Private Sector. The
Controller of Capital issues prescribes that debt-equity 12 years, share premium,
general reserve, P & L account balance, and development rebate reserve,
shareholders equity is equal to net worth. Debt includes preference shares
redeemable within 13 years, fixed interest bearing securities such as debentures,
secured loans and unsecured loans etc. The Controller of Capital issues treat
redeemable preference shares as part of the relative interest of creditors and
owners.
Barges and Alexander mention "The treatment of preference presents different
risk to shareholders. In one case failure to meet payments presents no such risk."
A high ratio is unfavourable and margin of safety for creditors will be less. "It
will be di fficult for the firm to meet the fixed interest charges in case of high
promotion of debt in the capital structure. Though a low ratio provides a higher
margin of safety for the creditors, Earnings per share (ESP) will be lower on the
basis of large equity base. Hence a finance manager has to work out an optimum
capital structure in order to ensure that EPS will be lower on the basis of large
equity base. Hence a finance manager has to work out an optimum capital
structure in order to ensure that EPS will be higher and shareholder's wealth will
be maximum.
Debt Equity ratio, an important tool of financial analysis, depicts an
arithmetical relation between loan funds and owners funds. This is a popular
measure in the hands of investors and creditors to assess the lenders and owners
against the company's assets.
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The optimum mix of debt and equity ensures maximum return for equity
shareholders and also guarantees the servicing of debt in the interest of creditors.
The following factors may be considered for working out the optimum debt-equity
ratio:
a) Profitability Potential
b) Debt-servicing potential i.e. Interest-coverage ratio
c) Current Capi tal market conditions, and
d) The Economic situation in the country.
Debt-equity ratio is one of the most critical parameters that, an investor should
look at for the following reasons:
(i) A medium/high ratio (in the range of 1.5 : 1 to 4 : 1) would indicate that
the Capital base is low and this would mean higher earnings per share in the future
once the debt is redeemed,
(ii) A debt component also ensures that a financial institution appraises the
project. The later would also monitor the utilisation of funds during the project
implementation stage as also once the company commences commercial
operations,
(iii) In a contrast situation, when a project is entirely financed by equity, the
company loses the flexibility of rescheduling funds in future,
(iv) Then again, when a project is entirely financed by equity, the risk to the
shareholders is higher as there is no financial appraisal as the investors are not
equipped or have access to monitor the course of the project.
(v) The general norm for debt to equity is 1.5 : 1, But capital -intensive projects
are allowed a debt/equity of 4:1 while finance companies can have a ratio as high
as 9:1.
2. 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 = 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡
𝑆ℎ𝑎𝑟𝑒 ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝐸𝑞𝑢𝑖𝑡𝑦
i.e 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 = 𝐿𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝑑𝑒𝑏𝑡 +𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦
𝑆ℎ𝑎𝑟𝑒 ℎ𝑜𝑙𝑑𝑒𝑟𝑠′ 𝐸𝑞𝑢𝑖𝑡𝑦
3. 𝐷𝑒𝑏𝑡 𝑡𝑜 𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑅𝑎𝑡𝑖𝑜 = 𝐿𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝐷𝑒𝑏𝑡
𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
Note : The widely – held approach and adopted by C.C.I. and financial
institutions is that of relating the long – term debt to shareholders’ Equity i.e. 1.
Ratio.
𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 = 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝐸𝑞𝑢𝑖𝑡𝑦
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
It is also called “ proprietary Ratio”
𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 𝑡𝑜 𝑛𝑒𝑡 𝑊𝑜𝑟𝑡ℎ 𝑅𝑎𝑡𝑖𝑜 = 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 𝑎𝑡 𝑊𝐷𝑉
𝑁𝑒𝑡 𝑊𝑜𝑟𝑡ℎ
80
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 𝑡𝑜 𝑁𝑒𝑡 𝑊𝑜𝑟𝑡ℎ 𝑅𝑎𝑡𝑖𝑜 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
𝑁𝑒𝑡 𝑊𝑜𝑟𝑡ℎ
𝐿𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝐷𝑒𝑏𝑡𝑡𝑜 𝑁𝑒𝑡𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 𝐿𝑜𝑛𝑔 − 𝑡𝑒𝑟𝑚 𝐷𝑒𝑏𝑡
𝑁𝑒𝑡 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
This ratio should be 1: 1 long – term debt should not exceed net working
capital.
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑡𝑜 𝑁𝑒𝑡 𝑤𝑜𝑟𝑡ℎ = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑏𝑖𝑙𝑖𝑡𝑦
𝑁𝑒𝑡 𝐸𝑜𝑟𝑡ℎ
𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑡𝑜 𝑁𝑒𝑡 𝑤𝑜𝑟𝑡ℎ = 𝑇𝑜𝑡𝑠𝑙 𝐿𝑖𝑏𝑖𝑙𝑖𝑡𝑦
𝑁𝑒𝑡 𝐸𝑜𝑟𝑡ℎ
1. Capital Gearing ratio(CGR)
Capital gearing ratio indicates the relationship between fixed interest bearing
securities (FIBS) and Equity Share Capital plus Reserves.
(i) If FIBS are higher than equity Highly-geared capital structure. Capital
plus reserves i.e. ratio is more than 1 : 1 .
(ii). If FIBS are lower than equity Low-geared capital structure. Capital plus
reserves i .e . ratio is more than 1 : 1 .
I f both are equa l p roport ion. Evenly-gea red cap ita l structure,
i.e. ratio is 1:1.
𝐹𝐼𝐵𝑆
𝐸𝑄𝑢𝑖𝑡𝑦 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
𝐷𝑒𝑏𝑒𝑛𝑡𝑢𝑟𝑒𝑠
𝐸𝑄𝑢𝑖𝑡𝑦 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
𝐷𝑒𝑏𝑒𝑛𝑡𝑢𝑟𝑒 + 𝑃𝑒𝑟𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
𝐸𝑄𝑢𝑖𝑡𝑦 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
𝐹𝐼𝐵𝑆
𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑
𝐹𝐼𝐵𝑆
𝐸𝑄𝑢𝑖𝑡𝑦 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝑓𝑢𝑛𝑑𝑠 𝑖. 𝑒. 𝑁𝑒𝑡 𝑊𝑜𝑟𝑡ℎ𝑙
FIBS include the Debentures, Term loans and preference shares (especially
when they are cumulative ). The last formula is a better one.
A highly geared company may give higher return to equity shareholders, if
profits are good and rate of return of capital is more than the rate of interest on
preference dividend. After meeting the interest charges and preference dividend out
of profits, the balance of profits will be available to the Equity Shareholders.
(iii
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The following factors may affect the decision of the firm about capital gearing.
a) Trading on Equity
b) Exercise of control
c) Attitude towards risk
d) Statutory requirements
e) Capi tal market condi tions
f) Fixed cost of financing
g) Rate of return on capital
The following factors may affect the decision of the firm about capital gearing.
a) Trading on Equity
b) Exercise of control
c) Attitude towards risk
d) Statutory requirements
e) Capital market conditions
f) Types of inventors
g) Period of financing
h) Fixed cost of financing
i) Rate of return on capital
Fixed Assets to long-term funds
Fixed Assets to long-term funds= 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 𝑎𝑡 𝑊𝐷𝑉
𝑙𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝑓𝑢𝑛𝑑𝑠𝑙
Long-term funds include shareholders' equity and long-term debt. The ratio
should not exceed 1:1, it means that working capital is nil. Then current assets are
financed fully by current liabilities only.
Interest Coverage Ratio (ICR)
ACR =𝐸𝐵𝐼𝑇
𝐹𝑖𝑥𝑒𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐ℎ𝑟𝑔𝑒𝑠
It is also called "Debt-service Ratio".
The ratio shows how many times the interest of the earnings cover charges
before interest and tax (EBIT). It indicates the ability of a firm to pay the interest
charges. It is also an important test of satisfactory. If the ratio is 1:1, EBIT will be
just sufficient to pay the interest charges. Then net profit will be nil and tax need
not be paid.
DSCR mean Debt Service Coverage Ratio. The company has to satisfy the
lender by calculating DSCR which should indicate clearly as to what extent it will
be able to discharge loan obligations. Each company should work out is own DSCR for
proper planning and monitoring which should be part of internal financial
discipline.
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If the internal generation of funds (i.e. cash in flow) is diverted for expansion,
modification or diversification of activities, it may result into default of payment of
interest and repayment of loan.
Preference Dividend Coverage Ratio (PDCR)
PDCR= 𝑷𝒓𝒐𝒇𝒊𝒕 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙
𝒑𝒓𝒆𝒇𝒆𝒓𝒆𝒏𝒄𝒆 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅
Operating Ratio
These ratios are calculated to show the variations of different expenses in the
operating cost. Generally these are expressed as percentages to net sales.
Cost of goods sold + Operating expenses . Operat ing ratio = —------------------------------------------------------ x 100
Net Sales If the operating ratio shows 90%, the balance 10% will be operating profit ratio.
This should cover interest, income tax, dividends and retained earnings.
Each item of expenses Expenses Ratio = ------------—----------------------- x 100
Net Sales In indicates the percentage of each item of expense in relation to net sales.
𝐸𝑥𝑝𝑒𝑛𝑠𝑒 𝑅𝑎𝑡𝑖𝑜 = 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 𝑡𝑜 𝑁𝑒𝑡 𝑤𝑜𝑟𝑡ℎ = 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
𝑁𝑒𝑡 𝑊𝑜𝑟𝑡ℎ
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 𝑡𝑜 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 = 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 𝑡𝑜 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 × 100
Turnover Ratios
Turnover ratios indicate the effectiveness with which the assets are utilised in a
firm. These are also called "Activity Ratios".
Inventory Turnover Ratio (ITR)
It is also called Stock Turnover Ratio. It is the number of times its average
inventory is sold during a year. There are 3 alternative formulas for this ratio as
given below:
i) ITR = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑎𝑡 𝑐𝑜𝑠𝑡
(ii) ITR = 𝑆𝑎𝑙𝑒𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑎𝑡 𝑐𝑜𝑠𝑡
(iii) ITR = 𝑆𝑎𝑙𝑒𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑎𝑡 𝑠𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒
83
A ratio of 6 or 7 times is considered satisfactory. But there is "on rule of
thumb". A high inventory turnover is an indication of good inventory slow-moving
and absolute i tems resul ting in blocking of funds. Too high frequent stock-
outs. These situations should be avoided. Significance of important ratios
Holding of inventory may be expressed in number of days also as follows:
Average holding period of inventory = 𝐷𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
𝐼 .𝑇.𝑅
Debtors Turnover Ratio (DTR)
This ratio indicates the speed at which the debtors are converted into cash. It
is also called "Receivable Turnover Ratio".
𝐷𝑇𝑅 = 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠 𝑖𝑛 𝑎𝑦𝑒𝑎𝑟
𝐷𝑒𝑏𝑡𝑜𝑟𝑠
The optimum ratio is dependent on the credi t policy of the fi rm and
credi t period allowed to the customers. If the credit period is 30 days, the ratio
should be 12:1. Suppose if the ratio is 12:2 i.e., 6:1 the realisation from debtors is
taking two months instead of credit policy of one month. Hence lower
The debtors include the gross amount of debtors (i.e. without deducting the
provisions for bad and doubtful debts and provision for discount on debtors) and
outstanding bills receivable which have not been discounted with the bankers.
Sometimes, we have to calculate the average collection period of debtors. In
such case, the formula is as follows:
Average Collection Period = --- 𝐷𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
𝐷𝑇𝑅-
Or
Average Collection Period =𝐷𝑒𝑏𝑡𝑜𝑟𝑠 ×Days in a year
𝐶𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
𝑖𝑒 𝐷𝑒𝑏𝑒𝑡𝑜𝑟𝑠
𝐶𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠 𝑝𝑒𝑟 𝑑𝑎𝑦
Creditors Turnover Ratio (CTR)
Similar to debtors Turnover Ratio, Creditors Turnover Ratio also can be
calculated.
𝐶𝑇𝑅 = 𝐶𝑟𝑒𝑑𝑖𝑡 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 𝑖𝑛 𝑎𝑦𝑒𝑎𝑟
𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠
This ratio indicates the speed at which the creditors are paid. The ratio here
also is dependent on the credit period allowed by suppliers. The creditors include
84
the gross amount of creditors (i.e. without deducting the provision for discount on
creditors) and bills payable.
Average payment period = Days in ayear
CTR
or Creditor × Days in ayear
Credit Purchases in a year
or Creditors
CreditPurchases per year
Fixed Assets Turnover = Sales
Fixed Assets
This ratio indicates the frequency with which the fixed assets are utilized
Total Assets Turnover = Sales
Total Assets
Working Capital Turnover = Turnover
Working Capital
Working Capital to inventory = Working Capital
Inventory
Working Capital to Total Assets = CWoriking CApital
Total Assets
Total Assets Turnover = Total Cash & Bank Payment
Average cash & Bank Balance
Current Assets Tournover = Turn over
Current Assets
Inventory to Working Capital = Inventory
Working Capital
Debtors to Working Capital = Debtors
Working Capital
Cash to Working Capital = Cash
Working Capital
Capital out put ratio = Capital
Value of produsction
7.3.6 SIGNIFICANCE OF IMPORTANT RATIOS
Current Ratios:
a) Current Ratio indicates the firm’s ability to pay its current liabilities; i.e.
day to day financial obligations.
85
b) It Shows short-term financial strength.
c) It is a test of credit strength and solvency of a firm.
d) It indicates the strength of working of capital
e) It indicates the capacity to canyon effective Operations.
f) It discloses the over-trading or under-capi talisation.
g) It shows the tendency of over-investment in inventory.
h) Higher ratio, ie., more than 2:1 indicates sound solvency position ,
i) Lower ratio, ie., less than 2:1 indicates inadequate working capital ,
j) It discloses the quantity of working capital position and not its quality.
k) By using the current ratio, a credit manager, or lending officer can lay
aside his "flipping coin" and arrive at decisions based on some figures of login and accuracy.
Liquid Ratio
a) It is a more stringent test of a firm's ability to meet its intermediate
liabilities.
b) It is true test of business solvency.
c) It is more of a qualitative concept whereas current ratio discloses
quantitative aspect of working capital.
d) It indicates the inventory build-up when studied along with current ratio
because of the following formula: Liquid Assets=Current Assets-
Inventory
e) Because of eliminating inventory in its calculations, it is a stringent test
of liquidity.
f) It is a more important ratio for financial institutions.
g ) Higher ratio, i.e., more than 1:1 indicates sound financial position
h) Lower ratio, i.e., less than 1:1 indicates financial difficulty.
Gross Profit Ratio
a) It indicates the basic profitability of a firm, i.e., trading results of a firm.
b) It indicates the degree of efficiency of the production department,
purchase department, sales department and the degree of cost control
(i.e. material control labour efficiency and overheads control).
c) A comparison of G.P. ratios over 5 to 10 years will indicate the trend of
trading results.
d) It shows whether the percentage of "mark up" on the goods is
maintained or not.
e) Higher ratio indicates the higher profitability.
f) Low ratio indicates the lower profitability and unfavourable mark-up
policy.
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Net Profit Ratio
a) It indicates the relationship between net profit and net sales.
b) It is the most significant of all revenue ratios as it indicates the ultimate
profitability of the firm.
c) It is useful to the share holders for knowing the earnings per share
(EPS).
d) It is useful to investors in judging the prospects of return on their
investments.
e) A study of operating ratio and N.P. ratio indicate the degree of efficiency
and profitability of the firm.
f) A study of operating net profit ratio and N.P. ratio will indicate scale of
company's non-operating expenses and non-operating income.
g) A study of G.P. ratio and N.P. ratio will indicate scale of company's non-
operating expenses and non-operating income.
h) It is described as an index of "Operational Efficiency".
i) Higher ratio indicates higher profitability.
j) Lower ratio indicates lower profitability.
Note: A high N.P. ratio is not always a favourable indication of a firm's
profitability. For a detailed study of the firm's profitability, the following factors are
also to be studied:
1) Market Conditions, 2) Sales Volume 3) Pricing policy 4) Sales Mix 5)
Stock turnover ratio 6) Debtors turnover ratio 7) Cost of capital 8) Return on
investment (ROI) of other firms in the same industry etc.
Earning Power or Return on Total Resources
a) It is an index of earning power of a firm. .
b) It is an index of optimum utilisation of funds or economic productivity of
capital.
c) It indicates the degree of efficiency of management.
d) It provides a standard measure of operating efficiency.
e) Capital investment decisions are made on the basis of this ratio.
f) Higher ratio is favourable and lower ratio is unfavourable
Note : Total Resources : Total Assets Employed
Earning Power = EBIT
Total Assets× 100
Return on Total Equity
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= Profit after Tax (PAT)
Total Shareholders Equity (or)total proproetprs Funds× 100
a) It shows the earnings capacity of proprietors funds (including
preference shareholders).
b) It is important to prospective investors and shareholders.
c) High ratio will improve the market price of the share in stock
exchange.
d) High ratio enables the management to raise finances easily even from
external resources.
e) A high ratio gives scope for more retained earnings which can be used
for expansion, diversification and consequential development of
business.
f) When the ratio has been high for a period of 4 or 5 years, shareholders
can expect the company to issue bonus share
g) Note: While calculating the above ratio, the preference dividend need
not be deducted.
Return on common equity
= PAT Less Perference Dividend
Equity Shareholders Funds× 100
a) It shows the efficiency in the management of equity share holders funds,
b ) Higher ratio indicates higher profitability and higher EPS
c) Lower ratio indicates lower profitability and ineffective utilisation of
equity share holders funds,
d ) If EPS is higher than the market value of equity shares will be higher in
stock exchange and issue of bonus shares will also be feasible.
Note : The Preference shares are considered as "Non-participating."
Earnings Per Share (EPS) = 𝑃𝐴𝑇 𝑙𝑒𝑠𝑠 𝑝𝑟𝑒𝑓𝑒𝑟𝑒𝑐𝑒 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑆ℎ𝑎𝑟𝑒𝑠
a) It indicates the earning power of equity share capital,
b) Dividend declaration is based on this ratio.
c) EPS is of considerable importance in estimating the market price of
shares,
d ) If EPS is higher, market value of equity share will be higher in the stock
exchange,
e) If EPS has been high for a period of 4 to 5 years, issue of bonus share
will also be feasible,
f) This ratio can be improved by use of borrowed funds to a greater extent.
88
NOTE: Dividend Per Share(DPS) = Dividend Declared / No of Equity shares.
Dividend pay Out Ratio =𝐷𝑃𝑆
𝐸𝑃𝑆× 100
Proprietary Ratio
i) It indicates long-term financial solvency of the firm.
i i ) It shows the general financial strength of the firm.
i i i ) It shows the proportion of assets financed by the proprietors.
iv) It measures the extent of protection available to the creditors.
v) It is a test of long-term credit strength.
vi ) It determines the extent of trading on equity.
vii) Higher Ratio i.e. more than 75% shows lesser dependence on external
sources, sound financial position; greater security available to creditors, no trading
on equity and low EPS(EPS=Earnings per Share), viii) Lower ratio i.e., less than
60% shows more dependence on external sources and unsound financial position.
It is dangerous during the period of depression.
Note: The Proprietary ratio can never exceed 1:1 i.e., 100%. When there are
outside liabilities, the ratio would he 1:1, standard ratio would, he 60% to 75%.
Capital Gearing Ratio
i. It analyses the capital structure of a company effectively.
ii. It is useful to ascertain whether a company is practicing "trading on
equity " and if so to what extent is done.
iii. Low gearing indicates trading on equity, over capitalization and low EPS,
iv. It aids in regulating a balanced capital structure in a company.
v. High gearing is favourable for a company earning high profits and it
indicates under capitalization. Earning per share(EPS) will be higher but
it will fall disproportionately against a slight fall in net profits.
vi. It affect the dividend policy of the company.
Note: According to capital issues control act a ratio of 1:4 between equity and
preference capital is reasonable.
Operating Ratio
i. It brings out. the relationship between cost of goods sold + operating
expenses and net sales.
ii. It is useful to ascertain the administration efficiency.
ii i . It is a test of operational efficiency of the business.
iv. It is useful for detecting the areas of inefficiency and consequential
lower profits.
v. Low ratio indicates operational efficiency and higher profits,
89
vi . High ratio indicates the lower profits.
vii. A trend analyses of operating ratios can be made for a period of 5 to 10
years and reasons analysed for any rise or fall in operational efficiency.
Expense Ratios
i . Expenses ratios bring out the relationship between various elements of
operating costs and net sales,
i i . A study of these ratios will enable the management in controlling costs
and improving the managerial efficiency,
iii. A study of these ratios over a perioft of 5 to 10 years will indicate trend
analysis and according to the ratio will improve the profitabili ty .
Inventory Turnover Ratio (ITR)
i. It indicates the number of times its averages inventory has been sold
and replaced during the year.
i i . It is an important factor that controls profitability of firm,
i i i . It indicates whether investment in inventory is high or not. This ratio
can be useful for introducing effective inventory management in the
areas mentioned below,
iv. Controlling inventory levels to avail! over-stocking and stock-outs,
avoiding slow-moving, non-moving inventories and surplus or obsolete
stores etc.
v. It indicates whether capital is blocked in slow-moving inventories and
thereby indicates the possibility of reducing selling prices of those items,
vi . This ratio reflects excess stock and/or accumulation of obsolete items in
stock,
vii. A study of inventory turnover ratio and inventory to working capital
ratio will be more significant.
viii. A ratio of six or seven times is considered satisfactory. A high inventory
turnover is an indication of good inventory management and favourable
trading situation. A low ratio indicates excessive inventory including
slow-moving and obsolete items resulting in blocking of funds.
Note: A too high inventory turnover ratio may be the result of low
level including frequent stock-outs. This situation should be avoided.
Debtors Turnover Ratio (DTR)
(i)If the credit period is 30 days, the ratio should be 12. If the ratio is 6:1, the
realization from debtors is taken 2 months instead of credit policy of one month.
Hence, Lower ratio indicates poor collection from the debtors. Then the bad debts
also will increase and profits will be lower. Hence, suitable measures are to be
taken to improve the credit collection.
90
(ii) It indicates the quality of debtors also, i.e. good, doubtful or bad etc.
(iii) It is useful in the preparation of working capital budgets.
(iv) It is a very useful supplementary test to the current ratio.
(v) It shows the effectiveness of credit control.
It indicates the speed at which the debtors are converted into cash.
Inventory to Working Capital Ratio
i. It shows the extent to which working capital is blocked in inventory.
Working capital is required for the firm but it should not be blocked up
in inventory.
ii. Higher ratio of more than 1:1 indicates unsound working capital, i.e,
iii. Lower ratio i.e, less than1:1 indicates sound working capital position and effective inventory management.
iv. It indicates whether working capital is adequate or not.
v. It is related to current ratio as well as liquid ratio.
Illustration:
1. The following is the balance sheet of Rajan limited as on 31st March 2000.
Liabilities Rs. Assets Rs.
Equity share Capital
7 % preference Share
Capital
Reserve and Surplus
3 % Mortgage
Debentures
Creditors
Bills payable
Outstanding expenses
Taxation provision
1,00,000
20,000
80,000
1,40,000
12,000
20,000
2,000
26,000
Fixed Assets 3,60,000
Less: Depre., 1,00,000
_________
Current Assets:
Cash
Investments
(Government securities
@ 10 % interest)
Sundry debtors
Stock
2,60,000
10,000
30,000
40,000
60,000
4,00,000 4,00,000
Other information:
(i) Net sales Rs.6,00,000
(ii) Cost of Goods sold Rs.5,16,000
Net income before tax 40,000
Net income after tax 20,000
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Calculate appropriate ratios from the given information.
Solution:
(a) Short – term solvency ratios:
(1) Current ratio =𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠=
1,40,000
60,000= 2.33 : 1
(2) liquid ratio =𝐿𝑖𝑞𝑢𝑖𝑑 𝑎𝑠𝑠𝑒𝑡𝑠
𝐿𝑖𝑞𝑢𝑖𝑑 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠=
80,000
60 ,000= 1.33 : 1
(b) Long term Solvency ratios:
(3) Proprietary ratio =𝑃𝑟𝑜𝑝𝑟𝑖𝑒𝑡𝑜𝑟 𝑠′ 𝑓𝑢𝑛𝑑
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠=
2,00,000
4,00,000= 0.5 : 1
Proprietary funds or
shareholder’s funds = Equity share capital + preference share
capital + Reserve & surplus
= 1,00,000+20,000+80,000
(4) Debt – Equity ratio = 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑖𝑒𝑠
𝐼𝑛𝑡𝑒𝑟𝑛𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑖𝑒𝑠=
𝐷𝑒𝑏𝑡
𝐸𝑞𝑢𝑖𝑡𝑦=
=2,00,000
2,00,000= 1 : 1
(5) Ratio of Fixed Assets to proprietors, funds:
= 𝐹𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠 (𝑎𝑓𝑡𝑒𝑟 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛)
𝑃𝑟𝑜𝑝𝑟𝑖𝑒𝑡𝑜𝑟 𝑠′ 𝑓𝑢𝑛𝑑𝑠=
2,60,000
2,00,000
= 1.3 : 1
(6) Interest coverage ratio= 𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 +𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 +𝑇𝑎𝑥
𝐹𝑖𝑥𝑒𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐ℎ𝑎𝑔𝑒𝑠=
=48,400
8,400= 5.7 𝑡𝑖𝑚𝑒𝑠
Fixed interest charges = 6 % on debentures of Rs.1,40,000
= Rs. 8,400
(c) Profitability ratios:
(7) Gross Profit ratio = 𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡
𝑠𝑎𝑙𝑒𝑠× 100 =
84,000
6,00,000× 100 = 14 %
Gross profit = Sales – Cost of goods sold
= 6,00,000 – 5,16,000
= 84,000
(8) Net profit ratio =𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡
𝑠𝑎𝑙𝑒𝑠× 100 =
20 ,000
600 ,000× 100 = 3.33
92
(9) Return of share holders’ funds
=𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 𝑠′𝑓𝑢𝑛𝑑× 100
=20,000
2,00,000× 100 = 10 %
(10) Return of capital employed
=𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 +𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 +𝑡𝑎𝑥
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑× 100
Capital Employed Rs.
Share Capital 1,00,000
7% preference share capital 20,000
Reserve and surplus 80,000
6% Debentures 1,40,000
3,40,000
Less: Investment (out side the business 30,000
Net capital employed at the end 3,10,000
Average capital employed = Net profit employed at the end- ½ of
Net profit after tax.
= Rs. 3,10,000- ½ of Rs. 20,000
= Rs. 3,00,000
Return of capital employed
=𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 +𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 +𝑡𝑎𝑥
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑× 100
= 40,000+8,400 −3,000 (10% 𝑜𝑛 30,000 )
3,00,000× 100
= 45 ,400
3,00,000× 100 = 15.13 %
(c) Activity ratios:
(11). Stock turnover ratio =𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑠𝑡𝑜𝑐𝑘
As there is no opening stock, closing stock is taken as the average
stock.
93
=5,16,000
60 ,000= 8.6 𝑡𝑖𝑚𝑒𝑠
(12). Average collection period = 𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡𝑜𝑟𝑠
𝐶𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠×
𝑁𝑜. 𝑜𝑓 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑑𝑎𝑦𝑠
All sales are assumed as credit sales and number of working days.
=40 ,000
6,00,000× 360 = 24 𝑑𝑎𝑦𝑠
(13). Capital structure ratio:
Capital gearing ratio
=𝑝𝑟𝑒𝑓.𝑠ℎ𝑎𝑟𝑒 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 +𝑓𝑖𝑥𝑒𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑏𝑒𝑎𝑟𝑖𝑛𝑔 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠
𝐸𝑞𝑢𝑖𝑡𝑦 𝑐𝑎𝑝𝑖𝑡𝑎𝑙+𝑅𝑒𝑠𝑒𝑟𝑣𝑒 𝑎𝑛𝑑 𝑠𝑢𝑟𝑝𝑙𝑢𝑠
=20,000+1,40,000
1,00,000 +80,000=
1,60,000
1,80,000= 0.89 ∶ 1
2. from the following information, prepare a balance sheet show the workings.
1. working capital Rs. 75,000
2. Reserve and surplus Rs. 1,00,000
3. Bank overdraft Rs. 60,000
4. Current ratio 1.75
5. Liquid ratio 1.15
6. Fixed assets to proprietor’s funds 0.75
7. Long – term liabilities Nil
Solution:
(a) Current Assets:
Current ratio =𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠= 1.75 ∶ 1
Working capital = Current Assets – Current Liabilities
= 1.75 – 1 = 0.75
If working capital is 0.75 , Current assets are 1.75 If working capital is Rs. 75,000, current assets are
= 75,000
0.75× 1.75 = 𝑅𝑠. 1,75,000
(b) Current Liabilities: If working capital is 0.75, current liabilities = 1
94
If working capital is Rs. 75,000, current liabilities are
75,000
0.75 × 1 = 𝑅𝑠. 1,00,000
(c) Quick assets:
Quick ratio = 𝑄𝑢𝑖𝑐𝑘 𝑎𝑠𝑠𝑒𝑡𝑠
𝑄𝑢𝑖𝑐𝑘 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠= 1.15
Quick liabilities = Current liabilities – Bank overdraft
= Rs.1,00,000 – Rs. 60,000 = Rs.40,000
= 𝑄𝑢𝑖𝑐𝑘 𝑎𝑠𝑠𝑒𝑡𝑠
𝑄𝑢𝑖𝑐𝑘 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠= 1.15
= 𝑄𝑢𝑖𝑐𝑘 𝑎𝑠𝑠𝑒𝑡𝑠
40,000= 1.15
Quick Assets = 40,000 × 1.15 = Rs. 46,000
(d) Stock :
Stock = Current assets – Quick assets = Rs. 1,75,000 – Rs. 46,000
= Rs. 1,29,000 (e) Proprietors’ funds:
Fixed assets to proprietor’s fund=
= 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠
𝑃𝑟𝑜𝑝𝑟𝑖𝑒𝑡𝑜𝑟 𝑠′ 𝑓𝑢𝑛𝑑𝑠= 0.75 ∶ 1
In the absence of long term loans, following equation can be had from the
Balance Sheet.
Total Assets = Total Liabilities
i.e., proprietors’ funds + Current liabilities = Fixed assets + Current assets
proprietors funds – fixed assets = Current assets – Current Liabilities
1 – 0.75 = Rs. 1,75,000 – Rs. 1,00,000
0.25 = Rs. 75,000
Proprietors’ fund 1 = Rs. 3,00,000
Fixed Assets 0.75 = Rs. 2,25,000
Share Capital :
Proprietors’ funds = Rs. 3,00,000
Less: Reserve and Surplus = Rs. 1,00,000 ____________
Share Capital = Rs. 2,00,000
___________
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The Balance Sheet will appear as follows:
Balance sheet as on .......
Liabilities Rs. Assets Rs.
Share Capital
Reserve and Surplus Current Liabilities:
Bank overdraft Quick liabilities
2,00,000
1,00,000
60,000 40,000
Fixed Assets
Current assets: Stock
Quick Assets
2,25,000
1,29,000
46,000
4,00,000 4,00,000
Illustration: 3
The following are the summarized profit and loss account of Sun India Ltd. For the year ending 3151Dec.2003 and the Balance sheet as on that date:
Dr. Profit and Loss Account Cr.
Particulars Rs. Particulars Rs. Rs.
To Opening Stock 10,000 By Sales 1,20,000
1,10,000 To Purchases 60,000 Less: Sales Return 10,000
To Freight Expenses 5,000 By Closing Stock
15,000 To Gross Profit c/d 50,000
To Operating Expenses:
1,25,000 By Gross Profit b/d
1,25,000
5,000
50,000
Office Expenses By Non-Trading Income:
5,000
Administrative Expenses 15,000 Interest on Investment
1,000
Selling and Distribution Expenses 5,000
To
Non-Operating Expenses:
1,000
Dividend Received
4,000 Loss on Sale of Fixed Assets
To Net Profit 34,000
60,000 60,000
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Balance Sheet for the year ending 31"'Dec.2001
Liabilities Rs. Assets Rs.
