COM 111
MANAGEMENT ACCOUNTING - I
YASHWANTRAO CHAVAN MAHARASHTRA OPEN UNIVERSITY
Dnyangangotri, Near Gangapur Dam, Nashik 422 222, Msharashtra
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University, Nashik.
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YASHWANTRAO CHAVAN MAHARASHTRA OPEN UNIVERSITY
Vice-Chancellor : Dr. M. M. Salunkhe
Director (I/C), School of Commerce & Management : Dr. Prakash Deshmukh
State Level Advisory Committee
Dr. Pandit Palande
Hon. Vice Chancellor
Dr. B. R. Ambedkar University
Muaaffarpur, Bihar
Dr. Suhas Mahajan
Ex-Professor
Ness Wadia College of Commerce
Pune
Dr. V. V. Morajkar
Ex-Professor
B.Y.K. College, Nashik
Dr. Mahesh Kulkarni
Ex-Professor
B.Y.K. College, Nashik
Dr. J. F. Patil
Economist Kolhapur
Dr. Ashutosh Raravikar
Director, EDMU,
Ministry of Finance
New Delhi
Dr. A. G. Gosavi
Professor
Modern College, Shivaji Nagar, Pune
Dr. Madhuri Sunil Deshpande
Professor
Swami Ramanand Teerth Marathwada
University, Nanded
Dr. Prakash Deshmukh
Director (I/C)
School of Commerce & Management
Y.C.M.O.U., Nashik
Dr. Parag Saraf
Chartered Accountant Sangamner
Dist. AhmedNagar
Dr. S. V. Kuvalekar
Associate Professor and
Associate Dean (Training)(Finance )
Dr. Surendra Patole
Assistant Professor
School of Commerce & Management
National Institute of Bank Management
Pune
Y.C.M.O.U., Nashik
Dr. Latika Ajitkumar Ajbani
Assistant Professor
School of Commerce & Management
Y.C.M.O.U., Nashik
Author
Editor
Instructional Technology Editing &
Programme Co-ordinator
1) Dr. Mahesh A. Kulkarni
Prof. V. V. Morajkar
Research Guide,
10, Vidya Society, Shikhare Wadi,
BYK College of Commerce,
Nashik Road - 422 101.
Nashik - 422 005.
2) Dr. Suhas Mahajan
Research Guide,
Ness Wadia College of Commerce,
Pune - 411 001.
Dr. Latika Ajitkumar Ajbani
Assistant Professor
School of Commerce & Management
Y.C.M.O.U., Nashik
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Y.C.M. Open University, Nashik - 422 222.
Copyright © Yashwantrao Chavan Maharashtra Open University, Nashik.
(First edition developed under DEC development grant)
First Publication
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September 2015
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CONTENTS
TOPIC 1
Introduction to Management Accounting
UNIT 1
Meaning and Definition of Management Accounting
1-16
1.0 Introduction 1.1 Unit Objectives 1.2 Meaning and Definitions of Management Accounting 1.2.1 Characteristics
of Management Accounting 1.3 Need and Importance of Management Accounting 1.4 Objectives of Management
Accounting 1.5 Scope of Management Accounting 1.6 Functions of Management Accounting 1.7 Summary
1.8 Key Terms 1.9 Questions and Exercises 1.10 Further Reading
UNIT 2
Financial Accounting, Cost Accounting and Management Accounting
17-38
2.0 Introduction 2.1 Unit Objective 2.2 Phases in the Evolution of Accounting 2.3 Use of Accounting Information
2.3.1 Application of Accounting Information 2.4 Structure of Accounting 2.4.1 Financial Accounting 2.4.1.1
Objectives of Financial Accounting 2.4.1.2 Functions of Financial Accounting 2.4.1.3 Limitations of Financial
Accounting 2.4.2 Cost Accounting 2.4.2.1 Objectives of cost Accounting 2.4.3 Emergence of Management
Accounting 2.5 Distinction between Management Accounting and Financial Accounting 2.6 Distinction between
Management Accounting and cost Accounting 2.7 Illustrations 2.8 Summary 2.9 Key Terms 2.10 Questions
and Exercises 2.11 Further Reading
UNIT 3 Tools and Techniques, Role of Management Accounting
39-52
3.0 Introduction 3.1 Unit Objectives 3.2 Tools and Techniques of Management Accounting 3.3 Advantages of
Management Accounting 3.4 Limitations of Management Accounting 3.5 Installation of Management Accounting
System 3.6 Management Accountant : Role, Functions and Duties 3.6.1 Functions of Management Accountant
3.6.2 Responsibilities of Management Accountant 3.6.3 Important Duties of Management Accountant 3.7 Essential
Qualities of Management Accountant 3.7.1 Traits of Successful Management Accountant 3.8 Summary 3.9 Key
Terms 3.10 Questions and Exercises 3.11 Further Reading
TOPIC 2 Analysis of Finnacial Statement
UNIT 4 Meaning Objectives and Tools of Financial Statement Analysis
53-82
4.0 Introduction 4.1 Learning objective 4.2 Meaning Objective and Interpretation of Financial Statement Analysis
(A) Meaning (B) Objective (C) Interpretation of Financial Statement 4.2.1 Steps involved in the Financial statement
Analysis 4.2.2 Role in Financial Analyst 4.2.3 Limitations of Financial Statements 4.3 Types of Financial Analysis
4.4 Tools of Financial Statement Analysis 4.4.1 Multi-steps Income Statement 4.4.2 Horizontal Analysis
4.4.2.1 Comparative statements 4.4.2.2 Procedure of Interfirm Comparison 4.4.2.3 Necessity of Interfirm
Comparison 4.4.2.4 Limitations of Comparative Financial Statement Analysis 4.4.2.5 Application of Interfirm
Comparison Method 4.4.2.6 Advantages of Interfirm Comparison 4.4.2.7 Disadvantages of Interfirm comparison
4.4.2.8 Precautions before Preparing comparative Statements 4.5 Illustrations 4.6 Summary 4.7 Key terms
4.8 Questions and Exercises 4.9 Further Reading
UNIT 5 Common Size Statement and Trend Analysis
83-104
5.0 Introduction 5.1 Unit objective 5.2 Common Size statements 5.3 Procedure for Preparation of Common size
Statement 5.3.1 Illustrations 5.4 Trend Analysis 5.4.1 Computation of Trend Percentage 5.4.2 Steps involved in
the Computation of Trend Ratios5.4.3 Illustrations
5.5 Analytical Balance Sheet 5.5.1 Illustrations
5.6 Summary 5.7 Key Terms 5.8 Questions and Exercises 5.9 Further Reading
UNIT 6 Ratio Analysis
105-158
6.0 Introduction 6.1 Unit objective 6.2 Meaning of Ratios 6.2.1 Ratio Analysis-Rationale 6.3 Nature of Ratio
Analysis 6.4 Objectives of Ratio Analysis 6.5 Principal Advantages of Ratio Analysis 6.6 Limitations of Ratio
Analysis 6.7 Classification of Ratios 6.8 Types of Ratios 6.8.1 Liquidity Ratios 6.8.2 Solvency Ratios 6.8.3
Profitability Ratios 6.8.4 Efficiency Ratios 6.8.5 Integrated Ratios 6.8.6 Tabular Representation of Type of Ratios
and their Significance 6.9 Illustrations 6.10 Summary 6.11 Key Terms 6.12 Questions and Exercises 6.13 Further
Reading
UNIT 7 Fund Flow Statement
159-186
7.0 Introduction 7.1 Unit Objectives 7.2 Meaning of Fund Flow Statement 7.3 Uses of Fund Flow Statement 7.4
Fund Flow Statement and Income Statement 7.5 Preparation of Fund Flow Statement 7.5.1 Fund from Business
Operations 7.5.2 Proforma of a Funds Flow Statement 7.5.3 Requirements for Preparation of Fund Flow Statement
7.5.4 Steps in Preparation of Fund Flow Statement 7.6 Advantages of Fund Flow Statement 7.7 Proforma of a
Funds Flow Statement 7.8 Illustration 7.9 Summary 7.10 Key Terms 7.11 Questions and Exercises 7.12 Further
Reading
UNIT 8 Cash Flow Statement
187-208
8.0 Introduction 8.1 Unit Objectives 8.2 Meaning of Cash Flow Statement 8.3 Difference between Cash Flow
Statement and Fund Flow Statement 8.4 Utility of Cash Flow Statement 8.5 Preparation of Cash Flow Statement
8.5.1 Transactions Affecting of Cash Inflows and Cash Outflows 8.5.2 Construction of Cash Flow Statement 8.5.3
Cash from Business Operations 8.5.4 Form of Business Statement of Cash from Business Operation 8.5.5 Proforma
of Cash Flow Statement 8.6 Limitations of Cash Flow Analysis 8.7 Illustrations 8.8 Summary 8.9 Key Terms
8.10 Questions and Exercises 8.11 Further Reading
TOPIC 3 Working Capital Management
UNIT 9 Concept and Definition of Working Capital
209-242
9.0 Introduction 9.1 Unit Objectives 9.2 Concept and Definition of Working Capital 9.2.1 Main Constituents of
Working Capital 9.3 Types of Working Capital 9.4 Meaning of Working Capital Cycle 9.5 Working Capital
Management 9.6 Determination of Working Capital 9.7 Assessment of Working Capital Needs 9.8 Preparation of
Statement of Working Capital Requirement 9.8.1 Common Items included in Calculation of Working Capital Required
9.9 Sources of Working Capital 9.10 Approaches for Determining the Financial Mix 9.11 Illustrations 9.12
Summary 9.13 Key Terms 9.14 Questions and Exercises 9.15 Further Reading
UNIT 10 Components of Working Capital - Management of Cash
243-268
10.0 Introduction 10.1 Units Objectives 10.2 Components of Working Capital - Management of Cash 10.3
Objectives of Cash Management 10.3.1 Importance of Cash Management 10.3.2 Strategies for Four Aspect of
Cash Management 10.4 Cash Planning 10.5 Cash Forecasting and Budgeting 10.6 Long-term Cash Forecasting
10.6.1 Managing the Cash Flows 10.6.2 Determining Optimum Levels of Cash Balance 10.7 Cash Management
Models 10.8 Investment of Securities 10.9 Illustrations 10.10 Summary 10.11 Key Terms 10.12 Questions and
Exercises 10.13 Further Reading
UNIT 11 Accounts Receivable Management
269-282
11.0 Introduction 11.1 Units Objectives 11.2 Meaning of Accounts Receivable 11.2.1 Meaning of Accounts
Receivable Management 11.3 Factors that Govern the Accounts Receivable 11.4 A Balance between Liquidity”
and “Profitability” 11.5 Computation the “age” of Accounts Receivable 11.6 Illustrations 11.7 Summary 11.8 Key
Terms 11.9 Questions and Exercises 11.10 Further Reading
UNIT 12 Inventory Management
283-317
12.0 Introduction 12.1 Units Objectives 12.2 Inventory Management 12.2.1 Role of Financial Manager in
Inventory Management 12.3 Determinant the Optimum level of Inventory 12.4 Purchase Control 12.5 Stock
Levels 12.6 Economic Order Quantity (EOQ) 12.7 Other Important Inventory Control Techniques 12.8 Illustrations
12.9 Summary 12.10 Key Terms 12.11 Questions and Exercises 12.12 Further Reading
INTRODUCTION
This book of self-instructional material is based on the syllabus for the subject
“Management Accounting” (COM 111). This book is written as per the revised
syllabus prescribed for M.Com. Part I students of Yashwantrao Chavan
Maharashtra Open University, Nashik from June, 2015. We do hope that this
book will definitely help to meet the emmerging and growing requirements of
distance education students of Management Accounting from the school of
commerce. This book adopts a moderate and novel approach towards the study
of Management Accounting in view with the specific and upcoming requirements
of the readers and practitioners of this Subject.
All the topics included in the revised syllabus are explained in simple but apt
language. Equal stress is also given for necessary basic accounting theories and
wide variety of practical problems. Authors have taken appropriate care to
incorporate basic management accounting concepts, accounting control techniques
and tabular representation of classified accounting statements and reports. Proper
emphasis has also being given on graphical presentation to simplify the accounting
theories and modern practices. This book has been designed to serve as a self
sufficient text for M. Com. students. Never-the-less, we do not rule out the
possibility of certain shortcomings or miss-prints still remaining, we will greatful to
the reader if such errors are pointed out from time to time. Any criticism or valuable
suggestions for further improvement of this book will be greatfully acknowledged
and highly appreciated.
The authors have also kept in mind the fact that the students concerned are
the distance education students spread over a large territory, different enviornment
and do not have regular interaction with the teachers. Therefore authors have
taken utmost efforts to simplify the matter without affecting scientific quality and
precision.
The editor and authors are greatful to the authorities of YCMOU for
guidence and co-operation.
Editor
Authors
TOPIC 1
Introduction to Management
Accounting
UNIT 1
Meaning and Definition of
Management Accounting
UNIT 2
Financial Accounting, Cost
Accounting and Management
Accounting
UNIT 3
Tools and Techniques, Role of
Management Accounting
UNIT 1 Meaning and Definition of
Management Accounting
Meaning & Definition of
Management Accounting
Structure
NOTES
1.0
Introduction
1.1
Unit Objectives
1.2
Meaning and Definitions of Management Accounting
1.2.1
Characteristics of Management Accounting
1.3
Need and Importance of Management Accounting
1.4
Objectives of Management Accounting
1.5
Scope of Management Accounting
1.6
Functions of Management Accounting
1.7
Summary
1.8
Key Terms
1.9
Questions and Exercises
1.10 Further Reading
1.0
Introduction
Management Accounting is a segment of accounting that deals specifically
with the accounting and reporting of information to management regarding the
detailed operations of the company in order for decisions to be taken in various
areas of business. It is oriented primarily towards managerial control and other
decision-making groups inside the organisation. Management frequently requires
timely financial information that deals with different aspects of the firm, ranging
from special purpose reports for a specific department’s operating performance
to the preparation of annual budgets and forecasts which encompass the entire
business.
Managers in all types of organisations need frequent information about
business activities to plan accurately for the further, to control business results, to
direct an enterprise toward achieving its goals and to make decisions that affect
the operations of the business. Information is vital for the management process
i.e. for functions carried out by the managers viz. Planning, controlling and decisionmaking. In the goal of providing information, managerial accounting identifies,
collects, measures, classifies and reports information that is useful to managers in
fulfilling the management process.
Management Accounting - I
1
Meaning & Definition of
Management Accounting
1.1
Unit Objectives
After going through this unit, you will be able to
NOTES
•
Explain the meaning of management accounting.
•
Define the term management accounting.
•
Know the objectives of management accounting.
•
Describe the functions of management accounting.
•
Identify the scope of management accounting.
•
Explain the use of accounting information.
1.2
Meaning & Definitions of Management
Accounting
Management Accounting is that field of accounting which deals with
providing information including financial accounting, information to managers for
their use in planning, decision making, performance evaluation, control,
management of cost and cost determination for financial reporting. Managerial
Accounting contains reports prepared to fulfill the needs of managements.
Management Accounting was not known to the business world until 1950.
The term was first formally described in a report entitled ‘Management Accounting’
in 1950. The report was published by the Anglo-American Council of Productivity
Management Accounting Team after its visit to United States during April, May
and June 1950. The team in its report defines Management Accounting as :
“the presentation of accounting information in such a way as to assist
management in the creation of policy and in the day-to-day operation of an
undertaking”.
(Refer - Sizer J. An Insight into Management Accounting. Pitman Publishing
Ltd., London 1979).
Thereafter number of attempts were and are being made by various
professional associations and authorities on the subject to define management
accounting in its right perspective.
Some important definitions given by the Professional Institutes and
Renowned Authors are as follows :
(1)
2
Management Accounting - I
The National Association of Accountants (US), in Statement No. 1 A
(Statements on Management Accounting 1982) has defined management
accounting as :
“....the process of identification, measurement, accumulation, analysis,
preparation and communication of financial information used by
management to plan, evaluate, and control within the organisation and to
assure appropriate use and accountability for its resources”.
(2)
Meaning & Definition of
Management Accounting
The Chartered Institute of Management Accountants, UK defines the term
management accounting in the following manner :
“Management Accounting is an integral part of management concern with
identifying, presenting and interpreting information used for : (i) formulating
strategy, (ii) planning and controlling activities, (iii) decision-making, (iv)
optimizing the use of resources, (v) disclosure to shareholders and others
external to the entity, (vi) disclosure to employees, (vii) safeguarding assets.
(3)
“Management Accounting is the application of appropriate techniques and
concepts in processing historical and projected economic data of an entity
to assist management in establishing plans for reasonable economic
objectives in the making of rational decisions with a view towards the
objectives”.
- American Accounting Association
(4)
“Management Accounting is the application of accounting and statistical
techniques to the specified purpose of producing and interpreting information
designed to assist management in its functions of promoting maximum
efficiency and in envisaging, formulating and co-ordinating their execution”.
- AACA, USA
(5)
The application of accounting knowledge to the purpose of producing and
of interpreting accounting and statistical informations designed to assist
management in its function of promoting maximum efficiency and in
formulating and co-ordinating future plans and subsequently in measuring
their execution”.
- H. M. Treasury
(6)
Management Accounting is the term used to describe the accounting methods,
system and techniques which, coupled with special knowledge and ability,
assist management in its task of maximizing profits or minimizing losses”.
NOTES
- J. Batty
(7)
“Management Accounting is the application of professional knowledge and
skill in the preparation of accounting information in such a way as to assist
management in the formation of policies and in the planning and control of
the operations of the undertaking”.
- ICMA, London
(8)
“Management Accounting is more intimate merger of the two older
professions of management and accounting wherein the informational needs
of the manger determine the accounting means for their satisfactions”.
- R. L. Smith
(9)
“Management Accounting is concerned with the efficient management of
a business through the presentation to management of such information as
will facilitate efficient and opportune planning and control”.
- Brown and Howard
Management Accounting - I
3
Meaning & Definition of
Management Accounting
(10) “Management Accounting is concerned with accounting information which
is useful to management”.
- Robert N. Atheany
(11)
NOTES
The term “Management Accounting” covers all those services by which
the accounting department can assist top management and other departments
in the formation of policy, the control of its execution and appreciation of its
effectiveness.
- Broad and Carmichael
(12) “Accounting which serves management by providing information as to the
cost of profit associated with some portion of firm’s total operations, is
called Management Accounting”.
- Shilling Law
(13) Management Accounting is the adaptation and analysis of accounting
information and its diagnosis and explanation in such a way as to assist
management”.
- T. G. Rose
(14) “Management Accounting is concerned with providing information to
managers; that is to those who are inside of an organisation and who are
charged with directing and controlling its operations”. - R. H. Garrison
(15) “Any form of accounting which enables a business to be conducted more
efficiently can be regarded as Management Accounting”.
- ICA England and Wales
All these definitions of Management Accounting reveal the following salient
features:
(i)
It is merger of ‘management’ and ‘accounting’.
(ii)
It is concerned with accounting information which is useful to management
in maximizing profits or minimizing losses.
(iii)
It is concerned with the improvement in the efficiency of the various phases
of management.
Briefly Management Accounting with all its paraphernalia, does not supplant
Financial Accounting as is erroneously misunderstood, but supplement the basic
structure of traditional package of accounts to cater to the diversified requirements
of modern management.
Thus, Management Accounting emphasizes on the information that
management requires to make specific intra-firm resource allocations. Such
emphasis assumes that accounting must perform the two separate, distinct functions
of financial and management reporting and that the data needs for each are often
different. ‘Few intelligent financial and economic decisions can be made in the
absence of the information reservoir. Involvement with both time dimensions, past
and further, places the executive near the centre of the control and decisionmaking processes in any organisation.
4
Management Accounting - I
1.2.1 Characteristics of Management Accounting
Meaning & Definition of
Management Accounting
The above definitions clearly indicate the following characteristics of
Management Accounting.
(a)
It is the application of professional knowledge and skill in the preparation of
accounting information in such a way as to assist management in the
formation of policies and in the planning and control of the operations of the
undertaking.
(b)
Management Accounting is the application of appropriate techniques and
concepts in processing historical and projected economic data of an entity
to assist management in establishing plans for reasonable economic
objectives in the making of rational decisions with a view towards achieving
the objectives.
(c)
Management Accounting rearranges for management control to a great
extent the accounting information provided by the financial accounting. It,
therefore, lies between the following two activities :
NOTES
(i) Completing the accounting results on the one hand, and
(ii) Controlling the business by the management , on the other.
(d)
Management accounting actually covers all rearrangement, combination or
adjustment of the orthodox accounting figures which may be required to
provide the Chief Executive with the information from which he can control
the business.
(e)
It comprises accounting methods, systems and techniques which coupled
with special knowledge and ability, assist management in its task of
maximizing profits or minimizing losses.
(f)
Management Accounting is the presentation of accounting information in
such a way as to assist management in the creation of policy and in he dayto-day operations of an undertaking”.
(g)
Management accounting is concerned with accounting information which
is useful to the management. Efficiency of the various phases of
management is, as a matter of fact, the common thread which underlies all
these definitions. However, it should be clearly understood that it does not
supplant financial accounting but rather it supplements it in order to serve
the diverse requirements of modern management.
(h)
The functions of the management are planning, organising, directing and
controlling. Management accounting helps in the performance of each of
these functions in the meaningful way.
(i)
Management accounting serves as a vital source of data for management
planning. The accounts and documents are a repository of a vast quantity
of data about the past progress of the enterprise which are a must for
making forecasts for the future.
Check Your Progress
Define
‘Management
Accounting and give its
characteristics.
Management Accounting - I
5
Meaning & Definition of
Management Accounting
NOTES
1.3
Need and Importance of Management
Accounting
Management Accounting deals with the internal reporting. On the basis of
the nature of these reports and their contents and the parties who receive these
reports, it may be said that the management accounting deals primarily with the
furnishing of required and relevant data to the managerial personnel for the purpose
of planning, controlling and decision making. The type of accounting information
required by the management differs from one type of decision to another. It is not
necessarily confined to the financial accounting information but it is much more
than this depending upon the type, importance, complexity, etc. of the problem.
The financial accounting and the cost accounting lay emphasis on different
objectives. Management cannot base its decision only on the information furnished
by the financial and cost accounting. Therefore there is a need for a system
which views, utilises and analyses the abundant data (generated by financial and
cost accounting) with the sole objective of furnishing the relevant data to the
management for the purpose of assisting it to take a number of appropriate
decisions. Management accounting furnishes only those data which are relevant
to the decision under consideration and these relevant data may include the data
collected from both financial and cost records and other sources.
The following points highlight the need and importance of management
accounting :
6
Management Accounting - I
1.
Management accounting includes all those accounting services by means
of which assistance is rendered to the management in their managerial
functions i.e decision making, profit planning, control etc. It also helps
management for execution of their plans and measurement of performance.
2.
Financial accounting in its traditional from cannot apply the informations
necessary to the management for functioning efficiently and effectively.
Management Accounting is the accounting which provides in non-technical
language, cost, profits and other information necessary to the management
for discharging their functions.
3.
Management accounting is the presentation of accounting information in
such a way as to assist management in the creation of policy in the day to
day operation of undertakings.
4.
Management accounting goes beyond the figures provided by financial
accounting which are mute in nature and make them self explanatory.
5.
Management accounting is an extension of the managerial aspects of cost
accounting. It utilises the principles and practices of both Cost Accounting
and Financial Accounting.
6.
The term accounting is used in more broad scene in Management Accounting
so that the scope of management is very wide and the term comprises
with every activity of a business.
7.
Since the managerial personnel are accountable to the owners of the
company and since their very continuation in the company depends upon
the results produced which in turn depends upon the quality of decisions
and their implementation, the managerial personnel need a system which
furnishes the relevant information to them to take decisions. Therefore, the
need for management accounting. It (i.e management accounting) has
been devised to serve the management through the report.
8.
It is very well known that planning, controlling, co-ordinating, organising,
motivating and communicating are the six important managerial functions.
Management accounting helps the managerial personnel to perform each
one of these functions more effectively and profitably by providing relevant
information at the right time. For this purpose, management accountant
collects the information from different sources, analyses them systematically
to find out their relevance to the decision under consideration and supplies
only the relevant information to the management to take proper decisions.
The work of the management is made easy by the management
accountant. Because, the management accountant will carry out a
comprehensive evaluation of all the possible and available alternatives and
suggest the best alternative. This way, management accounting renders a
very valuable service to the management in all its fields of activity. It is
because of this reason that management accounting has rightly been
interpreted as accounting for management, management-oriented
accounting, etc.
9.
‘Since the decisions have a number of implications on the determinants of
profit, performance, etc, it is necessary to have a comprehensive evaluation
of each of the possible and available alternatives so that the management
selects the best alternative. In order to evaluate the alternatives, it is
necessary to consider all the influencing factors. The influencing factors
include both the quantitative and the qualitative factors. Quantitative factors
are those factors whose effect can easily be measured in terms of monetary
units. They are therefore called monetary factors. (e.g material cost, labour,
cost, etc) On the other hand, qualitative factors are those factors whose
effect can not easily and directly be measured in terms of monetary units
(e.g labour relation.) Of course, these qualitative factors, also known as
non-monetary factors, influence the quantitative factors indirectly. For
instance, labour relation has an impact on wages, production, idle time wages,
over time costs, labour productivity etc.
Meaning & Definition of
Management Accounting
NOTES
From the above analysis, it is obvious that the management has to take
a number of decisions and to take decisions, it (i.e management ) needs
information about the relevant influencing factors. There is therefore a
need for a system of accounting which ensures the furnishing of relevant
informations to the management so that the management undertakes a
comprehensive evaluation of the problem and takes the most appropriate
decision. Hence, the need for an accounting system for management.
Management Accounting - I
7
Meaning & Definition of
Management Accounting
10.
Management Accounting, focussing on internal user, measures and report
financial and other information that assist mangers in fulfilling the goals of
organization. This furnishes the necessary informations to the management
frequently i.e as and when required and also it points out that what should
happen.
NOTES
1.4
Objectives Of Management Accounting
Management accounting, primarily aims at serving the people who are
internal to the business entity. This means, it furnishes the most pertinent facts
and figures to the managerial personnel and assists them to take various decisions.
For this purpose, it collects the data from different sources and presents the same
to the; management whenever required and in the suitable from. By doing so,
management accounting aims at assisting management to take appropriate
decisions and discharging their responsibility satisfactorily. Hence, management
accountings is called management -oriented accounting or accounting for
management. In order to accomplish this aim, management accounting, has to
perform a number of functions and process. These, functions may also be called
objectives of management accounting, Because these functions of management
accounting may also be interpreted as the factors which high-lights the need for
management accounting. However, the following are the major objective (i.e
functions) of management accounting.
8
Management Accounting - I
1.
Providing managers with information (data) for decision making and planning
aims at modifying the data to suit to the requirements of the decision.
2.
With the help of the tools of financial analysis to analysis and interpret the
data and present the results with necessary comments, conclusion etc. to
the management.
3.
Assisting Management (managerial personnel) in directing and controlling
operations with the help of standard costing, budgetary control and
responsibility accounting.
4.
Motivating managers and other employees towards the organisation’s goals.
5.
Measuring the performance of sub units, managers and other employees
within the organisation
6.
To submit comprehensive reports which includes both the quantitative and
the qualitative information.
1.5
Scope Of Management Accounting
Management Accounting covers not only the use of financial data and a
part of costing theory but may extend beyond the boundaries of accounting and
costing. It requires the aid of techniques of other disciplines such as economic,
finance, mathematics, statistics and operations research. The following are some
of the areas of specification included within the ambit of management accounting.
(1)
Financial Accounting : Management Accounting is an essential
prerequisite of any discussion of management accounting. Financial
statements contain enough information that is used by management of
decision-making. Management Accounting contains only tool and techniques
and it gets the data for interpretation and analysis mainly from financial
accounting. Thus, without efficient financial accounting system, management
accounting cannot operate.
(2)
Cost Accounting : Business executives depend heavily on accounting
information in general and on cost information in particular because any
activity of an organisation can be described by its cost. They make use of
various cost data in managing organisations effectively. Cost Accounting
is considered as backbone of management accounting as it provides the
analytical tools such as budgetary control, standard costing, marginal costing,
inventory control, operating costing etc. which are used by management to
discharge its reproducibilities efficiently.
(3)
Financial Statement Analysis : Frequently, the various users of financial
statements may need access to information that can be obtained only by
selecting individual numbers from the statements and by developing certain
trends and ratios. Any attempt in this direction is referred to as financial
statement analysis. A person can gain meaningful insights and conclusions
about the firm with the help of analysis and interpretation of the information
contained in financial statements. Numerous techniques have been developed
which can be used for proper interpretation and analysis of financial
statements.
(4)
Forecasting and Budgeting : This refers to the formulation of budgets
and forecasts, using standards norms in co-operation with operating and
other departments of a business concern. This ultimate success of any
budgeting depends on the proper setting to target figures in the budgets and
the actual realization of the same in practice, without even a slight deviation
due to external reasons beyond the control of the management.
(5)
Cost Control Techniques : These serves as effective tool for comparing
the actual result with the predetermined figures as laid down in budgets.
They greatly help in translating the budgets into operating plans.
(6)
Inflation Accounting : Inflation accounting attempts to identify certain
characteristics that tend to distort the reporting of financial results during
periods of rapidly changing prices. It devises and implements appropriate
methods to analyses and interpret the impact of inflation on the financial
Meaning & Definition of
Management Accounting
NOTES
Check Your Progress
What are the major objectives
of Management Accounting ?
How management accounting
requires the aid of techniques
of other disciplines ?
Management Accounting - I
9
Meaning & Definition of
Management Accounting
information.
(7)
Management Reporting : Clear, informative, timely reports are essential
management tools in machine decisions that make the best use of a
company’s resources. Thus, one of the basic responsibility of management
accounting is to keep the management well informed about the operations
of the business. To discharge this responsibility efficiently, he has to prepare
quarterly, half-yearly and other interim reports and submit the same to the
management.
(8)
Quantitative Techniques : Modern mangers believe that the financial
and economic data available for managerial decisions can be more useful
when analysed with more sophisticated and evaluation techniques.
Quantitative analysis methods allow mangers to develop information from
their financial database that is not otherwise available. The techniques
such as time series, regression analysis and sampling techniques are
commonly used for this purpose. Further, mangers also use techniques
such as linear programming, game theory, queuing theory etc. in their
decision-making process.
(9)
Taxation : Taxation plays an important role in the profitability of a commercial
concern. Therefore, it is essential for a management accountant to have a
complete knowledge of business taxation. The business profit and the tax
thereon is to be ascertained as per the provision of taxation. The filing of
tax returns and the payment of tax in due time is exclusively the responsibility
of management accountant.
NOTES
(10) Internal Audit : The internal audit as a discipline of management accounting
makes arrangements performance appraisal of the company’s various
departments. Thus, a management accountant must possess knowledge
about the fixation of responsibilities and measurement of results.
(11) Office Services : To discharge the responsibilities efficiently, a management
accountant has to deal with data processing, filling, copying, duplicating.
His area of responsibilities also includes the evaluation and reporting about
the utility of different office procedures and machines.
1.6
Functions Of Management Accounting
Broadly speaking the functions of management accounting embrace all
activities concerning to satisfy the needs of different levels of management. The
primary objective of a management accounting system is to supply meaningful
information into the management. To achieve this goal, it has to carry out many
activities which are normally referred to as functions of management accounting.
The major functions are summarized below:
(1)
10 Management Accounting - I
Planning and Forecasting : Planning is an activity of the management
that requires an efficient system of decision-making. In any type of enterprise,
plans should be made to guide future operations of the business. Thus, one
of the major functions of the management accountant is to help management
in the selection of company goals and in the formulation of policies and
strategies to allocate resources to achieve these goals. Different accounting
techniques are used by the management to discharge the function of planning
efficiently. The important among them are financial statement analysis,
budgeting, direct costing, capital budgeting and standard costing.
(2)
Furnishes Information as per Requirements : Management accounting
furnishes statistical information according to the varying requirements of
the different levels of management at periodic intervals. The three-tier
management which is in vogue in the recent times requires information of
various types at different intervals e.g. the top level management requires
information in a capsule form covering all aspects of the business at relatively
long intervals whilst detailed analysis relating to a particular aspect of the
business at short intervals will suffice the persons in the lower rungs of the
management ladder.
(3)
Not Confine merely Financial Data : Management accounting does not
confine itself merely to financial data to assist the management in the
decision-making process but frequently draws upon various sources other
than accounting for qualitative information which cannot be converted into
monetary terms. For this purpose, engineering records. Case studies, minutes
of meetings, productivity reports, special surveys and other business
documents are greatly relied upon.
(4)
Analysis and Interpretation : The economic and financial data as
collected from various statements do not have much management utility
unless it is properly analyzed in the light of the nature of the decisions. In
fact process of analysis and interpretation puts life in available data to speak
about future trends. The management accountant has to present the data
with his comments and recommendations to the management. Thus, the
analysis and interpretations of data are considered as the back-bone of
Management Accounting.
(5)
Co-ordinating : The techniques such as budgeting, financial reporting and
analysis and interpretation are commonly used by management accountants
to co-ordinate efficiently the various activities of the business. The efficient
control contributes to the efficiency or organisation which in turn increases
the profitability of a concern.
(6)
Communication : The management accountant spends his maximum time
in communicating to the management. He has to prepare various reports
required by the management from time to time to meet the challenges of
the business. The publication of company’s annual report is also an important
task of a management accountant.
(7)
Establishes Standards of Performance : Management accounting
establishes standards of performance in the different realms of activities
such that any deviation therefrom can be easily measured leading to further
investigation of the causes and institution of prompt remedial measures for
Meaning & Definition of
Management Accounting
NOTES
Check Your Progress
What are the major functions
of management accounting ?
Management Accounting - I
11
Meaning & Definition of
Management Accounting
rectifying the same. This is made possible through budgetary control and
standard costing which are essential adjuncts of management accounting.
(8)
Undertakes various Special Studies : Modern business is operating under
such dynamic conditions where even a minor change in business can have
a significant impact on the business results. Therefore, managements is
always interested to know the areas of business which can contribute to
the stability and profitability of the concern. To meet this objective,
management accountant undertakes various special studies such as sales
analysis, economic forecasts, price spread analysis etc.
(9)
Tax Administration : In modern business organisations, the responsibilities
of a management accountant also includes, the tax administration. This
task involves submission of necessary documents and return to the tax
authorities and supervision of all matters relating to tax administration.
NOTES
(10) Controlling : Management Accounting helps in the controlling by providing
performance reports and control reports which highlight variances between
expected and actual performances. Such reports serves as a basis for taking
necessary corrective action to control operations.
In short Management Accounting furnishes accounting data and statistical
information required for the decision-making process in management which
vitally affects the survival and the success of the business.
1.7 Summary
Meaning
•
Managerial Accounting has been originates to fulfil managerial needs by
providing the said important data which normal accounting fails to supply.
Management Accounting is a specialized course of study which attempts to
solve most of the problems the business faces, and to assist the management
in co-ordinating the various processes of management by generating needed
information.
•
Management Accounting emphasizes on the information that management
requires to make specific intra-firm resource allocation.
Need
•
12 Management Accounting - I
Management has to take a number of decisions and to take decisions it (i.e.
management) needs information about the relevant influencing factors. There
is therefore a need for a system of accounting which ensure the furnishing
of relevant information to the management so that the management
undertakes a comprehensive evaluation of the problem and take the most
appropriate decision. Hence, the need for an accounting system for
management.
Objectives
•
Meaning & Definition of
Management Accounting
Management accounting is called management oriented accounting or
accounting for management. In order to accomplish this aim, management
accounting has to perform a number of functions and process. These
functions may also called objectives of management accounting.
NOTES
Scope
•
Management Accounting covers not only the use of financial data and a
part of costing theory but may extend beyond the boundaries of accounting
and costing. It requires the aid of techniques of other disciplines such as
economic, finance, mathematics, statistics and operations research.
Functions
•
The major functions of management Accounting
i)
Planning and forecasting
ii)
Furnishing information as per requirements
iii)
Not confine merely financial data
iv)
Analysis & Interpretation
v)
Co-ordinating
vi)
Communications
vii)
Establishes standard performance
viii)
Undertakes various special studies
ix)
Tax Administration
x)
Controlling
1.8
1.
2.
Key Terms
Management Accounting consists of the
(i)
Financial Accounting
(ii)
Cost Accounting
(iii)
Financial Management
(iv)
Decision Accounting, and
(v)
Control Accounting
Financial Accounting is concerned with preparation, computation,
presentation analysis, interpretation and review of the financial statements.
Management Accounting - I
13
Meaning & Definition of
Management Accounting
3.
Financial Management is concerned with the aspect that finance flows
through every artery and capillary of business and to see that flow of finance
is steady.
4.
Decision Accounting is concerned with the art of management. It includes
preparation of short term and long term planning for profit, forecast,
evaluation of alternative investment decisions etc.
5.
Control Accounting is concerned with the function that all techniques of
control such as standard costing, budget and budgetary control, management
audit are in operation smoothly.
NOTES
1.9
I.
Objective Questions
A)
Multiple choice questions
(1)
The presentation of accounting information in such a way so as to assist the
management in the creation of policy and in the day-to-day operation of an
undertaking is termed as ......
(2)
(3)
(4)
14 Management Accounting - I
Questions And Exercises
a)
Management Accounting
b)
Operational Accounting
c)
Environmental Accounting
d)
National Accounting
Management Accounting provides accounting data and statistical information
required for ........... process in management.
a)
co-ordination
b)
decision-making
c)
reporting
d)
communication
Management Accounting and Cost Accounting are .............
a)
contradictory by nature
b)
supportive in nature
c)
complementary in nature
d)
co-operative in nature
Management Accounting provides the tools and techniques for .......... of
data.
a)
recording and classification
b)
identification and tabulation
c)
recording and summarizing
d)
analysis and interpretation
Meaning & Definition of
Management Accounting
Ans. : (1-a), (2-b), (3-c), (4-d)
II.
Long Answer Questions
(1)
Define “Management Accounting’. Explain the characteristics of
Management Accounting.
(2)
What is ‘Management Accounting’ ? State the need and importance of
Management Accounting.
(3)
Explain the term ‘Management Accounting’ state the objectives and scope
of Management Accounting.
(4)
What do you understand by ‘Management Accounting’. Enlist the various
functions of Management Accounting.
(5)
Describe the manner in which management accounting satisfies the various
needs of management in arriving at appropriate decisions.
NOTES
1.10 Further Reading
•
Prasad N. K. and Prasad A. K. - Cost and Management Accounting Kolkatta - Book Syndicate Pvt. Ltd. - 2010
•
Khan M. Y. and Jain P. K. - Management Accounting Text, Problems and
Cases - New Delhi - Tata McGraw Hill Publishing Co. Ltd. - 2010
Management Accounting - I
15
UNIT 2 Financial Accounting, Cost
Accounting and Management
Accounting
Structure
NOTES
2.0
Introduction
2.1
Unit Objectives
2.2
Phases in the Evolution of Accounting
2.3
Use of Accounting Information
2.3.1
2.4
Financial Accounting,
Cost Accounting and
Management Accounting
Application of Accounting Information
Structure of Accounting
2.4.1
2.4.2
Financial Accounting
2.4.1.1
Objectives of Financial Accounting
2.4.1.2
Functions of Financial Accounting
2.4.1.3
Limitations of Financial Accounting
Cost Accounting
2.4.2.1
2.4.3
Objectives of cost Accounting
Emergence of Management Accounting
2.5
Distinction between Management Accounting and Financial Accounting
2.6
Distinctions between Management Accounting and cost Accounting
2.7
Illustrations
2.8
Summary
2.9
Key Terms
2.10 Questions and Exercises
2.11
2.0
Further Reading
Introduction
General Accounting is concerned with receipt and payment of cash, recording
inventory, liabilities recognisation setting up of receivables and sales. Financial
Accounting is a discipline which is employed in industry and commerce to record,
classify and summarise the mercantile transactions that occur in an organisation.
Cost Accounting acts as a supplement to financial accounting. It strengthens
Management Accounting - I
17
Financial Accounting,
Cost Accounting and
Management Accounting
NOTES
the internal aspect of financial accounting It concerned with the application of
cost to job product, process and operations.
The term ‘Management Accounting’ covers all those services by which the
accounting department can assist top Management and other departments in the
formulations of policy, the control of its execution and appreciation of its
effectiveness.
In this unit we are going to discuss in details what Management Account is,
how the term is different from financial accounting and cost accounting.
2.1
Unit Objectives
After studying this unit you should be able to :
(a)
Explain use of accounting information
(b)
Discuss applications of accounting information
(c)
Understand the phases in the evaluation of accounting
(d)
Differentiate between management accounting & financial accounting as
well as
(e)
Differentiate between management accounting & cost accounting
2.2
Phases In The Evolution Of Accounting
The history of accounting indicates the evolutionary pattern which focuses
changing socioeconomic conditions and enlarged purposes to which accounting is
applied.
In the present situation, seven phases in the evolution of accounting can be
distinguished.
18 Management Accounting - I
(1)
Stewardship Accounting
(2)
Financial Accounting
(3)
Cost Accounting
(4)
Management Accounting
(5)
Social Responsibility Accounting
(6)
Inflation Accounting
(7)
Human Resource Accounting
Financial Accounting,
Cost Accounting and
Management Accounting
NOTES
(7)
Human Resource Accounting is accounting for people
Human
as organizational resources.
Resource
(i.e. measurement of the
Accounting cost and value of people for
organisation.)
(HRA)
Inflation Accounting is con(6)
cerned with the adjustment in
the value of assets (current and
fixed) and of profit in the light
Accounting
of changes in the price level.
Social Responsibility Accounting widen
(5)
the scope of accounting by considering
Social
the social effects of business decisions in
Responsibility additions to the economic effects. Social
Responsibility Accounting is a new phase
Accounting
in the development of accounting.
Management Accounting is a segment of accounting that deals specifically with accounting and re(4)
porting of information to management regarding
Management the detailed operations of the company in order
Accounting for decision to be taken in various areas of business, Management Accounting has a vital role to
play in extending the horizons of modern business.
Cost Accounting is concerned with the application
(3)
of costing principles, methods and techniques for
ascertaining the costs with a view to controlling them
Cost
and assessing the profitability and efficiency of the
enterprise. It helps the management in planning and
Accounting
controlling the costs relating to both, production and
distribution activities.
Inflation
(2)
Financial
Accounting
(1)
Stewardship
Accounting
Financial Accounting is a discipline, which is employed in
industry and commerce to record, classify and summaries
the merchantile transactions that occur in an organisation
In earlier times in history, rich people employed “stewards” to
manage their properties. Theses stewards rendered an account of
their stewardship to their owner periodically. Stewardship Accounting in a sense is associated with the need of business owners to keep records of their day-to-day transactions.
Management Accounting - I
19
Financial Accounting,
Cost Accounting and
Management Accounting
NOTES
2.3
Use Of Accounting Information
Accounting has been clearly defined as “the measurement and
communication of financial and economic data.’’ The science of accounting is
still in the evolutionary process. The traditional accounting, later styled as single
Entry system of book keeping, was in vogue right from time immemorial. The
modest beginning of accounting took the form of Financial Accounting based on
Double Entry system. Under this method all business transactions were at first
recorded in the books of prime entry, posted into respective ledger accounts,
balances were struck and the trial balances were prepared from and out of which
the annual Profit and Loss Account and Balance-sheet of a business concern
were prepared. The Final accounts of concern called as the Traditional Package’’
helped the management in the process of decision-making.
Accounting is concerned with providing Information to external users. It
refers to the preparation of general purpose reports for use by persons outside a
business enterprise, such as shareholders (existing and potential), creditors, Financial
analysis, labour unions, government authorities and the like. Financial accounting
is oriented towards the preparation of financial statements which summarizes the
results of operations for selected periods of time and show the financial position
of the business at particular dates.
The Accounting system includes the various techniques and procedures
used by the accountant in measuring, describing and communicating financial data
to users. Journals, ledgers and other accounting techniques used in processing
financial accounting information depend upon the concept of the double-entry
system. This technique includes generally accepted accounting principles. The
standard of generally accepted accounting principles includes not only broad
guidelines of general application but also detailed practices and procedures.
The end product of the financial accounting process are the financial
statements that communicate useful information to decision-makers. The financial
statements reflects a combination of recorded facts, accounting conventions and
personal judgments of the prepares. There are two primary financial statements
for a profit-making entity in India, viz the Income Statement (statement of revenues,
expenses and profit) and the Balance sheet i.e (statement of assets, liabilities and
owners equity) In U.S.A the Statements of changes in the Financial Position
(statement of cash inflows and outflows ) is not mandatory and has to be prepared
along with the Income Statement and Balance Sheet. The accounting information
generated by financial accounting in quantitative, formal, structured, numerical
and post-oriented material.
Financial Accounting is primarily concerned with measurement of economic
resources and obligations and changes in them. Financial Accounting measures
in terms of monetary units of a society in which it operates. For example, the
common denominator or yardstick used for accounting measurement is the rupee
in India and pound in the U.K The assumption is that the rupee or the pound is a
useful measuring unit.
20 Management Accounting - I
As stated earlier, financial accounting information is intended primarily to
serve external users. Financial Accounting information is used by a variety of
groups and for diverse purposes. Some users have direct interest in reported
information. Examples of such users are owners, creditors and suppliers potential
owners, suppliers management, tax authorities, employees, customers. Some users
need financial accounting information to help those who have direct interest in a
business enterprise. Examples of such users are financial analysts and advisers,
stock exchanges, financial press and reporting agencies, trade associations, labour
unions. These user groups having direct/indirect interest have different objectives
and diverse informational needs. The emphasis in financial accounting has been
on general-purpose information which, obviously, is not intended to satisfy and
specialized need of individual users or specific user groups.
Financial Accounting,
Cost Accounting and
Management Accounting
NOTES
2.3.1 Application of Accounting Information
Accounting information is useful for :
i) Score-Keeping, ii) Attention Directing, iii) Problem Solving
Attention
Directing
(ii)
Score-keeping
(i)
Purpose of
Accounting
Information
Problem
Solving
(iii)
Fig. 2.1 : Purposes of Accounting Information
The various purposes of Accounting information are described as follows :
i)
ii)
Score-keeping : The score-keeping function in one of the purposes of
accounting information. Score-keeping deals with the financial health of
the business. Accounting in its score card role, accumulates information
(data) and enables interested persons to understand and take stock of the
organisation’s performance.
Attention-directing : Attention- directing is nothing the process of giving
a signal to the user of accounting informations about the necessity to take a
Check Your Progress
What are the seven phases
in the evaluation of
accounting ?
How accounting information
is useful for (i) score-keeping
(ii) attention-directing & (iii)
problem solving.
Management Accounting - I
21
Financial Accounting,
Cost Accounting and
Management Accounting
decision. In this role accounting complements day-to-day operational planning
control activities.
iii)
NOTES
2.4
Problem Solving : Accounting. in its problem solving role, data, enables
quantification of the different alternative solutions, their relative pros and
cons.
Structure of Accounting
Accounting plays a critical role in the efficient use of a firm’s resources.
Decision-makers operate in a complex economic environment that is constantly
changing, Their information needs change with the environment, and accounting
must adapt to satisfy these changing needs. The importance of sound financial
information has always been recognized, but in the light of today’s conditions,
such information has become crucial to the survival of business and industry.
Accounting can be broadly classified into three types : (a) Financial
Accounting (b) Cost Accounting and (c) Management Accounting. These three
cannot be put in water-tight compartment classification. Each one supplements
the other. In fact, Financial Accounting Provides the basic for Cost Accounting
as well as Management Accounting and in the ultimate analysis management
accounting includes part of cost accounting.
2.4.1 Financial Accounting
The American Institute of Certified Public Accountants (AICPA) has
defined Financial Accounting as “the art of recording, classifying and summarising
in a significant manner and in terms of money transactions and events which are
in part at least of a financial character and interpreting the results thereof.’’
Accounting is the language effectively employed to communicate the
financial information of a business unit to various parties interested in its progress
such as proprietors, creditors, investors, employees, consumers, and the
government etc. Financial Accounting concerns that part of accounting which is
meant to serve all parties externally to the operating responsibility of the firm, e.g
creditors, investors, employees, regulatory bodies and the general public. But
Management Accounting is designed for the use in operational needs of the firm.
Financial Accounting is a discipline which is employed in industry and
commerce to record, classify and summaries the mercantile transactions that occur
in an organisation. The American Accounting Association has defined accounting
as the process of identifying, measuring and communication economic information
to permit informed judgements and decisions by users of the information.
The analysis of the above definitions brings following features to the light:
i)
22 Management Accounting - I
Art of recording and classifying business transactions and events in a
systematic manner;
ii|)
Transactions to be recorded in monetary terms;
iii)
Summarizing, analysing and interpreting the results of accounting information;
and
iv)
Communicating and explaining the information to decision-makers.
2.4.1.1
Objectives of Financial Accounting
Financial Accounting,
Cost Accounting and
Management Accounting
NOTES
A modern accounting system has to accomplish the following four objectives:
i)
To identify financial events and transactions that occur in an organisation.
ii)
To measure the value of these occurrences in terms of money.
iii)
To organise the accumulated financial data into meaningful information and
iv)
To analyse, interpret and communicate that information to a broad range of
persons and groups, both within and outside the organisation.
2.4.1.2
Functions of Financial Accounting
The major functions of Financial Accounting are summarised below :
1)
Recording : Since all business transactions cannot be kept in memory,
they have got to be systematically recorded and pass through journals, ledgers
and work sheets before they could take the forms of final accounts. This
aspect of financial accounting has assumed considerable importance with
the limitation of human memory.
2)
Validating : With the universal acceptance and enforcement of accounting
principles, every recorded entry in the books of accounts maintained by a
business unit gives validity or authenticity to all such transactions so recorded.
3)
Communicating : This is an important functions of financial accounting.
Accounting serves as a language for communicating the financial fact
about the enterprise or activity most effectively to all concerned interested
in using and interpreting them.
4)
Check Your Progress
Define the term financial
accounting.
Give
it’s
objectives & functions.
Interpreting : These aspects helps in unfolding the total financial picture
of an undertaking and investing the same with more meaning.
2.4.1.3 Limitations of Financial Accounting
Financial Accounting like any other branch of knowledge, is not without
limitations. The fast changing conditions and environmental factors have brought
the limitations of Financial Accounting as follows :
1)
Financial Accounting does not provide detailed cost informations for different
departments, processes, products, jobs in the production divisions. Similarly,
separate cost data are not available for different services and functions in
the administration division. Management may need information about
different products, sales territories and sales activities which are also not
Management Accounting - I
23
Financial Accounting,
Cost Accounting and
Management Accounting
available in Financial Accounting.
2)
Financial Accounting does not set up a proper system of controlling materials
and supplies. Undoubtedly, if material and supplies are not controlled in a
manufacturing concern, they will lead to losses on account of
misappropriation, misutilisation, scrap, defective etc. They may, in turn,
influence the reported net income of a business enterprise.
3)
The recording and accounting for wages and labour is not done for different
jobs, processes, products, departments. This creates problems in analysing
the cost associated with different activities. This also does not provide a
basis for rewarding workers and employees, for the above-average
performance.
4)
Financial Accounting contains historical cost information which is
accumulated at the end of the accounting period. This accounting does not
provide day-to-day information about costs and expense. This is the
reason why much dissatisfaction has been shown with external financial
reporting. The historical cost is not a reliable basis for predicting future
earnings, solvency, or overall managerial effectiveness. Historical cost
information is relevant but not adequate for all purpose. It is now rightly
contended that current cost information should be reported along with
historical cost information.
5)
It is difficult to know the behavior of cost in financial accounting as expenses
are not assigned to the product at each stage of production. Expenses are
not classified into direct and indirect and therefore cannot be classified as
controllable and uncontrollable. Control of cost which is the most important
objective of all business enterprise cannot be achieved with the aid of financial
accounting alone.
6)
Financial Accounting does not process an adequate system of standards to
evaluate the performance departments and employees working in
department. Standardisation is now applied to all elements of business.
Standards need to be developed for materials, labour and overheads so
that a firm can compare the work of laborers, workers, supervisors and
executives with what should have been done in an allotted period of time.
7)
Financial Accounting does not provide to analyses the losses due to various
factors, such as idle plant and equipment, seasonal fluctuations in volume of
business etc. It does not help management in taking important decisions
about expansion of business, dropping of a product line, starting a new
product, alternative methods of production, improvement in product etc.
the managerial decisions about theses business matters have now become
vital to the survival and growth of business enterprises.
8)
Financial Accounting does not provide cost data to determine the price of
the product being manufactured or the service being rendered to the
consumers. It is also not possible to prepare detailed cost reports for the
purpose of comparison and analysis between two periods of time within an
NOTES
24 Management Accounting - I
enterprise and also for making inter-firm comparison
9)
10)
Change in the economic conditions of the country have direct impact on the
business position of an organisation. The conditions of inflation or deflation
change significantly the value of the business. Such a change is not depicted
in the financial accounts as the accounts of the business have to be
maintained on the basis of cost concept. With the result the balance sheet
of an organisation fails to give true and fair view of the business.
The serious limitation to Financial Accounting is that it can only be understood
by such persons who have accounting knowledge.
Financial Accounting,
Cost Accounting and
Management Accounting
NOTES
Check Your Progress
What are the limitations of
financial accounting ?
2.4.2 Cost Accounting
Cost Accounting is an extension of general accounting system which have
as a goal the gathering, classifying, and analysing to cost data that management
needs in search for the most efficient methods of operating, achieving control of
cost and reducing expenses. “Cost accounting is the provisions of such analysis
and classification of expenditure as will enable the total cost of any particular unit
of production to be ascertained with reasonable degree of accuracy and at the
same time to disclose to exactly how such total cost in constituted.”
According to the Institute of Cost and Works Accountants (ICWA), London,
cost Accounting is “the process of accounting for cost from the point at which
expenditure is incurred or committed to the establishment of its ultimate relationship
with cost centres and cost units. In its widest usage it embraces the preparation
of statistical data, the application of cost control method and the ascertainment of
the profitability of activities carried out or planned.”
W.J. Morse defines Cost Accounting as “the processing and evaluation of
monetary and non-monetary data to provide information for external reporting,
internal planning and control of business operations and special analysis and
decisions”.
Thus, Cost Accounting is the branch of accounting designed to determine
the costs of manufactured products and to report cost information to management.
It provides the means to analyses that are relevant to management. Cost
Accounting procedures and routines are used as a means of accumulating and
allocating all elements of manufacturing cost in manner that will produce meaningful
data for the use of management.
2.4.2.1 Objective of Cost Accounting
The main objectives of Cost Accounting are mentioned below :
(i)
To aid in the development of long-range plans by providing cost data that
acts as a basis for projecting data for planning.
(ii)
To ensure efficient cost control by communicating essential data costs at
regular intervals.
Management Accounting - I
25
Financial Accounting,
Cost Accounting and
Management Accounting
(iii)
To determine cost of products or activities.
(iv)
To identify profitable areas of business.
(v)
To provide management with information in connection with various
operational problems.
NOTES
2.4.3 Emergence of Management Accounting
With the advancement of science and technology more sophisticated
equipments and gadgets have been put into operation in the realm of accounting
as well. This has changed the accounting from a mere device of recording to a
powerful tool of forecasting, budgeting, and budgetary control. Thus, Financial
accounting has been supplemented with financial and cost control, budgeting and
budgetary control and also production planning and control besides reporting on
business performance. Precisely, it has led to the emergence of management
accounting.
Check Your Progress
How cost accounting is an
extension
of
general
accounting system ?
The terms “ management Accounting” is of recent origin even in the U.S.A
This term was first coined and used by the British Team of Accountants that
visited the United Sates in 1950 under the auspices of Anglo-Amercian Productivity
Council. Since then management accounting has grown into a full fledged subject
as is looked upon as a subject distinct from accounting in recent years. It is also
otherwise known as “ Management Oriented Accounting” or “Accounting for
Management”
2.5
Distinction Between Management Accounting
And Financial Accounting
Though Management Accounting and Financial Accounting cannot be put
in water-tight compartment classification, it should be remembered that the former
is only an off-shoot of the latter. Precisely, Management Accounting supplements
the functions of Financial Accounting in as much as it provides the necessary
accounting data and statistical information needed by the management for improving
the efficiency as a whole. Despite the closer interrelationship that exists, there
are certain points of difference between the two and they are discussed below.
26 Management Accounting - I
Sr.
Points
Management Accounting
Financial Accounting
Primary
Users
of
Information
Management accounting
aims at preparing reports
and supplying information to
management for planning,
controlling and decisionmaking. The information
generated under the
accounting system is used by
members of management at
different levels. The nature
of internal reports and data
varies for different levels of
management in conformity
with their information
requirements for analysing
business operations and for
planning and control
purpose. Thus, different sets
of information could be
developed under managerial
accounting and supplied to
different persons responsible
for activities in the
organisation.
The users of financial
accounting statements are
mainly external to the
business enterprise. The
financial
statements
prepared under financial
accounting show how the
resources have been used
by a business enterprise
during a specific period of
time and thus are useful to
external users in making
sound economic decisions.
These financial statements
are relevant to management
but are not adequate for the
purpose of planning, control
and decision-making.
External users include
shareholders, creditors,
financial
analysts,
government authorities,
stock exchange, labour
unions, etc.
Nature
Management accounting is
mainly concerned with the
future plans and policies,
whereas
financial
accounting is concerned with
historical records relating to
the past. Management rely
on the past records for
formulation of future plans
and
hence,
the
interdependence
of
management accounting and
financial accounting cannot
be overemphasised.
The historical nature of
financial accounting serves
a limited purpose of
throwing light on the events
and results of the past. The
forward
looking
management accounting
greatly
helps
the
management in improving
the results in future through
various tools and techniques
of budgeting and budgetary
control, standard costing,
profit planning. etc.
Financial Accounting,
Cost Accounting and
Management Accounting
No.
1.
2.
3.
Accounting
Method
NOTES
Check Your Progress
Distinguish
between
:
Management Accounting &
Financial Accounting.
Management accounting is Financial accounting follow
not based on the double- the double-entry system for
entry system. The data recording, classifying and
summarizing business
Management Accounting - I
27
Financial Accounting,
Cost Accounting and
Management Accounting
NOTES
28 Management Accounting - I
under
management
accounting may be gathered
for small or large segments
or activities of an
organisation and monetary
as well as other measures
can be used for different
activities in the firm. The
only constraint regarding
managerial accounting
principles and methods is
that they should be useful for
management purpose.
transactions.
This
accounting process results
in aggregate balances of all
accounts maintained in a
firm’s books.
4.
Accounting
Principles
Management accounting is
not bound to use the
“generally”
accepted
accounting principles. It can
use any accounting
accounting technique or
practice which generates
useful information. Besides,
data
developed
in
management accounting
may be facts, estimates,
projections, analyses etc.
Financial accounting data is
primarily meant for external
users. The “generally
accepted
accounting
principles” are important in
financial accounting and are
used extensively while
recording, classifying,
summerising and reporting
business transactions. The
use of GAAP adds
creditability and reliability of
financial statements and
creates confidence among
the financial statement
users.
5.
Obligatory
In modern time, a business
concern is free to install any
system of management
accounting.
It is more or less obligatory
on the part of every
business concern to adopt
financial accounting for
disclosing the results of the
business to the rightful
owners.
6.
Time Span
Management accounting
reports and statements are
prepared whenever needed.
Reports may be prepared on
a monthly, weekly or even
daily basis. Frequency of
reports is determined by
particular
planning,
controlling and decision-
Financial accounting data
and
statements
are
developed for a definite
period, usually a year or a
half-year. It requires that
financial statements be
developed and presented at
regular time intervals.
Company annual reports
making needs.
may
be
prepared
semiannually or quarterly
but the important point is
that they are prepared on a
regular basis.
7.
L e g a l
Formalities
Since a business concern is
free to install the system of
management accounting.
There is no statutory
regulation fixing the norms
and
standards
for
preparation and presentation
of accounting statements.
Needless to state that these
statements can be adapted
to the changing needs of the
management since they are
meant for internal use.
Financial
accounting
statements are standardized
and meant for external use.
The preparation and
presentation of annual final
accounts of companies are
governed by the provisions
of the Companies and
Income Tax Act in force.
8.
Unit
of
Measurement
Besides the monetary units,
the management accountant
may find it necessary to use
such measures, as number
of labour hours, machine
hours and product units for
the purpose of analysis and
decision-making. The
common objective in all
measurement, reporting and
data analysis in managerial
accounting is usefulness for
a particular purpose.
Historical cost and past
transactions are essential to
financial accounting but may
be secondary to managerial
accounting as they are not
of
much
use
to
management.
All information under
financial accounting is in
terms of money. That is,
transactions measured in
terms of money have
already occurred. In
comparison managerial
accounting applies any
measurement unit that is
useful in a particular
situation.
9.
Purpose of
Report
The reports and data
developed in management
accounting are known as
specific purpose reports
designed for a particular user
(manager) or particular
decision.
Managerial
Financial
accounting
produces information and
reports which are general
purpose reports in order to
serve the informational
needs of many external
users such as shareholders,
Financial Accounting,
Cost Accounting and
Management Accounting
NOTES
Management Accounting - I
29
Financial Accounting,
Cost Accounting and
Management Accounting
accounting uses internal
reports to evaluate the
performance of entities,
product lines, departments
and managers.
creditors, potential investors,
customers,
supplier,
regulatory authorities,
employees and the general
public. Financial accounting
is concerned with overall
firm performance rather
than individual segments or
departments.
NOTES
10.
Focus
Management accounting
provides detailed and
disaggregated information
about products, individual
activities, divisions, plants,
operations, tasks or any
other responsibility centers.
Financial
accounting
focuses on the company as
a whole. Sometimes in
financial accounting, some
information is given about
different products or lines of
activity due to financial
reporting requirements as
provided in the Companies
Act/other rules and
regulations.
11.
P r e c i s i o n Management accounting
Exactness
lays no emphasis on
precision as the data and
particulars compiled are
merely estimates and relate
to the future.
In financial accounting
precision is stressed greatly
since the past result of the
business are reflected
through them.
12.
S u b j e c t Management accounting,
Matter and also known as internal
Scope
accounting, identifies,
collects measures, classifies
and reports information that
is useful to managers in
planning, control and
decision-making.
Financial accounting also
known
as
external
accounting, produces
information and reports for
external users.
2.6
Distinction Between Managment Accounting
And Cost Accounting
The term ‘management accounting’ is of recent origin and is used to describe
the modern concept of account as a tool of management. It is concerned with all
such accounting information that is useful to management. The management
accounting consist of four essential takes : (1) Cost determination ; (2) Cost,
control; (3) Performance evaluation and ; (4) Supplying information for planning
and decision-making.
30 Management Accounting - I
It will be seen from the above points that the scope of management
accounting is broader than that of cost accounting. In cost accounting the main
emphasis is on cost determination and cost control whereas management accounting
utilises the principles and practices of financial accounting and cost accounting in
addition to other modern management techniques for efficient operation of business,
The various techniques; employed by management accounting include marginal
costing and cost-volume-profit analysis, standard costing, budgetary control,
uniform costing and inter-firm comparison, funds flow statements, ratio analysis;
and also certain techniques from various branches of knowledge like mathematics,
statistics, economics which-so-ever can help management in achieving the business
goals. Cost accounting also uses many of these techniques and its objectives are
also quite similar to those of management accounting.
Financial Accounting,
Cost Accounting and
Management Accounting
NOTES
Inspite of above minor differences between the two, both work as
complementary. Because, management accountant will not be in a position to
discharge his responsibility in the absence of a sound cost-accounting system.
Because, cost accounting provides some of the useful data to the management
accountant who in turn utilises them to appraise the management. In the same
way, cot accounting would be of not much use to the managerial personnel in the
absence of a proper management accounting system. Hence, both are
complementary. Mr. M. N. Arora in his book, Cost Accountancy pointed out that:
In fact, management accounting is an extension of the managerial aspect of cost
accounting. The Scope of management accounting is wide and broad-based and
includes financial accounting, cost accounting, budgeting, audit, taxation, etc.
However, a very few minor differences that exist between Management
Accounting and cost Accounting are given in the following table.
Difference between Management Accounting and Cost Accounting
Sr.
Points
Management Accounting
Cost Accounting
No.
1.
P r i m e Management accounting
Objectives
aims at the presentation of
the cost data, to the extent
required, wherever and
whenever they are required
together with other relevant
information
to
the
management for taking
decisions.
Costing accounting aims at
ascertaining the cost of
goods and services. It lays
emphasis on the stage by
stage computation of costs.
For cost ascertainment
different techniques and
system of costing are used
under
different
circumstances.
2.
D a t a Cost data form a part of
managerial reports but not
coverage
the sole aspects. Report
includes both the quantitative
Cost reports deal mainly
with the costs incurred or
budgeted and standards,
variances, savings, etc. Cost
Check Your Progress
How
Management
Accounting differ from Cost
Accounting ?
Management Accounting - I
31
Financial Accounting,
Cost Accounting and
Management Accounting
reporting is a continuous
process and may be daily,
weekly, monthly etc.
of Management reports are
useful only to the
management but not to both
internal and external parties.
Though cost reports are
meant for management,
they are useful even to the
external parties.
3.
Use
Reports
4.
Control of Preparation of reports as per Cost accounts and reports
appropriate the rules of any appropriate are to be prepared as per
authority
authority etc.
certain rules, principles,
procedures etc. as specified
No such rigidity is there in
by the appropriate authority
the case of managerial
(e.g. ICWAI) to the industry
reports. The procedure,
to which the company
format etc. can be modified
belong to. It has been made
from time to time depending
obligatory to keep cost
upon convenience and
records
under
the
requirements.
companies Act.
5.
S t a t u t o r y Management reports are not
subject to any statutory
verification
audit. Of course, there is a
management audit. But, it is
voluntary and it evaluates the
managerial functions,
decisions, etc. However,
management reports include
both the objective and the
subjective data.
Cost accounts and reports,
in many cases, are subject
to statutory audit (i.e. cost
audit). Hence they should be
prepared, as far as possible,
on objective manner.
6.
Nature
Management accounting is
mainly concerned with the
future plan policies.
Management rely on the
past records for formulation
of future plans and hence,
the interdependence of
management accounting and
cost accounting cannot be
over emphasised.
Cost
accounting
is
concerned not only with
historical costs but also with
predetermined costs. This is
because cost accounting
does not end with what has
happened in the past and
extend to plans and policies
to improve the performance
in the future. Mostly cost
accounting helping in
determination of selling
price.
7.
S u b j e c t Management accounting is Cost accounting and
Matter and also known as Managerial Costing are offen used
Accounting, or Accounting interchangeably. Cost
Scope
NOTES
32 Management Accounting - I
and qualitative information.
for
Management
or
Management oriented
accounting etc. It is also
known
as
internal
accounting, identifies,
collects,
measures,
classifies, and report
information that is useful to
managers in planning, control
and decision-making.
accountancy is the widest of
all the terms and embraces
not only costing and cost
accounting but also cost
control and cost audit. Cost
accountancy is used to
describe the principles,
conventions, techniques and
systems
which
are
employed in a business to
plan and control the
utilisation of its resources.
Financial Accounting,
Cost Accounting and
Management Accounting
NOTES
As per the above mentioned table, though a few number of differences can
be identified between Management accounting and Cost accounting, the line of
difference is very thin. Because, both these accounting systems are closely linked
as they use common basic data and reports to a material degree.
The relationship between financial Accounting and cost Accounting can be
understood with the help of following illustrations
2.7
Illustrations
ILLUSTRATION 1
From the following accounting data available from the books of Akbar Ali
Bros Ahmedabad for the year ended 31st March 2014
You are required to prepare profitability statement under Financial
Accounting and cost Accounting separately.
`
Office Overheads
75,000
Direct Material
2,20,000
Selling on Cost
42,000
Prime Cost Labour
1,50,000
Distribution Expenses
33,000
Direct Expenses
20,000
Works Expenses
60,000
Turnover-cash and Credit
7,50,000
Also Calculate the percentage of profit on sales.
Management Accounting - I
33
Financial Accounting,
Cost Accounting and
Management Accounting
SOLUTION
A)
Profitability statement under financial Accounting
Trading Account for the year ended 31-3-2014
NOTES
Dr.
Cr.
Particulars
`
To Direct Material
2,20,000
To Prime Cost Labor
1,50,000
To Direct Expenses
20,000
To works Expenses
60,000
To Gross Profit C/D
300,000
Particulars
`
By sales
7,50,000
(40% on sales)
7,50,000
7,50,000
Profit and Loss Account for the year ended 31st March 2014
Dr
Cr.
Particulars
`
Particulars
To Office Overheads
75,000
By Gross Profit B/D
To Selling on Cost
42,000
To Distribution Expenses
33,000
To Net Profit
`
3,00,000
1,50,000
(20% on sales)
3,00,000
B)
3,00,000
Profitability statement under cost accounting
Cost Sheet for the year ended 31.3.2014
Particulars
`
Direct Material
2,20,000
Add Prime Cost Labour
1,50,000
Add Direct Expenses
Prime cost
(+)
(1)
Add works Expenses
Works cost
Cost of productions
20,000
3,90,000
(+)
(2)
Add Office overheads
(+)
(3)
3,90,000
60,000
4,50,000
4,50,000
75,000
5,25,000
Add Selling on cost
5,25,000
42,000
Add Distribution Expenses
(+)
33,000
Total Cost
(4)
6,00,000
6,00,000
Add Profit
(5) (+)
1,50,000
1,50,000
Sales
34 Management Accounting - I
`
Percentage of Profit on sales
7,50,000
20%
2.8 Summary
•
Phases in the evolution of Accounting
(a)
Stewardship Accounting
(b)
Financial Accounting
(c)
Cost Accounting
(d)
Management Accounting
(e)
Social Responsibility Accounting
(f)
Inflation Accounting
(d)
Human Resource Accounting
•
Use of Accounting Information
Financial Accounting,
Cost Accounting and
Management Accounting
NOTES
Finance accounting information is intended primarily to serve external users.
Finance Accounting information is uses by a variety of groups and for diverse
purposes.
•
Application of Accounting information
Accounting information is useful for
(i)
Score keeping
(ii)
Attention Directing &
(iii)
Problem Solving.
•
Structure of Accounting
Accounting can be broadly classified into three types :
(a)
Finance Accounting
(b)
Cost Accounting &
(c)
Management Accounting.
•
Difference between Management Accounting, Finance Accounting
& Cost Accounting
The scope of management accounting is wide and broad bases and includes
financial accounting & cost accounting. However a very few minor
difference that exist between Management Accounting, Financial
Accounting & Cost Accounting.
Management Accounting - I
35
Financial Accounting,
Cost Accounting and
Management Accounting
NOTES
2.9
Key Terms
(1)
Accounting : Accounting is language of business - language as to solvency,
profitability, efficiency and health of the business.
(2)
Financial Accounting : is a discipline, which is employed in industry and
commerce to record, classify and summaries the mercantile transactions
that occur in an organisation.
(3)
Cost Accounting : Cost Accounting is concerned with application of cost
to job, product process and operations. It is concerned with the development
of standard unit cost.
(4)
Cost and statistics : is concerned with generating statistical and analytical
cost information to all departments of the organisation.
(5)
Forecasting & Budgeting : are concerned with the preparation of cash
forecast, profit and loss forecast and budgeted balance sheet as well as
preparation of budgets in keeping with the requirement of operating and
other departments.
(6)
Audit : is concerned with the central aspect of accounting. It is concerned
with accounting control.
2.10 Questions And Exercises
I - Objective Questions
A)
Multiple choice Questions.
1)
Financial Accounting provides valuable information for -------a) fixation of selling prices.
b) cost control purposes.
c) assessing the financial position and profitability of the first.
d) cost reduction purposes
2)
---- is an important method of foresight and not a post-mortem examination
a) Cost Accounting
b) Inflation Accounting
c) Green Accounting
d) Financial Accounting
3)
36 Management Accounting - I
The different tools and techniques of ------ basically concerned with the
forecast of future.
a) Financial Accounting
Financial Accounting,
Cost Accounting and
Management Accounting
b) Management Accounting
c) Cost Accounting
d) Human Resource Accounting
4)
Management Accounting is often called as a tool for --------- control
NOTES
a) administrative
b) organisational
c) Price
d) Management
Ans (1-c) (2-a) (3-d) (4-d)
II - Long Answer Questions
1)
Explain in brief the phases in the evolution of accounting.
2)
What is Accounting information ? Explain in brief the external and internal
users of Accounting information.
3)
Define ‘Accounting Information’. State the various purposes of Accounting
Information.
4)
What is ‘Financial Accounting’ ? Explain the objectives and functions of
Financial Accounting.
5)
What is ‘Cost Accounting’ ? Sate the important objectives of ‘Cost
Accounting’.
6)
What is ‘Management Accounting’ ?
Accounting’ ?
7)
Define ‘Management Accounting’. How it differs from ‘Financial
Accounting’ ?
How it differs from ‘Cost
2.11 Further Reading
•
Prasad N. K. and Prasad A. K. - Cost and Management Accounting Kolkatta - Book Syndicate Pvt. Ltd. - 2010
•
Khan M. Y. and Jain P. K. - Management Accounting Text, Problems and
Cases - New Delhi - Tata McGraw Hill Publishing Co. Ltd. - 2010
Management Accounting - I
37
UNIT 3 TOOLS AND TECHNIQUES, ROLE
OF MANAGEMENT
ACCOUNTANT
Structure
NOTES
3.0
Introduction
3.1
Unit Objectives
3.2
Tools and Techniques of Management Accounting
3.3
Advantages of Management Accounting
3.4
Limitations of Management Accounting
3.5
Installation of Management Accounting System
3.6
Management Accountant : Role, Functions and Duties
3.7
Tools & Techniques,
Role of Management
Accountant
3.6.1
Functions of Management Accountant
3.6.2
Responsibilities of Management Accountant
3.6.3
Important Duties of Management Accountant
Essential Qualities of Management Accountant
3.7.1
Traits of Successful Management Accountant
3.8
Summary
3.9
Key Terms
3.10 Questions and Exercises
3.11 Further Reading
3.0
Introduction
The Management Accounting System consists of number of tools &
techniques which are frequently used by the management accountant to meet the
increasing needs of the business. Financial Planning, Statistical Analysis, Cost
Accounting, Standard Costing, Marginal Costing, Budgetary Control, Fund Flow
Analysis, Management Reporting, and Analysis of Financial Statements are the
important tools and techniques of Management Accounting. Cost and Management
Accounting involves presentation of accounting information in a manner that
facilitates prudent planning, correct decision making and effectively controlling
day to day operations. Besides co-ordination and controlling in the area of business
and financial management, the ‘Management Accountant’ has to play a vital role
to overcome the difficulties arising from the threat of rising prices. The
Management Accountant, thus hold key position upon whose negligence the
Management Accounting - I
39
Tools & Techniques,
Role of Management
Accountant
“integrity” of the business may be jeo pardised, the lack of alertness and foresight
on his part may tend the business toward, “erosion of real capital” unnoticed.
Management Accountant advising management in the formulation of plan and
policy on the basis of interpretation of various facts such as valuation of assets,
determination of income etc.
NOTES
3.1
Unit Objectives
After studying this unit you should be able to :
•
Name various tools and techniques of management accounting.
•
Identify advantages of management accounting.
•
Understand the Role, Functions & Duties of management accountant.
•
Describe essential qualities of management accountant.
•
Appreciate responsibility of management accountant.
•
Clarify the limitations of management accounting.
3.2
Tools And Techniques Of Management
Accounting
Management Accounting is an information system designed to communicate
meaningful economic and financial information to the management so that
management may discharge its functions efficiently. The Management Accounting
System consists of number of tools and techniques which are frequently used by
the management accountant to meet the increasing needs of the business. The
important among them are :
40 Management Accounting - I
(1)
Financial Planning : Planning is necessary not only for efficient utilization
of available resources but also for better and progressive business results.
It is more significant for finance function because finance plays a deciding
role in managerial decision. Financial planning is the process of deciding in
advance the financial objective by employing financial planning. In the short
term, it can help a concern in meeting its obligations by balancing flow of
funds. At the same time, its proper application can ensure efficient utilization
of available financial resources in the long period.
(2)
Statistical Analysis : Accountants frequently confront masses of data from
which they would like to draw systematic and logical conclusions. Statistical
analysis and in particular, statistical sampling theory provides scientific
method for drawing reliable and valid conclusions about the properties of
an entire population when only a properly chosen sample of the population
has been studied in detail.
Tools & Techniques,
Role of Management
Accountant
Accounting
Management
Financial
External
Reporting
NOTES
Interested
Parties or Users
(i) Income Statement
(ii) Balance Sheet
(iii) Cash Flow Statement
(i)
(ii)
(iii)
(iv)
(v)
(vi)
(vii)
(vii)
(ix)
(x)
(xi)
(xii)
(xiii)
(xiv)
Shareholders
Investors
Creditors
Governmental
Authorities
Managers
Employees
Stock Exchanges
Investors Association
Industry Association
Bankers
Insurance Companies
Customers
Multinationals
Competitors
Internal
Reporting
(i)
(ii)
(iii)
(iv)
(v)
(vi)
Planning
Decision-making
Performance Evaluation
Control
Management of Cost
Cost Determination
Interested
Parties or Users
Management
(or Managers)
(i) Top
(ii) Middle
(iii) Lower
Check Your Progress
Identify the tools and
techniques of management
accounting.
Fig. 3.1 Scope of Management of Accounting and Financial Accounting
(3)
Cost Accounting : Cost accounting is vital part of the total management
accounting system. It includes the recording, classifying, analysis and
reporting of all cost aspects of company performance. The cost accounting
and procedures have to be designed with great care keeping in view the
nature and requirement of the firm and the data required at the different
levels of management for effective cost control and cost reduction.
(4)
Standard Costing : Another major technique for operating control through
management accounting is standard costing. Under this arrangement,
standard costs are used to control the major activities of the business.
Standard costs are predetermined targets against which actual result are
Management Accounting - I
41
Tools & Techniques,
Role of Management
Accountant
evaluated. This is the basis for a system of management control, for which
a proper monitoring of performance is a key factor. The variances between
standard and actual costs are computed and reported to managements.
(5)
Marginal Costing : Marginal costing is a managerial technique that
considers only variable costs in the additional output decisions. It is reporting
system that values inventory and cost of sales at its manufacturing variable
cost. It is frequently used as an internal management reporting system.
(6)
Budgetary Control : Budgetary Control refers to a system of business
control that uses budgets to control the major activities of business. The
budgets for all major activities of the business are prepared in advance.
Generally the budget is prepared by updating the previous year’s figures in
the light of some forward projections.
(7)
Fund Flow Analysis : Funds Flow Analysis attempts to highlight the causes
of change in the financial condition of a business enterprise between two
dates. Any statement prepared for this purpose refers to as funds flow
statement . A funds flow statement helps management in the efficient planning
and control of cash.
(8)
Management Reporting : Management reporting is considered essential
component of a well designed planning and control system. Decision-makers
