UNIT 1 ACCOUNTING AND ITS FUNCTIONS

Objectives After studying this unit, you should be able to appreciate the: nature and role of accounting; activities of an accountant; and roles of accounting personnel and the accounting function in an organization.

Accounting and its Functions

Structure 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 1.10 1.11 1.12 Introduction Scope of Accounting Emerging Role of Accounting Accounting as an Information System Role and Activities of an Accountant Accounting Personnel Nature of Accounting Function Organisation for Accounting and Finance Summary Key Words Self-assessment Questions/Exercises Further Readings

1.1

INTRODUCTION

Accounting is often called the language of business. The basic function of any language is to serve as a means of communication. In this context, the purpose of accounting is to communicate or report the results of business operations and its various aspects. Though accounting has been defined in various ways. According to one commonly accepted definition. "Accounting is 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 financial character and interpreting the results thereof'. Another definition which is less restrictive interprets accounting as "The process of identifying, measuring and communicating economic information to permit informed judgements and decisions by the users of information"

1.2

SCOPE OF ACCOUNTING

The scope of accounting can be presented in a diagrammatic form as shown in Figure 1.1. Data creationr and collection is the area which provides raw material for accounting. The data collected is `historic' in the sense that it refers to events which have already taken place. Earlier, accounting was largely concerned with what had happened, rather than making any attempt to predict and prepare for future. After the historic data has been collected, it is recorded in accordance with generally accepted accounting theory. A large number of transactions or events have to be entered in the books of original entry (journals) and ledgers in accordance with the classification scheme already decided upon. The recording and processing of information usually accounts for a substantial part of total accounting work. This type of

Accounting Framework

Source: Adapted from R.J. Bull, Accounting in Business, Butterworths, London, 1969,p.2.

activity of accounting may be called recordative. The processing method employed for recording may be manual, mechanical or electronic. Computers are also used widely in modern business for doing this job. Data evaluation is regarded as the most important activity in accounting these days. Evaluation of data includes controlling the activities of business with the help of budgets and standard costs (budgetary control), evaluating the performance of business, analysing the flow of funds, and analysing the accounting information for decision-making purposes by choosing among alternative courses of action. The analytical and interpretative work of counting may be for internal or external uses and may range from snap answers to elaborate reports produced by extensive research. Capital project analysis, financial forecasts, budgetary projections and analysis for reorganisation, takeover or merger often lead to research-based reports. Data evaluation has another dimension and this can be known as the auditive work which focuses on verification of transactions as entered in the books of account and authentication of financial statements. This work is done by public professional accountants. However, it has become common these days for even medium-sized organisations to engage internal auditors to keep a continuous watch over financial flows and review the operation of the financial system. Data reporting consists of two parts-external and internal. External reporting refers to the communication of financial information (viz., earnings, financial and funds position) about the business to outside parties, e.g., shareholders, government agencies and regulatory bodies of the government. Internal reporting is concerned with the communication of results of financial analysis and evaluation to management for decision-making purposes. You will note that accounting theory has been shown in the centre of the diagram. We will turn to the role of accounting theory in the next unit. The central purpose of accounting is to make possible the periodic matching of costs (efforts) and revenues (accomplishments). This concept is the nucleus of accounting theory. However, accounting is moving away from its traditional procedure-based record-keeping function to the adoption of a role which emphasises its social importance.

Activity 1.1
List the various accounting activities that your organisation is undertaking. Can you ascribe any particular reason as to why your organisation is undertaking these accounting activities?

Accounting Activity 1 2 3 4 5 6 7 8

Reason 1 2 3 4 5 6 7 8

Accounting and its Functions

1.3

EMERGING ROLE OF ACCOUNTING

The history of accounting indicates the evolutionary pattern which reflects changing socio-ecoiom conditions and the enlarged purposes to which accounting is applied. In the present context four phases in the evolution of accounting can be distinguished.

Stewardship Accounting
In earlier times in history, wealthy people employed `stewards' to manage their property. These stewards rendered an account of their stewardship to their owners periodically. This notion lies at the root of financial reporting even today which essentially involves the orderly recording of business transactions, commonly known as 'book-keeping'. Indeed the accounting concepts and procedures, in use today for systematic recording of business transactions have their origin in the practices employed by merchants in Italy during the 15th century. The Italian method which specifically began to be known as `double entry book-keeping' was adopted by other European countries during the 19th century. Stewardship accounting, in a sense, is associated with the need of business owners to keep records of their transactions, the property and tools they owned, debts they owed, and the debts others owed them.

Financial Accounting
Financial accounting dates from the development of large-scale business and the advent of Joint Stock Company (a form of business which enables the public to participate in providing capital in return for `shares' in the assets and the profits of the company). This form of business organisation permits a limit to the liability of their members to the nominal value of their shares. This means that the liability of a shareholder for the financial debts of the company is limited to the amount he had agreed to pay on the shares he bought. He is into liable to make any further contribution in the event of the company's failure or liquidation. As a matter of fact, the law governing the operations (or functioning) of a company in any country (for instance the Companies Act in India) gives a legal form to the doctrine of stewardship which requires that information be disclosed to the shareholders in the form of annual income statement and balance sheet. Briefly speaking, the income statement is a statement of profit and loss made during the year of the report; and the balance sheet indicates the assets held by the firm and the monetary claims against the firm. The general unwillingness of the company directors to disclose more than the minimum information required by law and the growing public awareness have forced the governments in various countries of the world to extend the disclosure (of information) requirements.

Accounting Framework

The importance attached to financial accounting statements can be traced to the need of the society to mobilise the savings and channel them into profitable investments. Investors, whether they are large or small, must be provided with reliable and sufficient information in order to be able to make efficient investment decisions. This is the most significant social purpose of financial accounting.

Cost Accounting
The industrial revolution in England presented a challenge to the development of accounting as a tool of industrial management. Costing techniques were developed as guides to management actions. The increasing awareness on the part of entrepreneurs and industrial managers for using scientific principles of management in the wake of scientific management movement led to the development of cost accounting. Cost accounting is concerned with the application of costing principles, methods and techniques for ascertaining the costs with a view to controlling them and assessing the profitability and efficiency of the enterprise.

Management Accounting
The advent of management accounting was the next logical step in the developmental process.-The practice of using accounting information as a direct aid to management is a phenomenon of the 20th century, particularly the last 30-40 years. The genesis of modern management with its emphasis on detailed information for decision-making provide a tremendous impetus to the development of management accounting. Management accounting is concerned with the preparation and presentation of accounting and controlling information in a form which assists management in the 'formulation of policies and in decision-making on various matters connected. with routine or non-routine operations of business enterprise. It is through the techniques of management accounting that the managers are supplied with information which they need for achieving objectives for which they are accountable. Management accounting has thus shifted the focus of accounting from recording and analysing financial; transactions to using information for decisions affecting the future. In this sense, management accounting has a vital role to play in extending the horizons of modern business. While the reports emanating from financial accounting are subject to the conceptual framework of accounting, internal reports-routine or non-routine are free from such constraints.

Social Responsibility Accounting

Social responsibility accounting is a new phase in the development of accounting and owes its birth to increasing social awareness which has been particularly noticeable over the last two decades or so. Social responsibility accounting widens the scope of accounting by considering the social effects of business decisions; in addition to the economic effects. Several social scientists, statesmen and social workers all over the world have been drawing the attention of their governments and the people in their countries to the dangers posed to environment and ecology by the unbridled industrial growth. The role of business in society is increasingly coming under greater scrutiny\ The management is being held responsible not only for efficient conduct of business as expressed in profitability, but also for what it contributes to social well being and progress. There is a growing feeling that the concepts of growth and profit as measuredin traditional balance sheets and income statements are too narrow to reflect the social responsibility aspects of a business.

Human Resource Accounting

Way back in 1964 the first attempt to include figures on human capital in the balance sheet was made by Hermansson which later. came to be known as Human Resource

Accounting. However there had been a great socio-economic shift in the 1990's with the emergence of "Knowledge economy", a distinctive shift towards recognition of human and intellectual capital in contrast to physical capital. Human Resource Accounting is a branch of accounting which seeks to report and emphasis the importance of human resources (knowledgeable, trained, loyal and committed employees) in a company's earning process and total assets. It is concerned with "the process of identifying and measuring data about human resources and communicating this information to interested parties". In simple words it involves accounting for investment in people and replacement costs as well as accounting for the economic values of people to an organisation. Generally the methods used for valuing and accounting of human resources are either based on costs or on economic value of human resources., However providing adequate and valid information on human assets (capital), which are outside the concept of ownership, in figures is very difficult. Nevertheless HRA is a managerial tool providing valuable information to the top management to take decisions regarding adequacy of human resources and thus encouraging managers to consider investment in manpower in a more positive way.

Accounting and its Functions

Inflation Accounting
Inflation Accounting is concerned with the adjustment in the value of assets (current and fixed) and of profit in the light of changes in the price level. In a way, it is concerned with the overcoming of limitations that arise in financial statements on account of the cost assumption (that is recording of the assets at their historical or original cost) and the assumption of stable monetary unit (these are discussed in detail in the next unit). It thus aims at correcting the distortions in the reported results caused by price level changes. Generally, rising prices during inflation have the distorting influence of overstating the profit. Various approaches have been suggested to deal with this problem. If this little introduction of HRA and Inflation accounting provokes you to know more about them, we suggest that you listen to the audio programme "Emerging Horizons in Accounting and Finance-Part II and III" which deal with these two topics. You may also read "Money Measurement Concept" explained in the next unit which has a bearing on inflation accounting. Activity 1.2 In the context of your organisation, describe some of the cost and management accounting related activities. Please also identify any particular accounting practice in the area of social responsibility. . . . . . .

1.4

ACCOUNTING AS AN INFORMATION SYSTEM

While discussing the scope of accounting you must have observed that accounting involves a series of activities linked with each other, beginning with the collecting, recording, analysing and evaluating the data, and finally communicating information to its users. Information has no meaning unless it is linked with a certain purpose.

Accounting Framework

Accounting as a social science can be viewed as an information system since it has all the features of a system. It has its inputs (raw data), processes (men and equipment), and outputs (reports and information). If we consider accounting as an information system, then we are in a position to make some important observations. First, the goal of the system is to provide information which meets the needs of its users. If we can correctly identify the needs of the users, we are then able to specify the nature and character of the outputs of the system. Secondly, it is the output requirements that . determine the type of data which would be selected as the inputs for processing into information output. There are several groups of people who have a stake in a business organisationmanagers, shareholders, creditors, employees, customers, etc. Additionally, the community at large has economic and social interest in the activities of such organisations. This interest is expressed at the national level by the concern of government in various aspects of the firms' activities, such as their economic wellbeing, their contribution to welfare, their part in the growth of the national product, to mention only a few examples. We shall now briefly discuss what the information needs of various users are. Shareholders and Investors: Since shareholders and other investors have invested their wealth in a business enterprise, they are interested in knowing periodically about the profitability of the enterprise, the soundness of their investment and the growth prospects of the enterprise. Historically, business accounting was developed to supply information to those who had invested their funds in business enterprises. Creditors: Creditors may be short-term or long-term lenders. Short-term creditors include suppliers of materials, goods or services. They are normally known as trade creditors. Long-term creditors are those who' have lent money for a long period, usually in the form of secured loans. The main concern of the creditors is focused on the credit worthiness of the firms and its ability to meet its financial obligations. They are therefore concerned with the liquidity of the firms, its profitability and financial soundness. In other words, it can also be stated that creditors are interested mainly in information which deals with solvency, liquidity and profitability so that they could assess the financial standing of the firms. Employees: The view that business organisations exist to maximise the return to shareholders has been undergoing change as a result of social changes. A broader view is taken today of economic and social role of management. The importance of harmonious industrial relations between management and employees cannot be overemphasised. That the employees have a stake in the outcomes of several managerial decisions is recognised. Greater emphasis on industrial democracy through employee participation in management decisions has important implications for the supply of information to employees. Matters like settlement of wages, bonus, and profit sharing rest on adequate disclosure of relevant facts. Government: In a mixed economy it is considered to be the responsibility of the Government to direct the operation of the economic system in such a manner that it subserves the common good. Controls and regulations on the operations of private sector enterprises are the hallmark of mixed economy. Several government agencies collect information about various aspects of the activities of business organisations. Much of this information is a direct output of the accounting system, for example, levels of outputs, profits, investments, costs, and taxes, etc. All this information is very important in evolving policies for managing the economy. The task of the Government in managing the industrial economy of the country is facilitated if accounting information is presented, as far as possible, in a uniform manner. It is clear that if accounting information is distorted due to manipulations and window-dressing in the

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presentation of annual accounts, it will have ill-effects on the measures the government intends to take and the policies it wishes to adopt. Management: Organisations may or may not exist for the sole purpose of profit. However, information needs of the managers of both kinds of organisations are almost the same, because the managerial process i.e., planning, organising and controlling is the same. All these functions have one thing in common and it is that they are all concerned with making decisions which have their own specific information requirements. The emphasis on efficient and effective management of organisations has considerably extended the demand for accounting information. The role of accounting as far as management is concerned was highlighted earlier when we discussed about management accounting. Consumers and others: Consumers' organisations, media, welfare organisations and public at large are also interested in condensed accounting information in order to appraise the efficiency and social role of the enterprises in different sectors of the economy, that is, what levels of profits and outputs are being achieved, in what way the social responsibility is being discharged and in what manner the growth is being planned by the enterprises in-accordance with the national priorities etc. The above discussion perhaps has indicated to you that the information needs of the various users may not necessarily be the same. Sometimes, they may even conflict and compete with each other. In any case, the objective of accounting information is to enable information users to make optimum decisions.

Accounting and its Functions

1.5

ROLE AND ACTIVITIES OF AN ACCOUNTANT

Having discussed the scope of accounting and its emerging role, we are now in a position to describe as to who is an accountant. In an attempt to answer this question we reproduce below some statements in this regard: a) b) c) d) e) f) An accountant is one who is engaged in accounts-keeping. An accountant is a functionary who aids control. An accountant keeps the conscience of an organisation. An accountant is a professional whose primary duties are concerned with information management for internal and external use. An accountant is a fiscal adviser. An accountant produces an income statement and a balance sheet for an accounting period and maintains all supporting evidence and classified facts that lead to the final accounting statements. An accountant verifies, authenticates, and certifies the accounts of an entity.

g)

Tell us about your reactions. Perhaps you do have your own ideas but our thinking is that each of the foregoing statements contain some truth in it as it highlights some aspects of the functions of an accountant, except one statement which presents a somewhat comprehensive view. Can you identify this statement? We will help you in doing this. Statement (a) defines a person who maintains accounts. Statement (f) echoes almost a similar notion but extends his role to the production of financial statements. The work implied in these statements is that of score-keeping and the person performing such activity is known as a financial accountant (or maintenance accountant). Statement (b) is about the role which an accountant can play in the management control process. It is concerned with attention-directing and problem-solving. The functionary may be designated as management accountant (or a controller as in the United States).

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Accounting Framework

Statement (e) underlines a narrow, specific role of an accountant, though of critical significance. In view of high incidence of taxes on business in India, tax planning assumes a vital role in fiscal management. By planning the operations of the enterprise in a particular manner, the tax adviser attempts to minimise the liability of the firm by availing the concessions and incentives provided for in the applicable tax laws. Statement (g) stresses the `audit', `watchdog', or `certification role' of the accountant who is not an employee of a business but who performs an external verification of accounts. Such a functionary is a trained and qualified professional who, like any other professional, has an educational status and a prescribed code of conduct. Chartered Accountants in India, England-Wales, and Certified Public Accountants in USA belong to this category of accountants. Statement (c) presents the accountant as a conscience-keeper. He is seen as a person whose mission is to protect and promote the interest of the employer in a positive manner. He is there to see to it that none of the staff of the organisation carries on this work in an unethical way or in a manner prejudicial to the long-term legitimate interests of the firm. We are now left with statement (d) which defines an accountant as a professional and underlines his pre-occupation withi management of information for internal use (management accounting function) and for external use (financial accounting function). We are sure, our discussion of accounting as an information system has made it easier for you to comprehend this role of the accountant. We may clarify that information management is not necessarily associated with sophisticated (or hi-tech) area of computers. Small firms may `manage' information without a substantial degree of mechanisation or automation. Often the role of accounting in small businessis not properly recognised. It is widely known that a large number of small businesses fail and do not survive beyond a few years. One of the main reasons for their failure is that they do not have an adequate information system to help their managers to control costs, to forecast cash needs and to plan for growth. Organisations which have poor accounting system often find it considerably difficult to obtain finance from banks and outside investors.

1.6

ACCOUNTING PERSONNEL

There is hardly any organisation which does not have an accountant. His role is all pervasive and he is involved in a wide range of activities, particularly in a large and complex organisation. The exact duties of an accountant might differ in different organisations. However, a broad spectrum of responsibilities can be identified. The accountants can be broadly divided into two categories, those who are in public practice and those who are in private employment. The accountants in public practice offer their services for conducting financial and or cost audit. As such, they are known as auditors. The auditor examines the books of account and reports on the balance sheet and profit and loss account of the company as to whether they give a true and fair view of the state of affairs of the company and its profit respectively. The auditor in a company is appointed by the shareholders to whom he reports. Public accountants are generally members of professional bodies like the Institute of Chartered Accountants of India or the Institute of Cost and Works Accountants of India. In addition to conducting financial or cost audit (in accordance with the requirements of the Companies Act), as the case may be, they may also provide consultancy services for design Qing or improving accounting and management control systems. Accountants in employment may be in various business or non-business organisations to perform a variety of accounting and management control functions. Accountants at higher levels generally belong to professional accounting bodies but those who are at

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lower levels need not be so. Accounting chiefs in different organisations, depending upon their nature of work, are variously designated as finance officers or internal auditors or chiefs accounts officers, etc. The term `controller' as the head of the accounting and finance function is not very popular in India but of late it has been catching up. Several large organisations, both in the public and private sectors, have now controllers. Let us have an idea of who these people are and what they do. Internal Auditor: Internal Auditor is an employee of the organisation in contrast to an external auditor who is paid a fee for his services. The internal auditor is responsible for performing monitoring activities and other services, including designing and operating the system of internal control, auditingthe data reported to the directors ofthe company, and assisting external auditors. The head ofthe internal audit function reports directly either to the ch iefexecutive or to the audit committee of the Board of Directors. Internal audit includes continuous verification of entries appearing in the books of account with the original vouchers and proper accounting of assets. Further, it attempts to ensure that the policies and procedures regarding financial matters are being complied with. Internal auditing is also concerned with administering the system of internal check so that mistakes, innocent or intentional, are prevented from taking place. We should distinguish an internal auditor from an external auditor. While an internal auditor devotes his entire time and energy to the needs ofone company (i.e, his employer), an external auditor serves many clients. The primary function ofthe external auditor, as pointed out earlier, is to safeguard the interests ofthe shareholders (by whom he is appointed ) by an independent and impartial appraisal ofthe financial transactions ofthe company so that he could report on the net profit earned by the company and its financial position. His role is that ofan objective outsider, expressing expert opinions tothefinancial condition and operating results ofthe client's business. A part from shareholders, other parties such as banks, lending institutions, government agencies, etc. reply on the fairness of such financial reports in making certain decision about a given company. An auditor is bound by a set of professional regulations which include an examination on technical competence and adherence to a code of ethical conduct. Controller : Controller- the other name for Chief Accountant- is usually the head of the whole area of accounting, including internal audit. He is overall in - charge of all the activities comprising financial accounting, cost accounting, management accounting, tax accounting etc. He exercises authority both for accounting within the organisation and for external reporting. The external reports include reports to government revenue collecting and regulatory bodies, such as Company Law Board and Income Tax . Department He may also supervise the company's internal audit and control systems. In addition to processing historical data, he is expected to supply a good deal of accounting information to top management concerning future operations, in line with the management's planning and control needs. Besides, he is also expected to supply detailed information to managers in different functional areas ( like production, marketing, etc.) and at different levels of the organisation. We may enumerate the functions of the controller as follows: a) b) c) d) e) f) g) Designing and operating the accounting system Preparing financial statements and reports Establishing and maintaining systems and procedures Supervising internal auditing and arranging for external audit Supervising computer applications Overseeing cost control Preparing budgets

Accounting and its Functions

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Accounting Framework

h) i) j)

Making forecasts and analytical reports Reporting financial information to top management Handling tax matters.