Share Capital
Reserve
Debentures
Current Liabilities
Profit and Loss A/c
15,000
3,000
12,000
20,000
5,000
5,000
Cash in Hand
Cash at Bank
Marketable Securities
Inventories
Sundry Debtors
Prepaid Expense
Land and Building
2,000
3,000
5,000
15,000
6,000
4,000
20,000
55,000 55,000
You are required to calculate:
a) Current Ratio
b) Liquid Ratio
c) Gross Profit Ratio
d) Operating Ratio
e) Operating Profit Ratio
f) Net Profit Ratio
Solution: a. Current Ration
Current Ration = Current Assets/Current Liabilities
= `2000+3000+5000+15000+6000+4000
= `35000
= `20000
= 1.75 (or) 1.75:1
b. Liquid Ratio
Liquid Ratio = Liquid Assets/Current Liabilities
Liquid Assets = Current Assets–(Stock and Prepaid
Expenses)
= `35000-(15000+4000)
= `16000
= `20000
= 0.8 (or) 0.8:1
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c. Gross Profit Ratio
Gross Profit Ratio = 100
SalesNet
Profit Gross
= 100
110000
50000
= 45.45%
d. Operating Ration
Operating Ration = 100
SalesNet
Cost Operating Total
Total Operating Cost = Opening Stock + Purchases-Closing
Stock
= `10000+60000-15000
= `55000
Operating Expenses = Office Expenses + Administrative
Exp.o+
Selling and Distribution Exp.
= `5000+150000-5000
= `250000
Total Operating Cost = `55000+25000
= `80000
Operating Ratio = 100
10000
80000
= 72.72%
e. Operating Profit Ratio
Operating Profit Ratio = 100
SalesNet
Profit Operating Net
Net Operating Profit = Net Sales – Total Operating Cost
= `110000-80000
= `30000
Operating Profit Ration = 100
110000
30000
98
= 27.27%
Alternatively
Net Operating Profit = Net Profit + Non-Operating Expenses –
Non operating Income
= `34000-10000-(5000+1000+4000)
= `35000-10000
= `25000
Operating Profit Ration = 100
110000
25000
= 22.72%
f. Net Profit Ration
Net Profit Ratio = 100
SalesNet
tax) (After Prifit Net
= 100
110000
34000
= 30.90%
Answers
(a) Current Ratio = 1.75(or) 1.75:1
(b) Liquid Ratio = 0.8 (or) 0.8:1
(c) Gross Profit Ratio = 45.45%
(d) Operating Ratio = 72.72%
(e) Operating Profit Ratio = 27.27 % Or 22.72%
(f) Net Profit Ration = 30.90%
This ratio is also termed as ROI. This ratio measures are turn on the owner's or
share holders' investment. This ratio helps to the management for important
decisions making.
This ratio highlights the success of the business from the owner's point of view.
It helps to measure an income on the share holders' or proprietor's investments.
This ratio helps to the management for important decisions making.
It facilitates in determining efficiently handling of owner's investment
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This ratio shown the relationship between net profit after interest and taxes
and the owner's investment. Usually this is calculated in percentage. This ratio,
thus. Can be calculated as:
Return on Investment Ratio Shareholder's Investments
Net Profit (after interest and tax) Net Profit =------------X 100
Shareholders' Fund(or)Investments
= Equity Share Capital + Preference Share Capital + Reserves and Surplus
-Accumulated Losses
= Net Profit-Interest and Taxes
Illustration :4
The following information is given : Current ratio : 2.5, Fixed assets turnover ratio : 2 times
Liquidity ratio : 1.5, Average debt collection period : 2 months Working capital :Rs. 300000 Stock turnover ratio : 6 times, Fixed assets : shareholders networth 1 : 1
(cost of sales / closing stock)
Gross profit ratio : 20%, Reserves : share capital 0.5 : 1
Draw up a balance sheet from the above information
Solution
1. current liabilities and current assets :
Net working capital = current assets – current liabilities
Current ratio = 2.5
Let current liabilities be x to current assets will be 2.5 x
Net working capital = 2.5 x – x
Rs. 300000 = 2.5x – x
Rs. 300000 = 1.5x
X = Rs.300000/1.5 = Rs.200000
When current liabilities are Rs.200000, current assets will be
200000 x 2.5 = Rs.500000
Liquid assets = 200000 x 1.5 = Rs.300000
2. Stock :
Stock = current assets – liquid assets
Stock = Rs.500000 – Rs.300000 = Rs.200000
3. Cost of sales
100
Stock turnover ratio = cost of sales / stock
6 = cost of sales / Rs.200000
Cost of sales = Rs.200000 x 6 = Rs.120000
4. Sales
Cost of sales + gross profit
Gross profit = Rs.1200000 x 6 / 80 = Rs..300000
Sales = Rs.1200000 + Rs.300000 = Rs.1500000
5. Fixed assets
Fixed assets turnover ratio = sales / fixed assets
2 = Rs.1500000 / fixed assets
Fixed assets = Rs.1500000 / 2 = Rs.750000
6. Debtors:
Average debt collection period = total debtors x no. of months / sales
2 = total debtors x 12 / 1500000
Total debtors = 1500000 x 2 / 12 = Rs.250000
7. Shareholders net worth
Fixed assets : shareholders net worth
1 : 1
Rs.750000 : Rs.750000
8. Share capital:
Reserves : share capital
0.5 : 1
Shareholders net worth = share capital + reserves
Rs.750000 = 1 + 0.5
Share capital = Rs.750000 x 1 / 1.5 = Rs.500000
Reserves = Rs.750000 – Rs.500000 = Rs.250000
9. Long term debts :
Long term debts = total assets – (shareholders net worth + current liabilities)
= Rs.1250000 – Rs.950000
Long term debts = Rs.300000
Note : sales have been used for fixed assets turnover ratio, cost of sales
could also be used here
Balance sheet
Liabilities Rs. Assets Rs.
Share capital 500000 fixed assets 750000
Reserves 250000 liquid assets 300000
Long term debts 300000 stock 200000
Current liabilities 200000 ……….
1250000 1250000
101
102
Practical Problems: 1. Pushpa enterprises present you the following income statement and request
you to calculate (i) Gross profit ratio (ii) Net profit ratio (iii) Operating ratio (iv)
Operating profit ratio (iv) Expenses ratio.
Income statement
Particulars
Sales Less: Sales Returns
Net sales Less: Cost of Goods sold
Gross profit
Add: Non operating income: Profit on sale of building
Income from investments
Less: Operating Expenses: Administration exp.
Selling expenses Distribution expen.
Non-operating
Expenses: Finance expenses
Loss on sale of plant Provision for Income tax
Rs.
8,60,000 60,000
Rs.
8,00,000 3,50,000
30,000
20,000
4,50,000
50,000
40,000
60,000 20,000
30,000
20,000 30,000
5,00,000
2,00,000
3,00,000
2. You are given the following information
Cash
Debtors Closing Stock
Bills payable Creditors Outstanding expenses
Taxes payable
Rs. 18,000
1,42,000 1,80,000
27,000 50,000 15,000
75,000 Calculate (a) Current ratio (b) Liquidity ratio (c) Absolute liquidity ratio.
3.Given below is the summarized balance sheet and profit and loss of s.s.mills
Ltd., as on 31.12.2010. you are required to calculate.
103
(1) current ratio (2) quick ratio (3) Fixed assets ratio
Debt equity ratio (5) proprietary ratio (6) stock turn over ratio (7) Fixed assets
turnover ratio (8) Return on capital employed (9) Debtors turnover ratio (10)
Creditors turnover ratio (11) Gross profit ratio (12) operating ratio (13) Net profit
ratio.
Balance sheet as on 31.12.2010
Liabilities Rs. Assets Rs.
Issued Capital
4,000 shares of Rs.10 each
Reserves
Creditors
Profit and loss Account
40,000
18,000
26,000
6,000
Land & building
Plant and Machinery
Stock
Debtors
Cash at Bank
30,000
16,000
29,600
14,200
6,200
96,000 96,000
Profit and Loss Account
Particulars Rs. Particulars Rs.
To Opening stock
To Purchase
To Direct expenses
To Gross profit
To administration expenses
To selling expenses
To Financial expenses
To Other non- operating
expenses
To Net profit
19,900
1,09,500
2,850
68,000
By Sales
By Closing stock
By Gross profit
By non – operating income
1,70,000
29,800
1,99,800 1,99,800
30,000
6,000
3,000
800
30,000
68,000
1,800
69,800 69,800
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4. Following ratios are the related to the trading activities of National traders Ltd.,
Debtor’s velocity 3 months
Stock velocity 8 months
Creditors velocity 2 months
Gross profit ration 25 per cent
Gross profit for the ended 31st December,2009 amounts to Rs.4,00,00. Closing
Stock of the year is Rs.10,000 above the opening stock. Bills receivable amount to
Rs. 25,000 and Bills payable to Rs.10,000.
Find out (a) Sales (b) Sundry debtors (c) Closing Stock and (d) Sundry
creditors.
5. With the help of the following ratios regarding ABC Ltd., draw the balance
sheet of the company for the year 2009.
Current ratio 2.5
Liquidity ratio 1.5
Net working capital Rs. 3,00,000
Stock turnover ratio(cost of sales/ Closing stock) 6 times
Gross profit ratio 20%
Debt collection period 2 months
Fixed assets turnover ratio (on cost of sales) 2 times
Fixed assets to shareholders’ net worth 0.80
Reserve and Surplus to share capital 0.50
7.4 REVISION POINT
Ratio analysis is known as the relationship between two accounting figures
expressed mathematically. It help to make a qualitative judgement about the firm’s
financial performance.
Objectives of Ratio: financial forecasting , comparison, cost control,
communication, diagnose of the financial health of a firm, to know the overall
operating efficiency of the firm.
Difficulties in ratio Analysis – Nature of Ratio Analysis – Types of rario
analysis.—Solvency Ratio, Operating ratio, Turnover ratio, Capital gearing ration.
7.5 INTEXT QUESTION
1. What are the uses of ratio analysis?
2. Explain the various practical difficulties in using ratio analysis.
3. Explain the precautions in the ratio analysis.
4. Explain the nature of ratio analysis.
5. What are the objectives of ratio analysis?
6. Explain any three liquidity ratios and its importance.
7. Explain importance of return on capital employed ratio.
105
8. What are the uses of the profitability ratios?
7.6 SUMMARY
In recent times, ratio analysis, has emerged as key tool in analyzing the
financial statements. Accounting data are expressed in mathematical terms, which
carry vast data. This method not only helps the management in taking decisions
but also to the outsiders. The money lenders or the creditors or the investors may
use ratio analysis to evaluate the financial stability and earning power of the firm.
The ratio analysis should be followed with some precautions, since it has some
drawbacks like no proper basis for comparison, the situation may change from time
to time but this will not be considered in the ratio analysis, price level changes are
which also considered definitional differences of items which are used in ratio
analysis etc.,
According to the functions and nature of the accounting data, the ratios are
grouped into various sub titles. Important ratios are liquidity ratio, profitability
ratios, insolvency ratios, return on investment ratios on equity capital ratio.
Different ratios have different significances. According to the nature of the
financial information every ratio has its own unique nature and specific advantages
which are essential in evaluating the performance of the firm. The firm’s overall
performance are evaluated through every aspect.
7.7 TERMINAL EXERCISE
1. Higher debtors turnover ratio indicates
a. More cash sales (b) more credit sales (c) Efficient collection of
debts.
b. Expenses ratios are calculated
c. On the basis of expenses with net sales
d. On the basis of expenses with profit
e. On the basis of expenses with capital
f. On the basis of sales with capital
2. Which one is not included with shareholder funds
a. Reserves b. preference Capital c. Equity share capital
d. long term liability.
7.8 SUPPLEMENTARY MATERIALS
Indian journal of Accounting
Charted Accountant
7.9 ASSIGNMENTS
Apply those ratios into various accounting data, which are published in the
newspapers or magazines. Workout the exercises, from suggested Reading books.
106
7.10 SUGGESTED READINGS / REFERENCE BOOKS
Management Accounting ---- S.N.Maheswari
Management Accounting ---- R. S. N. Pillai and Bhavathi
7.11 LEARNING ACTIVITIES
Students may organize a group discussion and critically examine the use of
various ratios. They should be clear in what are the items to be included under the
particular title (eg) what are the items comes under net worth.
The ratio analysis does not cover all the transactions, the students may identify
such areas and suggest new guidelines which develop the reliability of the ratio
analysis.
7.12 KEYWORDS
Bench mark
Solvency
Industry average
Consolidated
Liquid ratio
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LESSON 8
FUND FLOW ANALYSIS
8.1 INTRODUCTION
The movement of funds from one period plays a vital role in making decisions
on working capital. Hence a detailed study of Fund Flow analysis is essential to
identify the sources and application of the particular period
8.2 OBJECTIVES
The student can understand the meaning, concept of Fund Flow Analysis from
this. This lesson also explains the techniques of preparing the fund flow analysis.
8.3 CONTENT
8.3.1 Fund Flow analysis Meaning
8.3.2 Concept of fund flow analysis
8.3.3 Uses of fund flow analysis
8.3.4 Funds flow statement and income statement
8.3.5 Preparation of funds flow statement
8.3.6 Techniques of funds flow statement
8.3.1 FUND FLOW ANALYSIS - MEANING
The fund flow analysis is a method by which we study the net funds – flow
between two points of time. The points confirm to beginning and ending financial
statement dates for whether period of examination is relevant a quarter of a year.
‘A statement of sources and application of Funds is a technical device designed
to analyse the change in the financial conditions of a business enterprise between
two dates’.
Thus a funds flow analysis is a flexible device designed to disclose and
emphasize all significant changes and transactions within the current asset or
liability group. Fund flow analysis is a report on financial operations changes Flows
are moving the period. Here the term funds denote the working capital. Working
capital is often regarded as the difference of current assets and current liabilities.
Hence the term’ fund and working capital’. Both are synonymous. Various titles are
used for this statement such as statement of Sources and Applications of funds,
summary of Financial Operations; Changes in Financial position Statement; Funds
Received and Disbursed; Funds Generated and expended. Financial Expansion and
Replacement, Money provided and its Disposition Statement, etc. It is really difficult
to find short title for any statement which conveys much to the students as to the
contents and functions. The title of a funds flow statements can be modified from
time to time in order to emphasis a particular event.
Funds refers to the net effect of all changes in sources and uses in cash flows.
It may mean change in cash only or change in working capital only. Funds may
mean change in financial resources arising from changes in working capital items
108
and from financing and investing activities of the enterprise, which may involve
only non-current items.
The term “Fund” generally refers to cash, and equivalents or to working capital.
There are two concepts of working capital-gross concept and net concept. Gross
working capital refers to firms investment incurrent assets while the term net
working capital means excess of current assets over current liabilities.
8.3.2 CONCEPT OF FUND FLOW ANALYSIS
The fund flow arise when the net effect of a transaction is to increase or
decrease the amount of working capital. Normally a firm will have some
transactions that will change net working capital and some that will cause no
change in net working capital. Transactions which change net working capital
include most of the items of the profit and loss account and those business events
which simultaneously affect both current and noncurrent balance sheet items.
For (eg) if a company issues ordinary shares for cash. Two accounts are
involved in this case – the cash account, which is a current (assets) account and
share capital account, which is not current assets account. Working capital gets
increase. Similarly a company purchase machinery for cash, the cash account
(current assets) and machinery account (fixed assets) are affected. This has the
effect of decreasing working capital.
Some transactions do not change working capital. For (eg) if a company receive
cash from its debtors. It represents increase of cash that is one current account
(cash) increased and another current assets (debtors) decreased. So there is no
change in the amount of working capital although the composition of working
capital will change.
8.3.3 USES OF FUNDS FLOW ANALYSIS
It is useful tool in the financial manager’s analytical kit. The basic purpose of
this statement is to indicate where funds came from and where they were used
during the given period.
1. It shows the past performance of the firm and future possible expansion
of the firm. He can detect imbalances in the uses of funds and
undertake appropriate actions.
2. It helps to evaluate the firm’s financing. An analysis of the major
sources of funds in the past reveals what positions of the firm growth
was financed internally and what position externally.
3. It clearly defines the past flow of funds and gives insight into the
evaluation of the present situation. The financial manager of the
company uses it to spot-light the causes of present financial strain.
4. It provides certain useful information to banker, creditors and
governments etc., for which they do not require to approach the top
management specially.
109
5. An analysis of fund statement for the future is extremely valuable in
long term financing. It tells the firms total prospective need for funds,
the expected timing of these needs and their nature.
6. It shows the exact liquidity position of the firm. It can be verified
through fund flow statement.
7. It enriches the planning function of the firm.
8. It gives clear picture of funds, the shareholders are satisfied and
motivated. It helps to distribute possible dividend.
9. It helps to allocate the resources, ie., scarce resources for meeting the
productive requirement of the business.
10. It is a test of effective use of working capital by the management during
a particular period.
11. Fund flow analysis is also helpful in preparing the budgets.
8.3.4 FUNDS FLOW STATEMENT AND INCOME STATEMENT
1. A funds Flow Statement deals with the financial resources required for
running the business activities. It explains how were the funds obtained
and how were they used. Where as an Income Statement disclose the
results of the business activities, i.e., how much has been earned and how
it has been spent.
2. A funds Flow Statement matches the “Funds raised” and “ funds applied”
during a particular period. The sources and applications of funds may be of
capital as well as of revenue nature. An Income Statement matches the
income of a period with the expenditure of that period which are both of a
revenue nature. For example, where shares are issued for cash, it becomes
a source of funds while preparing a funds flow statement but it is not an
item of income for an income statement.
3. Sources of funds are many besides operations such as share capital
debentures, sale of fixed assets, etc. An Income Statement which discloses
the results of operations cannot even accurately tell about the funds from
operations alone because of non fund items (such as depreciation, writing
off of fictitious assets, etc.,) being include therein.
4. Thus both Income Statement and Funds Flow Statement have different
functions to perform. Modern management needs both. One cannot be a
substitution for the other rather they are complementary to each other.
8.3.5 PREPARATION OF FUNDS FLOW STATEMENT
In order to prepare a Funds Flow Statement, it is necessary to find out the
“sources’ and “Application” of funds.
Sources of Funds
The sources of funds can be both internal as well as external.
110
Internal Sources
Funds from operations, is the only internal sources of funds. However,
following adjustments will be required in the figure of Net Profit for finding out real
funds from operations.
Add the following items as they do not result in outflow of funds
1. Depreciation of fixed assets.
2. Preliminary expenses or goodwill, etc., written off.
3. Contribution to debenture redemption fund, transfer to general reserve,
etc., if they have been deducted before arriving at the figure of net profit
4. Provision for taxation and proposed dividend are usually taken as
appropriations of profits only and not current liabilities for the purposes
of Funds Flow Statement. This is being discussed in detail later. Tax or
dividends actually paid are taken as applications of funds. Similarly,
interim dividend paid is shown as an application of funds. All these
items will be added back to net profit, if already deducted, to find funds
operations.
5. Loss on sale of fixed assets.
Deduct the following items as they do not increase funds:
1. 1.profit on sale of fixed assets since the full sale proceeds are taken as a
separate source of funds and inclusion here will result in duplication.
2. profit on revaluation of fixed assets.
3. non-operating income such as dividend received or accrued dividend
refund of income tax, rent received or accrued rent. These items
increase funds but they are non-operating incomes. They will be shown
under separate heads as “sources of founds” in the Funds Flow
Statement.
In case the profit and loss account shows “Net Loss” this should be taken as an
item which decreased the funds.
External Sources
These sources include:
i. Funds from long term loans
Long term loans such as debentures, borrowing from financial institutions will
increase the working capital and, therefore, there will be flow of funds. However, it
the debentures have been issued in consideration of some fixed assets, there will be
no flow of funds.
ii. Sale of fixed assets
sale of land, building, long term investments will result in generation of funds.
111
iii. Funds from increase in share capital
Issue of shares for each or for any other current assets results in increase in
working capital and hence there will be a flow of funds.
Application of funds
The uses to which funds are put are called ‘application of funds’. Following
are some of the purposes for which funds may be used:
i. Purchase of fixed assets
Purchases of fixed assets such as land, building, plant, machinery, long
term investments, etc., results in decrease of current assets without any
decrease in current liabilities. Hence, there will be a flow of funds. But
in case shares or debentures are issued for acquisition of fixed assets,
there will be no flow of funds.
ii. Payment of dividend
Payment of dividends results in decrease of a fixed liability and,
therefore, it affects funds. Generally, recommendation of directors
regarding declaration of dividend (ie., proposed dividends) is simply,
taken as an appropriation of profits and not as an item affecting the
working capital. This has been explained in detail
iii. Payment of fixed liabilities
Payment of a long term liability, such as redemption of debentures or
redemption of redeemable preference shares, results in reduction of
working capital and hence it is taken as an application of funds.
iv. Payment of tax liability
Provision for taxation is generally taken as an appropriation of profits
and not as an application of funds. But if the tax has been paid, it will
be taken as an application of funds.
8.3.6 TECHNIQUE FOR PREPARING A FUNDS FLOW STATEMENT
A fund flow statement depicts change in working capital. It will, therefore, be
better for the students to prepare first a Schedule of Changes in working capital
before preparing a Funds Flow Statement.
Schedule of Changes in Working Capital
The schedule of changes in working capital can be prepared by comparing the
current assets and the current liabilities of two periods. It may be in the following
form.
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Schedule of Changes in Working Capital
Items As on .... As on... Changes
increase decrease Current Assets (add) Cash balance
Bank balance Marketable securities Accounts receivable
Stock in trade Pre paid Expenses
Less Current Liabilities Bank overdraft Outstanding expenses
Accounts payable
Net increase/ Decrease in working capital
Rules for preparing the schedule
1. Increase in a current assets, results in crease (+) in “working capital”
2. Decrease in a current asset, results in decrease (-) in “working capital”
3. Increase in a current liability, results in decrease (-) in “working capital”
4. Decrease in a current liability, result in increase (+) in “working capital”
Funds Flow Statement
While preparing a funds flow statement, current assets and current liabilities
are to be ignored. Attention is to be given to change in Fixed Assets and Fixed
Liabilities. The statement may be prepared in the following form.
Sources of funds:
Issue of shares .............
Issue of debentures .............
Long term borrowings .............
Sale of fixed assets .............
Operating profit .............
If net decrease in working ............
_______________
Total Sources ............
_______________
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Application of funds
Redemption of redeemable
Preference shares .....................
Redemption of debentures ................
Purchase of fixed assets ................
Operating loss ................
Payment of dividends, tax, etc. .................
If net increase in working
Capital ................
_________________
Total Uses ..................
_________________
Practical problems:
1. The balance sheets of Sun and Moon Ltd. For the year ended 31st December
2008 and 2009 are as follows:
Balance Sheet
Liabilities 31.12.2008 31.12.2009 Assets 31.12.2008 31.12.2009
Share capital 80,000 1,20,000 Freehold
premises
55,400 1,13,200
Share Premium 8,000 12,000 Plant & Machinery
35,600 51,300
General reserve 6,000 9,000 Furniture &
Fixtures
2,400 1,500
Profit and Loss A/c
19,500 20,800 Stock 22,100 26,000
5% Debentures 26,000 Debtors 36,500 39,100
Creditors 33,500 36,400 Bank 4,800 4,000
Income tax
provision
9,800 10,900
1,56,800 2,35,100 1,56,800 2,35,100 Depreciation written off during the year 2009 was as under.
Plant & Machinery Rs.12,800
Furniture & Fittings Rs. 400
Prepare a statement of sources and uses of funds.
Solution:
114
Schedule of changes in working capital
particulars 2008 2009 Increase Decrease
Current Assets:
Stock
Debtors
Bank balance
Less: Current Liabilities:
Creditors
Income tax provision
Working Capital
Increase in working
capital
22,100
36,500
4,800
26,000
39,100
4,000
3,900
2,600
800
2,900
1,100
63,400
33,500
9,800
69,100
36,400
10,900
43,300 47,300
20,100
1,700
21,800
6,500
4,800
1,700
21,800 21,800 6,500 6,500
Statement of sources and uses of funds
Sources Rs. Uses Rs.
Issue of shares
Share premium
Issue of debentures
Sale of furniture and
fixtures
Funds from operations
40,000
4,000
26,000
500
17,500
Purchase of freehold
premises
Purchase of plant and
machinery
Increase in working capital
57,800
28,500
1,700
88,000 88,000
115
Plant and Machinery Account
Rs. Rs.
To balance b/d
To cash (purchase)
35,600
28,500
By adjusted profit and loss
a/c (depreciation)
By balance c/d
12,800
51,300
61,400 61,400
Furniture and Fitting Account
Rs. Rs.
To balance b/d
2,400
By adjusted profit and loss
a/c (depreciation)
By cash (sale)
By balance c/d
400
500
1,500
2,400 2,400
General Reserve Account
Rs. Rs.
To balance c/d
9,000
By balance b/d
By adjusted profit and loss
a/c
6,000
3,000
9,000 9,000
Adjusted Profit & loss account
Rs. Rs.
To plant & machinery
(depreciation)
To furniture and fixtures
(depre)
To General Reserve
To balance c/d
12,800
400
3,000
20,800
By balance b/d
By Funds from operations
(?)
19,500
17,500
37,000 37,000
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2. Balance sheets of M/s Black and White as on 1.1.2009 and 31.12.2009 were
as follows.
Balance Sheet
Liabilities 1.1.2009 31.12.2009 Assets 1.1.2009 31.12.2009
Creditors 40,000 44,000 Cash 10,000 7,000
Mrs. White’s loan 25,000 ---
-
Debtors 30,000 50,000
Loan from
P.N.Bank
40,000 50,000 Stock 35,000 25,000
Capital 1,25,000 1,53,000 Machinery 80,000 55,000
Land 40,000 50,000
Building 35,000 60,000
2,30,000 2,47,000 2,30,000 2,47,000
During the year a machine costing Rs. 10,000 (accumulated depreciation Rs.
3,000) was sold for Rs.5,000. The provision for depreciation against machinery as
on 1.1.2009 was Rs.25,000 and on 31.12.2009 Rs.40,000. Net profit for the year
2009 amounted to Rs.45,000. You are requested to prepare funds flow statement.
Solution:
Schedule of changes in working capital
particulars 2008 2009 Increase Decrease
Current Assets:
Cash
Debtors
Stock
Less: Current Liabilities:
Creditors
Working Capital
Increase in working
capital
10,000
30,000
35,000
7,000
50,000
25,000
20,000
3,000
-----
10,000
4,000
75,000
40,000
82,000
44,000
35,000
3,000
38,000 20,000 17,000
3,000
38,000 38,000 20,000 20,000
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Funds Flow Statement
Sources Rs. Uses Rs.
Issue of shares
Loan from P.N.Bank
Funds from operations
5,000
10,000
65,000
Purchase land
Purchase building
Drawings
Repayment of Mrs. White’s loan
Increase in working capital
10,000
25,000
17,000
25,000
3,000
80,000 80,000
Plant and Machinery Account
Rs. Rs.
To balance b/d
1,05,000 By Cash (sale)
By provision for
Depreciation a/c
By adjusted profit and
loss a/c (Loss)
By balance c/d
5,000
3,000
2,000
95,000
1,05,000 1,05,000
Provision for Depreciation on Mechinery
Rs. Rs.
To Machinery
(depreciation of machinery
sold)
To balance b/d
3,000
40,000
By balance b/d
By adjusted profit and loss
a/c (depreciation)
25,000
18,000
43,000 43,000
Capital Account
Rs. Rs.
To Drawings
To balance c/d
17,000
1,53,000
By balance b/d By Net profit
1,25,000 45,000
1,70,000 1,70,000
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Adjusted Profit & loss account
Rs. Rs.
To Machinery (loss on sale)
To provision for depreciation To balance c/d
2,000
18,000 45,000
By balance b/d By Funds from operations
(?)
65,000
65,000 65,000
Exercise: 1.From the summarized balance sheets of kissan industries Ltd., prepare a
Fund flow statement for the year ended 31st March 2008
Balance Sheet
Liabilities 31.3.2007 31.3.2008 31.3.2007 31.3.2008
Share capital 10,000 10,000 Good will 1,200 1,200
P & L account 1,600 1,300 Land 4,000 3,600
General reserve 1,400 1,300 Building 3,700 3,600
Creditors 800 600 Investments 1,000 1,100
Outstanding expenses
120 180 Bills receivable 2,000 2,300
Provision for taxation
1,600 1,800 Bank 700 1,500
Provision for bad debts
80 100 Inventories 3,000 2,400
15,600 15,700 15,600 15,700 Additional Information:
1. A piece of land has been sold for Rs. 400
2. depreciation of Rs. 700 has been charged on building.
3. provision for taxation Rs.2,000 has been made during the year.
2. Bata Ltd. Supplies you the following balance sheets on 31 st December
2007 and 2008
Balance Sheet
Liabilities 2007 2008 2007 2008
Share capital 70,000 74,000 Bank balance 9,000 7,800
Bonds 12,000 6,000 Accounts receivable
14,900 17,700
Accounts payable 10,360 11,840 Inventories 49,200 42,700
Provision for
doubtful debts
700 800 Land 20,000 30,000
Reserve and Surplus 10,040 10,560 Good will 10,000 5,000
1,03,100 1,03,200 1,03,100 1,03,200
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Following additional information has also been supplied to you:
1. Dividend amounting to Rs. 3,500 was paid during the year.
2. Land was purchased for Rs. 10,000
3. Rs. 5,000 was written off on goodwill during the year.
4. Bonds of Rs. 6,000 were paid during the course of the year. You are required to prepare a statement of sources and uses of funds.
8.4 REVISION POINT
Fund flow analysis is a detailed study of how the funds moved from one point
of time to another point of time. Net flow of funds between two points of time.
Concept of Fund Flow Analysis.
The fund flow arise when the net effect of a transaction is to increase or decrease the amount of working capital.
Uses of the Funds Flow Analysis
It shows the past performance of the firm. It helps to know the major sources of
funds. This statement help in planning the working capital requirements.
8.5 INTEXT QUESTIONS
1. What are the uses of funds flow analysis?
2. Differentiate the term fund flow statement and income statement.
3. Explain any three internal sources and external sources of funds.
4. Is there any difference between funds and working capital – suggest your views.
8.6 SUMMARY
In this lesson, the nature of the fund flow is clearly discussed. The
meaning and definition of the fund flow is given.
Fund flow is a statement of sources and applications of funds. It is a
techniques device designed to analyse the change in the financial
conditions of a business enterprise between two dates. If refers to the
net effect of all changes in sources and uses in cash flow.
Funds flow analysis is major tool in financial analysis. It shows the past
performance of the firm. It help to evaluate the firm’s financing it shows
the exact liquidity of position of the firm. The techniques of preparation
of fund flow statement is also explained in this chapter.
8.7 TERMINAL EXERCISES
1. Issue of shares relate with
a. Application of funds b. Funds from operation
c. Sources of funds
2. Increase in current assets relate with
a. Decrease in working Capital b. Increase in working capital
c. Increase in the cash level
120
3. Operating loss relates with
a. Application of funds b. Sources of funds c. Non-current assets
8.8 SUPPLEMENTARY MATERIALS
https://ocw.mit.edu
http://kesdee.com/
http://simplestudies.com/
http://repository.um.edu.my/
http://www.cimaglobal.com
8.9 ASSIGNMENT
Students may visit the organisations and consult the financial experts
regarding the uses and methods of preparing the fund flow analysis, collect the
reports of fund flow analysis from various journal and unpublished reports help the
students to get some practical knowledge. Write a note on practical uses of fund
flow analysis.
8.10 SUGGESTED READING / REFERENCE BOOKS
1. Management Accounting ---------- S.N. Maheswari
2. Management Accounting ---------- R.S.N. Pillai and Bhavathi
3. Financial management ---------- Khan and Jain
8.11 LEARNING ACTIVITIES
Students may do some problem solving sums with regard to the fund flow
analysis and get practical knowledge. Students may also meet the financial analysis experts and get through knowledge about fund flow analysis.
8.12 KEY WORDS
Sport light
Scarce resources
Non-operating income
Operating income
Funds from operation
Operational profit
Operating loss.
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LESSON-9
CASH FLOW ANALYSIS
9.1 INTRODUCTION
The movement of cash level in organisation plays a significant role in
determining the working capital. The cash level may increase or decrease during
the particular period due to various reasons. For (eg) if assets are purchased, the
cash level will be decreased. Maintaining proper level of cash is essential to meet
the day to day expenses and maintaining the liquidity of the firm.
9.2 OBJECTIVES
The student can understand the meaning of the cash flow analysis. This lesson
also explains the nature of the cash flow analysis. This lesson also gives guidelines
to prepare the cash flow statement.
9.3 CONTENT
9.3.1 Meaning
9.3.2 Cash flow and fund flow
9.3.3 Utility of cash flow analysis
9.3.4 Preparation of cash flow analysis
9.3.5 Format of a cash flow statement
9.3.1 MEANING
A cash flow statement is a statement depicting change in cash position from
one period to another. For example if the cash balance of a business is shown by its
balance sheet on 31 December 2012 is Rs. 20,000/- while the cash balance as per
its balance sheet on 31 December 2013 is Rs. 30,000/- there has been in flow of
cash Rs. 10,000 in the year 2013 as compared to the year 2012.