frequently require information on various aspects of business. Thus it is the
responsibility of the management accountant to communicate right
information to the management at the right time and in a right manner.
(9)
Analysis of Financial Statement : Financial statement analysis is a growing
and ever changing set of system and procedures designed to provide decision
makers with relevant information derived from the basic sources of data,
such as company financial statements and government and industry
publications. Over the years number of techniques have been devised to
analyses financial statements e.g. comparative financial statements, commonsize statements, ratio analysis, trend analysis, and fund flow statement.
NOTES
3.3
Advantages Of Management Accounting
Management Accounting offers the following benefits to the enterprise :
42 Management Accounting - I
(1)
It increases the efficiency in the activities of the business.
(2)
It ensures efficient regulation of business activities by establishing efficient
system of planning and budgeting.
(3)
It makes possible the efficient utilization of the available resources and
thereby increase the return on capital employed.
(4)
It ensures effective control by comparing actual results with the standards.
(5)
It maintains a good public relation by providing quality services to the
customers of the business.
(6)
It provides mens to motivate the employees of the organization.
(7)
It keeps management informed about the going operations enabling it to
suggest remedial measures in case of deviations.
(8)
It helps in evaluating the efficiency and effectiveness of the company’s
business policies with the incorporation of management audit.
(9)
It is one of the “diagnostic techniques” available to the managers and
executives for improving economic performance by realisation of the
accounting system in use.
Tools & Techniques,
Role of Management
Accountant
NOTES
(10) It helps in development of realistic data in respect of future transactions.
(11)
3.4
It provides technique for useful interpretation of accounting information.
Limitations Of Management Accounting
Following are the important limitations of Management Accounting :
(1)
Psychological Resistance : The management accounting system spells a
radical change in the management approach towards solving day-to-day
problems confronted by it. This calls for a reorganisation of personnel as
well as reorientation of their activities. This is bound to attract opposition
especially from the labour force misconstruing it as a tool meant for their
exploitation. Constant education about the benefits of such a new techniques
alone will allay the fears of the labour force by and large. Management
accounting, as a new discipline, is no exception to this rule and it encountered
psychological resistance at least in the initial stages.
(2)
Expensive Installation : For installation of a system of management
accounting in a business concern, an elaborate organisation and a large
number of manuals are very essential. This in turn escalates the
establishment charges such that only large scale organisations can afford
to install it.
(3)
Continuance of Intuitive Decision-making : Management accounting
eliminates the intuitive decision-making process of management and replaces
it with scientific decision-making. Unfortunately, many managements are
prone to take the easy and simple path of intuitive decision-making rather
than the difficult but reliable scientific decision-making process in the dayto-day management.
(4)
Broad-based Scope : The Scope of management accounting is wide and
broad-based and this creates many difficulties in the implementation process.
It is easy to record, analyse, and interpret an historical event converted into
monetary terms in a most objective manner. But it will be difficult to
perform the same functions in respect of future and unqualifiable situations
in the light of the past records.
Check Your Progress
Give
some
important
advantages and limitations of
Management Accounting.
Management Accounting - I
43
Tools & Techniques,
Role of Management
Accountant
(5)
Comprehensive Coverage : The fusion of a number of subjects like
financial accounting, statistics, engineering, economics, taxation has
culminated in the emergence of management accounting. Under the
circumstances, should be emergence of management accounting. Under
the circumstances, more of these subject will have its impact on the fixation
of standards as well as solutions to the problems connected with the
management performance.
(6)
Evolutionary Stage : management Accounting is a new discipline and a
growing subject too. It is still in the infancy stage and undergoing
evolutionary process. Naturally, it faces certain obstacles and impediments
before achieving perfection and finality. This necessitates sharpening of
the analytical tool and improving to techniques for removing the air of doubt
as regards uncertainty in their applications.
(7)
Persistent Efforts : the conclusion drawn by the management accountant
may not be readily and willingly implemented. For this purpose, the
management accountant has to strive to convince the staff members.
(8)
Basic Records : The management accounting collects the data from various
sources like Financial Accounting, Cost Accounting, Statistics and other
operational records. If such data or information is incorrect or partial the
decisions arrived at on the basis of such data may be incorrect and misleading.
(9)
Principle of Objectivity not Followed : The principle of objectivity is not
followed in its real spirit in management accounting. The collection and
analysis is considerably influenced by the personal bias of the management
accountant.
NOTES
(10) No Substitute for Management : In fact, Management Accounting is a
mean to an end, the end being the successful business operations for
achievements of business objectives. It cannot replace management as it
is simply a tool or a technique in the hands of management and ultimate
success in business depends upon the will and dedication of management.
However, number of the limitations from which Management Accounting
is suffering can be over come if the management is convinced about the importance
of, and the necessity for management accounting. As well as these Limitations do
not undermine the significance of Management Accounting.
44 Management Accounting - I
3.5
Installation of Management Accounting
System
The management process implies four basic functions i.e (a) Planning, (b)
Organising, (c) Controlling and (d) Decision-making. Management Accounting
plays a vital role in these managerial functions performed by managers.
Management Accounting has a very scope incorporating many disciplines. It
considered both monetary as well as nonmonetary factors.
Tools & Techniques,
Role of Management
Accountant
NOTES
The following steps will have to be take for installation of an efficient and
effective management accounting system :
(i)
An appropriate Organisational Manual should be prepared and adopted.
The Manual defines and confines explicitly the scope of authority of each
executive in the organisation. This prevents overlapping of functions,
powers and responsibilities. It also depicts the line of communication.
(ii)
The requisite staff will have to be recruited, trained and developed. During
this phase the training programmes are implemented to develop motivation
and skills among the staff members. Tests, group discussion and interviews
may be used in the recruitment of staff.
(iii)
It would seem obvious that careful attention given to correct design, proper
use and effective control of forms would result in appreciable savings to
any office. Therefore appropriate forms, returns, etc. should be designed,
prepared and made available.
(iv)
Classification and codification of accounts : Classification means the
systematic grouping of organisms into categories based on shared
characteristics or traits. Classification is the actor result of classifying data.
Coding is considered as the classification process. The purpose of coding is
to classify the answers to a question into meaningful categories which is
necessary for management accounting.
(v)
Developing a suitable system for the integration of cost and financial data.
(vi)
Setting up a suitable system of budgetary control.
(vii)
Setting up of standards, introducing standard costing techniques.
(viii) Setting up cost, budget and profit centres and introduction of operational
research techniques.
Management Accounting - I
45
Tools & Techniques,
Role of Management
Accountant
NOTES
3.6
Management Accountant : Role, Functions
And Duties
Management Accounting represents a happy blending of the two older
professions of ‘Management’ and ‘Accounting’. The two important elements in
the success of a business concern are accounting control and management
efficiency. These two determinants are completely merged in management
accounting through the harnessing of accounting for improving the efficiency of
management.
Management Accounting greatly assists the management in achieving better
results by making a clear shift in emphasis from mere recording of transactions to
their analysis and interpretation to give a new vista to the management. It concerns
with the tools and techniques of formulation of budgets and pre setting of standards
as well as evaluation of deviations in actual performance and also implementation
of prompt remedial measures. In short, management accounting eliminates intuition
from the field of business management and broadens the services of accounting
to management.
3.6.1 Functions of Management Accountant
The Management Accountant, often referred to as controller, is the manger
of accounting used in planning, control and decision-making areas. He is responsible
for collecting, processing and reporting information that will help managers/decision
makers in their planning, controlling and decision-making activities. He participates
in all accounting activates within the organisation. He performs many vital
responsibilities and functions within organization such as :
46 Management Accounting - I
(a)
Planning : He has to establish, co-ordinate and administer as an integral
part of management, an adequate plan for the control of the operations.
Such a plan would include profit planning, programmes of capital investment
and financing, sales forecasts, expense budgets and cost standards.
(b)
Controlling : He has to compare actual performance with operating plans
and standards and to report and interpret the results of operations to all
levels of management and the owners of the business. This is done through
the compilation of appropriate accounting and statistical records and reports.
(c)
Co-ordinating : He consults all segments of management responsible for
policy or action. Such consultation might concern any phase of the operation
of the business having to do with attainment of objectives and the
effectiveness of the organisation structures and policies.
(d)
Other Functions :
(1)
Providing help in the design of an accounting information system.
(2)
Collecting valuable data.
(3)
Helping in the maintenance of accounting records, preparation of financial
statements.
(4)
Helping in the budget preparation.
(5)
Preparation of performance reports, control reports, special managerial
reports/analyses for planning, control and decision making.
(6)
Co-ordinating budget-making and report preparation activities.
(7)
Interpreting accounting data based on the particular requirements of a
manager in a given situation.
(8)
Ensuring that the accounting information system is adequate and useful in
accordance with the budgets, plans, policies and decision requirements.
Tools & Techniques,
Role of Management
Accountant
NOTES
In additions to above, he has to (i)
Administers tax policies and procedures.
(ii)
Supervises and co-ordinates the preparation of reports to government
agencies.
(iii)
Ensures fiscal protection for the assets of the business through adequate
internal control and proper insurance coverage.
(iv)
Carries out continuous appraisal of economic and social forces, and the
government influences, and interprets their effect on the business.
3.6.2 Responsibilities of Management Accountant
The role and responsibility of a Management Accountant is one of support.
They provide help to these mangers who have primary responsibility to fulfill
basic managerial functions. Positions that have direct responsibility for the basic
objectives of an organisation are known as line positions. Positions that are
supportive in nature and have only indirect responsibility for an organization’s
basic objectives are called staff positions. For instance, a manager of a production
department holds a line position and has responsibility and authority to make
decisions concerning his department. The Production Manager and similar other
managers holding line positions formulate policies and goals and make decisions
that have impact on production. The Management Accountant, however, has no
authority over the production manger and other line positions mangers. But since
the management accountants have the responsibility of providing and interpreting
accounting information, they can have significant influence on the policies and
decisions made by production and similar line managers.
The management accountant should clearly understand that different decision
made in the organisation require different types of data. short-run decisions need
different data than long-run decisions. Similarly, decisions affecting the total
company such as product lines to be added in the existing product mix need more
aggregate data than some other decisions, say, the optimum use of a particular
machine. Therefore, the management account should ensure that the information
system of the organisation meets the needs of all decision maker within the
organisation, who require information for the performance of their jobs. For
example, mangers responsible for the sales of particular product might need a
Management Accounting - I
47
Tools & Techniques,
Role of Management
Accountant
weekly sales report for each territory. The chief sales executive may require
monthly reports of sales by product group and sales territories. the management
accountant must ensure that the information system meets these varying needs.
3.6.3 Important Duties of Management Accountant
NOTES
Following are important duties of a management Accountant.
1.
Maintain an appropriate level of professional competence.
2.
Communicate information fairly and objectively.
3.
Refrain for disclosing confidential information.
4.
Monitor subordinate’s activities to assure the maintenance of confidentiality.
5.
Refuse any gift, favour or hospitality that is for influence or appear to influence
the actions.
6.
Perform the duties in accordance with relevant laws, regulations and
technical standards.
3.7
Essential Qualities of Management Accountant
Following are the essential qualities of successful Management Accountant.
48 Management Accounting - I
1.
Management Accountants are emotionally mature so that they are neither
frustrated by failure nor over joyed by success.
2.
A Management Accountant’s knowledge of a subject (i.e Advanced
Accounting and Cost Accounting must be up-to-date and greater than that
of his subordinates.
3.
A Management Accountant must remember that “knowledge of subject is
important but what is more important is the knowledge of human nature.
4.
A Management Accountant must possess decisiveness. Vacillation is fatal
for a management accountant. But rigidity of decision is equally bad.
5.
A Management Accountant must also possess empathy or social sensitivity.
It is the ability to look at things objectively and understand them from
another’s point of view.
6.
A Management Accountant must be depends on his initiative in organizing
the means to achieve his objective. Initiative simply means doing the right
things without being told.
7.
A Management Accountant is also expected to handle the important duties
of processing as well as simplification of the data which essential for the
organisation in decision-making.
8.
A Management Accountant provides useful services of an interpreter in
connection with various financial statements, statistical charts, diagrams
etc.
9.
A Management Accountant should try to appraise economic and social
forces and governmental influences continuously and interpret their effect
on business.
10.
Tools & Techniques,
Role of Management
Accountant
NOTES
Since planning is presumed to be essential for the organisation for smooth
functioning and for continuity in operations, hence it is assumed that the
management accountant should perform the objectives in the most efficient
manner.
3.7.1 Traits or Special Merits or Characteristics of
Successful Management Accountant
Following are the traits of successful Management Accountant.
1. Adaptable to situations
2. Alert to the social environment
3. Ambitious and achievement oriented 4. Assertive (firm)
5. Co-operative
6. Proper decision advisor/taker
7. Persistent
8. Self-confident
9. Tolerance of stress and
10. Willing to assume responsibility
3.8
Summary
• Tools and Techniques of Management Accounting
The management accounting system consist of number of tools and techniques,
the important among them are :
(i)
Financial Planning
(ii)
Statistical analysis
(iii)
Cost Accounting
(iv)
Standard Costing
(v)
Marginal Costing
(vi)
Budgetary Control
(vii)
Fund Flow Analysis
(viii)
Standard Costing
(ix)
Analysis of Financial Statements.
• Limitation of Management Accounting
Following are the important limitations of Management Accounting
(i)
Psychological Resistance
(ii)
Expensive installation
(iii)
Continuance of Intuitive
Decision Making
(iv)
Broad-based Scope
Management Accounting - I
49
Tools & Techniques,
Role of Management
Accountant
NOTES
(v)
Comprehensive Coverage
(vi)
Evolutionary Stage
(vii)
Persistent Efforts
(viii) Basic Record
(ix)
Principle of Objectivity not followed (x)
No substitute for management
• Management Accountant
Management Accountant performs many vital responsibilities and functions
within organisation such as
a) Planning
3.9
b) Controlling
c) Coordinating
Key Terms
(1) Management Accounting : Different techniques of management accounting
i) Financial Accounting, ii) Cost Accounting, iii) Financial Management, iv) Decision
Accounting & v) Control Accounting
(2) Mental Revolution : The concept of human psychology regarding the
induction of the art of management in the field of accountancy.
(3) Fairness : Management Accounts must be prepared on a fair basis with no
conscious weighing of factors for or against a line of policy or point of view.
(4) Accuracy : Accuracy and completeness of management accounting figures
need be sufficient only to enable appropriate action to be based on them.
3.10 Questions And Exercises
I - Objective Questions
A)
Multiple Choice Questions
1)
Management Accounting helps in development of realistic data in respect
of ----------transactions.
(a) Future
(b) Current
(c) Past
(d) Credit
2)
In management accounting the principle of ----------- is not followed in its
real spirit.
(a) subjectivity
50 Management Accounting - I
(b) objectivity
(c) creativity
(d) diversity
3)
Tools & Techniques,
Role of Management
Accountant
Management Accounting is a Mid- way between ----------- accounting and---------- accounting.
(a) inflation - national
NOTES
(b) green-forensic
(c) financial - cost
(d) taxation - environmental
4)
The highest level of Management Accountant is called the ----------(a) chief
(b) executive
(c) in-charge
(d) controller
Ans : (1 - a), (2 - b), (3 - c), (4 - d)
II - Long Answer Questions
1)
Explain in brief the various tools and techniques of management accounting.
2)
State the advantages and limitations of management accounting
3)
What is ‘Management Accounting’ ? Explain in brief the steps to be taken
for installation of an effective system of management accounting.
4)
Explain the Functions of Management Accountant
5)
Explain in brief the duties and responsibilities of Management Accountant
6)
State the essential qualities of management accountant.
3.11 Further Reading
•
Prasad N. K. Prasad A. K. - Cost and Management Accounting - KolkattaBooks Syndicate Pvt. Ltd. 2010
•
Khan M.Y. and Jain P. K. - Management Accounting Text, Problems and
Cases - New Delhi -Tata Mc Graw Hill Publishing Co. Ltd. - 2010
Management Accounting - I
51
TOPIC 2
Analysis of Finnacial Statement
UNIT 4
Meaning Objectives and Tools of
Financial Statement Analysis
UNIT 5
Common Size Statement
and Trend Analysis
UNIT 6
Ratio Analysis
UNIT 7
Fund Flow Statement
UNIT 8
Cash Flow Statement
UNIT 4 Meaning Objectives and Tools of
Financial Statement Analysis
Meaning, Objectives &
Tools of Financial
Statement Analysis
Structure
NOTES
4.0
Introduction
4.1
Unit objectives
4.2.
Meaning Objective and Interpretation of Financial Statement Analysis
(A) Meaning (B) Objectives (C) Interpretation of Financial Statement
Analysis
4.2.1
Steps involved in the Financial statement Analysis
4.2.2
Role of Financial Analyst
4.2.3
Limitations of Financial Statements
4.3
Types of Financial Analysis
4.4
Tools of Financial Statement Analysis
4.4.1
Multi-Steps Income Statement
4.4.2
Horizontal Analysis
4.4.2.1
Comparative Statements Interfirm Comparison
4.4.2.2
Procedure of Interfirm Comparison
4.4.2.3
Necessity of Interfirm Comparison
4.4.2.4
Limitations of Comparative Financial Statement Analysis
4.4.2.5
Application of Interfirm Comparison Method
4.4.2.6
Advantages of Interfirm Comparison
4.4.2.7
Disadvantages of Interfirm Comparison
4.4.2.8
Precautions before Preparing Comparative Statements
4.5
Illustrations
4.6
Summary
4.7
Key terms
4.8
Questions and Exercises
4.9
Further Reading
Management Accounting - I
53
Meaning, Objectives &
Tools of Financial
Statement Analysis
NOTES
4.0
Introduction
Financial Statement analysis is an analysis which highlights important
relationships in the financial statements. It focuses on evaluation of past operations
as revealed by the analysis of basic statements. Financial Statement Analysis
embraces the methods used in assessing and interpreting the result of past
performance and current financial position as they relate to particular factors of
interest in investment decisions. It is an important means of assessing past
performance and in forecasting and planning future performance.
Financial Statement analysis is used by financial institutions, banks loaning
agencies and others to make sound lone or credit decisions Financial Statement
analysis is a significant tool in predicting the bankruptcy and failure probability of
business enterprises. The analysis of Financial Statement means a critical
examination of statement for better understanding and drawing fruitful conclusions.
Multi Steps Income Statement, Interfirm Comparison, Common Size
Statement, Trend Analysis, Analytical Balance Sheet, Ratio Analysis, Fund Flow
Statement, Cash Flow Statement are the important tools of financial statement
analysis.
4.1
Unit Objectives
After going through this unit you will be able to :
•
Understand the Meaning and objectives of financial statement analysis.
•
Explain interpretation of financial statement analysis.
•
Explain various types of financial analysis.
•
Identify various tools of financial statement analysis.
•
Discuss objectives and limitations of financial statement analysis
•
Listout different tools of financial statement analysis.
•
Prepare a comparative balance sheet
4.2
Meaning, Objectives And Interpretation
Financial Statement Analysis
(A) Meaning
According to Lev. “Financial Statement Analysis is an information
processing system designed to provide data for decision making models, such as
the portfolio selection model, bank lending decision models, and corporate financial
management models’’.
54 Management Accounting - I
“ Financial Statement Analysis, According to Myers” is largely a study of
relationship among the various financial factors in a business as disclosed by a single set
of statements and a study of the trends of these factors as shown in series of statement”.
In the words of W.B Meig, “Financial Statements thus are organised summaries of detailed
information and are thus a form of analysis. The type of statements accountants prepare,
the way they arrange items on these statements and their standards of disclosure are all
influenced by a desire to provide information in a convenient form”
Meaning, Objectives &
Tools of Financial
Statement Analysis
NOTES
The focus of Financial Analysis is on key figures contained in the Financial
Statements and the significant relationship that exists between them. “Analysis of financial
Statements” according to Metcalf and Titard, “is a process of evaluating the relationship
between component parts of a Financial Statement of obtain a better understanding of a
firm’s position and performance.”
(B) Objectives of Financial Statement Analysis
The major objectives of financial statement analysis is to provide decision makers
information about a business enterprise for use in decision-making. Users of Financial
Statements information are the decision makers concerned with evaluating the economic
situation of the firm and predicting its future course. The major groups of users are
management of evaluating the operational and financial efficiency of the enterprise as a
whole or of sub -units (e.g. departments), investors for making investment decision and
portfolio decisions, lenders and creditors for determining the credit worthiness and solvency
position; employees and labour unions for deciding economic status of the enterprise and
making, sound decisions in wage and salary negotiations, regulatory authorities for controlling
the activities of the firm and making overall corporate policy, economists, researchers and
planners for studying firm and specific data behavior.
Financial Statement analysis can be used by different users and decision makers to
achieve the following objectives :
(i) Assessment of Past Performance and Current Position :
Past performance is often a good indicator of future performance. Therefore, an
investor or creditors in interested in the trend of past sales, expenses, net income, cash
flow and return on investment. These trends offer a means for judging management’s
past performance and are possible indicator of future performance. Similarly, the analysis
of current position indicates where the business stands today. For instance, the current
position analysis will show the types of assets owned by a business enterprise and the
different liabilities due against the enterprise. It will tell what the cash position is, how
much debts the company has in relation to equity and how reasonable the inventories and
receivables are.
(ii) Loan Decision by Financial Institutions and Banks :
Financial statements analysis is used by financial institutions, loaning, agencies, banks
and others to make sound loan or credit decision. In this way, they can make proper
allocation of credit among the different borrowers. All lenders are primarily concerned
with repayment of loan and payment of interest on the due dates. This requires
comprehensive investigation and analysis of the financial statements submitted by the
borrowers. Financial statement analysis help in determining credit risk, deciding terms
Management Accounting - I
55
Meaning, Objectives &
Tools of Financial
Statement Analysis
NOTES
and conditions of loan if sanctioned, interest rate, maturity date etc.
(iii) Prediction of Net Income and Growth Prospects :
Financial Statement analysis helps in predicting the earning prospects and
growth rate in the earnings which are used by investors while comparing investment
alternatives and other users interested in judging the earning potential of business
enterprises. Investors also consider the risk or uncertainty associated with the
expected return. The decision makers are futuristic and are always concerned
with the future financial statements which contain information on past performances
analyzed and interpreted as a basis for forecasting future rates of return and for
assessing risk. The prediction of future earnings tends to improve the financial
decisions made by the investors and financial analysis.
(iv) Prediction of Bankruptcy and Failure :
Financial statement analysis is a significant tool in predicting the bankruptcy
and failure probability of business enterprises. Financial Statement analysis
accomplishes this through the evaluation of solvency position. After being aware
about probable failure, mangers and investors both can take preventive measures
to avoid or minimise losses. Corporate managements can effect changes in
operating policy, reorganise financial structure or even go for voluntary liquidation
to shorten the length of time losses.
In accounting and finance area, empirical studies conducted have suggested
a set of financial ratios which can give early signal of corporate failure. Such a
prediction model based on financial statement analysis is useful to mangers,
investors and creditors. Managers may use the ratios prediction model to assess
the solvency position of their firms and thus can take appropriate corrective action.
Investors and shareholders can use the model to make the optimum optimum
portfolio selection and to bring changes in the investment strategy in accordance
with their investment goals. Similarly, creditors can apply the prediction model
while evaluating the creditworthiness of business enterprises.
(C) Interpretation of Financial Statements
The analysis of financial statements means a critical examination of
statements for better understanding and drawing fruitful conclusions. It is only an
analytical study of statements which can help draw dependable conclusions.
Therefore, analysis becomes a pre-requisite for interpretation of financial data in
the form of annual account and statement. The technique of analysis depends
upon the objectives of analysis.
56 Management Accounting - I
The type and extend of relationship to be investigated depends upon primarily
the objective and purpose of analysis. The purpose of analysis differs among
various groups such as creditors, shareholder, potential investors, management,
government and so on. For example, the object of short-term creditors is primarily
to know about the short-term solvency and the long-term creditors, such as
debenture holder and financial institutions aim at knowing the long-term solvency
of the enterprises to which they have lent money. There are investors who are
interested in the declared rate of dividend; other investors, such as holding
companies are interested in the earning capacity and growth and development of
the enterprise. Thus, different persons will analyse the financial statements from
different objects in mind. Contrary to the above, the management of the business
unit looks to the financial statements from different angles. These financial
statements are required by the management for the purpose of evaluation and
decision making.
Meaning, Objectives &
Tools of Financial
Statement Analysis
NOTES
4.2.1 Steps involved in Financial Statement Analysis
There are three steps involved in the financial statement analysis and they are :
1. Selection
2. Classification
3
2
1
3. Interpretation
Interpretation
Classification of Information
Selection of Information
Fig. 4.1 : Steps involved in Financial Statement Analysis
The first step involved refers to the selection of information relevant to the
purpose of evaluation from the total of information contained in the financial
statements. The second step involved is the classification or grouping of information
in such manner to focus on the significant relationships. The final step is the
interpretation which includes drawing of inferences and conclusions.
4.2.2 Role of Financial Analyst
The joint stock companies are required to prepare their published accounts
on the prescribed proforma and in accordance with the guidelines provided in the
Acts. The financial analyst should see that the final accounts have been drawn
up according to law and nothing has been left or concealed. Once the analyst is
satisfied about the accuracy of published final accounts and statements, he can
safely proceed to further analyses them for the purpose of drawing conclusions.
The analysis and interpretation are closely interlinked since interpretation is
impossible without a proper analysis and any analysis which is not followed by
interpretation becomes a meaningless exercise. Thus, interpretation precedes a
proper analysis. For instance, the financial analyst would like to have more
detailed information regarding debts due within month or six months or so from
internal sources, since the same cannot be obtained from the financial statements.
Further, interpretation requires comparison. This necessitates dissection of financial
statements into its constituents in order to measure relative magnitude of the various
items contained therein. However, financial analyst should always keep in mind
the limitation of financial statements.
Management Accounting - I
57
Meaning, Objectives &
Tools of Financial
Statement Analysis
NOTES
58 Management Accounting - I
4.2.3 Limitations of Financial Statements
The Financial Statements (i.e Profit and Loss Account and Balance Sheet)
suffer from certain limitations, which are mentioned below :
1.
The financial statements do not show qualitative change which undoubtedly
affect greatly the performance of an undertaking. The financial accounts
do not account for events such as change in management, labour strikes,
changes in government policies affecting enterprise etc. The financial
analyst should try to assess the impact of qualitative changes on the
profitability of the concerning enterprise.
2.
Financial statements are historical in nature. They tell nothing about future.
Since the financial analyst is concerned with analysis and interpretation for
formulation of future business policies, he should restructure the statements
in such a manner, that they becomes more intelligible and useful for
projections for future.
3.
Generally, the audited Profit and Loss Account and Balance Sheet are
considered dependable statements. If the analyst is compelled to use the
unaudited accounting statements, he should first ascertain their truth. It is
very difficult to verify the correctness of the Income Statement and Position
Statement without the basic information in the form of ledger accounts and
other records.
4.
Concept of accounting period is not technically correct. The Profit and
Loss Account is prepared for an accounting year which is generally a period
of one year. This gives rise to the problem of cost and income allocation.
In fact, real profit or loss can be calculated only at the end with the units is
closed down. The annual accounts can best be considered as interim reports.
5.
The Profit or loss figure as shown by a Profit and Loss Account is not
necessarily a correct figure which is influenced by the personal judgment
of the management regarding depreciation, inventory valuation and
provisions for various reserves and contingencies. The management can
manipulate profit/loss figure to serve their interests. The financial analyst
should see that the income has been rightly computed by following consistent
accounting policies.
6.
Balance sheet is a static documents, which means, a documents showing
the economic position of an enterprise one given date. The Balance sheet
is prepared on the last day of a financial year. i.e on 31st December, 31st
March or 30th June. Generally, the Balance Sheet is prepared and published
very late after the close of the accounting year. The Balance sheet looses
much of its significance and practical utility due to a long time gap between
the close of an accounting year and the actual publication of the same. A
Financial analyst should always bear this limitation in mind.
7.
Assets shown in the Balance Sheet might not be shown at their fair or
current values. Goodwill is an item which is closely related to profits. If a
company suffers loss continuously for the last few years, It clearly means
that it no more enjoys the goodwill as shown in the books of the company.
But the companies continue to show goodwill at the usual figure despite
continuous losses. Similarly, companies in general do not account for the
impact of inflation on their fixed assets and liabilities and show them at cost
values. The financial analyst should take precaution and give due recognition
to the assets valuation as done by a company.
The business house is, generally, not in a position to understand properly the
financial statements instantly in their traditional forms. But, when the same
statements are presented to the management in an analytical form with brief
explanations on critical items, it becomes easier to understand them to take decision
without inconvenience and loss of time and energy.
4.3
Meaning, Objectives &
Tools of Financial
Statement Analysis
NOTES
Types of Financial analysis
The classification of financial analysis can be made either on the basis of
material used for the same or according to modus operandi of the analysis.
A
Classification of Financial Analysis
B
According to Material Used
1
External
Analysis
According to Modulus Operandi of Analysis
2
Internal
Analysis
3
Horizontal
Analysis
4
Vertical
Analysis
Fig. 4.2 : Financial Statement Analysis
(A) According to Material Used
(1) External Analysis : This is effected by those who do not have access to the
detailed accounting records of the concern. This group comprising investors,
credit agencies, government and public, depends almost entirely or publishes
financial statements. With the recent development in the Government regulation
requiring business concern to make available detailed information to the public
through audited accounts, the position of the external analysis has been considerably
improved.
Check Your Progress
Give meaning and major
objectives of financial
statement analysis.
What is interpretation of
financial statement ?
How you can classify it
according to material used and
Modus Operandi ?
(2) Internal Analysis : This is effected by those who have access to the books
of accounts and other information relating to the business concern. Any financial
analysis is conducted with reference to a part or the whole unit. This type of
analysis meant for managerial purpose, is conducted by executives and employees
of the business concerns as well as governmental agencies which have statutory
control and jurisdiction over such units.
Management Accounting - I
59
Meaning, Objectives &
Tools of Financial
Statement Analysis
NOTES
(B) According to Modus Operandi of Analysis
(3) Horizontal Analysis : When financial statements for a certain number of
years are examined and analysed, the analysis is called a horizontal analysis. It is
also called “Dynamic Analysis.” This is based on the data or information spread
over a period of years rather than on one date or period of time as a whole.
(4) Vertical Analysis : This refers to analysis of ratios developed for one date
for one accounting period. This is also known as “Static Analysis” But vertical
analysis does not facilitate a proper analysis and interpretation of figures in
perspective and also comparisons over a period of years. As such this type of
analysis is not resorted to the financial analysts.
4.4
Tools of Financial Statement Analysis
Analysis of Financial statements is a technical job which can be performed
properly only by a knowledgeable and experienced financial analyst. In order to
be successful his analysis and interpretation, a financial analyst must possess
thorough knowledge of accounting theory and practice and he must understand
various tools and techniques of accounting and their application in the analysis
and interpretation of data.
A study of the relationship and trends is undertaken as part of financial
analysis, to evaluate the financial position, the operational results as well as the
financial progress of a business concern. There are certain analytical methods or
devices used for measuring the relationship among the financial statement item of
a single set of statements and changes that have taken place in those items of a
single set of statements and changes that have taken place in their items as disclosed
in successive financial statements. Following are tools which are generally
employed to analyse the financial statements.
4.4.1 Multi-steps Income Statement
First, sales and other operating revenues are compared with the cost of
goods sold to give the gross Profit (If cost of goods sold exceeds the sales
revenue and other operating revenues then there will be a gross loss.)
Secondly, from the gross profit other operating expenses (often divided
into administration, selling and distribution expenses) are deducted to get
operating profit.
60 Management Accounting - I
Thirdly, to the operating profit other nonoperating incomes are added and
therefore other nonoperating expenses are deducted. The resultant figure is
net profit before tax. Nonoperating incomes arise form secondary activities.
For example, interest, rent and dividend received by a company whose main
business is not to deal in finance, property and investment. Other expenses
arise from incidental activities. For example, financing costs, such as the
payment of interest.
Fourthly, the provision for tax is deducted from the net profit before tax.
The result is net profit after tax.
Meaning, Objectives &
Tools of Financial
Statement Analysis
Fifthly, other extraordinary gains or losses e.g. gain or loss on the sale of
investments or loss by fire, are shown net of income taxes for arriving at the
final figure of net income.
The presentation of Profit and Loss Account in Vertical Form and “MultipleStep” is as under:
NOTES
ABC Co..Ltd
Profit and Loss Account
For the year ended 31st March, 2014
` in Crores
Particulars
`
Net Sales
18,70,520
Cost of Goods Sold
11,44,260
(i) Gross Profit
7,26,260
General and Administration Expenses :
Office Salaries
85,000
Office Salaries
65,160
Taxes
17,480
Insurance
Depreciation
3,760
47,960
219,360
Selling Expenses:
Sales Salaries
1,36,700
Advertising
68,560
Travel and Entertainment
18,740
Freight and Delivery
Depreciation
9,240
15,520
2,48,760
Total Operating Expenses
4,68,120
(ii) Operating Profit
2,58,140
Other Revenues and Expenses:
Interest and dividend Earned
Income from Rent
12,400
(+) 38,800
51,200
Less : Interest Expense
(iii) Net Profit Before Income Tax
10,400
40,800
2,98,940
Provision for Income-Tax (50%)
1,49,470
(iv) Net Profit after Income Tax
1,49,470
Gain on Sale of Investments
(v) Net Profits
9,330
1,58,800
Management Accounting - I
61
Meaning, Objectives &
Tools of Financial
Statement Analysis
NOTES
4.4.2 Horizontal Analysis
In case of this type of analysis, financial statements for a number of years
are reviewed and analysed. The Current year’s figures are compared with the
standard or base year. The analysis statement usually contains figures for two or
more years and the changes are shown regarding each item from the base year
usually in the form of percentage. Such an analysis gives the management
considerable insight into levels and areas of strength and weakness. Since this
type of analysis is based on the data from year to year rather than on one date, it
is also termed as “Dynamic Analysis.”
4.4.2.1 Comparative statements (Inter-firm Comparison)
Joint stock companies are required to provide in their annual published
accounts the corresponding figures for the year immediately proceeding the current
financial year so as to provide a comparative picture of their business affairs.
As the very term signifies, comparative financial statements are statements
of the financial position of a business so formulated as to focus on the elements
contained therein and provide the necessary time perspective to it. Normally, it is
the balance sheet and profit and loss account which alone are prepared in a
comparative form, since it is these two statements which are considered as
important financial statements. Moreover, it is through these two statements the
financial positional and the operational results of any business can be determined.
4.4.2.2 Procedure of Inter-firm Comparison
The decision-makers prefer to study the picture of not only for one or two
year but for few more year in the past. The Income Statement and Balance sheet
in their usual from are not much useful from management point of view. Therefore,
the analysts re-arrange the information in different group as the group study along
with the individual items is more meaningful for the purpose of interpretation and
decision-making. If two or more companies have to be compared (interfirm
comparison) the analyst should take care that the group are homogeneous. He
should also bear in mind the size of the enterprise in terms of capital investment
and turnover.
Comparative financial statements are designed to disclose the following
62 Management Accounting - I
1.
Absolute data (money value or rupee amounts)
2.
Increases or decreases in absolute data in terms of money value.
3.
Increases or decreases in absolute data in terms of percentage.
4.
Comparisons expressed in ratios.
5.
Percentage of totals.
It may be noted that the absolute figures, especially when they represent
large amount are not easy to remember; therefore, it is advisable that the figures
are expressed as a percentage or ratio.
Meaning, Objectives &
Tools of Financial
Statement Analysis
4.4.2.3 Necessity of Inter-firm Comparison
Comparative financial statements are very useful to the financial analyst
since they contain figures drawn from single statement and also provide necessary
information for the study of financial and operating results over a period of time.
The only point out the direction or the trends of the movement as regards financial
position and operating results of the business concern.
NOTES
When financial statement are prepared at periodic intervals of say one
month or three months, comparison can be effected with the corresponding month
or quarter of preceding accounting year or years. Cumulative totals for the expired
portion of the current year to the corresponding totals of the preceding year or
years may also be computed by the analyst. The percentage analysis of increase
and decrease in corresponding items in comparative financial statement is called
horizontal analysis. Comparative financial statement analysis helps in predicting
the earning prospects and growth rates in the earning which are used by investors
while comparing investment alternatives and other users interested in judging the
earning potential of business enterprises. Comparative financial statement analysis
is a significant tool in predicting the bankruptcy and failure probability of business
enterprises.
4.4.2.4
Limitations of Comparative Financial Statements
Analysis
Comparisons will have significance and will become more effective only if
the data compared truly reflect the constancy in the application of generally
accepted accounting principles from date to date or period to period. Where there
is no change in the accounting principles followed. It should be mentioned as
footnote in the financial statements as well as audited reports.
The analyst should also keep in mind the price level changes that have
taken place between the dates of different transactions and that of preparation of
financial statements. Where there is a substantial price fluctuation, the analyst
must exercise great caution while interpreting the assets revealed by comparative
statement. Again absolute comparison of the statements of different business
concerns for a certain years is not possible. Some degree of comparison can be
achieved by comparing the assets within different companies for a number of
years, say at least three years. This is more due to the effect to the choice of
certain alternatives that cause considerable difference in one year and tend to
even out over several years.
Management Accounting - I
63
Meaning, Objectives &
Tools of Financial
Statement Analysis
NOTES
4.4.2.5
Application on Inter-firm Comparison Method
While applying this method a comparative balance sheet and a comparative
Income statement are to be prepared.
(a) Comparative Income Statement : An income statement reveals the
operational results of the business for a stipulated period of time. The comparative
income statement shows the operational result of the business for a number of
accounting periods so that changes in absolute figures from one period to another
may be stated in terms of money and percentages.
The form of comparative income statements consist of two columns for the
data of the profit and loss account and the third column for disclosing increase or
decrease in various items. A fourth column shows the percentage of increase or
decrease.
XYZ Company Ltd.
Comparative Income Statement
(For the year ended 31st March (Last Year) and (Current Year)
Income and
Expenditure
March 31
Previous Year
Current Year
Items
1
64 Management Accounting - I
2
Amount of
Percentage of
Increase or
Increase or
Decrease in ...
Decrease in ...
3
4
Meaning, Objectives &
Tools of Financial
Statement Analysis
Specimen :
Proforma of Comparative Income Statement
................ Co. Ltd.
Comparative Income Statement for the year ended 31st March, 20XX and 20XX
March March
31 st
31 st
Amount of
Percentage of
increase or
increase or
decrease in
decrease in
20XX
20XX
20XX-20XX
20XX-20XX
`
`
`
%
NOTES
Net Sales
Less : Cost of Goods Sold
Gross Margin (or Profit)
Operating Expenses
Administrative Expenses
Total Administrative Expenses
Selling Expenses
Total Selling Expenses
Finance Expenses
Total Finance Expenses
Total Operating Expenses
Operating Profit
Add : Other Incomes
Less : Other Expenses
Income or Net Profit before
Income-Tax
Less : Income-Tax
Net Profit after Tax
(b) Comparative Balance Sheet :
Normally any increase or decrease in the value of various assets and liabilities
as well as in proprietors’s equity or capital, resulting form the operational activities
of the business, can be easily observed by means of comparison of the balance
sheet at the beginning and end of the accounting period. To facilitate comparison
a simple device known as “comparative balance sheet” may be employed. Such
method often yields valuable information as regards progress of the business
concern.
Management Accounting - I
65
Meaning, Objectives &
Tools of Financial
Statement Analysis
NOTES
While the single balance sheet represents balances of accounts drawn at
the end of an accounting period, the comparative balance sheet represents not
merely the balance of accounts drawn on tow different dates, but also the extent
of their increase or decrease between these two dates. The single balance sheet
focuses on the financial status of the concern as on a particular date, the
comparative balance sheet focuses on the changes that have taken two place in
one accounting period. The Changes are the direct outcome of operational
activities, conversion of assets, liability and capital form into others as well as
various interactions among assets, liability and capital.
Comparative Balance sheet can be prepared in the same manner as the
income statement as shown in the above representation. The management
accountant while presenting a comparative. Balance sheet under suitable heads,
should be very clear about that structure of different assets and liabilities i.e assets
may be grouped under four major heads viz (a) Liquid assets, (b) Non-liquid assets,
(c) Fixed assets and (d) Pre-operative expenses not written off. Similarly, the
liabilities may be grouped into trade liabilities and long-term liabilities. The breakup
of Balance sheet in this manner will provide a better picture of the state of affair
of an enterprise.
Format of Comparative Balance Sheet :
XYZ COMPANY LTD.
Comparative Balance Sheet
As on 31st March --------------- (Previous Year) and --------(Current
Year)
Liabilities
and
March 31
Previous Year
Current Year
Assets
1
66 Management Accounting - I
2
Amount of
Percentage of
Increase or
Increase or
Decrease in ...
Decrease in ...
3
4
Meaning, Objectives &
Tools of Financial
Statement Analysis
Specimen :
A Proforma of Comparative Balance Sheet
----------------- Co. Ltd.
Comparative Balance Sheet as on 31 st March, 20xx and 20xx
March
March
Amount of
Percentage of
31
31
increase or
increase or
decrease in
decrease in
20XX-20XX
20XX-20XX
st
20XX
st
20XX
NOTES
Assets :
Current Assets
Cash
Debtors (Less Reserve)
Stock-in-Trade
Total Current Assets (A)
Investments
Shares
Government Securities
Total Investments :
Fixed Assets
Building (Less Depreciation)
Machinery (Less Depreciation)
Furniture (Less Depreciations)
Total Fixed Assets (B)
Total Assets (A+B)
Liabilities and capital
Current Liabilities
Sundry Creditors
Bills Payable
Total Current Labilities (C)
Fixed Liabilities
Debentures
Long-Term Loans
Total Fixed Liabilities (D)
Total Liabilities (C)+(D)
Capital :
Equity Share Capital
Preference Share Capital
General Reserve
Retained Earnings
Total Surplus
Total Capital
Total Liabilities and Capital
Management Accounting - I
67
Meaning, Objectives &
Tools of Financial
Statement Analysis
NOTES
4.4.2.6
Advantages of Inter-Firm Comparison
Inter-firm comparison follow a system of uniform costing and so the
advantages of uniform costing would equally accrue in interfirm comparison as
well. In addition, the following advantages are obtained from interfirm comparison.
1. Benefits industry as a whole : Benefits like elimination of destructive and
unfair competition, increased productivity, standardisation of methods, better
bargaining power in dealing with the Government etc. are available to the industry
as a whole.
2. Maintains secrecy : As indicated earlier, the participating firms are known by
code numbers and the data is presented in the form of ratios. This helps in
maintaining secrecy for all the firms. Each firm knows only its own code number
but is unaware of the identify of other firms whose figures it receives for comparison
purposes.
3. Reveals weaknesses and strengths : Interfirm comparison spotlights
weakness or strength of a business in relation to other in the industry.
4. Creates cost consciousness : A sense of cost consciousness develops in
the member units which results in a tendency to control and reduce costs by the
optimum utilisation of resources.
5. Services of specialized agencies : Specialized knowledge and experience
of the central organisation are available. Research may be conducted for the
industry as a whole, the results of which are made available to the participating
firms.
6. Voluntary Pooling of Information : The scheme of interfirm comparison
involves voluntary pooling of information by participating firms, through a
representative body.
4.4.2.7 Disadvantages of Inter-Firm Comparison
A Scheme of inter-firm comparison may suffer from the following disadvantages
68 Management Accounting - I
1.
Difference in the nature and size of the member firms makes its operation
difficult.
2.
The top management may not be convinced of the utility of the scheme and
thus may be reluctant to disclose data of a confidential nature.
3.
Efficient firms may not like to participate because of the fear that information
supplied by them may be utilised to their disadvantage and inefficient firms
may come-up to their level.
4.
Where there is no proper system of cost accounting the figure supplied
may not be relied upon for the purpose of comparison.
5.
Suitable basis for comparison may not be available.
6.
Expert financial analysts are required for-this comparative study, usually, a
group of techniques is used for result oriented analysis and this is also a
costly affair.
4.4.2.8
Precautions before Preparing Comparative
Statements
Meaning, Objectives &
Tools of Financial
Statement Analysis
NOTES
Analysis of financial statements is a technical job which can be performed
properly only by a knowledgeable and experienced financial analyst. In order to
be successful in his analysis and interpretation, a financial analyst must possess
thorough knowledge of accounting theory and practice. In addition to this, he must
also understand the industry environment in which the unit is operating. His personal
qualities such as penetrating vision and insight, tactfulness, alertness, leadership
qualities, etc. help him greatly in the successful discharge of his functions as
financial analyst.
Before preparing comparative statements it is necessary to ensure that the
following precautions are taken. If the following principles are not followed, the
comparison cannot be made and if it is made the result will be misleading and
misinterpreting.
1.
The Financial statements should contain full disclosure of the information
by way of foot-notes, schedules, annexure.
2.
Proper accounting procedure is to be followed every year while preparing
the accounts and the financial statements.
3.
The items in the balance-sheet are to be properly classified and uniformity
is to be maintained in such classification and allocation.
4.
Concept of consistency and other relevant concepts and conventions are to
be followed in preparation of financial statements.
5.
Personal Judgements are to be properly exercised as the accuracy of the
accounting statements depends to a large extent on the integrity, experience
and wisdom with which judgements are exercised.
6.
If two or more companies are being compared, it should be seen that their
nature and size do not widely differ.
7.
If there has been any change in the depreciation policy, inventory valuation
method, or any other variable affecting profit figure and assets and liabilities,
the analyst should first make the data comparable by making necessary
adjustments in the concerning items.
8.
Sometimes a percentage figure is misleading. Therefore, the analysis of
statements submitted to management should contain absolute figures
alongwith their percentages.
The Comparative Financial Statements Analysis can be understood with the help
of following illustrations.
Management Accounting - I
69
Meaning, Objectives &
Tools of Financial
Statement Analysis
4.5
Illustrations
ILLUSTRATION 1
NOTES
On 31st March 2014 the Profit and Loss Account of Jaihind Industries Ltd.,
Nashik, Stood as under :
Profit and Loss Account for the year ended at 31st March 2014
Dr.
Cr.
2013
Expenditure
`
40,000 To Opening Stock
2,40,000 To Purchases
20,000 To Carriage Inward
1,00,000 To Direct Wages
2014
2013
`
`
40,000
3,00,000
Income
5,60,000 By Sales
40,000 By Closing Stock
2014
`
8,00,000
1,00,000
30,000
1,80,000
40,000 To Gas, Water &
Power
1,00,000
1,60,000 To Gross Profit C/D
2,50,000
6,00,000
9,00,000
16,000 To Salaries
18,000
5,000 To Rent & Taxes
6,000
2,000 To Printing & Stationery
3,000
1,600 To Advertising
2,000
4,000 To Interest on loans
2,000
1,31,400 To Net Profit C/D
1,60,000
6,00,000
9,00,000
1,60,000 By Gross Profit B/D
2,50,000
2,19,000
2,50,000 1,60,000
2,50,000
You are required to compare the performance of the company by rearranging
the data suitably and given your comments on the operational performance of the
enterprise.
70 Management Accounting - I
Meaning, Objectives &
Tools of Financial
Statement Analysis
SOLUTION
Comparative Income Statement
Particulars
31 st
31st
Increase or
Percentage
March
March
decrease
of increase
2013
2014
`
or decrease
`
`
4
5
NOTES
(Base Year)
1
2
3
1. Sales
5,60,000
8,00,000
+ 2,40,000
+ 43%
2. Purchases
2,40,000
3,00,000
+ 60,000
+ 25%
20,000
30,000
+ 10,000
+ 50%
1,00,000
1,80,000
+ 80,000
+ 80 %
40,000
1,00,000
+ 60,000
+ 150%
4,00,000
6,10,000
2,10,000
52%
40,000
40,000
_
_
4,40,000
6,50,000
2,10,000
+ 52%
40,000
1,00,000
60,000
+ 150%
4. Cost of Sales
4,00,000
5,50,000
1,50,000
+ 37%
5. Gross Margin
1,60,000
2,50,000
+ 90,000
+ 56%
16,000
18,000
+
2,000
+ 12½%
Rent and Taxes
5,000
6,000
+
1,000
+ 20%
Printing & Stationery
2,000
3,000
+
1,000
+ 50%
Advertising
1,600
2,000
+
400
+ 25%
24,600
29,000
+
4,400
+ 18%
1,35,000
2,21,000
+ 85,600
+ 63%
4,000
2,000
2,000
- 50%
1,31,000
2,19,000
+ 87,600
+ 67%
Carriage Inward
Direct Wages
Gas, Water & Power (+)
3. Direct Cost of Production
Opening Stock
(+)
Less : Closing Stock
(-)
6. Operating Expenses
Sales
(+)
Total Operating Expenses
Net Operating Income
Less : Interest Charges (-)
Profit after Interest but
before taxes
Comments : The above mentioned Profit and Loss account of Jaihind
Industries Ltd. Nashik Indicate that the variation in the individual item of 20132014 on compared to their corresponding figures in 2012-2013. There is an increase
of 43% of sales has led to an increase of 56% in gross profit which shows an
encouraging position. The operating cost has gone up only by 18% which shows
an efficient control over a overhead charges. A study of the composition of direct
cost reveals that the increase in direct wages and gas, water and power has been
80% and 150% respectively. Such an increase seems disproportionately high as
compared to increase in the volume of sales. The increase in these items need to
be further investigated in order to ascertain real causes for such an abnormal
increase in these direct expenses of production. However, the overall performance
of the Jaihind Industries Ltd. Nashik in 2013-2014 as compare to 2012-2013 is
quite satisfactory.
Management Accounting - I
71
Meaning, Objectives &
Tools of Financial
Statement Analysis
ILLUSTRATION 2
On 31st March 2014 the Balance sheet of Career Media India Ltd. stood as
under, you are required to recast the following Balance Sheet so as to reflect the
financial position clearly.
NOTES
Balance sheet as on 31st March 2014
2013
Capital &
2014
2013
`
Liabilities
`
`
8,00,000 Share Capital
1,20,000 General Reserve
Property & Assets
2014
`
10,00,000
5,00,000 Land & Buildings
5,90,000
1,60,000
9,00,000 Plant & Machinery
8,10,000
Investment
16,000 Fluctuation Fund
20,000
1,00,000 Furniture & Fixtures 1,50,000
30,000
2,00,000 Investments
3,00,000
2,50,000 Stock in trade
4,00,000
Workmen’s
12,000 Compensation Fund
4,00,000 15% Debentures
6,00,000
1,16,000 Sundry Debtors
3,00,000
4,00,000 Loans from ICICI
3,00,000
60,000 Bills Receivable
1,12,000
4,00,000 Fixed Deposit
6,00,000
40,000 Market Securities
1,60,000 Sundry Creditors
2,00,000
50,000 Cash Balances
8,000 Rent Outstanding
12,000
1,00,000
1,00,000 Pre-operation
Expenses
12,16,000
80,000
29,22,000 23,16,000
80,000
29,22,000
You are required to re-cast the above Balance sheet so as to reflect the
financial position more clearly.
72 Management Accounting - I
Meaning, Objectives &
Tools of Financial
Statement Analysis
SOLUTION
In the books of Career Media India Ltd.
Comparative Balance Sheet as on 31st March, 2014
Assets and Liabilities
1
31st March 31st March
Increase /
Percentage
2013
2014
decreases
of increase
`
`
in `
or decrease
2
3
4
5
NOTES
1. Fixed Assets
Land and Buildings
5,00,000
5,90,000
(+) 90,000
(+) 18%
Plant and Machinery
9,00,000
8,10,000
(-) 90,000
(-) 10%
Furniture
1,00,000
1,50,000
(+) 50,000
(+) 50%
15,00,000
15,50,000
(+) 50,000
(+) 3.3%
2,00,000
3,00,000
1,00,000
(+) 50%
50,000
1,00,000
(+) 50,000
(+) 100%
1,16,000
3,00,000
(+) 1,84,000
(+) 159%
- Bills Receivable
60,000
1,12,000
(+) 52,000
(+) 87%
- Marketable Securities
40,000
80,000
(+) 40,000
(+) 100%
2,66,000
5,92,000
3,26,000
(+) 123%
2,50,000
4,00,000
(+) 1,50,000
+ 60%
Total Current Assets
5,16,000
9,92,000
4,76,000
(+) 92%
4. Pre-Operative Expenses
1,00,000
80,000
(-) 20,000
(-) 20%
23,16,000
29,22,000
6,06,000
(+) 26%
- Share Capital
8,00,000
10,00,000
(+) 2,00,000
(+) 25%
- General Reserve
1,20,000
1,60,000
(+) 40,000
(+) 33%
16,000
20,000
(+) 4,000
(+) 25%
12,000
30,000
(+) 18,000
(+) 150%
9,48,000
12,10,000
2,62,000
(+) 28%
- Debentures
4,00,000
6,00,000
2,00,000
(+) 50%
- Loans from ICICI
4,00,000
3,00,000
(-) 1,00,000
(-) 25%
- Fixed Deposits
4,00,000
6,00,000
(+) 2,00,000
(+) 50%
12,00,000
15,00,000
(+) 3,00,000
(+) 25%
1,60,000
2,00,000
(+) 40,000
(+) 25%
8,000
12,000
(+) 4,000
(+) 50%
1,68,000
2,12,000
(+) 44,000
(+) 26%
23,16,000
29,22,000
6,06,000
(+) 26%
Total Fixed Assets
2. Investment :
3. Current Assets :
(a) Liquid Assets
- Cash balances
- Debtors
(b) Non-liquid Assets
- Stock in Trade
Total Assets
1. Capital and Internal
- Investment Fluctuation Fund
- Workmen Compensation
Fund
Total Capital
2. Long-term Liabilities
Total Long-term Liabilities
3. Current Liabilities
- Sundry Creditors
- Rent Outstanding
Total Current Liabilities
Total Liabilities
Management Accounting - I
73
Meaning, Objectives &
Tools of Financial
Statement Analysis
NOTES
Comments : As some body rightly pointed out that “Balance Sheet is a
snap shot of running train”. The above mentioned financial position of Career
Media India Ltd. show the following picture.
A Comparative study of assets structure reveals that there has been
negligible increase of 3.3% in the total fixed assets in 2013-14 in comparison with
2012-2013. The investments have gone up by 50% and there has been considerable
increase in liquid and non-liquid assets as they have gone up by 123% and 60%
respectively. Whether such an increase in current assets (92%) truly shows the
liquid position is an issue which should be decided in the light of the current liabilities
of the company. The decrease in the preparation expenses clearly shows that the
company has written of such expenses to the tune of 20 % during the current
year. On the other hand, as regards the liabilities, the shareholders funds as
represented by by capital and other reserves have gone up by 28%. There has
been marked increase of 150% in the workmen compensation fund due to transfer
of ` 18,000 in the current year, long-term liabilities and current liabilities have
increased by 25% respectively. The management should further investigate the
causes for marked variations in current assets and workmen’s compensation fund
with a view to review their credit policy and the policy for building up of the
workmen compensation fund. Value of plant and machinery decreased by 10%
as well as debtors are increased 159%. It means the recovery of debts also
required attention in future.
ILLUSTRATION 3
From the following Balance Sheet of Samir Ltd., prepare a comparative
Balance Sheet and comments of the Financial position of the concern.
Balance Sheet of Samir Ltd. as on -------Liabilities
31.3.2013 31.3.2014
`
Assets
`
31.3.2013 31.3.2014
`
`
Equity Shares
22,00,000
25,00,000 Buildings
14,00,000
17,00,000
Debentures
10,00,000
12,00,000 Machinery
12,00,000
15,00,000
8,00,000 Furniture
6,00,000
4,00,000
4,00,000
6,00,000
Securities
5,50,000
3,00,000
Stock
4,00,000
5,50,000
2,00,000
1,00,000
47,50,000
51,50,000
Reserves &
Surplus
6,00,00
Sundry Creditors
4,00,000
2,50,000 Sundry Debtors
Bills Payable
3,50,000
4,00,000 Marketing
Outstanding
Expenses
2,00,000
- Cash Bal.
47,50,000 51,50,000
74 Management Accounting - I
Meaning, Objectives &
Tools of Financial
Statement Analysis
SOLUTION
Comparative Balance Sheet of Samir Ltd.
as on 31st March, 2013 and 2014
Paticulars
31 st
31 st
Increase or Percentage
(Assets and Liabilities)
March
March
decrease in of Increase
2013
2014
Amount
(`)
(`)
(`)
2
3
4
1
or decrease
NOTES
5
Assets
A. Current Assets
Sundry Debtors
4,00,000
6,00,000
(+)2,00,000
(+) 50.00
Marketable Securities
5,50,000
3,00,000
(-)2,50,000
(-) 45.45
Stock
4,00,000
5,50,000
(+)1,50,000
(+) 37.50
Cash Balances
2,00,000
1,00,000
(-)1,00,000
(-) 50.00
15,50,000
15,50,000
Building
14,00,000
17,00,000
(+)3,00,000
(+) 21.43
Machinery
12,00,000
15,00,000
(+)3,00,000
(+) 25.00
6,00,000
4,00,000
(-)2,00,000
(-) 33.33
32,00,000
36,00,000
(+)4,00,000
(+) 12.50
47,50,000
51,50,000
4,00,000
8.42
Sundry Creditors
4,00,000
2,50,000
(-)1,50,000
(-) 37.50
Bills Payable
3,50,000
4,00,000
(+)50,000
(+) 14.29
Outstanding Expenses
2,00,000
(-)2,00,000
(-) 100.00
Total (A)
B. Fixed Assets :
Furniture
Total (B)
Total Assets (A+B)
Liabilities :
C. Current Liabilities :
Total (C)
9,50,000
6,50,000
(-)3,00,000
(-) 31.58
Equity Shares
22,00,000
25,00,000
(+)3,00,000
13.64
Debentures
10,00,000
12,00,000
(+)2,00,000
20.00
6,00,000
8,00,000
(+)2,00,000
33.33
38,00,000
45,00,000
(+)7,00,000
18.42
47,50,000
51,50,000
4,00,000
8.42
D. Long-Term Liabilities :
Reserves and Surplus
Total (D)
Total Liabilities (C+D)
Comments :
The analysis of the above Balance Sheets of Samir Ltd. indicates that the
monetary balance in each account increased between the end of 2013-2014 and
2012-2013 with exception of Bill Receivable, Cash Balance, Furniture and
Outstanding. The significant changes which have occurred in specific balance
sheet during the above mentioned period are as under :
Management Accounting - I
75
Meaning, Objectives &
Tools of Financial
Statement Analysis
1.
There is an 50% increase in sundry debtors, a 37.50% increase in stock,
and a 50% decrease in cash balances. Slower paying customers and/or
slower moving merchandise might explain this combination of changes.
2.
There has been no change in the amount of current assets during the two
periods but current liabilities has decreased by 31.58%. This change has
contributed to the liquidity of the company.
2.
There has been increase in share capital and debentures by 13.64% and
20% respectively. All this might be due to fresh issue of shares and
debentures.
4.
The increase in fixed assets during the two periods have been 12.50%.
This does not seem a financially sound sign when compared with the amounts
of current assets which have remained constant during the period under
study
NOTES
4.6
Summary
•
Financial Statements analysis is a critical examination of statements for
better understanding and drawing fruitful conclusions. The major objectives
of financial statement analysis is to provide decision makers information
about a business enterprise for use in decision-making. Financial statement
analysis can be used by different users and decision makers to achieve the
following objectives.
(i)
Assessment of Past Performance and current position.
(ii)
Loan decision by financial institutions and banks
(iii)
Prediction of net income and growth prospects and
(iv)
Prediction of bankruptcy and failure.
•
Steps involved in Financial Statement Analysis :
(i)
Selection of information
(ii)
Classification of information and
(iii)
Interpretation
•
Type of Financial Analysis :
(A)
According to Material Users
(i) External Analysis and
(ii) Internal Analysis
(B)
According to Modulus operandi of analysis
(i) Horizontal Analysis and
76 Management Accounting - I
(ii) Vertical Analysis
•
Tools of Financial Statement Analysis :
(I)
Multi-steps Income Statement
(II)
Horizontal Analysis
Meaning, Objectives &
Tools of Financial
Statement Analysis
(i) Interfirm comparison.
NOTES
4.7 Key Terms
(1)
Analysis of Financial Statement : is a process of evaluating the relationship
between component parts of financial statement to obtain a better
understanding of firm’s position and performance.
(2)
Horizontal Analysis : When financial statements for certain number of
years are examined and analysed the analysis is called a horizontal analysis.
(3)
Vertical Analysis : This refers to analysis of ratios developed for one date
for according period. This is also known as “Static Analysis.”
4.8
Questions and Exercises
I- Objective Questions
A) Multiple choice Questions
1)
An important means of assessing past performances and inforecasting and
planning future performance is termed as ----a) Analysis of Financial Statements
b) Recording of Financial Statements
c) Classification of Financial Statements.
d) Consolidation of Financial Statements.
2)
Vertical Analysis of Financial Statements reveal the company’s ------a) Problems
b) Position
c) Progress
d) Prospects
3)
When financial statements for a number of years are reviewed and analysed,
the analysis is called ----a) vertical Analysis
b) Internal Analysis
Management Accounting - I
77
Meaning, Objectives &
Tools of Financial
Statement Analysis
c) Horizontal Analysis
d) External Analysis
4)
NOTES
The detailed analysis made by the Banker for the purpose of granting cashcredit facilities to a company is an example of ------a) Horizontal Analysis.
b) External Analysis
c) Vertical Analysis.
d) Internal Analysis
Ans : (1 - a), (2 - b), (3 - c), (4 - d)
II- Long Answer Questions
1)
What is financial Statement Analysis ? Explain the important objectives of
Financial statements Analysis.
2)
Define ‘Financial Statement Analysis’. Explain in brief the various steps
involved in Financial Statements Analysis.
3)
Explain the term Financial Statement Analysis ? and discuss the role of
financial analyst.
4)
What do you understand by ‘Financial Statement Analysis’ Explain in brief
the limitations of financial statements analysis.
5)
Explain the different methods of classification of financial analysis.
6)
What are Multi steps Income Statements ? Explain the importance of Multi
steps Income statements as a tool of financial statements analysis.
7)
What is ‘Horizontal Analysis’ ? Explain the importance of Horizontal Analysis
as a tool of financial statements Analysis.
8)
What is Inter-firm comparison ? Explain the procedure and necessity of
Inter-firm Comparison.
9)
Define ‘Inter-firm comparison’ Explain the advantages and limitations of
Interfirm Comparison.
10)
What are ‘comparative statement’ ? Explain the precautions to be take
into account before preparing comparative statements.
III - Practical Problems
(1)
78 Management Accounting - I
Prepare a Comparative Income Statement from the following Profit and
Loss Account with absolute as well as percentages figures.
In the books of Glaxo Ltd., Gauhatti
Profit and Loss Account for the years ended 31st December, 2011,2012
Meaning, Objectives &
Tools of Financial
Statement Analysis
(` In Lakhs)
Particulars
To Cost of Goods Sold
2011
2012
`
`
600
750 By Net Sales
To Administrative Expenses
20
20
To Selling Expense
30
40
150
190
800
1,000
To Net Profit
Particulars
2011
2012
`
`
NOTES
800
1,000
800
1,000
(2) FIL (Pvt.) Ltd., Pune have applied to your client for an increase in their
credit limit the ground of increasing competition facing them. FIL have been
having satisfactory dealings with your client for over 30 yea` First as partnership
and since 2000 as a company when two of the partners sold their interest to the
remaining two partners who converted the business into a company. The FIL’s
financial statements for the proceeding three years are as under :
Balance Sheet as on 31st March, 2011, 2012 and 2013
(Figures in thousands of `)
2011 2012 2013
`
Equity Share Capital
`
2011 2012 2013
`
`
`
60
60
60 Land and Buildings (Net) 253
32
32
32 Investments
-
-
32
(5)
467
525
`
239 256
10% Preference Share
Capital
Capital Reserve
Earned Surplus (Deficit)
Secured Loan
19 Dues from Directors
(11) Deferred Charges
11
11
-
36
48
7
3
3
583 Current Assets
Current Liabilities
Account Payable
11
Sundry Debtors (Pledged) 231
144
145
154 Inventory
Due from Employees
12
13
Income Tax Outstanding
11
-
-
Misc. Current Liabilities
62
94
48
13 Cash
820 864 898
304
14
820
261 268
303 304
11
8
864 898
Management Accounting - I
79
Meaning, Objectives &
Tools of Financial
Statement Analysis
Income statements for the year ended 31st March, 2011, 2012 and 2013
(figure in thousands of `)
Particulars
NOTES
2011
2012
2013
`
`
`
Net sales
1,770
1.397
1,380
Cost of goods sold
1,077
854
859
Gross Profit
693
543
521
Operating Expenses
595
515
498
Operating Profit
98
28
23
Other Income
67
11
14
165
39
37
40
41
43
125
(2)
(6)
Dividends paid
35
35
-
Net to Surplus
90
(37)
(6)
Net after Other Income
Other Deductions
Net Profit/ Net Loss before Tax
Analyse the above statements, highlighting the strong and weak points of
FIL (Pvt) Ltd. Pune and suggests appropriate action to your client.
(3) The Bank Overdraft of Riofast Ltd. As at the end of 2011 was found to
have shot up to ` 82.5 lakhs compared with Rs 15 lakhs as at the end or pervious
year. The company was under pressure form the bank to reduce the overdraft
substantially due to a general credit squeeze in the economy. The Company was
contemplating reducing the amount by at least 50%
The Summarized Balance sheet figure at the end of 2010-2011 are give below :
Liabilities
` Lakhs
2010
Assets
2011
2010
2011
225.00
240.00
135.00
165.00
150.00
150.00
112.50
112.50
Stock
52.50
75.00
Debtors
45.00
75.00
Bank
10.50
Share Capital
300.00 300.00 Freehold Property
Reserves
225.00 240.00 (At cost)
6% Debentures (unsecured)
75.00
75.00 Plant And Machinery
Mortgage on Freehold
27.00
14.25 (at cost less depre.)
Property
Creditors
` Lakhs
Investments in Shares
45.00
45.00 of Companies under
Proposed Dividend subject
the same Management
to Deduction of Tax
22.50
23.25 (unquoted)
Provision for Taxation
21.00
37.50 Investments in Shares
Secured Overdraft
15.00
82.50 of Other Companies
(By a floating charge on
(Quoted)
Assets)
Market Value
2003 : 150 lakhs
2004 : 120 lakhs
80 Management Accounting - I
Total
730.50 817.50
Total
730.50 817.50
The following additional information for the years 2011 is also available :
(Figures In Rs Lakhs)
• Credit sales
675.00
• Credit purchases
520.00
• Overheads
83.75
• Depreciation on Pant and Machinery
17.50
Meaning, Objectives &
Tools of Financial
Statement Analysis
NOTES
• Dividend for 2010 was paid in full
• Amount paid towards taxation for the year 2007
21.50
Comment on the financial position of the company and suggest measure to
overcome the problem.
(4)
The following are the Balance Sheets of concern as on 31st December
2010 and 2011
Assets
Cash
2010
2011
`
`
25,000
18,000
1,60,000
2,00,000
Bill Receivable
20,000
30,000
Stock in Trade
77,000
1,09,000
Machinery
80,000
2,00,000
Building
2,00,000
1,70,000
Goodwill
1,15,000
90,000
6,77,000
8,17,000
2010
2011
`
`
Sundry Debtors
Total
Liabilities
Sundry Creditors
55,000
83,000
Bills Payable
20,000
16,000
Provision for Taxation
40,000
50,000
Proposed Dividend
42,000
50,000
1,50,000
1,00,000
General Reserve
40,000
70,000
Profit and Loss
30,000
48,000
300,000
4,00,000
6,77,000
8,17,000
6 Percent Debentures
Capital
Prepare a Comparative Balance Sheet on the concern and comment on
their financial position.
(5) From the following information prepare a Comparative Income Statement
and make brief comments on the same.
Management Accounting - I
81
Meaning, Objectives &
Tools of Financial
Statement Analysis
Income Statements for the year ended 31st March, 2010 and 2011
Particulars
Sales
NOTES
2010
2011
`
`
2,80,000
3,10,000
1,92,000
2,22,000
88,000
88,000
• Administrative Expenses
15,000
12,000
• Selling and Distribution Expenses
18,000
18,000
33,000
30,000
55,000
58,000
22,000
23,200
33,000
34,800
Less : Cost of goods sold
(-)
Gross Profit
Less :
Total Operating Expenses
(-)
Less : Tax (40%)
Net Income after Tax
(-)
4.9 Further Reading
82 Management Accounting - I
•
Khan M.Y. and Jain P. K. -Management Accounting Text Problems and
case- ew Delhi-Tata M Graw - Hill Publishing Co Ltd 2010
•
Rajasekara V. and Lalitha R. - Financial Accounting - New Delhi - Pearson
Education - 2012
UNIT 5 Common Size Statement and Trend
Analysis
Common size Statement
& Trend Analysis
Structure
NOTES
5.0
Introduction
5.1
Unit Objective
5.2.
Common Size Statements
5.3
Procedure for Preparation of Common size Statement
5.3.1
5.4
5.5
Illustrations
Trend Analysis
5.4.1
Computation of Trend Percentage
5.4.2
Steps involved in the Computation of Trend Ratios
5.4.3
Illustrations
Analytical Balance Sheet
5.5.1
Illustrations
5.6
Summary
5.7
Key Terms
5.8
Questions and Exercises
5.9
Further Reading
5.0 Introduction
Common size comparative statements provide a better historical prospective
of an undertaking. Common size statements are prepared in the following forms.
(i) Common Size Income Statement : show the percentage of net sales that
has been absorbed by each individual item representing cost or expense in the
income statement.
(ii) Common Size Balance Sheet : The common size balance sheet represents
the relation of each asset item to total assets and each liability and capital item to
total liabilities and capital respectively. The ratios expresses in the common size
Balance Sheet would reflect a change in the individual item, total or both.
Trend percentage or trends ratios, this method of analysis is adopted to
determine. The direction upward or downward. This involves the computation of
the percentage relationship that each item in the statement bears to the
Management Accounting - I
83
Common size Statement
& Trend Analysis
corresponding items contained in that of the base year. For this purpose, the earliest
year involved in comparison year may be considered as a base year.
Analytical Balance Sheet provides methodical classification of data given
in the financial statements.
NOTES
5.1
Unit Objectives
After learning this unit you should be able to :
•
Understand meaning of Common Size Statement.
•
Adopt the procedure for computation of Common Size Statement.
•
Prepare Common Size Profit and Loss Account.
•
Prepare Common Size Balance Sheet.
•
Explain the concept of “Trend Analysis.”
•
Identify steps involved in computation of Trend Ratios.
•
Prepare comparative Balance Sheet.
•
Prepare Analytical Balance Sheet.
5.2
Common Size Statement
The common size statements are also known as “componet percentage” or
“100 percent statement.” Each statement is reduced to the total of 100 and each
individual item contained therein is expressed as a percentage to the total 100.
Thus, each percentage in the statement shows the relationship of individual item
to its representative total.
84 Management Accounting - I
The Profit and Loss Account and Balance Sheet can also be presented int
eh form of Common-size statements. A statement in which individual items are
expressed as a percentage of same common base is termed as an common-size
statements. In a common-size Profit and Loss Account, the sale figure is generally
taken as base (sale-100) to calculate the proposition of other items figuring in the
Profit and Loss Account and a Common size Balance Sheet expresses individual
assets and liabilities as percentage of total assets or liabilities. “When the balance
sheet and income statement items are shown in analytical percentages, i.e. the
percentages that each item bears to the total of the appropriate item such as total
assets, total liabilities, capital and net sales, the common base for comparison is
provided. The statements compiled in this from are termed as “common-size
statements.” Common-size comparative statements provide a better historical
perspective of an undertaking. Any significant departure from the normal trend
need further investigation to ascertain the reasons for unusual movement in the
figures so that due care is taken in the formulation of future plan.
5.3
Procedure For Preparation Of
Common Size Statement
Firstly, the total assets, total liabilities, capital and total net sales are reckoned
as 100. Secondly, the ratio that each item bears to the total is ascertained by
dividing the individual money amount by the total amount as contained in the
statement. For instance, if selling and distributive expenses amount to `80,000
out of a net sales of ` 8,00,000 for a company in 2014 then the ratio that this item
bears to the total can be calculated as follows:
Selling and Distribution Expenses
Net Sales
=
80,000
` 8,00,000
Common size Statement
& Trend Analysis
NOTES
x 100
x 100
= 10%
This ratio of 10% denotes that the selling and distribution expenses of the
company are 10% of the net sales for 2014. In other words, they amount to `10
for every ` 100 worth of net sales.
(a)
Common-size Income Statement:
Common-size income statement percentages show the percentage of net
sales that has been absorbed by each individual item representing cost or expenses,
in the income statement. The comparison of the common-size income statement
ratios is significant since they indicate whether a larger or smaller amount of net
sales figure was used in meeting a particular cost or expense item. But it should
also be noted that variations in percentages may reflect change in the sales,
components of cost of goods sold or both.
(b)
Common-size Balance Sheet :
The common-size Balance Sheet represents the relation of each asset item
to total assets and each liability and capital item to total liabilities and capital
reproductively. As these percentages indicate the relationship to balance sheet
totals, variation form year to year do not necessarily indicate changes in money
amounts. The ratios expressed in the common-size balance sheet would reflect a
change in the individual item, total or both.
Check Your Progress
(1) How to prepare Common
Size Statement ? Give
details.
(2) Why
common
size
statement is known as
“100 percent statement”?
The value of common-size Balance Sheet can be further increased by
adding one additional column for each year to indicate the percentages of each
item within a group to the total of the group.
The common-size Balance Sheet percentages facilitate a horizontal
comparison from year to year and a study of the rends of relationships. They do
not throw light on the trends of the individual items from year to year. As the
trends of relationship are difficult for interpretation the value of common-size
balance. However, the usefulness of the common-size balance-sheet can be
improved by establishing norms of percentage for each item to the relative total.
Management Accounting - I
85
Common size Statement
& Trend Analysis
The concept of common size statement can be understood with the help of
following illustrations :
5.3.1 Illustrations
NOTES
ILLUSTRATION 1
The Income Statement of Adwani Ltd. Agra shows the financial results for
the year 2013-2014 as follows :
Trading Account for the year ended 31st March 2014
Dr.
Cr.
2013
Particulars
`
40,000 To Opening Stock
2,40,000 To Purchases
20,000 To Carrier Inward
100,000 To Direct wages
2014
2013
`
`
40,000
3,00,000
Particulars
2014
`
5,60,00 By Sales
800,000
40,000 By Closing Stock
1,00,000
30,000
1,80,000
40,000 To Gas, water
and Power
1,60,000 To Gross Profit G.D
6,00,000
1,00,000
2,50,000
9,00,000 6,00,000
9,00,000
Profit and Loss Account for the year ended 31st March 2014
Dr
2013
Cr
Particulars
`
16,000 To Salaries
5,000 To Rent and Taxes
2014
2013
`
`
18,000
Particulars
1,60,000 By Gross Profit
2014
`
2,50,000
6,000
2,000 To Printing and
Stationery
1,600 To Advertising
3000
2000
4000 To Interest on
Loans
1,31,400 To Net Profit G.D
1,60,000
2000
2,19,000
2,50,000
1,60,000
2,50,000
You are required to prepare a common-size Income Statement for the year
2013-14 and interprete the financial results.
86 Management Accounting - I
Common size Statement
& Trend Analysis
SOLUTION
Common size Income statement of Adwani Ltd. for the year 2013-2014
Particulars
2012-2013
Amount
2013-2014
% to Sales
Amount
% to Sales
Sales
5,60,000
100
8,00,000
100
Cost of Production
4,00,000
71.4
6,10,000
76.2
Cost of Sales
4,00,000
71.4
5,50,000
68.7
Gross Margin
1,60,000
28.3
2,50,000
31.2
Operating Expenses
24,600
4.4
29,000
3.6
Net Operating Profit
1,35,400
24.2
2,21,000
27.6
Profit after interest
1,31,400
23.4
2,19,000
24.9
NOTES
ILLUSTRATION 2
The Balance Sheet of Career Media India Ltd. as on 31st March, 2014
stood as under.
Balance Sheet as on 31st March 2014
Dr.
Cr.
2013
Capital and
2014
2013
Property and
2014
`
Liabilities
`
Assets
Assets
`
8,00,000 Share Capital
1,20,000 General Reserve
10,00,000
5,00,000 Land and Buildings
5,90,000
1,60,000
9,00,000 Plant and Machinery
8,10,000
16,000 Investment
Fluctuation Fund
Furniture
20,000
1,00,000 and Fixtures
1,50,000
30,000
2,00,000 Investments
3,00,000
12,000 Workmen’s
Compensation Fund
4,00,000 15% Debentures
6,00,000
2,50,000 Stock in Trade
4,00,000
4,00,000 Loan from ICICI
3,00,000
1,16,000 Sundry Debtors
3,00.000
4,00,000 Fixed Deposit
6,00,000
60,000 Bills Receivable
1,12,000
1,60,000 Sundry Creditors
2,00,000
40,000 Market Securities
8,000 Rent Outstanding
12,000
50,000 Cash Balances
80,000
1,00,000
Pre-operation
1,00,000 Expenses
23,16,000
29,22,000 23,16,000
80,000
29,22,000
You are required to prepare a common size Balance Sheet for the year
2013-14 and interprete the financial results.
Management Accounting - I
87
Common size Statement
& Trend Analysis
SOLUTION
Common Size Balance Sheet of Career Media India Ltd.
Items
2012-13
Assets
`
NOTES
(A) Land and Buildings
% of Total 2013-14
`
% to total
Assets
5,00,000
21.6
5,90,000
20.2
Plant and Machinery
9,00,000
38.8
8,10,000
27.7
Furniture and Fixtures
1,00,000
4.4
1,50,000
5.2
Fixed Assets
15,00,000
64.8
15,50,000
53.1
(B) Investments
2,00,000
8.6
3,00,000
10.2
50,000
2.2
1,00,000
3.4
1,16,000
5.0
3,00,000
10.4
Bills Receivable
60,000
2.6
1,12,000
3.8
Marketable Securities
40,000
1.7
80,000
2.7
Liquid Assets
2,26,000
11.5
5,12,000
20.3
Stock-in-Trade
2,50,000
10.8
4,00,000
13.7
Total Current Assets
5,16,000
22.3
1,12,000
34.0
(D) Pre-operating Expenses
1,00,000
4.3
80,000
2.7
23,16,000
100
29,22,000
100
Share Capital
8,00,000
34.5
10,00,000
34.2
General Reserve
1,20,000
5.2
1,60,000
5.5
16,000
0.7
20,000
0.7
12,000
0.5
30,000
1.0
9,48,000
40.9
12,10,000
41.4
Debentures
4,00,000
17.3
6,00,000
20.5
Loans
4,00,000
17.3
3,00,000
10.3
Fixed Assets
4,00,000
17.2
6,00,000
20.5
12,00,000
51.8
15,00,000
51.3
1,60,000
6.9
2,00,000
6.8
8,000
0.4
12,000
0.4
Total Current Liabilities
1,68,000
7.3
2,12,000
7.2
Total Liabilities (E+F+G)
23,16,000
100
29,22,000
100
(C) Cash Balances
Debtors
(Non-liquid asssets)
Total Assets (A+B+C+D)
(E) Capital and Liabilities
Investment Fluctuation
Fund
Workmen’s Compensation
Fund
Total Shareholders Fund
(F) Long Term Liabilities
Total Long-Term liabilities
(G) Current Liabilities
Sundry Creditors
Rent Outstanding
88 Management Accounting - I
Interpretation : The common size balance sheet indicate the assets and
liabilities structure in relation to total assets as well as total liabilities. As is evident
from the above illustration the fixed assets formed 53.1% of the total assets in the
same year.
The Current assets accounted for 34 % which consisted of liquid and nonliquid assets of 20.3%and 13.7% respectively. Preoperative expenses were only
2.7% of total assets. It may be understood that the asset structure of any enterprises
depends upon its very nature. In a capital intensive industry , the proportion of
fixed assets is much more than that of the current assets. Against it, the labourintensive-industries have lower proportion of fixed assets and higher percentage
of assets is deveoted to working capital in the form of current assets. Therefore,
the position of the constituents of total assets should be in terms of the very nature
of industry. In the above case the structure of assets in 2013-14 has substantially
changed. The fixed assets which were 64.8% in 2012-13 had gone down to 53.1%
despite additions to land and building and furniture. The decline seems due to
decrease in the value of asset due to depreciation. The liquid position of the company
has significantly improved from just 22.3% to 34.0% but this may be rightly
interpreted in relation to corresponding current liabilities.
Common size Statement
& Trend Analysis
NOTES
On the other hand, as regards liabilities, the share holders fund (owned
fund) represented by capital and reserves accounted for 40.9% and 41.5% at the
end of 2012-2013 and 2013-2014 respectively.
The long-term liabilities were 51.8% and 51.3% at the same point of time.
Current liabilities constituted 7.3% and 7.2% at the end of the same periods.
Thus the liabilities structure in the 2013-2014 is not much different from that at
the end of the year 2012-2013 From this type of observation, one may be tempted
to conclude that the company has not grown over a period of one year as the
percentage constituents of different liabilities is more or less the same. This type
of conclusion will be erroneous. It may be realized that the common size statements
present vertical representation of fact at a point of time and the comparison in the
above form may mislead the analyst. Therefore, the consideration of absolute
figures of assets and liabilities alongwith their percentages is highly important
before any conclusion is drawn.
Management Accounting - I
89
Common size Statement
& Trend Analysis
ILLUSTRATION 3
Prepare a Common-size Income statement of Kailash Ltd. on the basis of
data given below and interpret the financial results.
Income Statements for the year ended ......
NOTES
Particulars
2013
2014
`
`
Particulars
To Cost of goods sold
2,70,000
2,92,000 By Sales
To Gross Profit C/D
1,22,400
1,18,420 Less : Returns
Inward
3,92,400 4,10,420
To Administrative
2013
2014
`
`
4,00,400
4,20,420
8,000
10,000
3,92,400
4,10,420
1,22,400
1,18,420
1,22,400
1,18,420
By Gross Profit
Expenses
60,000
63,000
To Selling Expenses
30,000
35,000
To Net Profit C/D
32,400
20,420
B/D
1,22,400 1,18,420
SOLUTION
Common-size Income Statement of Kailas Ltd.
For the year ended 31.12.2013 and 31.12.2014
Particulars
2013
Percentage
Percentage
(`)
(`)
Sales
2014
4,00,400
-
4,20,420
-
8,000
-
10,000
-
3,92,000
100
4,10,420
100
Less : Cost of Goods Sold
2,70,000
68.90
2,92,000
71.20
Gross Profit
1,22,400
31.10
1,18,420
28.80
Administrative Expenses
60,000
15.30
6,300
15.37
Selling Expenses
30,000
7.70
35,000
8.53
Total Operating Expenses
90,000
23.00
98,000
23.90
Operating Net Profit
32,400
8.10
20,420
4.90
Less : Returns
Net Sales
(-)
(+)
Interpretation:
The cost of goods sold and other expenses have increased over the last
year. This has resulted in reducing the percentage of net income from 8.10% in
2013 to 4.90% in 2014 to net sales, even though the sales in 2014 have increased
by Rs.18,020. The cost of goods sold has increased from 68.90% to 71.20%, the
selling expenses from 7.70% to 8.53%.
90 Management Accounting - I
5.4
Trend Analysis
The financial statements for a series of years may be analyzed to determine
the trend of the data contained there in. The trend percentages are also referred
to as ‘trend ratios’. This method of analysis is adopted to determine the direction,
upward or downward. This involves the computation of the percentage relationship
that each item in the statement bears to the corresponding items contained in that
of the base year. For this purpose, the earliest year involved in comparison or any
intervening year may be considered as the base year.
Common size Statement
& Trend Analysis
NOTES
The absolute figure of an activity is not much useful in decision making.
Therfore, a set of figures for purposes of comparison in necessary. The accounting
figures relating to sales, production, profit, oveheads, working capital, etc., for the
last few years expressed as a percentage of some figure in a base period give
trend which throw more light on the related problem. Generally, the figures for
the last 3 to 5 years should be considered for better understanding of an economic
phenomenon. The trend percentages emphasize changes in the financial data
from year to year and facilitate horizontal comparison and study of the data.
These. Trend ratios can be considered as index numbers showing relative changes
in the financial data over a period of years.
5.4.1 Computation of Trend Percentage
The trend indicates general tendency or direction of change in which
management is more interested, but the fact that a trend is more influenced by the
base year figure, should always be borne in mind. The analyses and interpretation
will not be fruitful if the base year figure is usually high or low. Therefore, the
selection of the base year should be done carefully. It should be the year of normal
conditions. The trend can be rightly interpreted if the effect inflation on different
years figures of money income a neutralized.
5.4.2 Step involved in the Computation of Trend Ratios
The following are the steps involved int eh computation of trend percentages
or trend ratios. In the first place, the statement probably relating to the earliest
year under review is taken as the base, with reference to which all other financial
statements are compared and analysed. Secondly, each item in the base statement
is taken as 100. Thirdly, if the amount of the corresponding item in the other
statement is less than that in the base statement, the trend percentage would be
less than 100 and if the amount is more than the base amount, the trend percentage
would be more than 100. This trend ratio can be calculated by dividing each
amount in the other statement with the corresponding item found in the base
statement. It should be remembered that the trend ratio are generally computed
not for all the items in the statement. It should be remembered that the trend ratio
are generally computed not for all the items in the statement, as the primary
objective is only to make comparison between items which are interrelated to one
another.
Check Your Progress
Explain how trend analysis
adopted to determine the
direction upward or downward
in the financial data over a
period of years ? Give the
steps.
Management Accounting - I
91
Common size Statement
& Trend Analysis
Another method of proper analysis would be to calculate the percentage of
physical quantities, wherever possible, by the use of index numbers technique.
The percentage of current year may be calculated as under :
% for current year =
NOTES
Current year figure
Base year figure
x 100
In short, the calculation of trend percentage involves the following three steps :