Treasurer : He is the custodian arid manager of all the cash and near-cash resources of the firm. The treasurer handles credit reviews and sets policy for collecting receivables (debtors of the firm to whom the firm has sold goods or services) He also handles relationships with banks and other lending or financial institutions. The Financial Executive Institute (of United States of America) makes the following distinction between controllership and treasurership functions: Controllership Planning and Control Reporting and Interpreting Evaluating and Consulting Tax Administration Government Reporting Protection of Assets Economic Appraisal Treasurership Provision of Capital Investor Relations Short-term Financing Banking and Custody Credit and Collections Investments Insurance

Finance Officer: Finance is the life blood of business. Procuring financial resources and their judicious utilisation are the two important activities of financial management. Financial management, includes three major decisions: investment decision, financing decision and dividend decision. Investment decision is perhaps the most important decision because it involves allocation of resources . It is concerned with future which being uncertain involves risk. How the firm is allocating its scarce resources and is planning growth will largely determine its value in the market place. Financing decision is concerned with determining the optimum financing mix or capital structure. It examines the various methods by which a firm obtains short-term and long -term finances through various alternative sources. The dividend decision is concerned with question like how much of the profit is to be retained and how much is to be distributed as dividends. The finance manager has to strike a balance between the current needs of the enterprise for cash and the needs of the shareholders for a adequate return. The financial management of a large company is usually the responsibility of the finance director who may be in place of, or in addition to the controller. Often finance manager and controller are inter-changeable terms and only one of these two positions may be found in a company. The finance manager when there is a controller also in the organisation, is concerned with implementing the financial policy of the board of directors, managing liquidity, preparation of budgets and administration of budgetary control system, managing profitability, etc. Though financial management is regarded as a separate area, this function is performed in several countries, including India, by the Accountant( or the Financial Controller) Several large organisations however have a financial executive besides the ch ief accountant. Often, finance and accountingfunctions are clubbed together in one persons in small organisations.

Activity 1.3
Please meet one or more of the following personnel in any organisation and talk to them about their respective roles within the organisation. Accountant 1 2 3

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4 5 Chief Accountant 1 2 3 4 5 Controller 1 2 3 4 5 Finance Manager 1 2 3 4 5 Internal Auditor 1 2 3 4 5

Accounting and its Functions

1.7

NATURE OF ACCOUNTING FUNCTION

Accounting is a service function. The chief accounting executive (by whatever name he is called) holds a staff position except within his own department where he exerts. authority. This is in contradistinction to the roles played by production or marketing executives who hold line authority: The role of the accountant is advisory in character. He works through the authority of the chief executive. The accounts and or finance department(s) do`not exercise direct authority over line departments. In decentralised structure with a number of units and divisions, the accounting executive however exercises what is known as the functional authority over all the accounting staff deployed in different segments. There are two facets to the role of the accountant. For the top managers he works as a watchdog and for middle and lower level managers he acts as `helper'. The watchdog role is usually performed through `score-keeping' task of accounting and reporting to

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Accounting Framework

all levels of management. The `helper' role is usually performed through the task of directing managers' attention to problems and assisting them in solving problems. Mutual understanding and rapport between the accountant and the manager, in the tasks of attention-directing and problem-solving can be enhanced if accountant and his staff frequently interact with the line managers and guide them in matters concerned with preparation of budgets and control documents with which they might not be conversant. This will instill confidence among line managers regarding the reliability of reports.

1.8

ORGANISATION FOR ACCOUNTING AND FINANCE

A typical organisation chart for accounting and finance function is presented in Figure 1.2. You will note that the person at the helm of affairs the Director (Finance) who is a member of the Board of Directors. Reporting to him may be one or more general managers. If there is only one General Manager, he may be designated as General Manager (Finance), or General Manager (Finance and Accounts), or Controller or Financial Controller. In a large company four or five (as shown in Figure 1.2) Deputy General Managers incharge of different areas like systems and data processing, accounts, finance, internal auditing may report to him. Following the American pattern, a tendency has recently been observed among large companies, especially in the private sector, to designate General Manager (Finance) as President (Finance, or Finance and Accounts) and a Deputy General Manager as Vicepresident. Each of these Deputy General Managers is assisted by a number of senior managers who look after different components of similar activities, e.g., financial accounting, tax planning and administration, management auditing, etc. Management audit is a comprehensive review of the various sub-systems of the organisation like objectives and goals, structure, technical system, personnel policies, (including succession planning), control and coordination policies and procedures, adequacy and effectiveness of communication system, etc. This type of audit is usually done by a team of people comprising the internal resource persons drawn from various functional areas and external management consultant. Figure 1.2: Organisation Chart for Accounting and Finance

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We hope you now have a reasonably good idea of what accounting is, what its scope is, and what are the different types of activities which are generally included in accounting. While basic functions of accounting and finance are performed in all types of organisations, their relative emphases or relevance might differ in different types of organisations. Keeping this in view we have prepared an audio programme "Accounting and Finance Function in Different Types of Organisations" and we suggest that you listen to this tape. This will not only augment your familiarity with the basic aspects and functions of accounting but will also develop your appreciation for relative divergencies.

Accounting and its Functions

1.9

SUMMARY

Accounting is an important service activity in business and is concerned with collecting, recording, evaluating and communicating the results of past events. The history of accounting development reflects its changing role in response to the changing business and social needs. With the emergence of management accounting, the focus of ac-counting has been shifting from mere recording of transactions to that of aiding the management in decisions. Accounting can be perceived as an information system which has its inputs, processing methods and outputs. The usefulness of accounting lies in its capacity to provide information to various stakeholders in business so that they could arrive at the correct decisions. The top accounting personnel are designated with various nomenclature. The practice in this regard djffers in different companies. The organisational setting for accounting and finance function may also vary in different organisations, depending upon their peculiarities, nature and size of business, technology and structural form. At the helm of affairs is usually the Director of Accounts and Finance who is a member of the Board of Directors. Fle is assisted by a General Manager who in turn is helped by Deputy General Managers incharge of various sub-functions like, accounts, finance, internal audit, and data processing, etc. Each of the sub-functions is further subdivided into activities which are the responsibility of a subordinate manager.

1.10 KEY WORDS

Accountant is a professional who is responsible for the processing of financial data for score-keeping, attention-directing and problem-solving purposes. Controller of the management accountant is a staff-functionary who uses accounting information for management planning and control. Auditive work of an accountant comprises authentication of accounting statements. Recordative work extends to routine recording and classified posting of financial transactions and events. Score-keeping is the process of data accumulation or record-keeping which enables interested parties (internal and external) to ascertain how the organisation is performing. Attention-directing role of accounting consists of directing managerial attention to situations where corrective action is needed in the case of unfavourable (or even favourable) differences in operations, outputs or inputs. Information system is a system, sometimes formal and sometimes informal, for collecting, processing, and communicating data at the most relevant time to all levels of management. The data flowing through the system is helpful to managers for

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Accounting Framework

decision-making in the areas of planning and control, or is otherwise needed for financial reporting required under the laws. An essential requirement of information system is feedback, i.e. communicating the results of performance to operating managers for needed modifications. External reporting is the production of financial statements for the use by external interest groups like, shareholders and government. Planning is goal identification and decision-making. Control is the action that implements the planning decision and evaluates performance. Feedback comprises the performance reports which managers can use for improving their decision-making. Staff function is performed in an advisory capacity and without line or decisionmaking authority.

1.11 SELF-ASSESSMENT QUESTIONS/EXERCISES

1 2 3 4 5 6 7 8 9 "Financial Accounting is an extension of Stewardship Accounting". Comment. What new developments in Accounting have taken place over the past 20-25 years? Examine the main factors which have affected such developments. State the group of persons having an interest in a business organisation and examine the nature of their information needs. Discuss the role of accountants in modern business organisations. Differentiate between recordative, interpretative and auditive functions of Accounting. How can accounting reports, prepared on a historical basis after the close of a period, be useful to managers in directing the activities of a business? Distinguish management accounting from financial accounting. How does the accountant help in the planning and control process of a large commercial organisation? State whether the following statements are true or false: a) b) c) To have an accountant is the privilege ofa joint stock company only. A controller is entrusted with the responsibilities of raising funds Management control differs from engineering control since the latter is fully automatic and the former is highly complex. An accountant is the custodian of the properties and financial interests of a business enterprise. True/False True/False True/False

d)

True/False

Answers to Self-assessment Questions/Exercises

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9 (a) False, (b) False, (c) True, (d) True,

1.12 FURTHER READINGS

Anthony, Robert N. and James S. Reece, 1987. Accounting Principles, All India Traveller Book Seller: New Delhi (Chapter I). Bhattacharya S.K. and John Dearden, 1987. Accounting for Management: Text and Cases, Vikas Publishing 1-louse: New Delhi. (Chapter I). Paul Collier, May 09.2003. Accounting for Managers : Interpreting Accounting Infornration.for Decision Making. Wiley Publishers : Canada. (Chapter I),

Accounting and its Functions

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Accounting Framework

UNIT 2 ACCOUNTING CONCEPTS AND STANDARDS

Objectives After studying this unit, you should be able to: appreciate the need for a conceptual framework of accounting: understand and appreciate the Generally Accepted Accounting Principles (GAAP); and develop an understanding of the importance and necessity for uniformity in accounting practices.

Structure 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 2.10 2.11 Introduction Accounting Framework Accounting Concepts Accounting Standards Changing Nature of Generally Accepted Accounting Principles (GAAP) Attempts towards Standardisation Accounting Standards in India Summary Key Words Self-assessment Questions/Exercises Further Readings

2.1

INTRODUCTION

Any activity that you perform is facilitated if you have a set of rules to guide your efforts. Further, you find that these rules are of more value to you if they are standardised. When you are driving your vehicle, you keep to the left. You are in fact following a standard traffic rule. Without the drivers of vehicles adhering to this rule, there would be much chaos on the road. A similar principle applies to accounting which has evolved over a period of several hundred years, and during this time certain rules and conventions have come to be accepted as useful. If you are to understand and use accounting reports-the end product of an accounting system-you must be familiar with the rules and conventions behind these reports.

2.2

ACCOUNTING FRAMEWORK

The rules and conventions of accounting are commonly referred to as the conceptual framework of accounting. As with any discipline or body of knowledge, some underlying theoretical structure is required if a logical and useful set off practices and procedures are to be developed for reaching the goals of the profession and for expanding knowledge in that field. Such a body of principles is needed to help answer new questions that arise. No profession can thrive in the absence of a theoretical framework. According to Hendriksen (1977), Accounting theory may be defined as logical

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reasoning in the form of a set of broad principles that (i) provide a general frame of reference by which accounting practice can be evaluated, and (ii) guide the development of new practices and procedures. Accounting theory may also be used to explain existing practices to obtain a better understanding of them. But the most important goal of accounting theory should be to provide a coherent set of logical principles that form the general frame of reference for the evaluation and development of sound accounting practices. The American Institute of Certified Public Accountants (AICPA) discusses financial accounting theory and generally accepted accounting principles as follows. Financial statements are the product of process in which a large volume of data about aspects of the economic activities of an enterprise are accumulated, analysed, and reported. This process should be carried out in accordance with generally accepted accounting principles. Generally accepted accounting principle incorporate the consensus at a particular time as to which economic resources and obligations should be recorded as assets and liabilities by financial accounting, which changes in assets and liabilities should be recorded, when these changes should be recorded, how the assets and liabilities and changes in them should be measured, what information should be disclosed and how it should be disclosed, and which financial statements should be prepared. Generally accepted accounting principles encompass the conventions, rules and procedures necessary to define accepted accounting practice at a particular timegenerally accepted accounting principles include not only broad guidelines of general application, but also detailed practices and procedures. (Source: AICPA. Statements of the Accounting Principles Board No.4 "Basic Concept and Accounting Principles Underlying Financial Statement of Business Enter-prises", October, 1970, pp.54-55) The word `principles' is used to mean a "general law or rule adopted or professed as a guide to action, a settled ground or basis of conduct or practice". You will note that this definition describes a principle as a general law or rule that is to be used as a guide to action. This implies that accounting principles do not prescribe exactly how each detailed event occurring in business should be recorded. Consequently, there are several matters in accounting practice that may differ from one company to another. Accounting principles are man-made. They are accepted because they are believed to be useful. The general acceptance of an accounting principle (or for that matter any principle) usually depends on how well it meets the three criteria of relevance, objectivity, and feasibility. A principle is relevant to the extent that it results in meaningful or useful information to those who need to know about a certain business. A principle is objective to the extent that the information is not influenced by the personal bias or judgement of those who furnished it. Objectivity connotes reliability or. trustworthiness which also means that the correctness of-the information reported can be verified. A principle is feasible to the extent that it can be implemented without undue complexity or cost.

Accounting Concepts and Standards

2.3

ACCOUNTING CONCEPTS

Earlier in Unit 1 we had described accounting as the language of business. As with language, accounting has many dialects. There are differences in terminology. In dealing with the framework of accounting theory, one is confronted with a serious problem arising from differences in terminology. A number of words and terms have been used by different writes to express and explain the same idea or notion. Thus, confusion abounds in the literature insofar as the theoretical framework is concerned.

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Accounting Framework

The various terms used for describing the basic ideas are: concepts, postulates, propositions, basic assumptions, underlying principles, fundamentals, conventions, doctrines, rules, etc. Although each of these terms is capable of precise definition, general usage by the profession of accounting has served to give them loose and overlapping meanings. The same idea has been described by one author as a concept and by another as a convention. To take another instance, the idea implied in Conservatism has been labelled by one author as a (modifying) convention, by another as a principle and yet by another as a doctrine. The wide diversity in terminology to express the basic framework can only serve to confuse the learner. Without falling into the trap of this terminological maze, we are explaining below some widely recognised ideas and we call all of these concepts. We do feel, however, that some of these ideas have a better claim to be called `concepts', while the rest should be called `conventions'. Fundamental accounting concepts are broad general assumptions with underlie the periodic financial accounts of business enterprises. The reason why some of these ideas should be called concepts is that they are basic assumptions and have a direct bearing on the quality of financial accounting information. The alteration of any of the basic concepts (or postulates) would change the entire nature of financial accounting. Business Entity Concept In accounting we make a distinction between business and the owner. All the records are kept from the viewpoint of the business rather than from that of the owner. An enterprise is an economic unit separate and apart from the owner or owners. As such, transactions of the business and those of the owners should be accounted for and reported separately. In recording a transaction the important question is how does it affect the business? For example, if the owner of a shop were to take cash from the cash box for meeting certain personal expenditure, the accounts would show that cash had been reduced even though it does not make any difference to the owner himself. Similarly, if the owner puts cash into the business, he has a claim against the business for capital brought in. This distinction can be easily maintained in the case of a limited company because a company has a legal entity (or personality) of its own. Like a natural person it can engage itself in economic activities of producing, owning, managing, storing, transfer-ring, lending, borrowing and consuming commodities and services. Distinction, however, is difficult in the case of partnership, and even more so in the case of one-man business. Nevertheless, accounting still maintains separation of business and owner. This implies that owner's personal and household expenses or obligations (e.g., expenditure on food, clothing, housing, entertainment, debts, mortgages, etc.) will not appear in the books of account. It may be clarified that it is only for accounting purposes that partnerships and sole proprietorships are treated as separate and apart from the owners though law does not make such distinction. A creditor would be justified in looking to both the business assets and the private estate of the owner for satisfaction of his claim. One reason for this distinction is to make it possible for the owners to have an account of the performance from those who manage the enterprise. The managers are entrusted with funds supplied by owners, banks and others; they are responsible for the proper use of the funds. The financial accounting reports are designed to show how well this responsibility has been discharged. Activity 2.1 Apart from the reason mentioned above, can you think of any other reason for justitfication of Business Entity Concept? ......................................................................................................................................... ......................................................................................................................................... .........................................................................................................................................

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Accounting Concepts and Standards

Activity 2.2
The proprietor of a firm withdrew Rs. 50,000 for his personal use. This was shown as an expense of the firm. Profits were reduced to pay a lower tax. Is this right from accounting point of view?

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Money Measurement Concepts In accounting, only those facts which can be expressed in terms of money are recorded. As money is accepted not only as a medium of exchange but also as a store of value, it has a very important advantage since a number of widely different assets and equities can be expressed in terms of a common denominator. Without this adding heterogeneous factors like five buildings, ten machines, six trucks will not have much meaning. While money is probably the only practical common denominator and a yardstick, we must realise that this concept imposes two sever limitations. In the first place, there are several facts which, though vital to the business, cannot be recorded in the books of account because they cannot be expressed in money terms. For example, the state of health of the Managing Director of a company who has been the key contributor to the success of business is not recorded in the books. Similarly, the fact that the Production Manager and the Chief Internal Auditor are not on speaking terms, or that a strike is about to begin because labour is dissatisfied with the poor working conditions in the factory, or that a competitor has recently taken over the best customer, or that it has developed a better product and so on will not be recorded even though all these events are of great concern to the business. From this standpoint, one could say that accounting does not give a complete account of the happenings in the business. You will appreciate that all these have a bearing on the future profitability of the company. Secondly, use of money implies that a rupee today is of equal value to a rupee ten years back or ten years later. In other words, we assume stable or constant value of rupee. In the accounts, money is expressed in terms of its value at the time an event is recorded. Subsequent changes in the purchasing power of money do not affect this amount. You are perhaps aware that most economies today are in inflationary conditions with rising prices. The value of a rupee of 1980's has depreciated to an unbelievably low level in the 90s. Most accountants know fully well that purchasing power of rupee does change but very few recognise this fact in accounting books and make allowance for changing price level. This is so despite the fact that accounting profession has devoted considerable attention to this problem and numerous suggestions have been made to account for the effects of changes in the purchasing power of money. In fact, one of the major problem of accounting today is to find means of solving the measurement problem, that is, how to extend the quality and the coverage of meaningful information. It will be desirable to present in a supplementary analysis the effect of price level changes on the reported income of the business and the financial position.