The cash flow statement explains the reasons for such inflows or outfl ows of
cash as it also helps management in making plans for the immediate future. A
projected cash flow statement will help the management in ascertaining how much
cash will be available to meet obligations to trade creditors, to pay back loans and
to pay dividend to the share holders.
The cash flow have important role in the business’ firm’s there is constant
inflow and outflow of cash what blood is to human body, cash is to business
enterprises, so a major responsibility of financial management of firm is to maintain
an adequate balance of cash. In many respects, the essence of finance function is
found in the provision of cash in sufficient amount and in proper time to meet the
needs of business.
9.3.2 CASH FLOW VS FUND FLOW
CASH FLOW FUND FLOW
1 It is concerned only with the change
in cash position
It is concerned with changes in
working capital
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2 It is merely record of cash receipts
and disbursements
It is not only the study of cash
but also the current assets which
are converted into cash.
3 It is a more useful tool to the
management for financial analysis in
short period ie to estimate the cash
position to meet the payments in
near future.
Fund flow analysis is useful to
estimate the funds availability to
meet long term commitments.
4 Cash is the part of the working
capital. Therefore an improvement in
cash position result in improvement
in the fund position.
Sound fund position does not
necessarily mean a sound cash
position
5 There is some technical difference
between cash flow and fund flow i.e.
Decrease in current liability decrease
cash level in cash flow analysis, since
cash paid out
Decrease in the current liability
leads to increase in the working
capital in fund flow analysis.
6 Changes in working capital level is
not considered
Changes in working capital level
is treated as an important source
for fund variations
7 It is useful for short run planning It is useful for medium term as
well as long – term planning
9.3.3 UTILITY OF CASH FLOW ANALYSIS
A cash flow statement is useful for short term planning. A business enterprise
needs sufficient cash to meet its various obligations in the near future, such as
payment for purchase of fixed assets, payment of debts maturing in the near
future, expenses of the business, etc. A historical analysis of the different sources
and applications for the immediate future. It may then plan out for investment of
surplus or meeting the deficit, if any. Thus cash flow analysis is an important
financial tool for the management. Its chief advantages are as follows.
1. Helps in Efficient Cash Management:
Cash flow analysis helps in evaluating financial policies and cash position.
Cash is the basis for all operation and hence a projected cash flow
statement will enable the management to plan and coordinate the financial
operations properly, the management can know how much cash is needed,
from which source it will be derived, how much can be generated internally
and how much would be obtained from outside.
2. Helps in Internal Financial Management:
123
Cash flow analysis provides information about funds which will be available
from operations. This will help the management in determining policies
regarding internal financial management, e.g. possibility of repayment of
long term debts, dividend policies, planning, replacement of plant and
machinery, etc
3. Disclose the Movement Of Cash:
Cash flow statement discloses the complete story of cash management. The
increase or decrease of cash and the reason therefore can be known. It
discloses the reasons for low cash balance in spite of low profits, however,
comparison of original forecast with the actual results highlights the trends
of movements of cash which may otherwise go undetected.
4. Disclose Success or Failure Of Cash Planning:
The extent of success or failure of cash planning can be known by
comparing the projected cash flow statement with the actual cash flow
statement and necessary remedial measures can be taken.
5. Other Utilities:
a. To know the liquidity position of the firm.
b. To know the causes of changes in the firm’s working capital or cash
position.
c. To know the amount of sales proceeds out of fixed assets.
9.3.4 PREPARATION OF CASH FLOW ANALYSIS
Cash flow statement is a statement which shows the inflows and outflow of
cash (or cash equivalent like bank balance, temporary investments) in a firm during
a particular period, usually one year. It indicates the cause for changes in cash
between two balance sheet dates.
The securities Exchange Board of India amended Clause 32 of the listing
agreement, in June 1995. It requires every listed company to give a cash flow
statement in the prescribed format along with the profit and loss account and
balance sheet.
Accounting Standard 3,
The institute of Chartered Accountants of India had issued Accounting
Standards 3(AS3): cash flow statement. As per the revised AS3, cash flows are
classified and reported under three heads
a. Cash Flows from Operating Activities
b. Cash Flows from Investing Activities
c. Cash Flows from Financing Activities
124
1. Cash Flows from Operating Activities:
It means net cash flows generated from the operations of the business.
2. Cash Flows from Investing Activities.
It includes cash flows from the sale or purchase of fixed assets and also cash
generated by way of dividend or interest
3. Cash Flows from Financing Activities:
These are cash flows caused by issue of shares and other securities, raising of
long term loans, repayment of dividend etc. The cash flow statement shows the net
cash inflow or outflow from each group of activities. It shows the reasons for
changes in cash balance during the period.
The revised AS3 is mandatory for all listed companies and other firms with an
annual turnover of more than Rs. 50 crores.
9.3.5 FORMAT OF CASH FLOW STATEMENT AS PER AS3:
A cash flow statement can be prepared in the following form:
Cash Flow Statement for the year ending as on ...............
A. Rs. Rs.
A. Cash Flow from Operating Activities:
Net profit before tax and extraordinary items
Adjustments for:
Depreciation
Gain / Loss on sale of fixed assets
Foreign exchange
Miscellaneous expenditure written off
Investment income
Interest
Dividend
Operating profit before working capital changes:
Adjustments for:
Trade and other receivables
Inventories
Trade payables
Cash generated from operations
Interest paid
Direct taxes paid
Cash flow before extraordinary items
Net Cash from operating Activities
125
B. Cash Flow from Investing Activities:
Purchase of fixed assets
Sale of fixed assets
Purchase of investments
Sale of investments
Interest received
Dividend received
Net Cash from / used in investing activities
C. Cash Flow from Financing Activities
Proceeds from issue of share capital
Proceeds from long – term borrowings/banks
Payment of long-term borrowing
Dividend paid
Net cash from / used in financing activities
Net increase / decrease in cash and cash equivalents
(A+B+C)
Cash and cash equivalents as at(opening balance)
Cash and cash equivalents as at(opening balance)
Practical problems:
From the balance sheet as on 31st March 2007 and 31st March 2008,prepare a
cash flow statement.
Balance Sheet
Liabilities 31.3.2007 31.3.2008 31.3.2007 31.3.2008
Share capital 1,00,000 1,50,000 Fixed assets 1,00,000 1,50,000
P & L account 80,000 1,20,000 Good will 50,000 40,000
10% debentures 50,000 60,000 Stock 30,000 70,000
Creditors 30,000 40,000 Debtors 50,000 90,000
Outstanding
expenses
10,000 15,000 Bills receivable 30,000 20,000
Bank 10,000 15,0000
2,70,000 3,85,000 2,70,000 3,85,000
Cash Flow Statement
As – 3 Revised Method
126
A. Cash Flows from
Operating Activities:
Net profit before tax 40,000
Add: Goodwill written off(W.N.2) 10,000
Cash operating profit 50,000
Working Capital Charges: increase in creditors (inflow)
10,000
Increase in outstanding expenses
(inflow)
5,000
Decrease in bills Receivable (inflow) 10,000
(5,000)
(50,000)
60,000
Increase in stock (outflow) (40,000)
Increase in debtors (outflow) (40,000)
Net cash used in operating activities
(50,000)
B. Cash Flows from Investing
Activities:
Purchase of fixed assets (outflow) (W.N.1)
Net Cash used in investing activities
C. Cash Flows from Financing
Activities
Issue of shares (inflow)(W.N.3) Issue of debentures (inflow) (W.N.4)
Net cash from financing Activities Net increase in cash & Cash
equivalents Cash and cash equivalents at the
beginning
50,000 10,000
5,000
10,000
Cash and Cash equivalents at the end 15,000
Working Notes: Opening balance Closing balance
1. Fixed assets 1,00,000 1,50,000
Purchase of fixed assets 50,000 outflow – investment activity
2. Good will 50,000 40,000
Goodwill written off Rs.10,000. It is added back to net profit to find out cash from
operations.
127
3. Share capital 1,00,000 1,50,000
Issues of shares Rs. 50,000. Inflow – financing activity
4. 10% Debentures 50,000 60,000
Issue of debentures Rs. 10,000 – inflow – financing activity.
1. The following are the summarized balance sheets of Anand & Bala as on
1.1.2008 and 31.12.2008 .
Balance Sheet
Liabilities 1.1.2008 31.12.2008 1.1.2008 31.12.2008
Share capital 1,25,000 1,53,000 Fixed assets 1,00,000 90,000
Loan from Anand 20,000 Land 40,000 50,000
Loan from Bank 40,000 50,000 Stock 35,000 30,000
Creditors 40,000 44,000 Debtors 30,000 50,000
Provision for
depreciation on machinery
25,000 40,000 Building 35,000 60,000
Bank 10,000 7,000
2,50,000 2,87,000 2,50,000 2,87,000 Machinery costing Rs. 10,000 was sold without any loss during the year. Net
profit for the year 2008 amounted Rs.50,000 prepare Cash Flow Statement.
Cash Flow Statement
As – 3 Revised Method
B. Cash Flows from Operating
Activities:
Net profit before tax Add: provision for depreciation during
the year(W.N.2)
50,000 15,000
Cash operating profit 65,000 4,000 5,000
Working Capital Charges: increase in creditors (inflow)
Increase in Stock (inflow)
Increase in debtors (outflow) (20,000)
54,000
Net cash used in operating activities
128
B. Cash Flows from Investing
Activities:
Sale of machineary (inflow)(W.N.1) Purchase of land (outflow)
Purchase of building (outflow)
Net Cash used in investing activities
10,000
(10,000) (25,000)
(25,000)
(32,000)
C. Cash Flows from Financing
Activities
Loan from bank (inflow)
Repayment of Mrs. Anand’s loan (outflow)
Drawings (outflow) (W.N.3)
Net cash from financing Activities
Net increase in cash & Cash equivalents Cash and cash equivalents at the
beginning
10,000
(20,000) (22,000)
(3,000)
10,000
Cash and Cash equivalents at the end 7,000
Working Notes: Opening balance Closing balance
1. Machinery at cost Rs. 1,00,000 Rs. 90,000
Sale of machinery Rs.10,000 – inflow – Investment activity.
2. Provision for depreciation Rs.25,000 Rs.40,000
Provision made during the year Rs.15,000. The amount is added back to net profit
to find out cash flow from operation.
3. Capital Account
To Drawings (?)
To balance (c/d)
Rs.
22,000
1,53,000
By balance b/d
By Net profit
Rs.
1,25,000
50,000
1,75,000 1,75,000
Drawings Rs. 22,000 – outflow – financing activity
4. Loan from bank Rs. 40,000 Rs.50,000
Loan from bank Rs.10,000 – inflow – financing activity
5. Loan from the Mrs. Anand Rs.20,000 ------
Repayment of the Mrs Anand’s loan Rs.20,000 outflow – financing activity.
129
Exercise:
1. The comparative balance sheets of Mr. White for the last two years were as
follows.
Liabilities 2007 2008 Assets 2007 2008
Loan from wife --- 20,000 Cash 11,000 15,000
Bills payable 12,000 8,000 Debtors 40,000 35,000
Creditors 25,000 52,000 Stock 25,000 30,000
Loan from bank 43,000 60,000 Machinery 20,000 14,000
Capital 66,000 34,000 Land & buildings 50,000 80,000
1,46,000 1,74,000 1,46,000 1,74,000 Additional information:
1. Net loss for the year 2008 amounted to Rs.13,000
2. During the year a machine costing Rs.5,000(accumulated depreciation Rs.2,000)
was sold for Rs.2,500. The provision for depreciation against machinery as on
31.12.2007 was Rs.6,000 and on 31.12.2008 Rs.7,000.
From the above information prepare a cash flow statement.
2. The comparative balance sheets of Royal Ltd for the last two years were as
follows.
Liabilities 2007 2008 Assets 2007 2008
Share Capital 1,00,000 1,60,000 Fixed assets @ cost 1,52,000 2,00,000
Retained earnings 70,250 85,300 Inventory 93,400 89,200
Accumulated
depreciation
60,000
40,000 Debtors 30,800 21,100
12% Debentures 50,000 -------- Prepaid expenses 3,950 3,000
Creditors 28,000 48,000 Bank 28,100 20,000
3,08,250 3,33,300 3,08,250 3,33,300
Additional Information:
1. Net profit during the year was Rs. 27,750
2. Depreciation charged Rs. 10,000
3. Cash dividend declared during the year Rs.12,000
4. An addition to building was made during the year at a cost of Rs.78,000: a
fully depreciated equipment costing Rs. 30,000 was discarded and no salvage value
was realised.
5. Prepare a cash flow statement.
9.4 REVISION POINTS
The cash flow statement explain the reasons for the inflows or outflows of
cash. It helps the management in taking decision with regarded to working capital
requirements. A major responsibility of the financial management of a firm is to
maintain a adequate balance of cash.
130
Cash Flow and Fund Flow
Cash flow is concerned only with the change in cash position. Fund flow is
concerned with changes in working capital. Cash flow is useful for short-run
planning. Fund flow is useful for medium and long terms planning.
Fund flow is useful for medium and long term planning but cash flow is merely
record of cash receipts and disbursements.
9.5 INTEXT QUESTIONS
1. What do you mean by cash flow? Explain its importance in managerial
decision making?
2. Explain the difference between cash flow analysis and fund flow analysis.
3. Explain the various sources for cash flow.
4. Define the term cash flow.
5. How would you determine the efficiency of cash management?
9.6 SUMMARY
Cash flow statement is a statement depicting change in the cash position. Cash
flow statement explains the reasons for changes in the cash level. There are lot of
difference between cash flow analysis and fund flow analysis. The cash flow
statement only depicts the cash level changes. The fund flow statement is
concerned with the level of changes in working capital i.e., currents assets. The
cash flow statement has more managerial uses i.e., efficient cash management and
evaluate the cash planning.
9.7 TERMINAL EXERCISES
1. Loss on account of operations will be
a. Result in inflow of cash
b. Result in outflow of cash
c. Result in no change in cash
2. Gains from sale of fixed assets will be
a. Add with the current year net profit
b. Added with the previous year net profit
c. Deducted from the current year net profit
3. Decrease in current assets relate with
a. Increase in cash level
b. Decrease in cash level
c. No change in cash level
131
9.8 SUPPLEMENTARY MATERIALS
http://kesdee.com/
http://simplestudies.com/
http://repository.um.edu.my/
9.9 ASSIGNMENTS
Do some home works with regard to cash flow statement from the suggested
books. Arrange group discussion among the students and identify the items which
impact the cash flow.
9.10 SUGGESTED READINGS / REFERENCE BOOKS
Principle of management Accounting--Man Mohan and S.N. Goyal
Management Accounting – S.N. Mahewsari
Accounting for Management ---- Bhattacharya & john
9.11 LEARNING ACTIVITIES
Read various journals and published, unpublished research report. Do more
home work on cash flow statements from the above mentioned supplementary
materials. Students may organise a group discussion with regard to the latest
development in cash flow analysis.
9.12 KEY WORDS
Obligations --- responsibility to assign
Projected cash flow – Estimated cash flow
Goodwill ---- Reputation gained from the public or shortage of assets in
the balance sheet assets side named as goodwill.
Preliminary expenses --- Expenses connected with the promotion of a
new firm (eg) Registration expenses.
132
LESSON -10
WORKING CAPITAL MANAGEMENT
10.1 INTRODUCTION
Proper management of working capital is very important, for the success of .an
'enterprise. It aims at protecting the purchasing power of assets and maximi zing
the return on investment. Constant management is required to maintain appropriate
levels in the various working capital components. Sales expansion, dividend
declaration, plant expansion, new product line, increased salaries and wages,
rising price levels etc., put added strain on working capital maintenance. Failure
of business is undoubtedly due to poor management and absence of a
management skill. Shortage of working capital, so often advanced as the main
cause for failure of concerns, is nothing but the clearest evidence of
mismanagement which is so common.
It has been found that the major portion of a financial manager's time is
utilized in the management of working capital. Current assets account for a very
large portion of the total investment of a firm. In some of the industrial current
assets on an average represent over three-fifth of-the total assets. In the case of
trading concerns they account for about 80 per cent, A firm may, sometimes, be able
to reduce the investment in fixed assets by renting or leasing plant and machinery.
But it cannot avoid Investment in cash, accounts receivable and inventory.. The
management of working capital also helps the management in evaluating various
existing or proposed financial constraints and financial offerings. All these factors
clearly indicate the importance of working capital management in a firm.
10.2 OBJECTIVES
After reading this lesson you should be able to:
Understand the concept of working capital
Classify the different types of working capital
Recognize the element of working capital
Assess the requirements of working capital
Identify the strength and weakness 'of inadequate or excess working
capital..
10.3 CONTENT
10.3.1 Concept of Working Capital
10.3.2 Classification of Working Capita!
10.3.3 Elements of Working Capital
10.3.4 Assessment of Working Capital Requirements
10.3.5 Problems of Inadequacy of Working Capital
10.3.6 Reasons for inadequacy of Working Capital
133
10.3.7 Excessive Working Capital
10.3.8 Principles of Working Capital
10.3.9 Sources of Working Capital
10.3.1 CONCEPTS OF WORKING CAPITAL
There are two concepts regarding the meaning of working Capital that is Net
Working Capital and Gross Working capital. According to one school of thought
(supported by distinguished authorities like Lincoin, Dorisl Stevens and Saliers)
Working Capital is the excess of current assets over current liabilities, as
designated in the following equation:
Working Capital = Current Assets — Current Liabilities
According to the other School of thought (supported by authorities like Mead
Baker, Mallot and Field), Working Capital represents only the current (capital)
assets. There is basis for both these contentions. To understand them, correct
conception of current assets and liabilities is essential. Current Assets are those
assets that in the ordinary course of business can be or will be turned into cash
within a brief period -(not exceeding one year, normally) without undergoing
diminution of value and without disrupting the organisation. Examples of current
assets are given below: (i)Cash in hand and in bank; (ii) Accounts receivable from
customers (less reserve); (iii) Promissory Notes, and Bills receivable from
customers (less reserve); (iv)Inventories comprising of raw materials, work-in-
progress, finished goods (of manufactures) (v) Marketable securities held as
temporary investment; (vi) Prepaid expenses; (vii) Maintenance materials; (viii)
Accrued income.
Current Liabilities are those liabilities intended at then inception to be paid in
ordinary course of business within a reasonable short time (normally within a year)
out of the current assets or by creating another current liability or the income of
the business. Its examples : (i) Accounts payable to creditors; (n) Notes or Bills
payable; (iii) Accrued expenses, such as accrued taxes, salaries and interest; (iv)
Bank over draft, cash credit; (v) Bonds to be paid within one year; (vi) Dividends
declared and payable.
The arguments of the first school of thought in regarding working capital as the
excess of current assets over current liabilities are as follows: (1) It is an established
definition of working capital which is in use since long; (2) This concept of working
capital enables the shareholders to judge the financial soundness of the concern
and the extent of protection afforded to them. It is particularly because with an
increase in short-term borrowings the working capital does not increase; it will
increase only by following the policy of ploughing back of profits or conversion of
fixed assets into liquid assets or by procuring fresh capital from shareholders; (3)
Any concern with an excess of current liabilities can successfully tide over periods
of emergency, e.g., depression; (4) Further, there is no obligation on the part of the
134
company to return the amount invested by the shareholder, (5) Such a definition
is of great use in ascertaining the true financial position of companies having
currents assets of similar amount.
Those who regard working capital and current assets as synonymous advance
the following arguments in support of their contention. (1) Earnings in each
enterprise are the outcome of both fixed as well as current assets. Individually
these assets have no significance. The points of similarity in these assets are that
both are borrowed and they yield profit much more than the interest cost. But the
distinction in the two lies in the fact that assets constitute the fixed capital of a
company, whereas current assets are of circulating nature. Hence, logic demands
that current assets should be considered as the working capital of the company; (2)
This definition takes into consideration the fact that there would be an automatic
increase in the working capital with every increase in the funds of the company; but
it is not so according to the net concept of working capital; (3) Every management is
interested in the total current assets out of which the operation of an enterprise is
made possible, rather Chan in the sources from where the capital is procured; (4)
The former concept of working capital may hold good only in the case of sole trader
or partnership organisation; but under the modern age of company organisation,
where there is divorce between ownership, management and control , the
ownership of current or fixed assets is of little significance.
10.3.2 CLASSIFICATION OF WORKING CAPITAL
Generally speaking, the amount of funds required for operating needs varies
from time to time in every business. But a certain amount of assets in the form of
working capital are always required, if a business has to carry out its functions
efficiently and without a break. These two types of requirements-permanent and
variable are the basis for a convenient classification of working capital:
Fig. Types of Working Capital (p.18)
Permanent
(or Fixed)
Working Capital
Temporary (or
Variable/ Fluctuating)
Seasonal Special Regular Reverse Margin(or Cushion)
135
1. Permanent or Fixed Working Capital: As is apparent from the adjective
'permanent' it is that part of the capital which is permanently locked up in the
circulation of current assets and in keeping it moving. For example, every,
manufacturing concern has to maintain stock of raw materials, works-in-progress
(work-in-process), finished products, loose tools and spare parts. It also requires
money for the payment of wages and salaries throughout the year.
The permanent or fixed working capital can again be subdivided into (i) Regular
Working Capi tal and (ii ) Reserve Margin or Cushion Working Capi tal . It is the
minimum amount of liquid capital needed to keep up the circulation of the capital
from cash to inventories to receivables and back again to cash. .This would
include a sufficient cash balance in the bank to discount all bills, maintain an
adequate supply of raw materials for processing, carry a sufficient stock of
finished goods to give prompt delivery and effect the lowest manufacturing costs,
and enough cash to carry the necessary accounts receivables for the type of business
engaged in. Reserve margin or cushion working capital is the excess over the need
for regular working capital that should be provided for contingencies that arise at
unstated periods. The contingencies included (a) raising prices, which may make it
necessary to have more money to carry inventories and receivables, or may make
i t advisable to increase inventories; (b)business depressions, which may raise
the amount of cash required to ride out usually stagnant periods; (c)strikes, fires
and unexpectedly severe competition, which use up extra supplies of cash; and
(d)special operations, such as experiments with new products or with new method of
distribution, war contracts, contractors to supply new businesses, and the like,
which can be undertaken only if sufficient funds are available, and which in many
cases mean the survival of a business.
2. Variable Working Capital : The variable working capital changes with the
volume of business. It may be sub-divided into (i) Seasonal and (ii) Special Working
Capital. In many lines of business (e.g., Gur or sugar and Fur industry operations
are highly seasonal and, as a result, working capital requirements vary greatly
during the year. The capital required to meet the seasonal needs of industry is
termed as Seasonal Working Capital. On the other hand, Special Working Capital
is that part of the variable working capital which is required for financing special
operations, such as the inauguration of extensive marketing campaigns,
experiments with new products or with new methods of distribution, carry ing put
of special jobs and similar to the operations that are outside the usual business of
buying, fabricating and selling.
This distinction between permanent and variable working capital is of great
significance particularly in arranging the finance for an enterprise. Regular or fixed
working capital should be raised in the same way as fixed capital is procured,
through a permanent investment of the owner or through long-term borrowing. As
business expands, this regular capital will necessarily expand. If the cash returning
136
from sales includes a large enough profit to take care of expanding operations
and growing inventories, the necessary additional working capital may be provided
by the earned surplus of the business. Variable needs can, however, be financed
out of short-term borrowings from the Bank us from public in Cue form of deposits.
The position with regard to the 'fixed working capital' and 'variable working
capital' can be shown with the help of the following figures:
Fig. 10.1 Steady Firm's working capital requirement
From the above figure it should not be presumed that permanent working capital
shall remain fixed throughout the life of the concern. As the size of the business grows, permanent working capital too is bound to grow. The position can be
depicted with the help of the following figure:
Variable working
capital
Fixed working capital
Period O X
Y A
mou
nt
1
Fig. 10.2 Growth Firm's working capital requirement
So unlike a static concern, the fixed working capital of a growing concern will
increase with the growth in its size.
10.3.3 ELEMENTS OF WORKING CAPITAL
(i) Cash: Management of cash is very important from firm's point of view.
There must be balance between the twin objectives of liquidity and cost while
managing cash. There must be adequate cash to meet the requirements of all
segments of the organisation. Excess cash may be costly for the concern as it will
increase the cost in terms of interest. Less cash may also be harmful to the
concern as it will not be able to meet the liabilities as the appropri ate time. Thus
the requirements of the cash must be estimated properly either by preparing cash
flow statements or cash budgets. This will help the management to invest the idle
funds remuneratively and shortages, if any, may be met timely by making different
arrangements. Therefore, it is necessary that every segment of the organisation
must have adequate cash in order to meet the requirements of that segment
without having surplus balances. Cash management is highly centralised whereby
cash inflows and outflows are centrally controlled but in multi-divisional
companies it may be possible to decentralise cash requirements so that every
company may have cash for its requirements,
(ii) Marketable (Temporary) Investments: Firms hold temporary investments
for surplus cash flows arising either during seasonal operations or out of sale of
long term securities. In most cases the securities are held primarily for
precautionary purposes-most firms prefer to rely on bank credit to meet temporary
transactions or speculative needs, but to hold some liquid assets to guard against a
possible shortage of bank credit. The cash forecast may indicate whether excess
cash available is temporary or "hot. If it is found that excess liquidity will be
temporary, the cash should then be invested in marketable but temporary
Variable working
capital
Period O X
Y
Am
ou
nt
investments. It should be remembered that even if a substantial part of idle cash is
invested even though for a short period, the interest earned thereon is significant.
(iii) Receivables: Management of receivables involves a trade off between the
gains due to additional sales on account of liberal credit facilities and additional cost
of recovering those debts. If liberal credit facilities are given to the customers, sales
will definitely increase. But on the other hand bad debts, collection expenses and
interest charge will increase. Similarly if the credit policy is strict, the sales will be
less and customers may go to the competitors where liberal credit facilities are
available. This will result in loss of profit because of less sales but there will be saving
because of less bad debts, collection and interest charges. Management of debtors
also covers analysis of the risks associated with advancing credit to a particular
customer. Follow up of debtors and credit collections are the remaining aspects of
receivables management.
(iv)Inventories: Inventories include all investments in raw materials, work-in-
progress, stores, spare parts and finished goods; they constitute an important part
of the current assets. The purchase of inventory involves investment which must be
properly controlled. There are many issues of inventory management which must
be taken into consideration as fixation of minimum and maximum level, deciding
the issue of pricing policy, setting up the procedures for receipts and inspection,
determining the economic ordering quantity, providing proper storage facilities,
keeping control on obsolescence and setting up an effective information system with
reference to inventories. Inventory management requires the attention of stores
manager, production manager and financial manager. There must be adequate
inventories in order to avoid the disadvantages of both inadequate and excessive
inventories.
(v) Creditors: Management of creditors is very important aspect of working
capital. If the payment of creditors is delayed there is a possibility of saving of some
interest but it can be very costly because it will spoil the goodwill of the concern in
the market, As far as possible, the credit manager should try to get the liberal
credit terms so that payment may be made at the stipulated time.
10.3.4 ASSESSMENT OF WORKING CAPITAL REQUIREMENTS
The following factors are considered for a proper assessment of the quantum of
working capital requirements:
(i) The Production Cycle: There is bound to be time span in raw materials
input in manufacturing process and the resultant output as finished product. To
sustain such production activities the requirement of investment in the form of
working capital is obvious. The lesser the production cycle (or the operating cycle)
the lesser will be the requirements of working capital. There are enterprises due to
their nature of business will have shorter cycle than others. Further, even within
the same group of industries, the more the application of technological advances
in, will result in shortening the operating cycle. In this context the choice of product
requiring shorter or greater operating cycle will have a direct impact on the
working capital requirements. This is a factor of paramount importance irrespective
of whether a new industry is venturing production of the first time or an on-going
business. Hence it can be said that the time span for each stage of the process of
manufacture if geared to improve upon will lead to better efficiency and utilisation
of working capital.
(ii) Work-in-Process: A close attention is to be given to the accumulation of
work-in-progress or work-in-process. Unless the sequences of production process;
leading to conversion into finished product is kept under close observation to
achieve better production and productivity, more and more working capital funds
will be tied up. In this context, proper production planning and control is vital.
(iii) Terms of Credit from Suppliers of Materials and Services: The more
the terms of credit is favourable i.e., the more the time allowed by the creditor's to
pay them, the lesser will be the requirement of working capital. Hence, the
negotiation with the suppliers in respect of price and the credit period is an
important aspect in working capital management. In this process the impact of the
requirement of finance is shared by the creditors for goods and services.
(iv) Realisation from Sundry Debtors: The lesser the time span between
selling the product and the realisation the more will be the quicker inflow of cash.
This, in turn, will reduce the finance required for working capital purposes. A
realistic credit control will reduce locking up of finance in the form of sundry
debtors, The impact of better realisation will not only help in reducing the working
capital fund requirement but also can boost up the finance needed for other
operational needs. The important factors in credit control will be; (a) volume of credit
sales desired; (b) terms of sales and (c) collection policy.
(v) Control on Inventories, The decision to maintain appropriate minimum
inventories either in the form of raw material, stores materials, work-in-process or
finished products is an important factor in controlling finance locked up. The
better the control on inventories the lesser will be the requirements of working
capital. The following vital factors involved in inventory management are to be
considered for an effective inventory control: (a)volume of sales, (b) seasonal
variation in sales, (c)selling- 'off the shelf, (d) stocking to gain from higher price
under inflationary conditions, (e) the operating cycle, i.e., the time interval between
manufacturing, selling and realization and (f) safety or buffer stock. A minimum
policy levels of stock may have to be maintained to seize the opportunity of selling
when there is spark in demand for the product.
(vi) Liquidity- versus Profitability : The management dilemma as to the
optimal balancing between liquidity (or solvency) and the profitability is another
factor of great importance on the determination of the level of working capital
requirement. In other words, the level of liquidity and the profitability to be
maintained according to goals of the financial management.
(vii) Competitive Conditions: The whole question of cash inflow depends as to
the quickness in selling the products and the realization thereof. In this context,
the nature of business and the product will be the two important contributory
factors as to the policy on the quantum of working capital requirements.
(viii) Inflation and the Price Level Changes : In an inflationary trend, the
impact on working capital is that more finance is needed for the same volume of
activity i.e., one has to pay more price for the purchase of same quantity of materials
or services to be obtained; Such raising impact of prices can be fully or partly
compensated by increasing the selling price of the product. All business may not be
in a position to do so due to their nature of product, competitive market or
Government's regulatory price.
(ix) Seasonal Fluctuation and Market Share of Product : There are
products which are mostly in demand in certain periods of the year. In other words,
there may not be any sale or only a fraction of the total sale in off-season due to
seasonal nature of demand for the product. There may be shifting of demand due to
better substitute of the product available. This means the company affected by this
economics, attempts to plan diversification to sustain profit, expansion and growth
of the business. In certain businesses, demands for products are of seasonal in
nature and for certain businesses, the raw materials buying have to be done during
certain seasonal timings. Naturally the working capital requirement will be more in
certain periods than in others.
(x) Management Policy, on Profits, Retained Profit, Tax Planning and
Dividend Policy: The adequacy of profit will lead to strengthen the financial
position of the business through cash generation which will be ploughed back as
internal source of financing. Tax planning is an integral part of working capital
planning. It is not only the question of quantum of cash availability for tax
payment at the appropriate time but also through tax planning the impact of tax
payable can be reduced. Dividend Policy considers the percentage of dividend to be
paid to the shareholders as interin and/or final dividend. There must be cash
available at the appropriate time after the dividend is declared. This way the dividend
payment is connected with working capital management.
(xi) Terms of Agreement: It refers to the terms and conditions of agreement
to repay loans taken from bankers and financial institutions and acceptance of
'fixed deposits' from public. The question of fund arrangement whether for working
capital needs or to long term loans is to be decided after taking into account the
repayment ability. The cash flow projection will have to be made accordingly.
(xii) Cash (Flow) Budget: In order to meet certain cash contingencies it may be
necessary to have liquidity in form of marketable securities as cash reservoir. This
extra cash reserve may remain as an idle. fund. This type of cash reserve is
necessary to meet emergency disbursements.
(xiii) Overall Financial and Operational Efficiency ; A professionally
managed company always applies appropriate tools and techniques to achieve
efficiency and utilization of working capital fund. Adequacy of assessment and control
of business will lead to improve the 'working capital turnover'. Management also will
have-to keep itself abreast of the environmental, technological and other changes
affecting the business so that an effective and efficient financial management can
play a vital role in reducing the problems of working capital management.