i)
Selection of base year.
ii)
Assigning a weight of 100 to the value of the variable of base year, and
iii)
Expressing the percentage change in the value of variable from base year
to the study year as illustrated below.
Statement showing Trend Percentage in sales from 2007-2014
Year
Sales
Percentage
`
Increase or Decrease
2007-2008
2,00,000
100 (Base Year)
2008-2009
3,50,000
175
2009-2010
2,80,000
140
2010-2011
3,00,000
150
2011-2012
3,50,000
175
2012-2013
1,40,000
70
2013-2014
2,20,000
110
A trend for a single financial item is seldom very informative. A comparison
of trends for related items often help the analyst in perfect understanding of the
business facts The trend analysis can be understood with the help of following
statements showing trend percentage with imaginacy figures.
Comparative Balance Sheet as on 31 March
Assets
2012
2013
2014
Trend Percentage
(Base year 2012)
2012 2013 2014
A.
Current Assets
Inventory
2,00,000
3,00,000
2,50,000
100
150
125
Debtors
3,00,000
5,00,000
3,50,000
100
167
200
Cash Balances
2,00,000
3,50,000
3,00,000
100
175
150
7,00,000
11,50,000
11,50,000
100
164 164
Building
25,00,000
30,00,000
30,00,000
100
120
120
Plant
12,50,000
15,00,000
16,00,000
100
120
128
8,00,000
10,00,000
12,00,000
100
125
150
45,50,000 55,00,000 58,00,000
100
121 127
Total Assets (A+B) 52,50,000 66,50,000 69,50,000
100
127 132
Total(A)
B.
Fixed Assets
Investment
Total (B)
92 Management Accounting - I
Common size Statement
& Trend Analysis
The Concept of Trend Analysis can be understood with the help of following
illustations.
5.4.3 Illustations
ILLUSTRATION 1
NOTES
The trend analysis may be understood by pursuing the following financial
statement based on imaginary figures for few important items of Income and
Financial Statement of XYZ Co. Ltd.
Statement showing trends of various items of XYZ Co. Ltd.
for 5 years (i.e from 2010-2014)
Items
2010
2011
Amount % Amount %
(`)
Sales
(`)
2012
2013
Amount % Amount %
(`)
2014
Amount %
(`)
(`)
20,000 100 22,000
110
30,000 150
25,000
125
32,000 160
Direct Cost
8,000 100 10,000
125
14,000 175
11,000
137
13,000 163
Factory Overheads
1,000 100
1,200
120
1,400 140
1,200
120
1,500 150
Administration Overheads
800 100
800
100
1,000 125
1.000
125
1,000 125
Selling Overheads
200 100
250
125
300 150
250
125
350 175
Gross Margin
12,000 100 12,000
100
16,000 133
14,000
117
19,000 158
Profit before Tax
10,000 100
9,750
97
13,300 133
11,550
115
16,150 161
Gross Working Capital
40,000 100 45,000
112
45,000 112
50,000
125
80,000 200
Current Liabilities
20,000 100 25,000
125
25,000 125
30,000
150
35,000 175
SOLUTION
Interpretation : The sales shows the increasing tend. The sales in 2014 have
increased by 60% as compared to the base year 2010 (The direct cost also
increased by 63% In 2014, factory overheads also increased by 50%. The Gross
Margin also increased by 58% in 2014. The gross margin is increasing very
slowly which is not a good sign. It is necessary to exercise control over the
operating expenses to check the rising tendency and to increase the net margin.
Gross working capital position is better, it increased by 100% in the year
2014. On the other hand current liabilities position has also increased i.e 75% in
the year 2014 and these current financial position seems to be very bad.
ILLUSTRATION 2
The following are the comparative financial statement of a company for
three years. You are required to analyses them and give your valuable opinion.
Management Accounting - I
93
Common size Statement
& Trend Analysis
Comparative Income statements for the year ended ----(Amount in Rupees)
Particular
NOTES
Sales
Less :
Cost of goods sold
(-)
Gross Margin
Less :
Operating Expenses
2011
2012
2013
`
`
`
2,34,800
2,37,200
2,44,800
1,21,000
1,22,400
1,24,800
1,13,800
1,14,800
1,20,000
72,000
73,500
75.400
41,800
41,300
44,600
(-)
Net Income
Comparative Balance Sheet as on -----Capital and Liabilities
Share Capital
2011
2012
2013
`
`
`
1,74,000
Furniture
Bank Overdraft
Creditors
Accrued Expenses (+)
2011
2012
2013
`
`
`
1,73,000 1,85,000 Fixed Assets
Current Liabilities
Total
Assets
92,000
98,000
1,10,000
20,000
14,000
44,000
9,000 Current Assets
2,000
6,000
41,500
53,500
4,500
3,000
1,500 Debtors
42,000
49,000
27,000
48,000
62,500
97,000 Inventory
67,000
73,000
98,000
1,000
1,500
3,000
1,30,000
1,37,500
1,72,000
86,500 Cash
Prepaid Expenses
(+)
Total
Total Liabilities
2,22,000 2,35,500 2,82,000 Total Assets
2,22,000 2,35,500 2,82,000
SOLUTION
Trend Analysis
Particulars
94 Management Accounting - I
Base Year 2011
2012
2013
Sales
100
101
104
Cost of Sales
100
101
103
Expenses
100
102
103
Net Income
100
99
107
Current Assets
100
106
132
Current Liabilities
100
130
202
Debtors
100
117
64
Inventory
100
109
146
Fixed Assets
100
107
120
Capital
100
99
106
Interpretation :
1.
The Sales shows very slow increasing trend. The sales 2013 have increased
only 4% as compared to the base year 2011. In 2012 The sales have
increased by 1% Only. As against, cost of sales is also increased in 2013.
The net income in 2012 in reduced by 1%. The cost of sales and other
operating expenses are showing rapid increase from year to year which is
a very bad situation. It is almost necessary to exercise control over the
expenses.
2.
The current assets have increased by 6% and 32% in the year 2012 and
2013 respectively. On the other hand the current liabilities have been
increased by 30% and 102% during the same years, which results the shortterm solvency position very weak. Working capital cycle is disturing.
3.
The sundry debtors have gone down to 64% in 2013 whereas the Stock
position has gone up to 146% in 2013. This shown the surplus stock position
in the business. Unsold Stock lying in godown, not converted into sales,
which indicates the current financial position seems to be very bad.
4.
Investment in furniture is showing rising trend. As the long-term capital is
not available for new investment made in furniture, it means that working
capital fund is utilised for furniture purchases, which is not good situation.
Common size Statement
& Trend Analysis
NOTES
In short, corrective steps are necessary to overcome the financial difficulties
faced by the business. Change in police and strict control over the cost is essential
for better results.
5.5
Analytical Balance Sheet
Analytical Balance Sheet provides methodical classification of data given
in the financial statements. In order to have a meaningful analysis, it is necessary
that figures should be arranged properly. Usually instead the two-column (i.e ‘T’
form) financial statements, as ordinarily prepared, the statements are prepared in
single (vertical) column form “which should throw up significant figures by adding
or subtracting”. This analytical form of Balance Sheet also facilitates showing the
figures of a number of firms or number of years side by side for comparison
purposes.
Form of Analytical Balance Sheet :
Following Balance-Sheet provides methodical classification of financial data.
Management Accounting - I
95
Common size Statement
& Trend Analysis
Balance sheet as on ..........
`
NOTES
Cash in Hand
-------
Cast at Bank
-------
Bills Receivable
-------
Book Debts (less Provision for bad debts)
-------
Marketable Trade Investments
-------
Liquid Assets
(1)
Inventories (Stock of raw materials, finished goods, etc.)
Prepaid Expenses
Current Assets
------(2)
-------
Bills Payable
-------
Current Assets
-------
Trade Creditors
-------
Outstanding Expenses
-------
Bank Overdraft
-------
Other Liabilities payable within a year
Current Liabilities
(3)
-------
Provision for Tax
-------
Proposed Dividends
------
Other Provisions
-------
Provisions
(4)
Current Liabilities and Provisions (3)+(4)
(5)
------
Net Working Capital
(6)
------
[Current Assets-Current Liabilities and Provisions (2)-(5)]
------
Goodwill at cost*
------
Land and Building
------
Plant and Machinery
------
Loose Tools
------
Furniture and Fixtures
------
Investments in Subsidiaries
------
Patents, Copyright, etc.**
------
Fixed Assets :
(7)
------
Capital employed (6)+(7)
(8)
------
Other Assets:
(9)
------
--
------
Investment in Government securities,
unquote investments etc.
96 Management Accounting - I
Other Investments (non-trading)
------
Advances to Directors
------
Company’s Net Assets (8)+(9) =
(10)
------
Debentures
------
Other Long-term Loans (payable after a year)
------
Long-term Loans
(11)
------
(12)
-----
Preference Share Capital
(13)
------
Equity Shareholder’s Net Worth (12)-(13)=
(14)
------
Common size Statement
& Trend Analysis
Shareholders ’Net worth (10)-(11)=
(or Total Tangible Net Worth)
Equity Shareholder’s Net Worth is represented :
Less :
-------
Equity Share Capital
-----
Forfeited Shares
------
Reserves
-----
Surplus
-----
Equity Shareholders’s Claims
-----
Accumulated Losses
NOTES
--------
----
Miscellaneous Expenditure
(such as preliminary expenses,
discount on issue of shares or
debentures not written off)
Equity Shareholder’s Net worth
-----------
-------
* Goodwill to be included only when it has been paid for and has the value
** Patents, Copyrights, etc.. Should be shown only when they have the value. In
case this assets are valueless, they should not be included there but should be
written off again shareholders’ Claims with other losses.
The Concept of Analytical Balance Sheet can be understood with the help
of following illustrations.
Management Accounting - I
97
Common size Statement
& Trend Analysis
2.5.1 Illustrations
ILLUSTRATION 1
NOTES
The financial position of ABC Ltd. disclosed the following data as on 31st
March 2014
Balance Sheet as on 31st March 2014
(` in thousands)
Liabilities
Equity Share Capital
Dividend Equilisatin Reserve
Assets
`
`
500 Trade Investments
200
70 Patents
30
General Reserve
110 Land and Building (at cost)
320
Profit and Loss A/c
190 Plant and Machinery (at cost)
650
6% Debentures
250 Cash at Bank
Bank Overdraft
150 Stock
Staff Provident Fund
Creditors
88
80 Materials
90
210 Finished Goods
Unpaid Dividend
10 Work-in-progress
Proposed Dividend
60
160
60
Provision for Taxation
170 Sundary Debtors :
Provision for Depreciation
250 Less : Provision for Doubtful
Debts
2,050
310
230
(-)
8
222
Bills Receivable
30
Staff Provident Fund Investment
80
Deposits with Custom Authorities
30
AdvanceforPurchaseofMachinery
60
Preliminary Expenses
30
2,050
You are required to prepare Analytical Balance Sheet as on 31st March, 2014
98 Management Accounting - I
Common size Statement
& Trend Analysis
SOLUTION
Balance Sheet of ABC Ltd. as on 31 st March 2014
(` in thousands)
Liabilities and Assets
`
Cash at Bank
88
Book Debts (net)
222
Bills Receivable
30
Liquid Assets
(1)
NOTES
340
Deposit with Customs
30
Stock :
Materials
Finished Goods
Work-in-Progress
Current Assets
90
160
60
310
(2)
680
Bank Overdraft
150
Creditors
210
Unpaid Dividend
Current Liabilities
10
(3)
370
Proposed Dividend
60
Provision for Taxation
Current Liabilities and Provisions
Net Working Capital
170
(4)
(2)-(4)=(5)
600
80
Land and Building (at Cost)
320
Plant and Machinary (at Cost)
650
Patents
Fixed Assets
30
(6)
1,000
Less : Provision for Depreciation
250
Net Fixed Assets
750
Advance against Machinery
60
Trade Investments
Total Fixed Investment
200
(7)
1,010
Staff Provident Funds Investments
80
Less : Staff Provident Funds
80
Nil
Total Capital Employed
(8)
1,090
Less : 6% Debentures
(9)
250
Shareholders’ Funds
(10)
840
Represented by :
Equity share capital
500
General Reserve
110
Dividend Equalisation Reserve
Profit and Loss A/C
Less : Preliminary Expenses
70
190
30
160
840
Management Accounting - I
99
Common size Statement
& Trend Analysis
5.6 Summary
•
A Profit and Loss Account and Balance sheet can also prepared and
presented in the form of common-siz statements. A statement in which
indidual items are expresses as percentage of same common base is termed
as an common-size statements
•
The Financial Statements for a series of years may be analysed to determine
the trend of the data contained there in. This methods of analysis is adoptes
to determine the direction up word of down words. This involves the
computation of percentage relationship that each item in the statement bear
to the corresponding items contained in that of the base year.
•
Analytical Balance Sheet provides methodical classification of data given
in the financial statements. This analytical form of Balance Sheet also
facilitates showing the figures of a number of firms or numbers of years
side by side for comparision purposes.
NOTES
5.7 Key Terms
1)
Common size income statement : Common size income statement show
percentage of net sales that has been absorbed by each individual item
representing cost or expenses.
2)
Common Size Balance-Sheet : The common size Balance Sheet
represents the relation of each assets item to total assets and each liabilities
and capital item to total liabilities and capital respectively.
3)
Trend Analysis : The trend percentages are also refered to as “trend
ratios’’ This method of analysis is adopted to determine the direction up
ward or downwards. This involves computation of the percentage relationship
that each item in the statement bears to the corresponding items containes
in that the base year.
4)
Analytical Balance Sheet : This balance Sheet provides methodical
classification of data given in the financial statements.
5.8
Questions and Exercises
I) Objective Questions
A) Multiple Choice Questions
1)
Common size income statements present the various items as a percentage
of --------a) Turnover
100 Management Accounting - I
b) Purchases
Common size Statement
& Trend Analysis
c) Gross result
d) Net result
2)
The financial statements when expressed in componary percentages are
termed as.....
a) Comparative statements.
NOTES
b) Common size statements
c) Income statements
d) position statements
3)
The index numbers of the movements of the various items in the financial
statements for a number of periods are termed as----a) Operating Ratios
b) Current Ratios
c) Trend Ratios
d) Liquid Ratios
4)
The critical study of business trend over a period of time is known as---a) Horizontal Analysis
b) External Analysis
c) Critical Analysis
d) Trend Analysis
Ans : (1-a), (2-b), (3-d), (4-d)
II - Long Answers Questions
1)
What is a ‘common-size statement’ ? Explain the usefulness of Commonsize statements during financial statement analysis.
2)
What is a ‘common-size Balance-sheet’ ? Why do the bankers require
Balance-sheet of several years while examing the loan proposal ?
3)
Explain the procedure of preparing common-size Balance sheet.
4)
What is Trends Analysis ? Explain in brief the importance of Trend Ratios
5)
Define the term Analytical Balance sheet why there is a need to analyse
the Balance sheet ?
6)
Explain the importance of the following as a technique for financial statement
analysis ?
i) Common size statement
ii) Trend Analysis
Management Accounting - I
101
Common size Statement
& Trend Analysis
7)
Why is might be unwise to predict a firm’s financial future based on trends
derived from historical financial data ?
III - Practical Problems
NOTES
1)
From the following Balance Sheet of Sun Ltd and Moon Ltd on 31st March
2014 prepare a common size Balance sheet.
Balance Sheet as on 31st March, 2014
Liabilities
Sun Ltd.
Moon Ltd
`
`
Assets
Sun Ltd. Moon Ltd.
`
`
Equity Capital
2,50,000
5,00,000 Fixed Assets
3,50,000
6,00,000
Reserves
1,50,000
2,00,000 Current Assets
1,50,000
2,00,000
Current Liabilities
1,00,000
1,00,000
5,00,000 8,00,000
2)
From the following information made available from the Balance sheet of
chandra Ltd for the last four years compute the trend percentage taking
2010-2011 as the base year.
Assets and Properties
3)
5,00,000 8,00,000
2010-11
2011-12
2012-13
2013-14
`
`
`
`
Land and Buildings
3,00,000
3,50,000
3,75,000
4,00,000
Plant and Machinery
5,00,000
6,00,000
7,50,000
10,00,000
Furniture and Fixtures
1,00,000
1,50,000
1,50,000
1,50,000
Sundry Debtors
1,00,000
1,20,000
1,60,000
2,00,000
Cash in hand and at Bank
50,000
70,000
80,000
1,00,000
Bills Receivable
60,000
80,000
90,000
1,10,000
Convert the following Balance Sheet of Dabur Ltd. Dombivali into common
size Balance Sheet and make brief comments on the same.
Balance Sheets of Dabur Ltd, Dombivali as on 31st March 2010 to 2011
Liabilities
2010
2011
`
`
Assets
2011
`
`
Share Capital
5,00,000
6,50,000 Machinery
2,80,000
3,20,000
6% Debentures
3,40,000
2,00,000 Building
3,50,000
3,50,000
Sundry Creditors
1,60,000
2,40,000
2,65,000
70,000
55,000
40,000
30,000
60,000
40,000
40,000
25,000
67,000 Investment
Provision for
Goodwill
Doubtful Debts
4,500
Profit and Loss
75,500
3,000 Bank Balance
1,65,000 Inventory
Bills Receivable
10,80,000 10,85,000
102 Management Accounting - I
2010
10,80,000 10,85,000
4)
Following income statement of Femina Ltd., Fattepur are given for the
years ending 31st December 2010 and 2011
Particulars
Gross Sales
2010
2011
`
`
7,20,000
8,40,000
40,000
50,000
Net Sales
6,80,000
7,90,000
Cost of Goods Sold
5,00,000
5,80,000
1,80,000
2,10,000
Advertising Expenses
10,000
12,000
Sales Salaries
12,000
16,000
7,000
5,000
Depreciation Expenses
10,000
16,000
Total Selling Expenses
39,000
49,000
Office Salaries
50,000
75,000
Insurance
20,000
35,000
Depreciation
5,000
16,000
Bad Debts
3,000
12,000
78,000
1,38,000
1,17,000
1,87,000
63,000
23,000
Sales Returns and Allowances
Gross Profit from Sales
Common size Statement
& Trend Analysis
NOTES
Operating Expenses
Selling Expenses :
Delivery Expenses
General and Administrative Expenses :
Total : General and Administrative Expenses
Total : Operating Expenses
Operating Income
Prepare a Common-size Income Statements and Comment on the business
result.
5.9 Further Reading
•
Khan M.Y and Jain P. K. - Management Accounting Text, Problems and
cases - New Delhi - Tata Mc Graw Hill Publishing Co. Ltd. - 2010
•
Rajasekaran and Lalitha R. - Financial Accounting - New Delhi - Pearson
Education - 2012
Management Accounting - I
103
UNIT 6 Ratio Analysis
Ratio Analysis
Structure
6.0
Introduction
6.1
Unit objective
6.2.
Meaning of Ratios
6.2.1
Ratio Analysis-Rationale
6.3
Nature of Ratio Analysis
6.4
Objectives of Ratio Analysis
6.5
Principal Advantages of Ratio Analysis.
6.6
Limitations of Ratio Analysis
6.7
Classification of Ratios
6.8
Types of Ratios
6.9
NOTES
6.8.1
Liquidity Ratios
6.8.2
Solvency Ratios
6.8.3
Profitability Ratios
6.8.4
Efficiency Ratios
6.8.5
Integrated Ratios
6.8.6
Tabular Representation of Type of Ratios and their
Significance
Illustrations
6.10 Summary
6.11 Key Terms
6.12 Questions and Exercises
6.13 Further Reading
Management Accounting - I
105
Ratio Analysis
NOTES
6.0 Introduction
Ratio analysis is one of the popular tools of financial statement analysis. In
simple words, ratio is the quotient formed when one magnitude is divided by
another measured in the same unit. A ratio is defined as “the indicated quotient of
two mathematical expressions’’ and as “the indicated quotient of two mathematical
expressions” and as “the relationship between two or more things.” Usually the
ratio is stated as a percentage i.e. distribution expenses might be stated as 20.5
percent of sales. Often however, the ratio is expressed in units, thus sales might
be expressed as 20 times inventory. Thus, the ratio is a pure quantity or number,
independent of the measurement units being used. A financial ratio is defined as
a relationship between two variables taken from financial statements of a concern.
It is a mathematical yardstick that measures the relationship between two financial
figures. It involves the breakdown for the examined financial report into component
parts which are then evaluated in relation to each other and to exogenous standards.
Financial ratio expedite the analysis by reducing the large number of items involved
to a relatively small set of readily comprehended and economically meaningful
indicators.
As ratio represents a relationship between figures therefore, number of
ratios can be formed by taking any two figures from the financial statements.
However, such an approach would not fulfill any purpose unless the figures chosen
are significantly correlated with each other. Further more, many of the ratio tend
to deal with aspects of the same relationship, and there is little point in calculating
several ratios in order to investigate the same point. Experts have identified some
ratios as significant and important since they throw considerable light on the financial
position of a concern. However, given the large number of ratios available, it is
difficult to discern, the interrelationships among them required for a comprehensive
understanding of the entity being analysed.
6.1
Unit Objectives
After Learning this unit you should be able to :
106 Management Accounting - I
1.
Draw analytical balance-sheet.
2.
Describe meaning and types of accounting Ratios.
3.
Classify the accounting ratios in to different categories.
4.
Understand and compute different type of ratios.
5.
Make critical analysis of financial statements with the help of accounting
ratios.
6.
Discuss the Nature and Objectives of Ratio Analysis.
7.
Make tabular representation of types of ratios and their significance.
6.2
Meaning of Ratios
Ratios are relationships expressed in mathematical terms between figures
which are connected with each other in some manner. Obviously, no purpose will
be served by comparing two sets of figures which are not at all connected with
each other.
Ratio Analysis
NOTES
Ratios can be expressed in two ways :
1.
Times : When one value is divided by another, the unit used to express the
quotient is termed as “Times” For example, if out of 100 students in a class,
80 are present, the attendance ratio can be expressed as follows :
= 90/100 = 9 Times
2.
Percentage : If the quotient obtained is multiplied by 100, the unit of
expression is termed as “Percentage” For instance, in the above example,
the attendance ratio as a percentage of the total number of students is as
follows:
= 9 x 100 = 90%
Accounting ratios are therefore, mathematical relationships expressed
between interconnected accounting figures.
6.2.1 Ratio Analysis - Rationale
One of the most difficult problems confronting the analyst is the interpretation
and analysis of financial ratios. An adequate financial analysis involves more than
an understanding and interpretation of each of the individual ratios. Further more,
the analyst requires an insight into the meaning of the interrelationships among the
ratios and financial data in the statements. Gaining such an insight and understanding
requires considerable experience in the analysis and interpretation of financial
statements. Moreover, even experienced analyst cannot apply their skill equally
well to analyse and interpret the financial statements of different concerns. The
characteristics may differ from industry to industry and from firm to firm with the
same industry. A ratio that is high for one firm at one time may be low for another
firm or for the same firm at a different time. Therefore, the analyst must be
familiar with the characteristics of the firm of which e is interpreting the financial
ratios.
The analyst must not undertake the interpretation and analysis of financial
ratios in isolation from the information. The following factors must be considered
while analysing the financial ratios :
(a)
General economic condition of the firm.
(b)
Risk acceptance.
(c)
Future expectations.
(d)
Future Opportunities.
Management Accounting - I
107
Ratio Analysis
NOTES
(e)
Analysis and interpretation system used by other firms in the industry.
(f)
Accounting system of the industry.
The analysis and interpretation of the financial ratios in the light of above
listed factors can be useful, but the analyst must still rely on skill, insight and even
intention in order to interpret the ratios and arrive at a decision. The interpretation
of the ratios can be made by comparing them with :
(a)
Previous figures
-
Trend Analysis.
(b)
Similar firms
-
Inter Firm Comparisons.
(c)
Targets
-
Individual Ratio set to meet the objective.
(a) Trend Analysis :
The analyst usually use historical standards for evaluating the performance
of the firm. The historical standards represent the financial ratios computed over
a period of time- Trend. The trend analysis provide enough clues to the analyst for
proper evaluation of the financial ratios. However, the change in firm policies
over the period must be considered while interpreting ratio from comparison over
time. Further more, the average of the ratios, for several years can also be used
for this purpose.
(b) Inter-firm Comparisons:
Interfirm comparisons may claim the comparisons of similar ratios for a
number of different firms in the same industry. Such an attempt would facilitate
the comparative study of financial position and performance of the firm in the
industry. The published ratios of trade associations or financial institutions can be
of great help to the analyst in the interpretation of the financial ratio. However,
the variations in accounting system and changes in the policies and procedures of
the firm in comparison with the industry have to be taken care of while making
use of interfirm comparisons.
(c) Targets :
Under this method, the interpretation of the ratio is made by comparing it
with the standard set for this purpose, such a standard ratio, based upon well
conventions serves as measuring scale for the evaluation of the ratios. The best
example of such standard is the 1:1 ratio which is to be considered a good ratio for
analysing acid-test ratio.
Generally speaking the use of single standard ratio for the interpretation of
the ratios is not much useful. The accounting experts usually recommended the
use of the group of standard ratios for the evaluation of financial ratios.
108 Management Accounting - I
6.3
Nature of Ratio Analysis
Ratio Analysis
The ratio is calculated by dividing one figure by the other figure. It may be
expressed in any of the three ways- ‘times.’ ‘proportion’ or ‘percentage’ according
to the convenience or suitability.
A more meaningful financial analysis involves ratios and their comparisons
relating to a business concern (a) over a period of years, (b) against another unit,
(c) against the industry as a whole, (d) against the predetermined standards, (e)
for one department or division against another department or division of the same
unit.
NOTES
In fact, ratio analysis does not provide an end in itself, but only a means to
understanding of the business concern’s financial position. The nature of ratio
analysis indicate that quantitative ratio analysis does not provide solutions for all
the problems faced by a financial manager, unless several ratio, each of which
relates to other, are complied and analysed in perfect perspective.
While analysis based on a single set of financial statement is helpful, it may
often have to be supplemented with time series analysis which provides insight
into firm’s performance and condition over a period of time. In this context, index
analysis and analysis of time series of financial ratios are helpful tools.
Actual, for tackling any problem initially one should determine what ratios
would be helpful in throwing light on the above situations and compute only such
ratios.
Several ratios have some common element (Sales, for example, is used in
various turnover ratios ) and some items tend to move in harmony because of
some common underlying factor. Though industry averages and other yardsticks
are commonly used in financial ratios, it is some what difficult to judge whether a
certain ratio is ‘good’ or ‘bad’. Therefore, it is a process requiring proper care,
sophistication, experience, etc.
6.4
Check Your Progress
How ratios can be expressed
in times & percentage ?
Illustrate.
Objectives of Ratio Analysis
Following are important objectives of Ratio Analysis :
1.
To provide the necessary basis for interfirm comparison as well as intrafirm comparison.
Interfirm Comparison :
(a) Between one company and its competitor.
(b) Between one company and the best company in the industry.
(c) Between one company and the global average.
(d) Between one company and the average performance, in the industry.
Management Accounting - I
109
Ratio Analysis
2.
To Provide the necessary basis for Inter period comparison.
Inter period Comparison :
(a) Between two year
(b) Between two months
NOTES
(c) Between two quarters
(d) Between ‘X’ months of current year and ‘X’ month of pervious year.
3.
To help in providing a part of information needed in the process of decision
making.
4.
To focus on facts on a comparative basis and facilitate drawing of conclusions
relating to the performance of a firm.
5.
To evaluate the performance of a firm in determining the important aspects
of a business such as liquidity, solvency, operational efficiency, overall
profitability, capital gearing etc.
6.
To throw light on the degree of efficiency in the management and the
effectiveness the utilization of its assets.
7.
To Provide the way for effective control of the enterprise in the matter of
achieving the physical and monetary targets.
8.
To help the management in discharging its basic functions like forecasting,
planning coordination, control etc.
9.
To promote co-ordination among the departments and the staff by a study
of performance and efficiency of each department.
10.
To point out the financial condition of business whether it is very strong,
questionable or poor and enables the management to take necessary steps.
11.
To act as an index of the efficiency of an enterprise.
6.5
Principal Advantages of Ratio Analysis
Ratio analysis helps managements pin point specific areas that reflect
improvement or deteriorations as well as detect any trouble spots that may prevent
the attainment of objectives. The interested parties undertake frequently
examination of these three areas to evaluate managements ability to maintain a
satisfactory balance among them, and to appraise the efficiency and effectiveness
with which management directs the firms’s operations. Thus, the purpose of ratio
analysis is to help the reader of asset of accounts to understand the information
shown by highlighting a number of key relationships. However, the following are
the principal advantages claimed by the ratio analysis :
110 Management Accounting - I
(a)
It guides management in formulating future financial planning and policies.
(b)
It throws light on the efficiency of the business organisation.
(c)
It permits comparisons of the firm’s figures with data for similar firms, and
possibly with industry-wise data. And it permits the data to be measured
against yard stick of performance or of sound financial conditions.
(d)
It ensure effective cost control.
(e)
It provides greater clarity, perspective, or meaning to the data and it brings
out information not otherwise apparent.
(f)
It measures profitability and solvency of a concern.
(g)
It permits monetary figures of many digits to be condensed to two or three
digits which enhances the managerial efficiency.
(h)
It helps in investment decisions.
6.6
Ratio Analysis
NOTES
Limitations of Ratio Analysis
In using ratios the analyst must keep a few general limitations in mind. The
main limitations attached to it are as follows :
(a)
It lacks standard value for the ratio, therefore scientific analysis is not possible
(b)
As there are no standards with which to compare, it fails to throw light on
the efficiency of any activity of the business.
(c)
It gives only the relationship between different variable and the actual
magnitude are not known through ratios.
(d)
Ratios are derived from the financial statements and naturally reflect their
drawbacks.
(e)
It fails to indicate immediately where the mistake or error lies.
(f)
It does not take into consideration the market and other changes.
6.7
Check Your Progress
What
are
objectives,
advantages & limitations of
ratio analysis ?
Classification of Ratios
Ratios have been classified by different experts differently based on there
peculiar characteristics. Some authorities classify ratios on the basis of the financial
statements or statements from which the financial figures are selected.
Accordingly the following classification or ratio can be formed :
(a)
Profit and Loss Ratio :
These ratios indicate the relationship between two such variable which
have been taken from the Profit and Loss Account. Basically there are two type
of such ratios viz.
Management Accounting - I
111
Ratio Analysis
(i) Those showing the current year’s figure as a percentage of last year,
thus facilitating comparison of the changes in the various profit and loss items and
(ii) Those expressing a relationship among different items for the current
year, e.g. the percentage of distribution expenses to sales etc.
NOTES
(b)
Balance Sheet Ratios :
Top management will probably want to view the financial structure of the
company in terms of basic ratios of assets or liability categories to total assets.
These ratio attempts to express the relationship between two Balance sheet items.
e.g. the ratio of stock to debtors, or the ratio of owner’s equity to total equity.
(c)
Inter-statement Ratio/Mixed Ratios :
The components for computation of these ratios are drawn from the both
Balance sheet and Profit and Loss Account. These ratio deal with the relationship
between operating and Balance Sheet items. The example of such ratios are
debtors turnover ratio, fixed assets turnover ratio, working capital turnover ratio,
and stock turnover ratio.
Some authorities classify the ratio on the basis of time to which ratios
computed balance. On this basis the ratio can be divided into the following two
major groups
A) Structural Ratios
Structural ratios exhibit the relation between two such items which relate to
the same financial period. Thus, above mentioned classification of ratios. i.e. Profit
and Loss ratios Balance Sheet ratios, and Mixed ratios are covered under structural
ratios if the components for the computation of these ratios are drawn from the
financial statement that relate to the same period.
B) Trend Ratio
These ratios deal with the relationship between items over a period of time.
Trend ratios indicate the behavior of the ratios for the period under study and thus
provide enough scope for the proper evaluation of the business.
Another classification of ratios as developed by the financial experts is on
the basis of significance of the ratios. Some ratios are considered more important
than other when ratios are evaluated in the light of the objectives of the business.
Accordingly the following two main groups of ratios are covered under this
classification :
(a) Primary Ratios
Every commercial concern considers profit as its prime objective and therefor,
any ratio that relates to such objective is treated as primary ratio. The ratios
converted by this category are return on capital gross margin to sale., etc.
(b) Secondary Ratios :
112 Management Accounting - I
The ratios other than the primary ratio are known as secondary ratios.
Such ratios are treated as supporting ratios to the primary ratio because these
ratios attempt to explain the primary ratios. The ratios such as turnover ratios,
expenses ratios, earning per share are considered as secondary ratios.
Ratio Analysis
The ratios have also been classified according to their financial characteristics
that they describe. Accordingly, the following classification of ratio is given below:
i) Liquidity Ratio
NOTES
ii) Leverage Ratios;
iii) Profitability Ratios ; and
iv) Activity Ratios
The classification on the basis of characteristics is simple to calculate and
easy to understand as compared to other classification discussed above. Therefore,
this classification is always preferred by the financial analyst to evaluate the
business performance. Accordingly detailed discussion follows on the classification
of the ratios based on their financial characteristic.
6.8
Types of Ratios
Ratio can broadly be classified into four group i.e liquidity, capital structure
leverage, profitability, efficiency and integrated respectively.
Check Your Progress
How you can classify ratios ?
6.8.1 Liquidity Ratio
What are the types of ratios ?
Liquidity ratios measure the ability of a firm to meet its short-terms obligations,
and reflect its short-term financial strength or solvency. Important Liquidity Ratios
are : i) Current Ratio and ii) Quick, or Acid-Test Ratio. Current Ratio is the ratio
of total current assets to total current liabilities. A satisfactory current ratio would
enable a firm to meet its obligations even if the value of the current assets
declines. It is however a quantitative index of liquidity as it does not differentiate
between the components of current assets, such as cash and inventory which are
not equally liquid. The quick ratio - acid test ratios takes into consideration the
different liquidity of the components of current assets. It represents the ratio
between quick current assets, and the total current liabilities. It is a rigorous measure
and superior to the current ratio. However, both these ratios should be used to
analyse the liquidity of a firm.
6.8.2 Capital Structure/Leverage Ratios/Solvency Ratios
The capital structure-leverage ratios throw light on the long term solvency
of a firm. This is reflected in its ability to assure the long-term creditors. with
regard to periodic payment of interest and the repayment of a loan on maturity, or
in pre-determined installments at due date. There are two types of such rations :
i) Debt- equity or Debt assets, and ii) Coverage. The first type is computed from
the Balance Sheet and reflects the relative contribution/stake of owners and
Management Accounting - I
113
Ratio Analysis
NOTES
creditors in financing the assets of the firm. In other words, such ratios reflect the
safety margin to the long-term creditors. The second category of such ratios is
based on the income statements and shows the number of times the fixed obligations
are converted by earnings before interest and taxes. They indicate, in other words,
the extent to which a fall in operating profits is tolerable in that the ability to repay
would not be adversely affected.
6.8.3 Profitability Ratios
The Profitability of a firm can be measured by the profitability ratios. Such
ratios can be computed either from sales or investments. The Profitability ratios
based on sales are : i) Profit Margin (gross and net,) and ii) Expenses or Operating
ratios. They indicate the proportion of sales consumed by operating costs and the
proportion available to meet financial and other expenses. The Profitability related
to investments includes : i) Return on assets, ii) Return on capital employed and iii)
Return on shareholders equity, including earning per share, dividend payout ratio,
earning and dividend yield. The overall profitability (earning power) is measured
by the return on investment, which is computed as a combined product of net
profit margin and investments turnover it is central measure of the earning power
and operating efficiency of a firm.
6.8.4 Activity/Turnover/Efficiency Ratio
The Last Category of ratios is the activity ratios. They are also known as
the efficiency or turnover ratios. Such ratios are concerned with measuring the
efficiency in assets management. The efficiency with which assets are managed
/ used is reflected in the speed and rapidity with which they are converted into
sales. Thus, the activity ratios are a test of relationship between sales/cost of
goods sold and assets. Depending upon the type of asset, activity ratios may be :
i) Inventory or stock turnover ii) Receivables or Debtors turnover and iii) Total
assets turnover. The first of these indicates the number of times inventory is
replaced during the year, or how quickly the goods are sold. It is a test of
efficiency inventory management. The second category of turnover ratios is
indicative of the efficient of receivables managements as it shows how quietly
trading goods are sold. It reveals the efficiency in managing and utilizing the total
assets.
6.8.5 Integrated Ratios
Before we discuss the details of “Integrated Ratios” we must understand
what is “Integrated Accounting.”
“The method of keeping cost and financial accounts in a single set of books
is called integrated accounting.’’
114 Management Accounting - I
In this Connection, the views expressed by the Cost Accounting subcommittee of the Institute of Chartered Accountant in England and Wales. The
committee says that, “we consider it fundamental that there should be complete
integration between the cost and the financial records not only for the purpose of
cost control but also for the purpose of cost ascertainment. In order to achieve
such an integration it is necessary that an all-embracing accounting scheme should
be planned in the relation to which accounting records can be developed for all
purpose, both financial and costing.”
Ratio Analysis
Integrated Ratios :
Integrated ratios means combination of cost and financial records. There
is combination of financial figures and cost accounting figures for comparision.
Integrated ratios are relationships expressed in financial accounting terms and
cost accounting terms which are connected each other in some manner.
NOTES
Integrated ratios are related to following accounts:
i) Capital an other financial accounting
ii) Fixed Assets accounts.
iii) Stores Accounts.
iv) Work-in-Progress Accounts.
v) Finished Goods Stock Accounts.
vi) Cost Control Accounts
vii) Expenses Accounts
viii) Variance Accounts
Generally, ratios related to inventories’ are integrated to cost accounting
and financial accounting.
The financial accounts and cost accounts of an organisation should be
regarded as two parts of one whole, but both utilize the same basic information
although in different ways. With the help of integrated ratio we can verify that all
the sections of the accounting organisation contribute to the common end, that
redundancies and unnecessary operations are eliminated, that the information is
brought forward properly and reflected accurately. In short with the help of
integrated ratios we can find out that financial accounting and costing are so
keyed together that they contribute, each in its proper sphere to wards the common
objective. The integrated ratio analysis satisfies the needs of both proprietor and
management by providing pertinent cost and financial relationships expressed in
mathematical terms.
Management Accounting - I
115
116 Management Accounting - I
This ratio is sensitive to a number of
factors which must be taken into account
for accurate result such as :
(a) It must be ascertained whether the
Current Assets and Current Liabilities are
property valued.
(b) For proper inference the composition
of Current Assets should not be over
looked. If majority of Current Assets are
in the form of inventory, even a 2 : 1
ratio will not result into favourable
considered because inventory is
considered because inventory is
considered to be the least liquid Assets
out of all Current Assets of a firm.
(c) A very high Current Ratio may not
indicate a very favourable position
because it means that excessive
investments in Current Assets is made.
This will result in decrease in profitaility
because of long funds blocked in
working capital.
(d) For studying the solvency of the
concern from the Current Raio, still
another factors must not be lost sight of
i.e. shrinkage in the value of current
assets on a forced liquidation.
Precautions
NOTES
6.8.6 Tabular Representation of Types of Ratio and their Significance
1. Balance Sheet Ratios
Sr.
Name of the
Formula for Calculation
Types of Ratio
Significance
No.
Ratio
of Ratio
according to
Nature Function
1. Current Ratio
Balance Liquidity This ratio indicates the solvency of ther
business i.e. ability to meet the liabilities of
Current
Assets
or
Sheet Short-term the business as and when they fail due. This
Current Liabilities
Working
Solvency ratio also indicates how much Current Assets
are there as against each rupee of Current
Capital Ratio
Current Assets includes :
Liquidity Liabilities.
or
The Current Assets are the sources from
which the liabilities have to be met. It is also
‘2:1 Ratio’
Cash in hand / bank, marketable
the measure of the margin of safety that
management maintain in order to allow for
securities, other short-term high
the inevitable unevenness in the flow of funds
quality investment, bills
through the Current Assets and Liabitlities
receiables, prepaid expenses.
account. Certain authorities have
work-in progress, sundry debtrecommeded that in order to ensure solvency
ors and investmentories etc.
of a concern. Current Assets should be at
least
twice the Current the current Liabilities
Current Liabilities includes :
and therefore this ratio is known *2.1. Ratio*.
Sundry Creditors, bills payable
This ratio, also named as. Working Capital,
outstanding and accurued exbeing the excess of the Current Assets over
Current Liabilities.
penses, overdraft, proposed
Though 2 : 1 is considered desirable, it is not
divident etc..
must. It depends upon the nature of the
business. What is important is not the size of
the Current Ratio but the allocation and
charactersics of Current Assets and Current
Liabilities and their relation to the prospective
turnover.
Ratio Analysis
Name of the
Ratio
Quick or Liquid Assets
Quick or Liquid Liabilities
Formula for Calculation
of Ratio
or
Some experts advocate that
only stock from Current Assets
and overdraft from Current
Liabilities should be excluded.
Quick Liabilities includes :
All Current Liabilities except
overdraft
and
accured
expenses.
Quick Assets includes : All
Current Assets
except
Acid Test Ratio inventory (stock) and prepaid
expenses.
Quick Ratio
or
2. Liquid Ratio
Sr.
No.
Types of Ratio
Significance
according to
Nature Function
Balance Liquidity As regard to the ability to honour day to day
Sheet Short-term commitment, Liquid Ratio is a better tool. It
is the ratio betweem Liquid Assets and Liquid
Solvency Liabilities. An ideal Liquid Ratio is considered
as 1 : 1
It signifies a very short term liquidity of a
business concern and is, therefoer, also called
a still stiffer and rigorous test of solvency.
the application of Acid-test Ratio is suitable.
The Acid-test Ratio assumes that stock may
not be realised immediately and therefore,
this item is excluded in the computation of
this ratio.
The logic for exclusion of bank overdraft is
based on the fact that bank overdraft is
generally a permanent way of financing.
Too low a ratio suggests not only liability to
meet current claims but also inability to take
advantages of cash discounts and other
rewards for prompt payment. On the other
hand, an excessive amount of Quick Assets
could indicate that these assets should be put
more productive or profitable use elsewhere
in the enterprise.
I. Balance Sheet Ratios (continued from previous page)
An Acid-test Ratio of 1 : 1 is usually
considered an ideal and satisfactory
However, this is rule of thumb and
should be applied with care.
Precautions : Same as Current Ratio.
Care must be exercised in placing too
much reliance on 100% Acid-test Ratio
without further investigation. e.g. a
seasonal business which seeks to
stabilize production will tend to have a
weak. Acid-test Ratio during its period
of slack sales. but probably a powerful
one in its period of highest selling. so
that the earlier weak or downward
position would have to be judged in
relation to the market prospects for the
firm’s products in the latter period.
The adequacy of this ratio depends on
the industry in which the firm operates.
Precautions
Ratio Analysis
NOTES
Management Accounting - I
117
118 Management Accounting - I
Proprietor’s
Owners
Fund
Proprietor’s Fund
Total Assets/Total Capital
or
Formula for Calculation
of Ratio
Equity Ratio
or
Some experts are of the opinion
that Total Assets includes only
Tangible Assets. It means
“Goodwill” shall be excluded
from the total assets.
Total Assets includes : Fixed
and Current Assets.
Equity includes : Share
Capital to Total Capital*, Reserves and Surplus.
Assets Ratio * : both Preferential and Equity
or
Assets Ratio
Worth to Total
Tangible Net
or
3. Proprietory Ratio
Name of the
Ratio
This ratio is normally a test of strength of
credit worthiness of the business.
On the other hand, a low Proprietory Ratio
is a symptom of under capitalisation and an
exessive use of creditor’s fund to finance
the business.
A ratio nearing 100% often gives low
earnings per share and consequently a low
rate of dividend to shareholders.
A high proprietary ratio is however frequently
indicative of over capitalisation and an
excessive investment in Fixed Assets in
relation to actual needs.
As a very rough measure. It may be
suggested that 2/3 to 3/4th of the Total Assets
should be financed by proprietor’s funds.
However, the optimum ratio is different in
different lines of business.
Recall that the owner’s equity is the
residual interest in the firm’s assets after
allowance had been made for the claims
of creditors against assets.
Types of Ratio
Significance
Precutions
according to
Nature Function
Balance Leverage It is primarly, the ratio between Proprietor’s This ratio, should be considered
Funds and Total Assets. It indicates the alongwith the Current Ratio while
Sheet
observing the solvency of the business.
strength of the funding of the company.
NOTES
Sr.
No.
I. Balance Sheet Ratios (continued from previous page)
Ratio Analysis
Name of the
Ratio
Formula for Calculation
of Ratio
Low gearing indicateds that the Equity Share
Capital is not paid an adequate return
because the profits are swallowed up by the
high fixed charges in the form of interest and
divdiends Capital gearing signifies the
process of maintaining a desired and
appropriate gear ratio in a enterprise While
inflationary conditions are expected high
gearing is to be employed and in the period
marked by trade depression, low gearing
should be employed.
Types of Ratio
Significance
according to
Nature Function
4. Capital Gearing Equity Share Capital
Balance Leverage It is used to express the relationship between
Equity Share Capital and Fixed interest
Ratio
Sheet
+ Reserves and Surplus
bearing securities of company Whether
Pref. Share Capital*
fluctuation in profit of a company are
followed by a disproportionately large
+ Loan Capital
increase or decrease in return to equity
shareholders. a company is considered to be
(*Fixed interest bearing
highly geared. If the proportion of preferred
securities)
share and loan capital is high or where the
proportion of ordinary share capital to the
total capital is low. capital is said to be highly
geared and reserve is the position in low
gearing.
Sr.
No.
I. Balance Sheet Ratios (continued from previous page)
As it affects the company’s capacity
to maintain a stable dividend distribution
policy during the difficult trading
periods, it must be carefully planned.
Precutions
Ratio Analysis
NOTES
Management Accounting - I
119
120 Management Accounting - I
Total Debt
(i.e. Long+Short-term)
Net Worth/Owner’s Equity
Formula for Calculation
of Ratio
(There is difference of opinion
regards to Preference Share
Capital as to whether is to be
included in creditors or in
ownership claims).
Networth means Equity Share
Capital. Preference Share
Capital, Reserves and Surplus
i.e. Proprietor’s Funds or Equity.
Total Debts includes : All
to Proprietor’s debts i.e. long-term, short-term,
Fund Ratio.
mortages, bills, debentures, etc.
Total Liabilities
or
Ratio
5. Debt Equity
Name of the
Ratio
The normal and safe ratio is 2 : 1. If the ratio
is higher, it indicates that the firm is depending
heavily on creditors. If the ratio is low it
means that the firm is depending mainly on
internal source and owner’s funds. The
purpose of Debt to Equity Ratio is to derive
an idea of the amount of capital supplied to
the firm by the owners and of asset ‘Cushion’
avialable to the creditors on liquidation.
This Ratio reveals the claims of
shareholder’s and creditor’s against the
assets of the firm.
Here ‘Debt’ refers to the external or
borrowed capital and the equity refers to the
shareholder’s funds or internal capital.
The long-term solvency of the firm can be
assessed from this ratio.
Types of Ratio
Significance
according to
Nature Function
Balance Leverage The ratio establishes the relationship between
Owner’s Fund and External Debts, or there
Sheet
relationship between Proprietpr’s Fund and
Borrower’s Capital.
Too much reliance on external equities
may indicate under capitalisation where
as too much reliance on internal equity
may lead to over capitalisation.
The interpretaion of the ratio, however
depends almost entirely on the financial
and business policy of the enterprise.
From this point of view, the importance
of the ratio lies in highlighting the
seemingly irreconcilable view points of
the owners and creditors regarding the
method of financing the business : the
former having always the temptation of
doing business with other people’s fund
and the latter insisting on that the
owners should at least have as large an
investment as creditors. Therefore on
the average Debt to Equity Ratio 1 : 1
is also acceptable.
Precutions
NOTES
Sr.
No.
I. Balance Sheet Ratios (continued from previous page)
Ratio Analysis
Name of the
Ratio
Ratio
Working Capital
Inventory to
or
Capital Ratio
6. Stock Working
Sr.
No.
.
Closing Stock
Working Capital
Formula for Calculation
of Ratio
Types of Ratio
Significance
according to
Nature Function
Balance Liquidity The ratio is an index of the position of over
Sheet Short-term stocking. It shows what part of working
capital is represented by the closing stocks.
Solvency The size of closing stocks must bear a proper
proportion of the quantum of working capital.
The higer is the cover given by working
capital the lower is the risk of loss by the
likely fall in the value of inventories in future.
There is a need to supplement the ratio of
Net sales to Inventory by another ratio to
confirm the position shown by the
“Inventory” and the Net Working Capital and
provides a relatively more stable basis for
comparision than is supplied by the inventory
Turnover Ratio.
Inventory Ratio should be calculated as under :
Cost of goods sold
Average Inventory* at cost
*Average Inventory =
Opening Stock + Closing Stock
2
or
Net Sales
Average Inventory at selling price
I. Balance Sheet Ratios (continued from previous page)
The ratio should be interpreted with
maximum care. It should not be treated
as conclusive proof of overstocking.
This ratio should be considered
alongwith Stock Turnover Ratio to
arrive at correct decision.
Precutions
Ratio Analysis
NOTES
Check Your Progress
Give the formula for
calculating following Balance
Sheet Ratios.
(i)
(ii) Liquid Ratio
Current Ratio
(iii) Proprietory Ratio
(iv) Capital Gearing Ratio
(v) Debt Equity Ratio
(vi) Inventory to Working
Capital Ratio
Management Accounting - I
121
122 Management Accounting - I
Ratio
1. Gross Profit
Name of the
Ratio
.
Gross Profit
X 100
Net Sales
Formula for Calculation of Ratio
Types of Ratio
Significance
according to
Nature Function
Revenue Profitability The Gross Profit Ratio represents the gross
margin. It expresses the relationship of Gross
Profit on Sales to Net Sales in terms of
percentage. It is the ratio which is most
commonly employed by accountants for
comparing the earnings of business for one
period with those of other or earning of one
concern with those of another in the same
industry.
It indicates the degree to which selling prices
of goods per unit may decline without
resulting in losses on operations for the firm.
A high Gross Profit Ratio as compared with
that of the other firm in the same industry
implies that the firm in question produces its
products of lower cost. It is a sign of good
management.
On the other hand, a low Gross profit Ratio
may indicate unfavourable purchasing and
mark-up policies, the liability of management
to develop sales volume, theft, damage, bad
maintainance, marked reduction in scalling
prices not accompanied by proportionate
decrease in cost of goods sold.
Gross Profit is the ultimate result of
interaction between prices, sales volume
and costs. A change in the Gross Profit
can be effected by changes in any of
these factors. Thus Gross Profit
Indicates the limit beyond which the sale
price of goods cannot be allowed to fall.
Some times a high Gross Profit Ratio
may also be due to unsatisfactory basis
of valuation of stock. i.e. overvaluation
of closing stock or undervaluation of
opeing stock. A detailed analysis of
various factors alone give a proper due
for the increased gross profit ratio.
Precutions
NOTES
Sr.
No.
II. Revenue Statement Ratios
Ratio Analysis
Formula for Calculation
of Ratio
Types of Ratio
Significance
Precutions
according to
Nature Function
2. Expenses Ratio Specific Operating Expenses Revenue Profitability These supplement the information given by the While interpreting the Expense Ratios
Revenue Ratios. As there is a very important it should be remebered that certain
Sales
relationship existing between Operating Fixed Expenses e.g. Insurance
(a) Fixed Expenses to Total
Expenses and Volume of Sales. Expense Ratios
Cost Ratio =
are calculated by dividing Net Sales into each premium, Rates and Taxes would
Fixed Expenses
individual Operating Expenses. (Selling, decrease as the sales increase. But
Total Cost
Administrative and General Expenses). These Variable Expenses like commission of
ratio represents a summation of changes in Net sales would remain constant.
(b) Material Consumption to
Sales and in the expense items. These ratio are
Sales Ratio =
valuable in comparing two similar businesses or
Material Consumption
operating data from year to year of the same
X
100
Sales
business.
(c) Wages to Sales Ratio =
(a) Fixed Expenses to Total Cost Ratio :
This ratio shows the idle capacity in the
Wages
organisation. Sometimes this ratio increases
Sales
without corresponding increase in Fixed Assets.
(d) Office Administrative
In such circumstance, the matter should be
Expenses to Sales Ratio =
property examined.
Office Admin. Expenses
(b) Material consumption to Sales Ratio :
This ratio shows as to how much material is
Sales
consumed and what is its percentage share in
(e) Selling and Distribution
total sales. If the share is high, the profit of the
to Sales Ratio =
firm declines.
Selling and
(c) Wages to Sales Ratio : This ratio indicates
Distribution Expenses
the percentage of wages to sales. If the ratio is
higher, the profit margin will come down.
Sales
Sr. Name of the
No.
Ratio
II. Revenue Statement Ratios (Continued from previous page)
Ratio Analysis
NOTES
Management Accounting - I
123
124 Management Accounting - I
Ratio
3. Operating
Name of the
Ratio
100
Operating Expenses consist of factory Expenses.
Administrative Expenses
and Selling and Distribution Expenses.
Net Sales
+ Operating Expenses
Cost of goods sold
Formula for Calculation of Ratio
Revenue
(e) Selling and Distribution Expenses to
Sales Ratio : Thus ratio indicates the impact
of selling expenses particularly expenses on
(Advertisement) on sales. Higher the ratio
lower will be the margin of profit.
(d) Office and Administration Expenses
to Sales Ratio : This ratio indicates the
impact of indirect expenses on sales or profit.
Higher the ratio lesser will be the margin of
profit.
Significance
Precutions
Profitability The ratio indicates the percentage of Net In interpreting Operating Ratio full
Sales that is absorbed by the cost of goods recognition must be given to the
sold and Operating Expenses.
possibility of variatons in expenses from
year
to year or company to company,
Naturally, higher the Ratio the less
favourable it is, because it would have a due to changes or differences in policies
smaller margin to meet interest, dividends, involving expenses that are subject to
and other corporate needs. It can also be managerial decisions.
used as a partial index of overall profitability
but cannot be used as test of financial
condition without taking into account
financial and extraordinary items.
Types of Ratio
according to
Nature Function
NOTES
Sr.
No.
II. Revenue Statement Ratios (Continued from previous page)
Ratio Analysis
Operating Net Profit
X 100
Net Sales
Operating Net Profit is the Net
Profit minus income from
external securities and other
such as interest, dividend,
profit on sale of securities, etc.
=
Formula for Calculation
of Ratio
The profitability of a firm can be easily measured
by this ratio. The operating efficiency of a firm is
ultimately adjusted by the profits earned by it.
The Operating Profit Ratio is a tool in the hands
of management to control the cost of production
and other expenses like administrative and selling
expenses. It shows the amount of profit earned
for each rupee of sales. If the amount earned is
more, it means that there is a low cost operation
and if the profit is low the cost of pro
duction and other expenses are on the increase.
Types of Ratio
Significance
Precutions
according to
Nature Function
Revenue Profitability This ratio is mainly concerned with Operating Non-operating incomes and expenses
Profit or profit obtained from the main line of are strictly excluded when this ratio is
activity. Non-business income is also included calculated. This ratio indicates the
in the profit and when a ratio has to be obtained firm’s capacity to withstand adverse
from business profit this ratio has to be computed. economic conditions.
of Net Profit to Net Sales is established by this
ratio and is expressed in percentage.
Revenue Profitability Net Profit is that proportion of Net Sales which To get a meaningful interpretation of
5. Net Profit Ratio Net Profit after Taxes
X 100
remains with the owners or the shareholders after profitability of the firm, a financial
Net Sales
all costs, charges, and expenses including analyst must evaluate both the Gross
income-tax have been deducted. The relationship Profit Ratio and Net Profit Ratio jointly.
Profit Ratio
Operating
or
Profit Ratio
4. Net Operating
Sr. Name of the
No.
Ratio
II. Revenue Statement Ratios (Continued from previous page)
Ratio Analysis
NOTES
Management Accounting - I
125
Name of the
Ratio
Formula for Calculation of Ratio
126 Management Accounting - I
Types of Ratio
according to
Nature Function
A firm with high Net Profit Ratio would be
in an advantageous position to survive in the
face of falling sales prices, rising costs of
production or declining demand for the
product. A firm with a low Net Profit Ratio
may find it difficult to withstand these
adversities. A high Net Profit Ratio can
enable the firm to reap the benfits of
favourable conditions, such as rising sales
prices, falling costs of production or
increasing demand for the product. Such a
firm can accelerate its profit at a faster rate
than a firm with a low Net Profit Ratio.
This ratio shows the balance of profit left to
proprietor, after all expenses are met with.
This ratio normally ranges between 5% and
10%. Higher the ratio, higher will be the profit
left to the shareholders. This ratio assist the
management in controlling costs and in
increasing the turnover.
Significance
Precutions
NOTES
Sr.
No.
II. Revenue Statement Ratios (Continued from previous page)
Ratio Analysis
Formula for Calculation
of Ratio
Types of Ratio
according to
Nature Function
Significance
Precutions
Capital Employed
1. Return of Capi- Net Profit before Tax & Interest Composite Profitability The ratio show how well the firm has used the Following points are important regarding
resources of the owners. This ratio is a measure calculation of Capital Employed :
tal Employed
Capital Employed
X 100
of
the profitableness of an enterpise. It is also (a) Fictitious Assets like preliminary
Capital Employed means :
or
used
as basis for various managerial decisions.
expenses, accounts of deferred
either non-current Liabilities
There is difference of opinion regarding the
Net Profit to
revenue expenditure are excluded.
plus Shareholder’s Funds. or
calculation of Capital Employed. Some of the (b) Intangible Assets like goodwill are
Working Capital plus nonAssets Ratio
financial managers are of the view that the
generally excluded.
Current Assets.
amount of Capital Employed must be such that it
or
(c) Though idle assets are excluded
(If the term Capital Employed
may fairly represent capital investment
from Capital Employed, standby
Return on Total is taken as Gross Capital
throughout the year and therefore they bring the
plant
and equipment essential to
Employed then it means Total
Concept of Average Capital Employed.
Assets
normal
running of machinery should
Assets.)
or
Alternatively it is equal to Working Capital plus
not be excluded.
Capital Employed = Share CapiNon-current Assets. The term Operating Profit
(d) Investments made outside business
tal + Reserves and Surplus +
means profit before interest and tax.
are to be excluded but those made
Long Term Loan - (Non-busiIn fact, the starting point of business budgeting
for bonafide purposes of the
ness Assets + Fictitious Assets)
should be’ the determination of minimum rate of
business are included.
Variations of the ROCE
Profit on Capital Investment which is then worked
(e)
All
stocks are included, valuating
(Return on Capital Employed)
backwards for planning the details of business
them
on a consistent basis,
(a) ROCE =
operations. This is the minimum return expected
generally at cost.
Net Profit after Taxes
on Capital Employed and in order to attract capital
X 100
to particular business, a fair return has to be paid. (f) Trade debtors are included after
Capital Employed
taking into account provision for bad
There is hardly any criterion for determining the
(b) ROCE =
debts.
Net Profit after Taxes
(g) Any balance at bank in excess of
+ Interest
the normal requirements of business
X 100
may be excluded.
Sr. Name of the
No.
Ratio
III. Composite Ratios
Ratio Analysis
NOTES
Check Your Progress
Give the formula for
calculating following Ratios.
(1) Gross Profit Ratio
(2) Expenses Ratio
(3) Operating Ratio
(4) Operating Profit Ratio
(5) Net Profit Ratio
Management Accounting - I
127
128 Management Accounting - I
2
Net Profit after Taxes+Interest
Capital Employed
X 100
(d) ROCE =
Operating Profit
X 100
Capital Employed
Average Capital Employed =
Average Employed at the
begining of the year + Capital
Employed at the end of the
year.
(c) ROCE =
Formula for Calculation of Ratio
2. Return on
Net Profit after Interest
and Taxes
Proprietor’s Fund
Shareholder’s Funds X 100
or
The term ‘Net Profit’ here
means, Net Income after
Return on
Interest and Taxes. It is
Shareholder’s
different from ‘Net Operating
Profit’.
Investments
The
Shareholder’s Funds will
or
includes Equity Share Capital,
Return of Total
Preference Share Capital, Share
Premium and Reserves and
Shareholder’s
Surplus less Accumulated
Equity
Losses.
Name of the
Ratio
Composite Profitability
Types of Ratio
according to
Nature Function
This ratio shows how well the firm has used the
resources of the owners. This ratio is a measure
of the profitableness of an enterprise. The
realisation of satisfactory Net Income is the major
objective of a business and the ratio shows the
extent to which this objective is being achieved.
This ratio should be compared with the ratio of
similar companies. The Shareholder’s Equity also
refer to the Net Worth of a firm.
minimum return with reference to which Return
on Capital Investment may be judged. Return on
Capital Employed is the only measure which can
be said to show satisfactory, the overall
performanace of an undertaking from the
standpoint of profitibility. It enables the
management to show wheather the funds
entrusted to it have been property used or not.
Thus, it can become an itegral part of budgetary
control system in order that management may
able to follow the progress being made and to
take corrective action, if necessary.
Significance
Alonwith this ratio (a) Return on Assets
and (b) Return on Capital Employed should
also be useful for meaningful financial
analysis.
Precutions
NOTES
Sr.
No.
III. Composite Ratios (Continued from previous page)
Ratio Analysis
Formula for Calculation
of Ratio
Equity Share Capital
(EPS Ratio)
Earning per
Share Ratio
or
Number of Equity Shares
X 100
4. Earning per Net Profit (after taxes and
Eqity Share
preferential dividend)
will include : Paid-up Share
Capital (Equity) + Share
Premium + Reserve and
Surplus Less Accumulated
Losses.
X 100
Common EqEquity Shareholder’s Funds
uity
or
3. Return on Eq- Net Profit (after taxes and
uity Capital
preferential dividend)
Sr. Name of the
No.
Ratio
Significance
Precutions
available to Equity Shareholders or how
much return they earn per share. It is used
to compare the performanace of a company
with higer rate of return, will have greater
demand in the market resulting
Composite Profitability This ratio shows percentage of profit
While adopting EPS Ratio, it should
also be remembered that if there is
any increase in EPS ratio it should not
be taken to mean an increase in the
profitability of a firm, since retained
earnings might have been utilised for
payment of dividend. Another demerit
of EPS ratio is that it
Composite Profitability The profitability from the point of view of the Acutally this ratio is very useful to the
Euqity Shareholders will be judged after taking investors. It helps the investors to take
into account the amount of divident payable to
buying decisions.
Preference Shareholders.
This is one of the most important relationship in
Ratio Analysis. Obtaining a satisfactory return is
the most desirable objective of a business. The
ratio of Net Profit to Owner’s Equity reflects the
extent to which this objective has been
accomplished. This ratio is thus, of great interest
to present as well as prospective shareholders
and also of great concern to management, which
has the responsibility of maximising the owner’s
welfare.
The Return of Owner’s Equity ofthe company
should be compared to the ratio of other similar
companies and the industry average. This will
indicate the relative performanace and strength
of the company in attracting the prospective
investors.
Types of Ratio
according to
Nature Function
III. Composite Ratios (Continued from previous page)
Ratio Analysis
NOTES
Management Accounting - I
129
130 Management Accounting - I
Formula for Calculation of Ratio
Types of Ratio
according to
Nature Function
Significance
in increase in the market value. This ratio is
adopted to known the Return to shareholders
on the Capital Employed. According to this,
the Earning Net Profit (after tax and pref.
dividend) as numerator and number held by
the shareholders as denominator. EPS is a
popular ratio, as it measures the profitability
of a frim from the owner’s stand point. Like
other profitability ratios, this ratio should also
be compared with that of similar firms,
industry average and also over a period of
time.
5. Price Earning Market Price per Equity Share Composite Profitability The Price Earning Ratio is widely used by
Earning Per Equity Share
the security analyst to evaluate the firm’s
Ratio
.
performance as expected by the investors.
or
It indicates investor ’s judgement or
expectation of the firm’s performance.
PER Ratio
Management is also interested in this method
of market appraisal of the firm’s
or
performance and would like to find the causes
P/E Ratio
if the P/E Ratio declines. As a rule, higher
the P/E Ratio, the better it is for the Equity
Shareholders.
Name of the
Ratio
While estimating the earnings, only
normal earnigs associates with the
existing assets alone are considered.
demerit of EPS ratio is that it does not
clearly discloses as to what portion of
profits have been paid to the owners as
a dividend and what portion has been
retained in the business. This only
represents how much of the profit
belong to the Equity Shareholders rather
theoretically.
Precutions
NOTES
Sr.
No.
III. Composite Ratios (Continued from previous page)
Ratio Analysis
Formula for Calculation
of Ratio
Types of Ratio
according to
Nature Function
Significance
6. Earning Price Earning Per Equity Share
Composite Profitability This ratio is reciprocal or complementary of
Ratio
P/E Ratio.
Market Price
or
As low percentage may reflect a high rate of
per Equity Share
X 100
EP Ratio
growth in the past.
or
Earning Yield
Ratio
Composite Profitability This ratio is also known as Payout Ratio. It
7.
Divident
Total Dividend Paid to
measures the relationship between the
Payout
Equity holders
earnings
belonging to the Equity holders and
Ratio
Total Net profit belonging
dividends
actually paid to them. Precisely the
or
to Equity holders
D/P ratio expenses what percentage share
Payout Ratio
X 100
of Net profit after taxes and Preference
or
or
Dividend is paid out as divdidend to the Equity
D/P Ratio
Shareholders. This ratio is computed by
Dividend
dividing the Total Dividends paid to Equity
Per Share (DPS)
holders by the Total Profits belonging to them.
Earning
The D/P Ratio is popular ratio. A cmparison
Per Share (EPS)
of this ratio with that of similar firms, industry
X 100
average and over years, would reflect on the
adequacy or otherwise of dividend paid to
the equity holders. This ratio also indicate
another important aspect. It throws light on
Sr. Name of the
No.
Ratio
III. Composite Ratios (Continued from previous page)
Many companies after attaining a stage
would like to utilities the Self-Generated
Funds or Self Reliance Funds (i.e.
Retained Earnings) for expansion by
capitalising these funds. The Retained
Earning can be built up over a period, if
company follows a conservative
dividend policy. Hence the less payout
of the shareholders.
Besides indicating the genreal level of
market dividend yield reflects the
market estimates of future dividend
growth and risk. The higher the
dividend growth expedations for given
share the lower the current - yield, the
higher the markets estimate of risk the
higher the current yield.
Precutions
Ratio Analysis
NOTES
Management Accounting - I
131
132 Management Accounting - I
Ratio
8. Dividend Yield
Name of the
Ratio
Types of Ratio
according to
Nature
Function
the aspect of Retianed Earning. When the
dividend payout is high the Retained Earning
will be less and this means less internal finance.
The finance decision of the companies vary.
The Payout Ratio indicates whether the dividend
paid is high or loss and on this basis the firm
can decide whether it has to change its dividend
payout decision with a view to increasing the
Retained Earnings.
Significance
Precutions
Dividend per Equity Share
It means he will get the dividend @ 25 % on
his investment. The dividend yield is calculated
by dividing the Cash Dividends per Equity
Share by the market value per share.
pay Rs. 200 and on Rs. 200 he will get dividend
of Rs. 50.
Composite Profitability As the market price is different from face value Besides indicating the genral level of
and paid up value of equity share the rate of market, dividend yield reflects the
Market Price per Equity Share
return of the investor cannot be equal to the market estimates of future dividend
.
X 100
rate of dividend declared by the company. growth and risk. The higher the dividend
Suppose, the company had declared 50% growth expectations for given share, the
dividend on its Equity Shares of Rs. 100 each
lower the current yield, the higher the
and if the market price of the share is Rs. 200,
market’s
estimate of risk, the higher the
the purchaser of the share will have to pay Rs.
current
yield.
200, the purchaser of the share will have to
Formula for Calculation of Ratio
NOTES
Sr.
No.
III. Composite Ratios (Continued from previous page)
Ratio Analysis
Debtors
Turnover
Ratio
or
Receivable
Turnover
Ratio
or
Debtors
Velocity
(b) Debt Collection Period
Ratio
or
Average
Collection
Period Ratio
9.
(a)
Sr. Name of the
No.
Ratio
Types of Ratio
according to
Nature Function
Significance
Debtors contribute an important elements of
Accounts Receivables
Composite Profitability Current Assets and therefore, the quality of debtors
to a great extent determines the liquidity of a firm.
Average Daily Sales
Two ratios are used by a Financial Analyst to judge
or
the liquidity of a firm :
Accounts Receivables
X 365
(a) Debtors Turnover Ratio.
Net Sales
(b)
Debts collection period or
Credit Sales (Net)
Average collection period.
Average Debtors
(a) Debtors Turnover Ratio indicates the
Accounts Receivables includes
efficiency of the staff in-charge of the collection
Trade Debtors and Bills Receivof back debts. The higher the value of the debtors
ables
turnover, the more efficient is the management of
Months (or days) in a year
receivables.
The ratio should be compared with
OR
Debtors Turnover
ratio of similar firms and industry average to get a
Average Accounts Receivable
better picture of the quality of debtors. The ratio
also helps in Cash Budgeting since the flow of
Net Credit Sales
cash from customers can be estimated on the basis
for the year
of estimated sales.
X Months (or days) in a year
(b) This ratio indicates the number of times the
or
debtors turn each year. It also indicates the
Accounts Receivable
collection period of debtors. A high turnover is
Average (monthly or daily)
considered to be good as there will be better cash
Credit Sales (Net)
flow. If the collection period is shorter, the quality
of debtors
Formula for Calculation
of Ratio
III. Composite Ratios (Continued from previous page)
The collection period, however, has to be
compared with the standards and the
standard being the industry turnover.
When compared to the industry turnover,
if the ratio is low, it means that the firm is
not collecting the debts regularly. However
hard and fast rules cannot be adopted as
far as credit sales policy is concerned. The
firm should strike a balance between
rigidity and liberalization. Then only a
normal collection period prevails.
Many other factors, such as business
environment, outlook of the management,
the pricing policy, the nature of the product
sold etc. also decide the credit sales policy
and credit sales policy dicides the Debtors
Turnover Ratio.
Precutions
Ratio Analysis
NOTES
Management Accounting - I
133
134 Management Accounting - I
Turnover Ratio
Inventory
or
Ratio
10. Stock Turnover
Name of the
Ratio
Average Inventory at Cost
or
Net Sales
2
Opening Stock + Closing Stock
Average Inventory at at
Selling Price*
(Where cost of goods sold is not
available, Net Sales are taken.)
* Average Inventory of Stock=
.
Cost of goods sold
Note : In case credit sales
figure is not given, total
sales figure can be used to
compute Receivable Turnover.
Formula for Calculation of Ratio
will be good and this means the debtors promptly
pay their dues. The scope of bad debts will be
less. 40 to 60 days are usually considered as
normal ratio and the quality of the debts will be
good. If the turnover is low the cash in flows
will be slow and the quality of debts will not be
good. Change in the ratio indicates changes in
the company’s credit policy or changes in its
ability to collect its receivables.
The main objectives ofthe comparision implied
in the Debtors Turnover Ratio, is to learn how
old the accounts are and partly to learn how fast
cash will flow from their collections.
Significance
1,00,000 1,50,000
10,000
15,000
10 : 1
10 : 1
Precutions
Stock Rs.
Ratio
Working
Capital Rs.
by any unit and the reasonableness of the same. Sales : Rs
2,50,000
25,000
10 : 1
12.500
12,500
12,500
Composite Profitability This ratio relates the cost of good’s sold during The relation is between variables. If
a given period to the average inventory; This both items (Net Sales and Stock)
ratio helps in determining the liquidity of a increase in the same proportion the ratio
business concern in as much as it indicates remain unchanged and a situation may
the rate at which the inventory are converted develops that may inadveantly lead to
into sales and into cash ultimately. This ratio
bad financial condition. For Example
also throw light on the inventory policy pursued
Types of Ratio
according to
Nature Function
NOTES
Sr.
No.
III. Composite Ratios (Continued from previous page)
Ratio Analysis
Sr. Name of the
No.
Ratio
(If opening stock is not available,
closing stock is to be taken as
average stock.)
(The cost of goods sold refers to
goods sold-gross profit).
Formula for Calculation
of Ratio
Types of Ratio
according to
Nature Function
A high inventory Turnover Ratio is good from the
liquidity point of view. On the other hand, a low
ratio would indicate that the inventory does not
move fast and remains in warehouse for a longer
time.
A too high inventory turnover may be the result of
a very low level of inventory which results frequent
stock outs. The turnover will be very high if the
firm replenishes its inventory in too many small lot
sizes. The situations of frequent stock-outs and
too many small inventory ratios need to be
investigated into further. The computation of the
inventory Turnover Ratios for the individual
components of inventory may help the
management in detecting the imbalance
investments in various inventory components.
An Inventory Turnover Ratio, standing by itself,
means absolutely nothing because there is no fixed
norm for turnover. To give meaning to turnover
figure one must compare it with other such figures
so that a comparative analysis with industry or
over a time is possible.
Significance
III. Composite Ratios (Continued from previous page)
Though the ratio is constant for 3 years,
inventory may prove excessive for size of
business and could ultimately resul in
bankruptcy. In order to discem this danger
point this ratio must be supplemented by
the Ratio of Inventory to Working Capital.
While employing Inventory Turnover
Ratio, the following factors must be kept
in mind :
(i) Seasonal conditions
(ii) Supply conditions
(iii) Price trends and
(iv) Trend of volume of business
This ratio is combination of several factors.
The figures down from financial
statements are subject to change as time
passes the time value concept will notice
considered at the time of computing ratio.
Precutions
Ratio Analysis
NOTES
Management Accounting - I
135
Ratio
Creditors
Turnover
11.
136 Management Accounting - I
Name of the
Ratio
Credit Purchaes
Average Creditors*
(*Average Creditors are obtained by adding closing
creditors to opening creditors and dividing the same
by two).
In absesce of detailed information the following formula
can be adopted :
Total Credit Purchases
Closing Creditors
Alternative Method :
Creditos
x 365
Credit Purchases (or 360
days)
Formula for Calculation of Ratio
Types of Ratio
according to
Nature Function
Composite
Activity
This ratio reveals the number of times the
creditors turn on the average each year. This
tells at what speed the creditors are paid. If
the payment to creditors is delayed the firm
sometimes may have to bear burden of debt
service charges. This ratio can be computed
as per firmst method, when the information
regarding Credit Purchases, Opening and
Closing balances of creditors are available.
In absence of the detailed information as said
earlier, the alternative formula can be
adopted to compute the ratio.
From the stand point of liquidity and solvency
if longer credit period is allowed by the
creditors the firm will be in an advangeous
position the safety period is 60 to 90 days.
The creditworthiness of the firm is also
established by the ratio. The firm can pay
promptly to its creditors if the payment time
is property adjusted. The ratio will tell
whether the time period is normal or not.
Significance
This ratio is combination of several
factors. The figures drawn from
financial statements are subject to
change as time passes. The ‘time value
concept’ will not be considered at the
time of computing ratio.
Precutions
NOTES
Sr.
No.
III. Composite Ratios (Continued from previous page)
Ratio Analysis
(b)
Total Assets
Turnover Ratio
of times
Some analysts exclude intangible assets. In such case ratio
should be :
Sales
Total Tangible Assets
Sales
Total Assets*
Sales
Net Fixed Assets
12. Fixed Assets
(a) Turnover Ratio
X Number
Formula for Calculation
of Ratio
Sr. Name of the
No.
Ratio
The ratio indicates the efficiency in the
utilisation of Fixed Assets. This ratio also
indicates whether the Fixed Assets are being
fully utilised. It is an important measure of
the business. A high ratio is na index of the
overtrading, a low ratio suggestt idle capacity
and excessive investment in Fixed Assets.
Generally, a standard ratio is taken as five
times.
Not only fixed are directly concern with the
generation of sales, but other assets also
contribute to the production and sales activity
of the firm. The firm must manage its Total
Assets efficiently and should generate
maximum sales through their proper
utilization.
Activity
Activity
Composite
Significance
Composite
Types of Ratio
according to
Nature Function
III. Composite Ratios (Continued from previous page)
The analyst should be cautious in
deriving conclusions from the Fixed
Assets Turnover Ratio to obtain Fixed
Assets Turnover Ratio, sales are
divided by depreciated value of Fixed
Assets. Hence as with the Fixed
Assets Turnover Ratio, the Total
Assets Turnover Ratio should be
cautiously used. In the denominator of
this ratio assets are net of depreciation.
Therefore, older assets with lower book
value may create a misleading
impression of high turnover.
Precutions
Ratio Analysis
NOTES
Check Your Progress
Give the formula for
calculating following Ratios.
(i)
Return on Total Assets
Ratio
(ii)
Return on Proprietor’s
Fund
(iii) Return
Capital
(v)
of
Equity
(iv) Earning per share Ratio
(vi) D/P Ratio
P/E Ratio
(vii) Dividend Yield Ratio
(viii) Stock Turnover Ratio
Management Accounting - I
137
Ratio Analysis
FORMULAE TO REMEMBER
Ratios
NOTES
1) Current Ratio
2) Net Working Capital Ratio
3) Quick Ratio
Current Assets
Current Liabilities
Net Working Capital
Net Assets
Quick Assets
Liquid Liabilities
4) Cash Position Ratio
Cash (+) Marketable Securities
Liquid Liabilities
5) Proprietary Ratio
Shareholders’ Fund
Total Asset (or) Total Resources
6) Solvency Ratio
Outside Liabilities
Total Assets
7) Fixed Assetts to Proprietors Fund Ratio
Fixed Assets
Proprietors’ Funds
8) Current Assets to Proprietors’ Fund Ratio
Current Assets
Proprietors’ Funds
9) Capital Gearing Ratio
10) Debt-Equity Ratio
Fixed Interest Bearing Funds
Equity Share Capital
External Equities Outsiders Funds
or
Internal Equities Shareholders Fund
11) Fixed Assets to Current Assets
Fixed Assets
Current Assets
12) Reserves to Equity Capital Ratio
Revenue Reserve
Equity Capital
13) Gross Profit Ratio
14) Operating Ratio
15) Material Consumed Ratio
16) Conversion Cost Ratio
17) Particular Expense Ratio
Gross Profit
Net Sales
X 100
Cost of Goods Sold (+) Operating Exp.
X 100
Net Sales
Material Consumed
Net Sales
X 100
Cost of Goods Sold (-) Operating Exp.
Net Sales
Particular Expense
Net Sales
X 100
18) Net Profit Ratio
Net Profit
Net Sales
X 100
19) Return on Assets
Net Profit
Total Assets
X 100
20) Return on Capital Employed
138 Management Accounting - I
Formulae
Operating Profits
Capital Employed
X 100
21) Return on Shareholders’ Equity
22) Stock Turnover Ratio
Net Profit
Shareholder’s Fund
X 100
Cost of Goods Sold (or) Net Sales
Average Inventory
23) Debtors Turnover Ratio
Total Sales
Credit Sales
(or)
Closing Debtors
Average Debtors
24) Debt Collection Period
Months (or) days in a year
Debtors Turnover
25) Creditors Turnover Ratio
Net Credit Purchases
Average Accounts Payable
26) Average Payment Period
27) Working Capital Turnover Ratio
Accounts Payable
Net Credit Purchases
Cost of Sales
Net Working Capital
Cost of Sales
Net Fixed Assets
29) Total Capital Turnover
Cost of Sales
Total Capital Employed
30) Capital Turnover
Cost of Sales
Capital Employed
31) Interest Coverage
EBIT
Fixed Interest Charges
33) Equity Shareholders’ Coverage
34) Earning per Equity Shares
Net Profit after Tax and Interest
Preference Dividend
Net Profit
after Interest,
Tax and Pref. Dividend
Equity Dividend
Profits available for Equity Shares
Number of Equity Shares
35) Dividend Yield
Dividend Per Share
Market Price per Share
36) Price Earning Ratio
Market Price of a Share
Earning per Share
37) Fixed Interest Coverage
38) Dividend Per Share
39) Dividend Payout Ratio
NOTES
X 365
28) Fixed Assets Turnover
32) Dividend Coverage
Ratio Analysis
Operating Income
Annual Interest Expenses
Dividend Paid to Equity Shareholders
Number of Equity Shares
Dividend Per Share
Earning Per Share
The concept of Ratio Analysis can be unders food with the help of following illustrations.
Management Accounting - I
139
Ratio Analysis
6.9 Illustrations
ILLUSTRATION 1
NOTES
From the following Balance-Sheet Ashoka Ltd., Akola calculate the following
ratios :
i) Current Ratio
ii) Liquid Ratio
iii) Absolute Liquidity Ratio iv) Current Assets to Fixed Assets Ratio
v) Debt to Equity Ratio
vi) Proprietory Ratio
vii) Capital Gearing Ratio and viii) Fixed Assets Ratio
Balance Sheet as on 31st March 2014
Liabilities
Equity Capital
6 % Pref. Capital
General Reserve
Profit and Loss
Provision for Taxation
Bills payable
Bank Overdraft
Sundry Creditors
12 % Debenture
Assets
`
10,00,000
5,00,000
1,00,000
4,00,000
1,76,000
1,24,000
20,000
80,000
5,00,000
Goodwill (At cost)
Plan and Machinery
Land and Buildings
Furniture
Inventories
Bills Receivable
Sundry Debtors
Bank
Investment (Short-Term)
29,00,000
`
5,00,000
6,00,000
7,00,000
1,00,000
6,00,000
30,000
1,50,000
2,00,000
20,000
29,00,000
SOLUTION
i)
Current Ratio
Current Assets
= Current Liabilities
=
=
` 10,00,000
` 4,00,000
2.5 : 1
Note : Current assets include investories, sundry debtors, bills receivable, bank
balance and short-term investments. Current liabilities include sundry creditors,
bill payable, bank overdraft, provision for taxetion etc.
Liquid Assets
ii) Liquid Ratio
=
Liquid Liabilities
Liquid Assets
= Current Assets (-) Stock
Liquid Liabilities
= Current Liabilities (-) Bank Overdraft
` 10,00,000 (-) ` 6,00,000
=
` 4,00,000 (-) ` 20,000
=
` 4,00,000
` 3,80,000
= 1.05 : 1
iii) Absolute Liquidity Ratio
=
=
140 Management Accounting - I
Cash at Bank + Short - Term Investment
Current Liabilities
` 2,20,000
` 4,00,000
= 0.55 : 1
iv) Current Assets to Fixed
Assets
=
=
Ratio Analysis
Current Assets
Fixed Assets
` 10,00,000
` 19,00,000
= 0.526 : 1
Note : Fixed assets include Goodwill, Plant and Machinery, Furniture and Land
and Building.
v) Debt to Equity Ratio
NOTES
= i) Long-term Debt
Shareholders Fund
` 5,00,000
=
` 10,00,000 (+) ` 5,00,000 (+) ` 1,00,000 (+) ` 4,00,000
Equity
Capital
=
Pref.
Capital
General
Reserve
Profit and
Loss Account
` 5,00,000
` 20,00,000
= 0.25 : 1
ii)
=
=
Long-term Debt
Long-term Debt (+) Shareholders Funds
` 5,00,000
` 5,00,000 (+) ` 20,00,000
` 5,00,000
` 25,00,000
= 0.20 : 1
vi) Proprietary Ratio
=
Shareholders Funds
Total Assets
= ` 20,00,000
` 29,00,000
= 0.69 : 1
vii) Capital Gearing Ratio
=
=
Fixed Interest bearing securities
Equity Capital (+) Reserves and Surplus
` 10,00,000 i.e.[ ` 5,00,000 Pref.+ ` 5,00,000 Deb.]
` 10,00,000 + ` 5,00,000
=
` 10,00,000
` 15,00,000
= 0.66 : 1
viii) Fixed Assets Ratio
=
Fixed Assets
Capital Employed
=
` 19,00,000
` 25,00,000
= 0.76 : 1
Management Accounting - I
141
Ratio Analysis
ILLUSTRATION 2
Bharat Machines Co. Ltd., Banaras submits the following Profit and Loss Account
for the year ended 31st March 2014
Profit and Loss Account for the year ended on 31st March 2014
NOTES
Dr.
Cr.
Particulars
To Opening Stock
To Purchases
To Wages
To Manufacturing
Expenses
To Gross Profit C/D
To Selling Expenses
To Admin. Expenses
To Loss by Fire
To Loss on sale of Furniture
To Net Profit C/D
Particulars
`
`
52,00,000 By Sales
1,60,00,000 By Closing Stock
48,00,000
32,00,000
3,20,00,000
76,00,000
1,04,00,000
3,96,00,000
8,00,000 By Gross Profit B/D
45,60,000 By Profit on sale of
Shares
2,40,000
1,60,000
56,00,000
1,13,60,000
3,96,00,000
1,04,00,000
9,60,000
1,13,60,000
Calculate : i) Gross Profit Ratio ii) Net Profit Ratio iii) Operating Profit Ratio iv)
Operating Net Profit Ratio.
SOLUTION
i)
Gross Profit Ratio
=
Gross Profit
Sales
=
` 1,04,00,000
` 3,20,00,000
X 100
X 100
= 32.5 %
ii)
Net Profit Ratio
=
=
Net Profit
X 100
Sales
` 56,00,000
X 100
` 3,20,00,000
= 17.5%
Cost of Goods Sold (+) Operating Expenses
iii) Operating Profit Ratio
=
=
Sales
` 2,16,00,000 (+) ` 53,60,000
` 3,20,00,000
X 100
X 100
= 84.25%
iv) Operating Net Profit Ratio
142 Management Accounting - I
=
Operating Net Profit
X 100
Sales
=
` 56,00,000 (+) ` 1,60,000 (-) ` 9,60,000
= 15 %
` 3,20,00,000
X 100
Ratio Analysis
ILLUSTRAION 3
The following are summarised Profit and Loss Account for the year ending 31st
March 2014, and the Balance-Sheet as on that date of Cifco Ltd., Chennai.
Profit and Loss Account for the year ended 31st March 2014
Dr.
Cr.
Particulars
Particulars
`
To Opening Stock
10,000 By Sales
To Purchases
55,000 By Closing Stock
To Gross Profit C/D
50,000
1,00,000
15,000
1,15,000
To Admin. Expenses
1,15,000
15,000 By Gross Profit B/D
To Interest
NOTES
`
50,000
3,000
To Selling Expenses
12,000
To Net Profit C/D
20,000
50,000
50,000
Balance Sheet as on 31st March, 2014
Liabilities
Share Capital
Assets
`
1,00,000
`
Land and Buildings
50,000
(@ ` 10 each)
Profit and Loss
20,000
Plant and Machinery
30,000
Creditors
25,000
Stock
15,000
Bills Payable
15,000
Debtors
15,000
Bills Receivable
12,500
Cash and Bank
17,500
Furniture
20,000
1,60,000
Additional Information :
1,60,000
`
Average Debtors
12,500
Credit Purchases
40,000
Credit Sales
80,000
Calculate : i) Stock Turnover Ratio, ii) Debtors Turnover Ratio, iii) Creditors
Turnover Ratio, iv) Working Capital Turnover Ratio, V) Sales to Capital Employed,
vi) Return on Shareholders Funds, vii) Gross Profit Ratio, viii) Net Profit Ratio,
ix) Earning Per Share, x) Operating Ratio.
Management Accounting - I
143
Ratio Analysis
SOLUTION
i)
Stock Turnover Ratio
=
=
NOTES
=
Cost of Goods Sold
Average Stock
` 50,000 i.e. (Sales (-) Gross Profit)
` 10,000 (+) ` 15,000/2
X 100
` 50,000
` 12,500
= 4 times
ii)
Debtors Turnover Ratio
=
=
Credit Sales
Average Debtors
` 80,000
` 12,500
= 6.4 times
iii) Creditors Turnover Ratio
=
Credit Purchases
Average Accounts Payable
=
` 40,000
` 40,000 i.e. (Creditors (+) Bills Payable)
= 1 time
iv) Working Capital Turnover
Ratio
=
=
Sales
(
(
Working
Working
Current
(+)
(-)
Capital
Capital
Liabilities
Rs. 1,00,000
Rs. 20,000
= 5 times
v) Sales to Capital Employed
=
=
Sales
Capital Employed
` 1,00,000
` 1,00,000 (+) ` 20,000
Equity Capital
=
x 100
Profit and Loss Account
` 1,00,000
` 1,20,000
= 0.83 : 1
vi) Returns on Shareholders Funds =
=
Net profit
x 100
Shareholders Funds
` 20,000
x 100
` 1,20,000
= 16.67 %
vii) Gross Profit Ratio
144 Management Accounting - I
=
Gross proffit
x 100
Sales
=
` 50,000
x 100
` 1,00,000
= 50 %
viii) Net Profit Ratio
=
` 20,000
` 1,00,000
=
ix) Earning Per Share
Ratio Analysis
Net profit
x 100
Sales
x 100
=
20 %
=
Net profit
Number of Equity Shares
=
` 20,000
` 10,000
NOTES
= `2
x) Operating Ratio
=
Operation
Cost of
(+)
Expenses
Goods Sold
Sales
=
` 50,000 (+) ` 27,000
` 1,00,000
x 100
x 100
= 77%
ILLUSTRATION 4
The summarised Balance Sheet of David Green Ltd., Dombivali as on 31st
March 2012, 2013 and 2014 are given below :
Balance Sheet as on 31st March ----Liabilities
Paid-up Capital
Long-Term Borrowings
i) From Banks
ii) From Other
Current Liabilities
(+)
Assets
Net Block
Current Assets
Profit and Loss Account
(+)
2012
194
2013
194
2014
194
68
281
52
595
2012
286
143
166
97
343
54
688
2013
261
199
228
127
376
99
796
2014
239
234
323
595
688
796
Calculate the following ratios for the three years :
i)
Debt Equity Ratio
ii)
Current Ratio
iii) Fixed Asset Ratio
iv)
Proprietary Ratio
Management Accounting - I
145
Ratio Analysis
SOLUTION
Particulars
31.3.2012
Long-term debt
i) Debt Equity Ratio = Shareholders
equity funds
` 394
= `194 - `166
31.3.2013 31.3.2014
Negative Negative
` 349
NOTES
= `28
= 12.46
Current Assets
` 143
ii) Current Ratio = Current Liabilities = ` 52
=
= 2.75 : 1
iii) Fixed Asset Ratio =
iv) Proprietary Ratio =
Fixed Assets
*Capital
Employed
Shareholders Funds
Total Assets
` 199
` 234
` 54 = ` 99
= 3.685 : 1 = 2.36 : 1
` 286
` 261
` 239
= ` 377
= ` 406
= ` 374
= 0.76 : 1
= 0.64.1
= 0.639.1
Negative
Negative
` 28
= ` 429
= 0.652 : 1
* Capital employed = Paid-up capital + Long-term borrowing - Profit and Loss
Account (Debit balance)
ILLUSTRATION 5
Abstract of financial information of Elite Co. Ltd., Edlabad for three years are
given below :
Particulars
Gross Profit
Stock Turnover
Average Stock
Average Debtors
Income Tax Rate
Net Income after tax as % sales
Maximum credit period allowed
to the customers
31.3.2012
31.3.2013
31.3.2014
36 %
20 Times
Rs. 38,400
Rs. 87,500
50 %
6%
60 Days
33 1
30 %
14 Times
Rs. 70,000
Rs. 2,00,000
50 %
12 %
30 Days
3%
25 Times
Rs. 36,000
Rs. 1,68,750
50 %
7%
60 Days
Required :
i) A statement of profits in comparative form for three years.
ii) Evaluate the position of the company regarding profitability and liquidity
on the basis of information available.
iii) What additional information will you require to evaluate fully the position
of company on the liquidity front ?
146 Management Accounting - I
SOLUTION
i)
Ratio Analysis
Income Statement for the year ended....
Particulars
31.3.2012
31.3.2013
31.3.2014
`
`
`
12,00,000
13,50,000
14,00,000
7,68,000
9,00,000
9,80,000
4,32,000
4,50,000
4,20,000
2,88,000
2,61,000
84,000
1,44,000
1,89,000
3,36,000
72,000
94,500
1,68,000
72,000
94,500
1,68,000
Sales
Less : Cost of Goods Sold