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Accounting Framework

Activity 2.3
Suppose the Managing Director of a company is killed in a plane crash. To the extent "an organisation is the lengthened shadow of a man", the real value of the company will change immediately and this will be reflected in the market price of the company shares. Will this have any effect as far as the accounts of the company are concerned?

.............................................................................................................................. .............................................................................................................................. .............................................................................................................................. .............................................................................................................................. .............................................................................................................................. .............................................................................................................................. .............................................................................................................................. .............................................................................................................................. .............................................................................................................................. Continuity Concept
Accounting assumes that the business (an accounting entity) will continue to operate for a long time in the future unless there is good evidence to the contrary. The enterprise is viewed as a going concern, that is, as continuing in operation, at least in the foreseeable future. The owners have no intention nor have they the necessity to wind up or liquidate its operations. This assumption is of considerable importance for it means that the business is viewed as a mechanism for adding value to resources it uses. The success of the business can be measured by the difference between output values (sales or revenues) and input values (expenses). Therefore, all unused resources can be reported at cost rather than at market values. The assumption that the business is not expected to be liquidated in the foreseeable future, in fact, establishes the basis for many of the valuations and allocations in accounting. For example, depreciation (or amortisation) procedures rest upon this concept. It is this assumption which underlies the decision of investors to commit capital to enterprise. The concept holds that continuity of business activity is the reasonable expectation for the business unit for which the accounting function is being performed. Only on the basis of this assumption can the accounting process remain stable and achieve the objective of correctly recording and reporting on the capital invested, the efficiency of management, and the position of the enterprise as a going concern. Under this assumption neither higher current market values nor liquidation values are of particular importance in accounting. This assumption provides a basis for the application of cost in accounting for assets. However, if the accountant has good reasons to believe that the business, or some part of it, is going to be liquidated or that it will cease to operate (say within a year or two), then the resources could be reported at their current values (or liquidation values).

Activity 2.4
A company revalues its buildings which were purchased at a cost of Rs. 5,00,000 in 1985 to Rs. 50,00,000 in 2003 and records the difference of Rs. 45,00,000 as profit for the year 2003. Is this practice right?

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Cost Concept
The resources (land, buildings, machinery, property rights, etc.) that a business owns are called assets. The money values that are assigned to assets are derived from the cost concept. This concept states that an asset is worth the price paid for or cost incurred to acquire it. Thus, assets are recorded at their original purchase price and this cost is the basis for all subsequent accounting for the assets. The assets shown on the financial statements do not necessarily indicate their present market worth (or market values). This is contrary to what is often believed by an uninformed person reading the statement or report. The term `book value' is used for amount shown in the accounting records. In case of certain assets the accounting values and market values may be similar; cash is an obvious example. In general, the longer an asset has been owned by the company the lesser, are the chances that the accounting value will correspond to the market value. The cost concept does not mead that all assets remain on the accounting records at their original cost for all time to come. The cost of an asset that has a long but limited life is systematically reduced during its life by a process called `depreciation' which will be discussed at some length in a subsequent unit. Suffice it to say at this point that deprecation is a process by which the cost of the asset is gradually reduced (or written off) by allocating a part of it to expense in each accounting period. This will have the effect of reducing the profit of each period. In charging depreciation the intention is not to change depreciation equal to the fall in the market value of the asset. As such, there is no relationship between depreciation and changes in market value of the assets. The purpose of depreciation is to allocate the cost of an asset over its useful life and not to adjust its cost so as to bring it closer to the market value. You must be wondering as to why assets are shown at cost even when there are wide differences between their costs and market values. The main argument is that the cost concept meets all the three basic criteria of relevance, objectivity and feasibility.

Accounting Concepts and Standards

Accrual Concept
The accrual concept makes a distinction between the receipt of cash and the right to receive it, and the payment of cash and the legal obligation to pay it. In actual business operations, the obligation to pay and the actual movement of cash may not coincide. The accrual concept recognises this distinction. In connection with the sale of goods, revenue may be received (i)before the right to receive arises, or(ii) after the right to receive has been created, The accrual concept provides a guideline to the accountant as to how he should treat the cash receipt and the rights related thereto. In the former case the receipt will not be recognised as the revenue of the period for the reason that the right to receive the same has not yet arisen. In the latter case the revenue will be recognised even though the amount is received in the subsequent period. Similar treatment would be given to expenses incurred by the firm. Cash payments for expenses may be made before or after they are due for payment. Only those sums which are due and, payable would be treated as expenses. If a payment is made in advance (i.e. it does not belong to the accounting period in question) it will not be treated as an expense, and the person who received the cash will be treated as a debtor until his right to receive the cash has matured. Where an expense has-been incurred during the accounting period but no payment has been made, the expense must be recorded and the person to whom the payment should have-been made is shown as a creditor.

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Accounting Framework

Activity 2.5
The accounting year of a firm closes on 31st December each year. The rent for business premises of Rs 50,000 for the last quarter could not be paid to the owner on account of his being away in a foreign country. Should the rent payable be taken into account for computing the firm's income for the accounting year?

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A government contractor supplies stationery to various government offices. Some bills amounting to Rs. 10,000 were still pending with various offices at the close of the accounting year on 31st March. Should the businessman take the revenue of Rs. 10,000 into account for computing the net profit of the period?

.............................................................................................................................. .............................................................................................................................. .............................................................................................................................. .............................................................................................................................. .............................................................................................................................. .............................................................................................................................. .............................................................................................................................. .............................................................................................................................. .............................................................................................................................. .............................................................................................................................. Concept of Conservatism
The concept of conservatism, also known as the concept of prudence, is often stated as "anticipate no profit, provide for all possible losses". This means an accountant should follow a cautious approach. He should record lowest possible value for assets and revenues, and the highest possible value for liabilities and expenses. According to this concept, revenues or gains should be recognised only when they are realised in the form of cash or assets (usually legally enforceable debts) the ultimate cash realisation of which can be assessed with reasonable certainity. Further, provision must be made for all known liabilities, expenses and losses whether the amount of these is known with certainty or is at best an estimate in the light of the information available. Probable losses in respect of all contingencies should also be provided for. A contingency is a condition or a situation, the ultimate outcome of which-gain or loss-cannot be determined accurately at present. It will be known only after the event has occurred (or has not occurred). For example, a customer has filed a suit for damage against the company in a court of law. Whether the judgement will be favourable or unfavorable to the company cannot be determined for sure. Hence, it will be prudent to provide for likely loss in the financial statements. As a consequence of the application of this concept, net assets are more likely to be understated than overstated, and income is more likely to be overstated than understated. Based on this concept is the widely advocated practice of valuing inventory (stock of goods left unsold) at cost or market price. whichever is lower. You will note that this convention, in a way, modifies the

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earlier cost concept. It should be stated that the logic of this convention has been under stress recently; it has been challenged by many writers on the ground that it stands in the way of fair determination of profit and the disclosure of true ad fair financial position of the business enterprise. The concept is not applied as strongly today as. it used to be in the past. In any case, conservatism must be applied rational Y as overconservatism may result in misrepresentation.

Accounting Concepts and Standards

Materiality Concept
There are many events in business which are trivial or insignificant in nature. The cost of recording and reporting such events will not be justified by the usefulness of the information derived. Materiality concept holds that items of small significance need not be given strict theoretically correct treatment. For example, a paper stapler costing Rs. 30 may last for three years. However, the effort involved in allocating its cost over the three-year period is not worth the benefrt than can be derived from this operation. Since the item obviously is immaterial when related to overall operations, the cost incurred on it may be treated as the expense of the period in which it is acquired. Some of the stationery purchased for office use in any accounting period may remain unused at the end of that period. In accounting, the amount spent on entire stationery would be treated as expense of the period in which the stationery was purchased, notwithstanding the fact that a small part of it still lies in stock. The value (or cost) of the stationery lying in stock would not be treated as an asset and carried forward as a resource to the next period. The accountant would regard the stock lying unused as immaterial. Hence, the entire amount spent on stationery would be taken as the expense of the period in which such expense was incurred. Where to draw the line between material and immaterial events is a matter of judgement and common sense. There are no hard and fast rules in this respect. Whether a particular item or occurrence is material or not, should be determined by considering its relationship to other items and the surrounding circumstances. It is desirable to establish and follow uniform policies governing such matters.

Consistency Concept
In practice, there are several ways to record an event or a transaction in the books of account. For example, the trade discount on raw material purchased may be deducted from the cost of goods and net amount entered in the books, or alternatively trade discount may be shown as the income with full cost of raw material purchased entered in the books. Similarly, there are several methods to charge depreciation (which is a decrease in the value of assets caused by wear and tear, and passage of time) on an asset or of valuing inventory. The consistency concept requires that once a company has decided on one method and has used it for some time, it should continue to follow the same method or procedure for all subsequent events of the same character unless it has a sound reason to do otherwise. If for valid reasons the company makes any departure from the method it has been following so far, then the effect of the change must be clearly stated in the financial statements in the year of change. You will appreciate that much of the utility of accounting information lies in the fact that one could draw valid conclusions from the comparison of data drawn from financial statements of one year with data of the other year. Comparability is essential so that trends or differences may be identified and evaluated. Inconsistency in the application of accounting methods might significantly affect the reported profit and the financial position. Further, inconsistency also opens the door for manipulation of reported income and assets. The comparability of financial information depends largely upon the consistency with which a given class of events are handled in ac-counting records year after year.

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Accounting Framework

Activity 2.7
A company had been charging depreciation on a machine at Rs. 10,000 per year for the first 3 years. Then it began charging Rs. 9,000 for 4th year and Rs. 7,800 for 5th year and so on. Is this practice justified? Give reasons for your answer.

.............................................................................................................................. .............................................................................................................................. .............................................................................................................................. .............................................................................................................................. .............................................................................................................................. .............................................................................................................................. .............................................................................................................................. .............................................................................................................................. .............................................................................................................................. .............................................................................................................................. .............................................................................................................................. .............................................................................................................................. .............................................................................................................................. Periodicity Concept
Although the results of operations of a specific enterprise can be known precisely only after the business has ceased to operate, its assets have been sold off and liabilities paid off, the knowledge of the results periodically is also necessary. Those who are interested in the operating results of business obviously cannot wait till the end. The requirements of these parties therefore force the accountant to report for the changes in the wealth of a firm for short time periods. These time periods in actual, practice vary, though a year is the most common interval as a result of established business practice, tradition and government requirements. Some firms adopt calendar year, some others financial year of the government. But more and more firms are changing to the `natural' business year the end of which is marked by relatively lower or lowest volume of business activity in the twelve-month period. The custom of using twelve-month period is applied only for external reporting. The firms usually adopt a shorter span of interval, say one month or three months, for internal reporting purposes. The allocation of long-term costs and the difficulties associated with this process directly stem from this concept. While matching the earnings and the cost of those earnings for any accounting period, all the revenues and all the costs relating to the yearn question have to be taken into account irrespective of whether or not they have been received in cash or paid cash. Despite the difficulties that arise in allocations and adjustments, short-term reports (i.e., yearly reports) are of such importance to owners, management, creditors, and other interested parties that the accountant has no option but to resolve such difficulties. Obviously, the utility of the periodic financial statements outweighs the difficulties. Some other concepts e.g. Matching concept, Realisation concept and Dual Aspect concept are discussed in Units 4 and 5 and as such they have not been taken up here. While going through all these concepts, probably you have developed a feeling that they come in conflict with each other. You are right. We illustrate this by considering. some of these concepts in the context of valuation of business properties. Suppose, a firm acquired a piece of land in 2000 fora price of Rs. 6,00,000. Factory premises were constructed in 2001 and operations commenced in 2002. The firm has been successful in achieving desired profit for the past year. The Balance Sheet ( a statement of assets and liabilities) for the year 2003 is being prepared and `Land' is required to be valued. The estimated current market price of this land is Rs. 60,00,000.

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Should you recommend that the land be valued at Rs. 60 lakhs? The answer is `no' obviously. Land would be carried on the Balance Sheet at its original cost of Rs, 6,00,000 only. This decision is supported by several of the concepts discussed in this section. In the first place, the stability of purchasing power of money implied in the money measurement concept prevents us from recognising accretion in values as a result of changing price levels. Then, the realisation concept will not allow unrealised profits to be included as long as land is held by the company and not sold away. You may note that the continuity or going concern concept makes any possible market value of land irrelevant for balance sheet because the firm has to continue in business and land will be needed by it for its own use. In this connection, it could be argued that if land were shown on the balance sheet at its estimated current market value, the owner might decide to discontinue the business, sell the land and retire. The principle of objectivity is now introduced into the argument. It can be easily seen that in a situation like this the cost of acquisition of land at Rs. 6,00,000 in 2000 is the objective fact because it is based on a transaction that actually took place and this objective evidence is capable of being verified. In contrast, the estimate of current market value figure may be suspect. It raises many questions. Do you have a market quotation for an identical plot of land? Has a similar plot of land been sold recently and can we pick it up as verifiable evidence of the current market price? It may be said that even if market price for an identical plot of land is not available, estimates by an accredited valuer may be accepted as verifiable evidence of the market price. Further complications may be noticed if buildings and facilities have been erected on the plot of land. Is it possible to estimate the value of land without factory buildings and other facilities constructed on it? The answer is a flat `no' and the conservatism concept will then deter you from accepting an estimate of market value since it cannot be ascertained with reasonable accuracy.

Accounting Concepts and Standards

2.4

ACCOUNTING STANDARDS

The basic concepts discussed in the foregoing paragraphs are the core elements in the theory of accounting. These concepts (postulates or conventions), however, permit a variety of alternative practices to co-exist. As a result, the financial results of different companies cannot be compared and evaluated unless full information is available about the accounting methods which have been used. The variety of accounting practices have made it difficult to compare the financial results of different companies. Further, the alternative accounting methods have also enabled, the reporting of different results, even by the same company. Need for Standards: The information contained in published financial statements is of particular importance to external users, such as shareholders and investors. Without such information they would not be able to take right decisions about their investments. As in several other countries, Parliament in India has specified in the Companies Act the type and minimum level of information which companies should disclose in financial statements. It is the responsibility of the accounting profession to ensure that the required information is properly presented. It is evident that there should not be too much discretion to companies and their accountants to present financial information the 'way they like. In other words, the information contained in financial statements should conform to carefully considered standards. Public confidence in accounting information contained in financial statements will grow if they are satisfied as to the logic, consistency and fairness of the figures shown therein. For instance, a company could incur a loss and still "pay dividends by manipulating the loss into a profit. In the long run this course may have a disastrous effect on the company and its investors. 29

Accounting Framework

You would be better able to appreciate the function of accounting standards by relating them to the basic purpose of financial statements which is the communication of information affecting the allocation of resources. Ideally, such information should make it possible for investors to evaluate the investment opportunities offered by different firms and allocate scarce resource to the most efficient ones. In theory, this process should result in the capital distribution of resources within the economy and should maximise the potential benefit to society. In this context unless there are reasonably appropriate standards, neither the purpose of the individual investor nor that of the nation as a whole can be served. The purpose is likely to be served if the accounting methods used by different firms for presenting information to investors allow correct comparisons to be made. For example, they should not permit a company to report profits which result simply from a change in accounting methods rather than from increase in efficiency. If companies were free to choose their accounting methods in this way, the consequences might be that deliberate distortions are introduced, leading eventually to misapplication of resources in the economy. The relatively less efficient companies will be able to report frctitious profits, and as a result scarce capital of society will be diverted away from the more efficient companies which have adopted more strict and consistent accounting methods.

2.5 CHANGING NATURE OF GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)

Generally accepted accounting principles are usually developed by professional accounting bodies like American Institute of Certified Public Accountants (AICPA) and Institute of Chartered Accountants of India(ICAI). In developing such principles, however, the accounting profession has to reflect the realities of social, economic, legal and political environment in which it operates. Besides academic research, regulatory and tax laws of the government e.g., Companies Act, 1956, income Tax Act, 1961 etc., in a large measure, influence the formulation of acceptable accounting principles. Stock exchanges and other regulatory agencies like Controller of Capital Issues (CCI) have laid down rules for disclosure and extent of accounting information. Since the environment in which business operates, undergoes constant changes as a result of changes in economic and financial policies of the Government and changes in the structure of business, continued evaluation of the relevance of generally accepted accounting principles is required. In this sense, the principles of accounting are not ever-lasting truths. You will appreciate that it is the development of relevant accounting principles in tune with the present day needs of the society that would make it possible for the business enterprises to develop financial statements which would be acceptable and of value to the end users. Now we give you a brief account of the development of standards in the United Kingdom, United States of America, India, and at the international level.

2.6

ATTEMPTS TOWARDS STANDARDISATION

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Standardisation in UK and USA: Though the Institute of Chartered Accountants in England and Wales began making recommendations since 1942, the real progress started with the establishment of Accounting Statements Committee (ASC) by the Institute in 1969 in the wake of public criticism of financial reporting methods which permitted diverse practices. As a result of diversity in practices some big investors had suffered heavy losses on their investments in well known companies. The main objective of ASC has been to narrow areas of difference and variety in accounting practices. The procedure used for standardisation is initiated by the issue of an

"Exposure Draft" on a specific topic for discussion by accountants and the public at large. Comments made on exposure draft are taken into consideration when drawing up a formal statement of the accounting methods for dealing with that specific topic. The statement is known as a Statement of Standard Accounting Practice (SSAP). Once the statement of standard accounting practice is adopted by the accounting profession ( the fact that a statement has been issued by the Institute in itself signifies the acceptance by the profession), any material departure by any company form the standard practice in presenting its financial reports is to be disclosed in that report. So far, nineteen statements of standard accounting practice, in addition to some exposure drafts under consideration, have been issued by the ASC. The need for evolving standards in the USA was felt with the establishment of Securities Exchange Commission (SEC) in 1933. The SEC is the Government agency to regulate and control the issuance of and dealings in securities of the companies. A research-oriented organisation called the Accounting Principles Boards (APB) was formed in 1957 to spell out the fundamental accounting postulates. The Financial Accounting standards Board(FASB) was formed in 1973. The FASB pronounces statement from time to time articulating the generally accepted accounting principles. The constant support given by SEC to FASB pronouncements has given considerable credibility to its accounting policy statement. The FASB till 1985 has issued five statement of concepts and eighty-eight statements of financial accounting standards. Standards at International Level: In view of the growth of international trade and multinational enterprises, the need for standardisation at international level was felt. An international Congress of Accountants was organised in Sydney. Australia in 1972 to ensure the desired level of uniformity in accounting practices. Keeping this in view, International Accounting Standards Committee (IASC) was formed and was entrusted with the responsibility of formulating international standards. All the member countries of IASC resolved to conform to the standards developed by IASC or at least to disclose variations from recommended standards. After its formation in 1973, the IASC has issued 40 international accounting statement todate. Another professional body, the International Federation of accountants (IFAC) was established in 1978. Attempts have also been made in countries of European Economic Community (EEC) and Canada for standardisation of accounting practices regarding disclosure and consistency of procedures.

Accounting Concepts and Standards

2.7

ACCOUNTING STANDARDS IN INDIA

With a view to harmonrse varying accounting policies and practices currently in use in India, the Institute of Chartered Accountants of India (ICAI) formed the Accounting Standards Board (ASB) in April 1977 which includes representatives form industry and government. In line with the procedure followed in other countries, the preliminary drafts prepared by the study groups and approved by ASB are circulated amongst various external agencies, including the representative bodies of trade commerce and industry. So far, twenty eight standards have been issued by ASB, a brief description of which is provided in Appendix Ito this unit. The standards are recommendatory in nature in the initial years. They are recommended for use by companies listed on a recognised Stock Exchange and other large commercial, industrial and business enterprises in the public and private sectors.