(xiv) Urgency of Cash : In order to avoid product becoming obsolete or to
under-cut the competitors to hold the market share or in case of emergency for
cash funds, it may be necessary to sell out products at a cheaper rate or at a
discount or allowing cash rebate for early reali zation from sundry debtors
(customers). This situation may boost up the cash availability. However, this sort
of critical situation should be avoided as this results in reducing profit.
(xv) Importance of Labour Mechanization: Capital intensive industries,
ie., mechanized and automated industries, will require lower working capital, while
labour intensive industries such as small scale and cottage industries will require
larger working capital.
(xvi) Proportion of Raw Material to Total Costs : If the raw materials are
costly, the firm may require larger working capital while if raw materials are
cheaper and constitute a small part of the total cost of production, lower working
capita! is required.
(xvii) Seasonal variation: During the busy season, a business requires larger
working capital while during the slack season a company requires 'lower working
capital. In sugar industry the season is-November to June, while in the woollen
industry the season is during the winter. Usually the seasonal or variable needs of
working capital are financed by temporary borrowing.
(xviii) Banking Connections: If the corporation has good banking connections
and bank credit facilities, it may have minimum margin of regular working capital
over current liabilities. But in the absence of the availability of bank finance, it
should have relatively larger among of net working capital.
(xix) Growth and Expansion: For normal rate of expansion in the volume of
business, one may have greater proportion of retained profits to provide for more
working capital; but fast growing concerns require larger amount of working capital.
A plan of working capital should be formulated with an eye to the future as well as
present needs of a corporation.
10.3.5 PROBLEMS OF INADEQUACY OF WORKING CAPITAL
In case of inadequacy of working capital, a business may have to face the
following problems:
(i) Production Facilities: It may not be possible to have the full utilization of
the production facilities to the optimum level due to the inability of buying sufficient
raw material and/or major renovation of the plant and machinery.
(ii) Raw Material Purchases: Advantage of buying at cash discount or on
favourable terms may not be possible due to paucity of funds..
(iii) Credit Mating: When financial crisis continues, the credit worthiness of
the company may be lost, resulting in poor credit rating.
(iv)Seizing Business Opportunities: In case of boom for the products and for
the business, the company may not be in a position to produce more to earn
'opportunity profit' as there may be inadequacy of finished products availability.
(v) Proper Maintenance of Plant and Machinery : If the business Is on
financial crisis, adequate sums may not be available for regular repair and
maintenance, renovation or modernization of plant to boost up production and to
reduce per unit cost.
(vi). Dividend Policy: In the absence of fund availability it may not be possible
to maintain a steady dividend policy. Under such financial constraint, whatever
surplus is available will be kept in general reserve account to strengthen the
financial soundness of the business.
(vii) Reduced Selling: Due to the constraint in working capital, the company
may not be in a position to increase credit sales to boost up the sales revenue.
(viii) Loan Arrangement: Due to the emergency for working capital the
company may have to pay higher rate of interest for arranging either short-term or
long-term loans.
(ix) Liquidity versus Profitability : The lower liquidity position may also
result in lower profitability.
(x) Liquidation of the Business: If the liquidity position continues to remain
weak, the business may run into liquidation.
To remedy the situation of working capital crisis, the following steps are
required:
(a)An appraisal and review is to be conducted to minimize the operating cycle.
Adequate credit control measures are to be adopted for early and prompt
realization from the debtors.
Proper planning and control of cash management through cash flow
forecasting.
Whether more credit periods can be obtained for buying is to be explored.
10.3.6 REASONS FOR INADEQUACY OF WORKING CAPITAL
Inadequacy or shortage of working capital may arise for various reasons, of
which, the main reasons are the following:
(i) Operating losses: This may arise when the cost of production and other
related costs are more than the sales revenue, reduction in sales, falling prices,
increased depreciation.etc. It is obvious that a company facing losses will not have
any cash generation' to sustain its on-going business.
(ii) Extraordinary Losses: There may be exceptional losses due to fall in price
of finished product stocks, government action, obsolescence or otherwise. The effect
of such a loss will be a reduction in current assets or increase in current liabilities
without any corresponding favourable change in the working capital composition.
(iii) Expansion of Business: The company during the profitable years might
have invested substantially in fixed capital assets, increased production and
increased credit sales to make the sales volume grow rapidly. Against those activities,
the pitfalls of over-trading may show its ugly, face subsequently. That is why a
balancing judgement between investment, liquidity and profitability is to be drawn
and projected to save the business falling into financial crisis. Thus the continuity
and growth of the business may be jeopardised. Along with the increased sales
there may be increase in inventories and higher sundry debtors. Such excessive
build-up of inventories and receivables may amount to alarming figures.
:(iv) Payment of Dividend and Interest : The payment of interest for
borrowings will have to be made as per terms of agreement. Similarly, the payment
of dividend may have to be arranged to keep up the business prestige to the public
and to the shareholders. There may be profit to declare dividend but there may not
be adequate cash to disburse dividend. In case of insufficient funds to meet the
aforesaid, liabilities, the mobilizing of funds will be necessary.
10.3.7 EXCESSIVE WORKING CAPITAL
The following are the major disadvantages of having or holding excessive
working capital.
(i) Overtrading: A time may come when overtrading will engulf the financial
soundness of the business.
(ii) Excessive Inventories: The inventories holding may become excessive
under the influence of excessive funds availability.
(iii) Liquidity versus Profitability: The situation of liquidity and the
profitability may be misbalanced.
(iv) Inefficient Operation: Availability of excessive production facilities may
result in higher production but sales may not be anticipated to match goods
produced.
(v) Lower Return on Capital Employed : There may be reduced profi t in
relation to total capital employed resulting in lower rate of return on capital
employed,
(vi) Increased Fixed Capital Expenditure: As enough fund is available there
may be boost-up in acquiring plant and machinery to enhance production facilities.
In case there is not enough sales potentiality with adequate margin of profit
such fixed investment may not be worthwhile for fund employment.
10.3.8 PRINCIPLES OF WORKING CAPITAL MANAGEMENT
1.Principle of Risk Variation: If working capital is varied relative to sales, the
amount of risk that a firm assumes is also varied and the opportunity for gain or
loss is increased.
This principle implies that a definite relation exists between the degree of risk
that management assumes and the rate of return. That is, the more risk that a firm
assumes, the greater is the opportunity for gain or loss. It should be noted that
while the gain resulting from each decrease in working capital is measurable, the
losses that may occur cannot be measured. It is believed that while the potential
loss, the exactly opposite occurs if management continues to decrease working
capital that is to say., potential losses are small at first for each decrease in
working capital but increase sharply if it continues to be reduced. It should be the
goal of management to find that point of level of Working Capita! at which the
incremental loss associated with a decrease in Working Capital investment becomes
greater than the incremental gain associated with that investment. Since most of
the managers do not know what the future holds, they tend to maintain an
investment in working capital that exceeds the ideal level. It is this excess that
concerns since the size of the investment determines firm's rate of return on
investment. The obvious conclusion is that managers should determine whether
they operate in business that react favourably to changes in working capital levels, if
not, the gains realized may not be adequate in comparison to the risk that must be
assumed when working capital investment is decreased.
2, Principle of Equity Position: Capi tal should be invested in each
components of working capital as long as the equity position of the firm increases.
It follows from the above that the management is faced with the problem of
determining the ideal 'level' of working capital. The concept that each rupee
invested in fixed or variable working capital should contribute to the net worth of
the firm should serve as a basis for such a principle.
3. Principle of Cost of Capital: The type of capital used to finance working
capital directly affects the amount of risk that a firm assumes as well as the
opportunity for gain or loss and cost of capital.
Whereas the first principle dealt with the risk associated with the amount of
working capital employed in relation to sales, the third principle is concerned with
the risk resulting from the type of capital used to finance current assets. It has
been observed that return, to equity capital increases directly with the amount of
risk assumed by management. This is true but only to a certain point. When
excessive risk is assumed, a firm's opportunity for loss will eventually over-
shadow its, opportunity for gain, and at this point return to equity is threatened.
When this occurs, the firm stands to suffer losses. Unlike rate of return, cost of
capital moves inversely with risk; that is, as additional risk capital is employed by
management, cost of capital declines. This relationship prevails until the firm's
optimum capital structure is achieved; thereafter, the cost of capital increases.
4. Principle of Maturity of Payment: A company should make every effort to
relate maturities of payment to its flow of internally generated funds. There should
be the least disparity between the maturities of a firm's short-term debt
instruments and its flow of internally generated funds because a greater risk is
generated with greater disparity. A margin of safety should, however, be provided for
short term debt-payments.
5. Principle of Negotiation: The risk is not only associated with the amount
of debt used relative to equity, it is also related to the nature of the contracts
negotiated by the borrower. Some of the clauses of the contracts such as
restrictive clause and dates of maturity directly affect a firm's operation: Lenders of
short term funds are particularly conscious of this problem and they ask for cash
flow statements. Lenders realize that a firm's ability to repay short-term loan
directly related to cash flow and not to earnings and, therefore, a firm should make
every effort to tie maturities to its flow of internally generated funds. This concept
serves as the basis for the final hypothesis of this presentation. Specifically, it
may be stated as follows: "The greater the disparity between the maturities of
firm's short term debt instrument and its flow of internally generated funds, the
greater the risk and vice-versa". One can see that it is possible for a firm to face
insolvency or embarrassment even though it might be making a profit. It is
extremely difficult to predict accurately a firm's cash flow in an economy such as
ours. Therefore, a margin of safety should be included in every short term debt
contract; that is, adequate time should be allowed between the time the funds are
generated and the date of maturity.
Steps Involved in Efficient Management of working capital
1. Proper financial set up with appropriate authority and responsibility,
2. Coordination between the following functional areas in the organisation:
Production planning and control
Sales Credit control
Materials management
Optimal utiliztion of fixed plant and machinery together with other
facilities. Sale of uneconomical fixed assets
Acquiring plant and machinery to augment production.
Cost reduction programme
3. Financial planning and control for achieving increased profitability to have
adequate 'cash generation' and 'plough back' of profits so that there is adequate
internal source of finance.
4. Proper cash management through projection of cash flow and source and
application of funds flow statement.
Establishing appropriate Information and Reporting System.
10.3.9 SOURCES OF WORKING CAPITAL
1. Permanent working capital: Issue of shares , debentures and transfer
from retained earnings.
2. Term loans from the financial institutions (developments banks) (eg)
IDBI.
3. Cash advance from the customers.
4. Factoring: it involves an outright sale of receivables of affirm to a
financial institutions at discount rate. They will assume the collection
services from the debtors.
5. Discounting the bills with banks and accepting houses.
6. Credit from friends and relatives.
7. Issue commercial paper. It is a form of issuance promissory note
negotiable by endorsement and delivery. It may be issued even at
discount. It has been prescribed by the RBI of India. The investor is
assured of ready liquidity.
8. Certificate deposit is document of title similar to a deposit receipt issued
by a bank. It is a bearer document, hence readily negotiable. The
investor is assured of ready liquidity.
9. Issuing bonds to public for a specific period with fixed interest rate.
10. Attracting deposit from the public.
10.4 REVISION POINTS
Working Capital = Current Assets – Current Liabilities
Net Working Capital, Gross Working Capital
Fixed and variable working capital
Problems of inadequacy of working capital
Dangerous of excess working capital.
10.5 INTEXT QUESTIONS
1. Discuss the importance of working capital for a manufacturing concern.
2. Explain the various determinants of working capital of a concern.
3. What are the advantages of having ample working capital funds?
4. Differentiate between fixed working capital and variable working capital.
5. What are the different principles of working capital management?
6. Summarize the causes for and changes in working capital of a firm.
10.6 SUMMARY
Proper management of working capital is very important, for the success of .an
'enterprise. It aims at protecting the purchasing power of assets and maximi zing
the return on investment. Constant management is required to maintain appropriate
levels in the various working capital components. Sales expansion, dividend
declaration, plant expansion, new product line, increased salaries and wages,
rising price levels etc., put added strain on working capital maintenance.
There are two concepts of working capital. Net working capital and Gross
working capital.
There are two types of working capital, they are (i) fixed or Permanent and (ii)
Temporary or variable
10.7 TERMINAL EXERCISES
1. The total of all currents means
(a) Working capital (b) Net working capital (c) Gross working capital.
2. Generally the major portion of working capital constitutes
(a) Cash (b) Receivable (c) Inventories (d) Debtors
10.8 SUPPLEMENTARY MATERIALS
http://kesdee.com/
http://simplestudies.com/
http://repository.um.edu.my/
10.9 ASSIGNMENT
Prepare a report on various techniques used in working capital management.
Prepare an essay on effective management of working capital. How would you
determine the level of working capital.
10.10 SUGGESTED READINGS / REFERENCE BOOKS
Working Capital Management. by Agarwal . N. K. New Delhi, Sterling
Publications (P) Ltd.
Financial Management, by Khan M.Y. and Jain. P.K. New Delhi, Tata McGraw
Hill Co.,
Working Capital Management, by Ramamoorthy V.E. Madras, Institute for
Financial Management and Research.
10.11 LEARNING ACTIVITIES
Special conference may be arranged impart more knowledge about working
capital management to the students. Students may arrange group discussion and
identify new ideas or techniques to determine the optimum level of working capital.
Collect the information regarding the practical applications of working capital
management.
10.12 KEY WORDS
Working capital
Net working capital
Gross working capital
LESSON - 11
WORKING CAPITAL FORECASTING TECHNIQUES AND FINANCING
POLICY
11.1 INTRODUCTION
Working capital requirements can be determined mainly in three ways: Per
cent-of-sales method, Regression analysis method, and the working capital cycle
method
11.2 OBJECTIVES
After reading this lesson you should be able to:
Know the concept of working capital cycle
Identify the working capital gap
Explain the working capital forecasting techniques
11.3 CONTENT
11.3.1 Per cent-of-sales method
11.3.2 Regression analysis method
11.3.3 The working capital cycle method
11.3.4 Financing Policy Meaning
11.3.5 Matching ( Moderate) approach
11.3.6 Aggressive Approach
11.3.7 Conservative Approach
11.3.8 Balanced policy
11.3.1 PER CENT-OF-SALES METHOD
It i s a tradi tional and simple method of determining the volume of working
capital and its components, sales being a dominant factor. In this method, working
capital is determined as a percent of forecasted sales. It is decided on the basis of
past observations. If over the year, relationship between sales and working capital
is found to be stable, then this relationship may be taken as
a standard for the determination of working capital in future also. This
relationship between sales and working capital and its various components may be
expressed in three ways: (i) as number of days' of sales, (ii) as turnover, and (i ii) as
percentage of sales.
The per cent-of-sales method of determining working capital is' simple and easy
to understand and is useful in forecasting of working capital requirements,
particularly in the short-term. However, the greatest drawback of this method is
the assumption of linear relationship between sales and working capital. Therefore,
this method cannot be recommended for universal application. It may be found
suitable by individual companies in specific situations.
11.3.2 REGRESSION ANALYSIS METHOD
As stated earlier the regression analysis method is a very useful statistical
technique of forecasting. In the sphere of working capital management it helps in
making projection after establishing the average relationship in the past years
between sales and working capital (current assets) and its various components. The
analysis can be carried out through the graphic portrayals (scatter diagrams) or
through mathematical formula.
The relationship between sales and working capital or various components may
be simple and direct indicating complete linearity between the two or may be
complex in differing degree involving simple linear regressions or simple
curvil inear regression, and multiple regressions situations.
This method, with a range of techniques suitable for simple as well as complex
situations, is an undisputed refinement on traditional approaches of forecasting
and determining working capital requirements. It is particularly suitable for long-
term forecasting.
11.3.3 WORKING CAPITAL CYCLE METHOD
The working capital cycle refers to the period that a business enterprise takes
in converting cash back into cash. As an example, a manufacturing firm uses cash
to acquire inventory of materials that is converted into semi finished goods and then
into finished goods. When finished goods are disposed of to customers on credit,
accounts receivable are generated. When cash is collected from customers, we again
have cash. At this stage one operating cycle is completed. Thus a circle from cash-
back-to-cash is called the working capital cycle. This concept is also be termed as
"Pipe Line Theory" as popularly known.
Fig. 11.1 Working Capital Cycle
2.Inventory of raw
materials
3.Semi finished goods
4.Inventory of finished
goods
5.Accounts receivable
1.Cash
Thus we see that an working capital cycle, generally, has the following four
distinct stages:
1. The raw materials and stores inventory stage;
2. The semi-finished goods or work-in-progress stage;
3. The finished goods inventory stage; and
4. The accounts receivable or book debts stage.
Each of the above working capital cycle stage is expressed in terms of number of
days of relevant activity and requires a level of investment to support it. The sum
total of these stage-wise investments will be the total amount of working capital of
the firm.
A series of such operating cycle recur one after another and chain continues till
the end of the operating period. In this way the entire operating period has a
number of operating cycles. It is important to note that the velocity or speed of this
cycle should not slacken at any stage; otherwise the normal duration of the cycle will
be lengthened, resulting in an increased need for working fund. The faster the speed
of the operating cycle, shorter will be its duration and larger will be the number of
total operating cycles In a year (operating period) which in turn would be
instrumental in giving the maximum level of turnover with comparatively lower
level of working fund.
The four steps involved in this method are: (i ) computing the duration of the
operating cycle, (ii) calculating the number of operating cycles in the operating period,
(iii) estimating the total amount of annual operating expenses, and (iv) ascertaining
the total working capital requirements. Each step is discussed with some detail in
the following paragraphs.
(i) Duration of Operating Cycle: The duration is computed in days by adding
together the average storage period, of raw materials, works-in-progress, finished
goods and the average collection period and then deducting from the total the
average payment period. The formula to express the framework of the operating
cycle is:
O = (R + W + F + D) - C
where: O = Duration of operating cycle
R = Raw material average storage period
W = Average period of work-in-progress
F = Finished goods average storage period
D = Debtors collection period
C = Creditors payment period
The average inventory, trade creditors, work-in-progress, finished goods and
book debts can be computed by adding the opening and closing balances at the end
of the year in the respective accounts and dividing the same by two. The average
per day figures can be obtained by dividing the concerned annual figures by 365 or
the number of days in the given period.
(ii) Number of Operating Cycle in Operating Period : This is found out by
dividing the total number of days in the operating period by number of days in the
operating cycle as shown below :
N = P / O
where: N = Number of operating cycle in operating period
P = Number of days in the operating period
O = Duration of operating cycle (in days)
Suppose the operating period is one year (365 days) and the duration of
operating cycle is 73 days then the number of operating cycles in the operating
period will be:
𝑁 =365
73= 5 𝐶𝑦𝑐𝑙𝑒𝑠
(i ii ) Total amount of Annual Operating Expenses: These expenses include
purchase of raw materials, direct labour costs and the overhead costs-calculated on
the basis of average storage period of raw materials and the time-lag involved in the
payment of various items of expenses. The aggregate of such separate average
amounts will represent the annual operating expenses.
(iv) Estimating the Working Capital Requirement: This is calculated by
dividing the total annual operating expenses by the number of operating cycles in
the operating period as shown below:
R =E
𝑁
where : R = Requirement of Working Capital (Estimated)
E= Annual Operating Expenses
N = Number of operating cycles in the operating Period
The amount of working capital thus estimated is increased by a fixed percentage
so as to provide for contingencies and the aggregate figure gives the total estimate
of working capital requirements. The operational cycle method of determining
working capital requirements gives only an average figure. The fluctuations in the
intervening period due to seasonal or other factors and their impact on the working
capital requirements cannot be judged in this method. To identify these impacts,
continuous, short-run detailed forecasting and budget exercises are necessary.
Illustration 1
The following data have been extracted from the financial records of Prabhakar Enterprises Limited:
Raw Materials Rs. 8 per unit, Direct Labour, Rs. 4 per unit, and Overheads Rs.
80,000
Additional information
i. The company sells annually 25,000 units @ Rs. 20 per unit. All the goods
produced are sold in the market.
i i . The average storage period for raw materials is 40 days and for finished
goods it is 18 days.
i ii . The suppliers give 60 days credit facility to the firm for purchases. The firm
also sells goods on 60 days credit to i ts customers.
iv. The duration of the production cycle is 15 days and raw material is issued
at the beginning of each production cycle.
v. 25% of the average working capital is kept as cash for contingencies,
On the basis of the above information, estimate the total working capital
requirements of the firm under Operating Cycle Method.
Solution
Duration of Operating Cycle Days
i. Materials storage period 40
ii. Production cycle period 15
iii. Finished goods storage period 18
iv. Average collection period 60
________
133
Less : Average payment period 60
_________
Duration of Operating Cycle 73
Number of Operating Cycles in a year: Total Number of Days in a year divided
by Duration of operating Cycle =365
73= 5 𝑐𝑦𝑐𝑙𝑒𝑠 𝑖𝑛 𝑦𝑒𝑎𝑟.
Total Annual Operating Expenses
Raw Material 25,000×8 = 2,00,000
ii. Direct Labour 25,000×4 = 1,00,000
iii. Overheads 80,000
_________
Total Operating Expenses for the year 3,80,000
_________
Estimating Working Capital Requirements
=Total anual operation expenses
Number of operation cycles in the year=
3,80,000
5= 𝑅𝑠. 76,000
Add. 25% of the above by cash
(for Contingencies) 19,000
__________ Total Working Capital Requirement 95,000
__________
Illustration 2
Messrs Senthil Industries Ltd. are engaged in large scale retailing. From the
following information, you are required to forecast their working capital requirements
of this trading concern.
Projected annual sales 65 Lakhs
Percentage of Net Profit on cost of sales 25 %
Average credit allowed to Debtors 10 Weeks
Average credit allowed by Creditors 4 weeks
Average stock carrying (in terms of sales requirement) 8 weeks
Add 10% to computed figures to allow for contingencies.
Solution
Statement of Working Capital Requirements
Selling Price
Basis (Rs. In lakhs)
Cost Price
Basis (Rs. In lakhs)
Current Assets Stock Rs.1.00 lak x 8 Debtors
At cost equivalent Rs.1.00 lak x 10 = 10 lak
Profit Rs. 13
52× 10 = 2.5 lakhs
Less Current Liabilities Creditors Rs.1.00 x 4 =
Working Capital Computed Add. 10 % contingencies
Net Working Capital
8.00
12.50
8.00
10.00
20.50
4.00
18.00
4.00
16.50
1.65
14.00
1.40
18.15 15.40
Projected annual Sales --- 65 lakhs
Net profit 20 % on sales or 25% on cost of sales ... 13 lakhs
Cost of sales (65 – 13) = Sales – Profit ... 52 lakhs
Cost of sales per week ( 52 weeks in a year) 1 lakh
Note : It has been assumed that the creditors include those for both goods and
expenses and that all such creditors allow one month credit on average.
Interpretation of Results 4 The amount of working capital fund above is to
be interpreted as the amount to be blocked up in inventory, debtors (minus
creditors)at any time during the period(year)in view, in order that the anticipated
activity (sales primarily)can go on smoothly. The amount is not for a period of time
but at any point of time. It represents the maximum(or the highest)quantum of
locking up at any time during the period.
Illustration 3
Ramaraj Brothers private Limited sells goods on a gross
Profit of 25%. Depreciation is taken into account as a part of cost of
production. The following are the annual figures given to you.
Rs.
Sales (two months credit) 18,00,000
Materials consumed (one month’s credit) 4,50,000
Wages paid (one month lag in payment) 3,60,000
Cash manufacturing expenses (one month
Lag in payment) 4,80,000
Administration expenses(one month
Lag in payment) 1,20,000
Sales promotion expenses (paid quarterly in
Advance) 60,000
Income tax payable in 4 instalments of which
One lies in the next year 1,50,000
The company keeps one months’ stock each of raw materials and finished
goods. It also keeps Rs.1,00,000 in each. You are required to estimate the working
capital requirements of the company on cash basis assuming 15% safety margin.
Solution:
Statement of Working
Currents Assets: Rs.
Debtors (cash cost of goods sold i.e, 14,70,00 x2/12) 2,45,000
Prepaid sales expenses 15,000
Inventories 37,500
Raw materials (4,50,000/12) 1,07,500
Finished goods (12,90,000/12) 1,00,000
Current Liabilities:
Sundry creditors (4,50,000/12)
5,05,000
37,500
Outstanding manufacturing expenses (4,80,000/12) 40,000
Outstanding administration expenses (1,20,000/12) 10,000
Provision for taxation (1,50,000/4) 37,500
Outstanding wages (3,60,000/12) 30,000
1,55,000
Working Capital ( CA – CL) 3,50,000
52,500 Add. 15% for contingencies
Total Working Capital required 4,02,500
Working Notes:
1. Total Manufacturing Expenses RS.
Sales 18,00,000
Less : Gross profit 25% on sales 4,50,000
____________
Total cost 13,50,000
Less: Cost of materials Rs.4,50,000
Wages Rs.3,60,000
_________ 8,10,000 __________
Manufacturing Expenses 5,40,000
2.Depreciation:
Total Manufacturing Expenses 5,40,000 Less: Cash Manufacturing Expenses 4,80,000
_________ Depreciation 60,000 _________
1. Total Cash Cost:
Total Manufacturing Cost 13,50,000
Less: Depreciation 60,000
__________
12,90,000
Add. Administrat ion Expenses 1,20,000
Sales promotion Expenses 60,000
__________
Total Cash Cost 14,70,000
11.3.4 FINANCING POLICY
The current assets financing plan may be readily related to the broader issue of
the financing plan for all the firms' assets. The firm has a wide variety of financing
policies it may choose, and the fact that short-term financing usually is less costly
but involves more risk than long-term financing plays an important part in
describing the degree of aggressiveness or conservatism of the firm's financing
policy.
In comparing financing plans we .should distinguish between three different
kinds of financing; (i) permanent source of financing, (ii) temporary source of
financing and (iii) the spontaneous short-term financing. A firm's investment is
namely financed by the some of its spontaneous, temporary and permanent sources
of financing.
(i) A permanent investment in an asset is one that the firm expects to hold for
period longer than one year Permanent investments are made in the firm's
minimum level of current Assets as well in i ts fixed assets. Permanent sources of
financing include intermediate and long-terns debt, preference share and equity
share
(ii) Temporary investments are comprised of the firm's investments in current
assets, which will be liquidated and not replaced within the current year. For
example, a seasonal increase in the level of inventory is a temporary investment as
the holding up in inventories will be eliminated when it is no longer needed.
Temporary source of financing is a current liability. Thus, temporary financing
consists of the various sources of short-term debt including secured and unsecured
bank loans, commercial paper, factoring of accounts receivables, and public
deposits.
iii) Besides permanent and temporary sources of financing, there al so exist
spontaneous sources. Spontaneous sources consist of the trade credit and other
accounts payable- that arise spontaneously in the firm's day-to-day operations.
Examples include wages and salaries payable, accrued interest, and accrued
taxes.
These expenses generally arise in direct conjunction with the firm's ongoing
operations; they are referred to as spontaneous. Popular example of a spontaneous
source of financing involves the use of trade credit. As the firm acquires materials for
its inventories, credit is often made available spontaneously or on demand by the firm's
suppliers. Trade credit appears on the firm's balance sheet as accounts payable.
The size of the accounts payable balance varies directly with the firm's purchases
of inventory items, which in turn are related to the firm's anticipated sales. Thus, a
part of the financing needs by the firm is spontaneously provided by its use of trade
credit.
The long term working capital can be conveniently financed by (a) owners
equity e.g. shares and retained earnings,(b) lenders' equity e.g. debentures,
and(c)fixed assets reduction e.g., sale of assets, depreciation on fixed assets etc.
This capital can be preferably obtained from owners' equity as they do not carry
with them any fixed charges in the form of interest or dividend and so do not throw
any burden on the company. Intermediate working capital funds are ordinarily raised
for a period varying from 3 to 5 years through loans which are repayable in
instalments e.g., working capital term-loans from the commercial banks or from
finance corporations.
11.3.5 MATCHING (OR MODERATE) APPROACH
Matching approach is also called Hedging principle. It involves matching the
cash flow generating characteristics of a firm's assets with the maturity of the
source of financing used. The rationale for matching is that since the purpose of
financing is to pay for assets, when the asset is expected to be relinquished so
should the financing be relinquished. Obtaining the needed funds from a long-term
source (longer than one year) would mean that the firm would still have the funds
after the inventories have been sold. In this case the firm would have "excess"
liquidity, which they either hold in cash or invest in low yielding marketable
securities. This would result in an overall lowering of firm profits. Similarly arranging
finance for shorter periods that the assets require is also costly in that there will be
.extra transaction costs involved in continually arranging new short-term financing.
Also, there is always the risk that new financing cannot be obtained in times of
economic difficulty.
The firm's permanent investment in assets is financed by the use of either
permanent source of financing (intermediate-and long-term debt, preference shares,
and equity shares) or spontaneous source (trade credit and other accounts
payable,), its temporary investment in assets is financed with temporary (short-term
debt) and/or spontaneous sources of financing. Note the matching approach has
been modified to state: Asset needs of the firm, not financed by spontaneous
sources, should be financed in accordance with the rule: permanent asset
investments financed with permanent sources and temporary investments financed
with temporary sources.
Since total assets must always equal to the sum of spontaneous, temporary,
and permanent sources of financing, the hedging approach provides the financial
manager with the basis for determining the sources of financing to use at any point
in time.
11.3.6 AGGRESSIVE APPROACH
The firm's financing plan is said to be aggressive if the firm uses more short-
term negotiated financing than is needed under a matching approach. The firm is
no longer financing all its permanent assets with long-term financing. Such plans
are said to be aggressive because they involve a relatively heavy use of (riskier)
short-term financing. The more short-term financing used relative to long-term
financing, the more aggressive is the financing plan. Some firms are even financing
part of their long-term assets with short-term debt, which would be a highly
aggressive plan.
11.3.7 CONSERVATIVE APPROACH
Conservative financing plans are those plans that use more long-term financing
than is needed under a matching approach. The firm is financing a portion of its
temporary current assets requirements with long-term financing. Also, in periods
when the firm has no temporary current assets the firm has excess (unneeded)
financing available that will be invested in marketable securities. These plans are
called conservative because they involve relatively heavy use of (less risky) long-term
financing.
Comparison of Conservative, Hedging and Aggressive Approaches: These
approaches to working capital financing can be compared on the basis of (a) cost
considerations, (b) profitability considerations, and (c) risk considerations (probability
of technical insolvency). The following statement gives a comparative evaluation.
Comparative Evaluation of Financing Approaches
Financial
Approaches or plan
Cost Risk Return of profitability
Conservative High Low Low Hedging Moderate Moderate Moderate
Aggressive Low High High
11.3.8 BALANCED POLICY
Because of the impracticalities in implementing the matching policy and the
extreme nature of the other two policies, most financial managers opt for a compromise
position. Such a position is the balanced policy. As its name implies, management
adopting this policy balances the trade-off between risk and profitability in a manner
consistent with its attitude toward bearing risk. The long-term financing is used to
support permanent current assets and part of the temporary current assets. Thus
short-term credit is used to cover the remaining working capital needs during
seasonal peaks. This implies that as any seasonal borrowings are repaid, surplus
funds are invested in marketable securities.
This policy has the desirable attribute of providing a margin of safety not found
in the other policies. If temporary needs for current assets exceed management's
expectations, the firm will still be able to use unused short-term lines of credit to
fund them. Similarly, if the contraction of current assets is less than expected,
short-term loan payments can still be met, but less surplus cash will be available
for investment in marketable securities. In contrast to the other working capital
policies, a balanced policy will demand more management time and effort. Under
the policy, the financial manager will not only have to arrange and maintain short-
term sources of financing but must be prepared to manage the investment of excess
funds.
The Appropriate Working Capital Policy
The analysis so far has offered insights into the risk-profitability trade-off
inherent in a variety of different policies. Just as there is no optimal capital
structure that all firms should adopt, there is no one optimal working capital policy
that all firms should employ. Which particular policy is chosen by a firm will
depend on the uncertainty regarding the magnitude and timing of cash flows
associated with sales; the greater this uncertainty, the higher the level of working
capital necessary. In addition, the cash conversion cycle will influence a firm's
working policy; the longer the time required to convert current assets into cash, the
greater the risk of illiquidity. Finally, in practice, the more risk averse management
is the greater will be the net working capital position. The management of working
capital is an ongoing responsibility that involves many interrelated and
simultaneous decisions about the level and financing of current assets. The
considerations and general guidelines offered in this lesson should be useful in
establishing an overall net working capital' policy.