(-)
Gross Profit
Less : Operating Expenses

Profit Before Tax
Less : Taxes

(-)
(-)
Profit After Tax
NOTES
Working Notes :
Particulars
Cost of Goods Sold
31.3.2012
20 X ` 38,400
Stock Turnover X Average Stock = ` 7,68,000
Cost of goods sold as % of Sales
Sales
Net Income as % to Sales (given)
64 %
` 12,00,000
6%
31.3.2013
31.3.2014
25 X ` 36,000
14 X ` 70,000
= ` 9,00,000
= ` 9,80,000
66 2 3%
` 13,50,000
7%
70 %
` 14,00,000
12 %
Net Income / PAT
` 72,000
` 94,500
` 1,68,000
Profit Before Tax
` 1,44,000
` 1,89,000
` 3,36,000
` 2,61,000
` 84,000
Operating Expenses
(Gross Profit (-) Profit BeforeTax) ` 2,88,000
ii)
From the above statements it is quite clear that the profitability of the
company is increasing quite consistently. From 6 % in the year 2011-12 it
has gone up to 7 % in 2012-13 and upto 12% in 2013-14. However, stock
turnover ratio which was 20 times in 2011-12 has slumped to 14 times in
2013-14 after going upto 25% in 2007-08. This needs improvement for
improving liquidity position.
The debtors turnover ratio was 13.7 times in first year and 8 and 7
times respectively in the second and third year (Sales ÷ Average Debtors)
which has also gone down and needs to be improved. It should also be
noted that debtors turnover ratio is decreasing inspite of reducing credit
allowed to debtors in the third year. This suggest that collection policy needs
to be tightened.
iii)
In order to evaluate the position of the company regarding liquidity fully,
current liabilities and current assets should also be made available.
Management Accounting - I
147
Ratio Analysis
ILLUSTRATION 6
From the following information, prepare Balance-Sheet of Finolex Ltd.,
Faizpur as on 31st March 2014 with as many details as possible.
i)
Current Ratio = 2.5 : 1.
ii)
Liquid Ratio = 1.5 : 1.
iii)
Working Capital = ` 60,000
iv)
Reserves and Surplus = ` 20,000
v)
Bank Overdraft = ` 10,000
vi)
Fixed Assets to Proprietor’s Funds = 0.75
vii)
There are no long term liabilities or fictitious assets.
NOTES
SOLUTION
The Balance Sheet can be prepared with the help of the following working
notes :
i)
Working Capital
= ` 60,000 i.e.
Current Assets (-) Current Liabilities
Therefore, Current Assets (-) Current Liabilities = ` 60,000
or
2.5 (-)
= ` 60,000
(Current Ratio is 2.5 which means Current Assets are 2.5 times of Current Li
abilities).
or
1.5
= ` 60,000
1
= ` 40,000
Therefore, Current Liabilities
= ` 40,000
Current Assets are 2.5 X ` 40,000 = ` 1,00,000.
ii) To find out Liquid Current Assets, the following calculations can be made :
Liquid Ratio = 1.5 : 1
1.5
Liquid Current Assets
= Current Liabilities (-) Bank Overdraft
=
Liquid Current Assets
` 40,000 (-) ` 10,000
= 1.5 x ` 30,000 = Liquid Current Assets
Liquid Current Assets
148 Management Accounting - I
= ` 45,000
But, Current Assets (-) Stock
= Liquid Assets
But, Current Assets (-) Stock
= Liquid Assets

= ` 45,000
` 1,00,000 (-) Stock
Stock
= ` 55,000
iii)
Fixed Assets to Proprietor’s Funds = 0.75 : 1 which means that out of
proprietor’s funds, 75 % amount is invested in Fixed Assets. This suggests
that remaining 25 % of Proproietor’s Funds are invested in the Working
Capital.