We advise that you read all or at least some of these standards in order to get a feel of that these standards are all about. What policies and procedures of accounting these standards aim to standardise and why? Do not worry if you are unable to understand some of the ideas or expressions contained in the standards. You may like to come back to these standards after you have been through all the blocks of this course in order to have a better grasp of them.

31

Accounting Framework

Regarding the position in India, It has been stated that the standards have been developed without first establishing the essential theoretical framework. Without such a framework, it has been contended, any accounting standards and principles developed are likely to lack direction and coherence. This type of shortcoming also existed in UK and USA but then it was recognised and remedied long back. In the United States the first task which FASB undertook was to develop a conceptual framework project which aimed at defining the objectives of financial reporting ( a sample of which is presented in Appendix II). This was to be followed by the spelling out of concepts and standards establishing what have been frequently referred to as, generally accepted accounting principles (GAAP). Any attempt to develop a conceptual frame work regarding the objectives of reporting will have to take into consideration the answers to the following questions: i) ii) iii) Who are the users of financial reports ? What decisions these user groups have to take? What information can be provided which would assist them to take such decisions.

The objectives, as you have already noted, depend upon the economic, social, legal and political environment of the country. At this point it will be useful for you to watch Video Programme: Understanding Financial Statement - Part I.

2.8

SUMMARY

Accounting as a field of study in its developmental process has evolved a theoretical framework consisting of principles or concepts over period of time. These concepts enjoy a wide measure of support of the accounting profession ; that is why they are known as Generally Accepted Accounting Principles (GAAP) . Several concepts and their implications for business and information users were discussed in this unit. Since the accounting principles are broad guidelines for general application, they permit a wide variety of methods and practices. The lack of uniformity in accounting practice makes it difficult to compare the financial reports of different companies. Moreover, the multiplicity of accounting practices makes it possible for management to conceal economic realities by selecting those alternative presentations of financial result which allow earnings to be manipulated. The financial statements prepared under such conditions, therefore, may have limited usefulness for several users of information. This problem has been recognised all over the world and various professional bodies are engaged in the task of standardising accounting practices. There is a movement towards consensus building even at the international level. Such professional bodies, in fact , first look at the practices used by practising accountants They then try to obtain a refinement of those practices by a process of consensus. It is in this manner that the theory of accounting is built . In India also, some headway has been made by establishing twenty eight standards for accounting practice.

2.9

KEY WORDS

Accounting framework includes generally accepted accounting principles (GAAP) or the basis of which accounting data is processed, analysed and reported. Accounting theory is a set of inter-related principles and propositions which provide a general frame work for accounting practice and deal with new developments in the area.

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Consistency concept envisages that accounting information should be prepared on a consistent basis form period of period, and within periods there should be consistent treatment of similar items. Conservatism concept forbids the inclusion of unrealised gains but advocates provision for possible losses. Entity concept separates the business from owner(s), from the standpoint of accounting. Going concern concept refers to the expectation that the organisation will have indefinite life. This assumption has an important bearing on how the assets are to be valued. Materiality concept admonishes that events of relatively small importance need not be given a detailed or theoretically correct treatment. They may be ignored for separate recording. Money measurement concept ignores intangibles like employee loyalty and customer satisfaction as they cannot be expressed in money terms. It also assumes records on the basis of a stable monetary unit. Objectivity principle requires that only the information based on definite and verifiable facts be recorded.

Accounting Concepts and Standards

2.10 SELF-ASSESSMENT QUESTIONS/EXERCISES

1. 2. 3. 4. 5. 6. 7. Examine the role of accounting concepts in the preparation of financial statements. Is it possible to give a true or a fair view of a company's posrtion using accounting information? Do you find any of the accounting concepts conflicting with each other ? Give examples. In what way can accounting information help in the proper allocation of resources? Why accounting practices should be standardises? Explain. What progress has been made in India regarding standardisation of accounting practices? Answer whether the following statement are true or false: a) b) c) d) The materiality concept refers to the state of ignoring small items and values from accounts The generally accepted accounting principles prescribe a uniform accounting Practice. The conservatism concept leads to the exclusion of all unrealised profits. Statements of Standard Accounting Practice, were formulated by the Financial Accounting standards Board of USA. The Securities Exchange Commission of USA has played an important role in evolving the conceptual framework for accounting Making entries in the books of accounts a code of conduct for the accounting profession general principles for the preparation of accounting information planning and control of enterprise operations none of the above. True/False True/False True/False True/False

e)

True/False

8.

Conceptual frame work of accounting implies i) ii) iii) iv) v)

33

Accounting Framework

9.

Accounting Standards are statements prescribed by i) ii) iii) iv) v) Law Government regulatory bodies bodies of shareholders Professional accounting bodies none of the above

10.

Accounting concepts are i) ii) iii) iv) broad assumptions Methods of presenting financial accounts bases selected to prepare a specific set of accounts none of the above The Rs, 1,00,000 figure for inventory on a Balance Sheet is the amount for which is could be sold on the balance sheet date. The Balance Sheet of a retail store which has experienced a gross profit of 40% on sales contains an item of merchandise inventory of Rs. 1,15,00,00(Mechandise inventory ( at cost) Rs. 69,00,000. Company M does not charge annual depreciation, preferring instead to show the entire difference between original cost and proceeds of sale as a gain or loss in the period when the asset is sold. It has followed this practice for many yea's.

11.

Name the accounting concept violated, in any of the following situations: a) b)

c)

Answers to Activities
1. If separate entity concept ` is not observed, it becomes difficult to calculate the profitability of business and ascertain its financial position. It would be particularly difficult if the owner has several distinct businesses. Proprietory withdrawals reduce the capital of the enterprise unless they are in lieu of anticipated profits. It is not proper to show them as operating expense. They are also not admissible as deductions form profits for tax purposes. No, the money measurement concept does not permit the recording of such events What effect this event will have on the business cannot be objectively determined Revaluation violates several concepts like, cost concept, conservatism concept and continuity concept. To take credit for an extraordinary gain like this, is normally, not considered justified. However, were substantial gap exists between historical cost of a fixed asset and its market value, it has been observed that the accounting profession has been supporting such revaluations so that balance sheet could show a realistic position of the enterprise It should be taken into account otherwise profit would be overstated. It should be taken into account otherwise profit would be understated. It violates the consistency concept unless there is a solid reason for departing from the earlier practice.

2.

3.

4.

5. 6. 7.

Answer to self-assessment Questions Exercises 7. a) False, b)False, c)True, d) False, e) True. (iii)

34

8.

9. 10. 11.

(iv)

Accounting Concepts and Standards

(i)
(a) conservatism concept, (b) no violation, (c) periodicity concept.

2.11 FURTHER READINGS

Maheshwari, S.N. and S.K. Maheshwari, 2000. Financial Accounting, Vikas Publishing House: New Delhi (Chapter 2) Anthony, Robert, N. and James Reece, 1987. Accounting Principles, All India Traveller Book Seller : New Delhi ( Chapters 1-3) Meigs, Walter, B. and Robert F. Meigs,1987. Accounting. The Basis for Business Decisions, McGraw Hill: New York ( Chapter 1) Hendriksen, E. S., 1984. Accounting Theory, Khosla Publishing House Delhi (Chapters 2,3 and 6)

35

Accounting Framework

Appendix I Accounting Standards Board

Institute of Chartered Accountants of India (ICAI) has so far issued twenty eight standards: Framework for the Preparation and Presentation of Financial Statements (AS 1) Disclosure of Accounting Policies (AS 2) Valuation of Inventories (AS 3) Cash Flow Statements (AS 4) Contingencies and Events Occuring after the Balance Sheet Date (AS 5) Net Profit or Loss for the period, Prior Period and Extraordinary Items and Changes in Accounting Policies Announcement-Limited Revision to Accounting Standards (AS) 5 (AS 6) Depreciation Accounting (AS 7) Accounting for Construction Contracts Revised Accounting Standard (AS) 7, Construction Contracts, 28-05-2002 (AS 8) Accounting for Research and Development (AS 9) Revenue Recognition (AS 10) Accounting for Fixed Assets Announcement- Status of certain provisions of AS 10, Accounting for Fixed Assets pursuant to the issuance of AS 19, Leases and As 16, Borrowing Costs (AS 11) Accounting for the Effects and Changes in Foreign Exchange Rates (AS 11) (Revised 2003). The Effects of Changes in Foreign Exchange Rate 21-02200 (AS 12) Accounting for Government Grants (AS 13) Accounting for Investments (AS 14) Accounting for Amalgamations (AS 15) Accounting for Retirement Benefits in the Financial Statement of Employers (AS 16) on Borrowing Costs (AS 17) Segment Reporting Disclosure of corresponding previous year figures in the first year of application of Accounting Standards (AS) 17, Segment Reporting Accounting Standard 18, Related Party Disclosures Applicability of Accounting Standards (AS) 18, Related Party Disclosures (AS 19) Leases (AS 20) Earnings Per Share (AS 21) Consolidated Financial Statements (AS 22) Accounting for Taxes on Income Clarification on Accounting Standards (AS) 22, Accounting for Taxes on Income (AS 23) Accounting for Investments in Associates in Consolidated Financial Statements

36

(AS 24) Discontinuing Operations

Announcement- Accounting Standards (AS) 24, Discontinuing Operations (AS 25) Interim Financial Reporting (AS 26) Intangible Assets (AS 27) Financial Reporting of Interests in Joint Ventures (AS 28) Impairment of Assets 30-05-2002 For further details, please visit : http://www.icai.org/resource/o_ac_standard.html

Accounting Concepts and Standards

37

Accounting Framework

Appendix II Financial Accounting Standards Board (FASB)

Concepts No. 1: Objectives of financial reporting by business enterprises' The three objectives which are included in concepts No. I are reproduced below: 1) Financial reporting should provide information that is useful to the present and potential investors and creditors and other users in making rational investment, credit and similar decisions. The information should be comprehensible to those who have a reasonable understanding of business and economic activities and ai willing to study the information with reasonable diligence. Financial reporting should provide information to help present and potential investors and creditors and other users in assessing the amounts, timing and uncertainty of prospective cash receipts from dividends or interest and the proceeds from the sale, redemption, or maturity of securities or loans. Since investors' and creditors' cash flows are related to enterprise cash flows, financial reporting should provide information to help investors, creditors and others, assess the amounts, timing, and uncertainty of prospective net cash inflows to the related enterprise. Financial reporting should provide information about the economic resources of an enterprise, the claim to those resources (obligations of the enterprise to transfer resources to other entities and owners' equity), and the effects of trans-action, events, and circumstances that change its resources and claims to those resources.

2)

3)

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UNIT 3

ACCOUNTING INFORMATION AND ITS APPLICATIONS

Accounting Information and its Applications

Objectives After studying this unit, you should be able to appreciate the: nature of accounting information major purposes of accounting information; role of information in the control process; the uses of earnings information; and uses of information contained in balance sheet.

Structure 3:1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 3.10 Introduction Purposes of Accounting information Accounting and Control in Organisation Profit and Cash Balance Distinguished Uses of Earnings information Uses of Balance Sheet Summary Key Words Self- assessment Questions/Exercises Further Readings

3.1

INTRODUCTION

As you have observed in Unit I, historically, accounting developed as a system for reporting information to the owners including shareholders and other investors of the business. In the process of its evolution, accounting has branched off into two distinct directions- one dealing with information processing for external uses and the other dealing with information processing for internal (or managerial) uses. We refer to the first one as financial accounting and the second as managerial accounting. But when we talk about accounting information, we generally look at it in a broader sense to encompass information processing for both internal and external uses. In this unit we shall deal with some illustrative uses of accounting information so as to give you a feel of what accounting could contribute.

3.2

PURPOSES OF ACCOUNTING INFORMATION

At the outset, let us share with you that accounting information is useful for (1) score-keeping, (2)attention-directing, and (3) problem-solving . Let us ask a question: What precise information should the accountant provide for these purposes? Obviously, the type-coverage of information needed may vary from organisation to organisation. Further, the specific information needs in the actual decision-making process at different organisational levels influence the scope of an accounting information system.

39

Accounting Framework

Score-keeping: The score keeping function is one of the primary purposes of accounting information. It basically deals with the financial health of the enterprise. In other words, it answers: How are we doing ? Good , bad, or indifferent? Though it appears to be a simple question, a moment's reflection will show that it is not that simple. It involves answering questions such as : What is doing good? What is doing bad? Is profit earned good? If so, how much? Is it that profit alone is not sufficient? Thus we can go on increasing the string of questions intending to further clarify the basic question. Thus, score-keeping has two aspects, one is that of keeping record of actual data on performance- a constant process of measurement and valuation. The other aspect is concerned with putting the data in relation to predetermined standards. In order to answer the question whether the performance is good, bad or indifferent we have to have a constant process of comparison against some norms, standards or benchmarks. This is achieved by preparing a series of reports based on comparison of actual data with the planned data.

Activity 3.1
Complete five questions (two are already given below ) that will lead to the assessment of the financial health of a business organisation. 1. 2. 3. 4. 5. How much profit was made by the organisation in the preceding accounting year? Does the organisation have sufficient funds to meet its day to day expenditures?

Attention directing : Attention-directing is nothing but the process of giving a signal to the user of accounting information about the need to take a decision. As such the accounting information supplied arouses the user's attention to take a decision. For example, a report from an accountant comparing the actual performance data against budget data is a score-keeping record. In the hands of a decision-maker it is an attention-directing information. This would enable him to immediately focus his attention on the deviations or variances from the budgets or the plans. A whole series of actions will be triggered by this, namely, evaluation of reasons for the deviation, remedial actions to be taken, modifications in the feedback for future and so on Most of the formal reporting takes the form of annual reports. An annual report is the score card of activities for an accounting period. If properly analysed, this report can be helpful in understanding the problems of overall nature faced by the enterprise. It can also help the shareholders in assessing the actual performance of the company vis-avis their expectations. Problem-solving : The problem-solving function of accounting information involves provision of such information which enables the manager to find solutions to the problems. There are many problems which accounting information could highlight and provide for their possible solutions, such as make or buy decision with respect to component, parts or products, continue or drop decisions with respect to product lines leasing or acquisition decisions with respect to assets etc. Problem-solving is therefore an important purpose of accounting information system. Let us summarise the purposes of accounting information: Accounting, in its score card role, accumulates data and enables interested persons, both internal and external, to understand and take stock of the organisation's performance

40

In its attention-directing role accounting information, by reporting and analysing the data, focuses a manager's attention on operational deficiencies, weaknesses, threats and opportunities. In this role accounting complements day to day operational planning and control activities. In its problem-solving role, accounting enables quantification of the different alternative solutions, their relative merits and demerits.

Accounting Information and its Applications

Activity 3.2
Fill in the blanks: 1) 2 3 4) 5) Financial accounting deals with reporting information for ..uses and deals with reporting information for managerial uses. Accounting information addresses itself to three distinct activities (i).(ii)....(iii)... Score-keeping activity involves two functions, first, keeping ..and second a constant process of. Attention-directing information triggers the need for takingin the recipient's mind. Problem-solving in accounting involves provision of..to enable managers to find..to problems.

3.3

ACCOUNTING AND CONTROL IN ORGANISATION

In this course we shall deal with financial and management accounting together. You, probably know that both these branches of accounting, after all, are concerned with providing information about the same business. One of the tasks of the management is to control the operations of the organisation. Accounting is closely connected with control system in an organisation. To understand this, let us have a look at the control system in an organisation as shown in Figure 3.1. You know that the organisation is a system of inter-related parts and is linked with the environment. It derives its inputs from the environment and transforms them with the help of the operating system into outputs which it delivers to the environment. To control organisational system, we have first to measure inputs, operations and outputs. The measurements obtained men have to be evaluated against standards. This information has to be supplied to the concerned managers so that they could take appropriate actions form future point of view. In all these activities i.e, measuring evaluating and providing feedback the accountant is deeply involved. The process of evaluation brings out deviations which provide the basis for feedback in a system and lead to changes in inputs for operations to achieve desired outputs.

Figure 3.1

Structure of Control in an Organisation.

41

Accounting Framework

The annual accounts or financial statements of a business comprise balance sheet and profit and loss account. Sometimes they also include the fund flow statement. All these statements have only historical significance since they relate to an accounting period which has already expired. However, balance sheet and profit and loss account provide valuable information linking the profit to investment or assets used in business. We try to measure organisational performance using this information. The idea of relating profit to asset use can provide a basis for judgement about the efficiency of an organisation. As business often operates in an environment of uncertainty, estimation of `normal' profit is not easy. By making the best use of accounting information of the past in relation to the expectations of future, we try to make integrated financial plan for an organisation. Such plan includes projections about level of activity, resource, profit, financial assets, and car resources. From Figure 3.1 it is obvious that controller (or accountant) and managers obtain such information which enables them to diagnose the situation and to identify and define the problem at hand. Let us try to identify and define a problem in a hypothetical setting. Suppose you are managing a firm which sells three products p1, p2, p3,. You are confronted with a problem that the profit of your firm is decreasing. Now falling profit may be. due to many reasons. The first thing that you would like to do is to identify the problem more precisely before you set about solving it, Some of the possible hypotheses are: which of the three products is losing money? Are all of them losing money? If all of them are losing money, are they losing money to the same extent? Is the firm losing money due to increasing cost or decreasing prices? Many such question would enable you in diagnosing the problem more accurately. In general, such questions enable a manager to specify the causes of the problem. Let us examine how the accounting information could be helpful in identifying a problem of this nature. The following table is the summarised profit and loss account of a firm whose situation has been described above. Figures in Rs. Year Sales Less: Cost of goods Depreciation Other operating expenses Profit 400 200 100 700 300 500 200 100 80 200 2002 1000 2003 1000

From the above, it is clear that in one year the profit has declined by Rs. 100. An examination of the profit and loss account would show' that sales have remained the s a m e a n d all expenses other than the cost of goods sold have also remained the same: We are now in a position to state the problem thus: Problem : Decrease in profits during the period has come about as a result of overall increase in the cost of goods sold. If the organisation was dealing with a single product, the problem is easily identifiable. But as it is dealing with three products, you have to answer the question: Which product is losing money? The product-wise accounting information with respect to . sales and costs can help us in identifying the problem better.

42

Year Products Sales Less: Cost of sales Gross Profit P1 300 150 150

2002 P2 300 150 150 P3 400 100 300 400 200 200

2003 P3 400 200 200 P3 200 100 100

Accounting Information and its Applications

(Please recall that other costs which are common to all the products did not change) With the above additional information on different products you can now redefine the problem more precisely Problem: Sales of P1 and P. have increased. Cost of sales retains the same relationship with sales. 2. Sales of P3 had decreased. Cost of sales in relation to sales had doubled. 1

What we have done is nothing but a very simple use of accounting information to pin-point the problem so that we could initiate action.