Illustration 1
Following is the summary of Balance Sheets of a firm under the three
approaches:
Policy
Conservative Hedging Aggress ive
Liabilitie s
Current Liabilit ies 5,000 15,000 25,000 Long term loan 25,000 15,000 5,000 Equity 50,000 50,000 50,000
Total 80,000 80,000 80,000 Assets:
Current Assets
(a) Permanent Requirement (b) Seasonal Requirement
20,000 15,000 45,000
20,000 15,000
45,000
20,000 15,000
45,000 Fixed Assets Total 80,000 80,000 80,000
Additional Information
i. The firm earns, on an average, approximately 6% on investments in current assets and 18% on investments in fixed assets,
ii. Average cost of current liabilities is 5% and average cost of long-term funds is 12%.
Compute the costs and returns under any three different approaches, and
comment on the policies.
Solution
i. Computation of Costs under Conservative, Matching & Aggressive
Approaches.
Conservative Hedging (Matching)
Aggressive
Cost of Current
Liabilit ies 5 % on
5,000= 250 15,000 = 750 25,000=1,250
Cost of long term
funds 12 % on
75,000 = 9,000 65,000 = 7,800 55,000 = 6,600
Total Cost 9,250 8.550 7,850 ii. Computation of returns under the three Approaches
Conservative Hedging (Matching)
Aggressive
Return of Current Assets 6 % on
35,000 = 2,100 35,000 = 2,100 35,000 = 2,100
Return of Fixed Assets 18 % on
45,000 = 8,100 45,000 = 8,100 45,000 = 8,100
Total Return
Less: Cost of financing
Net Return
10,200
(9,250)
10,200
(8,550)
10,200
(7,850)
950 1,650 2,350
iii. Measurement of (a) Liquidity (b) Risk of Commercial Insolvency i.e.
illiquidity under the three approaches
Conservative Hedging (Matching)
Aggressive
(a) Net Working
Capital (CA-CL)
35,000 -5,000 = 30,000
35,000 -15,000 = 20,000
35,000 -25,000 = 10,000
(b) Current
Ratio (CA _ CL)
35,000
5,000
= 7 : 1
35,000
15,000
= 2.33 : 1
35,000
25,000
= 1.4 : 1
Comments
(i) Cost of financing is highest being Rs. 9,250 in conservative approach, and
lowest (Rs. 7,850) in aggressive approach (the total funds being the same, i.e., Rs.
80,000).
(ii) Return on investment (net) is lowest in conservative approach being
Rs.950 and highest in aggressive approach being Rs. 2,350.
(iii) Risk is measured by the amount of net working capital. The larger the net
working capital, the lesser will be the degree of technical insolvency or the lesser will
be the inability to meet obligations on maturity dates. In other words, larger net
working capital means less risk. The net working capital is comparatively larger in
conservative approach and therefore, the degree of risk is low. The net working capital
is comparatively lower in aggressive approach, and, therefore, the degree of risk is
high.
Risk is also measured by the degree of liquidity. The larger the degree of
liquidity, the lesser will be the degree of risk. One of the measurements of degree of
liquidity is current ratio; it is also known as 'Working Capital Ratio: This ratio signifies
the firm's ability to meet its current obligations. The larger the ratio, the greater
the liquidity, and the lesser the risk. In conservative approach, current ratio is the
highest being 7 : 1 , and in aggressive approach, this ratio is lowest being 1.4 : 1.
Therefore, there is low risk in conservative approach.
The aforementioned analysis leads to the following conclusions :
(i) In conservative approach, cost is high, risk is low, and return is low.
(ii) In aggressive approach, cost is low, risk is high, and return is high.
Hedging approach has moderate cost, risk and return. It aims at trade-off
between profitability and risk.
11.4 REVISION POINTS
Working capital requirements can be determined mainly in three ways: Per
cent-of-sales method, Regression analysis method, and The working capital cycle
method.
Approach of working capital --- Matching (or) Moderate Approach, Aggressive
Approach, Conservative Approach.
11.5 INTEXT QUESTIONS
1. What are the different methods of forecasting working capital
requirements?
2. Explain:, (a) Core current assets (b) Working Capital Gap (c) Working
capital cycle
3. What are the risk-return trade-offs involved in choosing a mix of
short- and long-term financing?
PRACTICAL PROBLEMS
1.The Board of Directors of Guru Nanak Engineering Company Private Ltd, requests you to prepare a statement showing the Working Capital Requirements
Forecast for a level of activity of 1,56,000 units of production.
The following information is available for your calculation: Raw materials 90 per unit Direct Labour 40 per unit
Overheads 75 per unit ______
205 Profits 60 ______
Selling price per unit 265 ______
B. (i) Raw materials are in stock on average one month. (ii) Materials are in
process, on average two weeks, (iii) Finished goods are in stock, on average one
month (iv) Credit allowed by suppliers one month (v) Time lag in payment from
debtors 2 months (vi) Lag in payment of wages 1 .j weeks.
(vii) Lag in payment of overheads is one month
20% of the output is sold against cash. Cash in hand and at Bank is expected
to be Rs.60,000. It is to be assumed that production is carried on evenly throughout
the year, wages and overheads accure similarly and a time period of 4 weeks is
equivalent to a month. [Ans: Working Capital Required Rs.74,13,000]
Notes(i) Since wage's and overheads accrue evenly on average, half the wages
and overhead would be included in working progress. Alternatively if it is assumed
that the direct labour and overhead are introduced at the beginning. full wages and
overhead would be included.
2. A proforma cost sheet of a company provides the following particulars:
Elements of Cost
Raw Materials 40%
Labour 10%
Overheads 30%
The following further particulars are available:
a. Raw materials are to remain in stores on an average 6 weeks.
b. Processing time is 4 weeks.
c. Finished goods are required to be in stock on average period of 8 weeks
d. Credit period allowed to debtors, on average 10 weeks.
e. Lag in payment of wages 4 weeks
f. Credit period allowed by creditors 4 weeks
g. Selling price is Rs.50 per unit
You are required to prepare an estimate of working capital requirements adding
10% margin for contingencies for a level of activity of 1,30,000 units of production.
[Ans: Working Capital Required=Rs.25,2,5000]
3. From the following information extracted from the books of a manufacturing concern, compute the operating cycle in days -
Period covered : 365 days
Average period of credit allowed by suppliers 16 days. Average total of debtors outstanding 4,80,000 Raw-Material Consumption 44,00,000
Total Production Cost 1,00,00,000 Total cost of Sales l ,05,00,000
Sales for the year 1,60,00,000 Value of average stock maintained -
Raw Materials 3,20,000
Work-in-Progress 3,50,000
Finished goods 2,60,000
[Ans.: Total period of operating cycle 44 days]
4. The management of Jayant Electrical Ltd. is faced with various alternatives
for managing its current assets. The company is producing 1,00,000 units of
electrical heaters. This is its maximum installed capacity. Its selling price per unit is
Rs.50. The entire output is sold in the market. Fixed assets of the company are
valued at Rs. 20 lakhs. '
The company earns 10% on sales before interest and taxes. The management is
faced with three alternatives about the size of investment in current assets. (i) to
operate with current assets of Rs. 20 lakhs, or (ii) to operate with current assets of
Rs, 15 lakhs, or (iii) to operate with current assets of Rs 10 lakhs.
You are required to show the effect of the above three alternative current assets management policies on the degree of profitability of the company. [Ans.: (i)
Conservative Policy (i i ) Moderate Policy ( i i i ) Aggressive Policy.
5. (a) Total investments:
In Fixed Assets 1,20,000
In Current Assets 80,000 ___________ 2,00,000
Earning (EBIT) is 25%. (b) Debt-ratio is 60%. (c) Rs. 80,000 being (40% assets) financed by the equity shareholder,
i.e., long-term sources. (d) Cost of short-term debt and long-term debt is 14% and 16% respectively.
(e) Assume Income-tax @ 50%. As a result of the financing policy, ascertain the return on equity shares.
[Ans.: Return on equity is highest in aggressive policy]
11.6 SUMMARY
Working capital requirements can be determined mainly in three ways: Per cent-of-sales method, Regression analysis method, and The working capital cycle method
Working capital is called cash – back – to – cash. Thus working cycle has four distinct stage, they are raw materials and stores inventory stage, semi finished
goods or Work in progress stage, finished goods inventory stage and finally accounts receivable stage.
There are three approaches in working capital, they are Matching or Moderate
approach, Aggressive approach, Conservative approach.
11.7 TERMINAL EXERCISE
1. Aggressive approach means
(a) using short term finance (c) using equity finance
(b) using long term finance (d) using retained earnings.
2. Matching approach is also called
(a) Aggressive Approach (b) Conservative Approach
(c) Hedging Approach
11.8 SUPPLEMENTARY MATERIALS
http://dosen.narotama.ac.id/
http://www.osbornebooksshop.co.uk/
http://www.fao.org/
11.9 ASSIGNMENT
1.Evaluate the following statement: "A firm can reduce its risk of illiquidity with higher current-asset investments, but the return on capital goes down."
2. There are four different policies that managers must consider in designing their working capital policy. Explain the salient features of each policy. What are
the advantages and disadvantages of each such policy?
11.10 SUGGESTED READINGS
1. Agarwal, F.K : Working Capital Management, New Delhi, Sterling Publications (P) Ltd.
2. Kulshrestha, R.S. : Financial Management, Agra, Sahitya Bhavan.
3. Ramamoorthy, V.E. : Working Capital Management, Madras, Institute for Financial Management and Researc
11.11 LEARNING ACTIVITIES
Make group discussion on working capital management in a manufacturing
industry. And write short note about various working capital forecasting technique adopted by those industry.
11.12 KEY WORDS
Working capital gap
Working capital cycle
Duration of operating cycle
Hedging Approach
Conservative Approach
Aggressive Approach.
LESSON 12
IMPORTANCE OF CAPITAL BUDGETING
12.1 INTRODUCTION
Capital budgeting decisions are of paramount importance in financial
decisions, because efficient allocation of capital resources is one of the most crucial
decisions of financial management. Capital budgeting is budgeting for capital
projects. It is significant because it deals with right kind of evaluation of projects.
The exercise involves ascertaining / estimating cash inflows and outflows, matching
the cash inflows with the outflows appropriately and evaluation of desirability of the
project. It is a managerial technique of meeting capital expenditure with the overall
objectives of the firm. Capital budgeting means planning for capital assets. It is a
complex process as it involves decisions relating to the investment of current funds
for the benefit to be achieved in future. The overall objective of capital budgeting is
to maximize the profitability of the firm / the return on investment.
Capital Budgeting is the process of making investment decision in Fixed
assets or Capital expenditure. Capital Budgeting is also known as Investment
decision making, planning of capital acquisition, planning of capital expenditure,
analysis of capital expenditure.
12.2 OBJECTIVES
After completing this Lesson you should be able to know
Meaning of Capital Budgeting
Need and importance of Capital Budgeting
12.3 CONTENT
12.3.1 Capital Expenditure
12.3.2 Capital Budgeting Definition
12.3.3 Need and Importance of Capital Budgeting
12.3.1 CAPITAL EXPENDITURE
A capital expenditure is an expenditure incurred for acquiring or improving the
fixed assets, the benefits of which are expected to be received over a number of
years in future. The following are some of the examples of capital expenditure.
1. Cost of acquisition of permanent assets such as land & buildings, plant & machinery, goodwill etc.
2. Cost of addition, expansion, improvement or alteration in the fixed assets.
3. Cost of replacement of permanent assets.
4. Research and development project cost etc.
5. Capital expenditure involves non-flexible long term commitment of funds.
12.3.2 CAPITAL BUDGETING – DEFINITION
“Capital budgeting” has been formally defined as follows.
“Capital budgeting is long-term planning for making and financing proposed
capital outlay”. - Charles T. Horngreen
“The capital budgeting generally refers to acquiring inputs with long -term
returns”. - Richards & Greenlaw.
“Capital budgeting is concerned with the allocation of the firms’ source
financial resources among the available opportunities. The consideration of
investment opportunities involves the comparison of the expected future streams of
earnings from a project with the immediate and subsequent streams of earning
from a project, with the immediate and subsequent streams of expenditure” - G.C.
Philippatos,
“Capital budgeting consists in planning development of available capital for the
purpose of maximizing the long-term profitability of the concern” - Lyrich
“Capital budgeting involves the planning of expenditure for assets, the
returns from which will be realized in future time periods”. Milton H. Spencer
It is clearly explained in the above definitions that a firm’s scarce financial
resources are utilizing the available opportunities. The overall objective of the
company from is to maximize the profits and minimize the expenditure of cost.
Further, the long-term activities are those activities that influence firms operation
beyond the one year period. The basic features of capital budgeting decisions are:
There is an investment in long term activities
Current funds are exchanged for future benefits
The future benefits will be available to the firm over series of years.
The Investment of Funds in long term activities which are usually non-
flexible.
Each project involves huge amount of funds
Objective :
1. To find out the profitable capital expenditure.
2. Ensure efficient control over large investment and expenditures.
3. To find out the quantum of finance required for to capital expenditure.
4. To facilitate long – range planning.
5. To evaluate the merits of each proposal to decide which project is best.
12.3.3 NEED AND IMPORTANCE OF CAPITAL BUDGETING
Capital budgeting is the process of evaluating and selecting long-term
investments that are consistent with the goal of the firm. There are many factors
responsible for determining the need for capital investment like Expansion,
Diversification, Obsolescence, Wear and tear of old equipment, Productivity
improvement, Replacement and modernization and so on.
When the investments are profitable the firm’s value will increase and they
add to the shareholders’ wealth. The investment will add to the shareholders’
wealth if it yields benefits, in excess of the minimum benefits as per the opportunity
cost of capital.
The need and importance of capital budgeting has been explained as follows:
1. Long-term Implication
Capital expenditure decision affects the company's future cost structure over a
long time span. The investment in fixed assets increases the fixed cost of the firm
which must be recovered from the benefit of the same project. If the investment
turns out to be unsuccessful in future or give less profi t than expected, the
company will have to bear the extra burden of fixed cost. Such risk can be
minimized through the systematic analysis of projects which is the integral part of
investment decision.
2. Irreversible Decision
Capital investment decision are not easily reversible without much financial
loss to the firm because there may be no market for second-hand plant and
equipment and their conversion to other uses may not be financially viable. Hence,
capital investment decisions are to be carried out and performed carefully and
effectively in order to save the company from such financial loss. The investment
decision which is undertaken carefully and effectively can save the firm from huge
financial loss aroused due to the selection of unfavourable projects.
3. Long-term Commitments of Funds
Capital budgeting decision involves the funds for the long-term. So, it is long-
term investment decision. The long-term commitment of funds leads to the financial
risk. Hence, careful and effective planning is must to reduce the financial risk as
much as possible.
The significance of capital budgeting can also analyzed with the help of
following points.
Capital budgeting involves capital rationing. This is the available funds that
have to be allocated to competing projects in order of project potential.
Normally the individuality of project poses the problem of capital rationing
due to the fact that required funds and available funds may not be the same.
Capital budget becomes a control device when it is employed to control
expenditure. Because manned outlays are limits to actual expenditure, the
concern has to investigate the variation in order to keep expenditure under
control.
A firm contemplating a major capital expenditure programme may need to
arrange funds many years in advance to be sure of having the funds when
required.
Capital budgeting provides useful tool with the help of which the
management can reach prudent investment decision.
Capital budgeting is significant because it deals with right mind of
evaluation of projects. A good project must not be rejected and a bad project
must not be selected. Capital projects need to be thoroughly evaluated as to
costs and benefits.
Capital projects involve investment in physical assets such as land, building
plant, machinery etc. for manufacturing a product as against financial
investments which involve investment in financial assets like shares, bonds
or mutual funds. The benefits from the projects last for few to many years.
Capital projects involve huge outlay and last for years.
Capital budgeting thus involves the making of decisions to earmark funds
for investment in long term assets yielding considerable benefits in future,
based on a careful evaluation of the prospective profitability / utility of such
proposed new investment.
It is clear from the above discussion what capital investment proposals involve
a. Longer gestation period
b. Substantial capital outlay
c. Technological considerations
d. Irreversible decisions
e. Environmental issues
f. Independent proposals
g. Mutually exclusory proposals
4. Permanent Commitments of Funds
The investment made in the project Results in the permanent commitment of
Funds. The greater risk is also involved because of permanent commitment of
Funds.
5. National Importance
The selection of any project results in the employment opportunity,
economic growth and increase per capital income. These are the ordinary positive
impact of any project selection made by any company.
12.4 REVISION POINTS
1.Capital Expenditure A capital expenditure is an expenditure incurred for
acquiring or improving the fixed assets, the .benefits of which are expected to be
received over a number of years in future.
2. Capital Budgeting Capital budgeting involves the planning of expenditure
for assets, the returns from which will be realized in future time periods
3. The need and importance of capital budgeting has been explained as
Long-term Implication Irreversible Decision .Long-term Commitments of Funds,
Permanent Commitments of Funds, National Importance.
12.5 INTEXT QUESTIONS
1. Define capital Budgeting
2. Define Irreversible Decision
3.What do you mean by Long term implication?
12.6 SUMMARY
Capital Budgeting is the process of making investment decision in capital
expenditures. A capital Expenditure is an expenditure incurred for acquiring or
improving the fixed assets, the benefits of which are expected to be received over a
number of years in future. Capital expenditure involves non flexible long term
commitment of funds. Capital Budgeting is also known as long term investment
decision. Capital Budgeting decisions are among the most crucial and critical
business decisions. Special care to be taken in making these decisions on account
of the following reasons; heavy investment, permanent commitment of funds, long
term effect on profitability, irreversible in nature .
12.7 TERMINAL EXERCISE
1. …………………………..is the process of making investment decisions in
capital expenditures.
2. ………………………..is an expenditure incurred for acquiring or
improving the fixed assets, the benefits of which are expected over a number of years in future.
12.8 SUPPLEMENTARY MATERIALS
http://www2.fiu.edu/
http://www.fao.org/
https://msu.edu
http://people.hss.caltech.edu/
http://www.investopedia.com/
http://umanitoba.ca/
http://isites.harvard.edu/
https://www.cfainstitute.org
www.cengage.com
www.hss.caltech.edu
12.9 ASSIGNMENTS
1. Examine the need and importance of Capital Budgeting.
2. Highlight the basic features of capital Budgeting Decisions.
12.10 SUGGESTED READINGS /REFERENCE BOOKS
1. Agrawal, Shah, Mendiratta, Agarwal, Sharma, Tailor — Cost and
Management Accounting ( Malik and Co.)
2. Agrawal, Jain, Sharma, Shah, Mangal — Cost Accounting ( RBD, Jaipur)
3. Agarwal. M.R. — Managerial Accounting (Garima Publications)
4. Agrawal — Management Accounting (RBD. Jaipur)
12.11 LEARNING ACTIVITIES
Identify the importance of capital budgeting and relates with any one of the
organizations which is nearby you and correlate how they are giving importance to capital Budgeting
12.12 KEYWORDS
Capital Budgeting, Capital Expenditure, Long-term Implication, Irreversible
Decision. Long-term Commitments of Funds, Permanent Commitments of Funds, National Importance.
LESSON 13
METHODS OF EVALUATING CAPITAL INVESTMENT PROPOSAL
13.1 INTRODUCTION
The capital Budgeting techniques or evaluation of investment proposals have
considerably gained the importance. This is more true in the modern business
environment. After the introduction of New Economic Policy, the environments in
the industry and service sector have considerably changed. Number of mergers,
acquisition, and joint ventures and continues innovation are being experienced in
the markets. Therefore it is very difficult to arrive at decision for financing the
project. It is absolutely essential for every business entity to make use of this scare
resource on the most profitable lines. Following are some of the important methods
used in practice in evaluating the investment proposals.
13.2 OBJECTIVES
After completing this Lesson you should be able to know
Various techniques of investment Appraisal
Discounted and Non-Discounted Cash Flow Methods
Merits and demerits of Various techniques
13.3 CONTENT
13.3.1 Techniques of Investment Appraisal
13.3.2 Non-Discounted Cash Flow Criteria
13.3.3 Discounted Cash Flow Criteria
13.3.4 Discounted Cash Flow Techniques Merits
13.3.5 Discounted Cash Flow Techniques Demerits
13.3.6 Comparison Between NPV and IRR
13.3.1 TECHNIQUES OF INVESTMENT APPRAISAL
There are many methods for evaluating or ranking the investment proposals.
In all these methods, the basic approach is to compare the investments in the
project to the benefits derived there from. These methods can be categorized as
Follows:
13.3.2 NON-DISCOUNTED CASH FLOW CRITERIA / TRADITIONAL METHODS
Pay-back period
Discounted payback period
Accounting rate of return (ARR)
13.3.3 DISCOUNTED CASH FLOW (DCF) CRITERIA
Net present value (NPV)
Internal rate of return (IRR) / Excess PV Index method/benefit
Profitability index (PI) / Benefit cost ratio
NON-DISCOUNTED CASH FLOW CRITERIA
Payback period Method
This method is popularly known as pay off, pay-out, recoupment period method
also. It gives the number of years in which the total investment in a particular
capital expenditure pays back itself. This method is based on the principle that
every capital expenditure pays itself back over a number of years. It means that it
generates income within a certain period. When the total earnings (or net cash-
inflow] from investment equals the total outlay, that period is the payback period of
the capital investment. An investment project is adopted so long as it pays for itself
within a specified period of time — says 5 years or less. This standard of
recoupment period is settled by the management taking into account a number of
considerations. While there is a comparison between two or more projects, the
lesser the number of payback years, the project will be acceptable.
The formula for the payback period calculation is simple when the cash inflow
is even throughout life of the project/ Machine/ Capital investment. First of all,
net-cash-inflow (Profit after Tax Before Depreciation) is determined. Then we divide
the initial cost (or any value we wish to recover) by the annual cash-inflows and the
resulting quotient is the payback period. As per formula:
If the annual cash-inflows are uneven, then the calculation of payback
period takes a cumulative form. We accumulate the annual cash-inflows till the
recovery of investment and as soon as this amount is recovered, it is the expected
number of payback period years. An asset or capital expenditure outlay that pays
back itself early comparatively is to be preferred.
Payback Method – Merits
The payback period method for choosing among alternative projects is very
popular among corporate managers and according to Quirin even among Soviet
planners who call it as the recoupment period method. In U.S.A and U.K. this
method is widely accepted to discuss the profitability of foreign investment.
Following are some of the advantages of pay back method:
1. It is easy to understand, compute and communicate to others. Its quick
computation makes it a favourite among executive who prefer snap answers.
2. It gives importance to the speedy recovery of investment in capital assets. So
it is useful technique in industries where technical developments are in full
swing necessitating the replacements at an early date.
3. It is an adequate measure for firms with very profitable internal investment
opportunities, whose sources of funds are limited by internal low availability
and external high costs.
4. It is useful for approximating the value of risky investments whose rate of
capital wastage (economic depreciation and obsolescence rate) is hard to
predict. Since the payback period method weights only return heavily and
ignores distant returns it contains a built-in hedge against the possibility of
limited economic life.
5. When the payback period is set at a large “number of years and incomes
streams are uniform each year, the payback criterion is a good
approximation to the reciprocal of the internal rate of discount.
Payback Method – Demerits
This method has its own limitations and disadvantages despite its simplicity
and rapidity. Here are a number of demerits and disadvantages claimed by its
opponents:-
1. It treats each asset individually in isolation with the other assets, while
assets in practice cannot be treated in isolation.
2. The method is delicate and rigid. A slight change in the division of labour
and cost of maintenance will affect the earnings and such may also affect
the payback period.
3. It overplays the importance of liquidity as a goal of the capital expenditure
decisions. While no firm can ignore its liquidity requirements but there are
more direct and less costly means of safeguarding liquidity levels. The
overlooking of profitability and over stressing the liquidity of funds can in
no way be justified.
4. It ignores capital wastage and economic life by restricting consideration to
the projects’ gross earnings.
5. It ignores the earning beyond the payback period while in many cases
these earnings are substantial. This is true particularly in respect of
research and welfare projects.
6. It overlooks the cost of capital which is the main basis of sound investment
decisions.
In perspective, the universality of the payback criterion as a reliable index of
profitability is questionable. It violates the first principle of rational investor
behaviour-namely that large returns are preferred to smaller ones. However, it can
be applied in assessing the profitability of short and medium term capital
expenditure projects.
Accounting Rate of Return Method
It is also known as Accounting Rate of Return Method / Financial Statement
Method/ Unadjusted Rate of Return Method also. According to this method, capital
projects are ranked in order of earnings. Projects which yield the highest earnings
are selected and others are ruled out. The return on investment method can be
expressed in several ways a follows:
(i) Average Rate of Return Method
Under this method we calculate the average annual profit and then we divide it
by the total outlay of capital project. Thus, this method establishes the ratio
between the average annual profits and total outlay of the projects.
As per formula,
Thus, the average rate of return method considers whole earnings over the
entire economic life of an asset. Higher the percentage of return, the project will be
acceptable.
(ii) Earnings per unit of Money Invested
As per this method, we find out the total net earnings and then divide it by the
total investment. This gives us the average rate of return per unit of amount (i.e.
per rupee) invested in the project. As per formula:
The higher the earnings per unit, the project deserves to be selected.
(iii) Return on Average Amount of Investment Method
Under this method the percentage return on average amount of investment is
calculated. To calculate the average investment the outlay of the projects is divided
by two. As per formula:
Here:
Average Annual Net Income does not mean average Annual Cash-inflow
Average Investment may be of the following:
OR
OR
Thus, we see that the rate of return approach can be applied in various
ways. But, however, in our opinion the third approach is more reasonable and
consistent.
Accounting Rate of Return Method – Merits
This approach has the following merits of its own:
1. Like payback method it is also simple and easy to understand.
2. It takes into consideration the total earnings from the project during its
entire economic life.
3. This approach gives due weight to the profitability of the project.
4. In investment with extremely long lives, the simple rate of return will be
fairly close to the true rate of return. It is often used by financial
analysis to measure current performance of a firm.
Accounting Rate of Return Method – Demerits
1. One apparent disadvantage of this approach is that its results by
different methods are inconsistent.
2. It is simply an averaging technique which does not take into account the
various impacts of external factors on over-all profits of the firm.
3. This method also ignores the time factor which is very crucial in
business decision.
4. This method does not determine the fair rate of return on investments. It
is left to the discretion of the management.
Discounted Cash flows (DCF) Techniques (or) Time Ad jested Method
Another method of computing expected rates of return is the present value
method. This method involves calculating the present value of the cash benefits
discounted at a rate equal to the firm’s cost of capital. The method is popularly
known as Discounted Cash flow Method. The concept of DCF valuation is based on
the principle that the value of a business or asset is inherently based on its ability
to generate cash flows for the providers of capital. To that extent, the DCF relies
more on the fundamental expectations of the business than on public market
factors or historical precedents, and it is a more theoretical approach relying on
numerous assumptions. A DCF analysis yields the overall value of a business (i.e.
enterprise value), including both debt and equity. In simple the “presen t value of
an investment is the maximum amount a firm could pay for the opportunity of
making the investment without being financially worse off.”
Key Components of a DCF:
Free Cash flow (FCF): Cash generated by the assets of all the business (both
tangible and intangible) available for distribution to all providers of capital. FCF is
often referred to as unlevered free cash flow, as it represents cash flow available to
all providers of capital and is not affected by the capital structure of the business.
Terminal value (TV): Value at the end of the FCF projection period (Horizon
Period).
Discount rate or Present Value factor (PV) – The rate used to discount the
projected FCFs and terminal value to their present values.
The financial executive compares the present values with the cost of the
proposal. If the present value is greater than the net investment, the proposal
should be accepted. Conversely, if the present value is smaller than the net
investment, the return is less than the cost of financing. Making the investment in
this case will cause a financial loss to the firm. There are four methods to judge the
profitability of different proposals on the basis of this technique
(i) Net Present Value Method
This method is also known as Excess Present Value or Net Gain Method. To
implement this approach, we simply find the present value of the expected net cash
inflows of an investment discounted at the cost of capital and subtract from it the
initial cost outlay of the project. If the net present value is positive, the project
should be accepted: if negative, it should be rejected.
NPV = Total Present value of cash inflows – Net Investment
If the two projects are mutually exclusive the one with higher net present value
should be chosen. The following example will illustrate the process:
Assume, the cost of capital after taxes of a firm is 6%. Assume further, that the
net cash-inflow (after taxes) on a Rs. 5,000 investment is forecasted as being
2,800 per annum for 2 years. The present value of this stream of net cash-inflow
discounted at 6% comes to 5,272 (1,813 x 2800).
Therefore, the present value of the cash inflow = 5,272
Less present value of net investment = 5,000
Net Present value = 272
(ii) Internal Rate of Return Method
This method is popularly known as time adjusted rate of return
method/discounted rate of return method also. The internal rate of return is
defined as the interest rate that equates the present value of expected future
receipts to the cost of the investment outlay. This internal rate of return is found by
trial and error. First we compute the present value of the cash-flows from an
investment, using an arbitrarily elected interest rate. Then we compare the present
value so obtained with the investment cost. If the present value is higher than the
cost figure, we try a higher rate of interest and go through the procedure again.
Conversely, if the present value is lower than the cost, lower the interest rate and
repeat the process. The interest rate that brings about this equality is defined as
the internal rate of return. This rate of return is compared to the cost of capital and
the project having higher difference, if they are mutually exclusive, is adopted and
other one is rejected. As the determination of internal rate of return involves a
number of attempts to make the present value of earnings equal to the investment,
this approach is also called the Trial and Error Method,
(iii) Profitability Index (PI) Method
This method is otherwise called benefit cost ratio method or Desirability
Factor. One major disadvantage of the present value method is that it is not easy to
rank projects on the basis of net present value particularly when the cost of
projects differs significantly. To compare such projects the present value
profitability index is prepared. The index establishes relationship between cash-
inflows and the amount of investment as per formula given below:
NPV GPV PI = --------------- x 100 OR -------------------- x 100
Investment Investment
For example, the profitability index of the Rs. 5,000 investment discussed in
Net Present Value Method above would be:
OR
The higher profitability index, the more desirable is the investment. Thus, this
index provides a ready compatibility of investment having various magnitudes. By
computing profitability indices for various projects, the financial manager can rank
them in order of their respective rates of profitability.
(iv) Terminal Value Method
This approach separates the timing of the cash-inflows and outflows more
distinctly. Behind this approach is the assumption that each cash-inflow is re-
invested in other assets at the certain rate of return from the moment, it is received
until the termination of the project. Then the present value of the total compounded
sum is calculated and it is compared with the initial cash-outflow. The decision rule
is that if the present value of the sum total of the compounded re-invested cash-
inflows is greater than the present value of cash-outflows, the proposed project is
accepted otherwise not. The firm would be different if both the values are equal.
This method has a number of advantages. It incorporates the advantage of re -
investment of cash-inflows by compounding and then discounting it. Further, it is
best suited to cash budgeting requirements. The major practical problem of this
method lies in projecting the future rates of interest at which the intermediate cash
inflows received will be re-invested.
13.3.4 DISCOUNTED CASH FLOW TECHNIQUES – MERITS
1. This method takes into account the entire economic life of an investment
and income there from. It gives the rate of return offered by a new
project.
2. It gives due weight to time factor of financing. In the words of Charles
Horngreen “Because the discounted cash-flow method explicitly and
routinely weights the time value of money, it is the best method to use
for long-range decisions.
3. It permits direct comparison of the projected returns on investments
with the cost of borrowing money which is not possible in other
methods.
4. It makes allowance for differences in the time at which investment
generate their income.
5. This approach by recognizing the time factor makes sufficient provision
for uncertainty and risk. It offers a good measure of relative profitability
of capital expenditure by reducing the earnings to the present values.
13.3.5 DISCOUNTED CASH FLOW TECHNIQUES – DEMERITS
This method is criticized on the following grounds:
1. It involves a good amount of calculations. Hence it is difficult and
complicated one. But this criticism has no force.
2. It is very difficult to forecast the economic life of any investment exactly.
3. The selection of cash-inflow is based on sales forecasts which are in
itself an indeterminable element.
4. The selection of an appropriate rate of interest is also difficult.
13.3.6 COMPARISON BETWEEN NPV AND IRR (NPV VS. IRR)
The Net Present value method and the Internal Rate of Return Method are
similar in the sense that both are modern techniques of capital budgeting and both
take into account the time value of money. In fact, both these methods are
discounted cash flow techniques. However, there are certain basic differences
between these two methods of capital budgeting:
1. In the net present value method the present value is determined by
discounting the future cash flows of a project at a predetermined or specified
rate called the cut off rate based on cost of capital. But under the internal
rate of return method, the cash flows are discounted at a suitable rate by hit
and trial method which equates the present value so calculated to the
amount of the investment. Under IRR method, discount rate is not
predetermined.
2. The NPV method recognizes the importance of market rate of interest or cost
of capital. It arrives at the amount to be invested in a given project so that
its anticipated earnings would recover the amount invested in the project at
market rate. Contrary to this, the IRR method does not consider the market
rate of interest and seeks to determine the maximum rate of interest at
which funds invested
3. in any project could be repaid with the earnings generated by the project.