25 %
= ` 60,00,000 i.e. Working Capital

100 %
= ` 2,40,000 (-) Proprietor’s Funds
Fixed Assets
Proprietor’s Funds
Ratio Analysis
NOTES
= 75 % = ` 1,80,000
= Share Capital (+) Reserves
= 2,00,000 (+) ` 40,000
= ` 2,40,000
Balance Sheet of A Ltd. as on 31st March 2014
Liabilities
Assets
`
Share Capital
`
2,00,000 Fixed Assets
Reserves and Surplus
40,000 Current Assets :
Current Liabilities :
Stock
Creditors
1,80,000
30,000
Other Current
55,000
(+) 45,000
1,00,000
Assets
Bank Overdraft
(+) 10,000
40,000
2,80,000
2,80,000
ILLUSTRATION 7
Using the following data, complete the Balance Sheet of Godrej Co., Gauhati
in the format given below :
Gross Profit : 20 % of Sales
` 60,000
Shareholders Funds
` 50,000
Credit Sales
80% of Total Sales
Total Assets Turnover
3 times
Inventory Turnover to Cost of Sales
8 times
Average collection period (360 days a year)
18 days
Current Ratio
Long-Term Debt to Equity
1.6
40 %
Management Accounting - I
149
Format of Balance Sheet of Godrej Co., Gauhati as on ......
Ratio Analysis
Liabilities
Creditors
Long-Term Debt
Shareholders Equity
Assets
Cash
Debtors
Inventory
Fixed Assets
`
-------
NOTES
---
`
-----------
SOLUTION
i)
Gross Profit is 20 % of Sales
= ` 60,000
Therefore,
= ` 3,00,000
Sales
But Cost of Sales
Cost of Sales
= Total Sales (-) Gross Profit
= ` 3,00,000 (-) ` 60,000
= ` 2,40,000
ii)
Inventory Turnover Ratio

= 8 times
8 =
Cost of goods sold
Average Inventory
=
` 2,40,000
Average Inventory
Average Inventory
= ` 30,000
Since Opening Stock is given ` 30,000 is taken as Closing Stock.
iii)
Total Assets Turnover = 3 times
3 times
=
iv)
vi)
` 3,00,000
Total Assets

Total Assets
= ` 1,00,000

Total Liabilities
= ` 1,00,000
Average collection period
= 18 days
360 days
18 days
= 20 times
Debtors Turnover Ratio
=
Debtors
=
Cost of Sales
v)
Sales
Total Assets
=
` 2,40,000
20
= ` 12,000
Debt-equity Ratio (long-term) = 40 %
Shareholders Funds
= ` 50,000
Debt 40 % of ` 50,000
= ` 20,000
Creditors
= Total Liabilities (-) Equity (-) Long-Term Debt
= ` 1,00,000 (-) ` 50,000 (-) ` 20,000
150 Management Accounting - I
= ` 30,000
vii) Current Ratio
=
1.6 x ` 30,000
Current Assets
` 30,000
= Current Assets
Current Assets
= ` 48,000
1.6