3.4

PROFIT AND CASH BALANCE DISTINGUISHED

How do we evaluate the results of a firm ? The answers could be many depending on what your interests are. But there is no difference of opinion regarding two important aspects. 1. 2. What is the worth of the business? How much does it earn?

The results of-these two inquiries usually become the basis for several decision of the management and their action plans. The initiatives the management takes in connection with improving the profitability of the enterprise and its worth will, in a large measure, be a reflection of managerial effectiveness.

Illustration
Shyam decided to start a small casting and machine shop. He undertakes job orders . for castings. He hired a shop floor with a backyard, bought the necessary equipment and hired a few workers. Shyam though he had very successful operation during the first year, because he was engaged throughout the year. He tried to prepare his accounts and discovered that his collection from customers was Rs. 24,000 and he had borrowed Rs. 30,000 from the bank. He had spent Rs. 72,000 for running the business. He had run down his savings substantially (Exhibit 3.1). Shyam discussed the situation with his friend who is a graduate student of management. He worked out Shyam's operating results for the period (Exhibit 3.2). Exhibit 3.1 Shyam Enterprises Summary of Cash transactions Receipts Receipts from bank loan Collections from customers Figures in Rs. Payments 30,000 Wages to employees 12,000 36,000 24,000 Materials purchased Payment of installment for 5,000 equipment purchased 1,000 Electricity charges 15,000 Withdrawals for personal use 3,000 Other Payments for Expenses 54,000 72,000 Rs. 18,000

Excess payments over receipts

43

Accounting Framework

Shyam's friend with the help of Exhibit 3.2 could convince Shyam that the situation not very bad. For proper appreciation of the situation he gathered several pieces of information, as given below: 1. He made sales of Rs.36,000 (at selling price), one-third of it (Rs.12,000) is yet be collected. In other words, on an average 4 month's sales remain uncollected. Even though he purchased materials worth-Rs. 36,000 he consumed only onehalf of it for- production and sales. In other words, materials sufficient for one yea consumption remain in inventory. Cash generation during the year was Rs.54,000 whereas the need for payment amounted to Rs. 72,000 Exhibit3.2 Shyam Enterprises Operating Summary Figures in Rs. Collections from sales Sales yet to be collected Less: Cost of sales: Purchases of materials paid Inventory at close Wages Electricity Other expenses Total expenses Net profits 24,000 12,000 36,000 36,000 18,000

3.

18,000 12,000 1,000 3,000 34,000 2,000

Exhibit 3.2 is based on the additional information presented above and shows that shyam has made a profit of Rs. 2,000 on sales of Rs.36,000. You will appreciate that there is a fundamental difference in approach and utility of information contained in the two Exhibits. While Exhibit 3.1 looks at the problem purely from the viewpoint a increases and decreased in cash. Exhibit 3.2 summarises all the revenues and expensed which belong to the period of one year irrespective of whether or not all the revenues have been received in cash and whether or not all the expenses have been paid in cash In fact, in doing so we are making practical use of Accrual Concept (discussed in the preceding unit) and principles of revenue recognition ( discussed in unit 5). You may note that cash balance is not synonymous with net profit earned by the business. A business firm might have earned a profit and still be short of cash and vice-versa. In this particular example you have seen that the business has earned a profit of Rs. 2,000 but without cash balance showing any surplus. In fact, payments, as shown in Exhibit 3.1, have far. exceeded in receipts. The excess of payments over receipts amounted to Rs.18,000 and this deficit was financed through the personal savings of Shyam. Since payments can never be more than receipts, the deficit must have been made good through Shyam's personal sources. This subject will be further expanded in Unit 6 dealing with funds flow and cash flow analysis.

3.5

USES OF EARNINGS INFORMATION

The earnings information is useful for (1) measuring accomplishment, (2) deciding how much could be withdrawn from the business without impairing its current level of

44

operations, (3) identifying the problems. and (4) determining a market value for the enterprise. Accomplishments : Profit is an important indicator of the accomplishment of business. Other things remaining the same, higher the profits greater is the accomplishment. Accomplishment of Shyam's enterprise can be summarised as follows: It has earned a net profit of Rs. 2,000 during the year (Exhibit 3.2) At the same time, it should be seen from Exhibit 3.1 that there is a severe cash constraint. Understandably, it was the start up situation which might have been responsible for the cash constraint. The profit earned in the very first year of operations shows that the business could be viable. But Shyam will have to predict several aspects such as whether sales can increase, whether costs remain the same, whether the earnings rate remains the same, and so on. At the same time, he will have to ensure better management of his cash resources. Appropriation Decision : An important question with which owners of a business are often confronted is: How much money can be withdrawn without impairing its current level of operations? This question in fact is concerned with appropriation decision. A prudent management would not only like to maintain the capital or the present capability of the enterprise intact but would also plan for future growth. The maximum amount that the owners can withdraw from business for their personal expenses should be I limited to the amount of earnings which remain after making good all the resources that have been used (or consumed) in the process of generating those earnings. In other words, it is the net profit after charging depreciation and all other losses incurred in the course of business operations that is available to the owners for withdrawal, provided the business has no tax liability. In case the business has tax liability the amount that can be withdrawn will be reduced by the estimated amount of tax liability. Thus, the remainder is the amount which is available for withdrawal without impairing its current level of operations. However, if business has any plan for future growth, the amount available for withdrawal by or distribution among owners shall be further reduced by a portion of profit ( or cash) needed for future growth depending upon the judgement of the management . in this context, the withdrawal by Shyam of Rs.15,000 against a profit of Rs.2,000 cannot be defended. Problem Identification Using Earnings Data: From the earnings data several problem areas can be identified. This is best done by computing ratios i.e, by examining the relationship of one item of earnings statement with another item. This will be taken up in details in a subsequent unit. At this stage it may only be stated that the lower earnings may be on accounts of excessive cost of inputs, excessive expenditure on overheads or low margin of profit on sales or excessive piling of inventories or other unanticipated losses. Insofar as Shyam's enterprise is concerned, we can identify two problems even from the very limited data that we have regarding his business. They are: 1) The inventory acquisition was not in tune with production and sales. This has led to large amount of accumulated inventory to the tune of one year's consumption. Credit granted to customers, shown by credit sales, amounts to four months, sales. This shows either grant of credit on liberal terms or slow collection of receivables.

Accounting Information and its Applications

2)

However, an analysis of operating summary along with cash summary will show that the business is facing a cash crisis since the present cash needs and cash availability are not in tune with each other. Determining the market value of a Firm: You will recall that we have viewed the business as a distinct operating entity. The economic value of the firm is determined

45

Accounting Framework

by the size and reliability of the stream of earnings (cash flows) produced by the business. Let us attempt the valuation of a hypothetical firm. Bharat Kitchenaids, which was incorporated as a company in 1998 by four non-resident young Indians to market a simple but revolutionary cooking gas lighter invented by one of its founders. In order to conserve its limited capital the company opened its business in rented premises with Rs.80,000 worth of equipment used mainly for research and development work. Arrangements were made with an established manufacturer to make the gas lighter on order under rigid supervision of one of the members of the young team. Because the gas lighter was able to meet a long felt need, the company reported a modest profit in its very first year of operations. The four-man team was remarkably well balanced combining talents in engineering research, marketing and management. In the next two years they developed three more appliances that were well received in the market. By 2003 the turnover had grown to about Rs. crore and net profit amounted to Rs. 14 Lakhs. At this point the total investment (or equity) of the owners amounted to Rs.32 lakhs. Annual earnings, therefore, represented an after tax rate of return of approximately 4 4 per cent of the equity. The high return could be attributed to using the facilities of other manufacturers rather than building their own, the patents that the company registered and the scientific and managerial skill the team possessed. An interesting development then took place. A large manufacturer in the household goods sector wanted to acquire the company and offered the owners a very attractive price. The four owners wanted to consider the offer (and make a decision) but asked for a few weeks time to make up their mind. The owners knew that they had established a solid position in the industry and had no doubt that they would be able to maintain this position. They, however, felt that the potential for further growth was limited . They drew very good salaries which they would continue to enjoy even if they were to sell the business. To work how much equity in the Bharat Kitchenaids was worth to them so that they . could take a decision on the price offered, the four men started by forecasting the company's future profits or cash flows( we shall assume here that the figures of profits and cash flows are the same). They believed that the net profit would continue to be around Rs.14 lakhs each year for the next 10 years. Further, if they did not sell out in 2004, they could sell their interest in business (that is their equity) 19 years later for about Rs.50 lakhs. In accordance with these estimates the anticipated net earnings from continued ownership would be as follows: Year 1 to 10 10 Earnings 14 lakhs a year 50 lakhs

You know that money has time value. You attach more value to an amount to be received now than the one to be received, say, a year or two later. Rs. 14 lakhs of profit to be received in the second year will be of lesser value to you than Rs. 14 lakhs to be received in the first year. Similarly Rs. 14 lakhs to be received in the third year will be of lesser value to you than Rs.14 lakhs to be received in the second year, and so on. In other words, the value of amounts to be received in future will progressively decline as time passes by. The process of reducing the future earnings to present values is known as discounting, but for this purpose a discounting rate is required. The discounting rate is nothing but the return which the owners desire to earn on their investment. The desired rate of return in a way is a rate of return which satisfies the owners of investment. The owners in this case thought that the rate of 15 per cent after taxes was a satisfactory return on investment for the type of business they were engaged in. The question

46

before them was how much the anticipated earnings were worth presently at this rate. A t 15 per cent desired rate they calculated the present value of the stream of earnings of Rs. 14 lakhs a year for ten years plus Rs.50 lakhs they were to receive at the end of 10th year. They found that the present value was Rs.82.62 lakhs. You must be wondering how they calculated this figure. The mechanics of calculating the present value of future earnings (or cash flows) will be explained in Unit -15 (Block-4). Till then we ask you to hold your inquisitiveness. However, in accordance with the concept of present value that we have just explained, you will agree with us that the present value of earning of Rs.140 laths to be received over a period of 10 years and lump sum of Rs. 50 lakhs to be received at the end of 10th year. i.e., a total amount of Rs. 190 lakhs, must be considerably less than this amount. Under these assumptions, therefore, the owners would not accept an offer of an amount less than say Rs. 80 lakhs which is the present value of the business or their equity. However, if the owners feel that Bharati Kitchenaids would continue to produce Rs. 14 lakhs a year indefinitely if it is managed adequately, the present value can be calculated simply by dividing the annual earnings by the desired rate of return:

Accounting Information and its Applications

On this basis the value of owner's business would be 93.33 lakhs. The process of ascertaining the value of business with the help of earnings and a desired rate of return is also known as the capitalisation of earnings. It means that if Rs. 93.33 lakhs is paid for infinitely long series of payments of Rs. 14 lakhs a year, the rate of return on investment will be 15 per cent:

3.6

USES OF BALANCE SHEET

The balance sheet is a summary of a firms' assets and liabilities, including share capital and reserves at a defined moment in time. That is why it has been described as a snapshot or still picture of the financial position of a business entity. It is also called the position statement. In addition to profit and loss account, the various groups interested in the company can also draw useful inferences form an analysis of the information contained in the balance sheet. Shareholders usually have twin interests: an interest in receiving a regular income and an interest in the appreciation of their investment in shares. The market worth of their shares depends not only on the dividends they receive but also on the extent of retained earnings which the company has accumulated over the years. The materialisation of the shareholders' expectations regarding bonus shares also depends on the retained earnings built up by the company. Investment decisions of the prospective investors and disinvestment decisions of the existing investors are influenced by the composition of assets and liabilities shown in the balance sheet. The main interest of the trade creditors, centres on the liquidity position of the company. They would like to make an assessment as to whether the company will be able to meet its obligations when the occasion arises. They are, therefore, concerned about the working capital available with the enterprise and its cash resources. All this information can be gleaned form the balance sheet. The interest of long-term creditors lies in two things; they are interested in the regular servicing of their debts ( that is payment of periodic interest) and repayments of their loans after the expiry of stipulated period.

47

Accounting Framework

They are interested not only in the profitability of the enterprise but also in its longterm solvency and financial viability. A study of the balance sheet of the company over the past several years can yield a lot of useful information to such long -term investors. Similarly, other interested parties like regulatory and developmental agencies of the Government, consumer and welfare organisations can derive useful conclusions from a study of the balance sheet about the working of the corporate sector and its contribution to the national economy. It should be emphasised here that it is not the profit and loss account and the balance sheet in isolation with each other but both of them in conjunction with each other that can yield a harvest of information for the interested parties or analysts. All this pertains to the broad area of analysis of financial statements which will be taken up in details in a subsequent unit. Activity 3.3 1 Mention four important uses of earnings information. i). ii) iii)... iv)... 2. Mention the three parts into which net profits are usually appropriated. i). ii) iii)... 3. Value of a firm is determined mainly on the basis of of earnings.

3.7

SUMMARY

Accounting information system addresses itself to three important business related problems, namely, score-keeping , attention-directing and problem-solving . Accounting information acquires relevance only in the context of an organisation. In this context accounting is closely related to control, Accounting helps in the process of guiding actions of the organisation into desired directions. In the process of initiating control actions, it helps the whole gamut of activities involving planning, organising and controlling. There may not necessarily be an exact correspondence between cash balance and the profit earned during an accounting period. The earnings information is useful for several purposes. It helps in measuring achievement of business and its management. It provides a basis for appropriation decisions and for determining the market value of the firm. It helps to identify the problems currently faced by the enterprise. They balance sheet reflects the financial position of the enterprise. It provides useful information to various users of information who might be interested in the firm. A proper analysis of the information contained in the balance sheet can enable them to draw conclusions which in turn help them in taking decisions.

48

3.8

KEY WORDS

Problem-solving role of accounting consists of supplying such information as would be useful to managers for taking a variety of routine and non-routine decisions. Profit and loss Account is a summary of the revenues and expenses, including gains and losses from extraordinary items of a business unit for an accounting period. Balance Sheet is a statement of financial position of a business unit disclosing an. given moment of time its assets, liabilities and ownership equities. Appropriation of net profit means the (allocation) disposal of net profit for various purposes. In the case of non-corporate entities, the net profit is distributed to the owners. In the case of corporate entities usually a part of the net profit is provided for estimated tax liability, a part is retained in business to strengthen its financial position and for, future growth, a part is distributed to shareholders in the form of dividends and any amount left is carried forward to the next ,period.

Accounting Information and its Applications

3.9
1. 2. 3.

SELF-ASSESSMENT QUESTIONS/EXERCISES

What are the purposes of accounting information? Explain briefly. What purpose, in your opinion, is the most important and why? "Accounting is closely connected with control". Elaborate the statement and discuss the role of accounting feedback in the process of control. Explain the uses of earnings information. Can you think of uses other than the four uses mentioned in this unit? 4. 5. What is a Balance Sheet and what information it conveys to an outsider? What groups of people would be interested in accounting reports and why?

6.

"An outsider, who reads the data relating to the business as revealed by the accounting statements, tends to assume that accounting gives an exact picture of the business." Utilising your understanding of accounting concepts, including the limitations imposed by such concepts on accounting information, discuss the above statements with your fellow students/accounting colleagues/office friends. Ram invested Rs.20,000 of his own money in small service business and borrowed another Rs. 10,000 from a bank, also for business use. At the end of his first year of operations, he found that there was Rs.34,000 in the enterprise's bank account. He owed his suppliers Rs. 6,000 and had not repaid the bank loan. His business assets other than cash were negligible. During the year he had paid himself his salary of Rs. 12, 000. a) What conclusions would you draw about his first year's operations?

7.

b)

For what decisions would this information be used? What additional information would the decision makers be likely to call for in making these decisions?

Answers to Activities
Activity 3.2 1. 2. 3. 4. 5. External, management accounting. (i) Score-keeping, (ii) attention-direction and (iii) problem-solving. Records of actuals, comparison. Decisions. Information, solutions.

49

Accounting Framework

Activity 3.3
1. (ii) (iii) (iv) (i) Measuring accomplishment,

Profit distribution Identifying problems Market valuation of the firm

2.

(i) (ii)
(iii)

Taxation Distribution to owners

Retained earnings

3.

Future stream

3.10 FURTHER READINGS

Paul D. Kimmel, Jerry J. Weygandt, Donald. E. Kieso, March 2003. Financio Accounting: Tools for Business Decision Making, 3rd Edition. Wiley Pub ;hers : Canada. Meigs, Walter, B. and Robert F. Meigs, 1987. Accounting: The Basis for Business Decisions, McGraw Hill: New York (Chapter 1) Gray, Jack and Kenneth S. Johnston, 1977. Accounting and Management Ac 9n, Tata McGraw Hill: New Delhi (Chapter 2).

50

UNIT 4

CONSTRUCTION AND ANALYSIS OF BALANCE SHEET

Construction and Analysis of Balance Sheet

Objectives After having studied this unit, you should be able to: understand and explain the terms used in a balance sheet classify the different assets, liabilities and capital accounts as they would appear on a balance sheet. apply simple principles of valuation of assets understand the idea of balance sheet equation.

Structure 4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9 Introduction Conceptual Basis of a Balance Sheet Constructing a Balance Sheet Balance Sheet Contents Form and Classification of Items Summary Key Words Self-assessment Questions/Exercises Further Readings

4.1

INTRODUCTION

One of the basic objectives of accounting is to convey information. This is achieved by different accounting reports prepared by an entity. One of the most important reports is the Balance Sheet. Balance sheet is concerned with reporting the financial position of an entity at a particular point in time. This position is conveyed in terms of listing all the things of value owned by the entity as also the claims against these things of value. The position as represented by the balance sheet is valid only until another transaction is carried out by the entity.

4.2

CONCEPTUAL BASIS OF A BALANCE SHEET

The above concept can be elaborated by an example. I want to purchase a car costing Rs. 8,00,000. To do so, I have to borrow. A bank agrees to finance me if I can invest Rs. 3,00,000 on my own. Now let us follow the sequence of events when I approach the bank with the proposal. Granting my ability to repay the loan, the banker will ask two specific questions: 1. 2. What are the things of value you own? How much do you owe, and to whom?

Understanding Financial Statements

In other words, the banker would like to know what I am worth in material terms. My replies to the questions could be tabulated as follows: Things of value owned by me Rs. Balance with bank 3,50,000 Fixed deposits 1,50,000 Other personal belonging 5,00,000 10,00,000 Amount owned by me Rs. Personal loan from friend 1,00,000

1,00,000

This implies I own Rs. 10,00,000 worth things of value, Rs. 3,50,000 of this could be withdrawn at any time in cash. We say I have Rs. 3,50,000 in liquid form. Another Rs. 1,50,000 is in monetary investment and the remaining Rs. 5,00,000 is in nonmonetary property. Further, I owe Rs. '1,00,000 to friend of mine. In other words, he has got a claim against the things of value owned by me to the extent of Rs. 1,00,000. In brief, we can say I am worth Rs. 10,00,000, claim against my worth is Rs. 1,00,000 and hence my net worth is Rs. 9,00,000. This implies Rs. 9,00,000 is my own claims against the things of value owned by me or my net worth. Now I can present my financial position in the following form: Financial Position Statement 1 Things of value owned Rs. Balance with bank Fixed deposits Other personal belongings 3,50,000 1,50,000 5,00,000 10,00,000 10,00,000 Own claim or net worth Claims against things of value Rs. Personal loan from friend 1,00,000 9,00,000

Now that the bank grants me the loan of Rs. 5,00,000 and I buy the car for Rs.8,00,000. After purchase of the car my financial position statement will change as follows: Financial Position Statement 2 Things of value owned Rs. Balance with bank Fixed deposit Car Other personal belongings 50,000 1,50,000 8,00,000 5,00,000 15,00,000 15,00,000 Personal loan from friend Own claim or net worth Claims against things of value Rs. 1,00,000 9,00,000 Mortgage loan from bank. 5,00,000

Now, as a result of this transaction my worth has increased from Rs. 10,00,000 to Rs. 15,00,000. However, since there is also an equal increase in claims against my worth in the form of mortgage loan from the bank, my net worth remains the same. Things of monetary value possessed by an entity are referred to as assets. Accountants use the term assets to describe things of value measurable in monetary terms.