4. The basic presumption of NPV method is that intermediate cash inflows are
reinvested at the cut off rate, whereas, in the case of IRR method,
intermediate cash flows are presumed to be reinvested at the internal rate of
return.’
5. The results shown by NPV method are similar to that of IRR method under
certain situations, whereas, the two give contradictory results under some
other circumstances. However, it must be remembered that NPV method
using a predetermined cut-off rate is more reliable than the IRR method for
ranking two or more capital investment proposals.
(a) Similarities of Results under NPV and IRR
Both NPV and IRR methods would show similar results in terms of accept or
reject decisions in the following cases:
1. Independent investment proposals which do not compete with one
another and which may be either accepted or-rejected on the basis of a
minimum required rate of return.
2. Conventional investment proposals which involve cash outflows or
outlays in the initial period followed by a series of cash inflows.
The reason for similarity of results in the above cases lies on the basis of
decision-making in the two methods. Under NPV method, a proposal is accepted if
its net present value is positive, whereas, under IRR method it is accepted if the
internal rate of return is higher than the cut off rate. The projects which have
positive net present value, obviously, also have an internal rate of return higher
than the required rate of return.
(b) Conflict between NPV and IRR Results
In case of mutually exclusive investment proposals, which compete with one
another in such a manner that acceptance of one automatically excludes the
acceptance of the other, the NPV method and IRR method may give contradic tory
results. The net present value may suggest acceptance of one proposal whereas, the
internal rate of return may favour another proposal. Such conflict in rankings may
be caused by any one or more of the following problems:
1. Significant difference in the size (amount) of cash outlays of various
proposals under consideration.
2. Problem of difference in the cash flow patterns or timings of the various
proposals and
3. Difference in service life or unequal expected lives of the projects.
Exercise:
1) Equipment A has a cost of 75,000 and net cash flow of `20,000 per year for
six years. A substitute equipment B would cost ` 50,000 and generate net cash flow
of ` 14,000 per year for six years. The required rate of return of both equipments is
11 per cent. Calculate the IRR and NPV for the equipments. Which equipment
should be accepted and why?
Solution:
Equipment A
NPV = 20,000 x PVAF6, 0.11 - 75,000
= 20,000 x 4.231 - 75,000
= 84,620 - 75,000 = ` 9,620
IRR = 20,000 x PVAF6, r = 75,000
PVAF6, r = 75,000 / 20,000 = 3.75
From the present value of an annuity table, we find:
PVAF6,0.15 = 3.784
PVAF6,0.16 = 3.685
Therefore,
3.784 – 3.75 IRR = r = 0.15 + 0.01
3.784 – 3.685 = 0.15 + 0.0034 = 0.1534 or IRR = 15.34%
Equipment B:
NPV = 14,000 x PVAF6,0.11 - 50,000
= 14,000 x 4.231 - 50,000
= 59,234 - 50,000 = Rs 9,234
IRR = 14,000 x PVAF6,r = 50,000
PVAF6, r = 50,000 / 14,000 = 3.571
From the present value of an annuity table, we find:
PVAF6,0.17 = 3.589
PVAF6,0.18 = 3.498
Therefore,
Equipment A has a higher NPV but lower IRR as compared with equipment B.
Therefore equipment A should be preferred since the wealth of the shareholders will
be maximized.
5) For each of the following projects compute (i) pay-back period, (ii) post pay-
back profitability and (iii) post-back profitability index
a) Initial outlay ` 50,000
Annual cash inflow
(after tax but before depreciation) ` 10,000
Estimated life 8 Years
b) Initial outlay ` 50,000
Annual cash inflow (after tax but before depreciation)
First three years ` 15,000
Next five years ` 5,000
Estimated life 8 Years
Salvage ` 8,000
Solution:
a) i) Pay-back period = Investment / Annual Cash Flow = 50,000 / 10,000 = 5 Years
ii) Post pay back profitability
= Annual cash inflow (Estimated life–payback period)
= 10,000 (8 – 5) = 30,000 iii) Post back profitability index
= 30,000 / 50,000 x 100 = 60%
b) i) As the case inflows are the equal during the life of the investment payback
period can be calculated as:
1st year’s cash inflow 15,000
2nd year’s cash inflow 15,000
3rd year’s cash inflow 15,000
4th year’s cash inflow 5,000
50,000
Hence, the pay-back period is 4 years. ii) Post pay back profitability
= Annual cash inflow x remaining life after pay –back period) = 5,000 x 4
= 20,000 iii) Post back profitability index
= 20,000 / 50,000 x 100
= 40% 6. X Ltd. is considering the purchase of a machine. Two machines are available
E and F. the cost of each machine is 60,000. Each machine has expected life of 5
years. Net profits before tax (50%) and after depreciation (20% WDV) during
expected life of Five years of the machines are given below:
Year E (Machine) F (Machine)
1 15,000 5,000
2 20,000 15,000
3 25,000 20,000
4 15,000 30,000
5 10,000 20,000
Total 85,000 90,000
Solution:
Statement of Profitability
Year Machine E Machine F
PBTAD Tax 50% PATD PBTAD Tax 50% PATD
1 15,000 7,500 7,500 5,000 2,500 2,500
2 20,000 10,000 10,000 15,000 7,500 7,500
3 25,000 12,500 12,500 20,000 10,000 10,000
4 15,000 7,500 7,500 30,000 15,000 15,000
5 10,000 5,000 5,000 20,000 10,000 10,000
Total 85,000 42,500 42,500 90,000 45,000 45,000
Machine E Machine F
Average profit after tax 42,500 x 1/5 = 8,500 45,000 x 1/5 = 9,000
Average investment 60,000 x ½ = 30,000 60,000 x ½ = ` 30,000
Average return on average 8,500/30,000 x 100
= 28.33%
9,000/30,000 x 100
= 30%
Thus, machine F is more profitable.
Capital Rationing – Meaning Capital rationing refers to a situation where a firm is not in a position to invest
in all profitable projects due to the constraints on availability of funds. We know
that the resources are always limited and the demand for them far exceeds their
availability, it is for this reason that the firm cannot take up all the projects though
profitable, and has to select the combination of proposals that will yield the greatest
profitability.
Capital rationing is a situation where a firm has more investment proposals
than it can finance. It may be defined as “a situation where a constraint is placed
on the total size of capital investment during a particular period”. In such an event
the firm has to select combination of investment proposals that provide the highest
net present value subject to the budget constraint for the period. Selecting of
projects for this purpose will require the taking of the following steps:
Ranking of projects according to profitability index or internal’-rate of return.
Selecting projects in descending order of profitability until the budget figures
are exhausted keeping in view the objective of maximizing the value of the firm.
PRACTICAL PROBLEMS
1. Project cost is Rs. 30,000 and the cash inflows are Rs. 10,000, the life of
the project is 5 years. Calculate the pay-back period. (Ans:3 years).
2. A project costs Rs. 20,00,000 and yields annually a profit of Rs.
3,00,000 after depreciation @ 12½% but before tax at 50%. Calculate
the pay-back period. (Ans: 5 years )
3. Certain projects require an initial cash outflow of Rs. 25,000. The cash
inflows for 6years are Rs. 5,000, Rs. 8,000, Rs. 10,000, Rs. 12,000, Rs.
7,000 and Rs. 3,000.Calculate payback period. (Ans: 3 yrs 2month )
4. F ltd is considering two projects. each requires an investment of
Rs.10,000.the firm cost of capital is 10%,the net cash inflows from
investment in the two projects X and Y are as follows :
Year X Y
1 5000 1000
2 4000 2000
3 3000 3000
4 1000 4000
5 - 5000
6 - 6000 The company has fixed 3 years pay-back period as the cut-off point, state
which project should be accepted .
Ans: Traditional pay-back period for:
Project X= 2 years &4 Months (2.33 years) Project Y=4 years.
Discounted pay-back period @ 10%Project:
X=2.95 years & project Y=4.79 years
5. Seshu Ltd has two projects under consideration which are mutually
exclusive. the projects have to be depreciated on straight line basis and the tax rate
may be taken as 50%.
Year Profit before Depreciation
A(Rs.) B(Rs)
1 80,000 20,000
2 60,000 40,000
3 40,000 60,000
4 20,000 80,000
5 10,000 1,00,000
Calculate payback period.
[Ans project A=2 Years ,4 months ;B = 3 years 2 months ]
6. A company is considering the purchase of the following machines:
Automatic machine Ordinary machine
Cost (Rs)
Life (Years )
Sales (Rs)
Cost :
Materials
Labour
Variable OH
2,24,000
5 ½
1,50,000
50,000
12,000
24,000
60,000
8
1,50,000
50,000
60,000
20,000
Compute the payback period and profitability beyond the payback period.
[Ans:payback period Automatic = 3.5 yrs , Ordinary = 3 yrs ; profitability beyond PB
period: automatic =Rs 1,28,000, Ordinary = Rs 1,00,000 ]
7. MM Ltd is considering the purchase of new machine which will carry out
operations performed by labour. A and B are alternative models. From the following
information, you are required to prepare a profitability statement and workout the
pay-back period in respect of each machine:
Particulars Machine A Machine B
Estimated life of machines years
Cost of machine
Cost of indirect materials
Estimated savings in scrap
Additional cost of maintenance
Estimated savings in direct wages:
Number of Employee not required
Wages per employee
5
1,50,000
6,000
10,000
19,000
150
600
6
2,50,000
8,000
15,000
27,000
200
600
Taxation is to be regarded as 50% of profit (ignore depreciation for calculation
of tax).which model would you recommend? State your reasons.
(Ans: payback period in case of machine A is 4 years and in case of machine
B,it is 5 years. Hence, Machine A is preferred)
8. No project is acceptable unless the yield is 10% Cash inflows of certain
project along with cash outflow are given below:
Year Outflow Rs. Inflow Rs.
0 1,50,000
1 30,000 20,000
2 30,000
3 60,000
4 80,000
5 30,000 The salvage value at the end of 5th year is Rs.40,000. Calculate the NPV.
[Ans:8,860]
9. A Ltd. has under consideration the following two projects. their details are as
under:
Project X Project Y
Investment in machinery
Working capital
Life of machinery
Scrap value of machinery
Tax rate
Income before depreciation and tax
at the end of year
1
2
3
4
5
6
Rs.10,00,000
5,00,000
4 yrs
10 %
50 %
8,00,000
8,00,000
8,00,000
8,00,000
-
-
15,00,000
5,00,000
6 yrs
10 %
50 %
15,00,000
9,00,000
15,00,000
8,00,000
6,00,000
3,00,000
You are required to calculate the accounting rate of return and suggest which project is to be preferred.
(Ans: ARR Project X Rs =19.1%,Project Y Rs = 17.75%)
10. A new capital project costing Rs.140 Lakhs will yield on an average a profit
before tax and depreciation of Rs.50 lakhs .depreciation will be Rs.20 lakhs per
annum and the tax rate is 50%. Work out the pay_back period and return on
investment.
Ans. pay back period = 4 years, ARR(on original investment)=10.71%;
ARR(on average investment)= 21.43 %
11. A project requires initial investment of Rs 85,000 and is expected to give
cash flows of Rs 18,000, Rs25,000,Rs 10,000,Rs.25,000 and Rs. 30,000 for 5 years
respectively. the project has a salvage value of Rs.10,000. The company ’s target
rate of return is 10%.calculate the profitability of the projects by using profitability
index method. (Ans: P.I = 1.017)
12. A project costs Rs.16,000 and is expected to generate cash inflows of
Rs.4,000 each for 5 years .calculate internal rate of return . (Ans.8%)
13. MM Limited considering a project with an Initial investment of Rs1,80,000,
the life of the project is four years and estimated net annual cash flows are as
follows
Year Rs
1
2 3
4
45,000
60,000 90,000
60,000 Calculate internal rate of return [Ans:14.49 %]
14. Easwar limited company is considering an investment in a project with a
capital outlay of Rs.2,00,000. The estimated annual income after depreciation but
before tax is Rs. 1,00,000; each in the first and second year 80,000; each in the
third and fourth year and Rs.40,000 in the fifth year. Depreciation may be taken
at 20% on original cost and taxation at 50% of net income you are required to
evaluate the project according to each of the following method:
a) Payback period method
b) Rate of return on original investment method
c) Rate of return on average investment method
d) Net present value method discounting in flow at 10%
YEAR 1 2 3 4 5
P.V.F 0.909 0.826 0.751 0.683 0.621
Ans : a)2.25 years b)20 % c) 40 % d) 1,08,130
15. The expected cash flows of a project are as follows :
Year 0 1 2 3 4 5
Cash flow 1,00,000 20,000 30,000 40,000 50,000 30,000
The cost of capital is 12% calculate:
a) NPV (b) IRR (c) Payback period and (d) Discounted payback period
Ans: a ) 19,060 b) 20.56% c) 3 years 2 months d) 3 yrs 11 months
Capital rationing
16. A ltd. has an investment budget of Rs.25 Lakh for next year.it has under
consideration three projects A,B and C(B and C are mutually exclusive )and all of
them can be completed within a year. Further details are given below :
Project Investment required Net present value
A
B
C
14
12
10
5.6
7.2
5.0
Recommend the best policy to utilize budget, supported by proper reasoning
[Ans: A&B is not possible as investment required exceeds Rs.25 lakh.
B&C is not possible as they are mutually exclusive projects:
A&C is only possible option thought NPV is lowest(i.e.,10.6lakh]
17. In capital rationing situation (investment limit Rs.25 Lakh ),suggest the
most desirable feasible combination on the basis of the following data (indicate
justification)
Project Initial outlay NPV
A
B
C
D
15
10
7.5
6
6
4.5
3.6
3
Project B and C are mutually exclusive.
[Ans: Projects A and B combination give highest NPV of Rs. 10.50 lakh. by
undertaking these projects wealth maximization is possible]
18. APJ Ltd. has the following proposals
Project Cost Net present value
A
B
C
D
E
1,00,000
3,00,000
50,000
2,00,000
1,00,000
20,000
35,000
16,000
25,000
30,000
Total funds available are Rs.3, 00,000 determine the optimal combination of
projects assuming that (i) the projects are divisible and (ii) if the projects are not
divisible
[Ans :(i) The company can get a NPV OF Rs.72,125 by selecting projects
C+E+A+ ¼ of D;
(ii)Combination of A+C+E(Total outlay Rs 2,50,000) is the best it gives a
maximum NPV of Rs.66,000]
19. Ram Ltd is considering the following six proposals
Project Cost NPV
1 2
3 4 5
6
1,000 6,000
5,000 2,000 2,500
500
210 1,560
850 260 500
95 You are required to calculate the profitability index for each projects and rank
them which projects would you choose if the total funds are Rs.8000.
[Ans: P.I:P1:1.21; P2:1.26; P3:1.17; P4:1.13; P5:1.20; P6:1.19;1,2 and 6 is the
best combination as it gives the highest NPV of Rs.1,865]
OTHER PROBLEMS FOR BEST PRACTICE
1. Evaluation of Cash Flows. Below are the cash flows for two mutually
exclusive projects.
year CFX CFY
0 (5,000) (5,000)
1 2,085 0
2 2,085 0
3 2,085 0
4 2,085 9,677
a. Calculate the payback for both projects.
b. Initially, the cost of capital is uncertain, so construct NPV profiles for the two
projects (on the same graph) to assist in the analysis. The profiles cross at what
cost of capital? What is the significance of that?
c. It is now determined that the cost of capital for both projects is 14%. Which
project should be selected? Why?
d. Calculate the MIRR for both projects, using the 14% cost of capital.
Answers: a. 2.4 yrs, 4 yrs; b. 10%; c. X; d. MIRRX = 19.69%
2. More practice with Cash Flow Evaluation. Cash flows for two mutually exclusive projects are shown below:
year CFM CFN 0 (100) (100)
1 10 70 2 60 50
3 80 20 Both projects have a cost of capital of 10%.
a. Calculate the payback for both projects.
b. Calculate the NPV for both projects.
c. Calculate the IRR for both projects.
d. Calculate the MIRR for both projects.
Answers: a. 2.4 yrs, 1.6 yrs; b. Rs.18.78, Rs.19.98; c. 18.1%, 23.56%; d. 16.5%,
16.9%;
3. Expansion Project. A machine has a cost of Rs.180. It will have a life of 3
years, and will be depreciated straight line to zero salvage value. It will result in
sales revenue of Rs.200 per year and cash operating costs of Rs.110 per year. Use
of the machine will require an increase in working capital of Rs.70 for the 3 years,
beginning at year 0. The appropriate discount rate is 8% and the firm’s tax rate is
40%.
a. Calculate the initial cash flow at time 0.
b. Calculate the annual operating cash flows (they are identical each year).
c. Calculate the relevant terminal cash flows at the end of year 3.
d. What is the NPV for the machine?
Answers: a. -250; b. 78; c. 70; d. Rs.6.58
4. Inflation adjustment: A project requires an initial investment of Rs.8,000,
has a 4-year life and provides expected cash flows as follows, based on year 1 prices
and costs:
Annual revenue = Rs.5,000
Annual cash operating costs = Rs.2,000
Annual depreciation = Rs.2,000
Terminal cash flow = 0
Cost of capital = 14% and Tax = 30%
a. Calculate the annual operating cash flows without adjusting for inflation.
(Are these cash flows real or nominal?) Calculate the associated NPV.
b. Adjust the cash flows to reflect the effects of inflation, which is expected to
affect sales revenue and cash operating expenses at the rate of 4% annually. (Are
these cash flows real or nominal?) Calculate the associated NPV.
c. Which NPV is the correct one for evaluating the project?
Ans: a. -Rs.133; b. Rs.202
5. Mutually Exclusive Projects with Unequal Lives. Murray’s Coffee House
is trying to choose between two new coffee bean roasters. The required rate of
return for either machine is 10%. Shown below are the after-tax cash flows
associated with each machine:
year CFX CFY
0 (50,000) (30,000)
1 20,000 20,000
2 20,000 20,000
3 20,000
4 20,000
a. Calculate the replacement chain NPV for each project.
b. Calculate the equivalent annual annuity for each project.
c. Which project should be selected? Why?
Answers: a. RCNPVX = Rs.13,397, RCNPVY = Rs.8,604; b. EAAX = Rs.4,226,
EAAY = Rs.2,714
6. Risk Adjustment and Project Selection. Acme Mfg is considering two
projects, A & B, with cash flows as shown below:
Period CFA CFB
0 -50,000 -100,000
1 20,000 60,000
2 20,000 25,000
3 20,000 25,000
4 20,000 25,000
The opportunity cost of capital for A is 14 percent. The opportunity cost of
capital for B is 10 percent.
a. Calculate the NPV for each project.
b. Calculate the IRR for each project.
c. Which project(s) should be accepted in each of the following situati ons?
(1) The projects are mutually exclusive and there is no capital constraint.
(2) The projects are independent and there is no capital constraint.
(3) The projects are independent and there is a total of Rs.100,000 of
financing for capital outlays in the coming period.
d. Explain why the cost of capital for A might be higher than for B.
Answers: a. NPVA = Rs.8,274, NPVB = Rs.11,065; b. IRRA = 21.86%, IRRB = 16.08%
7. Replacement project: Existing machine was purchased 2 years ago at a
cost of Rs.3,200. It is being depreciated straight line over its 8 year life. It can be
sold now for Rs.3,000 or used for 6 more years at which time it will be sold for an
estimated Rs.500. It provides revenue of Rs.5,000 annually and cash operating
costs of Rs.2,000 annually.
A replacement machine can be purchased now for Rs.7,800. It would be used
for 6 years, and depreciated straight line. It will result in additional sales revenue
of Rs.1,500 annually, but because of its increased efficiency it would reduce cash
operating costs by Rs.600 per year. The new machine would require additional
inventories of Rs.700, and accounts receivable would increase by Rs.300. Its
expected salvage value in 6 years is Rs.2,000.
The tax rate is 40% and the required rate of return is 13%. Should the old
machine be replaced?
a. Calculate the incremental cash flow at time 0.
b. Calculate the incremental annual operating cash flows that result from the
new machine.
c. Calculate the incremental terminal cash flow.
d. Show the incremental CFs in the table below.
Year Cash Flow
0 ________
1 ________
2 ________
3 ________
4 ________
e. Calculate the NPV for this project.
Answers: a. –Rs.6,040; b. Rs.1,620; c. 1,900; e. 1,349
Pay back period
(A) When Cash inflows are uniform
Initial investment Rs.2,00,000
Annual cash inflow Rs.50,000
Pay back period = Original Investment
Annual cash inflow
= 2,00,000 50,000 = 4 Years
(B) When cash inflows are not uniform
It investment in a project Rs.8,00,000 and net cash inflows after tax but before
depreciation are estimated for the next 6 years as Rs.20,000, Rs.25,000,
Rs,20,000, Rs.30,000, Rs.35,000 and Rs.15,000 Respectively, pay back period is
calculated as follows.
Solution
Year Cash Inflow Cumulative cash inflows
1 Rs.20,000 Rs.20,000
2 Rs.25,000 Rs.45,000
3 Rs.20,000 Rs.65,000
4. Rs.30,000 Rs.95,000
At end of 4th year the cumulative cash inflow exceeds the investment of Rs.80,000
Pay back period = 3 Years + 15000 30000
= 3 Years + ½ year = 3.5 Year
ARR on original investment method
Annual average net earnings ARR = ------------------------------------------- x 100 Original investment – scrap value
ARR on average investment method
Annual average net earnings ARR = ------------------------------------x 100
Average investment
Average investment = Original investment
2
Average investment = Original investment – Scrap value of asset
2
Original invest – scarp value
Average investment = + Additional working
2 + scrap capital value
Discount Factor
1 where
(1+r)n
r – Discount rate
n – No of years
For example
Discounting factor at 10% rate for a period of 5 year
P.V. Factor for 1st year = 1 = 1 = 0.909
(1 + 1)1 1. 1
P.V. Factor for 2nd year = 1 = 1 = 0.826
(1 + 1)2 1. 21
P.V. Factor for 3rd year = 1 = 1 = 0.751
(1 + 1)3 1. 33
ARR
The following data relating to two machines x and y
Mac x Mar y
Original cost Rs.2,00,000 Rs.2,00,000
Estimated life in year 5 5 Expected salvage value Rs.20,000 Rs.40,000 Additional working capital
Needed on average Rs.40,000 Rs.30,000 Income tax rate 40% 40%
Estimated incomes before depreciation and tax
X y
1st year 60,000 1,00,000 2nd year 80,000 80,000
3rd year 1,00,000 1,60,000 4th year 1,20,000 40,000 5th year 1,40,000 1,80,000
Depreciation is to be charges under SLM. you are required to calculate the
accounting rate of return on the average investment for both the machines.
Solution
ARR on average investment
= average annual net earnings x 100
Average investment
Aug Invest = org. invest – scrap values + Add net + scrap value working
2 capital
Mac X = 2,00,000 – 20,000 + 40,000 + 20,000
2
= Rs.1,50,000
Mac Y = 2,00,000 – 40,000 + 30,000 + 40,000
2
= Rs.1,50,000
38,400
ARR of Mac X = ------------ x 100 = 25.6% 1,50,000 Working notes
Calculation of average annual net earnings
Mac X
Ave annual earnings before dep and tax
60,000 + 80,000 + 1,00,000 + 1,20,000 + 1,40,000 = 1,00,000
5
(-) Dep. 2,00,000 – 20,000 = 36,000
5 64,000
(-) Tax at 40% = 64000 x 40% = 25600
Average annual net earnings, after = 38400
Dep. and tax
Mac Y
Avg annual earnings before depreciation and tax
= 1,00,000 + 80,000 + 1,60,000 + 40,000 + 1,80,000 = 1,12,000
5
(-) Dep. 2,00,000 – 40,000 = 32,000
5 = 80,000
(-) Tax 40% = 80,000 x 40% = 32,000
Ave annual net earnings after dep and tax = 48,000
Profitability Index and NPV method
Two projects a and b which mutually exclusive are being under consideration.
Both of them require an investment of Rs.1,00,000 each. The net cash inflows are
estimated as under.
Year A B
1 10,000 30,000
2 40,000 50,000
3 30,000 80,000
4 60,000 40,000
5. 90,000 60,000
The company’s targeted rate of return on investment is 12% you are required to
access the projects on the basis of the present values, using, 1)NPV Method 2)
Profitability Index Method.
Present values of Re 1 at 12% interest for five years are given below.
1st year : 0.893 : 2nd Yr : 0.797 ; 3rd year
0.712 ; 4th year 0.636 ; 5th year 0.567
Statement showing present values of projects
Year PV lf Re 1 at 12%
pa
Project
cash inflows
A Project B
Present value of
cash in flow
Cash
inflow
P.V.of cash
inflow
(1) (2) (3) (4) (5) (6)
1. 0.893 10,000 8930 30,000 26790
2. 0.797 40,000 31880 50,000 39850
3. 0.712 30,000 21360 80,000 56,960
4. 0.636 60,000 38160 40,000 25,440
5. 0.567 90,000 51,030 60,000 34,020
1,51,360 1,83,060
1) NPV Project A B
Present value of cash inflow 1,51,360 1,83,060
(-) Initial invest 1,00,000 1,00,000
51,360 83,060
Project B is accepted because higher NPV
2) Profitability Index (PI)
PI = PV of cash inflow
PV of cash outflow
Project A Project B
PV of cash inflows 1,51,360 1,83,060
PV of cash outflow 1,00,000 1,00,000
(Initial invest)
PI = 1,51,360 1,83,060
1,00,000 1,00,000
= 1.5136 1.8306
Project B is accepted because higher P.I
13.4 REVISION POINTS
1. Pay Back Method It gives the number of years in which the total investment
in a particular capital expenditure pays back itself.
2. Accounting Rate of Return method, capital projects are ranked in order
of earnings. Projects which yield the highest earnings are selected and others are
ruled out.
3. Average Rate of Return method establishes the ratio between the average
annual profits and total outlay of the projects.
4. Earnings per unit of money gives us the average rate of return per unit of
amount (i.e. per rupee) invested in the project.
5. Return on Average amount of Investment method under this method the
percentage return on average amount of investment is calculated.
6. Net Present Value Method we simply find the present value of the expected
net cash inflows of an investment discounted at the cost of capital and subtract
from it the initial cost outlay of the project. If the net present value is positive, the
project should be accepted: if negative, it should be rejected.
7. Internal Rate of Return Method The internal rate of return is defined as
the interest rate that equates the present value of expected future receipts to the
cost of the investment outlay.
8. Profitability Index Method The present value profitability index establishes
relationship between cash-inflows and the amount of investment.
9. Terminal Value Method approach is the assumption that each cash-inflow
is re-invested in other assets at the certain rate of return from the moment; it is
received until the termination of the project.
and subtract from it the initial cost outlay of the project. If the net present
value is positive, the project should be accepted: if negative, it should be rejected.
Internal Rate of Return Method The internal rate of return is defined as the interest
rate that equates the present value of expected future receipts to the cost of the
investment outlay. Profitability Index Method The present value profitability index
establishes relationship between cash-inflows and the amount of investment.
Terminal Value Method approach is the assumption that each cash-inflow is re-
invested in other assets at the certain rate of return from the moment; it is received
until the termination of the project.
13.5 INTEXT QUESTIONS
1. Define Internal Rate of Return.
2. What do you mean by Pay Back period ?
3. What do you mean by terminal value method?
4. What do you mean by profitability Index Method?
13.6 SUMMARY
There are number method are used for evaluating capital investment proposals.
Different firms may use different methods for evaluating the project proposals.
While evaluating two basic principles are kept in view namely, the bigger benefits
are always preferable to small ones and that early benefits are always better than
the deferred ones. While evaluating, the following methods are usually followed. Pay
Back Method It gives the number of years in which the total investment in a
particular capital expenditure pays back itself. Accounting Rate of Return method,
capital projects are ranked in order of earnings. Projects which yield the highest
earnings are selected and others are ruled out. Average Rate of Return method
establishes the ratio between the average annual profits and total outlay of the
projects. Earnings per unit of money gives us the average rate of return per unit of
amount (i.e. per rupee) invested in the project. Return on Average amount of
Investment method under this method the percentage return on average amount of
investment is calculated.Net Present Value Method we simply find the present value
of the expected net cash inflows of an investment discounted at the cost of capital
13.7 TERMINAL EXERCISE
1. The technique of long term planning for proposed capital outlays and
their financing termed as ………………………………………. .
2. The minimum rate of return expected on a capital investment project is
termed as…………………….. .
3. The rate of interest at which the present value of expected cash inflows
from a project equals the present value of expected cash outflows of the
same project is termed as…………………………. .
4. ………………………………….is the annual average yield on a project.
5. The period needed to recoup, in the form of cash inflows from
operations, the initial money invested is termed as………………………..
13.8 SUPPLEMENTARY MATERIALS
http://www2.fiu.edu/
http://www.fao.org/
https://msu.edu
http://people.hss.caltech.edu/
http://www.investopedia.com/
http://umanitoba.ca/
http://isites.harvard.edu/
wps.prenhall.com/wps
https://www.cfainstitute.org
www.cengage.com
www.hss.caltech.edu
13.9 ASSIGNMENTS
1. Critically evaluate the net present value criterion.
2. Evaluate internal rate of return as a investment criterion.
3. Describe and evaluate the average rate of return method.
4. Critically evaluate the payback period as method of investment
appraisal.
13.10 SUGGESTED READINGS / REFERENCE BOOKS
Agrawal & Agrawal — Management Accounting (RBD. Jaipur)
Jain, Khandelwal, Pareek — Cost Accounting (Ajmera Book depot, Jaipur)
Khan, Jain — Management Accounting (S. Chand & Sons.)
Oswal, Maheshwari, Modi — Cost accounting. Cost Accounting ( RBD, Jaipur)
Pandey. I. M. — Management Accounting (S. Chand & Sons.)
13.11 LEARNING ACTIVITIES
Go to an organization and observe in what ways investment appraisal are
evaluated. Find the positive and negative things in the appraisal
13.12 KEYWORDS
Pay Back Period, accounting rate of return, Net present value, Internal rate of
return, Profitability index method, Terminal value method, Average Investment,
original Investment, Annual cash inflow, Average annual profits after tax, total
earnings, scrap value.
LESSON – 14
MARGINAL COSTING AND BREAK – EVEN ANALYSIS
14.1 INTRODUCTION
Marginal costing is a new area in the field of Accounting. It refers to the
production of additional increments of output. It also discusses its relationship
with Break-even analysis.
Marginal Costing, also known as Direct Costing or Variable Costing or by such
other names, is a comparatively new area in the field of accounting and is one that
is gradually gaining more and more acceptance. Described by different names on
the two sides of the Atlantic. The term ‘Marginal Costing’ is common in U.K. and
other countries of the Continent while the expression ‘Direct Costing’ or ‘Variable
Costing’ is preferred in United States the technique signified by the use of the
meddle of these words has been able to generate strong views both for an against
itself with the result that it has become a subject of lively raging controversy during
recent times
14.2 OBJECTIVES
To understand the concept of Marginal Cost and Cost-volume- profit
Relationship .After reading this lesson you should be able to know the meaning of
Marginal Costing, Break Even point. Understand the concept of marginal costing
and uses of marginal costing.
14.3 CONTENT
14.3.1 Concept of Marginal Cost
14.3.2 Break-up of Semi-Variable Expenses
14.3.3 Practical Application of Marginal Costing
14.3.4 Advantages of Marginal Costing
14.3.5 Limitations of Marginal Costing
14.3.6 Cost-Volume – Profit Relationship Break-Even-Analysis
14.3.7 Marginal Costs are used primarily in guiding decision
14.3.1 CONCEPT OF MARGINAL COST
‘Marginal Cost’ derived from the word ‘Margin’ is well-known concept of
economic theory. Thus, quite in tune with the economic connotation of te term, it
is described in simple words as the cost which arises from the production of
additional increments of output and it does not arise in case the additional
increments are not produced.
It has been derived by the Institute of Cost and Works Accountants, London, in
its publication ‘A Report of Marginal Costing’ as “the amount at any given volume of
output by which aggregate costs are changed if the volume of output is increased or
decreased by one unit”.
From this point of view, marginal costs will be synonymous with variable costs,
i.e., prime costs and variable overheads, in the short run but, in a way, also include
fixed costs in planning production activities over a long period of time involving an
increase in the productive capacity of the business. Thus, marginal costs are
related to change in output under particular circumstances of a case.