Current Assets
(Current Liabilities i.e. (Creditors)
viii) Fixed Assets
Ratio Analysis
=
NOTES
= Total Assets (-) Current Assets
= ` 1,00,000 (-) ` 48,000
= ` 52,000
Balance Sheet of Godrej Co., Gauhati as on -----Liabilities
Assets
`
`
Creditors
30,000 Cash
6,000
Long-Term Debt
20,000 Debtors
12,000
Shareholders Equity
50,000 Inventory
30,000
Fixed Assets
1,00,000
52,000
1,00,000
ILLUSTRATION 8
The following is the Balance Sheet of Hindustan Tool Ltd., Himmatpur, a
limited company as on 31st March 2014
Balance Sheet
Liabilities
Share Capital
Assets
`
2,00,000 Land and Buildings
`
1,40,000
Profit and Loss
30,000 Plant and Machinery
3,50,000
General Reserve
40,000 Stock-in-Trade
2,00,000
12 % Debentures
4,20,000 Debtors
Creditors
1,00,000 Bills Receivable
10,000
50,000 Bank Balance
40,000
Bills Payable
8,40,000
1,00,000
8,40,000
Calculate :
i) Current Ratio,
ii) Quick Ratio
iii) Inventory to Working Capital
iv) Debt to Equity v) Proprietary Ratio vi) Capital Gearing Ratio
vii) Current Assets to Fixed Assets
Management Accounting - I
151
Ratio Analysis
SOLUTION
i)
Current Ratio
NOTES
=
Current Assets
Average Liabilities
=
` 3,50,000
` 1,50,000
= 2.33 : 1
Note :
Current Assets
= Stock (+) Debtors (+) Bills Receivable
(+) Bank Balance
Current Liabilities
ii)
Quick Ratio
Note :
iii)
Liquid Current Assets
Inventory to Working Capital
= Creditors (+) Bills Payable
Liquid Current Assets
=
Liquid Current Liabilities
` 1,50,000
=
` 1,50,000
= 1:1
= Debtors + Bills Receivables + Bank Balance
Inventory
Working Capital
` 2,00,000
=
` 2,00,000
=
= 1:1
Note :
iv)
Working Capital
Debtor to Equity Ratio
Note :
Long-term Debt
Shareholder’s Funds
v)
Proprietory Raio
= Current Assets (-) Current Liabilities
Long-Term Debt
Shareholders Fund
` 4,20,000
=
` 2,00,000
=
= 1.55 : 1
= 12% Debentures
= Share Capital (+) Reseres (+) Profit
and Loss Account
=
Proprietor’s Fund
Total Assets
` 2,70,000
` 8,40,000
= 0.32 : 1
=
Note :
Proprietor’s Funds
= Share Capital (+) Reserve (+) Profit
and Loss Account
vi)
Capital Gearing Ratio = Fixed Income Bearing
=
` 4,20,000
` 2,00,000
= 0.32 : 1
152 Management Accounting - I
Securities *
Share Capital
(* 12% Debentures)
vii) Current Assets to Fixed Assets = Current Assets
Fixed Assets
= ` 3,50,000
` 4,90,000
= 0.71 : 1
Ratio Analysis
NOTES
6.10 Summary
• ‘Ratio’ is the quotient formed when one magnitude is divided by another mesured
in the same unit. A ratio is defines as “the indicated quotient of two mathematical
expressions”. the relationship between two or more things”. Ratio can be expressed
in two ways :
(i) Time & (ii) Percentage (iii) Proportion
• Factors must be considered while analysing the financial ratios :
(i) General economic condition of the firm ii) Risk acceptance iii) Future
Expectations iv) Future Opportunites v) Analysis and interpretaion system used
by other firms in the industry. (vi) Accounting system of the industry.
• Objectives of Ratio Analysis - (i) Interfirm Comparison and (ii) Inter Period
Comparison.
• Classification of Ratios - (A) Accordingly to the Nature of Items :- (i) Balance
Sheet Ratios (ii) Revenue statement or Profit and Loss Account Ratios & (iii)
Inter-statement or composit Ratios. (B) Accordingly to functions (Functional
classification); (i) Liquidity Ratios (ii) Leverage Ratios (iii) Activity Ratios & (iv)
Profitability Ratios.
6.11 Key Terms
(1) Ratio : Ratio is the indicated quotient of two mathematical expressions” and
so as the relationship between two or more things”.
(2) Liquidity Ratios : Liquidity Ratios measures the ability of a firm to meet its
short term obligations, and reflect its short term financial strength or solvency.
(3) Leverage Ratios : Leverage ratios ‘throw light on the long term solvency of
a firm.
(4) Activity Ratios : Such ratios are concerned with measuring the efficiency in
assets management.
(5) Profitability Ratios : The profitability of a firm can be measured by the
Profitability Ratios. Such ratios can be computed either from sales or investment.
Management Accounting - I
153
Ratio Analysis
NOTES
6.12 Questions And Exercises
I.
Objective Questions
A)
Multiple choice Questions
(1)
Prompt collection on account of book debts, ---- current ratio.
(a)
has no effect on
(b)
increases
(c)
decreases
(d)
adversly affect
(2)
Generally the ratio of shareholders equity to non-current assets should be...
(a) 2 : 1,
(b) 1 : 1,
(c) 1 : 2
(d) 1 : 3
(3)
Usually the ratio which is used to ascertain the soundness of the long term
financial position is -----
(a)
Current Ratio, (b) Net Profit Ratio,
(d)
Gross Profit Ratio
(4)
Low turnover of stock ratio indicates -----
(a)
Under investment in inventory
(b)
Total monopoly in inventary
(c)
Over investment in inventory
(d)
Solventy position
(c) Debt - Equity Ratio,
Ans : (1 - a), (2 - b), (3 - c), (4 - c).
154 Management Accounting - I
II.
Long Term Questions
(1)
What is ‘Ratio Analysis’ ? state the rationale of Rati Analysis.
(2)
Define ‘Ratio Analysis’. Explain the nature and objectives of Ratio Analysis.
(3)
Explain in brief the advantages and limitations of Ratio Analysis.
(4)
How do you classify ‘Accounting Ratios’ ? Explain the significance of ‘Ratio
Analysis’ in Analysis of financial statements.
(5)
Define ‘Liquidity Ratio’. How they are useful in management Accounting ?
(6)
What are ‘solvency Ratio’s ? Explain the significance of solvency Ratios in
the decision making process.
(7)
What do you understand by ‘Profitability Ratios’ ? Explain the importance
Ratio Analysis
of Profitability Ratios in the computation of profitability of a concern.
(8)
What are ‘Activity Ratio’s ? Explain the role played by Activity Ratio in the
decision making process.
(9)
‘Ratio Analysis helps in Financial Forecasting of a concern’. Discuss.
NOTES
III. Practical Problems :
(1) The following are the summarised Profit and Loss Account for the year
ended 31.3.2014 and Balance Sheet on that date.
Profit and Loss Account for the year ended 31-3-2014
Particulars
Particulars
`
To Opening Stock
9,950 By Sales
To Purchases
54,525 By Closing Stock
To Incidental Expenses
`
85,000
14,900
1,425
To Gross Profit C/D
34,000
99,900
To Operating Expenses :
i) Selling and Distribution
ii) Administration
99,900
By Gross Profit B/D
3,000 By Non-Operating Incomes :
15,000 i) Interest
iii) Finance
34,000
1,500 ii)Profit on sale of shares (+) 600
300
900
To Non-Operating Expenses :
i)
Loss on sale of Assets
To Net Profit C/D
400
15,000
34,900
34,900
Balance Sheet as on 31.3.2014
Liabilities
`
Issued Share Capital :
2,000 Equity Shares of
Assets
`
Land and Building
15,000
20,000 Plant and Machinery
8,000
Rs. 10 each
Reserve
9,000 Stock in Trade
14,900
Profit and Loss Account
6,000 Sundry Debtors
7,100
Current Liabilities
13,000 Cash at Bank
48,000
Compute : i) Current Ratio,
3,000
48,000
ii) Operating Ratio,
iii) Stock Turnover Ratio and iv) Return on total resources
(2)
With the help of the following ratios regarding Tata Ltd., Tatanagar draw
the Balance-Sheer of the company for the year 2014.
Management Accounting - I
155
Ratio Analysis
Current Ratio
2.5
Net Working Capital ` 3,00,000
Liquid Ratio
1.5
Stock Turnover Ratio = 6 times
(Cost of Sales/Closing Stock)
NOTES
Gross Profit Ratio
20%
Fixed Assets Turnover Ratio
(on Cost of Sales) 2 times
Debt Collection Period
2 months Fixed Assets to Shareholders Net Worth
= 0.80
Reserves and Surplus to
Capital
(3)
0.50
The following is the Balance Sheet of ABC Ltd. Aurangabad as on 31st
March, 2014
Balance Sheet as on 31st March, 2014
Liabilities
`
Equity Share Capital
Assets
`
2,00,000 Goodwill
Capital Reserve
1,20,000
40,000 Fixed Assets
8 % Loan on Mortgage
2,80,000
1,60,000 Stock
60,000
Trade Creditors
80,000 Debtors
60,000
Bank Overdraft
20,000 Investments
20,000
Taxation - Current
20,000 Cash in Hand
60,000
Profit and Loss Account
Profit 31.3.2014 for the year
ending (After taxation and
interest on fixed deposit)
1,20,000
Less : Transfer to Reserve
(-) 40,000
80,000
6,00,000
6,00,000
The total Sales amounted to ` 12,00,000
You are required to calculate the following ratio : i) Current Ratio,
ii) Quick Ratio, iii) Equity Ratio, iv) Debt to Equity Ratio, v) Net proft Ratio.
(4) From the following ratios and additional information prepare the Balance
Sheet as on 31st March, 2014.
156 Management Accounting - I
i)
Current Ratio
:
2.1 to 1
ii)
Liquid Ratio
:
1.5 to 1
iii)
Working Capital
:
` 60,000
iv)
Bank Overdraft
:
` 10,000
Ratio Analysis
v)
Fixed Assets to Proprietor’s Fund
:
0.75
vi)
Reserve and Surplus
:
`40,000
There were no fictitious or long-term loans.
(5) Following is the Balance Sheet of Warrn Tea Ltd., Walchandnagar as on
31-3-2014 together with additional information as on that date.
NOTES
Balance Sheet as on 31.3.2014
Liabilities
Assets
`
`
Paid-up Capital
2,00,000 Goodwill
30,000
Reserve Fund
50,000 Building
1,20,000
Profit and Loss
12,750 Machinery
29,000
Bank Overdraft
11,250 Stock in Trade
66,000
Creditors
36,000 Debtors
85,000
Taxation Provision
20,000
3,30,000
3,30,000
Additional Information :
Gross Profit - `2,10,000, Average Stock on hand - ` 63,000, Turnover for the
year 2013-14 - ` 8,40,000.
You are required to calculate the following accounting ratios i)
Current Ratio,
ii)
Liquid Ratio,
iii)
Proprietary Ratio,
iv)
Stock Turnover Ratio,
v)
Gross Profit Ratio.
(6) Following is the Balance Sheet of Binaca Ltd., as on 31-3-2014
Liabilities
Paid-up Capital
Assets
`
12,00,000 Goodwill
`
2,00,000
Reserve
2,00,000 Land
6,00,000
Profit and Loss Account
4,30,000 Plant
4,30,000
Sundry Creditors
5,00,000 Sundry Debtors
8,20,000
Bank Overdraft
1,00,000 Stock of goods
2,50,000
Bank Balance
24,30,000
1,30,000
24,30,000
Management Accounting - I
157
Ratio Analysis
Additonal Information :
`
Gross Profit for the year 2013-14
NOTES
9,00,000
Sales for the year 2013-14
30,00,000
Stock of goods on 1-4-2013
2,00,000
From the above information calculate the following accounting ratios i)
Current Ratio,
ii)
Liquidity Ratio,
iii)
Gross Profit Ratio,
iv)
Stock Turnover Ratio,
v)
Proprietary Ratio.
(7) From the following information relating to Charminar Ltd., Chennai, calculate
the following ratios.
i)
Current Ratio,
ii)
Liquidity Ratio,
iii)
Debt Equity Ratio,
iv)
Proprietary Ratio,
v)
Fixed Assets to Proprietory Fund Ratio.
Assets and Liabilities
`
`
Fixed Assets
85,00,000
Current Assets :
85,00,000
i)
Stock in Trade
30,00,000
ii)
Stores and Spares
14,00,000
iii)
Sundry Debtors
35,00,000
iv)
Advances and Deposits
(+)
6,00,000
(+)
Share Capital and Reserves
1,70,00,000
1,00,00,000
Long-term borrowings - Debentures
50,00,000
Bank Overdraft - Cash Credit
20,00,000
1,70,00,000
6.13 Further Reading
158 Management Accounting - I
•
Khan M. Y. and Jain P. K. - Management Accounting, Text, Problems and
cases - New Delhi - Tata McGraw-Hill Publishing Co. Ltd. - 2010
•
Rajajsekaran V. and Lalitha R. - Financial Accounting - New Delhi - Pearson
Education - 2012.
UNIT 7 Fund Flow Statement
Fund Flow Statement
Structure
7.0
Introduction
7.1
Unit Objectives
7.2
Meaning of Fund Flow Statement
7.3
Uses of Fund Flow Statement
7.4
Fund Flow Statement and Income Statement
7.5
Preparation of Fund Flow Statement
7.5.1
Fund from Business Operations
7.5.2
Proforma of a Funds Flow Statement
7.5.3
Requirements for Preparation of Fund Flow Statement
7.5.4
Steps in Preparation of Fund Flow Statement
7.6
Advantages of Fund Flow Statement
7.7
Limitations of a Funds Flow Statement
7.8
Illustration
7.9
Summary
NOTES
7.10 Key Terms
7.11 Questions and Exercises
7.12 Further Reading
7.0 Introduction
Under the Companies Act, a company is required to include the figures of
previous year in the financial accounts so that the interested parties may compare
individual figures for better understanding of the corporate performance and
economic position. The schedules attached to published account explain important
items for the knowledge of the concerning parties. No doubt the annual accounts
in their traditional forms are very important but they suffer from certain limitations.
The serious limitation of a Balance Sheet is that it is a static document as it shows
the economic position at a point of time and fails to show fully the movements or
changes in the assets, liabilities and owners equity. From the financial accounts in
their usual form, it is not clear as to how the funds were generated and how they
were utilised between the closing dates of two Balance Sheets. In order to provide
such information, another document known as Statement of Changes in Financial
Management Accounting - I
159
Fund Flow Statement
Position is prepared. This document shows the changes in financial position between
the closing dates of the Balance Sheets.
Meaning of the word “fund”
NOTES
Meaning of “fund”
(a)In a narrow sense, fund means cash,
and the statement based on this
concept is known as cash flow
statement.
(b) In a broader sense, fund means all
financial resources which flows
through working capital accounts and
fixed capital accounts.
(c) Fund means, working capital i.e.
current assets minus current liabilities.
Fig. 7.1 : Meaning of fund which is used is three different dimension.
In this connection it is important to understand clearly the meaning of the
word ‘Fund’ which is used in three different senses. In a narrow sense, fund
means cash and the statement based on this concept is known as Cash Flow
Statement. In a broader sense, fund means all financial resources which flows
through working capital accounts and a fund flow statement based on this concept
is almost a new form of Balance Sheet. The APB (Accounting Principles Board.
U.S.A.) has recommended the preparation and presentation of statement of
changes in financial position according to the broadest sense of the term ‘Fund’.
However, the meaning of the ‘Fund’ in both the narrow as well as broader sense
do not find favour with many academicians and practitioners, who prefer to consider
Fund in the sense of Working Capital i.e. Current assets minus Current liabilities.
7.1
Unit Objectives
After studying this unit you should be able to :
160 Management Accounting - I
•
Understand the meaning of ‘Fund and Fund Flow Statement.
•
Explain the use of Fund Flow Statement.
•
Compare funds flow statement with Income Statement.
•
Prepare Fund Flow Statement.
•
Identify the requirements for preparation of Fund Flow Statement.
•
Prepare adjusted Profit and Loss Account.
•
Calculate funds from operation and prepare statement of change in working
capital.
•
List-out the advantages and Limitations of Fund Flow Statement.
7.2
Meaning of Fund Flow Statement
Balance Sheet is a static statement showing financial position of a business
on any particular day but it is unable to throw any light on the changes in the
position of assets and liabilities that have taken place over a certain period. For
this purpose it is necessary to compare the two balance sheets. The change in the
financial position does not result from operating profit. The success or the failure
of any business depends upon the availability of funds for better utilisation. The
fund flow statement reveals the sources from which the funds are made available
and how they are utilised or applied. In other words, the funds flow statement
explains in brief the changes occurred in the items in two balance sheet.
Fund Flow Statement
NOTES
The fund flow statement describes the sources from which additional funds
were derived and the uses to which these funds were put.
The term funds is used in different way. It also includes cash as well as
non-cash funds like depreciation. All receipt of cash form the sources of funds
where as all payments in cash form the application of funds.
When the term fund is used in broader sense it covers all assets and the
liabilities side shows the sources of funds.
In simple words, it means movement of funds i.e. incoming of funds from
different sources and their outgoing i.e. use for different purposes like as purchase
of assets or repayment of liabilities etc.
A Funds Flow Statement is known by different names such as :
(i)
Where Got Where Gone Statement,
(ii)
Statement of sources and application of funds,
(iii)
Statement of changes in working capital,
(iv)
Statement showing summary of financial operations,
(v)
Statement of sources and application of working capital,
(vi)
Statement of changes in financial position,
(vii)
Funds Flow statement, etc.
It may be noted that there is no official name of the statement as its
preparation is still obligatory. Only few enlightened firms in India publish this
statement for the guidance of their members and creditors. However, it is advisable
that the title of the statement reflects the concept of fund on which it is based.
While preparing fund flow statement funds from operation, increase in non
current liabilities, non operating incomes such as sales of fixed assets, dividends,
rent etc. and decrease in working capital shows as sources of funds.
Management Accounting - I
161
Fund Flow Statement
Following are various sources and applications of funds :
Sources of Funds
NOTES
`
Application of Funds
Funds from operations
Loss from operations
Issues of new share capital
Payment of dividend
Issue of debentures
Purchase of Assets
Long term borrowings
Payment of tax
Sales of investments
Redemption of shares
Sales of fixed assets
Redemption of debentures
Dividend received
Payment of long term Debt.
Decrease in working capital
Increase in working capital
(If application amount is
(If sources are more than
more than the sources
the application amount)
`
amount)
7.3 Uses of Fund Flow Statement
Funds flow statement helps the financial analyst in having a more detailed
analysis and understanding of changes in the distribution of resources between
two balance sheet dates. In case such study is required regarding the future working
capital position of the company, a projected funds flow statement can be prepared
Following are the uses of Fund Flow Statement :
Use of
Fund Flow
Statement
It acts as a
tool for allocation
of financial
resources
It is a test of
effective use of
working
capital
It explain the
finance
consequences of
Business
operations
It answers
complicated
questions
Fig. 7.2 : Uses of Fund Flow Statement
162 Management Accounting - I
1.
It explain the financial consequences of Business Operations :
Fund Flow Statement
Funds flow statement provides a solution to so many conflicting situations such as:
2.
(a)
While financing various types of investment which plan and policy is to
be implemented.
(b)
Why the liquid position of the business is becoming more and more
unbalanced in spite of business making more and more profits ?
(c)
How was it possible to distribute dividends in excess of current earnings
or in the presence of a net loss for the period ?
(d)
How the business could have good liquid position in spite of business
making losses or acquisition of fixed assets ?
(e)
Where have the profits gone ?
(f)
How the funds generated are to be utilize for the different purposes ?
(g)
Why were dividends not larger ?
It acts as a tool for Allocation of Financial Resources :
A projected funds flow statement will help the analyst in finding out how
the management is going to allocate the scarce resources for meeting the production
requirements of the business. The use of funds should be phased in such an order
that the available resources are put to the best use of the enterprise. The funds
should be managed in such a way that the business is in a position to make payment
of interest and loan installments as per the agreed schedule.
The fund flow statement is being used as a tool of financial analysis by the
Management other parties interested in understanding the changes in financial
position of an undertaking.
3.
NOTES
Check Your Progress
Illustrates, uses of Fund Flow
Statement.
It answers Complicated Questions :
With the help of fund flow statement the financial analyst can find out
answers to a number of complicated questions; such as :
4.
(a)
What should be the liquid position ? What should be the credit policy in
the light of the liquidity position indicated by the fund flow statement ?
(b)
What is the overall credit worthiness of the enterprise ?
(c)
What are the sources of repayment of the loans taken ?
(d)
How much funds are generated through normal business operations.
(e)
In what way the management has utilised the funds in the past and
what are going to be likely used of funds ?
It is a Test of Effective use of Working Capital :
Funds flow statement is a test of effective use of working capital by the
management during a particular period. The adequacy or inadequacy of working
Management Accounting - I
163
Fund Flow Statement
NOTES
capital will tell the financial analyst about the possible steps that the management
should take for effective use of surplus working capital or make arrangement in
case of inadequacy of working capital.
In practice, the financial requirements of industry for term loans are met by
the specialized financial institutions and working capital needs are generally satisfied
by commercial banks which ask for a copy of funds flow statement from the
borrowing party.
National Association of Accountants states the following uses of fund
statement :
(a)
Estimating the amount of funds needed for growth.
(b)
Improving the rate of income on assets.
(c)
Planning the temporary investment of idle funds.
(d)
Securing economies in the centralized management of cash in
organisations whose management is decentralized.
(f)
Planning the payment of dividends to shareholders and interest to
creditors.
(g)
Easing the effects of an insufficient cash balance.
7.4
Funds Flow Statement And Income Statement
A Funds Flow Statement differs from an Income Statement (i.e. Profit and
Loss Account) in several respects :
164 Management Accounting - I
(a)
Flow of funds is said to have taken place when a business transactions
makes a change in the amount of fund which exited just before the happening
of transaction. If the changes results in the increase of fund then the
transaction responsible for such a change is said to be a source of fund. If
the change results in the decrease of fund then the transaction responsible
for such a change is said to be application or a use of fund. On the other
hand, income statement or profit and loss account is a very important part
of financial statement in as much as the determination of net profit of a
business enterprise is the central feature of accounting. Business is
conducted primarily to earn profit. This statement matches revenues and
costs incurred in the process of earning revenues.
(b)
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 included therein.
(c)
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
incomes of a period with the expenditures 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.
Fund Flow Statement
(d)
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, whereas in Income Statement discloses the results of
the business activities, i.e., how much has been earned and how it has been
spent.
NOTES
(e)
The fund flow statement simply tells about the working capital position of
the business. It does not explain how much profit the business has really
earned. This can be found out only by an income statement.
7.5
Preparation of Funds Flow Statement (Based
on Working Capital Concept)
The preparation of Funds Flow Statement is not difficult, if we could identify
the various sources of funds and the items for which these sources are used. The
main sources of funds are : (i) Issue of equity capital and debentures, (ii) Sale of
any assets for cash, (iii) Sale of investments, (iv) Raising of additional loans, (v)
Non trading receipts, (vi) Business operations.
The funds so generated may be utilised for the following purpose : (i)
Repayment of preference share capital, (ii) Redemption of debentures, (iii) Purchase
of fixed assets, (iv) Purchase of long-term investments, (vi) Nontrading payments,
(vii) Operational losses etc.
Check Your Progress
How Fund Flow Statement
differs
from
Income
Statement ?
7.5.1 Fund from Business Operations
The business operations results in profit or loss. In case of profit the fund is
changed positively. Therefore, the profit becomes a source of fund. To find the
real fund from business operations, the Trading and Profit and Loss Account has
to be recast.
7.5.2 Proforma of Funds Flow Statement
The Income Statement and Balance Sheet are prepared in accordance
with the proforma as prescribed under the Indian Companies Act but there in no
prescribed proforma for a Funds Flow Statement because the law does not require
its preparation and publication. Therefore, a firm can prepare a Funds Flow
Statements in any manner it deem fit. A specimen proforma of the statement in an
account form is given below :
Management Accounting - I
165
Fund Flow Statement
Funds Flow Statement for the year ended on 31st March, 200X
Sources
Application
`
1. Funds from business
operations
NOTES
1.
-
2. Issues of additional capital
-
3. Issue of debentures
-
4. Sales of investments
-
5. Sales of Assets
`
Loss of funds due to
operations
2.
-
Redemption of preference
shares
-
3.
Redemption of debentures
-
-
4.
Purchase of investments
-
6. Loans raised
-
5.
Purchase of Assets
-
7. Non-trading receipts
-
6.
Payment of loans
-
8. Decrease in working capital
-
7.
Tax paid
-
8.
Dividend paid
-
9.
Nontrading payments
-
10. Increase in working capital
-
Total
A Fund Flow Statement can also be prepared in a horizontal form as under :
Fund Flow Statement as on 31st March, 200X
Sources of Funds
`
1. Funds from business operations
-
2. Issues of shares
-
3. Issues of debentures
-
4. Sales of investment
-
5. Sales of assets
-
6. Loans raised
-
7. Nontrading receipt
Total Funds Generated
Application of Funds
`
1. Loss of funds due to business operations
-
2. Redemption of preference capital
-
3. Redemption of debentures
-
4. Purchase of investments
-
5. Purchase of assets
-
6. Payment of loan
-
7. Nontrading payments
Total Funds Used
166 Management Accounting - I
-
-
7.5.3 Requirements for preparation of Funds Flow
Statement
For the preparation of a Funds Flow Statement, we need Balance Sheets
and Income Statements for the last two years and other informations which are
not revealed by the annual accounts but which have otherwise affected the
movements of fund during the financial year. In case only the Balance Sheets are
available, then other information affecting the funds from business operations and
the financial position should be collected. The other informations needed for the
preparation of a Funds Flow Statement are the depreciation charged on assets,
provision made for taxation and dividend, capital expenditure written off, asset
discarded without any recovery, loss on sale of assets, profit on sale of any capital
asset, transfer from one account to another account, taxes and dividend paid
during the year, interim dividend paid, non-trading incomes and expenditure or
losses debited to Profit and Loss Account, etc. With such an information in hand,
we can proceed to prepare the Funds Flow Statement in the following manner :
Fund Flow Statement
NOTES
Check Your Progress
Which steps are required in
preparation of fund flow
statement ?
7.5.4 Steps in Preparation of Funds Flow Statement
Following steps are required in preparation of funds flow statement.
Step I
:
Preparation of Adjusted Profit and Loss Account to find out funds
from business operations.
Step II
:
Preparation of statement of charges in working capital.
Step III :
Determination of other sources and application of fund.
Step I
Preparation of Adjusted Profit and Loss Account
:
To calculate the net operational flow of fund, the profit as shown by the
traditional Income Statement need to be recast as it contains items of non-fund
and nonoperating nature. For example, depreciation is a non-fund item which
does not result in the outflow of cash or it does not require any current expenditure
to be incurred during the financial year. Therefore, the amount of depreciation
charge should be added back to the profit in the calculation of Funds from Business
Operations. Similarly writing-off of goodwill, patents, trade marks, preliminary
expenses, discount on issue of shares and debentures, etc. are the items which
figure on the debit side of Income Statement but they are also in the nature of
depreciation not affecting the flow of funds. Such items, therefore, should be
added back to profit. All appropriations of profits such as transfers to different
reserves, provisions for taxation, proposed dividend, etc. not being operating costs
should be added back to the profit figures. From the total so arrived at, the
nonoperating incomes like dividend received income tax refund, compensation
received, profit on sale of asset, etc. should be deducted to arrive at the figure of
total operational inflow.
The funds from business operations for the financial year can be calculated
by deducting the profit at the beginning of the year from the total operational
inflow for the year. A specimen proforma of Adjusted Profit and Loss Account in
Management Accounting - I
167
Fund Flow Statement
an account form is given below :
Adjusted Profit and Loss Account or
Dr.
NOTES
Funds from Operation or Operational Flow
Sources
Application
`
To Depreciation
XXX
To Amount Written off on
account of :
Cr.
`
By Opening Balance of
Profit and Loss Account
XXX
(a) Discount of shares/
XXX
By Rent received and
receivables
debentures
XXX
By Dividend received and
(b) Preliminary Expenses
receivables?
(c) Goodwill/Trade Marks/
By Profit on Sale / Appropriation
Patents
XXX
of Fixed Assets
(d) Other differed expenses
By Income Tax Refund
To amount transferred out
(from Dept.)
of profit of current year to :
XXX
XXX
XXX
By Savings in excess provision
(a) General Reserve
made or
(b) Capital Reserve
By Decrease in revenue Reserve
(c) Dividend Equalization
caused by transfer to Profit
Reserve
and Loss Account
(d) Depreciation Sinking
XXX
XXX
By Funds from Operations
Fund
(Balancing figure)
(e) Provision of Taxation
(f) Proposed dividend
(g) Contingency Reserve
(h) Any other Revenue
Reserve
To Loss on Sale of Fixed
XXX
Assets (Building, Land,
Plant & Machinery)
To any other expenditure
XXX
charged to Profit and Loss
Account but not affecting
Cash
XXX
To Closing Balance of
XXX
Profit and Loss Account
Total
168 Management Accounting - I
XXX
Total
XXX
A funds from operation statement can also be prepared in horizontal form as under :
Sources of Funds
`
Profit / Loss as per Income statement.
Fund Flow Statement
`
XXX
(at the end of the year)
Add :
Depreciation
XXX
Preliminary expenses
XXX
NOTES
Discount on issue of shares and debentures
Less :
Less :
Step II
written off
XXX
Goodwill, trade mark, patents written off
XXX
Loss on sale of machine
XXX
Loss on investment sold
XXX
Interim dividend paid
XXX
Provision for taxation
XXX
Proposed dividend
XXX
Machine lost
XXX
Transfer to Reserves
XXX
XXX
other fixed assets
XXX
XXX
Dividend received
XXX
Tax Refund
XXX
Profit on sale of machine, investment or any
XXX
Profit / Loss at the beginning of the year
XXX
Funds from Business Operations.
XXX
: Preparation of statement of charges in working capital.
After bringing in all the items of sources and application of fund, the Funds
Flow Statement should be balanced. In case of ‘Sources’ exceed the ‘Application’,
there is an increase of working capital which means an use of Fund. On the other
hand, if the Applications are more than the Sources, the difference will represents
the Decrease in working capital or source of fund.
The Schedule of changes in Working Capital is not considered as a part of
Funds Flow Statement but it is generally accompanied with the Funds Flow
Statement. All current assets and current liabilities are brought into the Schedule
of Charges in Working Capital. The increase or decrease in individual items of
current assets and current liabilities affecting the net change in working capital
are depicted in the Schedule. The net increase or decrease in working capital is
the same as shown in the Funds Flow Statement. If there is any variation between
the two figures of increase/decrease of working capital as per Fund Flow Statement
and schedule of changes in working capital, then it is an indication that some
mistake has been committed somewhere in the calculation of funds from business
operations in the determination of other sources and application of funds.
Management Accounting - I
169
Fund Flow Statement
The Schedule of changes in working capital may be prepared as per the
proforma given below.
Statement or Schedule of changes in Working Capital
NOTES
Changes in
Assets and Liabilities
Previous
Current
Working
Capital
year
year
Increase
Decrease
Stock in Trade
XXX
XXX
XXX
XXX
Debtors
XXX
XXX
XXX
XXX
Cash Balance
XXX
XXX
XXX
XXX
Bank Balance
XXX
XXX
XXX
XXX
Prepaid Expenses etc.
XXX
XXX
XXX
XXX
Total (A)
XXX
XXX
Sundry Creditors
XXX
XXX
XXX
XXX
Outstanding Expenses
XXX
XXX
XXX
XXX
Bills Payable
XXX
XXX
XXX
XXX
Bank Overdraft etc.
XXX
XXX
XXX
XXX
XXX
XXX
XXX
XXX
Net Working Capital (A - B)
XXX
XXX
Increase/Decrease in
XXX
XXX
XXX
XXX
XXX
XXX
XXX
XXX
Current Assets :
Current Liabilities :
Total (B)
Working Capital
Total
Step III : Determination of other sources and application of fund.
After having calculation of the funds from business operations, the next
step should be to find out the other sources and application of fund. For this
purpose the Balance Sheet items should be carefully compared. For example, an
increase in the current year’s debentures amount generally means a source of
fund and a decrease in application of fund or increase in the value of current year
investment implies application and decrease means a source of fund.
7.6
Advantages of Funds Flow Statement
Following are the main advantages of funds flow statement :
1.
170 Management Accounting - I
The Funds Flow Statement is increasingly being used as a tool of financial
analysis by the management, bankers, financial institutions, investors and
other parties interested in understanding the changes in financial position of
an undertaking.
2.
A funds flow statement can be used as a control device to make the financial
planning more effective.
3.
The financial requirements of industry for term loans are met by the
specialized financial institutions and working capital needs are generally
satisfied by commercial banks which ask for a copy of Funds Flow Statement
from the borrowing party.
4.
5.
The potential shareholder can also form an idea about the financial health
of an organisation from the study of its funds flow statement and take
decisions about his investment plan.
A study of funds flow statement clearly tells about the liquid position and
the supplier of raw materials can review its own credit policy in the light of
the liquidity position indicated by the funds flow statement.
6.
Fund flow statement is a test of effective use of working capital by the
management in a particular period of time.
7.
It gives an insight into the financial operations of the concern which helps in
analysing past and future expansion plans.
8.
With the help of funds statement, a finance manager can ensure that the
business will have funds when required.
9.
This is an important and useful tool of management for which can threw
light on many financial problems.
10.
It shows liquid position of business more accurately.
11.
It also indicates what is the overall credit worthiness of the enterprise.
7.7
Fund Flow Statement
NOTES
Check Your Progress
How fund flow statement
can be used as a control
device to make the financial
planning ?
Which items are included in
statement of changes in
Working Capital ?
Limitations of Funds Flow Statement
The funds flow statement suffers from certain limitations, which are as under :
1.
It is based on the informations contained in the traditional final accounts.
Therefore, it also suffers from the same limitations with which the usual
published accounts suffer.
2.
A funds flow statement cannot replace the traditional final statements. Infact,
a funds flow statement is prepared from the balance sheets and other
important informations pertaining to sources and used of funds.
3.
A funds flow statement is not as much revealing as a balance sheet. It
simply fills the gaps where a balance sheet fails to reflect the changes in
financial position.
4.
It is argued that the component of cash is more important than the working
capital because it is the cash and not the other components i.e. stock and
receivables, which is required to pay off the liabilities of a concern.
Management Accounting - I
171
Fund Flow Statement
NOTES
5.
It is also argued that a balance sheet is itself in the nature of a fund flow
statement as the liability side depicts the sources from which the funds
generates and the assets side show the application of the funds and as such
a funds flow statement is not significant.
The concept of Fund Flow Statement can be understood with the help of
following illustrations.
7.8
Illustrations
ILLUSTRATION 1
The following are the comparative Balance Sheets of Akash Ltd, Agra as
on 31st March 2013 and 31st March, 2014
Balance Sheet
As on
Liabilities
As on
31-3-2013 31-3-2014 Assets
`
Equity Share Capital
70,000
7% Debentures
12,000
Bills Payable
11,360
Trade Creditors
Profit and Loss
`
74,000 Goodwill
As on
As on
31-3-2013 31-3-2014
`
`
10,000
5,000
20,000
30,000
11,840 Stock-in-Trade
49,200
42,700
5,740
6,360 Trade Debtors
14,900
17,700
4,000
5,000 Bank Balance
9,000
7,800
6,000 Buildings
1,03,100 1,03,200
1,03,100 1,03,200
The additional information relating to the above mentioned period is given
as follows :
a)
During the year 7% Debentures were redeemed at par amounted to `
6,000
b)
Interim dividend paid during the year was ` 3,500.
c)
Buildings purchased during 2013-14 amounted to ` 10,000.
d)
An amount of ` 5,000 was provided for amortisation of Goodwill for the
year.
Prepare a funds flow statement for the year ended 31st March, 2014.
172 Management Accounting - I
Fund Flow Statement
SOLUTION
In the books of Akash Ltd., Agra
Funds Flow Statement for the year ended 31st March, 2014
Sources
Application
`
`
NOTES
Issue of Equity Shares
4,000
Redemption of 7%
Decrease in Working Capital
6,000
Debentures as per
Funds from Operations
9,500
Purchase of Buildings
6,000
10,000
Payment of Interim
Dividend
3,500
19,500
19,500
Adjusted Profit and Loss Account for the year ended 31st March, 2014
Dr.
Cr.
Particulars
Particulars
`
To Amortisation of Goodwill
5,000 By Balance B/D
To Interim Dividend paid
3,500 (Opening Balance)
`
4,000
By Funds from Operations
9,500
(Balancing Figure)
To Balance C/D
5,000
(Closing Balance)
13,500
13,500
Statement showing changes in Working Capital
Particulars
Changes in
Working Capital
2012-13
2013-14
Increase
Decrease
`
`
`
`
Current Assets
i)
Stock-in-trade
49,200
42,700
6,500
ii)
Trade Debtors
14,900
17,700
iii)
Bank Balance
9,000
7,800
73,100
68,200
11,360
11,840
480
5,740
6,360
620
17,100
18,200
56,000
50,000
2,800
1,200
(+)
Total (A)
Less Current Liabilities
i)
Bills Payable
ii)
Trade Creditors
(+)
Total (B)
Working Capital (A-B)
Decrease in Working Capital
56,000
6,000
6,000
56,000
8,800
8,800
Management Accounting - I
173
Fund Flow Statement
ILLUSTRATION 2
The following are the Balance Sheets of Bokaro Ltd., Bangluru as on 31st March,
2013 and 31st March, 2014.
Balance Sheet
NOTES
As on
As on
31-3-2013
31-3-2014
1,25,000
1,50,000
8% Debentures
80,000
-
Profit and Loss
42,000
Creditors
Notes Payable
Liabilities
Share Capital
As on
As on
31.3-2013
31.3.2014
5,000
12,000
Land at cost
27,000
15,000
62,000
Investments
10,000
15,000
45,000
20,000
Debtors
90,000
98,000
35,000
23,000
Cash in Hand
70,000
25,000
1,20,000
87,000
5,000
3,000
3,27,000
2,55,000
Assets
Goodwill
Stock
Preliminary
Expenses
3,27,000
2,55,000
The following additional information is available from the records.
a)
During the year 8% Debentures were redeemed at a premium of 10%.
b)
Goodwill was appreciated by ` 7,000.
c)
Land costing ` 12,000 was sold during the year in the market for `
24,000.
d)
Investments of the face value of ` 5,000 were purchased during the year.
e)
Dividends paid during the year 2014 amounted to ` 30,000.
Prepare a statement showing changes in working capital and a funds flow
statement for the year ended 31st March, 2014.
SOLUTION
In the books of Bokaro Ltd., Bangluru
Funds Flow Statement for the year ended 31st March, 2014
Sources
`
Issue of Shares
25,000
Redemption of 8%
Sale of Land
24,000
Debentures at
Decrease in Working
10% premium
Capital
33,000
Purchase of Investments
Funds form Operations
41,000
Dividends paid
1,23,000
174 Management Accounting - I
Application
`
88,000
5,000
30,000
1,23,000
Adjusted Profit and Loss Account for the year ended 31st March, 2014
Dr.
Fund Flow Statement
Cr.
Particulars
Particulars
`
To 10% Premium on
By Balance B/D
Redemption of 8 %
(Opening Balance)
Debentures
`
42,000
NOTES
8,000 By Appreciation in
To Preliminary Expenses
written off
Goodwill
7,000
2,000 By Profit on Sale of Land
To Dividends Paid
12,000
30,000
By Funds from Operation*
(Balancing figure)
To Balance C/D
41,000
62,000
(Closing Balance)
1,02,000
1,02,000
Statement showing changes in Working Capital
Particulars
Changes in
Working Capital
2012-13
2013-14
Increase
Decrease
`
`
`
`
8,000
Current Assets
i)
Debtors
90,000
98,000
ii)
Cash in Hand
70,000
25,000
45,000
iii)
Stock
1,20,000
87,000
33,000
2,80,000
2,10,000
(+)
Total (A)
Less Current Liabilities
i)
Creditors
45,000
20,000
25,000
ii)
Notes Payable
35,000
23,000
12,000
80,000
43,000
2,00,000
1,67,000
(+)
Total (B)
Working Capital (A-B)
Decrease in Working Capital
2,00,000
33,000
33,000
2,00,000
78,000
78,000
Management Accounting - I
175
Fund Flow Statement
Working Notes :
1)
Redemption of 8% Debentures at 10 % premium
8% Debentures A/c
Dr.
80,000
Dr.
8,000
Premium on Redemption of
NOTES
8% Debentures A/c
To Bank A/c
2)
88,000
Sale of Land costing ` 12,000 for ` 24,000
Bank A/c
Dr.
24,000
To Land A/d
12,000
To Profit and Loss A/c
12,000
ILLUSTRATION 3
The Summarised Balance Sheets of Charvi Ltd., Chandrapur are as follows :
Balance Sheet
Liabilities
As on
As on
31-3-2013
31-3-2014
`
`
Assets
Share Capital
1,05,000
Reserve Fund
25,000
30,000 Buildings
Profit & Loss
15,000
Bank Loan
35,000
Trade Payables
75,000
15,000
2,70,000
As on
31.3-2013
31.3.2014
`
`
1,20,000 Goodwill
-
2,000
1,05,000
90,000
16,000 Machinery
75,000
84,000
- Inventories
48,000
36,000
Receivables
40,000
32,000
Cash in Hand
1,000
2,000
17,000 Bank Balance
1,000
4,000
2,70,000
2,50,000
67,000 Trade
Provisions for
Taxation
As on
2,50,000
Additional information for the year 2013-14 is supplied as under :
a)
Annual dividend paid during the year amounted to ` 11,000.
b)
Depreciation written off Buildings ` 15,000 and Machinery ` 7,000.
c)
A provision for taxation of ` 16,500 was charged to Profit and Loss Account.
Prepare a statement showing changes in working capital, adjusted Profit
and Loss Account and a Funds Flow Statement for the year ended 31st December,
2014.
176 Management Accounting - I
Fund Flow Statement
SOLUTION
In the books of Charvi Ltd, Chandrapur
Funds Flow Statement for the year ended 31st March, 2014
Sources
Application
`
Issue of Shares
15,000
Decrease in working Capital
Funds from Operations
8,000
53,500
`
Repayment of Bank Loan
35,000
NOTES
Payment of Annual
Dividend
11,000
Purchase of New
Machinery
16,000
Tax paid
14,500
76,500
76,500
Adjusted Profit and Loss Account for the year ended 31st March, 2014
Dr.
Cr.
Particulars
Particulars
`
To Transfer to
`
By Balance B/D
Reserve Fund
15,000
5,000 (Opening Balance)
To Depreciation on Buildings
15,000 By Appreciation in
To Annual Dividend paid
11,000 Goodwill
To Depreciation on Machinery
To Provision for Taxation
2,000
7,000 By Funds from
16,500 Operations*
53,500
(Balancing Figure)
To Balance C/D
16,000
(Closing Balance)
70,500
70,500
Statement showing changes in Working Capital
Particulars
Changes in
2012-13
2013-14
`
`
Working Capital
Increase Decrease
`
`
Current Assets
i)
Inventories
48,000
36,000
-
ii)
Trade Receivables
40,000
32,000
iii)
Cash in Hand
1,000
2,000
1,000
iv)
Bank Balance
1,000
4,000
3,000
90,000
74,000
12,000
8,000
(+)
Total (A)
Management Accounting - I
177
Fund Flow Statement
Less Current Liabilities
i)
Trade Payables
75,000
67,000
Total (B)
75,000
67,000
 Working Capital (A-B)
15,000
7,000
8,000
(+)
NOTES
 Decrease in Working Capital
15,000
8,000
8,000
15,000
20,000
20,000
Working Notes
1)
It is necessary to prepare a separate account for provision for taxation, as
the tax pair during the year is a missing item, which is as follows :
Provision for Taxation Account
Dr.
Cr.
Particulars
To Bank *
`
14,500
Particulars
By Balance B/D
(Tax paid i.e.
(Opening Balance)
Balancing figure)
By Profit and Loss
`
15,000
(Provisions charged to
Profit and Loss Account)
To Balance C/D
17,000
(Closing Balance)
31,500
2)
31,500
It is necessary to prepare a separate account for machinery, as purchases
of new machinery during the year is a missing item, which is as follows :
Machinery Account
Dr.
Cr.
Particulars
To Balance B/D
`
75,000 By Depreciation
(Opening Balance)
To Bank *
Particulars
`
7,000
(Depreciation written off)
16,000
(Purchases of new
machinery i.e.
By Balance C/D
balancing figure)
(Closing Balance)
91,000
178 Management Accounting - I
84,000
91,000
Fund Flow Statement
ILLUSTRATION 4
The following are the summarised Balance Sheets of Dinshaw Ltd., Delhi as on
31st March, 2013 and as on 31st March, 2014.
Balance Sheet
As on
As on
As on
31-3-2013 31-3-2014
Liabilities
`
Assets
As on
`
`
Preference Share
NOTES
31.3-2013 31.3.2014
Goodwill
`
95,000
80,000
Capital
8,95,000
9,40,000 Buildings
3,20,000
2,60,000
General Reserve
2,50,000
3,10,000 Machinery
4,50,000
6,10,000
Business Profits
70,000
70,000
40,000
Sundry Creditors
1,00,000
1,30,000
2,10,000
90,000 Furniture
1,00,000 Stock
Bills Payable
35,000
60,000 Sundry Debtors
2,40,000
4,00,000
Tax Provision
60,000
80,000 Cash at Bank
1,95,000
1,00,000
Proposed Dividend
90,000
1,20,000
15,00,000 17,00,000
15,00,000 17,00,000
Additional Information :
a)
During the year `50,000 were paid as income tax and `90,000 were paid
as dividend for the year 2012-13
b)
Goodwill to be written off ` 15,000.
c)
Depreciation Buildings by ` 60,000 and Machinery by ` 40,000
d)
Furniture costing `30,000 were sold for ` 48,000 whereas Machinery
costing `60,000 was sold for ` 55,000, during the year 2013-14.
Your are required to prepare a Funds Flow Statement for the year ended
31st March, 2014. Also prepare Provision for Taxation Account, Proposed Dividend
Account and Machinery Account separately.
SOLUTION
In the books of Charvi Ltd, Chandrapur
Funds Flow Statement for the year ended 31st March, 2014
Sources
Application
`
Issue of Shares
45,000 Increase in Working
Sale of Furniture
48,000 Capital
Sale of Machinery
55,000 Payment of Income Tax
Funds from Operations
3,72,000 Payment of Dividend
`
1,20,000
50,000
90,000
Purchase of New
Machinery
5,20,000
2,60,000
5,20,000
Management Accounting - I
179
Fund Flow Statement
Adjusted Profit and Loss Account for the year ended 31st March, 2014
Dr.
Cr.
Particulars
NOTES
Particulars
`
To Transfer to
`
By Balance B/D
70,000
General Reserve
60,000 (Business Profits Opening)
To Goodwill written off
15,000 By Profit on Sale of
To Depreciation on
of furniture
18,000
i) Buildings
60,000
ii) Machinery
40,000 By Funds from Operations*
To Loss on sale of Machinery
To Provision for Taxation
To Proposed Dividend
To Balance C/D
5,000 (Balancing Figure)
3,72,000
70,000
1,20,000
90,000
(Business Profits closing)
4,60,000
4,60,000
Statement showing changes in Working Capital
Particulars
2012-13
`
2013-14
`
Changes in
Working Capital
Increase Decrease
`
`
Current Assets
i)
Stock
1,30,000
2,10,000
80,000
ii)
Sundry Debtors
2,40,000
4,00,000
1,60,000
iii)
Cash at Bank
1,95,000
1,00,000
5,65,000
7,10,000
1,00,000
1,00,000
35,000
60,000
1,35,000
1,60,000
 Working Capital (A-B)
4,30,000
5,50,000
 Increase in Working Capital
1,20,000
95,000
(+)
Total (A)
Less Current Liabilities
i)
Sundry Creditors
ii)
Bills Payable
25,000
(+)
Total (B)
5,50,000
1,20,000
5,50,000
2,40,000
2,40,000
Working Notes :
1)
180 Management Accounting - I
It is necessary to prepare a separate account for provision for taxation as
the provisions for taxation made during the year, is a missing item which is
as follows :
Provision for Taxation Account
Dr.
Cr.
Particulars
To Bank
(Income Tax Paid)
To Balance C/D
(Closing Balance)
` Particulars
50,000 By Balance B/D
(Opening Balance)
By Profit and Loss *
(Provisions for taxation
made during the year
i.e. Balancing figure)
80,000
1,30,000
2)
Fund Flow Statement
`
60,000
70,000
NOTES
1,30,000
It is necessary to prepare a separate account for proposed dividend, as the
provisions for dividend made during the year is a missing item, which is as
follows :
Proposed Dividend Account
Dr.
Cr.
Particulars
To Bank
`
Particulars
90,000 By Balance B/D
(Dividend Paid)
`
90,000
(Opening Balance)
By Profit and Loss *
1,20,000
(Provisions for dividend
made during the year
i.e. Balancing figure)
To Balance C/D
1,20,000
(Closing Balance)
2,10,000
3)
2,10,000
It is necessary to prepare a separate account for Machinery as purchases
of new machinery during the year is a missing item, which is as follows :
Machinery Account
Dr.
Particulars
To Balance B/D
Cr.
`
Particulars
4,50,000 By Depreciation
(Opening Balance)
`
40,000
(Depreciation written
off)
To Bank *
2,60,000 By Bank
(Purchase of New
(Sale of Machinery)
Machinery
By Profit and Loss
i.e. Balancing figure)
(Loss on sale of
55,000
5,000
Machinery)
By Balance C/D
6,10,000
(Closing Balance)
7,10,000
7,10,000
Management Accounting - I
181
Fund Flow Statement
4) Sale of Furniture costing
`30,000 for ` 48,000 Bank A/c
NOTES
Dr.
48,000
To Furniture A/c
30,000
To Profit and
18,000
Loss A/c
5) Sale of Machinery costing
`60,000 for ` 55,000
Bank A/c.
Dr.
55,000
Profit and Loss A/c
To Machinery A/c
Dr.
5,000
7.9
60,000
Summary
• Fund Flow Statement :
The Fund Flow Statement reveals the sources from which the funds are
made available and how they are utilises or applies. The Fund Flow Statement
explain in brief the changes occurred in the items in two balance sheet.
• Sources of Funds :
(i) Funds from operation, (ii) Issue of New Share Capital, (iii) Issue of Debentures,
(iv) Long term borrowings, (v) Sales of investments, (vi) Sales of fixed assets,
(vii) Dividend Received, (viii) Decrease in Working Capital.
• Applications of Funds :
(i) Loss from operation, (ii) Payment of Dividend, (iii) Purchase of Assets,
(iv) Payment of Tax, (v) Redumption of Shares, (vi) Redemption of Debentures,
(vii) Payment of Long term debt, (vii) Increase in Working Capital.
• Use of Fund Flow Statement :
(i) It explain the finance consequences of Business operations, (ii) It acts as a tool
for allocation of financial resources, (iii) It answers complicated questions, (iv) It
is test of effective use of working capital.
• Steps in Preparation of Fund Flow Statement :
(I)
Preparation of Adjusted Profit and Loss Account to find out funds from
business operations.
(II)
Preparation of statement of changes in working capital.
(III) Determination of other sources and application of fund.
182 Management Accounting - I
7.10 Key Terms
(1)
Fund Flow Statement : It is a statement of sources and uses of funds.
(2)
Statement of change in working capital : It is prepare by computing the
Balance Sheets of different periods. Increase or decrease in working capital
may be reveals form a statement. By working capital means current assets
minus current liabilities.
Fund Flow Statement
NOTES
Current year’s Working Capital > Previous years Working Capital = Increase
in W.C.
Current year’s Working Capital < Previous years Working Capital =
Decrease/Releases in W.C.
(3)
Fund = A broader intepretation identifies “funds” as all financial resources
arising from transactions with parties external to the business enterprise.
7.11 Questions And Exercises
I - Objective Questions
A)
Multiple Choice Questions
(1)
Increase in non-current liabilities and decrease in non-current assets donate
__________ of fund.
(a) sources, (b) application, (c) undervaluation, (d) non-flow
(2)
A statement showing changes in financial position is a ______ statement.
(a) static, (b) flow, (c) profitability, (d) primary
(3)
Stock-in-trade as the end of the financial period results in ________ of
fund.
(a) non-flow, (b) application, (c) sources, (d) overvaluation
(4)
Now a days the term ‘fund’ is used to know the difference between _____
and _______
(a) current assets - fixed labilities, (b) fixed assets - current liabilities, (c)
current assets - contigent liabilities, (d) current assets - current liabilities.
Ans. : ( 1 - a ), ( 2 - b ), ( 3 - c ), ( 4 - d )
II- Long Answer Questions
(1)
What is ‘Fund” ? Explain the concept ‘fund’ in three different senses.
(2)
Define ‘fund flow statement’. Explain the important uses of Fund Flow
Statement.
Management Accounting - I
183
Fund Flow Statement
NOTES
(3)
What is ‘Fund Flow Statement’ ? How it differs from ‘Income Statement’
?
(4)
State the requirements for preparation of Fund Flow Statement.
(5)
Explain in brief the advantages and limitations of Fund Flow Statement.
(6)
What is ‘Funds from operation’ ? Explain the method of calculation of
Funds From Operation.
(7)
Explain the objectives and importance of schedule of changes in working
capital.
(8)
Explain in brief the accounting treatment of
(a) Provision for Taxation and (b) Proposed Dividend
in the preparation of Fund Flow Statement.
III- Practical Problems
(1)
Prepare a Fund Flow Statements for the year ended 31st March, 2014.
Balance Sheet
As on
Liabilities
31-3-2013
As on
31-3-2014 Assets
As on
31.3-2013
31.3.2014
10,000
5,000
Equity Capital
70,000
8% Debentures
12,000
6,000 Land
36,000
47,000
Creditors
10,000
12,000 Bank
9,000
7,800
14,900
17,700
40,100
42,500
1,10,000
1,20,000
Bills Payable
Profit and Loss
7,000
11,000
1,10,000
74,000 Goodwill
As on
5,200 Debtors
22,800 Stock-in-trade
1,20,000
Addition of Information
184 Management Accounting - I
a)
Dividends paid during the year amounted to ` 4,500.
b)
Land was purchased for ` 11,000.
c)
Goodwill of ` 5,000 was written off for the year 2013-14.
d)
8% Debentures amounting to ` 6,000 were redeemed at par.
(2) Bajaj Ltd. presents the following financial statements for the year 2012-13
and 2013-14.
Fund Flow Statement
Balance Sheet
As on
Liabilities
31-3-2013
As on
31-3-2014 Assets
`
`
Share Capital
3,00,000
4,00,000 Machinery
Reserve Fund
1,10,000
1,30,000 Land
As on
As on
31.3-2013
31.3.2014
`
`
1,70,000
2,10,000
-
1,35,000
Profit and Loss
30,000
60,000 Furniture
47,000
40,000
Creditors
40,000
50,000 Patents
10,000
12,000
Bills Payable
20,000
60,000 Debtors
1,40,000
1,55,000
Bills Receivable
70,000
80,000
Cash & Bank
63,000
68,000
5,00,000
7,00,000
5,00,000
7,00,000
NOTES
Addition of Information
a)
Income Tax of ` 25,500 has been paid during the year 2013-14.
b)
During the year patents appreciated by ` 2,000.
c)
New machinery purchased for the year amounted to ` 40,000
You are required to prepare a Funds Flow Statement for the year ended
31 March, 2014.
st
7.12 Further Reading
•
Jawaharlal - Accounting for Management - Mumbai - Himalaya Publishing
House Pvt. Ltd. - 2012
•
Prasad N. K. and Prasad A. K. - Cost and Management Accounting Kolkatta, Book Syndicate Pvt. Ltd. - 2010
Management Accounting - I
185
UNIT 8 Cash Flow Statement
Cash Flow Statement
Structure
8.0
Introduction
8.1
Unit Objectives
8.2
Meaning of Cash Flow Statement
8.3
Difference between Cash Flow Statement and Fund Flow
NOTES
Statement
8.4
Utility of Cash Flow Analysis
8.5
Preparation of Cash Flow Statement
8.5.1
Transactions Affecting of Cash Inflows and Cash Outflows
8.5.2
Construction of Cash Flow Statement
8.5.3
Cash from Business Operations
8.5.4
Form of Business Statement of Cash from Business Operation
8.5.5
Proforma of Cash Flow Statement
8.6
Limitations of Cash Flow Analysis
8.7
Illustrations
8.8
Summary
8.9
Key Terms
8.10 Questions and Exercises
8.11 Further Reading
8.0 Introduction
Fund flow statement indicates movement of funds or change in working
capital but cash flow statement shows movement of cash only. The statement of
changes in financial position can also be prepared on the basis of the cash
concept of the word ‘Fund’. It is knows as Cash Flow Statement is important to
understand the paradoxical situation in which a firm finds difficulty in honoring its
short-period business commitments despite the existence of sufficient working
capital as indicated by the Fund Flow Statement (working capital basis). This
happens when a large proportion of working capital is tied up in the form of
inventories and other working capital concept does not take into account the
qualitative structure of working capital. Cash is peculiar component of working
Management Accounting - I
187
Cash Flow Statement
NOTES
capital. It should be distinguished from other components in any scheme of shortperiod financial planning. The Cash Flow Statement enables a firm to know the
availability of cash from different sources and the manner of its utilization.
8.1
Unit Objectives
After studying this unit you should be able to :
•
Understand the meaning of Cash Flow Statement.
•
Differentiate between Cash Flow and Fund Flow Statement
•
Explain the utility of Cash Flow Statement.
•
Identify transactions affecting on Cash In Flows and Out Flows.
•
Construct the Cash Flow Statement.
•
Calculate Cash from business operations.
•
Prepare Cash Flow Statement.
•
Discuss the limitations of Cash Flow Statement.
8.2 Meaning of Cash Flow Statement
Cash Flow Statement as its name suggests takes into consideration only
those transactions which are related with movement of cash and all those dealings
which affects the cash position of the concern. With the help of cash flow statement,
a finance manager can ensure that business will have liquid assets for meeting
day to day expenses.
A plan of cash flow will show whether or not a company can expect a
sufficient flow of cash from operations to enable it to meet debt payment schedules
promptly with enough remaining for additional investment. Cash Flow Statement
is appropriate for a short range planning.
A projected Cash Flow Statement tells the management about the cash
position at different timings. The management can arrange for additional necessary
cash in case cash outflow exceeds the cash inflow in any particular period of
time. Similarly surplus cash, if any, can be invested for effective utilization of cash
balances.
When all transactions such as sales, purchases, incomes and expenses are
in cash, net profit is equivalent to net cash from operations.
In actual practice we never come across as stated above.
Most of the transactions of the business are on credit basis so that net profit
can be equal to net cash from operations.
188 Management Accounting - I
8.3
Difference Between Cash and Fund Flow
Statement
Fund Flow Statement
1. The term fund refers to working
Cash Flow Statement
1. The term cash refers to cash
capital and it shows change in
only and it shows change in
position of working capital.
cash position of business.
2. The analysis is more useful in
long term planning
3. This considers changes in all
Cash Flow Statement
NOTES
2. This is more useful in short
term planning.
3. This indicates simply cash
current assets and current
receipt and cash payments and
liabilities.
does not take into consideration
ohter Current Assets.
4. Improvement in working capital
4. Cash is one constituent of
does not mean improvement in
working capital as improvement
cash position.
in cash position results in
improvement in working capital.
5. This indicated inflow of fund
and outflow of fund.
6. Fund flow statement is vast
5. This indicates inflow of cash
and out flow of cash.
6. As compare to fund flow
concept which includes flow
statement, cash flow statement
of cash also.
is a narrow concept which
includes inflow and outflow of
cash only.
7. This is test of effective use of
7. This a test of effective flow of
working capital by the
cash by the management in a
management in a particulars
particular period of time.
period of time.
8. With the help of funds statement,
8. With the help of cash flow
a financial manager can ensure
statement, a financial manager
that the business will have funds
can ensure that the business
Management Accounting - I
189
Cash Flow Statement
when required.
will have liquid asssets for
meeting day to day expenses.
9. This explains in brief the
NOTES
9. This explains the movement of
changes occurred in the items
cash and all those dealings which
in two balance sheet.
affects the cash position of
the concern.
10. It indicates the overall credit
10. It shows how much money
worthiness of the business.
should be in balance in cash
box at any given time.
8.4
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.
Discloses
the
movements
of cash
Providing
information
about funds
available
from
operations
Utility of
Cash Flow
Analysis
Discloses
success of
failure of
cash planning
Help in
evaluating
financial policies
and
cash position
Fig. 8.1 :
Following are the uses of Cash Flow Analysis :
1.
190 Management Accounting - I
Discloses the movement of cash : Cash flow statement discloses the
picture of cash movement. The reason for increase in and decrease for
cash can be indicated by the cash flow statement. Cash flow analysis also
discloses the various reasons for low cash balance inspite of heavy operation
profits or for heavy cash balance inspite of low profits.
2.
Discloses success or failure of cash planning : With the help of
comparing the projected cash flow analysis, the extent of success or failure
of cash planning can be determined. The projected cash flow statement is
compared with the actual cash flow statement and necessary remedial
measures can be taken by the organisation.
3.
Help in evaluating financial policies and cash position : Cash is the
basis for all operations and hence a projected cash flow statement will
enable the management to plan and co-ordinate 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 could be obtained from outside.
4.
Providing information about funds available from operations : 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
debt, dividend policies, planning replacement of plant and machinery, etc. In
this way, cash flow analysis helps in managing internal financial sources.
5.
Other uses of cash flow statement : Cash flow statement is a useful
supplementary instrument. It discloses the volume as well as the speed at
which the cash flows in the different segments of te business. This helps
the management in knowing the amount of capital tied up in a particular
segment of the business. The technique of cash flow analysis, when used in
conjunction with ratio analysis, serves as a barometer in measuring the
profitability and financial position of the business.
8.5
Cash Flow Statement
NOTES
Check Your Progress
How cash flow statement is
useful for short term
planning ?
Preparation of Cash Flow Statement
A Cash Flow Statement is prepared to show the movements of cash between
the closing dates of two Balance Sheets. It starts from the opening cash and ends
with the closing balance of cash showing different sources from where cash was
received and the manner in which it was utilised during the period for which Cash
Flow Statement is prepared.
8.5.1 Transactions affecting on Cash Inflows and Cash
Outflows
The useful transactions resulting in cash inflows are :
(i)
Issue of shares;
(ii)
Issue of debentures,
(iii)
Sale of investments,
Management Accounting - I
191
Cash Flow Statement
(iv)
Sale of assets,
(v)
Cash from business operations.
Cash outflows due to its application for various purpose such as :
NOTES
(i)
Redemption of preference shares,
(ii)
Redemption of debentures,
(iii)
Purchase of investments,
(iv)
Purchase of assets,
(v)
Cash Issues in business operations.
Cash outflows due to its application for various payments purpose such as :
(i)
Redemption of preference shares,
(ii)
Redemption of debentures,
(iii)
Repayment of loans,
(iv)
Payment of taxes,
(v)
Payment of dividend.
8.5.2 Construction of Cash Flow Statement
Check Your Progress
Which
transactions
affecting on Cash Inflows
& Cash Outflows ?
192 Management Accounting - I
While constructing the cash flow statement, following points are important :
1.
An increase of share capital, debentures and loans clearly means that cash
inflow took place due to additional issue of shares and debentures and
obtaining further loans during the year.
2.
A decrease in current year figures of the liabilities will mean liquidation of
liabilities and hence an application of cash.
3.
A comparison of non-current assets like land and buildings, plant and
machinery, furniture, trade investment, etc. will tell whether there had been
increase or decrease in cash or an item resulted in cash inflow or cash
outflow. (For example An increase in current year’s amount of furniture
clearly means cash outflow due to purchase of additional furniture.
Conversely, a decrease in current years amount of furniture means sale
and hence an application of cash).
4.
To calculate, how variations in noncurrent assets and liabilities generate or
use funds (cash) the following general rules are to be kept in mind.
(a)
Increase in Non-current liability
=
Cash Inflow
(b)
Decrease in Non-current liability
=
Cash Outflow
(c)
Increase in Non-current asset
=
Cash Outflow
(d)
Decrease in Non-current asset
=
Cash Inflow
(Note : The net cash inflow or outflow can be arrived at only after preparing the
relevant account by allowing for appropriate adjustments, if any).
Cash Flow Statement
8.5.3 Cash from Business Operations
The traditional Profit and Loss Account is based on certain accounting
concepts and conventions such as accrual and matching principles according to
which non-operating and non-cash items are also brought into it. Therefore, the
net profit as shown by a traditional Profit and Loss Account cannot be equivalent
to cash and as such it needs certain adjustments to arrive at net cash inflow or
cash losses due to business operations. The adjustments are required in respect of
the non-operating and non-operating and non-cash items which do not affect the
cash flows.
NOTES
Adjustments for changes in current assets and current liabilities.
The changes in current assets and current liabilities affecting changes in
cash position should, therefore, be taken into account in the calculation of cash
from business operations.
“Notional Cash Concept” and “Actual Cash Concept”.
There are two methods to deal with the current assets and current liabilities
in preparation of cash from business operations. One is “Notional Cash Concept”
and another is “Actual Cash Concept” Method. The variations in working capital
components may either be shown in the Cash Flow Statement itself or they may
be considered separately in the calculation of cash from business operations. The
former course is adopted when notional concept of cash is followed and later
method is applied when actual cash concept is implemented.
Check Your Progress
(i) “Motional
Concept” ?
Cash
(ii) “Actual Cash Concept” ?
According to ‘Notional Cash’ concept, a decrease in current assets and an
increase in current liability is taken as a source of cash. Similarly, an increase in
current assets and decrease in current liability is considered as an application of
cash. The ‘Notional Cash Concept’ can be understood with the help of an example.
Suppose a firm has purchased raw material worth ` 15,000 on credit and it has
not paid the amount by the end of accounting year. In this case ` 15,000 will
appear as creditors on the liability side of the Balance Sheet of the firm, and this
will be taken as a source of cash. How is this when there is no actual receipt of
cash. The ‘Notional Cash Concept’ assumes that the firm will borrow ` 15,000
and make payment to the supplier of raw materials. Thus borrowings ` 15,000
means a source of cash.
In actual practice, generally, “actual cash concept” is followed in the
preparation of cash flow statement. It means actual cash received and actual
cash paid are brought in to the cash flow statement and the variations in the
current assets and current liabilities are separately treated in the statement of
cash from business operations.”
Management Accounting - I
193
Cash Flow Statement
8.5.4 Form of “Statement of Cash from Business
Operation”
Cash from Business Operations can be calculated by collecting and
summarising the relevant informations in the following form :
NOTES
Statement of Cash from Business Operations
`
Net Profit as per Profit and Loss A/c :
1. Add :
Add :
2. Less :
Less :
3. Add :
4. Less :
194 Management Accounting - I
-
Decrease in Current Assets
Decrease in debtors
-
Decrease in stock
-
Decrease in Prepaid expenses
-
Decrease in Accrued Incomes
-
Increase in Current Liabilities
Increase in creditors
-
Increase in bills payable
-
Increase in outstanding expenses
-
Increase in income received in advance
-
Increase in Current Assets
Increase in debts
-
Increase in stock
-
Increase in prepaid expenses
-
Increase in accrued incomes
-
Decrease in Current Liabilities
Decrease in creditors
-
Decrease in Bills Payable
-
Decrease in outstanding expenses
-
Decrease in advance incomes
-
Non-current Expenses
Depreciation
-
Assets discarded
-
Preliminary expenses written off
-
Provision for losses, etc.
-
Non-operating Incomes
Profit on sale of asset
-
Tax refund
-
Unusual incomes
-
Cash From Business Operation of Cash Losses
-
Cash Flow Statement
Statement of Cash From Operations
Net Profit as per P and L A/c
Add :
`
`
XXXX
XXXX
(a) Non Cash items like :
Depreciation
XXXX
Loss on Sale of Assets
XXXX
Intangible Assets written off (Goodwill)
XXXX
Deferred Revenue Expenses
XXXX
NOTES
(Discount on debentures, brokerages, preliminary exp.
etc.) written of
Provision for RDD
Add :
XXXX
(b) Other items :
Decrease in Debtors
Decrease in Stock
Decrease in Prepaid Expenses
Decrease in Accrued Income
Check Your Progress
(i.e. Decrease in Current Assets)
Increase in Creditors
Which items increases in
Current assets & decreases in
current assets ?
Increase in Out Standing Expenses
Increase in Income received in Advance
(i.e. Increase in Current Liabilities)
Less : (a) Non Business Incomes like :
XXXX
XXXX
XXXX
Profit of Sale of Fixed Assets
Rent Received
Dividend Received etc.
XXXX
Less : (b) Income in Debtors :
Increase in Stock
Increase in Prepaid Expenses
Increase in Accrued Incomes
(i.e. Increase in current Assets)
Decrease in creditors
Decrease in Outstanding Expenses
Decrease in Income Received in Advance
(i.e. Decrease in Carate Liabilities)
Cash from Trading Operation
XXXX
XXXX
Management Accounting - I
195
Cash Flow Statement
NOTES
If instead of “Net Profit” there is “Net Loss” the items added here will be
deducted and items deducted will be added. Imp : If the total of less items is more,
the resulting figures is the outflow of cash on account of operation i.e. Cash lost in
operation.
8.5.5 Proforma of Cash Flow Statement
A specimen proforma of cash flow statement in an account form is given below :
Inflow (Sources)
Check Your Progress
Which items included in
“Cash Inflow” ?
Opening Cash Balance
`
`
XXX Outflow of Cash
Add : Cash Inflow
*Cash from Operation
Outflow (Uses)
(a)
XXX (b)
Sources (Inflow)
Purchase of freehold
Purchase of Plant and
Machinery
(a)
Sale of Machinery
-
(b)
Sale of Fixture
-
(c)
Share Capital
-
(d)
Share Premium
(e)
(c)
-
Purchase of Furniture
and Fixture
-
(d)
Purchase of Vehicle
-
-
(e)
Purchase of Building
-
Increase in Creditors
-
(f)
Purchase of Investment
-
(f)
Loans
-
(g)
Repayment of Debentures
-
(g)
Sale of Investment
-
(h)
Repayment of O.D.
-
(h)
Decrease in Sundry Debtors
-
(i)
Repayment of Bank Loan
-
(i)
Sale of Vehicle
-
(j)
Payment of Dividend
-
(j)
Bank Overdraft
-
(k)
Payment of Tax
-
(k)
Loan from wife
-
(l)
Increase in Pre-Paid Exp.
-
(l)
Increase in Bank Loan
-
(m) Increase in Outstanding
-
(Rent)
(m)
Wages
Increase in Stock
-
(Inventory)
(n)
Decrease in Stock
-
(n)
Increase in Sundry Debtors
-
(o)
Increase in Current
-
(o)
Increase in Accounts
-
Liabilities for goods
Receivable
(p)
Mortgage Loan
-
(p)
Decrease in Creditors
-
(q)
Increase in Accounts
-
(q)
Decrease in Outstanding
-
Payable
(r)
Increase in Accrued
Expenses
-
(r)
Expenses
Decrease in Account
-
payable (B.P.)
(s)
Drawings
-
Cash lost on Operation /
Operating Loss
Cash / Bank Balance (Closing)
XXX
196 Management Accounting - I
XXX
XXX
8.6
Cash Flow Statement
Limitations of Cash Flow Analysis
Following are the limitations of cash flow analysis :
1.
The cash balance as disclosed by the cash flow statement may not represent
the real liquid position of the business since it can be easily influenced by
postponing purchases and other payments.
2.
Cash flow statement cannot replace the Income Statement or the Funds
Flow Statement Each of them has a separate function to perform.
3.
Cash flow statement cannot be equated with the Income Statement. An
Income Statement takes into account both cash as well as non-cash items
and, therefore, net cash flow does not necessarily mean net income of the
business.
4.
In cash flow statement, comparison of original forecast with actual results
highlights the trends of movement of cash which may otherwise go
undetected.
NOTES
The concept of Cash Flow Statement can be understood with the help of
following illustrations.
8.7 Illustrations
ILLUSTRATION 1
From the following summary of assets and liabilities from the records of
Activa Ltd., Ajmer calculate Cash and Cash Equipments as on 31-3-2013 and
31-3-2014.
Assets and Labilities
As on
As on
31-3-2013
31-3-2014
`
`
Cash in Hand
3,600
2,400
Bank Overdraft with Dena Bank
8,700
7,300
Current Account Balance - Union Bank
18,900
16,600
Cash Credit - Bank of Maharashtra
10,400
9,600
Marketable Securities (Short Term)
10,300
8,100
Fixed Deposit - Indian Bank Account
17,200
12,900
Short Term Loan from Bank of India
10,900
8,100
Management Accounting - I
197
Cash Flow Statement
SOLUTION
In the books of Activa Ltd.
Statement showing Cash and Equivalents
NOTES
Particulars
As on
As on
31-3-2013
31-3-2014
`
`
3,600
2,400
Assets
i)
Cash in Hand
ii)
Current Account Balance - Union Bank
18,900
16,600
iii)
Marketable Securities (Short Term)
10,300
8,100
iv)
Fixed Deposit - Indian Bank Account
(+)
17,200
12,900
Total (A)
50,000
40,000
8,700
7,300
Less Liabilities
i)
Bank Overdraft with Dena Bank
ii)
Cash Credit - Bank of Maharashtra
10,400
9,600
iii)
Short Term Loan from Bank of India
10,900
8,100
30,000
25,000
20,000
15,000
Total (B)
 Cash and Cash Equivalents (A-B)
ILLUSTRATION 2
From the following operating activities undertaken during the year 2014 calculate
net cash flow from Operating Activities
`
Payment of works overheads
Income-Tax paid
Wages to managerial staff
Trading goods purchased for cash
3,89,000
64,000
1,04,700
Rent of factory workshop
13,000
Sales Commission paid
27,300
Commission on Trading Activities received
39,000
Refund of Income Tax
10,000
Taxes on Business Premises
46,900
Turnover for cash
Distribution on cost
Insurance claim received
5,74,000
17,100
2,70,000
Payment of Administration on cost
52,300
Salary to Production Staff
35,000
Periodic payment to credit suppliers
83,700
Collection from credit customers
198 Management Accounting - I
77,000
Royalties Received
13,67,000
20,000
Cash Flow Statement
SOLUTION
Statement showing Net cash flow from Operating Activities
Particulars
`
Cash Inflows
i)
Turnover for cash
ii)
Collection from credit customers
iii)
Commission on Trading Activities received
iv)
Royalties Received
5,74,000
13,67,000
NOTES
39,000
(+)
Total (A)
20,000
20,00,000
Cash Outflows
i)
Payment of works overheads
77,000
ii)
Wages to managerial staff
64,000
iii)
Trading goods purchased for cash
iv)
Rent of factory workshop
13,000
v)
Sales Commission paid
27,300
vi)
Taxes on Business Premises
46,900
vii)
Distribution on cost
17,100
vii)
Payment of Administration on cost
52,300
1,04,700
viii) Salary to Production Staff
ix)
Periodic payment to credit suppliers
35,000
(+)
Total (B)
83,700
5,21,000
 Cash from Operations before Tax (A-B)
14,79,000
Less Income Tax (Net of Refunds)
3,79,000
(Tax paid Less I. Tax Refund)
(3,89,000 Less 10,000
(-)
 Cash flow before Extra Ordinary item
Add Insurance claim received
 Net Cash Flow from Operating Activities
11,00,000
(+)
2,70,000
13,70,000
Management Accounting - I
199
Cash Flow Statement
ILLUSTRATION 3
From the following summary of fixed assets and reinvestment and additional
information find out the Net Cash Flow from Investing Activities.
Particulars
NOTES
As on
As on
31-3-2013
31-3-2014
`
`
Furniture and Fixtures
1,12,000
1,40,000
6% Investments in shares
3,20,000
2,82,000
27,000
39,000
Plant
2,40,000
3,00,000
Machinery
1,75,000
1,42,000
Buildings
4,19,000
2,56,000
Motor Vehicles
1,86,000
1,20,000
Copyrights
Addition of Information :
i) Cash dividends received on shares invested amounted to ` 20,000
SOLUTION
Statement showing Net Cash Flow from Investing Activities
Particulars
`
Cash Inflows
i)
Disposal of 6% investments in shares
38,000
ii)
Sale of Old Machinery
33,000
iii)
Sale of Buildings
iv)
Disposal of Motor Vehicles
v)
Cash Dividends on Shares Invested
1,63,000
66,000
(+)
20,000
Total (A)
3,20,000
Cash Outflows
i)
Purchase of Furniture and fixtures
28,000
ii)
Copyrights purchased
12,000
iii)
Purchase of Plant
 Net Cash Flow from Investing Activities (A-B)
200 Management Accounting - I
(+)
60,000
Total (B)
1,00,000
2,20,000
ILLUSTRATION 4
Cash Flow Statement
From the following summary of debt equity financing transactions and additional
information find out the Net Cash Flow from financing Activities.
Particulars
As on
As on
31-3-2013
31-3-2014
`
`
Equity Share Capital
3,50,000
6,20,000
8% Mortgage Debentures
1,80,000
1,28,000
-
1,60,000
Govt. Bonds
3,75,000
4,50,000
6% Redeemable Preference share capital
2,10,000
1,75,000
-
20,000
Long Term Borrowings from Bank
Underwriting commission on Issue of Equity Shares
NOTES
Additional Information :
a)
Cash dividends paid during the year amounted to ` 30,500.
b)
Interest on 8% Mortgage Debentures paid amounted to ` 17,500.
SOLUTION
Statement showing Net Cash Flow from Financing Activities
Particulars
`
Cash Inflows
i)
Cash processed form Issue of Equity Shares
2,70,000
ii)
Long Term Borrowings from Bank
1,60,000
iii)
Cash proceeds form Issue of Govt. Bonds
Cash Outflows
i)
Redemption of 8% Mortgage Debentures
ii)
Redemption of 6% Redeemable Preference
Share Capital
iii) Undertaking commission on issue of Equity Shares
iv) Payment of Cash Dividends
v) Interest on 8% Mortgage Debentures paid
 Net Cash Flow from financing Activities (A-B)
(+)
75,000
Total (A)
5,05,000
52,000
(+)
Total (B)
35,000
20,000
30,500
17,500
1,55,000
3,50,000
Management Accounting - I
201
Cash Flow Statement
ILLUSTRATION 5
The Income Statements of Bosco Ltd., Baroda for the year ended 31st March,
2014 is as follows.
Profit and Loss Account for the year ended 31st March, 2014
NOTES
Dr.
Cr.
Particulars
To Opening Stock
To Purchases
`
Particulars
8,500 By Sales
`
80,000
23,000 Less Ref. Inwards
Less Ref. Outwards
To Productive Wages
3,700 By Closing Stock
To Carriage on Purchases
1,200
To Gross Profit C/D
50,600
87,000
Particulars
7,000
`
To Depreciation on
87,000
Particulars
By Gross Profit B/D
Buildings
4,400 By Profit on Sale of
To Sales Depot. Rent
3,300 Furniture
`
50,600
2,000
(Cost Price ` 3,000
To Loss on Sale of
Machinery
1,600 Market Price ` 5,000)
To Salary
9,600 By Commission received
To Goodwill written off
1,600 By Rent received
To Printing
1,000
To Provision for Tax
2,800
To Additions to Reserve Fund
5,900
1,600
800
To Preliminary Expenses
written off
1,800
To Discount on issue of shares
1,000
To Net Profit C/D
22,000
55,000
You are required to calculate cash from operations.
202 Management Accounting - I
55,000
Cash Flow Statement
SOLUTION
In the books of Bosco Ltd., Baroda
Statement showing Cash from Operations
Particulars
`
`
NOTES
Net Profit as per Profit and Loss Account
Add Non-cash charges
22,000
(which do not result in outflow of cash)
19,100
i)
Depreciation of Buildings
4,400
ii)
Loss on sale of Machinery
1,600
iii)
Goodwill written off
1,600
iv)
Provision for tax
2,800
v)
Additions to Reserve Fund
5,900
vi)
Preliminary Expenses written off
1,800
vii)
Discount on Issue of Shares
1,000
(+)
(+)
41,100
Less Non-Cash Incomes
2,000
(which do not result in inflow of cash)
i) Profit on Sale of Furniture
2,000
(+)
(+)
 Cash from operations
39,100
ILLUSTRATION 6
The Assets and Liabilities as on 31st March, 2013 and 31st March 2014 were as
under :
Assets and Liabilities
Trade Receivables
Trade Payables
Notes Receivables
Notes Payables
Expenses Payable
Incomes Receivables
Prepaid Expenses
Pre-received Incomes
As on
31-3-2013
`
19,350
14,750
7,500
4,900
700
450
1,100
170
As on
31-3-2014
`
16,350
19,750
10,000
2,900
900
600
1,000
120
Additional Information :
a)
Net Profits (after tax) made during the year 2013-14 amounted to ` 15,400.
Management Accounting - I
203
Cash Flow Statement
NOTES
b)
Depreciation on Machinery as per written down value method was ` 6,500
c)
Profit on sale of investments amounted to ` 1,500.
Prepare a statement showing cash from operations for the year ended
31st March, 2014.
SOLUTION
Statement showing Cash from Operations for the year ended 31st March, 2014
Particulars
`
`
Net Profit (after tax) made during the year 2013-14
15,400
Add Non-cash charges
i)
Depreciation on Machinery
6,500
(+)
6,500
(+)
21,900
Use Non-cash Incomes
i)
Profit on Sale of Investments
1,500
(+)
1,500
(-)
Operating Profit before working capital charges
20,400
Add
A)
3,100
Decrease in Current Assets
i) Trade Receivables
ii) Prepaid Expenses
B)
3,000
(+)
100
Increase in Current Liabilities
5,200
i) Trade Payables
ii) Expenses Payables
5,000
(+)
200
(+)
28,700
Less
A)
2,650
Increase in Current Assets
i) Notes Receivables
ii) Income Receivables
B)
2,500
(+)
Decrease in Current Liabilities
2,050
i) Notes Payables
ii) Pre-received Incomes
 Cash from Operations
204 Management Accounting - I
150
2,000
(+)
50
(-)
24,000
8.8 Summary
•
Cash Flow Statement : Cash Flow Statement as its name suggests take into
consideration only those transactions which are related with the movement
of cash and all those dealings which affects the cash position of the concern
•
Utility of Cash Flow : (i) Discloses the movements of cash (ii) Discloses
success or failure of cash planning (iii) Help in evaluating financial policies
and cash position (iv) Providing information about funds available from
operations.
•
Useful transactions resulting in Cash Inflows : (i) Issue of shares, (ii) Issue
of Debentures, (iii) Sale of Investments, (iv) Sale of Assets, (v) Cash from
Business operations etc.
•
Useful transactions resulting in Cash Outflows : (i) Redemption of prefinance
shares, (ii) Redemption of debentures, (iii) Purchase of Investments, (iv)
Purchase of assets, (v) Cash losses in operations etc.
Cash Flow Statement
NOTES
8.9 Key Terms
(i)
‘CASH’ Flow Statement : In cash flow analysis each item of the revenue
and expenditure is placed on a cash basis by relating it to a particular current
assets or current liability classification.
(ii)
‘Notional Cash’ concept and ‘Actual Cash’ concept : These are the
two methods to deal with the current assets and current liabilities in
preparation of cash from business operations. According to ‘Notional Cash’
concept, a decrease in current assets and increase in current liability is
taken as a source of cash. On the other hand, in ‘Actual Cash’ concept actual cash received and actual cash paid are brought into the cash flow
statement and the variations in the current assets and current liabilities are
separately treated in the statement of cash from business operations.
8.10 Questions and Exercises
I- Objective Questions
A) Multiple Choice Questions
(1)
Funds Flow Statements are prepared for ----- period, whereas cash flow
statements are of --------- duration.
(a) Long term - Short term
(b) Short term - Long term
(c) Subsequent - Long term
Management Accounting - I
205
Cash Flow Statement
(d) Short term - Endless
(2)
Cash flow statement is an effective instrument of ------(a) Profit Planning
(b) Cash Planning
NOTES
(c) Business Planning
(d) Cost Planning
(3)
The stock of inventory at the beginning and at the end of the year are `
3,700 and ` 3,7000 respectively. The cash purchases of inventory and credit
purchases of inventory amounted to ` 30,100 and ` 64,200. The cash
sales and credit sales made during the year amounted to ` 29,900 and `
86,400. Hence cash generated from operation is --------(a) ` 56,500,
(4)
(b) ` 1,16,1300,
(c) ` 29,900,
(d) ` 30,100
Goodwill written off is ---------- the profit made during the year for calculation
of cash generated from operations.
(a) ignored from
(b) adjusted to
(c) deducted from
(d) added back to
Ans. : (1 - a), (2 - b), (3 - c), (4 - d)
II- Long Answer Questions
(1)
What is ‘Cash Flow Statement’ ? How it differs from funds flow statement.
(2)
Define ‘Cash Flow Statement’. Explain the utility of Cash Flow Analysis.
(3)
Explain in brief the important steps involved in the preparation of Cash
Flow Statement.
(4)
What do you understand by ‘Cash Flow statement’? Explain in brief the
transactions affecting cash inflows and cash outflows.
(5)
Explain in brief the uses and limitation of cash flow analysis.
(6)
Write short notes on :
(a) Utility of Cash Flow Analysis
(b) Cash Inflows and Cash Outflows
206 Management Accounting - I
(c) Construction of Cash Flow Statement
Cash Flow Statement
(d) Cash from Business Operations
(e) Notional Cash Concept
(f) Limitations of Cash Flow Analysis
NOTES
III - Practical Problems
(1)
Calculate Net Cash Flow from following operating activities undertaken
during the year 2013-14 by Amco Enterprises, Ahmedabad.
Particulars
Royalties received on production basis
Cash received from Trade Receivables
`
12,400
2,69,300
Payment to Sundry Creditors
15,700
Remunerations to Administrative staff
20,900
Management Expenses paid
Receipt of Insurance claim
Payment of Distribution overheads
Cash Sales
5,600
1,45,100
27,800
1,72,900
Corporation Tax paid
17,200
Income Tax Refund
18,400
Commission received on trading activities
3,900
Selling commission paid
2,100
Rent of Business premises
7,800
Purchases of Goods - cash
31,300
Productive Wages
46,700
Payment of Income Tax
53,900
Factory Expenses paid
10,400
(2)
Calculate the Net Cash Flow from the following Investing activities.
a) Additional Information :
i)
Cash dividends received on shares purchased during the year amounted
to ` 15,000
b) Summary of fixed assets and reinvestments during the year 2013-14.
Management Accounting - I
207
Cash Flow Statement
Particulars
NOTES
As on
As on
31-3-2013
31-3-2014
`
`
Business Premises
3,27,000
4,72,000
Machinery
5,72,000
2.69,000
Furniture
1,61,000
1,89,000
Motor Vehicles
1,79,000
1,06,000
Investments in Govt. Bonds
1,27,000
1,41,000
36,000
40,000
2,48,000
1,17,000
Goodwill
Land
(3)
From the following accounting information calculate cash inflow from total
debtors and cash outflows to total creditors
Particulars
`
Total Debtors as on opening
12,800
Closing balance of Total Creditors
20,400
Turnover on credit basis
Returns to credit suppliers
2,27,200
4,100
Acceptances received from credit customers
10,600
Purchases for cash
18,100
Discount Allowed to trade debtors
Total Purchases
7,300
1,98,100
Credit customers becoming insolvent
2,700
Bills payable issued during the period
13,500
Returns from credit customers
3,200
Discount received from Creditors
6,900
Closing balance of Total Debtors
35,700
Cash Sales
31,300
8.11 Further Reading
208 Management Accounting - I
•
Prasad N. K. and Prasad A.K. - Cost and Management Accounting - Book
Syndicate Pvt. Ltd. - Kolkatta - 2010
•
Jawahar Lal - Accounting for Management - Mumbai - Himalaya Publishing
House Pvt. Ltd. - 2012
TOPIC 3
Working Capital Management
UNIT 9
Concept and Definition of
Working Capital
UNIT 10
Components of Working Capital Management of Cash
UNIT 11
Accounts Receivable Management
UNIT 12
Inventory Management
UNIT 9 Concept and Definition of
Working Capital
Concept & Definition
of Working Capital
Structure
NOTES
9.0
Introduction
9.1
Unit Objectives
9.2
Concept and Definition of Working Capital
9.2.1
Main Constituents of Working Capital
9.3
Types of Working Capital
9.4
Meaning of Working Capital Cycle
9.5
Working Capital Management
9.6
Determination of Working Capital
9.7
Assessment of Working Capital Needs
9.8
Preparation of Statement of Working Capital Requirement
9.8.1
Common Items included in Calculation of Working
Capital Required
9.9
Sources of Working Capital
9.10 Approaches for Determining the Financial Mix
9.11 Illustrations
9.12 Summary
9.13 Key Terms
9.14 Questions and Exercises
9.15 Further Reading
9.0 Introduction
In accounting, “Working Capital is the difference between the inflow and
outflow of funds”. In other words, it is the net cash inflow. It is defined as the
excess of current assets over current liabilities and provisions. In other words, it is
“net current assets or net working capital”. This definition of working capital is
qualitative in character.
A study of working capital is of major importance to internal and external
analysis because of its close relationship with the day-to-day operations of a
Management Accounting - I
209
Concept & Definition
of Working Capital
NOTES
business. As pointed out by Ralph, Kennedy and steward Mc Muller the
inadequacy or mismanagement of working capital is the leading cause of business
failures. Working capital is the portion of the assets of a business which are used
on or related to current operations, and represented at any one time by the operating
cycle of such items as against receivables, inventories of raw materials, stores,
work-in-process and finished goods, merchandise, notes or bill receivables and
cash. The assets of the type are relatively temporary in nature.
9.1 Unit Objectives
After going through this unit, you will be able to :
•
Understand the concept and definition of Working Capital.
•
Explain determination of Working Capital.
•
Prepare a statement of Working Capital requirement.
•
Appreciate assessment of Working Capital need.
•
Identify the sources of Working Capital.
•
Identify the main constituents of Working Capital.
•
Explain the types of Working Capital.
•
Explain the Working Capital Cycle
•
Explain the term “Working Capital Management.”
•
Discuss the ‘Approaches for Determining the financial mix’.
9.2
Concept and Definition of Working Capital
Working Capital comprise current assets which are distinct from other assets.
In the first instance, current assets consist of these assets which are of short
duration. For example, cash is held idle for a week or so, accounts receivable may
not have a life span of more than three months and inventories may be held for
one to three months. The actual duration of each of these assets is contingent
upon the time required in the activities relating to procurement, production, sales
and collection and degree of synchronisation among them.
210 Management Accounting - I
Another distinguishing characteristic of current assets is that they change
their character swiftly. For instance, cash is used to buy raw materials which in
turn are transformed into work-in-progress and then in finished goods. With the
sale of the merchandise, finished goods turn into accounts receivable when goods
are sold on credit term. Collection of the receivables generates cash. A part of the
cash is used for defraying operating expenses, to pay creditors, pay taxes and
dividends and the rest is put into circulation again. This is why working capital is
also called Circulating capital.
Working capital may be regarded as the life blood of a business. Its effective
provision can do much to ensure the success of a business while its inefficient
management can lead not only to loss of profits but also to the ultimate downfall of
what otherwise might be considered as a promising concern.
Broadly speaking, the term working capital is understood in two different
but interlinked senses. In the first sense, working capital refers to sum total of all
current assets employed in the business process. This is know as ‘Gross working
capital’ concept. This is also known as going concern concept since finance
manager is highly concerned with the management of these assets with a view to
bringing about productivity from other assets. The gross concept of working capital
is considerably useful in making correct estimate of working capital needs of the
firm. Working capital is also understood in terms of net concept according to
which excess of current assets over current liabilities represents working capital.
Concept & Definition
of Working Capital
NOTES
Both the gross and net concepts are not to be regarded us mutually exclusive.
Each has its relevance in specific situations. Gross working capital concept focuses
on the problems of managing individual current assets in day-to-day operations. It
is in the nature of a quantitative definition that highlights attention on the levels of
current assets for given activity.
The emphasis, however, shifts when we consider the net working capital
concept. This is a qualitative definition which highlights the character of the sources
from which the funds have been procured to support that portion or current assets
which is in excess of current liabilities.
Working capital represents the total of all current assets. In other words it
is “gross working capital”. It is also known as circulating capital or current capital,
for current assets are rotating in their nature. Where current liabilities and provisions
exceed current assets, the difference is referred to as, negative working capital.
Working capital is rightly an adjunct of fixed capital investment. It is a financial
lubricant which keeps business operations going. In fact working capital
management is concerned with handling problems arising in course of managing
interrelationships between current assets and current liabilities. Those, who are to
pay off current liabilities and the quantum of funs which will be required by the
firm to fund the excess portion of current assets, will find the net concept
significantly useful.
Check Your Progress
How Working
Capital
Comprise current assets
which are distinct from other
assets ?
9.2.1 Main Constituents of Working Capital
The Net working capital represents current assets minus current liabilities.
Current assets refer to those assets which are used for day-to-day activities of
the firm.
(A) Current Assets:
These assets constitute the following :
(i)
Inventories : Inventories represent raw materials and components
work in progress and finished goods.
Management Accounting - I
211
Concept & Definition
of Working Capital
(ii) Trade debtors: Trade debtors comprise credit sale is to customers.
(iii) Prepaid expenses : These are those expense which have been
paid for goods and service whose benefits have yet to be received.
NOTES
(iv) Loans and advances : They represent loans and advances given
by a firm to other firms for a short period of time.
(v) Investment : These assets comprise short-term surplus funds
invested in government securities, shares and short-term bonds.
(vi) Cash and bank balances : These assets represent cash in hand
and at bank which are used for meeting operational requirements. This
kind of current assets is purely liquid but nonproductive.
(B) Current Liabilities :
Current libilities represent that part of obligations which the firm has to
clear to the outside parties in a short-period, generally within a year. These liabilities
comprise the following :
(i) Sundry Creditors : These liabilities stem out of purchase of raw materials on
credit terms usually for period of one to two months.
(ii) Bank Overdrafts : These include withdrawals in excess of credit balance,
standing in the firm’s current account with banks.
(iii) Short-Term Loans : Short-term borrowings by the firm from banks and
others form part of current liabilities as short-term loans.
(iv) Provisions : These include provisions for taxation, proposed dividends and
contigencies.
Chart showing Examples of Current Assets and Current Liabilities
Current Assets
1. Cash and bank balances.
Current Liabilities
1. Short-term borrowings (including
bills purchased and discounted
from banks and others).
2. Investments (marketable securities) 2. Unsecured loans maturing within
‘Governments and other trustee
one year.
securities (other than for long-term
purpose. e.g., Sinking fund, Gratuity
fund etc.)
212 Management Accounting - I
3. Fixed deposits with banks one
(maturing within one year)
3. Public deposits maturing within
year.
4. Receivables arising out of sales
4. Sundry creditors (trade) for raw
other than deferred receivables
materials and consumable stores
(including bills purchased and
and spares.
Concept & Definition
of Working Capital
discounted by bankers).
5. Installments of deferred receivables 5. Interest and other charges due for
due within one year.
payment.
6. Raw materials and components
used in the process of manufacturing
6. Advance/Progress payments from
NOTES
customers.
including those in transit.
7. Stocks-in-process including semifinished goods.
8. Finished goods including goods in
transit.
7. Deposits from dealers, selling
agents etc.
8. Installments on term loans, deferred
payment credits, debentures, and
long term deposits payable within
one year.
9. Other Consumable Spares
9. Statutory labilities.
10. Advance payment for Tax
10. Provident fund dues.
11. Pre-paid expenses
11. Provision for taxation.
12. Advances for Purchase of raw
12. Sales-Tax, excise, etc.
Check Your Progress
materials, components and
Give the list of current assets
& current liabilities included
in Balance Sheet ?
consumable stores.
13. Deposits kept with public bodies 13. Statutory obligations towards
etc. for normal business operation
workers. Miscellaneous current
(e.g. earnest deposit kept by
liabilities:
construction companies etc.maturing
(a) Dividends
maturing within the normal operating
(b) Liabilities for expenses
cycle).
(c) Gratuity payable within one year
(d) Any other payment due with 12
months.
14. Money receivable from contracted
sale of fixed asset during the next
12 months.
Management Accounting - I
213
Concept & Definition
of Working Capital
9.3 Types of Working Capital
Working Capital can be classified as follows :
1
2
3
Permanent
Working Capital
Temporary
Working Capital
Gross
Working Capital
NOTES
4
5
Net
Working Capital
Negative
Working Capital
Fig. 9.1 : Types of Working Capital
214 Management Accounting - I
1.
Permanent working capital : It means the minimum amount of investment
in all current assets which is regarded at all times to carry on minimum level
of business activities. The operating cycle is a continuous process and
therefore, the need for current assets. But the magnitude of current assets
increases and decreases over time. There is a always a minimum level of
current assets required at all time by the firm to carry on its business
operations. This minimum level of current assets required known as
‘permanent working capital’ or ‘fixed working capital’. Tendon Committee
has named it as ‘core current assets’. Thus, minimum amount of current
assets which the firm has to hold for all the time to come to carry on
operations at any time is termed as ‘permanent or regular working capital.
It represents ‘hard core’ of the working capital’. Financing of this portion
of working capital should be made on the line of fixed assets. However,
permanent working capital differs from fixed assets. Permanent working
capital will tend to expand so long as the firm experiences growth in its
operations.
2.
Temporary working capital : This is also called the ‘fluctuating or variable
working capital’. The amount of temporary working capital keeps on
changing depending upon the change in production and sales. For example,
extra inventory of finished goods will have to be maintained to support the
peak periods of sale and the investment in receivables may also increase
during such period. On the other hand investment in raw material, work-in
progress and finished goods will decrease if the market is slack. The extra
working capital required to support the changing production and sales
activities is known as ‘temporary working capital’.
This additional amount of working capital represents variable or temporary
working capital, size of which depends upon changes in levels of, production
and sales resulting from changes in market conditions. Fund requirements
for this purpose are of short duration.
3.
Gross working capital : It is the amount of funds invested in the various
components of current assets. The gross working capital is considerably
useful in making current estimate of working capital needs of the firm.
4.
Net working capital : It is the difference between current assets and
current liabilities. The concept of net working capital enables a firm to
determine the exact amount available at its disposal for operational
requirements.
5.
Concept & Definition
of Working Capital
NOTES
Negative working capital : When current liabilities exceed current assets
negative working capital emerges. Such a situation occurs when a firm is
nearing a crisis of some magnitude.
9.4 Meaning of Working Capital Cycle
(1)
The duration of time required to complete the following cycle of events in
case of a manufacturing firm is called the operating cycle (Working Capital
Cycle):
1.
Conversion of cash into raw materials.
2.
Conversion of raw materials into work in process.
3.
Conversion of work in process into finished goods.
4.
Conversion of finished goods into debtors and bills receivables through sales.
5.
Conversion of debtors and bills receivables into cash.
Factors which decide the approximate amount of working capital, can be
easily observed in the ‘Operating Cycle’ of any manufacturing firm. (Please see
the figure).
2. Raw
Materials
3. Work In
Progress
1. Cash
5. Debtors
Operating Cycle
of Manufacturing
Firm
4. Finished
Goods
Fig. 9.2 : Operating Cycle of Manufacturing Firm
Management Accounting - I
215
Concept & Definition
of Working Capital
NOTES
Every business firm requires to have 1.
Minimum cash in hand for daily transactions (i.e. for ready liquidity).
2.
Minimum stock of raw material for avoiding production stoppage or problem
of scarcity of material in market.
3.
Minimum days time required for ‘production process’ i.e. for conversion of
a raw unit into a finished unit. Such process also consumes wages and
production overhead.
4.
Minimum stock of finished goods for avoiding loss of sales due to stakeout
(‘stack-out’ means a situation of inadequate stock of finished goods in the
warehouse to cater the demand fully. Hence, it causes ‘loss of sales’ leading
ultimately to ‘loss of profit’ and ‘loss of reputation in market’).
5.
Minimum days of credit to be given to customers. This involves block-up of
funds for the days of credit.
(2)
The operating cycle of a trading firm has the following cycle of events:
(i)
Cash into inventories.
(ii)
Inventories into accounts receivable.
(iii)
Account receivables into cash.
Therefore in the case of a “Trading firm”, the operating cycle will include
the length of time required to convert.
Operating Cycle of a Trading Firm is as follows :
3. Accounts Receivable
1. Cash
2. Stock of Finished Goods
Fig. 9.3 : Operating Cycle of a Trading Firm
(III) In the case of service and financial firms the operating cycle include
the length of time taken for :
216 Management Accounting - I
(i)
Conversion of cash into debtors and
(ii)
Conversion of debtors into cash.
9.5 Working Capital Management
Working capital management is a significant part of business decisions and
is of major concern to a finance manager in as much as accomplishment of value
maximization goal depends essentially on prudent working capital with which
finance manager is seriously concerned because problem of trade off between
risk and return is involved. A firm is required to carry adequate amount of working
capital so as to carry on the productive and distributive activities smoothly. The
level of working capital of a firm is fluctuating, depending upon changes in level of
fixed assets, seasonal factors, fiscal and monetary policies of the country and the
management policies.
Concept & Definition
of Working Capital
NOTES
In view of the above, decisions relating to working capital management are
repetitive and frequent. While taking any decisions in respect of one component
of working capital, thoughtful consideration of its implications on other components
needs to be given simultaneously.
A clever finance manager has to manage working capital in such a way as
to maximise profits of the firm without impairing its liquidity. This calls for setting
optimal level of working capital. Setting optimal level of working capital requires
an exercise of determining that level of current assets where total cost of liquidity
and cost of illiquidity is minimum. This is why management of working capital
calls for careful attention of a finance manager.
Float is the amount of money required to get into business. This is the
minimum amount necessary for maintaining a going concern which is in a position
to serve its customers. This amount of float in the form of a cash, inventory, and
other current assets is the minimum cushion needed to support a business. A
business needs working capital over and above the float. The requirements of a
business, moreover, are governed by the rate of its turnover, type of credit, the
seasonality of its operations, break-even point and other general considerations. A
financial manager has to maintain this float amount also.
Working capital management is particularly more important to small firms.
A small firm may reduce its fixed assets requirements by renting or leasing plant
and equipment , but there is no way it can avoid an investment in current assets.
Finance manager should, therefore, devote considerable time to manage current
assets. Further, owing to limited assess to the capital market, small firm has to
rely heavily on trade credit and short-term bank loans. Both affect net working
capital by increasing current liabilities.
Both the excessive and the inadequate working capital positions are
dangerous from the firm's point of view. Excess working capital results in idle
funds, which do not earn any return for the firm. Shortage of working capital
impairs firms' profitability, because of production interruptions.
Therefore, it is the duty of financial manager, to maintain a right amount of
working capital in the firm on a continuous basis. Working Capital management
involves two main processes :
Management Accounting - I
217
Concept & Definition
of Working Capital
NOTES
(a)
Determination of size of the amount of working capital.
(b)
Arranging the sources of working capital.
Working capital management is practiced by taking into account the
following aspect:
(a)
Management of cash.
(b)
Accounts receivables management.
(c)
Inventory management.
9.6 Determination of Working Capital
A large number of factors influence working capital needs of the business
house. The main aim of working capital management is to manage the firm’s
current assets and current liabilities in such way that a satisfactory level of working
capital is maintained. Before making a precise estimate of working capital needs
of the enterprise, finance manager must be well versed with the variables that
influence the magnitude of cash, receivables and inventories. The following factors
determine the amount of working capital.
Determinants of Working Capital
Nature of an
Enterprise
(1)
Size of
Business
(2)
Business
Cycle
(7)
Growth and
Expansion
(11)
218 Management Accounting - I
Production
Policy of the
Firm (3)
Terms of
Buying and
Selling (4)
Supply of
Raw
Materials
(8)
Operating
Efficiency
(12)
Volume of
Sales
(5)
Profit
Margin
(9)
Capital
Structure of
the Company
(13)
Manufacturing
Process
Cycle (6)
Profit
Appropriation
(10)
Price Level
Changes
(14)
Fig. 9.4 : Determinants of Working Capital
Credit Policies
of R. B. I.
(15)
1. Nature of an enterprise : For a firm engaged in manufacturing activity,
sufficiently large amount of funds will required to carry inventories. Small companies
have smaller proportions of cash, receivables and inventory than large corporations.
This difference becomes more marked in large corporations. A public utility concern,
for example, mostly employs fixed assets in its operations, while a merchandising
department depends generally on inventory and receivables. Generally public utility
concerns which are setup the render public services required large amount of
finished assets, their inventory requirement is usually less. Thus, needs for working
capital are determined by the nature of an enterprise.
Concept & Definition
of Working Capital
NOTES
2. Size of the business : The size of business have also an important impact on
its capital needs. Size may be measured in terms of operation. A firm with the
larger scale of operation will need more working capital than a small firm. The
composition of current assets is a function of the size of business and the industry
to which it belongs.
3. Production policy of the firm : The production policies pursued by the
management have significant effect on the requirements of working capital of the
business. For example, if the management of an enterprise decides to hold inventory
worth 3 months production requirement to maintain fairly steady production
throughout the year, it will require large amount of cash to finance the inventory
requirements than the one following hand-to-mouth policy of carrying inventories.
4. Terms of buying and selling : Terms on which goods are bought and sold
decide, to a large extent, the amount of cash reserve that a firm will have to hold.
If a business firm can manage to buy materials on credit terms but sells its products
on cash, it can run its affairs with a little cash balance. The reserve tendency
will be found where the firm makes purchases on cash basis but it has to sell its
products to customers on credit terms. In short, the working capital requirement
are also affected by the credit facilities enjoyed by the firm.
5. Volume of sales : Needs for working capital are mostly determined by the
volume of sales. This is the factor, which affects the size of working capital. A
firm maintains current assets because they are needed to support the operational
activities which result in sales. The volume of sales and the size of working capital
are directly related to each other. As the volume of sales and the size of the
working capital are directly related to each other. As the volume of sales increases,
there is an increase in the investment of working capital.
6. Manufacturing process (Cycle) : Magnitude of investment in work-in-process
is essentially dependent upon time lag between feeding raw materials in production
process and completing the finished product. Longer the time required for
inventories to travel through the various product process, greater would be fund
requirements to carry work-in-process inventory and the vice-versa. It is usually
observed that length of production period is greater where production process is
complex and complicated. By perfecting engineering techniques and thereby
eliminating some process of production or speeding up manufacturing process
inventory requirements for work in process can, to some extent, be reduced.
7. Business cycle : Business expands during the period of prosperity and declines
Check Your Progress
Which factors determine the
amount of working capital ?
Management Accounting - I
219
Concept & Definition
of Working Capital
NOTES
during the period of depression. Consequently, more working capital is required
during the period of prosperity and less during the period of depression. Raw
materials inventory requirements vary depending on fluctuation in level of economic
activity. Where the management expects expansionary tendency to set in the
ensuring months and prices of materials are very likely to shoot up, it would be in
fitness of things to buy the materials in bulk to exploit the forthcoming opportunities.
But in the event of depressions the firm would be hesitant to stockpile.
8. Supply of raw materials : Need to pile substantially large stock of materials
increase the level of investment in raw materials inventory. In case of specific
manufacturing certain companies have to obtain and maintain large reserve of
raw materials due to their irregular sales and intermittent supply. This is particularly
true in case of companies requiring special kind of raw materials has to be kept in
store to avoid any possibility of the production process coming to a dead halt.
Thus, the working capital requirements in case of such industries would be large.
9. Profit margin : The net profit is an important source of working capital to the
extent it has been earned in cash. Every business house have a different capacity
to generate profit from trading operations. Some firms enjoy a dominant position
(i.e. known as cash cow position) due to quality product or good marketing
management or monopoly power in the market and earn a high profit margin.
Some other firms may have to operate in an environment of intense competition
and may earn low margin of profit is a high net profit margin contributes towards
the working capital pool. Now a days the internal profitability rate of the firm
provides a basis for comparing the productivity of retained profitability rate of the
firm margin contributes towards the working capital pool. Now a days the internal
profitability rate of the firm provides a basis for comparing the productivity of
retained earnings to the alternative return which could be named elsewhere. Thus,
alternative investment opportunities also play an important role in quantifying the
margin of profit.
10. Profit appropriation : Corporate taxes affect the rate of dividend of the
concerns, ultimately its affect on working capital also. Even in net profits are
earned in cash at the end of the period, whole of it is not available for working
capital purposes. The contribution towards working capital would be affected by
the way in which profits are appropriated. The availability of cash generated from
operations thus, depends upon taxation dividend and retention policy and
depreciation policy. If the tax liability increases, it will impose an additional strain
on working capital. The financial manger must do tax planning in order to avail the
benefits of all sorts of tax concessions and incentives. If the profit are retained in
the firm, the firms marking capital position will be strengthened.
The depreciation policy, through its effect on tax liability and retained earnings,
has an influence on working capital. Depreciation is tax deductible. The higher
the amount of depreciation, the lower the tax liability and more the cash profit.
Firm can retained earning and preserving it’s working capital position indirectly,
by way of depreciation.
220 Management Accounting - I
11. Growth and Expansion : Another factor which influence the need of working
capital in the policy of growth and expansion of the business. If a business concern
has ambitious plans for growth and expansion, it requires large amount of working
capital, to fulfill such requirements. On the other hand, in case the company has
already expanded considerably, it does not require funds for further expansions.
12. Operating Efficiency : By accelerating efficiency of production engineers
and planners, length of production period can be shortened. Consequently, fund
requirements to carry investment in work-in process will decline.
Concept & Definition
of Working Capital
NOTES
A firm, which is engaged in a few processes of production of goods, if contracts
with others for other processes, its inventory requirements will be less then what
it would have been had the firm engaged in complete production. The operating
efficiency of the firm relates to the optimum utilisation of resources at minimum
cost. The firm will be effectively contributing to its working capital if it si efficient
in controlling the operating costs. The use of working capital is improved and pace
of the cash cycle is accelerated with operating efficiency.
13. Capital structure of the company : Capital structure of a company refers
to the composition of its capitalisation and it includes all long term capital sources
viz. loans, reserves, shares and bonds. If shareholders have provided some funds
towards the working capital needs also (at least to satisfy the permanent working
capital needs) the management will find it relatively easy to manage working
capital. If the company has to-depend entirely upon outside sources for both
permanent and temporary working capital needs, it faces an uphill task under dear
money conditions.
14. Price level changes : Generally, rising price levels will require a firm to
maintain higher amount of working capital. The some levels of current assets will
need increased investment when prices are increasing. However, the companies
which can immediately revise their product prices with rising price levels will not
face a severe working capital problem. Further, the effects of increasing general
price level will be felt differently by the firms as individual prices may move
differently. It is possible that some companies may not be affected by the rising
prices while others may be badly hit by it.
15. Credit policy of R.B.I. : Credit policy of R.B.I. is another important factor
which influence the requirement of working capital. If the Reserve Bank of India
follows selective and restrictive credit policies, the working capital position becomes
difficult. Suppliers insist on advance payments, while it will be difficult to sell,
unless competitive credit terms are offered to the customers. Therefore, before a
precise estimate of working capital needs of the enterprise, finance manager must
be well versed with the variables that influence the magnitude of cash, receivables
and inventories.
Management Accounting - I
221
Concept & Definition
of Working Capital
NOTES
9.7 Assesment of Working Capital Needs
After taking into consideration myriad of factors influence working capital
needs of the firm, finance manager prepares a working capital forecast. In preparing
such forecast, first of all the estimate of the current assets should be made. Thus,
estimate of amount of raw materials and finished goods to be held in - stock and
amount of materials that will remain tied in process and outstanding receipts from
different parties and other receipts will have to be made. This estimate should be
followed by estimate of current liabilities comprising outstanding payments of wages,
stores, materials, rent, administrative expenses, taxes and other expenses.
Difference between the forecasted amount of current assets and current liabilities
gives net working capital requirements of the firm.
The above requirements block-up a considerable amount of fund.
Statement of Gross-Block up and Net Working Capital
`
Daily Cash Reserve
xx
Add :
Daily stock of raw material
xx
Add :
Work-in-progress (i.e. on going production)
xx
Add :
Daily stock of finished goods
xx
Add :
Average amount receivable From customers on every day
xx
(i.e. average debtors)
Gross Working Capital (i.e. Current Assets)
xx
The above gross block-up of funds is reduced to some extent,
by the credit available from suppliers (i.e. average amount
payable to suppliers every day).
Hence Net working capital
`
Gross Working Capital
xx
Less : Average amount payable everyday (i.e. Average Creditors)
Net Working Capital
xx
xx
So, the factors influencing the requirement of working capital can be
summarized as below :
1.
Credit to be given to customers (debtors).
2.
Credit available from suppliers (creditors).
3.
Daily minimum stock of raw material required
(based on the ‘production schedule’).
222 Management Accounting - I
4.
Daily minimum stock of finished goods required (based on the
demand frequency and fluctuations).
5.
Duration of ‘production process’ (cycle).
6.
Daily liquidity to be maintained.
7.
‘Safety amount’ required for unforeseen reasons.
8.
Government’s guidelines and lender’s expectations (in certain cases).
A firm has to make profit to maintain its image in the capital market. The
investors will also be looking forward to the continuous growth of profitability.
Gradual increase in profit will result in capital growth of the firm. To earn substantial
profit, sales volume has to be increased. It is observed that the sale of goods will
not immediately be converted into cash, when the sale transactions are more
credit in nature. There will be a time lag. Additional capital is required to have
uninterrupted business operations, the amount will be locked up in the current
assets like accounts receivable, stock etc. This, actually happens due to the ‘Cash
Cycle’ or ‘Operating Cycle’. By the time the cash is converted back to cash to
stock to sales to accounts receivable to cash. The firm needs extra funds and
hence the need for working capital. If this is not provided, the business operations
will be affected to a greater extent and hence this part of finance has to be
managed well.
9.8
Concept & Definition
of Working Capital
NOTES
Preparation of Statement of Working Capital
Requirement
There are two techniques of forecasting the working capital needs. First, is
known as ‘cash cost’ technique of forecasting. In this method all transactions are
shown in the working capital forecast on cost basis.
There is another technique of forecasting working capital requirements and
it is ‘Balance Sheet Method’. In this method a forecast is made of the various
assets and liabilities. Thereafter, the difference between the two is taken out. This
difference will indicate the deficiency or surplus of cash.
Working capital forecast based on cash cost technique is likely to differ
from the one determined on the balance sheet method. This is to be explained by
the fact that the current assets shown in the balance sheet also indicate the amount
which the firm is likely to realise sooner or later and this amount will be partly
towards recovery of depreciation and the other non-cash charges and partly
towards profit. When the cash is realised, it is for the firm to decide upon its
utilisation. It may be used for acquiring fixed assets or for redeeming liabilities. It
is no at all necessary that the whole of the cash should be kept as liquid asset.
9.8.1 Common Items included in Calculation of Working
Capital Required
The following items are usually included in the calculation of working capital
required at a particular level of business operation.
a)
Total costs incurred on materials, wages and overhead as obtained from
cost records.
b)
Time lag during which raw materials are to remain in stock before they are
Check Your Progress
Identify the common items
included in calculation of
Working Capital required.
Management Accounting - I
223
Concept & Definition
of Working Capital
NOTES
issued for productive purposes.
c)
Duration of the production cycle so that longer the duration of the cycle,
larger will be the working capital required.
d)
Length of the sales cycle indicating the duration of times during which
finished products have to stay in the warehouse before sale. For certain
business concerns having seasonal sales of goods, stocks have to be
maintained throughout the rest of the year and the working capital
requirement will be very heavy.
e)
Period of credit allowed to debtors. If longer periods of credit are allowed
to the customers by a company without the same being extended to it by its
suppliers, a larger working capital will be needed.
f)
The period of credit extended by creditors. When a longer period of credit
is extended by supplier of a company than that extended by it to its customers,
working capital requirement will be considerably reduced.
g)
Time lag involved in the payment of wages and other overheads.
The quantum of working capital required will be determined by taking all
the above factors into account and by adding finally a flat percentage to this
amount by way of provision for meeting contigencies. This provision or meeting
contingencies must be effected since the forecast of working capital is compiled
on the basis of estimates only. This provision helps in eliminating all the uncertainties
involved in making the estimates.
9.9 Sources of Working Capital
There are three types of working capital requirements : (i) Long term
financing requirement, (ii) Short-term financial requirement and (iii) Spontaneous
financial requirement.
Sources of Working capital
Long Term Financing
Financial Institutions
Issue of Debentures
Public-Deposit
Shares
Internal Source
224 Management Accounting - I
Short Term Financing
Short-term Credit
Loans form Banks,
Commercial Papers
Factoring Bills
Discounting
Fig. 9.5 : Sources of Working Capital
Spontaneous
Financing
Trade Creditors
Outstanding
Expenses
Actually, commercial banks play an important role in providing working
capital to business houses. In view of mounting , inflation, the R.B.I. has taken up
certain fiscal measures to check the money supply in the economy. The first
choice before a financial manager, when a part of additional working capital is not
provided by commercial banks, is to switch over to the long term sources of
finance.
a)
Long-Term Financing : In long-term financing following are the sources
which can be tapped by the financial manager.
Concept & Definition
of Working Capital
NOTES
(i) Loans from financial institutions.
(ii) Floating of debentures : In this context, the mode of raising funds by
issuing convertible debentures or bonds is also gaining ground.
(iii) Accepting public deposits.
(iv) Issue of additional equity shares.
(v) Raising funds by internal financing (i..e profitability through cost control,
cost reduction, rationalizing inventory stocks etc).
b)
Short Term Financing : These sources include short term bank loans,
commercial papers, and factoring receivables, cash credit, overdraft bills
discount, etc.
c)
Spontaneous Financing : The major sources of such financing are trade
credit, and outstanding expenses. (In fact, spontaneous sources of financing
are cost free, therefore a business house would like to finance its current
assets from spontaneous sources as much as possible).
Management Accounting - I
225
Concept & Definition
of Working Capital
NOTES
9.10 Approaches for Determine the Financial Mix
1
Matching Approach
or Hedging Approach
Conservative Approach
2
or Low Profit Low Risk
Approach
When the firm follws matching approach, longterm financing will be used to finance
permanent working capital. Temporary working
capital should be finance out of short term
funds. The rational underlying matching
approach is that the maturity of source of funds
should match the nature of assets to be financed.
According to this approach all requirements of
funds should be met from long-term sources.
Short-term sources should be used only for
emergency requirements. Under a conservative
plan a firm finances its permanent current
assets and a part of the temporary current
assets with a long-term financing. In periods
when the firm has no temporary current assets,
it stores liquidity by investing surplus funds, in
marketable securities. Conservative approach
is less risky but more costly as compared to
matching approach.
In the other words, it is low profit low risk
approach.
3
226 Management Accounting - I
Aggressive
Approach
Under an aggresive policy firm uses more shortterm financing than warranted by the matching
plan, i.e. the firm finances a part of its
permanent current assets with short-term
financing. On the other hand more use of shortterm financing makes the firm more risky.
Concept & Definition
of Working Capital
Hedging Principle :
The firm’s assets not financed by spontaneous sources should be financed
in accordance with the rule : Permanent Assets financed with long-term sources
and Temporary Assets financed with short-term sources.
NOTES
Temporary Current, Assets
Short Term Financing
`-Amount
Hedging
Financing
Strategy
I
Current Assets
Permanent Current Assets
Short Term Plus
Fixed Assets
0
Spontaneous Financing
Time/Period
Note that permanent assets needs are matched exactly with spontaneous
plans long-term sources of financing while temporary current assets are financed
with short-term sources of financing.
Conservative
Marketable securities
Financing
Long Term
Financing
exceeds
Permanent
`-Amount
Strategy
Assets
Short Term
Financing
Current Assets
Permanent Current Assets
Spontaneous
Fixed Assets
II
0
Long Term Plus
Financing
Time/Period
Note shaded are represents the firm’s use of long-term plans spontaneous
financing in excess of the firm’s permanent asset financing need.
Permanent Dependance on
Short Term Financing
Aggressive
Strategy
Permanent
Short Term
Financing
`-Amount
Financing
III
Short Term Financing
Current Assets
Permanent Current Assets
Fixed Assets
0
Time/Period
Long Term Plus
Spontaneous Financing
Note-Shaded area reflects
the firm’s continuous of
short term financing to
support its permanent
asset needs
The statement of Working Capital Requirement can be understood with
the help of following illustrations.
Management Accounting - I
227
Concept & Definition
of Working Capital
9.11 Illustrations
ILLUSTRATION 1
NOTES
The management of Nilkamal Udyog Ltd. desires to determine the quantum
of working capital needed to finance programma formulated to be put into operation
with effect from 1st April, 20. The following percentages which various elements
of cost bear to the selling price have been extracted from the proforma cost sheet:
Material - 50% Labour - 20% Overhead - 10%
Production in 2012 was 2,00,000 units and it is proposed to maintain the
same during 2013. Following further particulars are available.
1.
Raw materials are expected to remain in stores for an average period of
one month before issue to production.
2.
Finished goods are to stay in the warehouses for two months on the average
before being sold and sent to customers.
3.
Each unit of production will be in process for one month on an average.
4.
Credit allowed by suppliers from the date of delivery of materials is one
month.
5.
Debtors are allowed two months credit from the date of sale of goods.
6.
Selling price is ` 9 per unit.
7.
Sales and production follow a consistent pattern.
The relevant items of the balance sheet are :
`
Paid up share capital
6% Debentures
23,00,000
2,00,000
Fixed Assets as of 1 April, 2013
st
18,00,000
Prepare an estimate of working capital requirements as well as projected
Profit and Loss Account and Balance Sheet of Nilkamal Udyog Ltd.
228 Management Accounting - I
Concept & Definition
of Working Capital
SOLUTION
Statement of Working Capital Requirements :
Current Assets and Current Liabilities
`
Current Assets :
75,000
1.
Stock of Raw Materials (1 months)
2.
Stock of Finished Goods (2 months)
3.
4.
NOTES
Materials
75,000 x 2
1,50,000
Labour
30,000 x 2
60,000
Overhead
15,000 x 2
30,000
2,40,000
Work-in-progress (1 month)
Materials
75,000
Labour
30,000
Overhead
15,000
1,20,000
Debtors
(at cost equivalent for 2 months)
Materials
75,000 x 2
1,50,000
Labour
30,000 x 2
60,000
Overhead
15,000 x 2
30,000
2,40,000
6,75,000
Less : Current Liabilities :
Creditors (one month)
75,000
Net Working Capital required
6,00,000
Note : Calculation of amount locked up in materials, labour and overhead per
month
= ` 18,00,000 x 1 = ` 1,50,000
2
Projected Profit and Loss Account for the year ending 31st March, 2014
Particulars
`
Particulars
To Materials consumed
9,00,000
By Cost of Goods
To Wages
3,60,000
Manufactured C/D
To Overhead
1,80,000
14,40,000
`
14,40,000
14,40,000
To Cost of Goods
Manufactured
To Gross Profit C/D
14,40,000
By Sales
3,60,000
18,00,000
To Debenture Interest
To Net Profit
18,00,000
12,000
18,00,000
By Gross Profits B/D
3,60,000
3,48,000
3,60,000
3,60,000
Management Accounting - I
229
Concept & Definition
of Working Capital
NOTES
Materials cost for one month
=
50% of ` 1,50,000 = ` 75,000
 Labour cost for one month
=
20% of ` 1,50,000 = ` 30,000
 Overhead cost for one unit
=
10% of ` 1,50,000 = ` 15,000
Note : Profit locked up in closing debtors will not increase the amount of working
capital needed to carry on the business.
Projected Balance Sheet as on 31st March, 2014
Liabilities
Assets
`
Share Capital
Fixed Assets
Issued Subscribed and
Working Capital
Paid Up
23,00,000
Profit and Loss Account
3,48,000
6% Mortgage
Debentures
2,00,000
Creditors
75,000
18,00,000
Stocks :
Raw Materials
Balance
`
75,000
Work-in-progress
1,20,000
Finished Stock
2,40,000
Debtors
4,35,000
3,00,000
Cash at bank
(Balancing Figure)
3,88,000
29,23,000
29,23,000
Working Notes and Assumptions :
1.
Reconciliation of Working Capital requirements under the two methods :
The difference of ` 4,88,000 (` 10,48,000 - 6,00,000) in the estimated
working capital requirements under the two methods can be reconciled as thus :
Estimation of Working Capital Requirement
`
Working Capital as per projected Balance Sheet
(11,23,000-75,000)
10,48,000
Less : Cash at Bank (being balancing figure) not considered
in the former method
(-)
3,88,000
6,60,000
Less : Excess of Sales value of Closing Debtors and their
cost equipment because Debtors have been taken
at Sales value in projected Balance Sheet.
(` 3,00,000 - ` 2,40,000)
(-)
60,000
Estimated Working Capital requirements as perFormer Method 6,00,000
(II) Assumptions;
230 Management Accounting - I
(i)
It is assumed that the interest on debentures has been paid and hence not
shown in the projected balance sheet.
(ii)
Funds from profit have not been considered.
Concept & Definition
of Working Capital
ILLUSTRATION 2
From the following information prepare a statement in columanar form showing
the estimated working capital requirements.
(a)
in total and
(b) as regards each constituent part of working capital. Budgeted sales `
2,60,000 per annum. Analysis of cost of each unit.
NOTES
`
Raw Material
3
Labour
4
Overdrafts
2
Profit
1
10
It is estimated that :
(a)
Pending use, raw materials are carried in stock for three weeks and finished
goods for two weeks.
(b)
Factory processing will take three weeks.
(c)
Suppliers will give five weeks credit and customers will require eight weeks
credit.
It may be assumed that production and overheads accrue evenly throughout
the year.
SOLUTION
Statement of Working Capital Requirements
Inventories
Stock of Raw Materials
`
3
26,000 units x x 3
52
4,500
Raw Materials
3
26,000 x 52 x 3
4,500
Labour
26,000 x
3
x4
52
6,000
Overheads
26,000 x
3
x2
52
3,000
Raw Materials
26,000 x
2
x3
52
3,000
Labour
2
26,000 x 52 x 4
4,000
Overheads
26,000 x
2
x2
52
2,000
13,500
Stock of finished goods:
9,000
Management Accounting - I
231
Concept & Definition
of Working Capital
Sundry Debtors
26,000 x 8 x 9
52
36,000
63,000
NOTES
Less : Sundry Creditors
26,000 x 5 x 3
52
7,500
Net Working Capital required
55,500
ILLUSTRATION 3
M/S Sheetal Industries Ltd. are engaged in large scale customer retailing.
From the following information, you are required to forecast their working capital
requirements.
Projected annual sales
` 65 Lakhs
Percentage of net profit on cost of sales
25%
Average credit allowed to debtors
10 weeks
Average credit allowed to creditors
4 weeks
Average stock carrying (in terms of sales requirement)
8 weeks
Add 10% to computed figures to allow for contingencies
SOLUTION
Projected annual sales
` 65 lakhs per annum
Net profit (20% on sales)
` 13 lakhs per annum
Cost of sales (65-13)
` 52 lakhs per annum
Cost of sales per week
` 1 lakh
Statement of Working Capital Requirement
Current Assets
(Rupees in Lakhs)
Stock
` 1.00 x 8
Debtors at cost equivalent
` 1.00 x 10 = 10
Profit
` 13 x
10
= 2.50
12
8.00
12.50
Less :Current Liabilities
Creditors
Working capital computed
Add : 10% for contingencies
Net Working Capital required
232 Management Accounting - I
` 1.00 x 4
4.00
16.50
1.65
18.15
Concept & Definition
of Working Capital
ILLUSTRATION 4
X wishes to commence a new trading business and gives the following information
(a)
The total estimated sales in a year will be ` 12,00,000
(b)
His expenses are estimated at a fixed expense of ` 2,000 per month plus a
variable expense equal to 5 per cent of his turnover.
(c)
He expects to fix a sale price for each product which will be 25 percent in
excess of his cost of purchase.
(d)
He expects to turnover his stock four times in the year.
(e)
The sales and purchases will be evenly spread throughout the year. All
sales will be for cash but he expects one month’s credit for purchases.
NOTES
Calculate :
(1)
His estimated profit for the year.
(2)
His average working capital requirements.
SOLUTION
`
(a)
Yearly estimated profits of X
Sales
12,00,000
Purchases
Gross Profit
9,60,000
25
x 12,00,000
125
Expenses
`
Fixed
24,000
Variable (5% of ` 12,00,000)
60,000
Net Profit
(b)
2,40,000
84,000
1,56,000
Average Working Capital required
Stocks
`
2,40,000
Cash
7,000
2,47,000
Less : Sundry Creditors
80,000
1,67,000
Working Notes
Stocks
`
12,00,000
Sales
2,40,000
Gross Profit
9,60,000
Stocks (1/4 of 9,60,000)
2,40,000
Sundry Creditors (1/12 of 9,60,000)
Cash
80,000
7,000
Management Accounting - I
233
Concept & Definition
of Working Capital
It is assumed that X will have minimum cash balance to atleast cover his
expenses for a month.
`
NOTES
Fixed Expenses
2,000
Variable Expenses
5,000
7,000
ILLUSTRATION 5
Calculate working capital from the following particulars :
`
(a)
(b)
(c)
Annual expenses :
Wages
52,000 p.a.
Stores and Material
9,600
Office Salaries
12,480
Rent
2,000
Other Expenses
9,600
Average amount of stocks to be maintained :
Stock of finished goods
1,000
Stock of material and stores
1,600
Expenses paid in advance :
Quarterly advance
(d)
(e)
(f)
234 Management Accounting - I
1,600 p.a.
Annual Sales :
Home market
62,400
Foreign market
15,600
Lag in payment of all expenses
Wages
11/2 weeks
Stores and Material
11/2 months
Office Salaries
1/2 month
Rent
6 months
Other expenses
11/2 months
Credit allowed to customers
Home market
6 weeks
Foreign market
11/2 weeks
Concept & Definition
of Working Capital
SOLUTION
Statement of requirement of Working Capital
Particulars
Current Assets :
(i) Stock finished goods
Stock on materials and stores
(ii)
Debtors : Home market
Debtors : Foreign
(iii) Prepaid Expenses
Amount
Amount
`
`
10,650
1,000
1,600
6
62,400 x 52 =
11/2
15,600 x
=
12
3
1,600 x
=
12
(+)
7,200
450
400
Less : Current Labilities
11/2
=
12
11/2
(ii) Creditors for expenses : Wages
52,000 x
=
12
1
(iii) Office Salaries
12,480 x 24 =
6
(iv) Rent
2,000 x 12 =
1 1/2
(v) Other Expenses
9,600 x 12 =
(+)
(i)
Creditors for stores and materials 9,600 x
NOTES
4,220
1,200
1,500
520
1,000
1,200
(-)
 Working Capital Required
6,430
9.12 Summary
•
‘Working Capital’ may be regards as the life blood of a business. The Working
Capital is understood in tow different but interlinked senses. In the firstsense. Working capital refers to sum total of all current aspects employed
in the business process. This is known as “Gross Working Capital” concept.
The Net Working Capital represents current assets minus current liabilities.
Current assets refer to those assets which are used for day-to-day activities
of the firm.
•
Main Constituents of Working Capital : (A) Current Assets - (i) Inventories,
(ii) Trade Debtors, (iii) Prepaid Expenses, (iv) Loans and advances (given),
(v) Investments, (vi) cash in hand and at bank. (B) Current liabilities - (i)
Sundry Creditors, (ii) Bank overdraft, (iii) Short term Loans, (iv) Provisions.
•
Types of Working Capital : (i) Permanent Working Capital, (ii) Temporary
Working Capital, (iii) Gross Working Capital, (iv) Net Working Capital, (v)
Negative Working Capital.
•
Determinants of Working Capital : (i) Nature of an enterprise, (ii) Size of
Management Accounting - I
235
Concept & Definition
of Working Capital
the business, (iii) Production Policy of the firm, (iv) Terms of Buying &
Selling, (v) Volume of Sales, (vi) Manufacturing Process, (vii) Business
Cycle, (viii) Supply of Raw Material, (ix) Profit Margin, (x) Profit
Appropriation, (xi) Growth & Expansion, (xii) Operating Efficiency, (xiii)
Capital Structure of the company, (xiv) Price Level Charges, and (xv) Credit
Policies of RBI.
NOTES
•
Preparation of Statement of Working Capital Requirement : There are
‘Two’ technique - (i) Cash Cost Technique, (ii) Balance Sheet Method.
•
Sources of Working Capital : (a) Long term financing, (b) Short term financing
and (c) Spontaneous financing.
•
Approaches for Determining the financial mix : (i) Hedging Approach, (ii)
Conservative Approach and (iii) Aggressive Approach.
9.13 Key Terms
(1)
Working Capital : Excess of current assets over current liabilities and
provisions.
(2)
Gross Working Capital : It is the amount of funds invested in the various
components of current assets.
(3)
Net Working Capital : It is the difference between current assets and current
liabilities.
(4)
Negative Working Capital : When current liabilities exceed current assets
negative working capital emerges.
(5)
Operating Cycle : The duration of time required to complete the following
cycle of events in case of a manufacturing firm is calls the operating cycle
(Working Capital Cycle).
9.14 Questions and Exercises
I - Objective Questions
(A) Multiple Choice Questions
(1) The gross working capital represents -------(a) total current assets, (b) total current liabilities, (c) the excess of current assets
over current liabilities, (d) total non-current assets.
(2) The minimum level of current asses required at all time by the firm to carry on
its business operation more effectively is termed as ---------- working capital.
(a) gross, (b) permanent, (c) temporary, (d) net.
236 Management Accounting - I
(3) Inadequate amount of working capital can adversely affect the ------ position
of the firm.
(a) insolvency, (b) stability, (c) solvency, (d) administrative.
Concept & Definition
of Working Capital
(4) Longer the manufacturing cycle, ------- will be the company’s working capital
requirements.
(a) shorter, (b) larger, (c) minimum, (d) smaller.
Ans. : (1 - a), (2 - b), (3 - c), (4 - b)
NOTES
II - Long Answer Questions
(1)
What is ‘Working Capital’ ? Explain in brief the main constituents of working
capital.
(2)
Define ‘Working Capital’. Prepare a suitable chart showing examples of
current assets and current liabilities.
(3)
What do you understand by ‘Working Capital’ ? State the types of Working
Capital.
(4)
Illustrate the concept of ‘Working Capital’. Differentiate between Permanent
Working Capital and Temporary Working Capital.
(5)
What is ‘Gross Working Capital’ ? How it differs from Net Working Capital?
(6)
What is ‘Working Capital Cycle’ ? Explain in brief the operating cycle of
manufacturing firm.
(7)
Explain the concept of ‘Working Capital Cycle’. State in brief the operating
cycle of a trading firm.
(8)
What is ‘Working Capital Management’ ? Explain the main processes
involved in the management of Working Capital.
(9)
Explain in brief the determinants of Working Capital.
(10) Explain the process involved in the assessment of working capital needs.
(11)
Explain in brief the sources of Working Capital.
(12) What is ‘Long term financing of Working Capital’? Explain the major sources
of long-term financing of Working Capital.
(13) Explain in brief the importance and utility of following approaches for
determining the financial mix of working capital.
(a) Hedging Approach, (b) Conservative Approach, and (c) Aggressive Approach.
III - Practical Problems
(1) Nashik Decoder Ltd. is about to commence a subsidiary business. You are
required to advise the Directors about the additional amounts which should be
made available for working capital. You are provided with the following estimates
Management Accounting - I
237
Concept & Definition
of Working Capital
for the coming year and you are in formed that an overdraft limit of ` 1,50,000
has been arranged with the company’s banke `
Average period
Estimate for
of credit
coming year
(`)
NOTES
Sales : Cash
14,000
Credit
7 weeks
6,50,000
Purchase of materials
6 weeks
2,60,000
11/2 weeks
1,95,000
Rent, etc. (Factory Rent ` 20,000)
2 months
40,000
Directors, managers salaries
1 month
36,000
Travelling and Office Expenses
2 weeks
45,500
Factory Overheads (Depreciation 20%)
2 months
60,000
Wages
Overheads :
Raw materials are in stock for one month
It takes 15 days to convert raw materials into finished products. Factory
overheads and wages accrue evenly. Finished goods are in stock for 1 month.
The company would like to maintain an average cash balance of ` 40,000.
You are required to prepare from the above figures and information, a
statement for submission to the directors giving an estimate of the average of
working capital which they should provide. Also show the estimate on the basis of
cash cost of working capital.
(2) Zenith Industries Ltd., are engaged in large scale customer retailing. From
the following information you are required to forecast their working capital
requirement.
Projected annual sales : ` 65 lakhs
Percentage of Net Profit on cost Sales : 25 %
Average credit allowed to Debtor : 10 weeks
Average credit allowed by creditor : 4 weeks.
Average stock carrying (in terms of sales requirement : 8 weeks
Average 10% of computed figures to allow for contingencies.
238 Management Accounting - I
(3) Chennai leasing Ltd., is taking up a new project which will have a weekly
sales of 40,000 units at ` 45 a unit. Credit to customers is being given for six
weeks. Unit costs will be ` 18 for direct material and ` 7.50 for direct labour.
While overhead will run at ` 6,00,000 per weeks Planned stocks will include `
37,50,000 raw materials and 2,00,000 units in the finished goods store. Creditors
will be paid for materials at the end of the months that follows the month of
delivery and for overheads four weeks after incurring the expenses. Wages are
paid at the end of each week for the whole of that week. Units are two weeks in
production and profits is remitted to the parent company. At the moment of sale, a
cash flow of ` 15,00,000 is considerable. Prepare a working capital estimate for
Chennai Leasing Ltd.
(4) A client of yours, Rakshit Ltd., is about to commence a new business, and
finance has been provided in respect of fixed assets. They have, however, asked
you to advise the additional amount which they should make available for working
capital. N. P. They provide you with the following estimate for their first year and
inform you that they have arranged an overdraft limit with their banker of `
1,50,000.
Average period
Estimate for
of credit
first year
Concept & Definition
of Working Capital
NOTES
(`)
Purchase of materials
6 weeks
26,00,000
11/2 weeks
19,50,000
Rent, etc.
6 months
1,00,000
Directors and Managers Salaries
1 months
3,60,000
Travelling and Office Salaries
2 weeks
4,55,000
Travellers Commission
3 months
2,00,000
Other Overheads
2 months
6,00,000
-
1,40,000
7 weeks
65,00,000
Work-in-progress
-
3,00,000
Average amount of undrawn profits
-
3,10,000
Wages
Overheads :
Sales : Cash
Credit
Average amount of stock and
Sales were made at an even rate for the year. You required to prepare form
the above figures and information, a table for submission to your client, giving an
estimate of the average amount of working capital which they provide.
(5) From the following estimates prepare a statement showing the average amount
of working capital required for MS and Co. Ltd.
Figures for the year
(`)
(a)
(b)
(c)
(d)
Amount locked up in stock :
Raw Materials
5,000
Finished products
8,000
Average credit given
Inland sales - 6 weeks credit
78,000
Export sales - 1 1/2 weeks credit
39,000
Lag in-payments
For goods purchases - 1 1/2 weeks credit
65,000
Wages and Salaries - 1 1/2 months
24,000
Payment in advance :
Sundry Expenses - 2 months
4,000
Management Accounting - I
239
Concept & Definition
of Working Capital
(6) A proforma cost sheet of a company provides the following particulars :
Elements of costs :
Raw material - 40%
NOTES
Labour - 10%
Overheads - 30%
The following further particulars are available :
(a)
Raw materials remain in store for six weeks.
(b)
Processing time - 4 weeks
(c)
Finished goods are required to be in stock for a period of 8 weeks.
(d)
Credit period allowed to debtors - 10 weeks.
(e)
Lag in payment of wages - 2 weeks.
(f)
Credit period allowed to creditors 4 weeks.
(g)
Selling price is ` 50 per unit.
You are required to prepare an estimate of working capital requirements
adding 10% for contingencies. The level of activity is 13,000 units of production.
(7)
Prepare a working capital forecast from the following information :
Issued-share capital (`) 2,00,000
8% debentures (`) 75,000
The fixed assets are valued at ` 21 lakhs. Production during the previous
year was 50,000 units. The same level of activity is intended to be maintained
during the current year. The expected ratios of cost of selling price are
Raw materials : 50 %
Wages : 10 %
Overheads : 25
The raw materials normally remain in stores for 2 months before production.
Every unit of production remains in process for one month. Finished goods remain
in the warehouse for 4 months. Credit allowed by creditors is 3 months and credit
allowed to debtors is 3 month. Selling price is ` 6 per unit. Both production and
sales are in a regular cycle. Add 10 % for contingencies.
240 Management Accounting - I
9.15 Further Reading
•
Rustagi R. P. - Fundamentals of Financial Management - New Delhi Galgotia Publishing Company - 2010.
•
Sharan Vyuptakesh - Fundamentals of Financial Accounting - New Delhi Pearson Education PVt. Ltd. - 2012.
Concept & Definition
of Working Capital
NOTES
Management Accounting - I
241
UNIT 10 Components of Working Capital Management of Cash
Components of
Working Capital Management of Cash
Structure
NOTES
10.0 Introduction
10.1 Units Objectives
10.2 Components of Working Capital - Management of Cash
10.3 Objectives of Cash Management
10.3.1
Importance of Cash Management
10.3.2
Strategies for Four Aspect of Cash Management
10.4 Cash Planning
10.5 Cash Forecasting and Budgeting
10.6 Long-term Cash Forecasting
10.6.1
Managing the Cash Flows
10.6.2
Determining Optimum Levels of Cash Balance
10.7 Cash Management Models
10.8 Investment of Securities
10.9 Illustrations
10.10 Summary
10.11 Key Terms
10.12 Questions and Exercises
10.13 Further Reading
10.0 Introduction
Working capital management is practiced by taking in to accounts the
following components (aspect) : (a) Management of cash, (b) Accounts receivable
management, (c) Inventory management
Management Accounting - I
243
Components of
Working Capital Management of Cash
Management
of
Cash
NOTES
1
3
Components
of
Working
Capital
Inventory
Managment
2
Accounts
Receivable
Management
Fig. 10.1 : Components (aspect) of Working Capital
It is observed that ‘Cash’ is an oil and lubricate the ever turning wheels of
the business, without it, the process grinds to a stop. Thus one of the basic objective
of Cash management is to maintain the image of the organisation by making prompt
payment to Creditors and avail cash discount facilities. Accounts receivable is a
major component of the current asset. This account emerges because of the
existing credit sales. Inventory generally represent a very significant proportion
to total assets. Hence the importance of inventory management cannot be over
emphasizes.
10.1 Unit Objectives
After studying this unit you should be able to :
244 Management Accounting - I
•
Describe components of working capital.
•
Explain meaning and objectives of Cash Management.
•
Identify Four aspects of Cash Management.
•
Prepare Cash Budget.
•
Discuss Cash Management Models.
•
Explain Inventory model, The Triller and our Model and Stone Model.
•
Discuss the term “investment of securities”.
•
Explain the term “Management of Cash” in details.
10.2 Components of Working Capital Management of Cash
Cash is the most liquid asset that a business owns. It includes money and
such instruments as cheques, money orders and bank drafts. Cash in the business
enterprises may be compared to the blood in the human body. Blood gives life and
strength to the human body and the cash imports life and strength; profits and
solvency to the business organisation. Though firms differ in a considerable degree
in terms of nature of business, capital structure, personnel employed, risk technology
and so on, they have in common the basic mechanism involving conversion of
funds into saleable products and back into liquid form. Cash in its ultimate state
yields no return as such it is barren.
Cash is needed by a firm to meet its transaction, precautionary and
speculative requirements. The firm with generous amount of cash can readily pay
bills and take advantage of trade discount. If, for example, term of trade provides
that extra discount @ 2.5 per cent will by given to the buyer paying the bill in ten
days otherwise full payment will be required in thirty days in any event (alternatively
it may be expressed as 2/10, net 30); failure to pay within ten days means foregoing
the discount and paying additional 2 per cent for every twenty days period. Thus,
if for every twenty days additional 2 per cent is paid, the firm is required to pay
extra 36 per cent in a year (360 days / 20 days = 18 x 2% = 36%). Besides, ample
cash is helpful to meet unexpected adversities and useful to exploit favorable
opportunities that may come along from time to time. Furthermore, credit standing
of the firm with sufficient stock of cash is strengthened.
However, keeping any excess stock of cash is largely waste of resources
because it is a non-earning asset and the firm will be failing to maximise its profits
at the cost of high liquidity. If, on the other hand, more, and more cash is put to
profitable use, the firm’s liquidity will be impaired causing the firm to lose benefits
of cash discount, liberal loans from banks and easy supplies from the reputable
suppliers.
Components of
Working Capital Management of Cash
NOTES
Check Your Progress
How
you
components of
capital ?
describe
working
A control of the cash position is a vital aspect, of the financial management
of a concern. There should be a balance between cash and cash demanding
activities-operations, capital additions etc. The objectives of cash management
are to make the most effective use of funds, on the one hand, and accelerate the
inflow and decelerate the outflow of cash on the other.
A clever finance manager is one who strikes a golden mean between these
two conflicting goals of the firm. (i.e. profitability and liquidity).
10.3 Objectives of Cash Management
The primary goal of cash management in a firm is to strike trade-of between
liquidity and profitability in order to maximise long-term profit. This is possible
only when the firm aims at optimising the use of funds in the working capital pool.
Management Accounting - I
245
Components of
Working Capital Management of Cash
NOTES
Keeping these two views. viz. liquidity and profitability (i) to make cash
payment and (ii) to maintain minimum cash reserves, these are the two main
objectives of cash management. It is observed that Cash is an oil to lubricate the
ever turning wheels of business, without it, the process grinds to a stop. “Thus one
of the basic objectives of cash management is to maintain the image the image of
the organization by making prompt payments to creditors and to avail cash discount
facilities. Another important to objective of cash management is to maintain
minimum reserve. This means, in the process of meeting obligations on time, the
firm should not unnecessarily maintain heavy cash reserves. It cannot keep the
cash idle. These objectives can be converted into the following operational goals.
1.
To build image of creditworthiness.
2.
To earn on cash balance.
3.
To build reservoir for net cash inflows till the availability of better uses of
funds by conscious planning.
4.
To minimise the operating costs of cash management.
5.
To satisfy day-to-day business requirements.
6.
To provide for scheduled major payments.
7.
To face unexpected cash drains.
8.
To seize potential opportunities for profitable long-term investments.
9.
To meet requirements of bank relationships.
10.
To ensure that cash is flowing in and flowing out as per the plan.
10.3.1 Importance of Cash Management
(a) Cash management assumes more importance than other current assets
because cash is the most significant asset that the firm holds. It is significant
because it is used to pay firm’s obligations. However, cash is unproductive and as
such, the aim of cash management is to maintain adequate cash position to keep
the firm sufficiently liquid and to use excess cash in some profitable way.
(b) It is interesting to observe that in real life, management spends considerable
time in managing cash which constitutes relatively a small proportion of a firm’s
current assets. This is why in recent years a number of new techniques have
been evolved to realized cash holding of the firm.
(c) Management of cash is also important because it is difficult to predict cash
flows accurately and that there is no perfect confidence between inflows and
outflows of cash. Thus, during some periods, cash outflows exceed cash inflows,
because payments for taxes, dividends, excise duty, seasonal inventory build up
etc. At other times cash inflows will be more than cash payments, because there
may be large cash sales and debtors may be realized in large sums promptly.
246 Management Accounting - I
10.3.2 Strategies for Four Aspects of Cash Management
Cash Planning
1
Four Aspects
of
CASH
MANAGEMENT
Investing Idle
Cash
4
Components of
Working Capital Management of Cash
NOTES
Managing the
2 Cash Flows
3
Optimum Cash Level
Fig. 10.2 : Four Aspects of Cash Management
Strategies regarding the following four aspects four aspects of cash
management should be evolved by the firm :
1.
Cash planning : Cash inflows and outflows should be planned to project
cash surplus or deficit for each period of planning. Cash budget should be
prepared for this purpose.
2.
Managing the cash flows : The inflow and outflow of cash should be
properly managed. The inflows are cash should be decelerated as far as
possible.
3.
Optimum cash level : The firm should decide on the appropriate level of
cash balances. The cost of excess cash and the danger or cash deficiency
should be matched to determine the optimum level of cash balances.
4.
Investing idle cash : The idle cash or precautionary cash balances should
be properly invested to earn profit. The firm should decide on the division of
such cash balances between bank deposits and marketable securities.
10.4 Cash Planning
Cash planning is a process of predicting cash inflows and outflows of the
firm over the fourth coming period so as to determine surplus or shortage os cash.
In case of excess cash inflows, the firm can invest in most profitably and in case
of dearth of cash the firm can make adequate provision forth some. Thus, cash
planning can help anticipate future cash flows and needs of the firm and thus can
reduce the possibility of idle cash balances (which lowers firm’s profitability) and
cash deficits (which can cause the firm’s failure).
Cash planning may be done daily, weekly or monthly basis. The period and
frequency of cash planning generally depends upon the size of the firm and
philosophy of management. Large firms prepare daily and weekly forecast.
Medium-size firms usually prepare weekly and monthly forecasts. Small firms
Management Accounting - I
247
Components of
Working Capital Management of Cash
NOTES
may not prepare formal cash forecasts because of the non-availability of
information and unsophistication of operations. But, if the small firms prepare
cash projection, it is done on monthly basis.
10.5 Cash Forecasting and Budgeting
Cash budget is the most significant device for planning and controlling the
cash receipts and payments. Cash budget is a summary statement of the firm’s
expected cash inflows and outflows over a projected time period. It gives information
on the timing and magnitude of expected cash flows and cash balances over the
projected period.
Cash Forecasting : Cash forecasts are required to prepare cash budgets. Cash
forecasting may be done on short term or long-term basis. Generally, forecasts
covering periods of one year or less are considered short-term. Those extending
beyond one year are considered long-term.
Short-term Forecasting Methods : Two most commonly used methods of
short-term cash forecasting are :
(a)
The Receipt and Disbursements Method.
(b)
The Adjusted Net Income Method.
(a) The Receipt and Disbursements Method : In receipt and disbursement
method forecast for each item of cash receipts and cash payments has to be
made. All cash receipts of income and non-income nature are considered. Thus,
cash inflows from sales, cash inflows from sales, liquidation of assets, dividend
and interest form part of cash receipts. Likewise, cash disbursements such as
payment on account of purchase of materials, wages and other payments of revenue
and non revenue nature have to be prognosticated.
After anticipating cash receipts and disbursements periodically, the firm
can integrate them in tabular form (what is know as cash budget) to find out net
cash inflow or overflow for each month.
(b) The Adjusted Net Income Method : In the adjusted net income method
only those receipts and payments are predicted which are of revenue nature.
Thus, receipts from sale of shares and debentures and fixed assets would not
form part of the forecast under this method. In the same way , disbursements in
respect of purchase of fixed assets or dividend distribution would not be considered.
Further, adjusted net income method considers all receipts and payment on accrual
basis. Finally, all appropriations such as depreciation and amortisation of patents
have to be forecasted under this method.
Forecast prepared on adjusted income method helps in anticipating the
working capital requirements. But it fails to monitor cash movements and is,
therefore not helpful for cash management purpose.
248 Management Accounting - I
The receipts and disbursements method in generally employed to forecast
for limited periods, such as a week or a month. The adjusted net income method,
on the other hand, is preferred for longer durations ranging from a few months to
a year. Both the methods have their pros and cons. The cash flows can be
compared with budgeted income and expense items if the recipients disbursements
approach is followed. On the other hand, the adjusted income approach is
appropriate in showing a company's working capital and future financing needs.
The information required for preparing the adjusted net income forecast is derived
mainly from the budgets prepared by the firm.
Components of
Working Capital Management of Cash
NOTES
A format for the Adjusted Net Income Method
Sources and Uses
2009
2010
2011
2012
2013
Net Income after tax
-
-
-
-
-
Non-cash charges
-
-
-
-
-
Increase in borrowings
-
-
-
-
-
Sale of securities
-
-
-
-
-
Miscellaneous
-
-
-
-
-
Capital expenditure
-
-
-
-
-
Repayment of borrowings
-
-
-
-
-
Increase in current assets
-
-
-
-
-
Dividend payment
-
-
-
-
-
Surplus / Deficit
-
-
-
-
-
Sources :
Uses :
Check Your Progress
How you explain a format for
the adjusted net income
method ?
10.6 Long-Term Cash Forecasting
Long term cash forecast are prepared to give an idea of the company’s
financial requirements of future. They are not as detailed as the short term
forecasts are. Once a company has developed a long, term cash forecast can be
used to evaluate the impact of new product development or plant acquisition on
the firm's financial position, three, five, or more years in future. In addition to
short-term cash forecasting, a finance manager has to predict long-term cash
requirements for the firm. Long-term cash forecast serves as an objective tool to
evaluate the impact of new product - market strategy on the firm's financial position
in the long run. Besides, it also helps in prognosticating working capital needs for
the firm. Long-term cash forecast are also useful in streamlining corporate planning.
Such forecasts force each division to plan for future and to formulate projects
carefully.
Long-term forecasts can be made either by the receipts and disbursements
method or by the adjusted income method.
Management Accounting - I
249
Components of
Working Capital Management of Cash
NOTES
10.6.1 Managing the Cash flows
Once the cash budget has been prepared and appropriated net cash flows
established, the financial manager should ensure that they does not exist a significant
deviation between projected cash flows and actual cash flows, To achieve this,
cash management efficiency will have to be improved through a proper control of
cash collection and disbursement. The twin objectives in managing the cash flows
should be to accelerate cash collections as much as possible and to decelerate or
delay cash disbursements as much as possible.
(a) Methods of Accelerating the Cash Inflows :
(i) Quick Deposit of Customer's Cheques : One way of shortening the time
lag between the date when a customer signs a cheque and the date when the
funds are available for use is to mark an arrangement for quick deposit of the
cheques in the bank. Special attention should therefore be given to large remittances.
For example, these may be deposited individually or air mail services should be
used for such remittances. Speed post or courier service can also used for this
purpose.
(ii) Establishing Collection Centres : To accelerate the cash turnover a nation
wide organisation may, instead of, a single collection centre, establish collection
centres in various marketing of the country. The customers are instructed to remit
their payments to the collection centre of their region. The collection centre deposits
the cheques in the local bank. These cheques are collected quickly because many
of them originate in the very city in which the bank is located. Surplus of money of
the local bank can be transferred to the company’s main bank.
(iii) Lock Box System : In a Lock Box System, the firm establishes a number
of collection centres considering number of customers and volume of remittances.
At each centre, firm hires a post office box and instructs customers to mail their
remittances to the box. Firms local bank is given the authority, to pick up cheques
directly from the box and deposit the cheques in firm’s account. For internal
accounting purposes of the firm, the bank prepare a detailed statement of cheques
picked-up.
(b) Methods of controlling disbursements :
(i) Paying the Float : The firm may use the technique of playing the float for
maximising the availability of funds. The term ‘float’ means the amount tied up in
cheques that have been drawn, but have not yet been presented for payment.
There is always a time lag between the issue of a cheque by the firm and actual
presentment for payment. As a result of this a firm’s actual balance at bank may
be more than the balance as shown by its books. This difference is called “a
payment in float.” The longer the float period, the greater is the benefit to the
firm. A firm can expand the opportunities for playing the float by having many
bank accounts at different places.
250 Management Accounting - I
(ii) Delaying Outward Payment : By delaying the payment on bills until the last
date of the no-cost period, finance manager can economize cash resources
purchases are made on terms of 1/10/30, this method suggests that payment should
be made on 10th day. In this way the firm not only avails of benefits of discount
but also releases funds for eight days for investment in short-term channels.
(iii) Slowing Disbursment by use of Drafts : A company can delay disbursement
by the use of drafts on fund located else where. Payments could be made through
cheques but for that drawer of the cheque must have the funds in the bank.
Contrary to this, draft is payable only on its presentation to the issuer for collection.
Thus funds have to be provided to meet a draft only when it is presented by the
bank for payment. This arrangement will delay the time the company is required
to deposit money in its bank to cover draft.
Components of
Working Capital Management of Cash
NOTES
(iv) Making payroll periods Less Frequent : This can also help a company
to economize cash. If the company is currently disbursing pay to its employees
weekly, it can affect substantial cash saving in cases say it disbursed only once in
a month.
(v) Inter bank Transfer : Another method of making efficient use of cash
resources is to transfer funds quickly from one bank to another bank where
disbursements are to be made. This would prevent building up of excess cash
balances in one bank. This procedure could be adopted by company having accounts
with several banks.
10.6.2 Determining Optimum Level of Cash Balance
One of the primary responsibilities of a financial manager is to maintain a
sound liquidity position of the firm so that dues may be settled in time. The firm
needs cash not only to purchase raw materials and pay wages, but also for payments
of dividend, interest, taxes and countless other purposes. The test of liquidity is
really the availability of cash to meet the firm’s obligation when they become due.
This task is so important that carrying of excess cash balance entails loss or
interest earnings to the firm and thus causes low profitability and maintaining a
small cash balance renders the firm’s liquidity position weak although a higher
profitability is ensured. Thus determination of suitable level of cash holding involves
risk-return trade-off. Determination of appropriate level of cash balance is not
only necessary to optimise cash utilisation but also to decide the level of investment
in marketable securities.
10.7 Cash Management Models
A number of cash management models have been developed to decide the
optimal level of cash balance. These models are based on such major considerations
as the demand for cash, the interest rate on marketable securities and the cost of
transfers between marketable securities and cash. Here we can discuss two models,
which are widely used in practice.
(a) Inventory model.
(b) The Miller or Orr models.
Management Accounting - I
251
Components of
Working Capital Management of Cash
NOTES
Check Your Progress
Explain the EOQ formula.
(c) Stone model.
(a) Inventory Model : The Economic Order Quantity (EOQ) formula, basically
used in inventory decision has now come to be popularly employed to determine
the optimal level of cash holding for the firm. William Baumol was the first man
who applied the inventory model to the problem of cash management. Inventory
model to cash management is very useful to the firming as much as it helps in
determining optimum level of cash holding. By using this approach finance manager
can minimise costs of carrying and maintaining cash. This model clearly indicates
the idle cash balance which can be gainfully employed in securities. It also saves
the firm from dangers of liquidity by furnishing advance signal and advising when
the securities of the firm have to be sold to obtain cash. Thus finance manager
can improve the efficiency of cash management with the held of the inventory
model.
Formula: According to the EOQ model, optimum level of cash should be
determined on by balancing the carrying cost of holding cash (the interest foregone
on marketable securities) against the fixed cost of transferring marketable securities
to cash or vice-versa so as to minimise total costs. The level of cash at which the
turn of inventory carrying costs and the fixed costs associated with transferring
marketable is minimum, will be the optimum cash balance of the firm. The following
formula is used to determine this optimum level :
Q=
 2CB
K
Where,
= Stands for optimum size of cash inventory.
C
= Stands for average fixed cost of securing cash from market.
B
= Stands for the total amount of transaction demand for cash over the
period of time involved.
K
= Stands for the cost of carrying the inventory of cash i.e., interest rate
on marketable securities for the period.
C/2 Average Amount
of cash Balance
Q
C
C/2
Time
Fig 10.3 : Inventory Model to Cash Management
252 Management Accounting - I
Inventory model of cash management when graphically depicted partakes
the saw-tooth lines as in Figure 10.3. This model presumes that the firm has a
steady demand for cash over some period of time, say one month.
The firm obtains cash during this period by liquidating marketable securities.
Suppose that the firm starts its business with a cash balance (c) which it spends
during the period of one month. As a result, cash balance reaches zero. The firm
replenishes it by liquidating C rupees of marketable securities. Thus transfer of
funds from securities to cash takes place only when cash touches zero. When the
policy of the management is to main cushion or transfer of securities to cash or
vice involves lead time, the threshold for initiating a transfer will be higher. However,
the overall principle remains the same.
Components of
Working Capital Management of Cash
NOTES
The management must specify the value of C, which minimizes the total cost.
Limitations:
This model suffers from several practical problems. One such difficulty is
related with determination of fixed cost associated with replenishing cash. The
fixed cost consisted of explicit and implicit cost is determinable, it is very difficult
to compute the implicit cost. Another limitation is that the model assumes a constant
rate of inflow and outflow per period. However, in rate life cash flows are of
stochastic nature. Where cash flow are expected to be steady this model is
applicable.
(b) Miller and Orr Model : Miller and Orr have provided the simplest model to
determine the optimal behavior in a stoch stic. The model is essentially a control
limit model designed to determine the time and size of transfers between an
investment account and cash account. The Miller and Orr model specifies two
control limits designating 'h' for upper limit and (zero) for the lower limit when
model is illustrated in Figure 10.4. According to the model when cash balances of
the firm reach the upper limit cash equal to h-z should be invested in marketable
securities (i.e investment account) so that new cash balance touches Z point. If
the cash balances touch O point, finance manager should immediately liquidate
that much portion of the investment portfolio which could return the cash balance
to Z point. It may be interesting to note that cash balances are allowed to wander
in h, z as the target cash balance level.
h
Cash
z
0
t1
t2
Fig. 10.4
Time
Management Accounting - I
253
Components of
Working Capital Management of Cash
NOTES
Limitations:
There are practical problem involved in estimating transfer costs holding
costs, number of transfers, expected average cash balance. Lot of subjectively is
involved in these estimates. The model used variance as the measure of dispersion
in the cash flows. This is possible only in predictable and stable situation. When
cash flows actuate violently in short period of time, the model may not provide
optimal results.
Formula of Miller-Orr-Model :
Miller Orr cash management model is basically an application of control
limits theory to the cash/investment decision. When the firm's total cash goes out
side the upper control limit investment are made to bring the cash balance bank to
the return point.
When the firm's cash balance goes below the lower control limit disinvestment
are made to bring the balance back to the return point.
The formula developed by Miller and Orr is as under : R = (3AV/4i) 1/3
Check Your Progress
Explain the formula of Miller
Orr Model.
Where, 'V' = is the variance of daily cash flows.
i = is the daily interest rate on investment
a = is the transaction cost of investment or disinvestment.
If 'L' is the lower limit, the optimal return point is = (R+L).
The lower limit 'L' is set by the firm and is not determined with the model it
may zero cash balance (so that the firm does not overdraft) or the firm's minimum
compensating balance. The optimal upper control limit is (3 R + L).
Example : Suppose a firm has policy to maintain a minimum cash balance of R
100000 at all time. Further assume that using historical data the firm has calculated
‘R’ as ` 75,000 given this estimate of ‘R’ the would set the lower point control
limit at ` 1,00,000. The return point at ` 175 on and the upper control limit at `
3,25,000 on (3 R + L = 75000 x 3 = 225000 + 100000).
Let us track the effects of this strategy for some hypothetical cash flows.
Assume that the, firm's starting balance was ` 150000 and following cash flows
occurs as shown in table. The control limits, the return point and the effects of
these cash flows are shown in Figure 10.5.
Day
Net Cash Flow
(`)
254 Management Accounting - I
1
(-) 25,000
2
(-) 75,000
3
1,00,000
4
(-) 25,000
5
1,25,000
(` 000)
Cash Balance
400
350
325
300
250
200
175
150
125
100
75
50
25
0
375000
250000
275000
500
Components of
Working Capital Management of Cash
UCL = 325
NOTES
Return Point = 175
LCL = 100
1
2
3
4
5
6
days (Time)
Fig. 10.5 Cash balance control limits (Miller-Orr-Model)
(c) Stone Model :
The stone model used two sets of control limit. The inner control limit
(U.C.L., and LCL). The firm performs no evaluation unit its cash balance fall out
side the outer control limit. When this occurs the firm looks ahead by adding the
expected cash flows for the next few days. If some falls outside the inner control
limit a transaction is made, otherwise, the transaction is foregone. The transactions
are the same as those in Miller Orr model. Investments are made to bring the
cash balance back to the return point if the upper control limit exceeds,
corresponding disinvestment are made if the lower control limit is exceeded. Optimal
procedures for setting the return point the two sets of control limits and the number
of days a firm looks ahead are not specified. The outer control limit could be set
by the Miller-Orr model or could be based on the cash manger's own assessment
for the best limits and the outer control limits.
Let us once again consider the example we used in the discussion of Miller
- Orr model. Also, assume that the inner control limits are set ` 20000 inside the
outer control limits (i.e. rs. 305000 and ` 1,20,000) and the firm looks ahead at
the next two days cash flows. At the end of day 1, the cash balance is ` 25,000
but since the outlier control limit have not breached no evaluation is made. At the
end of day 2, however the cash balance has been reduced to ` 50,000. At this
point the firm totals the text two day’s cash flow which is equal to ` 75,000 (i.e.
` 1,00,000 - ` 25,000). Additing this to current balance of ` 50,000 given expected
balance of ` 1,25,000. Since this expected cash balance is within the inner control
limit no disinvestment is made. Figure 10.6 illustrates cash balances for other
days. It should be noted that the 'Stone Model. does not suggest investments or
disinvestment over the five day period of the example.
Check Your Progress
What is inner and outer
control limit in Shone
Model ?
Management Accounting - I
255
Components of
Working Capital Management of Cash
Cash Balance (` 000)
NOTES
400
350
UCL 2 = 325
UCL 1 = 305
300
250
200
Return Point = 175
150
LCL 1 = 120
LCL 2 = 100
100
0
1
2
3
4
5
Days
Fig. 10.6 Cash Balances Control Limits
(Stone Model)
10.8 Investment of Securities
After determining optimum cash balance which a firm has to carry to satisfy
its transaction needs, finance manager employs the excess cash in securities so
as to earn return thereon without exposing the firm to high risk. Cash in excess of
"working cash balance requirements" may be held for two reasons. Firstly, the
working capital requirements of firm fluctuate because of the element of seasonality
and business cycles. The excess cash many build up during slack seasons but it
would be needed when he demand picks up. Thus, excess cash during slack
season is idle temporarily but has a predictable requirement later on. Secondly,
excess cash may be held as a buffer to meet unpredictable financial needs. A
firm holds extra cash because cash-flows cannot be predicted with certainty.
Cash balance held to cover the future exigencies is called the precautionary balance
and usually is invested in marketable securities until needed. Finance manager
should, therefore, bear in mind the following factors while choosing securities for
investment purpose.
(a) Marketability
(b) Safety
Check Your Progress
Which factors financial
manager should bear in mind
while choosing securities for
investment purpose ?
256 Management Accounting - I
(c) Maturity
(d) Taxability
(a) Marketability : Marketability refers to convenience and speed with which a
security can be sold quickly without loss of price, it is highly liquid or marketable.
The government treasury bills fall under this category. Municipal bonds as well as
port trust securities also made the test of marketability.
(b) Safety : Safety in investment here means free from credit risk i.e. risk arising
from default of the debtor in the payment of principal or interest. The credit risk is
a product of the character of the debtor, the economy which supports the obligations
and borrowing powers of the debtor. Therefore it is advisable that, to minimise the
chances of default risk and ensure safety of principal or interest, the firm should
invest in safe securities.
Components of
Working Capital Management of Cash
(c) Maturity : Maturity refers to the time period over which interest and principal
are to be made over. The price of long-term security fluctuates more widely with
the interest rate changes than the price of short-term security. Interest rates have
a tendency to change over a period of time. Because of these two factor the long
term securities are relatively more risky. For safety reasons, short-term security
are preferred by the firm for the purpose of investing excess cash. If for example,
the market rate of interest moves from 3 to 4 percent , the price of a 20 year, 3
percent bond would drop to ` 87.32, but a 5-year percent bond would drop to only
` 95.51. This is a sizable difference which indicate that why short-term securities
are preferred against long term obligations.
NOTES
(d) Taxability : Market yield of securities is also affected by tax factor. There
are certain category of securities which are exempted from levy of income tax
and wealth tax treatment in view of the differential tax, yields of different securities
differ. Tax exempted securities are sold in the market at lower yield than other
securities of the same maturity. Tax factor should therefore be considered while
choosing securities for the secondary reserves. Therefore while selecting a security
to test its suitability, the above mentioned factors must be considered by the financial
manager. The preparation of cash Budget and computation of optimum cash balance
can be understood with the help of following illustrations.
10.9 Illustrations
ILLUSTATION 1
Prepare a Cash Budget for three months ended 31st March, 2014 from the
following particulars relating to Bharat Forge Co. Ltd., Bangalore.
2013-2014
Credit Sales
Purchases
Wages
Months
`
`
`
November 2013
1,00,000
80,000
5,000
December 2013
90,000
70,000
6,000
1,10,000
1,00,000
4,500
February, 2014
60,000
95,000
5,500
March, 2014
80,000
1,30,000
7,000
January 2014
40% of the credit sales will be realised in the month following the sales and
the remaining 60% in the second month following. The creditors will be paid in the
month following the purchases. Interest of ` 5,000 will have to be paid in the
month of February, 2014. Income-tax of ` 15,000 will have to be paid in the
month of March, 2014. Wages are paid in the same month. The opening balance
Management Accounting - I
257
Components of
Working Capital Management of Cash
of cash as on 1-1-2014 was ` 20,000.
SOLUTION
In the Books of Bharat Forge Ltd., Bangalore
NOTES
Cash Budget for the three months ending 31st March, 2014
Particulars
Cash Balance Opening :
January
February
March
`
`
`
20,000
41,500
29,000
36,000
44,000
24,000
(+)
60,000
54,000
66,000
(B)
96,000
98,000
90,000
1,16,000
1,39,500
1,19,000
70,000
1,00,000
95,000
(A)
Add Receipts :
(i)
Collection from Debtors
(a) 40% of credit Sales one months credit
(b) 60% of Credit Sales two months credit
 Actual Receipts
(+)
 Total Receipts (A + B)
(C)
Less Payments :
(i)
Creditors for purchases one
month credit
(ii)
Interest
-
5,000
-
(iii)
Income-tax
-
-
15,000
(iv)
Wages
(+)
4,500
5,500
7,000
 Total Payments
(D)
74,500
1,10,500
1,17,000
41,500
29,000
2,000
(-)
Cash Balance Closing (C - D)
(E)
ILLUSTRATION 2
Cadbury India Ltd. Cochin wants to avail overdraft facility with Bank of India for
the period October - December 2014 for meeting the orders. From the following
particulars prepare a Cash Budget and find out the amount of overdraft facility
required.
258 Management Accounting - I
2014
Credit Sales
Purchases
Wages
Months
`
`
`
July
1,30,000
1,60,000
14,000
August
2,10,000
1,55,000
15,000
September
2,20,000
1,80,000
18,000
October
3,00,000
3,20,000
15,000
November
1,50,000
2,20,000
17,000
December
1,50,000
3,50,000
16,000
The credit sales are realised as mentioned below:
•
50% of the amount in the second month following, the sales two months or
•
50% of the amount in the third month following the sales three months
The creditors for purchases are paid in the month following the month of purchase.
The bank pass book showed a balance in the current account as on 30th
September 2014 as ` 10,000.
Components of
Working Capital Management of Cash
NOTES
SOLUTION
In the Books of Cadbury India Ltd., Cochin
Cash Budget for the three months ending 31st December, 2014
Particulars
Cash at Bank Opening
October
November
December
`
`
`
(A) (+) 10,000
(-) 15,000 (-) 1,37,000
Add Receipts:
(1) Collection from Debtors
(a) 50% of Credit Sales,
two months credit
(b)
1,05,000
1,10,000
1,50,000
(+)
65,000
1,05,000
1,10,000
(B)
1,70,000
2,15,000
2,60,000
1,80,000
2,00,000
1,23,000
15,000
17,000
16,000
(+)
1,80,000
3,20,000
2,20,000
(D)
1,95,000
3,37,000
2,36,000
50% of Credit Sales three months credit
 Actual Receipts
(+)
 Total Receipts (A+B)
(C)
Less Payments:
(1)
Wages
(2)
Creditors for purchases
one month credit
 Total Payments
(-)
Cash at Bank Closing (C-D)
(E)
(-) 15,000 (-) 1,37,000 (-) 1,13,000
ILLUSTATION 3
Desnso Ltd., Delhi wishes to arrange overdraft facility with its bankers
during the period April to June 2014 when it will be manufacturing mostly for
stock. Prepare a Cash Budget for the above period from the following cost data
indicating the extent of bank facilities the company will require at the end of each
month.
(a)
Cost Data made available is as follows :
Management Accounting - I
259
Components of
Working Capital Management of Cash
NOTES
2014
Sales
Purchases
Wages
Months
`
`
`
February
1,80,000
1,24,800
12,000
March
1,92,000
1,44,000
14,000
April
1,08,000
2,43,000
11,000
May
1,74,000
2,46,000
10,000
June
1,26,000
2,68,000
15,000
(b)
50% of Credit Sales are realised in the month following the sales and the
remaining 50% in the second month following. Creditorsare paid in the
month following the month of purchases.
(c)
Cash at Bank on 1st April, 2014 estimated ` 25,000.
SOLUTION
In the Books of Desnso Ltd., Delhi
Cash Budget for the three months ending 30th June, 2014
Particulars
Cash at Bank Opening :
April
May
June
`
`
`
(+) 25,000
(+) 56,000
(-) 47,000
96,000
54,000
87,000
(+)
90,000
96,000
54,000
(B)
1,86,000
1,50,000
1,41,000
2,11,000
2,06,000
94,000
1,44,000
2,43,000
2,46,000
(A)
Add Receipts :
(i)
Collection from Debtors
(a) 50% of credit Sales one month credit
(b) 50% of Credit Sales two months credit
 Actual Receipts
(+)
 Total Receipts (A + B)
(C)
Less Payments :
(i)
Payment to Creditors for purchase
of materials one month credit
(ii)
Wages
(+)
11,000
10,000
15,000
 Total Payments
(D)
1,55,000
2,53,000
2,61,000
(-)
Cash at Bank Closing (C - D)
(E)
(+) 56,000
(-) 47,000 (-) 1,67,000
ILLUSTATION 4
260 Management Accounting - I
Eskay Ltd., Emakulam wishes to prepare Cash Budget from January.
Prepare a Cash Budget for the first six months from the following estimated
revenue and expenses of 2014.
2014
Total Sales
Materials
Wages
Months
Overheads
Production
Selling and
Components of
Working Capital Management of Cash
Distribution
`
`
`
`
`
January
20,000
20,000
4,000
3,200
800
February
22,000
14,000
4,400
3,300
900
March
24,000
14,000
4,600
3,300
800
April
26,000
12,000
4,600
3,400
900
May
28,000
12,000
4,800
3,500
900
June
30,000
16,000
4,800
3,600
1,000
NOTES
Cash balance on 1st January 2014 was ` 10,000. A new machine is to be
installed at ` 30,000 on credit to be repaid by two equal installment in March and
April 2014. Sales commission @ 5% on total sales is to be paid within the month
following actual sales. ` 10,000 being the amount of second call may be received
in March 2014. Share premium amounting to ` 2,000 is also receivable with
second call.
•
Period of credit allowed by suppliers - 2 months.
•
Period of credit allowed by customers - 1 month.
•
Delay in payment of overheads - 1 month
•
Delay in payment of wages - 1/2 month.
Assume cash sales to be 50% of total sales.
Management Accounting - I
261
262 Management Accounting - I
In the Books of Eskay Ltd., Ernakulam
2,000
2,000
18,000
(+)
(D) (-)
(E)
4,500
44,800
20,000
900
800
4,200
9,200
29,800
3,300
4,600
38,900
6,100
800
3,300
14,000
20,000
3,200
15,000
1,200
15,000
1,100
1,000
10,000
20,000
4,700
24,300
8,800
900
3,400
14,000
1,300
14,000
13,000
27,000
33,100
May
`
6,100
NOTES
(+)
(B) (+)
(C)
13,000
12,000
25,000
45,000
10,000
2,000
12,000
11,000
35,000
64,800
11,000
10,000
21,000
39,000
April
`
20,000
10,000
March
`
29,800
Feb.
`
18,000
Jan
`
10,000
Cash-Budget for six months ending 30th June, 2014
Cash Balance - Opening (A)
Add Receipts :
1. Share Second Call
2. Share Premium
3. Cash Sales : 50% of Total Sales
4. Collection from Debtors 50% of Total Sales 1 month credit