The amount owed by an entity or individual which represent claims against it or his assets by outsiders are liabilities. It is the claims of outsiders which are legally enforceable claims against an individual or entity that are referred to as liabilities. The assets owned by the entity, less liabilities or outsider's claims, is the net worth. Since the net worth represents the claims of owner(s) in case of an entity, it is referred to as owner's equity. Now we can understand that the position statement is a summary of the assets, liabilities and net worth as of a specific point in time. A comparison of the two position statements before and after purchase of the car will help to clarify some of these ideas better. Comparative Financial Position Statement Assets Liabilities and Net Worth Before After Before After I II I II Balance 3,50,000 50,000 Personal loan 1,00,000 1,00,000 from friend with Banks Fixed Deposits 1,50,000 1,50,000 Mortgage loan - 5,00,000 from bank Car - 8,00,000 Other personal 5,00,000 5,00,000 Net Worth 9,00,000 9,00,000 belonging 10,00,000 1,50,000 10,00,000 15,00,000 The following points may be noted from the above example: 1. Even after purchasing the car, my net worth remains the same. This is due to the fact that increase in assets of Rs. 5,00,000 was balanced by increase in liability of Rs. 5,00,000. However, it could be noticed that the Rs.3,00,000 spent from my savings amount to only a transformation of my assets from bank deposit to motor car. Outsiders' claim has priority over the owners' claim on the assets and hence net worth or owner's equity is a residual claim against assets. It follows from this that at any point in time, owners equity and liabilities for any accounting entity will be equal to assets owned by that entity. This idea is fundamental to accounting and could be expressed as the following equalities: ASSETS = LIABILITIES + OWNERS EQUITY OWNERS EQUITY = ASSETS - LIABILITIES (1) (2)

Construction and Analysis of Balance Sheet

2.

It could easily be visualised that the position statements we prepared are nothing but the equality (I). In simple terms, a position statement which shows the balance between assets owned by an entity and its liabilities and owner's equity is referred to as a balance sheet. Our position statements were based on a personal situation and a single transaction. In a business situation there can be scores of such transactions. However, these impacts could be reflected on the fundamental equality in the same way. This equation represents the corner-stone on which the accounting edifice is built. It shows the duality represented by `benefit-sacrifice' from the point of view of an entity. In other words, assets of an entity, are always equal to the claims of the outsiders and owners. This equality enables us to reduce impact of all transactions in term of the following possibilities: 1. 2. 3. 4. An increase in assets is followed by an increase in liabilities and/or equity and vice versa. A decrease in assets is followed by a decrease in liabilities and/or equity and vice versa. An increase in an asset is followed by a decrease in another asset and vice versa. An increase in a liability is followed by a decrease in another liability and vice versa.

Understanding Financial Statements

Activity 4.1 Please answer by completeing the blanks. 1. An increase in assets in a position statement is possible: a) b) c) 2. An increase in liability could result in: a) b) c) 3. Outsiders claim against assets of an entity is called: .. 4. Things of value to the entity are called by accountants as: ..

Activity 4.2
Mark whether the following statements are `True' or `False' by circling T or F opposite each statement. 1. An increase in asset always results in increase in owner's equity 2. Assets = liabilities + owner's equity is always true 3. Outsiders claim against business is a residual claim 4. An increase in assets could be equalled by increase in liabilities 5. Losses result in increase in owner's equity 6. All assets in the balance sheet are valued at their realisable value Activity 4.3 Answer the following questions by filling in the boxes with figures or words. 1. The fundamental accounting equation could be written as: T/F T/F T/F' T/F T/F T/F

4.3

CONSTRUCTING A BALANCE SHEET

Construction and Analysis of Balance Sheet

Now, let us examine how the ideas we have learned so far could be used in a business situation. Please recall that based on the entity principle we shall be dealing with the `business' as distinct and separate from the owners. We shall demonstrate this by means of an illustration: Ram starts a store on, January 1, 2003 with an investment of Rs.2,00,000 from his personal savings. He decides to call his venture Ramstore. Suppose now, we want to prepare the balance sheet of Ramstore on January 1, 2003. How do we proceed? Based on the equality we have studied, we have to answer the following questions: 1 2. What are the assets of Ramstore on that date? What are the liabilities of Ramstore on that date?

If we have answers to these questions it also follows that assets minus liabilities is Ram's equity and this information would complete the equality and hence the balance sheet. Answer to the first question is that the only asset of Ramstore on January 1, 2003 is Rs.2,00,000 in cash. Answer to the second question is that Ramstore has no liability on that date or, in other words, it does not owe anything to outsiders. Thus it follows that the only claim on the assets in that of Ram. This could be represented as the balance sheet below: RAMSTORE Balance Sheet as on January 1, 2003 Assets Cash Liabilities and Owners Equity Rs. 2,00,000 Owners equity Rs. 2,00,000

On January 2 the Store purchases a shop for Rs.5,00,000 paying Rs.1,00,000 cash and signing a mortgage for Rs.4,00,000. This transaction changes the balance sheet as on January 2 as follows: 1. Cash is reduced by Rs.1,00,000 on account of payment for the shop premises. hence cash balance is Rs.1,00,000. 2. A new asset, shop, is acquired worth Rs.5,00,000.

A new liability, mortgage on the shop, is contracted in the amount of 3. Rs.4,00,000. 4. Owner's equity = Total asset - liabilities

= Rs.6,00,000 - Rs.4,00,000 = Rs.2,00,000. That is, there is no change in the owner's equity since increase in an asset is followed by an increase in liability. Thus the new balance sheet will be as follows: RAMSTORE Balance Sheet as on January 2, 2003 Assets Rs. Cash Shop premises 1,00,000 Mortgage on shop 5,00,000 Owners equity 6,00,000 Liabilities & Owners Equity Rs. 4,00,000 2,00,000 6,00,000

Understanding Financial Statements

On January 3, the store purchased Rs.50,000 worth of merchandise paying cash and Rs.1,50,000 worth of merchandise on credit from Mr. Vanik. The impact of these transactions is that the assets in the form of merchandise increase by Rs.2,00,000. These assets are intended for resale and hence have a short life span. However, part of this increase is accounted by decrease in another asset, cash. The other Rs.1,50,000 increase is accounted by the liability owed to Vanik. The amounts payable on account of purchases of merchandise are called accounts payable or sundry creditors. Usually these are short duration liabilities to be paid at the end of the normal credit period. The balance sheet on January 3, 2003 reflects the position of the business after these transaction. RAMSTORE Balance Sheet as of January 3, 2003 Assets Rs. Cash Shop premises 50,000 5,00,000 7,50,000 Accounts payable Mortgage on shop Owner s equity
'

Liabilities & Owner's Equity Rs. 1,50,000 4,00,000 2,00,000 7,50,000

Merchandise inventory 2,00,000

On January 4, he sells half the merchandise inventory (that is Rs. 1,00,000 worth inventory) for Rs.1,50,000 cash. Apparently, this transaction shows the transformation of an asset into another asset at higher monetary value. This is yet another basis of economic transaction where business profits are earned in the process of exchange of utility differential for a monetary differential. The balance sheet after this transaction will clarify some of the conceptual issues arising out of this transaction. RAMSTORE Balance Sheet as of January 4, 2003 Assets Rs. Cash 2,00,000 Merchandise inventory 1,00,000 Shop premises 5,00,000 8,00,000 Accounts payable Mortgage on shop Owner's equity Liabilities & Owner's Equity Rs. 1,50,000 4,00,000 2,50,000 8,00,000

Please note the change in owner's equity figure. For the first time since we started following the transactions of Ramstore, the owner's equity figure has changed. How did this come about? The answer is simple. We followed the equality of "Assets liabilities = Owner's equity". Thus the increase in owner's equity is the result of increase in assets arising out of exchange of merchandise inventory for cash at a higher monetary value. Thus we find that the owner's equity increases to the extent of revenue earned over the cost of earning that revenue. In this case the revenue earned is Rs.1,50,000 (the amount realised from sales of merchandise is usually referred to as sales revenue). The direct cost of earning that revenue was the merchandise inventory parted within the amount of Rs.1,00,000. We refer to this as cost of goods sold.

10

Another important fact should also be noted in this context. All along we represented the assets on the balance sheet at the original cost. The unsold inventory is still valued

at the original cost. This is yet another concept we follow in the preparation of balance sheet. As a general principle all assets are valued at their original cost. The increase in the owner's equity is equal to the profit earned out of trading. Normally, it is profitable operation which increases the owner's equity. Thus owner's equity could be understood as comprising of two parts, namely, contributed capital and retained earnings. Retained earnings is the profits earned and not withdrawn by the owners. This relationship could be expressed by yet another equality: OWNERs EQUITY = CONTRIBUTED CAPITAL + RETAINED EARNINGS(3) The above illustration would enable us to evaluate the balance sheet in the context of accounting concepts. The dual aspect principle has particular relevance to balance sheet. This is shown by the equality of assets to liabilities and owner's equity. All the figures are expressed in monetary units irrespective of its nature. In our example we had cash, merchandise inventory and shop premises all expressed in monetary quantities. All the transactions we reflected were in respect of only the business entity, Ramstore' rather the methodology was applied to the specific entity. All the valuations were based on the assumption of a going concern, and not based on break up value. All the assets were based on cost as the basis of valuation.

Construction and Analysis of Balance Sheet

Activity 4.4
Complete the following blanks: 1. Balance sheet is prepared at the end of a specified period. This period in accounting is variously referred to as: a) b) c) 2. _________________________ ___________________________ _________________________ ___________________________ _________________________ ___________________________

Balance sheet prepared at the end of an year summarises the balances in : a) ___________________Accounts c) __________________Accounts. b) _________________Accounts

3.

Assets on a balance sheet are usually grouped together as: a) ___________________assets c) __________________assets. b) _________________assets

4.

Claims against the assets on the balance sheet are summarized as: a) _________________ liabilities c) _________________equity. b_________________liabilities

4.4

BALANCE SHEET CONTENTS

Having examined the conceptual basis of the balance sheet we now try to study the balance sheet itself. We have seen that every transaction affects the financial position. Since it is not feasible to draw up a balance sheet after every transaction, it is prepared at the end of a specified period, usually, an year. This period is referred to as accounting period or fiscal year or financial year. This period as a convention has become one calendar year, though, there is no accounting justification for it.

11

Understanding Financial Statements

The balance sheet as prepared at the end of the accounting period shows the year end status of each of the assets of the firm and the various claims on these assets. We could also say that the balance sheet shows the year end balance in the asset, liability and capital accounts. Read the following illustration carefully. It is a typical summarised balance sheet. We shall follow this balance sheet for subsequent discussions. It shall be useful if you could copy it on a sheet of paper for ready reference. It may be clarified that there are two conventions of preparing the Balance sheet- the American and the English. According to the American convention, assets are shown on the left hand side and the liabilities and the owner's equity on the right hand side. The English convention is just the opposite. i.e., assets are shown on the right hand side of the Balance Sheet and the liabilities and the owner's equity on the left hand side. In India, generally the English conventions is followed. However, in all our illustrations and working here in this booklet, we shall be using the American pattern because it appears to be more logical as it is in tune with the way the transactions are recorded in the books of account and the balances are taken out.

Illustration
Table 4.1: RAMSONS LTD. Balance Sheet as on December 31, 2003
(Rupees in thousands) Assets Current Assets Cash Marketable Securities Notes/Bills Receivable Accounts Receivable Less: Estimated Loss on collection 1,000 100 900 500 200 300 Liabilities and Owner's Equity Current Liabilities Notes Payable Accounts Payable Accrued Liabilities Income Tax Payable Total Current Liabilities Long term Liabilities Merchandise Inventory Prepaid Expense Total Current Assets Property, Plant & Equipment Land 2,000 Buildings, Plant Less: Accumulated Depreciation Other Assets Deferred Expenditure Total Assets 3,000 1,000 2,000 1,500 1,000 10,000 1,100 500 3,500 10% Debentures 1,000 2,000 6,000 1,200 800 400 3,000 600

Secured Long-term loan from IFCI Total Liabilities

Shareholders' equity 9% Cumulative Preference Shares of Rs.100 each 500 Ordinary Shares of Rs. 10 each Capital Reserves Reserves & Surplus Total Liabilities and Shareholder's equity 10,000 2,000 500 1,000

4.5

FORM AND CLASSIFICATION OF ITEMS

12

The balance sheet lists assets, liabilities and capital separately. It is an accepted convention that the assets and liabilities are shown into sub-groups and listed in the order of their liquidity. Liquidity implies the length of time required to convert them into cash. Assets which are likely to be converted into cash in the near future are grouped as current assets. Similarly, liabilities which are due for payment in the short run are classified as current liabilities.

The balance sheet in our example is presented in the I account form. That is the assets are listed on one side and liabilities and owners' equity on the other. Another commonly used way of presentation is the report form where liabilities and capital are listed below the assets. However, the presentation matters very little since the balance sheet represents the equality between assets, liabilities and capital.

Construction and Analysis of Balance Sheet

Current Assets
Current assets are assets which will normally be converted into cash within a year or within the operating cycle. The operating cycle is the duration in time taken by a unit of cash to circulate through the business operations. For example, in a simple trading operation, we use cash to buy merchandise and sell it to recover cash. The operating cycle in such a situation will consist of the period for which cash, merchandise inventory, and receivable are held. The cycle starts with cash and ends with the collection of cash. The items comprising current assets are listed in the order of their relative liquidity and hence, cash is listed first.

Cash
Cash is usually taken to include currency (legal tender), cheques or any other document that circulates as cash. Cash is usually classified as a current asset when it is available for a firm's day-to-day operations. It includes cash kept in the cash chest as also deposits on call on current accounts with banks. If cash is specifically earmarked for any purpose and not available for transactions it is better classified as other assets.

Temporary Investments
Whenever firms have short-term excess cash it may be invested in readily marketable securities. These securities may include shares, debentures and Government securities. These assets are readily marketable and could be sold whenever cash is required. They are classified as current assets only when these investments are held with the objective of realisation within a year. These securities are usually recorded at cost at which they are acquired. Since they are only held for short duration and should reflect their cash value, the principle of accounts receivable to their estimated realisable value. For instance: lower than the original cost, they are valued at their market price or realisable value. Apparently, the valuation rule `lower of cost or market price' may look contradictory. Why should one not value the securities at higher than cost? This distinction is made, based on the generally accepted accounting principles. We do not anticipate gains but only losses. Gains are recognised in accounting only when outside transaction takes place. This is the essence of conservatism in accounting. When the firm values its securities at cost or market price, whichever is lower, we say the firm is conservative. That is, whenever presented with two alternatives the firm chooses the one which shows the lower valuation of assets or higher valuation of liabilities.

Accounts Receivable
Accounts receivable are amounts owed to the company by debtors. This is the reason why we also use the term sundry debtors to denote the amounts owed to the firm. This represents amounts usually arising out of normal commercial transactions. In other words, `accounts receivable' or sundry debtors represent unpaid customer

13

Understanding Financial Statements

accounts. In the balance sheet illustration these represent amounts owed to the firm by customers on the balance sheet date. These are also known as trade receivables, since they arise out of normal trading transactions. Trade receivables arise directly from credit sales and as such provide an important information for management and outsiders. In most situations these accounts are unsecured and have only the personal security of the customer. It is normal that some of these accounts default and become uncollectable. These collection losses are called bad debts. It is not possible for the management to know exactly which accounts and what amount will not be collected. However, based on past experience , it is possible for the management to estimate the loss on the receivable or sundry debtors as a whole. Such estimates reduce the gross value of accounts receivable to their estimated realisable value. For instance: Accounts Receivable Less: Estimated collection loss at 10% Net realisable value of accounts receivable 7,50,000 75,000 6,75,000

The estimated collection loss is variously referred to as reserve for doubtful debts, reserve for bad debts or reserve for collection losses. It is a common practice to refer to this as a provision instead of reserve. It is a usual practice for debts to be evidenced by formal written promises to pay or acceptance of an order to pay. These formal documentary debts represent promissory Notes Receivable or Bills Receivable. These instruments used in trade are negotiable instruments and hence enable the trader to assign any of his receivables to another party or a bank for realizing immediate liquidity. It is also usual for accounts receivables to be pledged or assigned mostly to banks against short-term credits in the form of cash credits or overdrafts.

Inventory
In a trading firm inventory is merchandise held for sale to customers in the ordinary course of business. In case of manufacturing firms inventory would mainly consist of materials required to manufacture the products, namely, raw materials, materials remaining with the factory at various stages of completion i.e., work in process and goods ready for sale or finished goods. Apart from these there may be inventory of stores and supplies. Thus we have raw material inventory, work in process inventory, finished goods inventory and stores and supplies inventory. It is common to refer to inventory as stock-in-trade and thus we could come across stock of raw materials, stock of work in process and stock of finished goods.. Inventory is usually valued on the basis of "lower of cost or market price". Market price is taken to mean the cost of replacement either by purchase or by reproduction of the material in question. As a general principle, inventory is valued on cost at situation. It implies that all normal costs incurred to make the goods available at the place where it can be sold or used are treated as costs of inventory. In trading firms, inventory costs include freight-in, transit insurance costs, import or entry levies as also the invoice cost. Warehouse costs, handling costs, insurance costs in storage and interest costs are not included as costs. They are treated as expenses of a period of the firm. In case of manufacturing units, valuation of inventory costs is more complex and involved. As a general rule all costs of materials, labour and plant facilities used for manufacturing the goods are included in the valuation of inventory.

14

In valuing inventory at lower of cost or market price, care should be taken to see that the valuation does not exceed the realisable value or selling price in the ordinary course of business.

Construction and Analysis of Balance Sheet

Prepaid Expenses
In many situations, as a custom, some of the item of expenses are usually paid in advance such as rent, taxes, subscriptions and insurance. The rationale of including these prepayments as current assets is that if these prepayments were not made they would require use of cash during the period.