However, where an increase in fixed costs is envisaged in the walk of an
accretion to the production capacity and consequently to the level of activity, fixed
costs are dealt with as a part of what are called ‘Different Costs’ so that the usage of
the term ‘Marginal Cost’ is restricted in actual practice only to cases involving a
more effective illustration of the existing installed capacity intended for a better
recovery of fixed costs per unit of output.
According to the Institute of Cost and Works Accountants, London, “Marginal
Costing is the ascertainment, by differentiating between fixed costs and variable
costs, of marginal costs and of the effect on profit or changes in the volume and
type of output.
In this context, marginal costing is not a system of costing in the sense in
which other systems of costing, like process or job costing, has been designed
simply as an approach to the presentation of accounting information meaningful to
management from the viewpoint of adjusting the profitability to management from
the viewpoint of adjusting the profitability of an enterprise by carefully studying the
impact of the entire range of costs according to their respective nature.
The concept of marginal costing is a formal recognition of ideas underlying
flexible budgets, break-even analysis and cost-volume profit relationship. It is
application of these relationships which involves a change in the conventional
treatment of fixed overheads in relation to income determination.
(A) BASIC CHARACTERISTIC OF MARGINAL COSTING
The concept of marginal costing is based on the important manufacturing
between product costs and period costs, the former being related to the volume of
output and the latter to the period of time rather than the volume of production.
Marginal costing regards as product costs only these manufacturing cost
which have a tendency to vary directly with the volume of output. This is in
complete contrast to the conventional system of costing under which all
manufacturing costs-fixed as well as variable are treated as product costs.
Variability with volume is the criterion for the classification of costs into product
and period categories.
Thus, marginal costing necessities analysis of costs into fixed and variable.
Even the semi-variable costs have to be closely and critically, analysed in order to
resolve themselves into their fixed and variable components depending upon
whether they tend to remain fixed or vary. In this way, marginal costing highlights
the effect of costs on the level of output planned.
(B) WORKING OF MARGINAL COSTING-INCOME DETERMINATION UNDER ABSORPTION AND MARGINAL COSTING
According to traditional costing system, fixed costs of production are
assigned to products to be subsequently released by way of expenses as part of cost
of goods sold or are carried forward as part of the cost of inventory depending upon
whether a period’s production was sole or not during the same period. Such an
approach to the treatment of fixed costs has brought into vogue various methods of
allocation of overheads to different departments on an equitable basis and their
proper apportionments to units produced. However, the various methods devised
fail to give precise results and sometimes even leads to absure situations. Marginal
results costing removes all the difficult involved in the allocation apportionment
and recovery of fixed costs. It is able to accomplish this by excluding fixed costs
from product costs and by writing them of entirely against operations of the period.
Consequently, when the volume of output differs from the volume of sales
the net income reported under marginal costing will differ from that reported under
absorption costing.
(C) ROLE OF CONTRIBUTION
Contribution is of vital important for the system of marginal costing. The
rationale of contribution lies in the fact that, where a business manufactures more
than one product, the profit realized on individuals products cannot possibly be
calculated due to the problem of apportionment of fixed costs to different products
which is done away with under marginal costing. Therefore, some method is
required for the treatment of fixed costs and marginal costing answer to the
challenge is ‘Contribution’.
Contribution is the difference between sales and the variable cost of sales and
is therefore, sometimes referred to as “gross margin”. It is visualized as some sort
of ‘fund’ or ‘pool’ out of which all fixed costs, irrespective of their nature, are to be
met and to which each product has to contribute either profit or loss as the case
may be.
The concept of contribution is useful in the fixation of selling prices,
determination of break-even-point, selection of product mix for profit maximization
and ascertainment of the profitability of produces, departments, etc.
14.3.2 BREAK-UP OF SEMI-VARIABLE EXPENSES
In view of the fact that marginal costing classifies all costs broadly into fixed
and variable only, it becomes necessary to insolate the two components of semi -
variable costs. In fact, the exercise of segregating the fixed and variable costs. In
fact, the semi-variable expenses constitutes by the most challenging problem of
marginal costing.
(a) The method is based on the analysis of historical data relating to periods of
high and low business activity which represent condition at two different levels of
business operations. In selection these periods and in dealing with costs incurred
during such periods, care should be taken to see that figures are not distorted and
by any abnormal factors.
(b) Statistical Scatter graph Method
This is widely used diagrammatic or graphic technique for insolating the fixed and variable portions of semi-variable costs.
According to this methods, costs and relevant figures relating to the level of
activity are plotted on along the vertical or Y-axis and horizontal or X axis
respectively thereby resulting in a scatter graph with each dot on the graph
representing the expense for a particular period at a certain level of activity. A line
is then drawn by visual inspection in such a manner that there are ideally as many
dots above the line as there are below it in order to make it typical of the majority of
dots on the graph. From the point of contact of this line with the vertical axis,
another line across the face of the graph is drawn parallel to the base so that it
represents the fixed component of a particular item of semi-variable expense while
the portion of the diagram lying between the two lines shows variability of an
expense as volume of production increase.
In spite of the fact that dots in the diagram are never to be found in a perfect
linear pattern, the line of total expenditure is drawn as a straight line and, in most
cases, the straight line would for all intents and purpose be a fair representation of
the single line would conform to all observations.
(c) Method of Least Squares
A mathematical techniques of ‘least squares’ is also used for computing a
more exact line, called ‘regression line’ representing total cost of an item of semi-
variable expense than what is possible according to the scatter graph method.
The method of least squares is based on the basic regression equation
y = a + bx where ‘a’ is the fixed portion and ‘b’ is the degree of variability.
Steps involved in putting the method to use are as follows:
i. The simple means of two concerned variables scales of operations and
total expense are calculated.
ii. The deviations of actual figures in the two variables from their respective
average calculated under step (i) above are found out with proper
algebraic signs.
iii. The deviations relating to the variable to relating variables from their
respective means are multiplied together and products obtained.
iv. Deviations of the actual figures of the two variables from their respective
means are multiplied together and products obtained.
v. Products under point (iv) are added.
vi. Squared deviations under point (iii) are totalled.
vii. To total of point (v) is divided by the total of point (vi) to arrive at the
variable rate of an expense.
viii. The fixed portion of the total expense can be calculated by deducting the
products of variable rate and the average cost of the item of expense.
14.3.3 PRACTICAL APPLICATION OF MARGINAL COSTING
(A) Level of Activity Planning
One of the very common problems confronting a business is regarding the
level of activity for which it should have plans in hands, such plans may envisage
an expansion or contraction of productive activities depending upon the qualitative
conditions in the market. The expansion or contraction has to be arranged before
the events overtake the business. In this context, management like to have an idea
of the contribution at different levels of activities and marginal costing proves very
useful from this point of view.
(B) Maximization of Sales
Usually, business enterprises have a variety or product lines, each making
its own contribution to fixed expenses. Changing in the operating profit can result
from shifts in the mixture of products sold in spite of the fact that sales expressed
in terms of money remains the same. Such a situation may also be brought about
by changes in distribution channels, or sales to different classes of customers, if
such an arrangement affects the quantum of contribution over variable costs. It is
in this context that marginal costing is called upon to inform management
regarding the most profitable mix of sales from the entire range of selected
alternatives.
(C) Marginal Costing and Pricing
The determination of prices of products manufactured or services rendered,
by business is often considered to be a difficult problem generally faced by
management of an expertise. However, the basic problem involved in pricing is the
matching of demand and supply.
To illustrate, of a person travels from Delhi to London by a leading
international airline, he may be able to arrange to trip of a country of the Middle
East, he may be able to arrange diametrically by paying only half of the normal
face. These two diametrically opposite position can be reconciled by pointing out
that while normal fares are so determined by leading airlines companies as to
normal overall costs of operation including fixed costs which are bound to be
considerable, smaller companies may fix fares at a level as to cover only marginal
costs and yield some contribution towards profit owing to their inability or
reluctance to do away with their business due to huge funds being sunk in capital
investments.
By placing emphasis on contribution margin, the technique of marginal
costing offers a simple as well as clear portrayal of the relationship between specific
product costs and the different possible selling prices considered. This is due to
the fact that contribution margin is unaffected by the allocation of indirect costs.
(D) Profit Planning
Marginal costing, through the calculation of contribution ratio, enables the
planning of future operations in such a way as to attain either maximum profit or
to maintain a specified level of profit. Thus, it is helpful in profit planning.
14.3.4 ADVANTAGES OF MARGINAL COSTING
(i) Constant in Nature
Marginal costs remain the same per unit of output irrespective of the volume of
production.
(ii) Realistic Valuation
Elimination of fixed overheads from the cost of production means that finished
goods and work-in-progress are valued at their marginal cost and therefore, the
valuation is more realistic and uniform as compared to the one when they are
valued at their total cost.
(iii) Simplification of Overhead Treatment
Marginal costing does away with the need for allocation, apportionment and
absorption of fixed overheads thereby removing an important source of accounting
complications by way of under absorbed over-absorbed overheads.
(iv) facilitating Cost Control
The clear-cut division of costs into their fixed and variable components paves
the way for a better cost control through flexible budget which is based on this
important distinction.
(v) Meaningful Managerial Reporting
As reports to management are based on figures of sales rather than of
production, marginal costing constitutes a better approach in as much a stocks do
not affect the comparisons of efficiency which are made on the basis of sales.
(vi)Basis for Pricing and Tendering
Marginal costing furnishes a better and more logical basis for the fixation of
sales prices as well as in tendering for contracts when business is at a low ebb.
(vii) Aid to Profit Planning
The technique of marginal costing enables data to be presented to
management in a manner as to show cost-volume-profit relationships. In this
connection use is made of break-even charts.
14.3.5 LIMITATIONS OF MARGINAL COSTING
(i) Difficulty in analysis
Considerable difficulty is always experienced in analysis overheads into their
fixed and variable components.
(ii) Lop-sided Emphasis
Marginal costing has a tendency to attach more importance to the selling
function which has the effect of relegating production function to a comparatively
unimportant position. However, the efficiency of a business is to be judged by
taking together its selling as well as production functions into account.
(iii) Difficulty in Application
The technique of marginal costing cannot be adequately applied in the case
of industries in which, according to the nature of business, large stocks have to be
carried by way of work-in-progress.
(iv) Limited Scope
‘As marginal costing distinguishes between the treatment of fixed and
variable components as parts of fixed costs, it is difficult to adopt the technique in
capital-intensive industries where fixed costs are very large.
(v) Inappropriate Basis for Pricing
Selling price cannot reasonably be fixed on the basis of contribution alone
because then there is the danger of too many sales being affected at marginal cost
resulting either in loss to the business of inadequate profits.
In the light of these advantages and disadvantages, marginal costing may be
considered to be a very useful technique from the point of view of management, but
it must be applied with a full awareness of its limitations as well as of the
circumstances in which it can be fruitfully used.
14.3.6 COST-VOLUME-PROFIT RELATIONSHIP – BREAK-EVEN-ANALYSIS
These days, in management accounting a great deal if importance is being
attached to cost-volume-profit relationship which, as its name implies, is an
analysis of three different factor-costs, volume and profit. In this case, an analysis
is made to find out.
What would be the cost of production under different circumstances?
What has to be the volume of production?
What profit can be earned?
What is the difference between the selling price and cost of production?
The answers to these queries underline the important fact that the three
factors of cost, volume and profit are interconnected and dependent on one
another.
14.3.7 MARGINAL COSTS ARE USED PRIMARILY IN GUIDING DECISIONS
The most useful contribution of marginal costing is the assistance if renders to
the management in vital decision-making. The presentation of information under
marginal costing is of use in making policy decisions in cases where the
information obtained from total cost method would be incomplete. Sometimes the
information revealed by total cost method may be even misleading.
The following are a few of the managerial problems which are simplified by the
use of marginal costing techniques:
(1) Pricing of products, (2) Make or buy decisions, (3) Selection of a suitable
product mix, (4) Alternative methods of production and (5) Closing down of
business.
(A) Pricing of Products
Although prices are regulated more by market conditions and other
economic factors than by decision by management, the management while fixing
prices has to keep in view the level of profits expected. In normal times the price
fixed must cover full costs as otherwise profits cannot be earned. But under
certain circumstances, products may have to be priced at a level below total cost, if
sucha course is necessary to meet the situation arising due to trade depression.
This is so because fixed costs will have to be incurred irrespective of whether
production continues or not. Any contribution towards the recovery to fixed costs
will reduce the losses which will be incurred if production is stopped. As a word of
caution fixation of prices below total cost should be made only on a short-term
basis. Marginal costing presents information regarding the rate of contribution at
various levels of prices and capacity, so as to enable the management to know the
price limits within which it can operate.
(B) Make or But Decisions
Decision to make of buy has to be taken when the product begin
manufactured has a component part that can either be made within the factory or
purchased from an outside firm. This decision can be arrived at only by comparing
the supplier’s price with the marginal cost. For example, the total cost of making a
component part comes to Rs.11, consisting of Rs.8 as variable cost and Rs.3 as
fixed cost. Suppose an outside firm is willing to supply the same component part
at Rs.10. The prima facie conclusion is that it is cheaper to buy the component.
But a study of cost analysis above shows that each unit of component contributes
Rs.3 towards the recovery of fixed cost. This fixed cost has to be incurred whether
to make or buy. The real cost in making one unit of component is only Rs.8, which
is its variable cost. The offer should, therefore, be rejected because the acceptance
will mean that the total cost of the purchased part will come to Rs.13 i.e. Rs.10
(Purchase Price) plus Rs.3 (Fixed cost, which cannot be saved if production is
suspended).
However, in arriving at a final decision, other factors may have to be
considered. Thus, the production facilities related by stoppage of production may
be put to some alternative use in which the above argument may not hold good. It,
however, remains true that cost analysis on the marginal cost technique
illuminates an important aspect of decision-making.
(C) SELECTION OF A SUITABLE PRODUCT MIX
When a concern manufactures more that one product, a problem often
arises as to which product mix will yield the highest profits. The cost-profit relation
to different products would vary depending upon the structure and composition of
cost elements and sales price. The products which give the maximum profits are to
be retained and their production pushed up. The production of comparatively
disadvantageous products should be reduced or closed down altogether. Marginal
costing helps management tin taking a decision to continue, increase, reduce or
suspend production of a product or to change the product mix. The best product
mix is one which yields the maximum contribution margin.
(D) ALTERNATIVE METHODS OF PRODUCTION
If the management has to choose from among alternative methods of
manufacturing a product, the changes in the marginal contribution under each of
the proposed methods has to be worked out. Thus for example, a new product may
have been development and the management is faced with the problem of
employing a machine or to manufacture entirely by manual labour. The method of
manufacture which yields the greatest contribution is to be selected keeping of
course, the various key factors in view.
(E) CLOSING DOWN OF BUSINESS
If a sufficient volume of business cannot be secured, the management may be
faced with the problem of deciding whether production should be stopped or not.
This business may take the shape of either temporary suspension of production or
permanent closing down of business.
If the production is temporarily suspended, the object is to close down
operations until trade recession has passed. If the products are making a
contribution towards fixed costs, then generally speaking, production should not be
stopped. This is so because if prices exceed marginal costs, losses will tend to be
minimized by continuing the operations.
Permanent closing down of business is a very drastic decision and will be
carried out only in extreme cases. In the long run selling price must exceed the
total cost so as to give a net margin, otherwise it will not b economical to continue
the production. If the business is not earning sufficient return for the risk involved,
then the production may be closed down permanently.
PRACTICAL PROBLEMS:
COST-VOLUME PROFIT LINKAGE
To understand break-even analysis, it is necessary to understand the
relationship between sales, variable costs and profit. The division of costs into
“Variable” and “Fixed” entails the establishment of a constant linkage between
selling price and variable costs. This leaves behind a surplusous of the sales
revenue. The surplus is called contribution which bears a constant relationship
with sales.
The linkage between revenue and cost data are presented as follows:
Rs.
Sales --------
LESS Variable cost --------
Contribution --------
LESS Fixed Cost --------
Net Profit --------
The relation of the contribution to sales is known as P/V ratio (Profit-Volume
ratio). This ratio is the vital instrument in the hands of the management
accountant while shifting operational data. The P/V ratio has the following special
feature:
1. It is the result of linking contribution to the relevant sales which provides
the contribution.
2. It remains constant so long as the selling price and variable costs per unit
remain constant or fluctuate proportionately.
3. It is unaffected by an change in the level of activity. Hence the ratio would
be constant whether studied on 10,000 units basis, 1000 units basis or a
single unit basis.
4. The ratio is unaffected by any fluctuation in the fixed cost, because the
latter does not enter into the computation of contribution at all.
A substitute for P/V ratio is “Contribution per unit”. This is also an equally
effective instrument of the management accountant in analyzing data. The utility
of P/V ratio or contribution per unit is varied. The following illustration will show
how the instrument is used.
ILLUSTRATION 1
A factory produces 300 units of a product per month. The selling price is
Rs.120 and variable cost Rs.80 per unit. The fixed expenses of the factory amount
to Rs.8,000 per month. Calculate:
(i) The estimated profit in a month wherein 240 units are produced.
(ii) The sales to be made to earn a profit of Rs.7,0000 per month.
SOLUTION
Rs.
Selling Price per unit 120
LESS Variable cost per unit 80
Contribution per unit 40
P/V ratio = PriceSelling
onContributi x 100
= 120
40x 100 = 33 1/3 %
(i) Profit on Sale of 240 Units
Sales of 240 units at Rs.240 each = Rs. 28,800
Contribution from the above at 33 1/3% = Rs. 9,600
LESS: Fixed cost of the month = Rs. 8,000
Profit Rs. 1,600
The result can also arrive at as follows:
Number of units to be sold = 240
Contribution per unit = Rs.40
Contribution from 240 units = 240 x 40 = Rs.9,600
LESS: Fixed Cost = Rs.8,000
Profit = Rs.1,600
(ii) Sales required to earn a profit of Rs.7,000/-
Profit required to earn a profit of Rs.7,000/-
Profit required to be earned = Rs. 7,000
ADD: Fixed Cost = Rs. 8,000
Total Contribution to be earned = Rs.15,000
Since P/V ratio = 33 1/3%
Sales required to earn Rs.15,000
31 33
15,000 x 100 = Rs.45,000
This result can also be arrived as follows:
Contribution per unit Rs.40
Number of units to be sold to earn Rs.15,000
= 40
15,000 = 375 Units
Selling Price per unit = Rs.120
Total Sales = 375 x 120 = Rs.45,000
DETERMINATION OF BREAK-EVEN POINT (BEP)
A break-even point is that level of activity where cost equals total revenue so
that the firm neither earns profit nor suffers any loss. At this stage the firm is said
to break even. This is the point at which the total contribution is just equal to the
fixed costs, hence, no profit or loss is earned. No first would be content to reach
only this point. But this represents a point which one must reach before one goes
further to earn a profit. If one does not reach this point, one has suffered a loss.
By determining this point, the firm can very well assess for itself how far away it
actually is from that point. If the firm is actually at a level higher than the BEP, it
means that it is very profitable. If difficulties develop, it has a cushion or margin of
safety on which to fall back upon.
Out of the contribution after meeting fixed expenses, the net profit is to be
ascertained. But at the BEP there is no profit or loss, hence at the BEP,
contribution equals total fixed expenses. This idea can be stated as follows:
Sale(S) – Variable cost (V) = Fixed Cost (F) + Profit (P)
S – V = F + P
S = V + F + P
P = S – V + F
Therefore, the number of units at the break even point can be worked out
as:
unit per onContributi
Expenses Fixed =
C
F
If the sales have crossed the BEP, it means that the contribution obtained by
the extra sales over the BEP is completely profit because all fixed expenses have
already been met at the BEP stage itself.
ILLUSTRATION 2
The sales of company are at (Rs.200 per unit) Rs. 20,00,000
Variable cost Rs. 12,00,000
Fixed cost Rs. 6,00,000
The capacity of the factory 15,000 units
Determine the BEP. How much profit is the company making?
SOLUTION
Rs.
Selling Price per unit 200
Variable cost per unit 120
Contribution per unit 80
Fixed expenses . . . . . . . Rs.6,00,000
Break-even point = 80
6,00,000 = 7,500 units
Profit Being Earned
Annual Sales (Units) 10,000
BEP (Units) 7,5000
Sales above BEP (Margin of Safety) 2,500
Contribution at Rs.80 per unit
80 x 2500 = 2,00,000
PROOF
S = V + F + P
= 12,00,000 + 6,00,000 + 2,00,000
Sales = 20,00,000
At break even point the contribution is just equal to fixed costs. Any sale
above the BEP also provides the contribution. But as fixed costs are all met already
such contributions become completely profit. The Sales above BEP are known as
margin of safety. The contribution from margin of safety sales is profit as P/V ratio
Sales
onContributi x 100 and as profit is the contribution from these sales above BEP
(ie. margin of safety), the following formula is also true.
Safety of Margin
Profitx 100 = P/V ratio
ILLUSTRATION 3
From the following particulars, Calculate a break-even point for (a) unit, and
(b) sales value.
Total variable costs Rs. 10,000
Total fixed costs Rs. 20,000
Total sales Rs. 50,000
Selling price per unit Rs. 5
Output 10,000 units
Variable cost per unit Rs. 1.00
SOLUTION
Brea-Even point for unit
= Cost Variable Unit - PriceSelling Unit
Cost Fixed
= 1 - 5 Rs.
20,000 Rs. =
4
20,000 = 5,000
= Profit Net - Cost Fixed
Cost Fixed x 100
= 20,000 Rs. 20,000 Rs.
20,000
.sR x 50,000
= Rs.25,000
ILLUSTRATION 4
From the following particulars calculate the break-eve point. Find out the
net profit if sales are 10% and 15% above the break even volume.
Rs.
Selling price per unit 10
Trade Discount 5%
Direct material cost per unit 3
Direct labour cost per unit 2
Fixed overheads 10,000
Variable overheads 100% on Direct labour cost.
SOLUTION
Variable cost per unit (Rs.3 + Rs.2 + Rs.2) = Rs.7
Selling price Rs. 10.00
LESS: 5% Discount Rs. 0.50
9.50
Contribution per unit Rs.9.50 – Rs.7.00 = Rs.2.50
B.E.P. = onContributi
F = Rs.
2.50
10,000 = 4,000 units
B.E.P. Units 4,000
ADD: 10% 400
4,400 @ Rs.2.50 = 11,000 – 10,000
Profit = Rs.1,000
B.E.P. Units 4,000
ADD: 15% 600
4,600 @ Rs.2.50 = 11,500 – 10,000
Profit = Rs.1,500
PROFIT PLANNING-DESIRED PROFIT
All business want to do something better than the just break-even. Cost-
Volume-Profit analysis is incorporated into break-even analysis by applying the
following formula for x
Xn =
Sales necessary to reach desired profit:
=
Sales
costs Variable -1
profit Desired cost Fixed
Desired Profit unit sales volume:
Margin onContributi Unit
profit Desired cost Fixed
V -P
F
If the selling prices increase, the formula would be,
B.E.P. =
PriceSelling New
costs Variable -1
cost Fixed
If the change in the variable cost takes place, the B.E.P would be
B.E.P. =
ILLUSTRATION 5
Given the following information:
Units of output 5,00,000
Fixed costs Rs.7,50,000
Variable cost per unit Rs.2
Selling price per unit Rs.5
You are required to determine:
i) the break-even point
ii) the sales needed for a profit of Rs.6,00,000 and
iii) the profit if 4,00,000 units are sold at Rs.6 per unit
SOLUTION
(i) Break-even point =
= = c
= 7,50,000 x = Rs.12,50,000
ii) Sales needed for profit of Rs.6,00,000
= =
5
3
00Rs.13,50,0
= Rs.13,50,000 x = Rs.22,50,000
Sales
Cost VariableNew -1
cost Fixed
unit per Sales
unit per cost Variable -1
cost Fixed
5
2 -1
0Rs.7,50,00
3
5
5
2 -1
0Rs.6,00,00 0Rs.7,50,00
3
5
= = 5
22,50,000 = 4,50,000 Units
OR
= V P
F
=
3
0Rs.6,00,00 0Rs.7,50,00 = 5,40,000 Units
iii) Profit on sale of 4,00,000 units at Rs.6 per unit
Sales = 4,00,000 units x Rs.6 = Rs.24,00,000
1
24,00,000=
1
24,00,000 =
6
2-1
Profit 0Rs.7,50,00
1
24,00,000 x
3
2 = 7,50,000 + Profit
Profit = 16,00,000 – 7,50,000 = 8,50,000
Profit = 8,50,000
ILLUSTRATION 6
You are given the income statement of A company Limited
Rs. Rs.
Net Sales 5,00,000
LESS: Expenses:
Variable 3,50,000
Fixed 2,50,000 6,00,000
1,00,000
Assuming that variable expenses will always remain the same percentage of sales.
Compute
(a) What amount of sales will cause the firm to break-even, if fixed expenses
are increased by Rs.1,00,000?
(b) What amount of sales will yield a net profit of Rs.50,000 with the proposed
increase in fixed expenses?
SOLUTION
(a) Break-Even Point =
unit per Sale
00Rs.22,50,0
unit per Sales
cost Variable -1
Profit Desired cost Fixed
Sales
Expenses Variable -1
Profit Desired Expenses Fixed
OR
=
=
or = 0.30
0Rs.3,50,00 B.E.P. = Rs.11,66,667
(b) Required Sales (R.S.) =
= = Rs.13,33,333
MARGIN OF SAFETY
Margin of safety is an important concept in the context o, marginal costing
and cost-volume-profit analysis. The margin of safety refers to the amount by
which sales revenue can fall before a loss is incurred. In other words, it is the
difference between the actual sales and sales at the break-even point or spread
between anticipated sales and break-even sales. Margin of safety can be expressed
in absolute sales amount or in percentage. For example, if a company can break-
even at 50 percent of expected sales, then it has margin of safety of 50 percent. If
the present sales level is Rs.1,000 or 1,000 units the break-even volume may be
sales Rs.500 or 500 units, so the margin of safety is Rs.500 or 500 units. The
margin of safety is given by the formula:
Margin of Safety =
= x 100 = 50 percent
or Rs.1,000 – 500 = Rs.500
Margin of safety =
OR
Margin of Safety (M/S) = x 100
Actual Sales – Sales at BEP
ILLUSTRATION 7
Ratio Margin onContributi
Profit Desired Expenses Fixed
0Rs.5,00,00
0Rs.3,50,00 -1
0Rs.1,00,00 0Rs.2,50,00
Ratio Margin onContributi
Profit Desired Expenses Fixed
0.30
0Rs.4,00,00
Sales Actual
Sales EvenBreak - Sales Actual
Rs.1,500
Rs.500 -Rs.1,000
Sales Budget
Point Even -Break above Sales
RatioP/V
Profit
From the following calculate the break-even point and the turnover required
to earn a profit of Rs.36,000.
Fixed Overheads Rs. 1,80,000
Variable cost per unit Rs. 2
Selling Price Rs. 20
If the company is earning a profit of Rs.36,000, express the ‘margin of safety’
available of it.
SOLUTION
Break-Even Point (in units)
=
= 2 - 20
1,80,000 = 10,000 units
Break-even point (in amount) = 10,000 units @ Rs.20 per unit
= Rs.2,00,000
Turnover required to earn a profit of Rs.36,000:
Turnover units = unit per cost Marginal - unit per PriceSelling
Profit - Expenses Fixed
= = 12,000 units
Turnover is Rs.12,000 units @ Rs.20 per unit
= Rs.2,40,000
MARGIN OF SAFETY
Units Amount
Rs.
Sales to earn a profit of Rs.36,000 12,000 2,40,000
LESS: Sales at Break-Even Point 10,000 2,00,000
Margin of safety 2,000 40,000
Margin of safety can also be calculated by the other formula
Margin of safety = =
= Rs.36,000 x = Rs.40,000
unit per cost Marginal - unit per PriceSelling
Expenses Fixed
Rs.2 - Rs.20
Rs.36,000 -0Rs.1,80,00
RatioP/V
Profit
20
18
36,000 Rs.
18
20
P/V Ratio = = Sales
Cost Marginal - Sales
Rs.20
Rs.2 - Rs.20 =
20
18x 100 = 90%
ILLUSTRATION 8
From the following profit and loss statement, prepare a break-even chart
and determine:
(a) The break-even point
(b) The margin of safety
(c) The sales necessary to obtain a profit of Rs.10,000
Rs. Rs.
Sales 84,000
Costs: Variable 56,000
Fixed 24,000 80,000
Profit 4,000
SOLUTION
Break-even point by algebraic formula:
(a) Break-even point for sale = Profit Cost Fixed
Sales x Cost Fixed
= 4,000 24,000
84,000 x 24,000
= Rs.72,000
Sales
onContributi
(b) Margin of safety = Actual Sales – Break-even sales
= Rs.84,000 – Rs.72,000 = Rs.12,000
(c) Sales at desired profit =
Sales
cost Variable - 1
Profit Desired Cost Fixed
=
84,000
56,000 - 1
10,000 24,000
= 28,000
34,000x 84,000
= Rs.1,02,000
From the break-even chart shown above it will be seen that:
(a) The break-even point is at sales of Rs.72,000
(b) The margin of safety is Rs.84,000 – Rs.72,000 = Rs.12,000 = 14%
(c) The gap between the sales and total cost curves, (i.e., the profit) reaches
Rs.10,000 when the sales are Rs.1,02,000
ILLUSTRATION 9
A radio manufacturing company finds that while it costs Rs.6.25 each to
make component x 273 Q, the same is available in the market at Rs.5.75 each, with
an assurance of continued supply.
Materials Rs.2.75 each
Labour Rs.1.75 ”
Other variables Rs.0.50 ”
Depreciation and other fixed cost Rs.1.25 ”
Rs.6.25
(i) Should you make or buy?
(ii) What would be your decision if the supplier offered the component at
Rs.4.85?
SOLUTION
(i) The variable cost of producing the component is Rs.5 made up as follows:
Rs.
Materials 2.75
Labour 1.75
Other variables 0.50
Variable 5.00
Since the depreciation and other fixed costs are sunk costs, the cost that
can be saved if it is decided to buy the component instead of making it Rs.5 per
unit which is the variable cost. Hence, there will be no saving. Secondly, the cost
of buying will be more Rs.5.75 unless the capacity released, by the decision to buy,
can be utilized in making some other profitable product. So the decision to make or
buy will be influenced by the fact whether the capacity to be released by the
stoppage of production of the component can be utilized profitably or not. If yes,
then buying is preferable, if not, making is preferable.
(ii) If the price offered by the supplier is reduced to Rs.4.85 each then there
will be a saving of 15 paise per unit even if the capac ity released cannot be
profitably employed. In such a case it would be advantageous to buy the
component and efforts may be made to utilize the spare capacity in producing other
profitable products.
Foreign Market
ILLUSTRATION 10
A manufacturer of a certain product has been selling exclusively in the
Indian Market up to now. He has just received his first export enquiry and wants
to quote as competitively as the circumstances will allow. This latest Indian Cost
Sheet is:
Rs.
Raw materials 34 per unit
Direct labour 13
Services 6
Works overhead 7
Office overhead 2
Profit earned in India 62
Indian Selling Price 6
68
Management is thinking of quoting a selling price somewhere between Rs.62
and Rs.68 per unit for this export order. One of the Directors suggests quoting an
even lower price based on the principles of marginal costing. As the firm’s
Accountant you are requested to compute the lowest the management could quote
on these principles. State clearly any assumptions that you may make on the
above facts and also on any other costs or facts.
Statement showing the lowest price for the Export Enquiry:
Rs.
Raw materials 34 per unit
Direct labour 13
Services 4
Marginal Cost 51 per unit
The cost sheet depend on the assumption made. The above is one
illustrative cost sheet based on the principles of marginal costing using the figures
given in the latest “total” cost sheet. The assumptions are given below:
1. It is assumed that sufficient manufacturing capacity exists not to disrupt
the supplies now being made to the Indian mark while fulfilling this export order. If
any such disruption takes place the negative costs of this disruption will be another
direct or opportunity cost of fulfilling this export order.
2. It is assumed in the above calculation that service costs to the extent of
Rs.4 per unit are directly variable with the production put through the shops, and
that the balance of Rs.2 is a fixed expense.
3. Similarly, it is assumed that works overhead is entirely fixed and should,
therefore, be excluded in marginal costing. It is possible that on occasion a part of
the works overhead may actually be variable. Similarly, it is assumed that office
overhead is totally fixed.
4. Certain direct costs of this export order like insurance, special packing,
import duties in the foreign country, special commissions, etc., would have to be
separately calculated and added on to the above marginal cost of Rs.51 before the
selling price is finally fixed. We would have to carefully determine whether the
quoted price should be on FOB or CIF basis. In the same way, the benefit available
from exports, such as cash subsidy that may be available, should be added to the
available price.