Actual Receipts
Total Receipt (A+B)
Less : Payments
1.
Purchase of Machine
2.
Sales Commission @ 5% on Total Sales
3.
Payment to Suppliers for
purchase of material (2 months credit)
4.
Payment of Production
Overheads (1 month credit)
5.
Payment of Selling and
Distribution (1 month credit)
6.
Payment of Wages
(1/2 month credit)

Total Payment

Cash Balance Closing (C-D)
Particulars
SOLUTION
4,800
22,600
15,200
900
3,500
12,000
1,400
15,000
14,000
29,000
37,800
June
`
8,800
Components of
Working Capital Management of Cash
ILLUSTRATION 5
Arya Ltd., Ajmer estimated total cash payment of ` 8,00,000 for a monthly period.
The average fixed cost of security cash from market is ` 2,000 and the interest
rate on marketable securities is 1% for one month period.
You are required to calculate optimum level of cash holding as per inventory
model.
Components of
Working Capital Management of Cash
NOTES
SOLUTION
Q=
 2 KC B
where,
Q = Optimum size of cash Inventory
C = Average fixed cost of security cash from market i.e. ` 2,000
B = Total amount of transaction demand for cash over the period of time
involved i..e. ` 8,00,000
K = Cost of carrying inventory for cash i.e. interest rate on marketable
securities for the period i.e. 1% per month.

=
2 X ` 2,000
X ` 8,00,000
1%
=
` 5,65,685
Hence optimum size of cash Inventory = ` 5,65,685
Average Cash Balance
= ` 5,65,685 / 2
= ` 2,82,843
ILLUSTRATION 6
From the following particulars related to Boxin Ltd. Baroda, calculate optimum
cash Balance
Monthly Cash Requirements
-- ` 90,000
Fixed Cost per transaction
--- ` 50
Interest Rate on marketable securities
--- 6 % p.a.
SOLUTION
C=

2UP
S
Management Accounting - I
263
Accounts Receivable
Management
Where
C = Optimum Cash Balance
U = Monthly Cash Requirements i.e. ` 90,000
NOTES
P = Fixed Cost per Transaction i.e. ` 50
S = Opportunity Cost of one rupee i.e. 6% p.a.
=