Fixed Assets
Fixed assets are tangible, relatively long lived items owned by the business. The benefit of these assets are available not only in the accounting period in which the cost is incurred but over several accounting periods. Current assets provide benefits to the organisation by their exchange into cash. In the case of fixed assets. value addition arises by facilitating the process of production or trade. In other words, benefits from fixed assets are indirect rather than direct. All man made things have limited life. In accounting we are concerned with useful life of the assets. Useful life is the period for which a fixed asset could be economically used. This implies that the benefits from the fixed assets will flow to the organisation throughout its useful life. Another aspect of this is that the cost incurred in the period of purchase of the asset will be providing benefits over the useful life of the asset. Valuation of the fixed assets is usually made on the basis of original cost. However, since the assets have limited life the cost will be expiring with the expiration of the life. Thus, valuation of the asset is reduced proportionate to the expired life of the asset. Such expired cost is referred to as depreciation in accounting. We shall discuss this idea in more detail in a subsequent unit. The conceptual basis could be clarified with an example. Suppose a trader buys a delivery van at a cost of Rs. 10,00,000. Assume that the van will have to be discarded as junk at the end of five years. At the time of purchase: Delivery van at cost At the end of first year it will be represented as: Delivery van at cost Less: Depreciation to date Net Value Rs. 10,00,000 2,00,000 Rs. 8,00,000 Rs. 10,00,000

At the end of second year it will be:

Delivery van at cost Less: Depreciation to date Net Value Rs. 10,00,000 4,00,000 Rs. 6,00,000

The process of providing depreciation for each year will continue. At the end of five years the valuation of the asset will be zero. The value of the assets at cost is usually referred to as gross fixed assets and the amount of depreciation to date as accumulated depreciation. Net value of the asset is usually referred to as net fixed assets. Please note that we reckoned the amount of depreciation by equally distributing the cost of asset over its useful life. This is the simplest method of determining the annual depreciation of the assets. Thus, we can say that the annual depreciation over the useful life of the asset shall not exceed its net cost. We say net cost because the actual

15

Understanding Financial Statements

cost of the asset to be depreciated is its purchase cost less any salvage value at the end of its useful life. Hence depreciable cost of the asset is net cost which is equal to original cost minus salvage value. The relationship between cost and depreciation could be visualised as follows: Year 1 Depreciation Rs. 2,00,000 Year 2 Depreciation Rs.2,00,000 Year 3 Depreciation Year 4 Depreciation Year 5 Depreciation Rs. 2,00,000

Rs., 2,00,000 Rs. 2,00,000 Rs. 10,00,000

Cost of the asset :

Depreciation represents the cost of earning revenue in an accounting period on account of use of fixed assets. Fixed assets are valued on the basis of cost making the asset available and ready for use. Thus cost includes the price as well as charges for delivery, assembly and erection. Fixed assets normally include assets such as land, building, plant, machinery and motor vehicles. All these items, with the exception of land, are depreciated. Land is not subject to depreciation and hence shown separately from other fixed assets.

Intangible and Other Assets

Intangible assets are assets or things of value without physical dimensions. They cannot be touched, they are incorporeal, representing intrinsic value without material being. One of the most common of these assets is goodwill. Goodwill reflects the ability of a firm to earn profits in excess of normal return. Almost all firms may have some goodwill. However, they appear in the books and balance sheet only when it has been purchased. Usually, when a going concern is purchased, the purchase price paid in excess of the fair value of the assets is considered goodwill. The amount is classified as another asset `goodwill' on the balance sheet. Many intangible assets have limited life too. Examples are patent rights, copy rights, franchise rights, incorporation costs and so on. Since they have limited useful life, the cost of acquiring such assets have to become expired costs over such useful life. This process of expiration of the cost of intangible assets is called amortisation. Even those intangible assets which have almost infinite life are amortised over a limited period. In reality the material effect of amortisation and depreciation is almost the same. The category "Other Assets" is used to classify assets which are not normally classified as current, fixed and intangible.

Current Liabilities
We have studied that liabilities are claims of outsiders against the business. In other words, these are amounts owed by the business to people who have lent money or provided goods or services on credit. If these liabilities are due within an accounting period or the operating cycle of the business, they are classified as current liabilities. Most of such liabilities are incurred in the acquisition of materials or services forming part of the current assets. As was the case with current assets, current liabilities are . also listed in the order of their relative liquidity.

Acceptances and Promissory Notes Payable

Acceptances are bills of exchange accepted by the firm usually for goods purchased. Similarly, promissory notes are written promises to pay the debts at specified future dates. Both these liabilities specify the amount payable on due date and any other

16

conditions of payment. If such notes or bills payable are for longer duration than one year, then the portion which is due for payment during the current period alone is treated as current liability. Long-term bills may be used for purchase of machinery.

Construction and Analysis of Balance Sheet

Accounts Payable
Accounts Payable or sundry creditors are usually unsecured debts owed by the firm. These are also referred to as payables on open accounts. They are not evidenced by any formal written acceptance or promise to pay. They represent credit purchase of goods or services for which payment has not been made as on the date of the statement.

Accrued Liabilities
Accrued liabilities represent expenses or obligations incurred, in the previous accounting period but the payment for the same will be made in the next period. In many cases where payments are made periodically, such as wages, rent and similar items, the last month's payment may appear as accrued liabilities (especially if the practice is to pay the same on the first working day of a month). This obligation shown on the balance sheet indicates that the firm owed the said amount on the balance sheet date.

Provisions or Estimated Liabilities

Where the liabilities are known but the amounts cannot be precisely determined, we estimate the liability and provide for it as a liability. A common example is income tax payable. Unless the tax liability is determined the amount payable cannot be accurately determined. There could be other examples too, such as product warranty expenses to be met and so on. The common practice is to estimate these liabilities based on past experience.

Contingent Liabilities
Contingent liabilities should be distinguished from estimated liabilities. Estimated liabilities are known liabilities where the amount is uncertain. Contingent liabilities on the other hand are no liabilities as of now. They become liabilities only on the happening of a certain event. In other words, both the amount and the liability (or obligation) are uncertain till the specified event occurs in future. These may include items like a claim against the company contested in a court. Only if the court gives an unfavourable verdict, it becomes a liability. They are not listed as liabilities in the body of the balance sheet. However, in order to give a fair view of all known facts about the affairs of the firm, contingent liabilities are disclosed as foot-notes to the balance sheet. They are not mentioned in the balance sheet as the firm is not liable as on that date; they are mentioned as notes because all those who are concerned may know that there is possibility that the events might occur.

Long-term Liabilities
Long-term liabilities are usually for more than one year. They cover almost all the liabilities not included in the current liabilities and provisions. These liabilities may be unsecured or secured. Security for long-term loans, are usually the fixed assets owned by the firm assigned to the lender by a pledge or mortgage. All details such as interest rate, repayment commitment and nature of security are disclosed in the balance sheet. Usually, such long-term liabilities include debentures and bonds, borrowings from financial institutions and banks.

17

Understanding Financial Statements

Activity 4.5
Fill in the blanks: 1. 2. As a convention, items appearing on the balance sheet are listed in the order of their relative. Balance sheet could be presented either in a) b) 3. 4. 5. 6. 7. 8. .from, or

Operating cycle is the duration.. Temporary investments are valued in the balance sheet by applying the principle of Accounts receivable are also referred to as.. Expired cost with respect to as expense. Expiration of cost of as... Sundry creditors are a fixed asset is is referred referred to to ,

intangible referred

assets to

also

as.

Activity 4.6
1. 2. 3. 4 5. 6. 7. 8. We judge an item as a current asset if it is converted into cash during and. Liquidity refers to nearness of an item to. Items classified as current assets are usually listed in the order of their relative.. The basis of valuation as applied to temporary investment is. Asset losses expected out of non-collection called of receivables are

Formal written/documented debts refer to. Items commonly referred to as inventory include (i) , (ii).and (iii) Inventory is usually valued on the basis of

Capital
We have seen earlier in this unit that the fundamental accounting equality states: assets = liabilities + owners equity. From the example of balance sheet we can easily establish this. See Rainsons balance sheet: Total assets Total liabilities Owner s equity
'

Rs. 1,00,00,000 Rs. 60,00,000 Rs. 40,00,000

We also know that the owner's equity consists of the contributed capital and the retained earnings of the firm. If Ramsons were an individual proprietorship business, the owner's equity will be reflected directly as: Capital Rs 40,00,000 If 'Ramsons' were a partnership firm with four partners W, X, Y and Z all sharing equally, the capital would be represented as: CapitalPartner W Partner X Partner Y Rs. 10,00,000 Rs. 10,00,000 Rs. 10,00,000 Rs. 10,00,000 Rs. 40,00,000

18

Partner Z Total

In our example the balance sheet was titled `Ramsons Ltd.', implying that it was an incorporated limited company. We did not provide the detailed balance sheet incorporating all the legal requirements in order to avoid confusion. According to the company law the capital has to be disclosed in greater detail. This requirement could be related to the corporate legislation's need for ensuring maintenance of capital or keeping the firm's assets intact. This is ensured by insisting that the distribution by way of dividends to shareholders is made only out of accumulated earnings. According to the legal requirements, the owner's equity section of the company balance sheet is divided into two parts: (1) the share capital representing contributed capital and (2) reserves and surplus representing retained earnings. The contributed capital is the amount paid by shareholders. Share capital is the joint stock predetermined by the company at the time of registration. It may consist of either ordinary share capital or preference share capital (having preferential right to fixed dividend and repayment of capital at the time of liquidation), or both. This share capital stock is divided into units or shares. Thus if the company decides to have a share capital it could be either ordinary shares alone or ordinary and preference shares. A company has an authorised share capital of Rs. 2,00,000 divided into 15,000 ordinary shares of Rs. 10 each and 500 10% cumulative preference shares of Rs. 100 each. This will be represented as: Authorised capital: 15,000 ordinary shares of Rs. 10 each 500 10% cumulative preference shares of Rs. 100 each Total Rs. 1,50,000 Rs. 50,000 Rs. 2,00,000

Construction and Analysis of Balance Sheet

The company need not raise the entire amount of-the predetermined or authorised capital. That portion of the authorised capital which has been issued for subscription is referred to as issued capital. Suppose the company offered to the public 7500 ordinary shares and 500 preference shares for cash which were fully subscribed and paid up. The share capital of the company in summary will be: Authorised Capital: 15,000 ordinary shares of Rs. 10 each 500 10% cumulative preference shares of Rs. 100 each Issued Capital 7,500 ordinary shares of Rs. 10 each 500 10% cumulative preference shares of R. 100 each Subscribed, called up and paid up 7,500 ordinary shares of Rs. 10 each 500 10% cumulative preference shares of Rs. 100 each 75,000 50,000 Rs, 1,25,000 75,000 Rs. 50,000 Rs. 1,25,000 Rs.1,50,000 50,000 Rs. 2,00,000

In the above example, even though the company was authorised to issue 15,000 ordinary shares, it needed only part of the capital and hence choose to issue only one half of the total authorised ordinary shares. The implication of authorised capital is that it is the maximum amount of capital a company may raise without altering the registration deed.

19

Understanding Financial Statements

Ordinary and Preference Shares

Preference shares are so called because they have some preferences over the ordinary shares. These preferences relate to repayment of capital and payment of dividend. In the event of liquidation of the company the assets that remain after payments to creditors are first distributed to preference shareholders. Similarly, whenever the company earns profits and decides to distribute dividends the preference shareholders are first paid their pre-fixed dividend in preference to ordinary shareholders. Preference shares could be made redeemable after a specified period. Similarly, the preference shares could be granted the right to cumulate unpaid dividends. It is also possible to provide to preference shareholders the opportunity to share the excess profits (i.e. over and above their fixed dividends). Under the company law it is not necessary that a company should have preference shares. Ordinary shares have no preferential or fixed rights with respect to either repayment of capital or distribution of profits. They have the residual claims against assets after the claims of creditors and preference shareholders have been met. We have hinted earlier that even if the company earns profit, shareholders, including preference shareholders, have no right to dividend unless the company decides to distribute it. However, in case of cumulative preferences sareholders such unpaid dividends will accumulate and will have to be paid before any dividend can be paid to ordinary shareholders.

Reserves and Surplus

Reserves and surplus or retained earnings normally arise out of profitable operations. It is a surplus not distributed by the firm as dividends. In other words, these are profits decided to be retained within the business. When a firm starts its operations it has no retained earnings. If in the first year it earns say Rs. 10,000 profit and decides to distribute Rs. 5,000 as dividends, the reserves and surplus at the end of the year will be Rs. 5,000. During its second year of operation if the firm makes a loss of Rs. 3,000 then the retained earnings at the end of the year will be Rs. 2,000. Retained earnings (or reserves and surplus) are in the nature of earned capital for the firm. We have seen earlier that the dividends are limited to retained earnings. This implies that at no point in item the original capital of the firm is depleted. In other words, the capital originally contributed is maintained intact. It is possible to allocate the profits earned and accumulated as reserves or retained earnings to be earmarked for specific purposes. The earmarked reserves are not distributed. Only non-earmarked or free reserves are available for distribution as dividends.

Activity 4.7
Fill in the blanks with the correct word(s) 1. 2. 3. 4. 5. Balance sheet is a statement of. ..............represents the owners' claim against assets of a business. .are claims of outsiders against the business. ..increase owners' equity. Amounts owed by a business on account of purchase of inventory are usually called..or Amounts receivable by a firm against credit sales are usually called.

20
6.

7. 8. 9. 10.

As a general rule all assets are valued at their to the business. Owner's equity could be understood parts:and as comprising two

Construction and Analysis of Balance Sheet

The dual aspect principle has special relevance to All valuations in a balance sheet are based on the assumption about the entity as a.

4.6

SUMMARY

Balance Sheet as we have seen is one of the most important financial statements. It is a periodic summary of the position of the business. It is the statement of assets, liabilities and owners' capital as of a particular point in time. This statement in itself does not reveal anything about the details of operations of the business. However, a comparison of two balance sheets could reveal the changes in business position. A realistic understanding of the operations of the business would require two other statements - Profit and Loss Account and Funds Flow Statement. We shall take them up in subsequent units.

4.7

KEY WORDS

Asset: Anything, tangible or intangible, of monetary value to a business entity. Liability: Any amount owed by one person (the debtor) to another (the creditor). In a balance sheet all those claims against the assets of the entity, other than those of the owners. Current Assets: All of the assets held by a firm with the objective of conversion to cash within the operating cycle or within one year whichever is longer. Current Assets include items such as cash, receivables, inventory and prepayments. Current Liabilities: All those claims against the assets of the firm to be met out of cash or other current assets within one year or within the operating cycle, whichever is longer. Usually include items such as accounts payable, tax or other claims payable, and accrued expenses. Intangible Assets: Any long-term assets useful to the business and having no physical characteristics. Include items such as goodwill, patents, franchises, formation expenses and copyrights. Contingent Liability: A liability which has not been recognised as such by the entity. It becomes a liability only on the happening of a certain future event. An example could be the liability which may arise out of a pending law suit. Fixed Asset: Tangible long-lived asset. Usually having a life of more than one year. Includes items such as land building, plant, machinery, motor vehicles, furniture and fixtures. Owner's Equity: It is the owner's claim against the assets of a business entity. It could be expressed as total assets of an entity less claims of outsiders or liabilities, includes both contributed capital and retained earnings.

4.8
l.

SELF-ASSESSMENT QUESTIONS/EXERCISES
Explain the following terms giving examples; Accounts Receivable Inventory Current Liabilities Reserves and Surplus Contingent Liabilities

21

Understanding Financial Statements

2. 3. 4. 5. 6.

By definition , a balance sheet `balances'. Can you think of any advantages that flow from accountants' adherence to this convention? "Financial statements are most useful if they report only the value of assets that are tangible". Do you agree? "Current assets are producing assets. The most profitable firm will practically have few assets which are current compared to other assets". Evaluate fully. For a company, the excess of assets over liability is commonly represented by several items. What are they? What is the caption placed over them? "Fixed assets are physical assets that provide operating capacity for a number of accounting periods". Explain with the help of suitable examples. Are all fixed assets depreciable assets? Peninsular Transport Company began trucking operations on January 1, 2003. The company's bank account showed a balance of Rs. 90,000 on December 31, 2003, which was in agreement with the bank statement received on the same date. The company had Rs. 6,000 cash in the office and Rs. 4,000 worth cheques received from customers.

7.

On December 31, receivables outstanding amounted to Rs. 3,00,000. Company also had Rs. 30,000 worth promissory notes signed by their customers. Employees had drawn festival advance, which was outstanding in the amount of Rs. 6,000. Peninsular owed Rs. 3,60,000 to Southern Service Station as on December 31, 2003. During the year Peninsular purchased stationery and office supplies costing Rs. 11,000 from Ramlinga lyer & Sons. The use of stationery and supplies during the year was estimated at Rs. 8,000. Peninsular purchased eight trucks during the year, each costing Rs. 4,00,000. They owed Rs. 20,00,000 to Southern Sales and Finance at the end of the year on account of trucks bought. The obligation was supported by hire purchase agreement for payment at the rate of Rs. 50,000 per month. Depreciation was Rs. 80,000 per truck for the year. Spare parts and tyres inventory amounted to Rs. 13,000. Company had rented a garage on a 30 year lease, office space and parking space at Rs. 1,00,000 a year on the NH 47 within the city limits. Because of the real estate boom, Peninsular could easily sublet the premises for Rs. 1,50,000 a year. On January 1, 2003 when Peninsular started operations they had paid first two years' rent in advance. On December 31, 2003 Peninsular purchased an airconditioned car for office use costing Rs. 1,00,000. Insurance and registration cost amounted to Rs. 8,000. The company had a bulk storage tank for diesel needed for its trucks. The tank was filled on 4 occasions with 50,000 litres each. On December 31 the meter reading indicated that 1,80,000 litres had been used during the year. Average cost per litre of diesel was Rs. 3.00. Peninsular paid employees' salary on the last day of each month. Bonus for the employees was due in the amount of Rs. 2,12,000 relating to 2003 and will be paid along with first salary in 2004. The owners of Peninsular originally invested Rs. 6,00,000. Net income for 2003 was Rs. 2,08,000. Drawings by the owners during the year amounted to Rs. 1,00,000. Prepare the balance sheet as on December 31, 2003 for Peninsular Transport Company in the blank proforma provided as Table 4.2.

22

Table 4.2 Peninsular Transport Company Balance Sheet as on 31st December, 2003
Assets Current Assets Cash Cash at Bank Promissory Notes Accounts receivable Advances to employees Office supplies inventory Prepaid insurance and license Prepaid rent Inventory of diesel Spare parts inventory Liabilities and Capital Current Liabilities Hire purchase payment due in one year Accounts payable Bonus payable Long Term Liabilities Hire purchase payable Capital Owners Capital Net income for the year ________ Less: Owners drawings ________

Construction and Analysis of Balance Sheet

Plant and equipment Trucks ______ Less: Accumulated Depreciation ______ Motor Car Total Assets Total Liabilities and Capital

________

8.

The following Balance were extracted from the books of account of Punjab Ceramics Limited, on 30th June, 2003 after the income statement for that year had been prepared and all the relevant adjustments had been made. Balance as on 30th June 2003

Freehold land and building at cost Bank overdraft Cash in hand Inventory Creditors 10% Debentures Dividends Proposed - 8% Preference shares Ordinary shares Accrued expenses General reserves (at 1 July 2002: Rs. 8,000) Share capital: 200 8% Preference share of Rs. 100 each 6,000 Ordinary shares of Rs. 10 each Investments at cost Motor vehicles at cost Provision for depreciation on 30 June 2003 Plant and machinery at cost Provision for depreciation on 30 June 2003 Retained income (At 1 July 2002, Rs. 28,000) Share premium Accounts Receivable

Rs. 32,000 27,200 1,680 74,400 18,560 34,000 1,600 6,000 2,400 20,000 20,000 60,000 14,800 37,200 9,600 84,960 24,160 32,800 14,240 25,520

The authorised share capital consists of 400 8% preference shares of 100 each and 1,200 ordinary shares of Rs. 10 each. Prepare the Balance Sheet of Punjab Ceramics Limited as on 30th June, 2003. Also ascertain the net income for the year.