On the above basis, any price above Rs.51 (plus the items mentioned in Notes
1 and 4 above) will be the lowest possible price which can be quoted by the
company.
Exercise:
1. From the following information calculate contribution, p/v Ratio, BEP and
Margin of safety.
Total sales Rs. 6,00,000
Selling price per unit Rs. 100
Variable cost per unit Rs. 60
Fixed cost Rs.2,00,000
2. From the following data you are required to calculate break-even point
and net sales value at this point:
Rs.
Direct Material cost per unit 8
Direct Labour cost per unit 5
Fixed overhead 24,000
Variable overheads @ 60% on direct labour
Selling unit 25
Trade Discount 4%
If sales are 15% and 20% above the break-even volumes determine the net
profits.
3. An Analysis of Seshu co. Ltd, led to the following information
Variable cost (% on
sales)
Fixed cost (Rs.)
Direct material
Direct labour
Factory overheads
Distribution overheads
Administration
overheads
32.8
28.4
12.6
4.1
1.1
1.89,000
58,400
66,700
Budgets sales for the year Rs.18,50,000. You are required to calculate .(i)
The break – Even sales. (ii) The profit at the budgets sales, (iii) The profit if
actual sales
(a) Drop by 10%
(b) Increase by 5% from budgeted sales.
4. Assuming that the cost structure and selling price are remain in periods I
and II. Find out
1. P/V Ratio
2. BEP in amount
3. Profit when sales are Rs. 1,00,000
4. Margin of safety in II period
5. Sales required to earn a profit of Rs. 20,000
6. Variable cost for both periods.
Period Sales(Rs.) Profit (Rs.)
I 1,20,000 9,000
II 1,40,000 13,000
Decision Making Problems:
5. Following information has been made available from the cost records of
United Automobiles Ltd, manufacturing spare parts:
Direct Materials Per Unit
X Rs.8
Y 6
Direct Wages
X 24 hours @ 25 paise per hour
Y 16 hours @ 25 paise per hour
Variable overhead 150% of direct wages
Fixed Overheads (total) Rs.750
Selling Price
X Rs.25
Y Rs.20
The directors want to be acquainted with the desirability of adopting any one
the following alternatives sales mixes in the budget for the next period.
(a) 250 units of X and 250 units of Y
(b) 400 units of Y only
(c) 400 units of X and 100 units of Y
(d) 150 units of X and 350 units of Y
6. The cost sheet of a product is given below
Rs.
Direct material 5.00
Direct wages 3.00
Factory Overheads:
Fixed Re. 0.50
Variable Re. 0.50 1.00
---------
Administrative expenses 0.75
Selling or distribution overhead:
Fixed Re. 0.25
Variable Re. 0.50
--------- 0.75
______
Total cost per unit 10.50
______
Selling price per unit is Rs. 12.00
The above figures are for an out put of 50,000 units. The capacity for the firm
is 65,000 units. A foreign customer is desirous of buying 15,000 units at a price of
Rs.10 per unit.
Advise the manufacturer whether the order should be accepted what will be
you advise if the order were from a local merchant?
14.4 REVISION POINTS
Basic characteristic of marginal costing- working of marginal costing, Role of
contribution- Practical Application of Marginal costing – limitations of marginal
costing.
14.5 INTEXT QUESTIONS
1. Define the term ‘Marginal Costing’?
2. Distinguish between absorption costing and marginal costing?
3. Explain the advantages of classifying the cost into fixed and variable
elements?
4. What do you mean by Semi-Variable expenses?
5. Explain the various methods of separating semi-variable expenses into fixed
and variable components?
6. Explain the following terms: Contribution, P/V Ratio, BEP, Margin of
safety.
7. Explain the advantages and disadvantages of marginal costing.
8. What are the limitations of marginal costing?
14.6 SUMMARY
Marginal costs are useful for pricing of products, make or buy decision and
selection of a suitable product mix. Besides the marginal costing help the
organisation in implication of overhead treatment on the other hand the limitations
of marginal costing is difficulty to analysis the overhead in short for marginal cost
some experiences is need.
14.7 TERMINAL EXERCISE
1. Marginal cost is known as
(a)Cost per unit (b) fixed cost (c) variable cost (d) Total cost.
14.8 SUPPLEMENTARY MATERIALS
Emerald / Journal of Accounting Research – emerald insinght.Com
Journal of Management Accounting Research Amercican/
aaahq.org/mad/JMAR/contents,ctm.
14.9 ASSIGNMENTS
1. How can the cost be classified on the basis of variability?
2. Discuss the applications of the marginal costing technique?
14.10 SUGGESTED READINGS / REFERENCE BOOKS
1. De paule. F C ---- Management Accounting in Practice.
2. P.N. Reddy & H.R. Appaniah--- ‘Essential of Management
Accounting
14.11 LEARNING ACTIVITIES
Students are requested to draw a Break Even chart with imagery figures.
14.12 KEYWORD
Marginal Cost, Break Even analysis, Cost volume.
LESSON – 15
MERGERS AND ACQUISITIONS, AND SWOT ANALYSIS
15.1 INTRODUCTION
A company may grow internally, or it may go externally through acquisitions.
The objective of the firm in either case is to maximise existing shareholders wealth.
Another company can be acquired through merger, take-over, consolidation etc. A
merger is a combination of two companies where only one survives. The merged
company goes out of (corporate) existence, leaving its assets and liabilities to the
acquiring corporation. Consider the merger of Tata Fertilisers Ltd. (TFL) with Tata
Chemical Limited (TCL), the promoting company. Under the scheme of merger, TFL
shareholders are offered 17 shares of TCL (market value per share was Rs. 114), for
every 100 shares of TFL held by them. Further, TFL's cumulative convertible
preference (CCP) shareholders who may not want to accept shares in exchange were
given the option of cash payment of Rs. 15 for every share they held. In this merger,
TCL is an acquiring company, which survives where as TFL is being the acquired
company, which ceases to exist,
15.2 OBJECTIVES
After reading this lesson you should be able to:
Understand the meaning of merger, take-over, etc,
Know the different kinds of mergers.
Identify the circumstances which influence merger of companies.
Specify the regulations/guidelines for take-over and merger.
List out recent mergers and acquisitions in India.
15.3 CONTENT
15.3.1 Concept of Merger and Acquisition.
15.3.2 Classification of Mergers-Operating Mergers Versus Financial Mergers
15.3.3 Circumstances which influence merger of Companies Financial and Non
financial factors
15.3.4 Major Mergers in Indian Corporate Sector
15.3.5 Merger process in India
15.3.6 Regulations of Mergers and Take-over.
15.3.7 Tender Offer -
15.3.8 Defensive Strategies
15.3.9 Issues to be considered in Mergers and Acquisitions.
15.3.10 Meaning of SWOT Analysis
15.3.1 CONCEPT OF MERGER AND ACQUISITION
A merger is different from a 'consolidation', or amalgamation which involves the
combination of two or more companies whereby entirely new company is formed.
All the old companies cease to exists, and their equity shares (common stock) are
exchanged for shares in the new company. For example, Hindustan Computer Ltd
(HCL), Hindustan Instruments Ltd., Indian Software Company Ltd. (ISCL) and
Indian Reprographics Ltd (REL) were amalgamated in April 1986 as a new company
called HCL Ltd. In this amalgamation, all the four amalgamated companies lost their
identify and formed a new company known as HCL Ltd. When two companies of
about same size combine, they usually consolidate; on the other hand, when the
two companies differ significantly in size, usually a merger is involved. Though it is
important to understand the distinction, the terms 'merger' and 'consolidation'
tend to be used interchangeably to describe the combination of two companies.
The term 'take-over' means the acquisition by one person or group of persons
or by a company of sufficient shares in another company to give the purchaser
control of that other company. A 'take-over' in this sense differs from merger as the
company which is taken over by the purchaser remains in existence while in merger
one of the two companies goes out of existence. Thus, the take-over tends to denote
the situation where one business offers to buy out of the owners of another, often
against the wishes of the board of directors or groups of shareholders. The dividing
line between the two is indistinct. A number of situations which are presented as
mergers are effectively take-over bids. The directors of the taken over company,
being unable to control effectively the course of events in their business, are glad
of the opportunity to come to an arrangement with another business which
preserves their self-esteem by presenting the operation as merger.
The primary motivation for mergers is to increase the value of combined
enterprise. If companies A and B merge to form company C, and if C’ s value
exceeds that of A and B taken separately, then synergy is said to exist. Synergistic
effects can arise from three sources (i) operating economies resulting from
economies of scale in production or distribution, (ii)financial economies, including a
higher Price-Earnings ratio or a lower cost of debt, or both, and (iii)increased
market power due to reduced competition. Operating and financial economies are
socially desirable, but mergers that reduce competition are both undesirable and
illegal.
15.3.2 CLASSIFICATION OF MERGERS
Economists classify mergers into three groups (a) horizontal, (b) vertical, and (c)
conglomerate.
a. Horizontal Merger: When two or more companies producing the same goods
or offering the same services decide to merge, it becomes a horizontal merger. The
horizontal merger will involve reduction in the number of competition companies in
the effected markets; for example, the emergence of Associated Cement Companies
(ACC) Limited when small cement plants all over the country decided to merge into
one company. The National Textile Corporation (NTC) resulting from the merger of
several sick units manufacturing textile products into one corporation. Merger
of Sundaram Clayton Limited's (SCL) moped division with TVS Suzuki Limited (TSL),
and take-over of Universal Luggage Company by Blowplast Company are other
examples for horizontal merger,
b. Vertical Merger: A vertical merger or integration on the other hand is a
merger between two companies manufacturing different products but having
customer supplier relationship wherein the product of one company is used as raw
materials by the other company. The merger between Tata Iron and Steel Company
Ltd. and. Indian Tube Company Limited is in the nature of a vertical merger
c. Conglomerate, Mergers: Pure Conglomerate merger occurs where-
one company takes over another company in a completely different industry, with
no important common factors between them in production, marketing, research
and development or technology. Such mergers result in no reduction in competition
in the industries concerned, the example of this is the merger between Mahindra
and Mahindra Limited and Indian Aluminium Company Limited,
In any type of merger parties such as the shareholders of the company, the
creditors, the employees, the government through monopoly commissions, the
lending financial institutions, the stock exchange, high courts etc., get involved. In a
decision to allow merger of public limited companies the interest of minority
shareholders and the public interest in general should always be considered before
the necessary permission to merge is granted by the authorities concerned. These
parties should evaluate the proposal of merger in proper perspective considering
carefully the following factors affecting the mergers:
(i) The capacity to influence its market share, (ii)efficiency of the merged
enterprise, (iii)the regional imbalance and the employment, (iv)the effects on
balance of payment, and (v)the public interest.
Operating Mergers Versus Financial Mergers
From the standpoint of financial analysis, there are two basic types of mergers:
1. Operating mergers, in which the operations of two companies are
integrated with the expectation of operating economies for obtaining
synergistic effects.
2. Pure financial mergers, in which the merged companies will not be
operated as a single unit and from which no operating economies are
expected.
The primary benefit from an operating merger is high expected profits. For
example, the combined company may be able to reduce overheads and thereby
raise profits. The expected benefits of financial mergers are more varied. In one
case, the target company may have no financial leverage, so the acquiring firm may
plan to buy the company, pay for it by issuing debt, and gain market value from
the capital structure change. In another instance, one of the firms may be so small
that its stock is illiquid, and its Price-Earning ratio is low. In such a case the stock
will have a low value, and it may represent .a bargain purchase for the acquirer
value. In other instances, one firm may have excessive liquidity, large annual cash
flows, and unused debt capacity, while another firm may need financial resources to
take advantage of growth opportunities.
Financial and Managerial Considerations
Amalgamation is the blending of two or more existing undertakings, the
shareholders of each company becoming substantially shareholders in the company
which is to carry on the blended undertakings. The term amalgamation has not
been defined in the Companies Act. It is an arrangement whereby the assets of two or
more companies become vested in or under the control of one company.
Amalgamation comes into play when two companies are joined to form a third
company or one is absorbed into or blended with another. Amalgamation generally
takes place between companies which are associated with one another in some form
or other e.g. common shareholders, unity of management, common line of business,
location of activities etc. But amalgamation between two companies which have
nothing in common can also take place and this has become equally popular in
the present emphasis on diversification and insulation against economic, socio-
political vicissitudes besides uncertainties of nature. The overall considerations of
business and the needs of socio-economic changes including of scale, industrial
and trade policies of the state may also influence the merger of companies with a
view to achieving long term, economic and financial benefi t, both for the
companies concerned and the
15.3.3 CIRCUMSTANCES WHICH INFLUENCE MERGER OF COMPANIES
(a) Gap between corporate objectives and achievements: Despite reasonable
internal growth, management might find a clear gap between expectations and
realizations ei ther due to time constraint, want of special managerial skills,
productive capacity, technology, research and development etc. Merger of companies
may facilitate companies to grow from a higher take off point and record incremental
sales volume, marshal effectively the available resources and ensure optimum
returns.
(b) The need for diversification: With a view to ensuring greater stability in
the earnings and working capi tal management and to get over the limi tation of
managerial know-how, product and production technology, marketing skills and
other key factors, amalgamation may provide the answer for exchange of all the
readymade skills of the companies concerned so that the new emerging
management may adopt them to advantage. With the transplanting of new skills,
the new management will also be revitalized and the company poised for further
accelerated growth.
(c) Spreading the risk : A small company is exposed to relatively more risk
in embarking upon a new product line. Initial and potential losses may be too
high when compared to capital base. Combination with a larger company would
spread the risk.
(d) Elimination of unhealthy competition : Two companies running identical
business can merge together to avoid competition and save huge money on
competitive advertisements.
(e) Related lines of business: Where activities of companies are complimentary
to one another, merger can help reduce cost of products. Different companies
dealing with product at different stages of production, all of which ultimately
result in the production of one or more major items or products can also merge
together under a common ownership.
(f) Long gestation period : A capital intensive company with a long gestation
period can advantageously increase i ts 'debt, capaci ty' by merging wi th
another noncapital intensive company, especially when the latter company is a
cash rich company and the idle cash can be profitably invested.
(g) Shareholders Net worth: Shareholders of a closely held company can
reasonably expect a better return upon the company merging with a widely held
company besides ensuring enough liquidity and feasibility of altering their
investment portfolio. Further the earning per share of the amalgamating company
is bound to improve and future earnings ensured.
(h) Tax Benefits: The various fax benefits that accrue from amalgamation form
additional incentives.
(i ) Non financial factors : Apart from the financial factors the following
nonfinancial factors have also to play a part in merger proposals: (i ) Role and
compensation of the earlier management over the new or amalgamated company,
(ii)Continuation and promotion of the existing products, (iii) Opportunity to enter new
markets, (iv) Bargaining capacity after merger, (v) Safeguards for future growth,
(vi)Does the amalgamating company gain by the merger? and (vii) Does the
amalgamated company gain by the merger?
(j) In a merger proposal the amalgamated company not only takes over the
physical assets and liabilities of the amalgamating company but its experience,
organisation, proven performance, skilled staff apart from goodwill and these
factors have to be qualitatively assessed end taken note of.
(k) Seasonal or cyclical companies can merge with either non seasonal or other
companies for various reasons like funds management etc. For sick companies,
perhaps, amalgamation with a successful company is a practical proposition. For
successful companies, amalgamation would help securing certain potential tax
incentives apart from providing for external expansion. Small companies can merge
with other small companies if they have necessary managerial talent and
competence in addition to ensuring funds flow, Closely held companies may merge
with widely held companies in order to take advantage of the tax benefits. Even
foreign companies can merge and make the amalgamated company an Indian
company to ensure the tax benefits, by first converting the foreign branch into an
Indian company even as a subsidiary of the foreign company which in turn can be
merged with an Indian company, subject of course to the restriction imposed by other
legislations like MRTP., FERA, etc.
15.3.4 MAJOR MERGERS IN INDIA
Merging Companies Merged Company Remarks David Brown Greaves Cotton
Ruston & Homsby Greaves Semi – conductors VST
industries
ITC Vertical amalgamation increase market share and
enter agri - business Renusagar Power supply Hindalco Industries To generate additional funds
& diversity into extensive
product (merged) Tomcod Hinsustan Lever To become leader in
detergent & soap market Ucal components Pentafour products To increase turnover and
profits
Quest Internal India Ponds India - Wardhaman Auto Electrical Kirloskar Electrical Revival of the Company
Orisa Synthetics Straw Products Rehabilitation
Sources: Economic Times
15.3.5 MERGER PROCESS IN INDIA
The process of amalgamation is legislated by the Companies Act, 1956. The
following procedure for the amalgamation s normally followed:
Examination of object clause
Intimation to Stock Exchange
Approval of Amalgamation Draft
Making Application in the High Court
Drafting of notice and explanatory statements, and its despatch
Filing an affidavit in the court.
Holding of meeting of shareholders and creditors
Petition to the court for confirmation
Passing of orders by High Court
Transfer of the assets and liabilities
Issue of shares and debentures.
Historical Perspective: In India, the whole business of mergers and takeovers
till the 1970's was at a low key, though profitable affair: discussions were generally
conducted across the board and negotiated settlements reached amongst the
parties concerned. In the negotiated settlement, shareholders other than the
controlling interests had no real say, though in the case of mergers they were
required to vote for or against the merger resolution. The enormous clout wielded
by the financial institutions came to light when the famous raid of DCM Ltd. and
Escorts Ltd. was launched by Swaraj Paul in the early 1980's. Given the enormous
amount of floating short term funds held by institutions, industrialists realised that
an institutional vote could make or mar their future. Consequently, a demand was
made to curtail their power.
Though the role of financial institutions in takeover battles is rightly interpreted
as a connivance between political powers and industrialists, it must be borne in
mind that financial institutions are vested with the responsibility of moderating the
stock exchanges. Therefore, it is a matter for them to deal in large quantities of
shares and own large proportions of the share capital.
Financing the Acquisition (Method used in India): The three widely adopted
methods are (i ) using asset based financial to finance acquisition of a divirion,
(ii) buying of shares from the promoters by paying cash or Paying through own shares,
and'(iii) paying own shares in exchange for the company.
15.3.6 REGULATION OF TAKEOVERS
Basically the framework for regulating takeovers must seek to (i) impart
transparency to the process, (ii) protect the interest of the shareholders, and (iii)
facilitate the realisation of economic gains.
Transparency of the Process: A takeover affects the interests of many parties
and constituents, such as the contending acquirers, shareholders, employees,
customers, suppliers, and others. Hence, it-should be conducted in an open manner.
If the process is transparent, take-overs will be viewed favourably by all concerned
and regard a< a legitimate device in the market for corporate control.
Interest of Shareholders: In a take-over, the 'controlling block', which often
tends to be between 10 per cent and 40 per cent, is usually acquired from a single
seller, (Occasionally it may be acquired from many sellers through market
purchases.) Typically the 'controlling block' is bought at a 'negotiated' price which is
higher than the prevailing market price. The Securities and Exchange Board of
India (SEBI) has come out with some guidelines on Corporate Takeovers. The
essential thrust of these guidelines are to make takeovers as transparent as
possible in order to protect target companies and individual shareholders. As per
the guidelines, if a person who holds shares in a company has agreed to acquire
further shares through negotiations, which when taken together with the shares
already held by him, would carry more than 10% of the voting capital, he has to make
a public announcement of an offer to the remaining shareholders of the company,
before he acquires those additional shares.
Realisation of Economic Gains : The primary economic rationale for take-
overs should be to improve the efficiency of operations and promote better
utilisation of resources. In order to facilitate the realisation of these economic gains,
the acquirer must enjoy a reasonable degree of latitude for infusion of funds,
restructuring of operations, liquidation of non-viable division, widening of product
range, redeployment of resources, etc.
Role of Financial Insti tutions : Financial institutions, thanks to their
substantial equity holding in a large number of companies, often hold the balance
of power. Without their support, the acquirer may not be able to enjoy control.
Hence, they have a crucial role to play. Ideally, they should serve as guardians of
larger public interest and ensure that: (a) the process of take-over is open and
transparent", (b)potential acquirers operate on level ground, (c) the takeover is
likely to produce economic gains, (d) the interest of shareholders and other
constituents is reasonably protected, and (e) to undue concentration of market
power arises as a sequel of take-over.
Major Acquisitions in India
Acquired Acquirer Remarks
Polyester Libredivn. of Indian
Organic Chem
Reliance-Industries Cost saving
Sewa Paper and Chewdar Unit
of Titaghur Paper
Ballarpur Industries Acquired
Poysha Industries Tinplate Co. For diversifying to
package business
Andhra Pradesh Steel Balaji Group For revival and
expansion
Andhra Cement India Cement —
Gemini Breweries (P) Ltd. Kishor Chhabria Group Acquired
Kumardhubi Fire Clay Electro Fuel Mfg. Co. For revival
Source: Economic Times,.
15.3.7 TENDER OFFER
A tender offer is a formal offer to purchase a given number of a company's
shares at a specific price. In a tender offer, a company wants to acquire another
company and asks the shareholders' of the target company to "tender" their shares
in exchange for a specific price. The price is generally quoted at a premium i.e.,
above the market price, in order to induce the shareholders to tender their
shares. Tender offer is one of the ways of acquiring control of another company.
Tender offer can be used in two circumstances. First, it can be negotiated directly
through the management. The acquiring company requests the management of
target company to gel i ts approval. When the management of the target
company does not oblige, then the acquiring company can request directly the
shareholders by means of the tender offer. Second, the acquiring company can
directly request the shareholders of the target company to "tender" their shares at
a specific price. The shareholders are informed of the offer through announcement in
the financial press or through direct communication
individually. In USA, the tender offers have been used for a number of years,
but the pace has been intensified rapidly since 1955 whereas in India, there has
been no such tender offers till recently. In September 1989, Tata Tea Ltd. (TTL),
the largest integrated tea company in India, has made an open offer for controlling
interest to the shareholders of the Consolidated Coffee Ltd. (CCL). TTL's Chairman,
Darbari Seth, offered one share in TTL and Rs.1OO in cash (which is equivalent of
Rs. 140) for a CCL share which was then quoting at Rs. 88 on Madras Stock
Exchange. TTL's decision is not only novel in the Indian corporate sector but also a
trend setter. TTL had notified in the financial press about its intention to buyout
some tea estates and solicited offers from the shareholders concerned.
The exchange price for "tender" shares may be either purely cash or purely
shares of the acquiring company. Sometimes, the exchange consideration for tender
shares would be partly by cash and partly by shares of the acquiring company. In a
number of cases, the management of target company resists such tender offers.
There are many reasons for this resistance: (i) the acquiring firm may fail to
understand the culture and problems of the target company, (ii) future plans may not
be in the interests of target company's shareholders, (iii) tender offer or exchange
ratio is too low to accept, and (iv) acquiring company may replace the present
management with a new management.
15.3.8 DEFENCE STRATEGIES
There are a number of tactics and devices to defend the tender offer and avoid
being taken over by another company. The important defensive tactics are
divestitures or spin off, poison pill, green mail, white knight, crown jewels, blank
check, pac-man, shark repellent, gray knight, etc.
Divestiture (spin off): The target company disposes some of its operations or
part of the business in the form of a newly created company.
Crown Jewels: Disposal of profitable divisions / asset coveted by the acquirer,
thus making the target unattractive.
Blank Check: Authorising issuance of new shares, usually preferred at the
discretion of the Board of Directors. Its purpose is to vote down a hostile take -over
attempt.
Poison Pill: Taking on a large debt, usually at exorbitant terms, making the
acquisition less attractive. Scorched earth is an extreme form of this tactics.
Pac-man: This is similar to the popular video game - each company tries to
gobble up the other. The target seeks to acquire the predator, adding to accounting
and legal confusion.
Shark Repellent: Amending the Memorandum or Articles to make a takeover
complex and costly, thereby discouraging it.
Green Mail: Threatening fight for over control of the firm, but with the ultimate
objective of raising the market price of shares and sell ing them at a premium.
White Knight; Inducing a cash rich ally to out-bid the predator and avert a
takeover.
Gray Knight: Enlisting the services of friendly company to purchase the shares
of the predator, keeping him busy with defending his own company.
15.3.9 ISSUES TO BE CONSIDERED IN MERGERS AND ACQUISITIONS
From the above discussion, it is clear that the management of the company,
which is taking over another company, should carefully examine the following aspects
before a final decision is made :
1. How does the merger help the parent company? Does it add to the existing
strengths? Does it provide an assured source of raw materials? Does it
provide forward integration? Does it help in optimal utilisation of the
existing resources?
2. Why should they take over this particular unit, and not some other unit?
What are its unique features? How do they mesh-in with the existing
features of the parent company?
3. Why is the present management selling out? Is the unit inherently alright?
Are there any basic problems, which are not open to easy solution?
4. What kind of post-merger problems are likely to arise? Is the parent company
fully prepared to tackle them?
5. How would the financial insti tutions react to the proposal? What new
conditions are they likely to impose?
6. What would be the impact on the share prices of the parent company?
7. What would be the impact on sales turnover, and profitability of the parent
company after the take-over and merger?
8. What is the right price for the unit? How should it be paid? What should be
the exchange ratio between the shares of the parent company and the merger
company?
Many merchant bankers have impressive shopping lists of companies available
for sale. Some of these bankers are extremely persuasive and sophisticated in their
match-making practices. Even when you are paying through your nose, you may be
under the illusion that it is a steal. Be careful and be on the alert when you are
dealing with she merchant bankers, specialising in take-over deals. It is possible
that your company may be raided by a hostile take-over specialist. In the West,
merchant bankers have devised schemes which help the existing managements to
acquire another company.
Management Buy-outs and Leveraged Buy-outs: During the 1980s, a new
scheme' of corporate restructuring become extremely popular in the USA and the
Western Europe. This new scheme came to be known as leveraged buy out (LBO). As
the name implies, an LBO has two major aspects:
(i ) Using the LBO, the management buys out the entire shareholding of the
company from the public and gets it delisted.
( i i ) For buying shares on such a massive scale, the management takes a loan
and thus leverages the transaction.
The LBO package is usually designed and structured by investment or
merchant bankers. LBOs are a mixed bag with some advantages and
disadvantages, as indicated below
Advantages
1. If the public shareholders get a value higher than the market price
(close to the break-up value) they are benefited, at least, in the short run,
2. The owner-managers and/or the professional managers can run the
companies without any fear of losing control from a hostile take-over.
3. LBOs help to restructure the companies, basically weeding out inefficient
and incompetent managements.
Disadvantages
1. As an LBO usually results in a very high proportion of debt, servicing of the
debt becomes a great financial strain for the company in the post-LBO period.
2. Since the management resorts to asset-stripping and jettisoning of the
subsidiaries to reduce the debt burden after an LBO, it might weaken the company
in the long ran.
3. Continuity and stability will be adversely affected when bankers and stock
market experts start running manufacturing enterprises. The management focus
tends to shift to short term.
Some Policy Issues : LBOs give rise to some major policy issues as listed below:
1.Joint-stock companies which go public and get listed on the stock exchanges
promote a wide dispersal of share ownership. LBOs tend to result in the reverse
namely concentration of share ownership and economic power.
2.LBOs involve considerable debt-financing which- works both ways, When the
operational profits are high, a high debt equity ratio results in high earnings per
share. When the operational profits are stagnating or low, a high debt-equity ratio
is not in the interest of the equity owners.
3.Financing an LBO transaction by way of so-called junk bonds (i.e. high-yield
bonds) may lead to reckless financing affecting the long-term stability of interest
rate structures. Default rates in junk bonds are quite-high.
4. LBOs andxjunk bonds help managements as well as raiders. Thus they tend
to disturb the equilibrium by rocking the boat rather too often.
15.3.10 SWOT ANALYSIS
The overall evaluation of a company’s strength, weakness, opportunities, and
threats is called SWOT analysis. It is a way of monitoring the external and internal
marketing environment.
SWOT (strengths, weakness, opportunities and threats) is one of the technique
that appraise the organisational strengths and weakness and matches them with
environmental opportunities and threats. For example, if a firm has strength in
financial area. It can improve its market share through expanding production
facilities or technological capabilities.
Strengths refers to the competitive advantage and core. Competence (in relation
to the competitor) that a company can exert in the market place. This may lie in
superior technical knowhow, wide distribution channel, motivated employees. Etc.
Weakness are the limitations, constraints or obstacles in resources and
capacities. These weakness may be due to financial resources or technical
knowledge, etc.
Opportunities are the external factors and forces in the business environment
that provide scope for the company to grow and enhance its market share and
profitability Government’s decision to reduce excise or sales tax, increase in GDP,
deli censing, etc are opportunities for business to grow.
Threats are the external factors and forces in the business environment that
pose challenge or check the growth, market share or profitability of the business.
Slow market growth, entry of MNC, etc. Are threats for Indian business houses?
SWOT is basically on exercise in identification and analysis of internal and
external environment. SWOT analysis itself provides no formal set of rules for
strategic success. However there are certain guidelines like objective and open
assessment of strength, weakness, opportunities and threats, that can bring the
company on route of success. Secondly, for successful choice and implementation
of strategies, firm should exploit its competitiveness and strengths and avoid
competing on work areas as W. Stewert Home remarks. “The application of SWOT
analysis to competitors as well as one self should indicate to a business its relative
position in the market and again direct the firm towards appropriate strategies”.
15.4 REVISION POINTS
Merger and Acquisitions- merger means a combination of two companies where only one survives. The term ‘take over’ means the acquisition by one person or
group of persons or by a company of sufficient shares in another company to give the purchaser control of that other company.
Classification of Mergers – in to three groups – they are
(i) Horizontal Merger (ii) Vertical Merger (iii) conglonmerate.
15.5 INTEXT QUESTIONS
1. Define 'Merger' and state the primary motives for mergers.
2. Distinguish between operating mergers and pure financial mergers.
3. Examine several recent mergers and point out the principal motives for
merging in each case
4. Examine a recent merger in which at least part of the payment made to the
seller was in the form of stock. Use stock market prices to obtain an
estimate of the gain from the merger and the cost of the merger.
5. Explain the distinction between a tax free and a taxable merger. State the
circumstances in which you would expect buyer and seller to agree to a
taxable merger.
6. Do you have any rational explanation for the great fluctuations in
aggregate merger activity and the apparent relationship between merger activity and stock prices?
7. What is a tender offer? State the defensive strategies adopted to defend the tender offer,
8. What is meant by Leveraged Buy-out? State its advantages and
disadvantages in the present Indian context.
15.6 SUMMARY
A company may grow internally, or it may go externally through acquisitions.
The objective of the firm in either case is to maximise existing shareholders wealth.
Another company can be acquired through merger, take-over, consolidation etc. A
merger is a combination of two companies where only one survives. The merged
company goes out of (corporate) existence, leaving its assets and liabilities to the
acquiring corporation.
A merger is different from a 'consolidation', or amalgamation which involves the
combination of two or more companies whereby entirely new company is formed.
All the old companies cease to exists, and their equity shares (common stock) are
exchanged for shares in the new company.
Economists classify mergers into three groups (a) horizontal, (b) vertical, and (c)
conglomerate.
From the standpoint of financial analysis, there are two basic types of mergers:
Operating mergers, in which the operations of two companies are integrated
with the expectation of operating economies for obtaining synergistic effects.
Pure financial mergers, in which the merged companies will not be operated as
a single unit and from which no operating economies are expected.
SWOT ANALYSIS:
The overall evaluation of a comapany’s strength, weakness, opportunities, and
threats is called SWOT analysis. It is a way of monitoring the external and internal
marketing environment.
15.7 TERMINAL EXERCISES
1. When two or more companies producing the same goods or offering the same
services decide to merge is known as
(a) Vertical Merger (b) Horizontal Merger (c) Conglomerate Merger
2. One company takes over another company in a completely different industry is
known as
(a) Vertical Merger (b) Horizontal Merger (c) Conglomerate Merger
15.8 SUPPLEMENTARY MATERIALS
http://dosen.narotama.ac.id/
http://www.osbornebooksshop.co.uk/
http://www.fao.org/
15.9 ASSIGNMENTS
Explain the various issues to be considered in Mergers and Acquisitions
decisions.
Give brief summary of SEBI guidelines on merger of companies in India,
15.10 SUGGESTED READINGS /REFERENCE BOOKS
1. Brealey, R. and Myers, S.
Principles of Corporate Finance, New York, McGraw Hill Co.
Acquisitions, Mergers, Sales &
Takevoers : A Hand Book,
15.11 LEARNING ACTIVITIES
Group discussion during PCP dates.
15.12 KEY WORDS
Merger
Horizontal Merger
Vertical Merger
Conglomerate Merger
Acquisition
Take over
Tender offer
SWOT.
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ANNAMALAI UNIVERSITY PRESS 2016 – 2017