2 X ` 90,000
X ` 50
6%
12 Months
=
` 42,426
Hence optimum cash Balance
= ` 42,426
Average cash Balance
= ` 42,426 / 2
= ` 21,213
Hence firm should make 4 transactions
(
` 90,000
` 21,213
= 4.23 i.e. U
regarding sales of
Marketable securities for conversion into cash during the month. Hence
total cost of holding cash is the least when the cash balance is kept at ` 21,213.
10.10 Summary
Cash Management is a “Universal business activity”. The main aim of any
company is to manage day-to-day cash transactions. It is some time found that
reported profit is blocked in receivable which constitute the item of “Dovment
Capital”. To overcome problem how cash should be made available for the smooth
running of the business, that requires the knowledge of “CASH
MANAGEMENT”.
Cash management is a trade-off between two objectives - maximising liquidity
and minimising cost associated with liquidity.
Four Aspects of Cash Management : (i) Cash Planning, (ii) Managing
the cash flows, (iii) Optimum cash level, (iv) Investing Idle Cash.
Cash forecasting and Budgeting : Cash forecasts are required to prepare
‘Cash Budgets’. Cash forecasting may be done on short term or long-term basis.
Two methods commonly used for short term cash forecasting - (i) The receipt
and disbursement method and (ii) The adjusted net income method.
264 Management Accounting - I
Managing the Cash Flows : (A) Methods of Accelerating the Cash
Inflows - (i) Quick Deposit of Customer’s Cheques, (ii) Establishing Collection
Centres, (iii) Lock-Box System, (B) Methods of controlling disbursements - (i)
Paying the float, (ii) Delaying outward payment, (iii) Showing disbursement by
use of Drafts, (iv) Making payroll periodless frequent, (v) Interbank Transfer.
Cash Management Models : (a) Inventory Model, (b) The Miller and Orr
Models and (c) Stone model.
Components of
Working Capital Management of Cash
Investment Securities : Factors while choosing securities (a) Marketability, (b) Safety, (c) Maturity, (d) Taxability.
NOTES
10.11 Key Terms
(1)
Cash Forecast : Cash forecast is to estimate cash requirement in advance.
(2)
Managing Cash Flows : The concept of Cash Flow Management
embraces the following points (i) Speeding up Collections (ii) Controlling
Payments and (iii) Controlling Bank Balances.
(3)
Float : Cheques are received from traders and the same are issued to
supplier. All these cheques are sent or deposited to Bank or clearance.
There is always a time gape between date of issue of cheque or deposit the
cheque to bank and the date of clearance. This time gap is known as ‘Float’.
(4)
Payment Float : It refers to a situation where issued cheques are not
presented to bank for payment.
(5)
Receipt Float : Cheque deposited to the Bank but not cleared by the
Bank, that is to say not credited in the banks account.
10.12 Questions and Exercises
I - Objective Questions
A) Multiple Choice Questions
(1)
The cash required for conducting business transactions is termed as ------motive of holding cash.
(a) transaction, (b) precautionary, (c) speculative, (d) profit
(2)
The difference between the available cash balance and the ledger balance
is termed as -------.
(a) collection, (b) disbursement, (c) float, (d) net cash
(3)
Ability to transform a security into cash is termed as ------(a) physibility, (b) convertibility, (c) liquidity, (d) viability.
(4)
The important objective of ------- management is to accelerate the inflow
and decelerate the outflow of cash.
(a) inventory, (b) receivable, (c) modern, (d) cash
Ans. : (1 - a), (2 - c), (3 - c), (4 - d)
Management Accounting - I
265
Accounts Receivable
Management
NOTES
II - Long Answer Questions
(1)
What is ‘Cash Management’ ? State the important objectives of cash
management.
(2)
Define the term ‘Management of Cash’. Explain in brief the importance of
‘Cash Management’.
(3)
Explain the various aspects of ‘Cash Management’.
(4)
What do you understand by ‘Cash Management’? Explain the various
motives of holding cash.
(5)
Define ‘Cash Management’. Explain the various methods of accelerating
the cash inflows.
(6)
What is ‘Cash Management’ ? Explain the various methods of controlling
the cash outflows.
(7)
Explain in brief various models of Cash Management.
(8)
Explain the important factors to be taken into account while selecting
securities for investment purpose.
III - Practical Problems
(1) A company expects to have ` 37,500 cash hand on 1st April , 2014 and requires
you to prepare an estimate of cash position during the three months April to June
2014. The following information is supplied to you.
2014
Sales
Purchases
Wages
Months
266 Management Accounting - I
Factory
Office
Expenses
Expenses
Selling
February
75,000
45,000
9,000
7,500
6,000
5,500
March
84,000
48,000
9,750
8,250
6,000
4,500
April
90,000
52,500
10,500
9,000
6,000
5,250
May
1,20,000
60,000
13,500
11,250
6,000
6,570
June
1,35,000
60,000
14,250
14,000
7,000
7,000
(i)
Period of credit allowed by suppliers - 2 months.
(ii)
20% of sales is for cash and period of credit allowed to customers for
credit sales in one month.
(iii)
Delay in payment of all expenses - 1 month.
(iv)
Income tax of ` 57,500 is due to be paid on June 15, 2014.
(v)
The company is to pay dividends to shareholders and bonus to workers
of ` 15,000 and ` 22,500 respectively in the month of April, 2014
(vi)
Plant has been ordered to receive and paid in May 2014. It will cost `.
1,20,000.
10.13 Further Reading
•
Rustagi R. P. - Fundamentals of Financial Management - New Delhi Galgotia Publishing Co. - 2010
•
Sharan Vyuptakesh - Fundamentals of Financial Management - New Delhi
- Pearson Education Pvt. Ltd. - 2010
Components of
Working Capital Management of Cash
NOTES
Management Accounting - I
267
UNIT 11 Accounts Receivable Management
Accounts Receivable
Management
Structure
11.0 Introduction
NOTES
11.1 Units Objectives
11.2 Meaning of Accounts Receivable
11.2.1 Meaning of Accounts Receivable Management
11.3 Factors that Govern the Accounts Receivable
11.4 A Balance between “Liquidity” and “Profitability”
11.5 Computation the “age” of Accounts Receivable
11.6 Illustrations
11.7 Summary
11.8 Key Terms
11.9 Questions and Exercises
11.10 Further Reading
11.0 Introduction
Problem of management of receivable arises only when merchandise is
sold on credit. If a company makes all sales for cash, it would have no accounts
receivables and therefore the question of management of such assets does not
arise all. Although concessions like price discount are granted to induce customers
to make immediate cash pay payments, practice of extending credit to the
customers is very popular. If the firm decides to sell on cash it will save cost of
carrying receivables. But the firm in that situation may lose some of its previous
customers who will turn to other concerns extending credit facilities. Consequently
value of sales of the firm and its earnings may show declines. The firm should not
expect to survive long by pursuing the policy of cash sales while similar other
firms have followed liberal credit policy.
Accounts receivable is a permanent investment in the business. As old
accounts are collected, new accounts are created. Accounts receivable is a major
component of the current assets. This account emerges because of the existence
of credit sales. As this account constitutes a major share it has got a greater
significance in working capital management. Credit sales no doubt increases
turnover and profit of the business. But carrying permanently the accounts
receivable in the firm involved greater risk. Hence there is a need for management
to establish the level of accounts receivable.
Management Accounting - I
269
Accounts Receivable
Management
11.1 Units Objectives
After studying this unit you should be able to
NOTES
•
Understand the meaning of ‘Accounts Receivable’.
•
Discuss the ‘factors govern the accounts receivable.
•
Explain the terms - “Credit policy, Credit Sales Volume, Terms & conditions
of credit sales.
•
Explain types of discount allowed.
•
Discuss the term “A balance between “liquidity” and profitability.
•
Compute the ‘age’ of accounts receivable.
•
Prepare statement of Accounts Receivable their Average Age.
11.2 Meaning of Accounts Receivable
Accounts receivable is a component of current asset. It shows the amount
receivable from the purchases. “Trade debt” due to the firm from the purchaser
who purchase goods or avail service on credit basis. This is called by different
names such as Accounts Receivable Trade Debtors, Sundry Debtors, Trade
Receivables etc. This account emerges out of credit sales. Almost all the business
enterprises today carry on their business on credit basis. There will be both selling
and buying on credit basis and when credit sales take place. The buyers will have
little time to pay back the purchase price. This allowance of time sentences the
trade activity and results in good turnover to the business and better profitability.
Hence, accounts receivable is an account maintained by the firm which shows
the amount owing to the firm and it is a permanent investment.
11.2.1 Meaning of Accounts Receivable Management
While planning working capital requirement for the firm, finance manager
must decide the amount of funds that firm will-require to carry receivables. For
that matter firm’s receivable turnover has to be determined. Receivable turnover
refer to the number of times the receivable turnover during the year. A shorter
period collection period would result in looking up of working capital for a short
period in effecting credit sales which would, in its turn, increase the requirement
of working capital. Slow turnover is indicative of the fact that it take longer period
to collect receivables.
270 Management Accounting - I
As stated earlier, accounts receivable is a permanent investment and is an
ever rolling account. The finance manager has to determine the level of this account
suitably so that there will be an easy flow of working capital. The manager should
see that debtors turn fast. If the debtors turnover velocity is high then the firm can
minimise borrowings for working capital. All this, viz. maintenance of debtors at
optimum level, the degree of credit sales to be made, making the debtors turn fast
involves the “Accounts Receivable Management.” Thus account receivable
management is a decision-making process which takes into account the creation
of debtors, turnover and minimising the cost of borrowing of working capital due
to lacking of funds in accounts receivable. In establishing the level of accounts is
receivable the finance manager has to assess the following aspects :
(i)
How best the accounts receivable contribute to the firm’s earnings.
(ii)
Whether it is feasible to tie the funds in this asset rather than in some other
asset.
(iii)
How best the accounts receivable can be reduced without affecting the
sales.
(iv)
Whether the accounts receivable contribute anything for achieving the
objective is of the enterprise.
Accounts Receivable
Management
NOTES
11.3 Factors that Govern the Accounts Receivable
There are several factors or issues that govern the accounts receivable.
They are as follows :
Factors govern the Accounts Receivable
1
2
3
4
5
6
Credit Policy
Credit Sales
Terms and
Location of
Competition
Life of
Volume
Conditions of
Business
Credit Sales
Product
or item
(a) Credit Policy : Credit policy of a firm contains guidelines regarding quality
of trade accounts to be accepted, the length of the credit period, the cash discount,
any special term given such as seasonal datings the collection programme and
policy as to discounting of bills. Pursuance of liberal credit policy will boost sales
of the firm as it tempts the customers to mark purchases from the firm on easier
terms. Consequently, the firm will need larger amount of working capital, to finance
receivables. This would not be so in the case of firms following sticker creditpolicy. This is because of the fact that credit standards of the firm are so high that
it is difficult for most of the customers to satisfy them. Further, even those who
qualify the credit standards might feel reluctant to avail of credit facilities on
stiffer terms and conditions. Sometime firms adopt the policy of discounting bills
from banks. In that case money is not tied in receivables for long-time. Such a
policy is usually followed by those business enterprises which affect most of their
sales on credit and where receivables constitute predominant share of assets.
The credit policy varies also with changes in the economy. If the economy is
experiencing a tight situation, then businessmen will have to adopt a liberal credit
Check Your Progress
Which factors govern the
Accounts Receivable ?
Management Accounting - I
271
Accounts Receivable
Management
NOTES
sales policy. This means, the increase in accounts receivable. Again, the customers
may take longer time to make payments. On the hand if the economy is experiencing
a boom period, trade credit will be on a low key and the volume of accounts
receivable will also be less and the collection period will also be reduced.
The credit policy may be liberal or rigid one. If the firm adopts a rigid policy,
the volume of accounts receivable will be less and the firm plays safe. There will
be better debtor management. On the other hand, if the firm adapts a liberal credit
policy, the volume of Accounts Receivable increases and the risk of the firm even
the sound customers would like to avail the facility of credit sales. This reduced
the cash inflow and increases the volume of debtors. Another defect in this policy,
is that the quality of the account receivable suffer. There will be more defaults
and bad debts. Thus, the volume of accounts receivable depends upon the condition
in the economy and the nature of credit policy adapted by the firms. A finance
manager should find ways and means of reducing the volume of receivable without
impending the firm’s sales potential. He has to manage receivable in such a ways
as to optimize profits. The basic consideration guiding the formulation of credit
policy of a firm is matching incremental profits resulting from sales with incremental
costs associated with receivable.
(b) Credit Sales Volume : In order to increase the profit and ‘Push sales, many
firms will have “Credit Sales” Higher the volume of credit sales, higher will be
accounts receivable. The level of credit sales will also be determined by the custom
that exists in that busyness. If the business need the credit sales will also be
determined by the custom that exists in that business. If the business need the
credit sales to push the product, it becomes inevitable that the firm has to adopt
credit policy on a larger scale. This naturally gives place for the emergence of
account receivable. The volume of this account changes with the change in credit
sales. Thus credit sales volume is one of the factor which governs the volume of
account receivable.
(c) Terms and condition of Credit Sales :
The volume of accounts receivable also depends on the terms and condition
relating to credit sales. These conditions include
272 Management Accounting - I
(i)
The time period allowed to pay back purchase price.
(ii)
The types of discounts allowed.
(iii)
Seasonal datings.
(i) The time period or Length of the Credit Period : Credit terms specify
the length of the credit period and size of the cash discount offered for quick
payment. There is no legal restriction on a firm to set terms of sales. The firm can
fashion its own terms and use them as a dynamic instrument in its bid to stimulate
sales. But the freedom to determine the terms of credit is constrained by the
customs of an industry. Each trade has its customary terms of credit which
frequently dictate the nature of the credit terms to be offered by a firm. The
competitive pressures also compel a firm to have uniformity in respect of cash
discount and period of credit extension. New firms are forced to offer as liberal
terms of credit as are being already given. Sometime, a firm may offer still more
favorable term in order to hold old customers to attract new ones.
The time period allowed to clear the trade debt by the customers determine
the volume of accounts receivable. Longer the period allowed, higher will be the
credit sales and rise in size of the accounts receivable. The time period will be
determined by taking into account the business condition and firms internal situation
relating to working capital . If the firm’s micro and macro environment provide for
longer credit period, it can do so. Otherwise it can adopt short period policy.
However the payment should be made exactly on or before the due date which
may be 15, 30 or 60 days. The term “Net date” is used to express the exact credit
period allowed.
Accounts Receivable
Management
NOTES
(ii) Types of Discount Allowed : There are three categories of discounts allowed
by the traders to customers, viz. (a) Trade Discount, (b) Cash Discount and (c)
Quantity Discount.
(a) Trade Discount is the normal and usual discount allowed on the invoice price.
This also influences the sales. Supposing higher trade discount allowed on the
invoice price. This also influences the sales. Supposing higher trade discount is
allowed on the invoice price the purchasers are motivated and sales volume
increases and results in increase of accounts receivable. However, the firm cannot
lose on counts - 1) extending credit and 2) allowing a higher trade discount. It has
to strike a balance between these two and have a sound discount policy to pushup sales figure.
(b) Cash Discount is a powerful device to speed up collection of receivable. This
would result in reduction of investment in receivable. But offering each cash
discount involves cost. A finance manager should match the earnings resulting
from investment of funds released by reducing the level of receivables with the
cost of the discount to decide whether or no cash discount should be offered.
(c) Quantity Discount is one which is allowed in terms of physical units. This also
pushed the sales and increases the size of accounts receivable. If the seller finds
that the stock he holds is in excess if he anticipates a fall in price of the product, he
will think of allowing quantity discount to push sales, reduce the excess stock and
avoid the expected loss. The stock then can be converted into accounts receivable.
This again increase the size of accounts receivable.
(iii) Seasonal datings : By means of seasonal datings firm particularly those
dealing in seasonal products can boost sales. In seasonal datings customers are
sold goods without being required to pay until sometime to come. Seasonal datings
are usually tailored to the cash flow of the customers. Decision to offer seasonal
datings facility involves balancing of profitability of additional sales with the cost
of carrying additional receivables.
(d) Location of Business : Location of business unit also contributes for the
size of accounts receivable. If the business firms are located in far off place, they
are forced to adopt a credit policy which attracts the customer. If the product is
exclusive, location will not be a problem and customer development will be good.
In such a case the firm can adopt a stringent credit policy which reduces the
Management Accounting - I
273
Accounts Receivable
Management
NOTES
account receivable. On other hand, if product is competitive in character, the
business unit dealing in such product and operating from a distant place from the
market area, has to adopt a liberal credit policy which results in increase in accounts
receivable.
(e) Competition : Another factor which governs the size of the accounts receivable
is competition. If firm is having a competitive nature, it will have liberal credit
policy and this increases the size to the accounts receivable. They compete with
the object of pushing sales and easy credit terms become inevitable. When the
firms severely compete, the credit policy will be so liberal that all and sundry
purchase the products on credit. This results in some amount of bad debts although
it increases the volume of sales.
(f) Life of Product : The life of the product varies from segment to segment. In
health care, for instance a product can last 15 years. In other segments, products
may have a four or five year life-span. Industrial products generally have a longer
life span than consumer product. When the new product are introduced, the firm
has to extend the liberal credit policy till the such time product catches the market
and even afterwards the policy has to continue to maintain customers. This naturally
increases the size of accounts receivables.
11.4 A Balance between “Liquidity” and
“Profitability”
In order to reach a maintainable size (optimum), the firm has to strike a
balance between “liquidity” and “profitability”. Liquidity here refers to the quality
of the accounts receivable. This means, the firm has to maintain debtors which
are readily convertible into cash to meet the business needs. As far as possible the
credit should be extended, to those who have good credit standing. Then the
accounts receivable will be qualitative one and results in good funds inflow.
‘Profitability’ refers to the earning more profit by increasing the credit sales volume.
But when the credit sales increase, more risk is involved. This result in more
locking of funds, increase in occurrence of bad debts and increased cost of
collection. Hence sales volume has to be increased minimising these limitations.
The firm cannot have a rigid credit sales policy either. If it adopts such a policy,
the quality of debt may become good for then may be good inflow of funds but
sales figure falls resulting in decline in profits. Considering every aspect, the firm
has to maintain a balance between these two - liquidity and profitability to hold a
“manageable size” of the accounts receivable. The credit policy should not be too
loose or too tight. It should be moderate to maintain a qualitative and good size of
accounts receivable.
274 Management Accounting - I
11.5 Computation the “age” of Accounts
Receivable
The ‘age’ here refers to the time involved in collecting the purchase price
from the trade debtors. This age actually contributes to the sound management of
working capital. If the collection period is long then the inflow of-fund will be slow
and may not synchronies with the payments to be made to the trade creditors.
Hence it is always advisable to determine the collection period and the average of
the debtor. Shorter the collection period and age faster will e fund inflow . This
helps in minimising expenses or trade creditors or any other payment to be made.
Accounts Receivable
Management
NOTES
The age of accounts receivable can computed by taking the following variables :
(i)
Credit sales for a given period.
(ii)
Opening debtors.
(iii)
Closing debtors.
Check Your Progress
Which variables affect on
the age of accounts
receivable ?
Steps involved in the calculation of the age of the accounts
receivable: The following steps are involved in the calculation of the age of the
accounts receivable.
Step 1 :
Ascertain the average debtors by adding opening and closing debtors and dividing
it by 2.
i.e.
Opening Debtors + Closing Debtors
= Average Debtors.
2
Step 2 :
Calculate the Debtors turnover by dividing credit sales by
Average Debtors =
Credit Sales
Average Debtors
Step 3 :
Find out age by dividing the period from the debtors turnover =
Months in the period
Debtors Turnover
The various concepts used in Accounts Receivable Management can be
understood with the help of following illustrations.
Management Accounting - I
275
Accounts Receivable
Management
11.6 Illustrations
ILLUSTRATION 1
NOTES
Calculate the age of accounts receivable by applying alternative methods and
comment on the position.
Accounts Receivable - Opening .............................
80,000
Accounts Receivable - Closing ..............................
60,000
Annual Credit Sales ..............................................
7,00,000
SOLUTION
Calculation of the Age of Accounts Receivable
Alternative Method I :
i) Calculation of Average Debtors
=
=
Opening Debtors + Closing Debtors
2
` 80,000 + ` 60,000
2
= ` 70,000
ii) Calculation of Debtors Turnover
=
=
Credit Sales
Average Debtors
` 7,00,000
` 70,000
= 10 times
iii) Calculation of Age of Accounts Receivable
=
=
Monthly Period
Debtors Turnover
12 Months
10 times
= 1.2 Months
Alternative Method II :
i) Calculation of Age of Accounts Receivable
=
=
276 Management Accounting - I
Average Debtors x Monthly Period
Credit Sales
` 70,000 x 12 months
` 7,00,000
= 1.2 months
Accounts Receivable
Management
Alternative Method III :
i) Calculation of Age of Accounts Receivable
=
=
Average Debtors
Monthly Sales
NOTES
` 70,000
` 7,00,000 / 12 months
= 1.2 months
Comment
The age of accounts receivable is 1.2 months i.e. 36 days, which means the
accounts receivable turn once in 36 days which is considered to be a good
management of accounts receivable. Any period between 15 days to 45 days is
adjudged as a sound period of collection and working capital management will not
suffer.
ILLUSTRATION 2
A company’ collection pattern is as follows :
10% of the sales in the same month
20% of the sales in the 2nd month (i.e., in the month following the sales)
40% of the sales in the 3rd month
30% of the sales in the 4th month
The sales of the company for the year 2008 are as follows :
Month
First Quarter Second Quarter Third Quarter Fourth Quarter
First
2,00,000
1,00,000
1,50,000
2,25,000
Second
2,00,000
2,00,000
2,00,000
2,00,000
Third
2,00,000
3,00,000
2,50,000
1,75,000
Total
6,00,000
6,00,000
6,00,000
6,00,000
Working Days
90
90
90
90
Calculate average age of receivable and comment upon the results.
SOLUTION
The pattern of collections indicates that the outstanding receivable at the
end of each month consist of :
(i)
90 % of the month’s sales.
(ii)
70% of the previous month’s sales
(iii) 30% of the sales made two months ago therefore the amount of accounts
receivable and the average age of receivables at end of each quarter will be :
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277
Accounts Receivable
Management
Statement of Account Receivable their Average Age
Particulars
NOTES
First
Second
Third
Fourth
Quarter
Quarter
Quarter
Quarter
30% of 1st month’s Sales
60,000
30,000
45,000
67,500
70% of 2nd month’s Sales
1,40,000
1,40,000
1,40,000
1,40,000
90% of 3rd month’s Sales
1,80,000
2,70,000
2,25,000
1,57,500
Total Account
3,80,000
4,40,000
4,10,000
3,65,000
Receivables
Average Age of
3,80,000
Receivables
6,00,00
x 90
= 57 days
4,40,000
6,00,000
x 90
4,10,000
6,00,000
= 66 days
x 90
= 61 days
3,65,000
6,00,000
x 90
= 55 days
Comments :
The above statement show that collection process has suffered a set back
in II and III Quarters while it has improved in the IV Quarter. The average age of
receivables has form one quarter to another because of fluctuations in the sales
pattern. The fact is that there has been neither any deterioration nor any
improvement in the collection machinery.
ILLUSTRATION 3
A firm decides the liberalise credit standards to sell a group of customers
with 10 percent risk of non-payment. The firm estimates that this course of action
would result in an additional sales of ` 2,00,000 the marginal cost of production
and distribution of the additional units is estimated to be about 50 per cent of the
selling price. It is further anticipated as a result or change in credit policy collection
cost will increase be 5 percent of additional sales. Should the firm liberalise
standards?
SOLUTION
Particulars
Added Sales Revenue
Less :
Less :
Bad Debts Allowable (by assuming 10% risk group)
`
2,00,000
20,000
Added Revenue Collection
1,80,000
Production and Selling Cost (50% of selling price)
1,00,000
80,000
Less :
Collection Cost
Net Revenue added from marginal accounts
10,000
70,000
Thus despite increase in credit losses involved in relaxation of credit
standards, the firm will be able to improve its earning position by ` 70,000.
278 Management Accounting - I
Accounts Receivable
Management
ILLUSTATION 4
XYZ company which currently sells goods on net 30 days terms, is
considering the possibility of lengthening its credit terms to 60 days. The current
year sale is anticipated to be the order of 2,00,000 units at a selling price of ` 10
each, with an average total unit cost at this volume of ` 9.50. Lengthening credit
period is expected additional units of sale at ` 9.00 per unit because it is hoped
that overhead costs would to spread over higher volume of production in cost
reduction by 0.50 paise per unit. Management anticipates that is a result of increase
in credit period from one month to two month. Collection cost would increase
from ` 6.000 to ` 8,000 annually and bad debt losses would increase from 2 per
cent to 2.5 per cent of sales. A finance manager of the company feels that any
additional investment in receivables should earn at least 14 per cent before selling
and administrative cost.
NOTES
Should the Company lengthen its credit policy ?
SOLUTION
The policy decision regarding lengthening of credit period from 50 days to
60 days calls for, in the first instance calculation of average investment in
receivables.
As the estimated sales of 2,50,000 unit total manufacturing cost and average
cost are :
Current sales (units) x average total cost
=
2,00,000 x ` 9.50
=
` 19,00,000
=
50,000 x ` 9.00
=
` 4,50,000
Total costs for manufacturing 2,50,000 units
=
` 23,50,000
Average cost per unit
=
` 9.40
Increased Sales x Variables Cost
The average investment in receivables may be computed with the help of the
following equation :
Average investment in receivables =
Annual Sales
Turnover of
x
Average Cost
Selling price
= Receivables
When the above equation is substituted by figures given in XYZ Company.
The average investment in receivables is :
` 20,00,000 ` 9.50
= 1,58,333.
x
12
10.00
The average investment in receivables under the proposed credit policy.
Management Accounting - I
279
Accounts Receivable
Management
Sales (Units)
Sales (`)
Cost of goods sold
Gross Profit
NOTES
Less : Collection Costs
Bad Debts Losses
Net Profit
Net 30 Days
Net 60 Days
2,00,000
2,50,000
` 20,00,000
` 25,00,000
19,00,000
23,50,000
` 1,00,000
` 1,50,000
6,000
8,000
40,000
62,500
` 54,000
` 79,500
(exclusive of Selling and Distributive Expenses)
The expected return on this investment is, therefore, 15.2 percent. Since
the rate of return is higher than the minimum expected return of 14 percent, the
company can afford liberal credit terms by lengthening credit from 30 days to 60
days.
11.7 Summary
280 Management Accounting - I
•
Accounts Receivable : Accounts Receivable is a major component of
current assets. Credit sales no doubt increases turnover and profit of the
business. But carrying permanently the accounts receivable in the business
involves greater risk. Therefore there is a need for management to establish
the level of accounts receivable.
•
Factors given the Accounts Receivable : There are six important factors
that govern the accounts receivable - (i) Credit Policy, (ii) Credit Sales
volume, (iii) Terms and conditions of Credit Sales, (iv) Location of business,
(v) Competition, and (vi) Life of product or item.
•
Types of Discount Allowed : (i) Trade Discount, (ii) Cash Discount, &
(iii) Quantity Discount.
•
A balance between ‘liquidity’ and ‘profitability’ : This means the firm
has to maintain debtors which are readily convertible in the cash to meet
the business need and on the otherhand, credit should be extended to those
who have good credit standing.
•
Considering every aspect the firm has to maintain a balance between these
two liquidity and profitability to hold a manageable size of the accounts
receivable.
•
Computation the ‘age’ of accounts receivable : The ‘age’ here refers
to the time involved in the collecting the purchase price from the trade
debtors. This age actually contributes to the sound management of working
capital.
11.8 Key Terms
(1)
Accounts Receivable : Account receivable is a component of current
asset. It shows the amount receivable from the purchases.
(2)
Trade Discount : Trade Discount is the normal and usual discount allowed
on invoice price which influences the sales.
(3)
Cash Discount : Cash discount is a powerful device to speed up collection
of receivable which would result in reduction of investment and risk in
receivable.
(4)
Quantity Discount : Quantity discount is one which is allowed in terms of
physical units, which also pushes the sales and increases the size of accounts
receivable.
(5)
Liquidity : Liquidity here refer to the quality of the accounts receivable.
This means the firm has to maintain debtors which are readily convertible
into cash to meet the business needs.
(6)
Profitability : Profitability here refers to the earning more profit by increasing
the credit sales volume.
Accounts Receivable
Management
NOTES
11.9 Questions and Exercises
I- Objective Questions
(A) Multiple Choice Questions
(1)
If the firm adopts a rigid credit policy, the volume of accounts receivable
will always be ----(a) more, (b) less, (c) stable, (d) fixed.
(2)
Higher the volume of credit turnover, ------ will be the accounts
receivable.
(a) higher, (b) lower, (c) stable, (d) smaller.
(3)
Average size of accounts receivables is equal to --------(a)
Sales - Receivables Turnover
(b)
Sales x Receivables Turnover
(c)
Sales + Receivables Turnover
(d)
Sales / Receivables Turnover
(4)
Provision of discount ------- average collection period.
(a) has no effect on, (b) increates, (c) decreates, (d) compensates.
Ans : (1 - b), (2 - a), (3 - d), (4 -
Management Accounting - I
281
Accounts Receivable
Management
NOTES
II - Long Answer Questions
(1)
Define ‘Accounts Receivable Management’. Explain the factors that govern
the accounts receivable.
(2)
What is ‘Age of Accounts Receivable’ ? Explain the method of computing
the Age of Accounts Receivable.
(3)
What is ‘Accounts Receivable’ ? Explain the utility of Accounts Receivable
Management.
(4)
How credit policy of a firm affects the Accounts Receivable ?
III - Practical Problems
(1)
In Bharat Ltd., Belapur, if the size of outstanding receivables is ` 24,000 in
0-40 days class, ` 20,000 in 41-80 days class and ` 16,000 in 81-90 days
class, find out the average age of receivables.
11.10 Further Reading
282 Management Accounting - I
•
Rustagi R. P. - Fundamentals of Financial Management - New Delhi Galgotia Publishing Co. - 2010
•
Sharan Vyuptakesh - Fundamentals of Financial Management - New Delhi
- Pearson Education Pvt. Ltd. - 2010.
UNIT 12 Inventory Management
Inventory Management
Structure
12.0 Introduction
NOTES
12.1 Units Objectives
12.2 Inventory Management
12.2.1 Role of Financial Manager in Inventory Management
12.3 Determining the Optimum level of Inventory
12.4 Purchase Control
12.5 Stock Levels
12.6 Economic Order Quantity (EOQ)
12.7 Other Important Inventory Control Techniques
12.8 Illustrations
12.9 Summary
12.10 Key Terms
12.11 Questions and Exercises
12.12 Further Reading
12.0 Introduction
The term “inventory” has a wider meaning then the term “materials”.
Inventory includes stock of raw material, work-in-progress, finished goods,
components and supplies. ‘Inventory’ may be classifies as - (i) Production
Inventories e.g. raw materials, spare parts, components etc. which are used in
production process. (ii) Non Productive inventories e.g. office stores, machine
spare parts scrap, lubrication, Oil etc. (iii) In-process material i.e. semifinished
goods lying at different stages of production process. (iv) finished goods inventories
i.e. products ready for sales, (v) Scrap, Obsolete materials are also some times
considered as form of inventory. Inventory management ensures smooth running
production by providing quality and quantity material with minimum amount of
capital.
Inventory control is a planned method of investment in inventories held in
study and maintained is such a manner that it ensures proper and smooth flow of
materials needed for production operations as well as sales, while at the same
time the total costs of investment in inventories is kept at a minimum.
Management Accounting - I
283
Inventory Management
NOTES
The financial manager has to play significant role in all spheres of inventory
management because financial needs and investment of the firm are influenced
directly in inventory policies. In order to avoid over and under investment in materials.
The management should decide the various levels of stock to be kept in the stores.
It is therefore necessary to strike out a balance between the two extremes and
maintain to optimum level of investment in inventory. The exact quantity to be
ordered at a time so as to achieve this objective is known as the Economic Order
Quantity (EOQ). EOQ is thus, the size of order which produces the lowest cost of
the material ordered.
12.1 Unit Objectives
After the studying this unit you should be able to :
•
Understand the meaning of inventory management.
•
Explain the role of financial manager in Inventory mgt.
•
Explain the term “Determination of order point”.
•
Explain the terms “Purchase Control”.
•
Discuss the various types of stock levels.
•
Understand “EOQ” and its Determination, methods and assumptions.
•
Discuss the other important inventory control techniques.
12.2 Inventory Management
Inventory generally represent a very significant proportion to total assets.
Hence the importance of inventory management cannot be over emphasized.
284 Management Accounting - I
Inventory represents, by for, the most prominent component of assets in a
business enterprise. For manufacturing firm, it is necessary to have inventory of
raw materials, goods in process and inventory of finished goods. How much funds
a firm would require to carry different kinds of inventories to ensure continuous
production and to meet customers demand without any delay should be determined
by finance manager very prudently, as too have much or to little inventory will
have undesirable effects on the profitability of the firm, Thus, if the firm maintains
inventory in excess of the required amount it will have to incur additional costs in
carrying excess inventory which other wise could not arisen. Likewise, holding
inventory less than what is actually required is likely to adversely affect rate of
return because in the first instance the firm will have to spend additional costs for
more setups, extra planning and coordination and increased clerical efforts to
handle frequent orders. Secondly, in the absence of adequate raw materials
production work is likely to be hampered rendering capital and labour in the firm
under-utilised. Finally, the firm carrying insufficient stock of finished goods often
times fails to meet the delivery schedules and thereby it not suffers losses goodwill
at the same time.
Inventory Management
12.2.1 Role of Financial Manager in Inventory
Management
The finance manager has to play significant role in all spheres of inventory
management because financial needs and investment of the firm are influenced
directly in inventory policies. In order to ensure that funds procured from numerous
sources are allocated efficiently in inventories, finance manager must help
production and marketing managers in formulating such inventory policies as are
consistent with the firm’s financial objectives. In the event of liquidity Crisis facing
the firm, role of a finance manger becomes more pronounced.
In formulating inventory policies, Finance manager is in dilemma over
conflicting goals of non-finance managers. Finance manger should study critically
the circumstances under which the firm will operate and which have their direct
bearing on inventory level. It would be germane to discuss the impact of these
situations or the level of different kinds of inventories separately.
The marketing executive aims at satisfying ever-increasing demands for
improved customer service by having large finished goods. The objective of
production manager is to maintain stable production operations by having large
inventory of raw materials .However, these objectives conflict with the objective
of finance manager to keep the investment in inventory at minimum possible
level. Large holdings of inventories increase production, sales and inventory at
minimum possible level. Large holdings of inventories increase production, sales
and investments in inventories but increase in inventories cause decrease in return
on investments.
NOTES
Check Your Progress
In the event of liquidity
crisis facing. How the role
of a finance manager
becomes more important ?
For accomplishment of the goal of efficient management of inventories,
finance manager must aim at resolving the above conflicts. This he can do by
matching benefits and costs of carrying inventories and determining the optimum
level of inventory determining when to order, deciding acceptability of stock but
probabilities and level and determining degree of inventory control.
12.3 Determining the Optimum level of Inventory
Determining the right amount of inventory calls for matching of gains derived
from carrying such amount of inventory. It must also be remembered in this regard
that as orders increase in size, additional savings decline per unit of added purchasebecause saving due to fixed cost is spread over a larger number of units even if
quantity discounts are availed of whereas the additional variable costs tend to
move up constantly with an increase in size of orders. Therefore the carrying
costs of inventory may tend to rise in proportion to the amount of inventory but the
same may not hold true in respect of saving from purchasing or producing in large
lots. To determine the appropriate level of inventory and for that matter to balance
costs of carrying inventory against the benefits the holding this amount of inventory
finance Manager must consider a number of different levels of inventory for a
Management Accounting - I
285
Inventory Management
particular item, and select that level which yield the total cost.
One of the most widely used techniques which provides a full proof solution
to the problem of determining optimal size if inventory in a firm is Economic Order
Quality (EOQ).
NOTES
(a) Determination of Order Point :
Check Your Progress
The order point is the level of inventory and we should order the economic
order quality of additional stock. Thus, order point determines the level of inventory
when fresh order should be placed to the suppliers for procuring additional stock
to the economic order quality.
Which are the three major
variables
used
in
determination
of Order
Point ?
Three major variables which have to be kept in view while determining
order point under conditions of certainty are : Usage rete, lead time and economic
order quantity.
Usage rate means quantity of raw materials consumed daily of quantity of
finished goods sold daily. Lead time refers to span of time between the date of
placing the order and the actual delivery of materials. For example, if the order is
placed on 1st of the month and the materials are delivered on 16th of the month,
the lead time is 15 days. For efficient management of inventory, the purchase
manager must ensure that order for materials before it runs out of materials.
Thus order point can be determined with the help of the following formula :
Order point L x u Where, L = Lead time, u = Usage rate.
EXAMPLE
The economic order quantity of a firm is 300 units, lead time is 2 weeks and
the average. Consumption of materials of the firm is 30 units per week. Calculate
the order point for firm.
ANSWER
Order point = 2 weeks x 30 units = 60 units
Thus, the firm will have to record for the materials when its stock level
reaches 60 units. In other Words, the order will be placed at the end of 8th week
when 60 units will be left for consumption during the lead time.
Assume for example, the expected stock out is 15 units per week. The firm
(in the previous illustration) should maintain a safety stock of 30 units (15 units x
2 weeks). Thus, the recorder point will be 90 units (60 units + 30 units). The
maximum inventory of the firm will be equal to the economic order quantity plus
the safely stock, i.e., 300 units + 30 units = 330 units.
Thus, in conditions of uncertainty order point can be determined with the
help of the following formula : Order point = L x u + s, where, S = Safety stock.
286 Management Accounting - I
(b) Determination of optimum size of Safety stock : In a simple situation
where only the usage rate is variable and the maximum usage rate can be specified,
the safety stock required to seek total protection against stock out is simply :
(Maximum usage rate (-) Average usage rate) x Lead time.
Inventory Management
When both the lead time and usage rate vary, which is often the case and
the range of variation is wide, complete protection against stock out may require
an excessively large safety stock.
For example, if the lead time various between 60 days and 180 days with an
average of 90 days and the usage rate varies between 75 units and 125 units per
day with an average value of 100 units per day, a safety stock of 13500 units is
required for complete protection against stakeout. This has been worked out as
follows.
NOTES
Minimum Possible usage (-) Normal usage
(Maximum daily usage rate x maximum lead time - (Average daily usage rate x
Average lead time)
125 x 180 (-) 100 x 90 = 13,500.
Safety stock relieves the firm of the peril of production halts and minimizes
the possibility of losing of customers because of shock outs. But the firm has to
incur cost to carry safety stock.
It the firm does not carry safety stock, it is likely to incur the opportunity
costs of stock outs. The larger the size of safety stock, the larger the carrying
costs but the lower the opportunity costs of the stock out. But if a very low level
of safety is maintained the firm will experience frequent stakeout resulting in the
larger opportunity but the carrying costs will be lower.
Thus, for determining the optimum level of safety stock, a finance manager
must compute the costs of stock out and the inventory carrying costs. Since the
two costs are related inversely, the finance manager should strike trade of between
the two. The size of safety stock, which involves minimum total costs, will be the
optimum size.
12.4 Purchase Control
Purchase Control is an element of material control. Material procurement
is known as the purchase function. The functional responsibility of purchasing is
that of the Purchase Manager or the Purchaser. Purchasing is an important function
of materials management because in purchase of materials, a substantial portion
of the company’s finance is committed which affects cash flow position of the
company. Success of a business is a large extent influenced by the efficiency of
its purchase organisation. The advantages derived from a good and adequate
system of the purchase control areas follows:
1.
Continuous availability of materials : It ensures continuous flow of
materials. So production work may not be held up for want of materials. A
manufacturer can complete schedule of production in time.
2.
Purchasing of right quantity : Purchase of right quality of materials avoids
Check Your Progress
Illustrate the different
derived from a good and
adequate system of purchase
control.
Management Accounting - I
287
Inventory Management
locking up of working capital. It minimises risk of surplus and obsolete
stores. It means there should not be possibility of overstocking or
understocking.
3.
Purchasing of right quality : Purchase of materials of proper quality and
specification avoids waste of materials and loss in production. Effective
purchase control prevent wastages the losses of materials right from the
purchase till their consumptions. It enables the management to reduce cost
of production.
4.
Economy in purchasing : The purchasing of materials is a highly
specialised function. By purchasing materials at reasonable prices, the
efficient purchaser is able to make a valuable contribution to the success of
a business.
5.
Works as information centre : It serves as a function centre on the
materials knowledge relating to prices, sources of supply, specifications,
mode of delivery, etc. By providing continuous information to the
management it is possible to prepare planning for production.
6.
Development of business relationship : Purchasing of materials from
the best market and from reliable suppliers develops business relationships.
The result is that there may be smooth supply of materials in time and so it
avoid disputes and financial loss.
7.
Finding of alternative source of supply : If a particular supplier fails to
supply the materials in time, it is possible to develop alternate sources of
supply. The effect of this is that the production work is not disturbed.
8.
Fixing responsibilities : Effective purchase control fix the responsibilities
of operating units and individuals connected with the purchase, storage and
handling of materials.
NOTES
In short, the basic objective of the effective purchase control is to ensure
continuity of supply of requisite quality of material, to avoid held up of production
and loss in production and at the same time reduces the ultimate cost of the
finished products.
12.5 Stock Levels
288 Management Accounting - I
Materials are received and issued by the store-keeper to different production
departments. One important duty of a store-keeper is the re-stocking of stores in
order to ensure efficient functioning of the stores department and constant flow
of materials to the production departments. The inflow and outflow of materials
has to be regulated in such a way that neither production is adversely affected
due to want of materials nor there is unnecessary blocking of capital funds due to
overstocking of raw materials. This means that there is always a limit to the
minimum and maximum quality of materials of stock in the store. Hence, it is
necessary to decide when to requisition the purchase of various items of materials
Inventory Management
and what quantity of requisition.
In order to avoid over and under investment in materials the management
should decide the various levels of stock to be kept in the store. The limits set by
the management should be observed by the storekeeper. The various stock levels
commonly fixed are as follows :
NOTES
1. Re-order Level :
This is the level on reaching of which a fresh order is prepared and placed
with a supplier. This level is fixed in between maximum stock level and minimum
stock level. Re-order point is lower than the maximum level to avoid excess stock.
It is higher than minimum stock level so as to tackle emergencies like abnormal
delay in supply. The re-order level depends upon the lead time and the rate of
consumption during lead time. Re-order level is computed as follows:
Formula :
Re-order Level = Maximum Consumption x Maximum Delivery Time
OR
Re-order Level = Minimum Stock + ( Average Usage x Average Re-order Period)
Note : The choice of formula depends upon the information given in the problem.
Re-order level is computed after considering the following factors :
(i)
Average rate of consumption or usage.
(ii)
The normal delivery time i.e. maximum re-order period.
(iii)
Emergencies like delay in supply, abnormal wastages etc.
(iv)
Maximum consumption or usage.
(v)
Minimum level.
Re-order Level should be reviewed periodically and changed (if necessary)
so that changes in the pattern of production, supply position, lead time, inventory
policy etc. may be taken into account.
2. Maximum Stock Level :
The upper limit beyond which the quantity of any item is not normally allowed
to rise is known as the maximum stock level. The maximum stock level indicates
the maximum quality of stock which can be held in stock at any time. The main
purpose of this level is to avoid blocking up of capital unnecessarily on materials.
The maximum stock is fixed by taking into account the following factors :
(i)
Average rate of consumption.
(ii)
Lead time (i.e. the normal delivery time).
(iii)
Amount of capital required and available.
Management Accounting - I
289
Inventory Management
NOTES
(iv)
Nature and durability of materials.
(v)
Supply conditions e.g. seasonal or available throughout during the
year.
(vi)
Storage space and facilities and cost of carrying inventory.
(vii)
Economic Order Quantity (EOQ).
(viii)
Price fluctuations.
(ix)
Incidence of insurance costs which may be important for certain
inventory.
(x)
Government restrictions.
(xi)
Any restrictions imposed by local or national authority in regard to
stock of materials.
The maximum stock level can be calculated by applying the following formula :
Formula :
Maximum Stock Level = Re-order Level + Re-order Quantity Minimum Rate
Minimum
x
of Consumption
Delivery Time
3. Minimum Stock Level :
This is also known as Safety Stock or Buffer Stock. The minimum stock
level is that quantity below which the stock of any item should not be allowed to
fall. If the stock of an item falls below this level there is the danger of stoppage of
production. Hence, the minimum level is fixed to prevent the possibility of stoppage
of production due to non-availability of materials. Hence, the store-keeper and
purchase manager have to give topmost priority for the acquisition of new supplier.
The following factors are to be considered while fixing this level :
(i)
Average rate of consumption of materials
(ii)
Lead time i.e. normal delivery time.
(iii)
Re-ordering level
(iv)
The source of supply
(v)
Nature of the item
(vi)
Stock-out costs
Minimum Stock Level is computed by applying the following formula :
Formula :
Minimum Stock Level = Re-order Level - (Average rate of Consumption x
Average Delivery Time).
290 Management Accounting - I
Inventory Management
4. Average Stock Level :
This stock level indicates the average stock level by the concern. It is
calculated with the help of the following formula.
(i) Averaging Formula :
Average Stock Level =
Maximum Stock Level + Minimum Stock Level
NOTES
2
A more refined method of measuring average stock level is one involving
re-order quantity.
(ii) Reorder Quantity Formula :
Average Stock Level = Minimum Stock Level
5.
1
+ (Re-order Quantity)
2
Danger Level :
This is a level at which normal issues are stopped and materials are issued
to important jobs only. It is generally fixed below minimum stock level. This level
indicates emergency of stock position and urgency of obtaining fresh supply at
any costs. Purchasing of materials on an urgent basis results in increasing of cost
of purchases. It is calculated as follows :
Formula :
Danger Stock Level = Average rate of Consumption x Maximum Delivery
Time for Emergency Purchases.
This level is particularly fixed to control materials during the period of
emergency so that urgent and priority orders are not held up. The factors considered
are quickest possible means of transport or time required for obtaining supplies
from any available sources. The Figure 5.5 indicates the graph which is based on
the consumption of constant lead time and constant rate of consumption with no
interruption in production. However, in actual practice, both leads time and rate of
consumption may not remain constant.
Maximum level
X
1000
fc
700
su
on
600
n
tio
mp
Quantity (Units)
800
te o
Ra
900
500
Reorder level
400
300
Minimum level
200
Lead Time
100
0
1
2
3
4
5
6
7
8
9
10
11 Y
Time (Weeks)
Fig. 12.1 : Position of Stock Levels with Constant Lead Time and
Rate of Consumption
Management Accounting - I
291
Inventory Management
The position of Stock Levels with Changing Lead Time and Rate of
Consumption is indicated in the Figure 12.2
NOTES
1000
Maximum level
X
te o
Ra
900
700
fc
su
on
600
n
tio
mp
Quantity (Units)
800
500
400
Reorder level
300
Minimum level
200
100
0
1
2
3
4
5
6
Time (Weeks)
7
8
9
10
11 Y
Fig. 12.2 : Position of Stock Levels with Changing Lead Time and
Rate of Consumption
12.6 Economic Order Quantity (EOQ)
It is also termed as “Re-ordering Quantity” or “Economic Lot Size”. It is
the most economics quantity to be ordered under normal conditions. In every
concern one basic problem is always faced by the Purchase Manager and that is
much quantity of materials should be purchased at one time. The answer to this is
the quantity of materials to be ordered should be economic order quantity. This
quantity is decided by keeping in view the costs associated with holding inventories.
There are two types of ordering cost, ordering cost, ordering cost and inventory
carrying cost. Ordering costs are the costs of getting an item into the stores and
are incurred each time an order is placed for purchase of them. Such costs consists
of processing a purchase order, inspections cost and general administrative
overheads costs comprising salaries, stationery, rent etc. Inventory carry costs
are the costs which are incurred for the maintenance of material in the stores and
include interest on capital invested in materials. Obsolescence and storage costs
including, heating, refrigeration, lighting, salaries of storekeeping, depreciation costs
etc.
292 Management Accounting - I
Purchase of large quantities and the resultant overstocking increases the
cost of carrying the stores. On the other hand, if purchases are made in small
quantities and also frequently, the ordering cost will increase. It is therefore,
necessary to strike out a balance between the two extremes, and maintain the
optimum level of investment in inventory.
The exact quantity to be ordered at a time so as to achieve this objective is
known as the “Economic Order Quantity” (EOQ). EOQ is thus, the size of the
order which produces the lowest cost of the material ordered. In other words, it is
the order quantity which minimises the balance of the cost between carrying
costs and ordering costs.
Assumptions underlying EOQ (Limitations of EOQ) :
(i)
Ordering costs and carrying costs are known and they are fixed per unit.
(ii)
Anticipated usage is known.
(iii)
Cost per unit is known and it is constant.
(iv)
Quantity ordered is delivered immediately.
(v)
It assumes that demand is uniform.
(vi)
It is applied without considering the possibility of a falling demand and can
lead to a high value of inventory obsolescence.
Inventory Management
NOTES
Determination of EOQ :
(a)
Tabular Method
(b)
Graphic Method
(c)
Formula Method
(a)
Tabular Method
Check Your Progress
What are the assumptions
underlying EOQ Model ?
In this method, different values of quantity within the feasible range are
substituted in the total cost equation until the least total cost point corresponding to
selected values of quantity is located. Even this point may not be the mathematically
minimum, but the range is reduced to a close approximation to the minimum point.
One advantage is this method is that it is valid for both simple and complex function
in a situation of multivariability. Problems of graded quantity discount can also be
integrated into this method.
(b)
Graphic Method
The two cost components are plotted for the Carrying Cost and Ordering
Cost as well as the corresponding Total Cost, C for different vales of q, the ordering
quantity. The point on the quantity axis (X-axis), for which the combination of the
two costs gives the least value of C shows the EOQ point. It should be noted that
in a situation of certaining (Fixed Lead Time and Fixed Demand) the point of
intersection of the two curves for curves for Carrying Costs and Ordering Costs
determines the EOQ.
(c)
Formula Method
The Economic Order Quantity can be calculated by the simple mathematical
formula introduced by Simpson which is as follows :
Management Accounting - I
293
Inventory Management
NOTES

2AO
EOQ
=
EOQ
=
Economic Order Quantity
A
=
Annual Consumption or Usage in units or in Value
O
=
Ordering and Receiving Cost per order
C
=
Cost of Carrying one unit of inventory for one year
C
This formula is based on three assumptions.
(i)
Price will remain constant throughout the year and quantity discount is not
involved.
(ii)
Pattern of consumption, variable ordering costs per order and variable
inventory carrying charge per unit per annum will remain the same throughout
and
(iii)
EOQ will be delivered each time the stock balance, excluding safety stock
is just reduced to nil.
The Fig. 12.3 indicates EOQ Models under Different Situations.
0
A
A
N-Lead time - B
M (order
point)
C
P
T
X
0
M
(order point) N
Cycle time line
R
Cycle time line
A
M (order
point)
X
Y
Y
N-Lead time - B
R
P
X
(a) Under certainty conditions (b) Under certainly with
S
0
Cycle time line
Expended cycle time line
Y
Q-Lead time - B
(c) Under certainty with
QA = Economic order
demand fluctuation but
fluctuating demand and
M = Maximum inventory
fixed lead time
fluctuating lead time
AP = EOQ
AP = EOQ
OP = Safety stock
OP = Safety stock
M = Order point
M = Order point
reorder Point
NB = Lead time
= Safety Stock + OEQ
OA = Maximum inventory
= Safety Stock + EOQ
Fig. 12.3 EOQ Models under Different Situations
294 Management Accounting - I
V
FORMULAE TO REMEMBER
Inventory Management
Stock Levels :
(1) Reorder Level
= MX . C x MX . RP
= Maximum Rate of Consumption x Maximum
NOTES
Re-order Period
(2) Maximum Level = RL + RQ - (MN . C x MN . RP)
= Re-order Level + Re-order Quantity - (Minimum Rate
of Consumption x Minimum Re-order Period)
(3) Minimum Level
= RL - (A . C x A . RP)
= Re-order Level - (Average Rate of Consumption x
Average Re-order Period)
(4) Average Level
= MN . L + ½ RQ = Minimum Level + ½ of Re-order
Quantity
(a) Re-order Quantity Formula :
Or
(b) Average Level
= MN . L + MX . L / 2
= Minimum Level + Maximum Level
2
(5) Danger Level
= A . C x MX . RP for EP
= Average Rate of Consumption x Maximum Re-order
Period for Emergency Purchases
where,
C
= Rate of Consumption of material or Rate of Usage
which is ascertained by dividing quantity of materials
issued on a certain date by the number of days which
elapse between this date and the date of subsequent
issue.
RP
= Re-order Period or Delivery Period or Lead Time or
Time Lag for procurement of materials or Period for
Receiving the goods, which indicated time lapse
elapsing between the date of placing an purchase
order and the date of the receipt of corresponding
material.
RQ
= Re-order Quantity or Ordering Quantity or Economic
Order Quantity or Standard Ordering Quantity
A
= Average or Normal
MX
= Maximum
MN
= Minimum
L
EP
= Level
= Emergency Purchases
Management Accounting - I
295
Inventory Management
Economic Order Quantity :
1.
EOQ =
where,

2AO
C
EOQ
NOTES
2.
= Economic Order Quantity or Standard Ordering
Quantity or Optimum Ordering Quantity or Reorder
Quantity
A
= Annual or Monthly consumption or usage or needs or
demand or requirements or production rate in terms of
units
O
= Cost of placing one purchase order or placing and
receiving cost or procurement cost or buying cost.
C
= Cost of carrying one unit or inventory carrying cost.
Number of orders to be placed in a year or month or order schedule
=
A
EOQ
where,
A
EOQ
= Total consumption of material during the year or month
= Economic Order Quantity
12.7 Other Important Inventory Control Techniques
Material cost is significant portion of Total Cost. Therefore material or
inventory control is every important. Inventory control can be achieved by using
one or more of the following techniques :
Check Your Progress
List out the other important
control techniques used in
Inventory Control.
(I) FNSD Analysis (a) The Perpetual
Inventory System
(b) Output/
(h) Just in Time
Input Ratio
Inventory Control
Techniques of
(c) Material
Inventory Control
(g) VED Analysis
Wastage Report
(f) ABC Analysis (e) Standard (d) Budgetary
Control
Costing
Fig. 12.4
(a) Perpetual Inventory Control System : This is a full proof, bureaucratic
control system. Whenever the production department require material, it sends a
Material Requisition Note to the stores. The store-keeper send the same note
with his remarks to the purchase department. The Purchase Officer sends a
‘Purchase Order’ to the supplier. The supplier sends material along with an invoice.
296 Management Accounting - I
This material is received by the ‘Goods Receiving cum Inspection’ department
located at the entrance of the factory. Here the material is received & checked.
This department then prepares a ‘Goods Received Note’ Material is sent to this
stores, along with this note. Ultimately the Store-keeper issues material to the
productions department. Thus a complete cycle of material requisition takes place.
Purchase Order, Invoice and Material Requisition Note, are then sent to the Accounts
Department for proper accounting. The above system may be shown as follows :
Invoice (5)
Inventory Management
NOTES
Inspection Department
Supplier
Goods Received Note (6)
Purchase Order (4)
(7)
Purchase Order (3)
Store Keeper
M.R. Note with
comments
(2)
Production Department
(1)
M. R. Note
Fig. 12.5 : Cycle of Material Requisition Note
(b) Output / Input Ratio : This ratio explains final out put of finished product by
consuming raw material. It gives control on the consumption of raw material.
Higher the ratio, better is the output and efficiency of material consumption.
Indirectly, it explains the material wastage during productions process. This ratio
may be defined for each individual, process of production.
(c) Material Wastage Report : Periodic report on material wastage is normally
sent by production supervisor, to his superior. Wastage may be normal or abnormal.
Normal wastage is due to normal reasons like intrinsic features of the process,
plant or material itself. Normal wastage can not be minimised. Abnormal wastage
is on account of accidents, plant failure, poor quality of material handling etc.
Abnormal wastage can be avoided with due care and control.
(d) Budgetary Control : Budget for each item of inventory is prepared. Actual
usage of inventory can be compared with budget figure and control can be achieved.
(e) Standard Costing : Standard material Consumption per Unit is fixed along
standard price. Periodically these standard figures are compared with actual figures
and difference (Which is called “variance”) is found out Reasons for such variances
are also found out for better future control.
(f) ABC Analysis : Item of inventory are classified into three classes i.e. A, B
and C. Most costly item are grouped under ‘A’ Cheapest item are grouped under
‘C’ and moderate item are called ‘B’ item. Following table explains this better.
Class
% of Total Quality
% of Total Cost
A
5
75
B
20
20
C
75
05
Total
100%
100%
Check Your Progress
Explain the ABC analysis
table.
List out other important
inventory
control
techniques.
Management Accounting - I
297
Inventory Management
NOTES
EOQ is 600 units which given the total least cost, this point carrying cost
and ordering cost are equal.
ABC approach is a managerial technique of determining the degree of
control to be exercised over various item of inventories. This is done by analysing
the stock - usage patterns by money value of importance. ABC analysis is based
on “Parento’s Law Cause and Effect” which states that only 20% of the activity
causes 80% of effect. This 20/80 rule is very useful in business. It suggests keep
an eye on this 20% and you will cover 80% of the effect. When this rule is applied
to inventory items, it is known as ABC analysis.
ABC analysis seeks to segregate all inventory items into three categories
A, B and C on the basis of their annual usage. Thus, under category A those few
item are included which occur for bulk of the annual expenditure on materials and
hold the key to business. The ‘C’ items represent least expensive item though
numerous in number. Category ‘B’ items constitute a moderate class which are
neither substantial nor Insignificant in relation to the product value. ABC approach
is a very useful tool in the hands of management with which desired control over
inventory items can be exercised. Any sound inventory control system should
ensure that every item gets right amount of attention at the right time. ABC analysis
makes it possible with considerably effort by its selective approach. It concentrates
on important items. It recommends very strict control for ‘A’ items which are of
high usage value, moderate control for ‘B’ item which are of moderate value and
low control for low values ‘C’ items. This enables the management to secure
maximum benefits.
(g) VED Analysis : Under this control technique, inventory items are divided
into three categories in the descending order of their criticality. Thus ‘V’ item
includes vital items which need more attention because stock out of such items
will result in haltage of production. These items must be stored adequately so as
to ensure uninterrupted functioning of the plant. In ‘E’ items are included those
which are essential for efficient functioning of the operating system. Care has to
be taken to ensure that they are always in stock. ‘D’ stands for desirable items
which do not have bearing on the production immediately but availability of such
item will lead to more efficiency and less fatigue.
VED analysis can be very useful to capital intensive process industries. As it
analyses items based on their critically, it can be used for those special raw materials
which are difficult to procure.
(h) Just-in-Time Inventory Control : This system of inventory control was
developed by Taichi Okno of Japan. According to this system, the firm should
maintain a minimum level of inventory and rely on suppliers to provide parts and
components just-in-time to meet its assembly requirements. Thus, this system is
different from the traditional inventory management system which calls for
maintaining a reasonable amount of safety stock to provide a reasonable protection
against uncertainties of consumption and supply.
298 Management Accounting - I
The just-in-time inventory system appears to be quite useful in as much as
it reduces the level of investment in inventory holding through reduction in safety
stock as also cost of ordering. However, it is difficult to implement this system
because it demands significant change in the entire production and management
system. Further the system is based on the premise that there exists, strong and
dependable relationship with suppliers who are geographically nearer to the firm.
There is a reliable transportation system and a convenient physical access in the
form of enough doors and conveniently located docks and storage areas to adjust
incoming suppliers to the needs of assembly line.
Inventory Management
NOTES
(i) NSD Analysis : FNSD analysis seeks to categories the inventories into four
groups in descending order of their usage. A portion of the inventory items is fast
moving ‘F’ which are consumed in a short span of time. Some part of the inventory
items move normally (N) and are used for over a period of a year or so. Some
items are slow moving (S), stock of which would last for more that one year.
Some materials may be dead stock (D) in the sense that no further demand of
such materials are foreseen.
According to the technique, fast moving items of stock needs to be constantly
monitored and replenishment orders to be placed in time to avoid stock out situations.
In case of slow moving items, careful review is required before any order is
placed for their replenishment. The reorder level and quantities for such item
should be on the basis of a new estimate of future demand, to minimise the risks
of a surplus stock being left when a slow moving items become obsolescent or
minimise the risks of a surplus stock being left when a slow moving items become
obsolescent of dead. Dead stock represents that portion of inventory which is of
no value to the enterprise but occupies useful space. Hence, once such items are
identified, efforts should be made to find all alternative uses for it. Otherwise, it
must be disposed off.
The computation of stock levels and Economic Order Quantity (EOQ) can
be understood with the help of following illustrations.
12.8 Illustrations
ILLUSTRATION 1
From the following information calculate (a) Re-ordering Level, (b) Maximum
Level, (c) Minimum Level, (d) Average Stock Level, (e) Danger Level.
Lead Time : (i) Average 10 days
(ii) Maximum 15 days
(iii) Minimum 6 days
(iv) Maximum for emergency purchases 4 days
Rate of Consumption : (i) Average 15 units per day
(ii) Maximum 20 units per day
(iii) Minimum 10 units per day
Management Accounting - I
299
Inventory Management
Ordering Quantity : 200 units
SOLUTION
(a) Re-ordering Quantity
= MX . C x MX . RP
= Maximum Rate of Consumption per day x
NOTES
Maximum Lead times in days
= 20 units x 15 days
=
(b) Maximum Level
300 units
= RL + RQ - (MN . C x MN . RP)
= Re-ordering Level + Ordering Quantity (Minimum Rate of Consumption per day x
Minimum Lead Times in days)
= 300 units + 200 units - (10 units x 6 days)
= 500 units - 60 units
=
(c) Minimum Level
440 units
= RL - (A . C x A . RP)
= Re-ordering Level - (Average Rate of
Consumption per day x Average Lead Times
in days)
= 300 units - (15 units x 10 days)
= 300 units - 150 units
=
(d) Average Stock Level
150 units
= MN . L + ½ RQ
= Minimum Level + ½ of Ordering Quantity
= 150 units + ½ x 200 units
= 150 units + 100 units
=
(e) Danger Level
250 units
= A . C x MX . RP for EP
= Average Rate of Consumption per day x
Maximum Lead Times for Emergency
purchases in days
300 Management Accounting - I
= 15 units x 4 days
=
Inventory Management
60 units
ILLUSTRATION 2
Two Components ‘A’ and ‘B’ are used in Swastic Industries, Pune as follows :
NOTES
Normal Usage : 150 units per week each
Minimum Usage : 75 units per week each
Maximum Usage : 225 units per week each
Re-order Quantity : A - 900 units
B - 1,500 units
Re-order Quantity : A - 4 to 6 weeks
B - 2 to 4 weeks
Calculate for each component.
(a) Re-order Level, (b) Maximum Level, (c) Minimum Level, (d) Average Stock
Level.
SOLUTION
(a) Re-order Level
= MX . C x MX . RP
= Maximum Usage per week x Maximum
Re-order period in weeks
Component A’
= 225 units x 6 weeks
= 1350 units
Component B’
= 225 units x 4 weeks
=
(b) Maximum Level
900 units
= RL + RQ - (MN . C x MN . RP)
= Reorder Level + Re-order Quantity (Minimum Rate of Consumption per day x
Minimum Re-order period in weeks)
Component A’
= 1,350 units + 900 units - (75 units x 4 weeks)
= 2,250 units - 300 units
=
Component B’
1,950 units
= 900 units + 1,500 units - (75 units x 2 weeks)
Management Accounting - I
301
Inventory Management
= 2,400 units - 150 units
=
(c) Minimum Level
2,250 units
= RL - (A . C x A . RP)
= Re-order Level - (Normal Usage per week x
Normal Re-order period in weeks)
NOTES
Component A’
= 1,350 units - (150 units x 5 weeks)
= 1,350 units - 750 units
=
Component B’
600 units
= 900 units - (150 units x 3 weeks)
= 900 units - 450 units
=
(d) Average Stock Level
450 units
= MN . L + ½ RQ
= Minimum Level + ½ of Re-order Quantity
Component A’
= 600 units + ½ x 900 units
= 600 units + 450 units
=
Component B’
1,050 units
= 450 units + ½ x 1,500 units
= 450 units + 750 units
=
1,200 units
ILLUSTRATION 3
The following particulars are furnished by Casio Ltd., Ahmednagar for 12
months ended 31st March, 2014
Month in 2013-14
302 Management Accounting - I
Budget Consumption in units
April
300
May
400
June
500
July
600
August
800
September
1,000
October
1,000
November
900
December
800
January
700
February
600
March
800
Total Yearly Consumption
Delivery Period
8,400
Inventory Management
NOTES
: 2 to 4 months
Re-order Quantity : 1,000 units
Calculate : (1) Re-order Level, (2) Maximum Level, (3) Minimum Level, (4)
Average Level using Re-order Quantity.
SOLUTION
(1) Re-order Level
= MX . C x MX . RP
= Maximum Rate of Consumption per month x
Maximum Delivery Period in months
= 1,000 units x 4 months
=
(2) Maximum Level
4,000 units
= RL + RQ - (MN . C x MN . RP)
= Reorder Level + Re-order Quantity (Minimum Rate of Consumption per month x
Minimum Delivery Period in months)
= 4,000 units + 100 units - (300 units x 2 months)
= 5,000 units - 600 units
=
(3) Minimum Level
4,400 units
= RL - (A . C x A . RP)
= Re-order Level - (Average Rate of
Consumption per month x Average Delivery
Period in months)
= 4,000 units - (700 units x 3 months)
= 4,000 units - 2,100 units
=
(4) Average Stock Level
1,900 units
= MN . L + ½ RQ
= Minimum Level + ½ of Re-order Quantity
Management Accounting - I
303
Inventory Management
= 1,900 units + ½ x 1,000 units
= 1,900 units + 500 units
=
NOTES
2,400 units
Calculation and Notes :
1. Calculation of Rate of Consumption per month
(a)
Maximum
=
1,000 units (i.e. September and October)
(b)
Minimum
=
300 units (i.e. April)
(c)
Average
=
700 units (i.e. 8,400 units / 12 months)
ILLUSTRATION 4
The following information is available in respect of a material
Economic Ordering Quantity :
Rate of Consumption per week :
900 units
25 units
(1) Normal
25 units
(2) Maximum
35 units
(3) Minimum
15 units
Delivery Period
(1) Minimum
20 weeks
(2) Normal
25 weeks
(3) Maximum
30 weeks
Calculate : (1) Re-order Level, (2) Maximum Level, (3) Minimum Level, (4)
Average Stock Level.
SOLUTION
(1) Re-order Level
= MX . C x MX . RP
= Maximum Rate of Consumption per week x
Maximum Delivery Period in weeks
= 35 units x 30 weeks
=
(2) Maximum Level
1,050 units
= RL + RQ - (MN . C x MN . RP)
= Reorder Level + Economic Order Quantity (Minimum Rate of Consumption per week x
304 Management Accounting - I
Minimum Delivery Period in weeks)
= 1,050 units + 900 units - (15 units x 20 weeks)
Inventory Management
= 1,950 units - 300 units
=
(3) Minimum Level
1,650 units
= RL - (A . C x A . RP)
= Re-order Level - (Normal Rate of
NOTES
Consumption per week x Normal Delivery
Period in weeks)
= 1,050 units - (25 units x 25 weeks)
= 1,050 units - 625 units
=
(4) Average Stock Level
425 units
= MN . L + ½ RQ
= Minimum Level + ½ of Economic Order
Quantity
= 425 units + ½ x 900 units
= 425 units + 450 units
=
875 units
ILLUSTRATION 5
Find out Re-order Level, Maximum Level, Minimum Level and Average
Stock Level from the following particulars :
Normal Consumption
:
300 units per day
Maximum Consumption
:
420 units per day
Minimum Consumption
:
240 units per day
Re-order Quantity
:
3,600 units
Minimum Period for receiving the goods - 10 days
Maximum Period for receiving the goods - 15 days
Normal Period for receiving the goods - 12 days
SOLUTION
(a) Re-order Level
= MX . C x MX . RP
= Maximum Rate of Consumption per day x
Maximum Period for receiving the goods in days
= 420 units x 15 days
Management Accounting - I
305
Inventory Management
=
(b) Maximum Level
6,300 units
= RL + RQ - (MN . C x MN . RP)
= Re-order Level + Re-order Quantity (Minimum Consumption per day x
NOTES
Minimum Period for receiving the goods in days)
= 6,300 units + 3,600 units - (240 units x 10 days)
= 9,900 units - 2,400 units
=
(c) Minimum Level
7,500 units
= RL - (A . C x A . RP)
= Re-order Level - (Normal Consumption per
day x Normal Period for receiving the goods
in days)
= 6,300 units - (300 units x 12 days)
= 6,300 units - 3,600 units
=
(d) Average Stock Level
2,700 units
= MN . L + ½ RQ
= Minimum Level + ½ of Re-order Quantity
= 2,700 units + ½ x 3,600 units
= 2,700 units + 1,800 units
=
4,500 units
ILLUSTRATION 6
Amit Enterprises Ahmedpur manufacturers a special product ‘Sumit’. The
following are the particulars collected for the year 2013-14.
(1)
Monthly Demand of Sumit
(2)
Cost of Placing an order
(3)
Annual Carrying Cost per unit
(4)
Rate of Usage per week
1000 units
` 100
` 15
Normal - 50 units, Maximum - 75 units, Minimum - 25 units
(5)
Re-order Period
4 to 6 weeks
From the above information compute Average Stock Level.
306 Management Accounting - I
Inventory Management
SOLUTION
Average Stock Level can be computed only after calculating Re-order
Quantity, Re-order Level, Maximum Level and Minimum Level.
(1) Re-order Quantity i.e. Economic Order Quantity
 2 AC O
EOQ
=
EOQ
= Economic Order Quantity
where,
A
NOTES
= Annual Demand in units i.e. 1,000 units x
12 months
= 12,000 units
O
= Ordering of Placing an order i.e. ` 100
C
= Annual Carrying Cost per unit i.e. ` 15


= 1,60,000 units

= 2 x 12,000 units x ` 100
` 15
=
24,00,000 units
` 15
=
(2) Re-order Level
400 units
= MX . C x MX . RP
= Maximum Rate of Usage per week x
Maximum Re-order Period in weeks
= 75 units x 6 weeks
=
(3) Maximum Level
450 units
= RL + RQ - (MN . C x MN . RP)
= Re-order Level + Re-order Quantity (Minimum Rate of Rate of Usage per week x
Minimum Re-order Periods in weeks)
= 450 units + 400 units - (25 units x 4 weeks)
= 850 units - 100 units
=
(4) Minimum Level
750 units
= RL - (A . C x A . RP)
= Re-order Level - (Normal Rate of Usage per
week x Normal Re-order Period in weeks)
Management Accounting - I
307
Inventory Management
= 450 units - (50 units x 5 weeks)
= 450 units - 250 units
=
NOTES
(5) Average Stock Level
200 units
= MN . L + ½ RQ
= Minimum Level + ½ of Re-order Quantity
= 200 units + ½ x 400 units
= 200 units + 200 units
=
Average Stock Level
=
(Average Formula
=
400 units
MN . L + MX . L
2
Minimum Level + Maximum Level
2
Method)
=
=
=
200 units + 750 units
2
950 units
2
475 units
ILLUSTRATION 7
From the following relevant details calculate (1) Re-order Quantity, (2)
Re-order level, (3) Maximum Level, (4) Minimum Level, (5) Average Stock Level
by Re-order Quantity Method, (6) Danger Level.
Total Cost of Purchasing relating to the order
:
`2
Number of units to; be Produced during the year
:
` 5,000
Purchase Price including Transport Cost
:
` 50 per unit
Annual Carrying Cost per unit
:
`5
Maximum Lead Time for Emergency Purchases
:
4 days
Lead Times :
(a) Average - 10 days, (b) Maximum - 15 days, (c) Minimum - 5 days,
Rate of Consumption per day :
(a) Average - 15 units, (b) Maximum - 20 units, (c) Minimum - 10 units
308 Management Accounting - I
Inventory Management
SOLUTION
(1) Re-order Quantity i.e Economic Order Quantity
 2CA O
EOQ
=
EOQ
= Economic Order Quantity
where,
A
= Number of units to be Purchased during the
year i.e. 5,000 units
O
= Total Cost of Purchasing i.e. `20
C
= Annual Carrying Cost i.e.` 5
=
NOTES
 2 x 5,000 units x ` 20
`5
=
 2,00,000 units
`5
(2) Re-order Level
=
 40,000 units
=
200 units
= MX . C x MX . RP
= Maximum Rate of Consumption per day x
Maximum Lead Times in days
= 20 units x 15 weeks
=
(3) Maximum Level
300 units
= RL + RQ - (MN . C x MN . RP)
= Re-order Level + Re-order Quantity (Minimum Rate of Rate of Consumption per
day x Minimum Lead Times in days)
= 300 units + 200 units - (10 units x 5 days)
= 500 units - 50 units
=
(4) Minimum Level
450 units
= RL - (A . C x A . RP)
= Re-order Level - (Average Rate of
Consumption per day x Average Lead Times in
days)
= 300 units - (15 units x 10 days)
Management Accounting - I
309
Inventory Management
= 300 units -150 units
=
(5) Average Stock Level
150 units
= MN . L + ½ RQ
= Minimum Level + ½ of Re-order Quantity
NOTES
= 150 units + ½ x 200 units
= 150 units + 100 units
=
250 units
= A . C x MX . RP for EP
(6) Danger Level
= Average Rate of Consumption per day x
Maximum Lead Times for Emergency
Purchases
= 15 units x 4 days
=
60 units.
ILLUSTRATION 8
Calculate the Economic Order Quantity from the following particulars :
Annual Consumption
:
675 units
Cost of Material
Cost of Placing an Order
:
:
` 30 per unit
`18
Annual Carrying Cost of one unit
:
10% of Inventory Value
SOLUTION
 2 AC O
EOQ
=
EOQ
= Economic Order Quantity
where,
A
= Annual Consumption in units i.e. 675 units
O
= Cost of Placing an order i.e. ` 18
C
= Inventory Carrying Cost i.e. 10% of
` 30 = ` 3
=
x ` 18
 2 x 675 units
`3
=
units
 24,300
`3
 8,100 units
=
=
310 Management Accounting - I
90 units
Inventory Management
ILLUSTRATION 9
A manufacturer buys certain equipments from outside suppliers at ` 30 per
unit. Total Annual Needs are 1,600 units. The following further data are available Annual Return on Investment
:
10%
Rent, Insurance, Tax per unit per year
:
`1
Cost of Placing an Order
:
` 50
NOTES
Calculate the Economic Order Quantity
SOLUTION
 2 AC O
EOQ
=
EOQ
= Economic Order Quantity
where,
A
= Annual Needs in units i.e. 1,600 units
O
= Cost of Placing an order i.e. ` 50
C
= Inventory Carrying Cost including Rent,
Insurance, Tax per unit per year i.e. 10% of
` 30 = ` 3 + ` 1 = ` 4
=
=
x ` 50
 2 x 1,600`units
4
units
 1,60,000
`4
=
40,000 units
=
200 units
ILLUSTRATION 10
A Company uses 10,000 units per year of an item costing ` 25 each. The
cost of processing a purchase order is ` 10 and the stock holding cost amounts to
20% per year of the money value of inventory. How much should the company
buy at a time in a single order, in order to minimise the inventory cost ?
SOLUTION
 2CA O
EOQ
=
EOQ
= Economic Order Quantity
where,
A
= Annual Usage in terms of units i.e. 10,000 units
O
= Cost of Processing a purchase order i.e. ` 10
C
= Stock Holding Cost i.e. 20% of ` 25 = ` 5
Management Accounting - I
311
Responsibility
Accounting
=
x ` 10
 2 x 10,000 `units
5
units
 2,00,000
`5
=
40,000 units
=
NOTES
=
200 units
Conclusion : The Company should buy 200 units in a single order at a time, to
minimise the inventory cost.
12.9 Summary
•
Inventories generally represent a very significant proportion to total assets.
The finance manager has to play significant role in all the spheres of inventory
management because financial needs and investment of the firm are
influences directly in inventory policies.
•
EOQ : (Economic Order Quantity) - One of the most widely uses
techniques hich provides a full proof solution to ; the problem of determining
optimal size of inventory in a firm is Economic Order Quantity (EOQ).
•
Purchase Control : Purchase Control is an element of material control.
Purchasing is an important function of materials management because in
purchase of materials. A substantial portion of the company’s finance is
committed which affects cash flow position of the company
•
Stock Level : In order to avoid over and order investment in materials the
management should decide the various levels of stock to be kept in the
store. The various stock levels commonly fixed are - (i) Re-order level (ii)
Maximumstock level (iii) Minimum stock level (iv) Average stock level (v)
Danger level.
•
Determination of EOQ : (a) Tabular method (b) Graphic method (c)
Formula method
•
Other Important Inventory Control Techniques : (a) The perpetual
Inventory system (b) Output-Input Ratio (c) Material wastage Reports (d)
Budgetary control (e) Standard Costing (f) ABC Analysis (g) VED Analysis
(h) Just in time inventory control (i) FNSD Analysis.
12.10 Key Terms
(1) Reorder level : This is the level on reaching of which a fresh order is prepares
and place with a supplier.
(2) Maximum Level : The upper limit beyond which the quantity of any item is
not normally allowed to rise is known as the maximum stock level.
312 Management Accounting - I
(3) Maximum Stock Level : The minimum stock level is that quantity below
which the stock of any item should not be allowed to full.
Inventory Management
(4) Average Stock Level : This stock level indicates the average stock level by
the concern. It is calculated with the help of the following formula.
Average Stock Level = Maximum Stock level + Minimum Stock Level
2
NOTES
(5) Danger Level : This is a level at which normally issues are stopped and
materials are issues to important jobs only. It is generally fixed below minimum
stock level.
(6)
2 ACO
EOQ
=
EOQ
= Economic Order Quantity
A
= Annual Consumption or Usage in units or in
value
O
= Ordering and Receiving cost per order
C
= Cost of Carrying one unit of Inventory for one
year.
12.11 Questions and Exercises
I. Objective Questions
(A)
Multiple choice Questions
(1)
The inventories which are either being purchases by the firm or are being
produced in the firm are termed as-----
(2)
(a) Finished goods,
(b) Raw materials,
(c) Work-in-progress,
(d) Stock-in-trade.
The specific motive for holding inventory may be to capitalise an opportunity
to make profit are----motive.
(a) Transactionary, (b) Speculative, (c) Precautionary, (d) Opportunity
(3)
The cost of funds invested in the inventories are cost of ----(a) Financing (b) Storage, (c) Selling, (d) Production
(4)
Under -----level of stock materials are issued to important jobs only.
(a) Maximum, (b) Average, (c) Minimum, (d) Danger.
Ans : (1 - a), (2 - b), (3 - a), (4 - a)
Management Accounting - I
313
Responsibility
Accounting
NOTES
II. Long Answer Questions
(1)
What is ‘Inventory Management’? Explain the role of financial manager in
inventory management.
(2)
What is ‘Optimum Level of Inventory’? Explain in brief the steps involved
in the determination of
i) order point and ii) Optimum size of safety stock.
(3)
What is ‘Purchase Control’ Explain the advantages derived from a good
and adequate system of purchase control.
(4)
Explain the brief the different stock levels for the standard items of stores
used in a manufacturing concern.
(5)
What is Reorder Level’ of stock ? Explain the important factors to be
considered while computing Re-order Level.
(6)
What is ‘Maximum stock level’? State the factors to be taken into account
while fixing the maximum stock level.
(7)
Define ‘Minimum Stock level’. Which are the factors to be considered
while fixing ‘Minimum Stock Level’.
(8)
What is ‘Average Stock Level’? Explain the methods to calculate Average
Stock Level.
(9)
What is Danger level of Stock’? How it is more useful to control materials
in large scale manufacturing firms ?
(10) What is ‘Economic Order Quantity’ (EOQ) ? State the limitations of
Economic Order Quantity.
(11)
Explain in brief the important techniques to control inventory.
III - Practical Problems
(1) Two Components A and B are used as follows :
Normal Usage
50 per week each
Minimum Usage
25 per week each
Maximum Usage
75 per week each
Re-order Quantity
A : 300 ; B : 500
Re-order Period
A : 4 to 6 weeks ; B : 2 to 4 weeks
Calculate for each component
(a) Re-order Level
(b) Minimum Level
314 Management Accounting - I
Inventory Management
(c) Maximum Level and
(d) Average Stock Level
(2) From the following data, Calculate,
(a) Re-order Level,
NOTES
(b) Minimum Stock Level
(c) Maximum Stock Level
Re-order Quality
1,500 units
Re-order Period
4 to 6 week
Maximum Consumption
400 units per week
Normal Consumption
30 units per week
Minimum Consumption
250 units per week
(3) From the following particulars, Calculate,
(a) Re-order Level
(b) Minimum Level
(c) Maximum Level and
(d) Average Level
Normal Usage
100 units per day
Minimum Usage
60 units per day
Maximum Usage
130 units per day
E.O.Q.
5,000 units
Re-order Period
25 to 30 days
(4) You have been asked to calculate the following levels for Part No. ‘T’
from the following information.
(a) Re-ordering Level, (b) Maximum Level, (c) Minimum Level, (d) Danger stock
Level, (e) Average Stock Level,
The Re-ordering Quantity is to be calculated from the following data :
Total Costs of Purchasing relating to the order are ` 20
No. of Units to be purchased during the year is 5000.
Purchase price per unit including transportation costs is ` 50.
Annual Cost of Storage of one unit is ` 5.
Management Accounting - I
315
Responsibility
Accounting
Lead Times :
NOTES
Rate of Consumption :
Average
10 days
Average
15 units per day
Maximum
15 days
Maximum
20 units per day
Minimum
6 days
Minimum
10 units per day
Maximum for emergency
4 days
Purchases
(5)
(6)
Calculate the stock Levels for an item of material from the following
information :
Normal Usage
200 units per day
Maximum Usage
250 units per day
Minimum Usage
120 units per day
Re-order Period
5 to 15 days
Economic Order Quantity
4,000 units
From the following particulars, calculate the Economic Order
Quantity.
Annual Requirement
:
1,600 units
Cost of Materials per units
:
` 40
Cost of Placing and Receiving one order :
` 50
Annual Carrying Cost of Inventory
10% of Inventory Value.
:
(7)
A unit of article A costs ` 50 and the Annual Consumption is 2,000
units. The Cost of Placing an Order is ` 40 and the Interest is 10%
per annum. Find the Economic Order Quantity.
(8)
From the following figures, you are required to calculate Economic
Order Quantity and number of orders to be placed per year.
(9)
Total Consumption of Materials per year :
1,000 kgs.
Procurement Cost per Order
:
`5
Unit price of Materials
:
`2
Storage and Carrying Cost
:
8%
If the Annual Usage of a component is 4,000 pieces, set Up and
Order Processing Cost ` 50, Annual Rate is 10% and Cost of
Manufacturing a unit is ` 100. Calculate the Economic Order
Quantity.
(10) Find out the Economic Order Quantity from the following particulars :
316 Management Accounting - I
Annual Usage
:
6,000 units
Cost of Materials per units
:
` 20
Cost of Placing and Receiving one Order :
` 60
Annual Carrying Cost of one unit
10% of Inventory Value
:
(11) From the following information determine E.O.Q.
Annual Usage
:
90,000 units
Cost per units
:
` 50
Buying Cost per Order
:
` 10
Cost of Carrying Inventory
:
10% of Cost
Inventory Management
NOTES
(12) Given Annual Usage of material 600 units, Ordering Costs are ` 12
per one order, price of material is ` 20 per unit, and Cost of Storage
is 20% of Inventory Value, find out EOQ.
(13) Suppose the Annual Consumption is 675 units, 10% is the interest
and cost of storing an article costing ` 30 per unit, Cost of Placing
an order is ` 18. Calculate the Economic Order Quantity.
(14) A factory requires 15,000 units of certain for the year. Cost of carrying
one unit of material of calculated to be ` 20 per annum, and it is
estimated that the expenses of placing an order and receiving would
amounts to ` 375. Calculate Economic Order Quantity.
(15) From the following particulars determine the E.O.Q.
Cost of Materials per unit
:`5
Demand per month
: 500 units
Cost of Placing each Order
: ` 15
Inventory Carrying Cost
: 20%
12.12 Further Reading
• Rustaji R.P. - Fundamentals of Financial Management - New Delhi - Golgotia
Publishing Company -2010
• Sharan Uyuptakesh - Fundamentals of Financial Management - New Delhi Pearson Education Pvt. Ltd. - 2010.
Management Accounting - I
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