23

Understanding Financial Statements

Answers to Activities Activity 4.1

1 2 3 4 1 F. a) By a decrease in another asset. b) by an increase in liability . c) by an increase in owner's equity. a) an increase in asset. b) decrease in another liability. c) decrease in owner's equity. Liability Assets. 2 T. 3 F. 4 T. 5 F. 6 F.

Activity 4.2 Activity 4.3

1 2 3 4 1 2 3 4 Assets = liabilities + owner's equity Rs. 25,000 Rs, 25,000= Rs. 1,00,000 - Rs. 75,000 Rs. 70,000 = Rs. 1,00,000 - Rs 30,000 (a) Accounting period (b) fiscal year (c) financial year (a) asset (b) liability (c) capital (a) current (b) property, plant (c) other (a) current (b) long-term (c) shareholders.

Activity 4.4

Activity 4.5
1 Liquidity 2 a) T account form b) Report 3 In time taken by a unit of cash to circulate through the business. 4 Lower of cost or market price 5 Sundry debtors 6 Depreciation 7 Amortisation 8 Accounts payable

Activity 4.6
1 2 3 4 5 6 7 Operating cycle Cash Liquidity Lower of cost or market price. Bad debts. Promissory Notes receivable or bills receivable. Raw material (ii) Work-in-Process (iii) Finished goods. Lower of cost or market price if Ramsons were an individual proprietorship business, the owners equity will be reflected directly as: Assets, Liabilities and capital Owners equity Liabilities Profits Accounts payable or sundry creditors Accounts receivable or sundry debtor Original cost Contributed capital and retained earnings Balance sheet Going concern.

Activity 4.7
1 2 3 4 5 6 7 8 9 10

24

Answers to Self-assessment Questions/Exercises 7. Solutions: Peninsular Transport Company Balance Sheet as on 31st December, 2003 Assets Current Assets Cash Cash at Bank Promissory Notes Accounts receivable Advances to employees Office supplies inventory Prepaid insurance and license Prepaid rent Inventory of diesel Spare parts inventory Liabilities and Capital Current Liabilities Hire purchase payment due in one year Accounts payable Bonus payable

Construction and Analysis of Balance Sheet

10,000 90,000 30,000 3,00,000 6,000 3,000 8,000 1,00,000 60,000 13,000

6,00,000 3,60,000 2,12,000

Long Term Liabilities 11,72,000 Hire purchase payable 14,00,000 Capital Owners Capital 6,00,000 Net income for the year 2,08,000 Less: Owners drawings 1,00,000 1,08,000

Plant and equipment Trucks 32,000 Less: Accumulated Depreciation 64,000 Motor Car Total Assets

25,60,000 1,00,000 32,80,000 Total Liabilities and Capital 32,80,000

4.9

FURTHER READINGS

Horngren C.T. and Harrison, 01/23/2003, Financial Accounting, Prentice Hall : New Delhi (Chapter 1) Fraser Lyn M. and Aileen Ormiston, 04/10/2003, Understanding Financial Statements, Prentice Hall : New Delhi (Chapter 2) Glantier M. W. E., Underdown B. and A.C. Clark, 1979, Basic Accounting Practice, Arnold Hieneman: Vikas Publishing House, New Delhi (Chapter 5, Section 2). Bhattacharya, S. K. and John Dearden, 1984. Accounting For Management: Text and Cases (2nd Ed.) Vani: New Delhi. (Chapter 3, 10 and 11) Hingorani, N.L. and A. R. Ramanathan, 1986, Management Accounting, Sultan Chand: New Delhi. (Chapter 3).

25

Understanding Financial Statements

UNIT 5 CONSTRUCTION AND ANALYSIS OF PROFIT AND LOSS ACCOUNT

Objectives The purpose of this unit is to introduce to you the profit and loss account. After you have studied this unit, you should be able to: appreciate the importance of income measurement classify income and expense accounts prepare a profit and loss accounts

appreciate the linkage between accounting records and profit and loss account
appreciate the linkage between profit and loss account and balance sheet.

Structure 5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8 5.9 5.10 5.11 5.12 5.13 5.14 5.15 5.16 Introduction Profit and Loss Account and Balance Sheet: The Linkage Measurement of Income Preparation of Profit and Loss Account Some Indirect Expenses Methods of Depreciation Form of Profit and Loss Account Cost of Goods Sold Methods of Inventory Valuation Gross Profit Operating Profit Net Profit Summary Key Words Self-assessment Questions/Exercises Further Readings

5.1

INTRODUCTION

26

The balance sheet, as we have studied in the previous unit, is intended for reporting the value of assets, liabilities and owners' equity at a particular point in time. It does not disclose anything about the details of operation of the business. All it tells about are the details of operation of the business. It tells about the net change in owner's equity brought about by operations during the period between the previous balance sheet and present one. Was it a good year or a bad year? What was the volume of operations? What was the margin available on sales? How was sales rupee distributed among different expenses and profit? All these questions cannot be answered without the help of an additional financial statement addressed exclusively to summarise revenues and expenses of the particular period. This statement is what is referred to variously as Profit and Loss Account, Income Statement or Income summary. This statement is so named since it summarises all the revenues or incomes and all the expenses for earning that revenue showing the net difference, that is profit or loss for the period.

5.2

PROFIT AND LOSS ACCOUNT AND BALANCE SHEET: THE LINKAGE

Construction and Analysis of Profit and Loss Account

When you sell an item costing Rs. 70 for Rs. 100, assuming no other costs, you earn a profit of Rs. 30. What we have done is nothing but measurement of the net income. This is achieved by comparing the revenue from sales against the cost of materials parted with for earning that revenue. Net difference of this comparison, in simple terms, represents the net income or profit. The importance of profit and its measurement in accounting leads in turn to the significance of profit and loss account. However, it will be interesting to see how this document is related to the balance sheet. In the previous unit we have seen that the earning of revenue increases owners' equity. Please recall the balance sheet equation we had seen in the previous unit. It stated: Assets = Liabilities + Owner's Equity....(1) We also saw that owners equity at any point in time is represented by the following relationship: Owner's Equity = Assets - Liabilities.(2) This implies that except in the case of first balance sheet, owners' equity need not be equal to contributed capital. We also saw that the owners' equity changed with the sale transactions. How did this happen? It happened as follows: l 2 The amount of sales revenue realised increased the owner's equity. The amount of goods 'parted with decreased the owner's equity.

Thus, resultant increase in owners' equity was equal to the net increase in assets. That is, equal to the profit. We explained owners' equity in the previous unit as: Contributed Capital + Retained Earnings' Assuming no withdrawals, `retained earnings' is nothing but all the revenue minus expenses. Thus, we could write our relationship as follows: Retained earnings = Revenue - Expenses (3)

Now, substituting right hand side of equality (1) in our earlier balance sheet equation we have: Assets = Liabilities + Contributed Capital + Revenue Expenses..(4) It is the last two terms in equality (4) above which is referred to as profit and loss account or income summary. Thus, we find that profit and loss account is an integral part of any balance sheet in that it is an expansion of one of the terms of the balance sheet. In order to appreciate and understand profit and loss account, we should clearly understand the conceptual basis of the same.

5.3

MEASUREMENT OF INCOME

Profit and loss account measures the income generated by the entity. The income is generated from or with the use of its assets. Thus, the concern of the profit and loss account is the income arising out of the assets, rather than the assets themselves. In order to make this segregation and make the process of measurement practical, we

27

Understanding Financial Statements

should have precise idea of what constitutes revenue and expenses. Recognition and measurement of revenue and expense are based on the ideas of realisation, accrual, accounting period, and matching.

Realisation
Realisation is technically understood as the process of converting non-cash resources and rights into money. It is understood to mean sale of assets for cash or claims to cash. As an accounting principle, it is used to identify precisely the amount of revenue to be recognised and the amount of expense to be matched to such revenue for the purpose of income measurement. Realisation, thus, usually pertains to the recognition of revenue from sale or provision of goods or services to customers. When should we recognised revenue? This is the question that realisation principle tries to answer. There can be several arguments for and against recognising revenue at the time when the inventory is acquired, when the goods are made ready for sale, when the order is received, when the goods are delivered, or when the sale proceeds are collected. In order to avoid such confusion in accounting, revenue is generally recognised when goods are delivered or services are rendered. This is done despite the fact that delivery is only one of a series of events related to sale. The rationale is that delivery validates a claim against the customer. Realisation being the point of recognition of revenue, it also enables us in recognising the expiration of costs incurred in making available such goods or services. Thus, the realisation principle facilitates the process of income measurement by identifying revenues and the expiration of costs with respect to such revenues. By implication, if costs are incurred in producing the goods, such costs are not considered as expenses unless sales are made. There are two major exceptions to the notion that an exchange is needed to justify the realisation of revenue. First, in case of long run construction contracts revenue is often recognised on the basis of a proportionate or partial completion method. Thus in this case revenue is recognised without satisfying the test of completion and delivery. Second, in case of long run instalment sales contracts, depending on the uncertainties involved, revenue is regarded as realised only in proportion to the actual cash collections. In this case even though delivery is complete at the time of contract, recognition of revenue is deferred and related to actual cash collections.

Accrual
It is generally accepted in accounting that the basis of reporting income is accrual. Resources and obligations change in time periods other than those in which money is received or paid. Economic activity of an enterprise in a short period is complete if the cycle of productive resources to money is completed. In reality, continuous production, use of credit, and long lived assets produce several overlapping cycles. This makes the process of evaluation of income very complex. Accrual principle tries to evaluate every transaction in terms of its impact on the owners' equity. In simple terms it implies that recognised revenues result in increases in the owners' equity while expired costs or recognised expenses result in decrease in the owners' equity. The essence of the accrual concept is that net income arises from events that change the owners' equity in a specified period and that these are not necessarily the same as change in the cash position of the business. Thus, realisation and accrual together lay down the ground rules for measurement of income.

28

Activity 5.1 Fill in the blanks 1. 2. 3. 4. 5. 6. 7. Profit and loss account is summary of..andfor an accounting period. Realisation in accounting is the basis of ..recognition. Income measurement is achieved by matching.. Costs with respect to realised revenues are considered as Recognised revenue..to owners' equity Expenses result inof owners' equity Expenses could be recognised in relation to..realised or an.period.

Construction and Analysis of Profit and Loss Account

Accounting Period
Once we accept the concept of `going concern', it is inconceivable to approach the problem of profit measurement without a clear understanding of the idea of accounting period. The most accurate way to measure the results of an entity's operations will be to measure them at the time of liquidation. Considering the whole life of the business, net income is nothing but the excess of amount the owners get over what they have put into it (investment). But it is inconceivable and impractical to imagine that one has to wait till the winding up of the business for ascertaining the profit. Accountants choose some convenient segment of time, such as a calendar year, to collect, summarise and report all information on material changes in the owners' equity during that period. There is no sanctity about an accounting period being a year. It has evolved as a convention out of convenience over the years. There is some historical evidence to suggest that accounting periods used to be a couple of years or the entire life time of a venture and so on, in the past. Even now, there are firms which follow the system of certain number of weeks as an accounting period. However, generally, as a convention, most enterprises try to have a uniform length of accounting period for period to period comparison of results. The crux of the matter is that the realisation and accrual principle, as we have seen earlier, will have to be applied in the context of the accounting period. It is the revenue which is realised during that accounting period which is treated as accruing to the owners' equity. Thus, accounting period enables us to have a practical system of valuation and measurement. Accounting periods are bounded by balance sheets at the beginning and at the end of the period. Operations during the period are summarised by income statements. This process can be illustrated in the following form:

Here accounting periods could be seen as links in the chain which makes up the life of the enterprise. Accounting period is variously referred to as fiscal year and financial year also.

29

Understanding Financial Statements

Matching
In reality we match revenues and expenses during the accounting periods. Matching is the entire process of periodic earnings measurement, often described as a process of matching expenses with revenues. In a narrow sense this means deducting from the revenues of a period the cost of goods sold or other expenses that can be identified with such revenues of that period on the basis of cause and effect.

Revenue
In a broad sense revenue is the total amount realised from the sale of goods or provision of services together with earnings from interest, dividend, rents and other items of income. Revenue is recognised when the enterprise has a right to income. In practice we make a segregation of an enterprise's income as obtained from its main operations and from activities incidental to the main operations. The former is referred to as operating income and the latter as other income or non-operating income. Realised revenue as we have seen earlier need not be realised in cash. If the right to receive that income is created or the time to which the income relates has expired, we treat the income as accrued. For example, a credit sale to be collected during the next accounting period is an income of this period. Similarly, interest to be received on a specified date is treated as accrued and hence earned for the period covered by the current accounting period.

Measurement of Expenses
Expenses are costs incurred in connection with the earnings of revenue. As such the point of reference for recognition of expense becomes the recognition of revenue. Costs incurred do not become expenses until the goods or services in question are exchanged. Expense is sacrifice made, resource consumed in relation to the revenues earned during an accounting period. Thus cost is not synonymous with expense. Only costs that have expired during an accounting period are treated as expenses. Consider the following example: Rakesh purchases merchandise worth Rs. 1,000 during the period and sells one half of this during the same period for Rs. 750. Here, we have: Cost Revenue Expense : Rs. 1,000 : Rs. 750 : Rs. 500 The purchase price f the merchandise. The sale proceeds realised in exchange of one half of the merchandise. The cost of the merchandise parted with or given over to the customer in exchange of the revenue i.e. cost with respect to the revenue earned and hence expired cost. The unexpired cost. An asset i.e. merchandise inventory (as a convention, valued at cost).

Inventory

: Rs. 500

Generally, unexpired costs represent assets. All assets which have limited life expire as expenses with respect to revenue earned during their useful life. Expense means a decrease in owners' equity that arises from the operation of a business during specified accounting period. Thus, cost means any sacrifice, whether or not the sacrifice affects the owners' equity during a given accounting period. American Accounting Association provides the following description for expense:

30

Expense is the expired cost, directly or indirectly related to a given fiscal period of the flow of goods or services to the market and of related operations. Recognition

of cost expiration is based on a complete or partial decline in the usefulness of assets, or on the appearance of a liability without a corresponding increase in assets. Expenses of a given period are: i) Expenses of this year. These are costs incurred during the accounting period which become expired costs during the same period. Example: cost of material bought and sold during the same accounting period. Costs incurred in a previous accounting period that become expenses or expired costs during this year. Example: inventory purchased during the previous period but sold during this period. The amount of inventory which represented unexpired costs and hence an asset at the close of the previous accounting period becomes expired cost and hence expense during the period in which it is sold. Expenses of this year, the monetary outlay for which will be made during a subsequent period. These are also expired costs of the current period, but the costs are incurred by contracting a liability.

Construction and Analysis of Profit and Loss Account

ii)

iii)

Expenses are recognised under the following circumstances: a) Expenses are given recognition in the period in which there is a direct identification or association with the revenue of the period. This implies that recognition of expense is directly related to the realisation of revenue. An indirect association with the revenue of the period. Example: rent, salaries, insurance, depreciation and such other costs which are not usually inventoried. Measurable expiration of assets though not associated with the production of revenue for the current period. Example: loss from flood, fire and similar events.

b) c)

Assets that become expenses

Examination of some specific cases of assets that become expenses will enable us to understand the concept very clearly. Inventories: Inventory of merchandise become expense when it is sold. In case of manufacturing organisations all the costs incurred on transformation of raw materials add value to the inventory. These costs are treated as expenses only when the inventory in question is sold. Prepaid Expenses: Prepaid expenses represent services or assets paid for, prior to their actual use. Thus, they represent unexpired costs. They become expenses when the services are used or assets are consumed. Long-lived Assets: Fixed assets have a limited useful life. The costs of such assets expire during the life of the assets in question. Such expiration of costs of the assets are referred to as depreciation. What we have examined so far are some of the conceptual bases necessary for the understanding and preparation of a profit and loss account. In the subsequent part of this unit we shall examine the mechanics of how to prepare a profit and loss account.

5.4

PREPARATION OF PROFIT AND LOSS ACCOUNT

Profit and Loss Account, as we have seen, is a summary of all `accounts' dealing with transactions relating to revenue and expenses. An account is a statement wherein information is accumulated relating to an item or a group of similar items. This accumulation is done in such a manner that it is fairly easy to summarise by combining several such items. In case of profit and loss account, the process of preparation is nothing but a summarisation of all individual accounts, accumulating information on different items of expense and revenue.

31

Understanding Financial Statements

We have seen the expanded balance sheet equation at the beginning of this unit using abbreviations) as follows: A=L+C+R-E where: A = assets L = liabilities C = contributed capital R = revenues E = expenses ...(4)

For the sake of simplicity we ignore withdrawals. However, if we consider withdrawals, it will imply assets being less to that extent and equality being provided with one more negative term of withdrawals or drawings. Thus, the equality will be: A=L+C+R-(E+D) Where D = dividends or drawings ...(5)

By transposing this equality it is possible for us to write it without negative symbols. Thus we have: A+E+D=L+C+R ...(6) This equality is the basic accounting equality. The quantities on the left hand side (LHS) are normally referred to as `debit' or `Dr.' in short and quantities on the right hand side (RHS) as `credit' or `Cr.'. in short. We have also seen that because of the basic balance sheet equality, this accounting equality will always hold true. The terms on the RHS and LHS are represented by one or more separate accounts where information is accumulated using the same framework. LHS terms, namely, A, E and D have debit balances. In other words, normally these accounts have debit side entries more than or equal in value to entries on the credit side. Hence, for those accounts: Debits - Credits > 0. When it is equal to zero there is no balance in the account. Similarly, the accounts relating to the terms on the RHS of the equality, that is L, C, and R, normally have credit balances. Hence, these accounts imply: Credits - Debits >= 0. The process of accumulating information is also simple. In the accounts representing LHS terms, all increases of those items are debited in the respective accounts and decreases are credited, net difference showing actual position at any point in time. Similarly, in case of accounts representing RHS, increases with respect to an item are credited in a particular account, and decreases are debited to that account. Net difference shows balance of that item as of a point in time. From this, it is also clear that the terms `debit' and `credit' in accounting have no more practical significance than `left' and `right' of an account. An account thus could be represented as a capital letter T denoting the nature of information accumulated in that. Thus, we have `cash account' or `receivable account' or payables account or `inventory account' and so on. Example:

Cash Account Cr.

Dr.

32

In this case LHS will represent all cash receipts or increase and RHS will represent all cash payment or decreases. Let us illustrate the ideas we have discussed with the help of a simple example: January 1 January 1 January 8 January 10 January 15 January 17 January 31 Started business with Rs.1,000. Bought merchandise worth Rs.800 and stored it. Received order for half the merchandise from A. Delivered the merchandise, customer invoiced Rs.500. Received order for the other half of merchandise Delivered merchandise and cash received Rs.500 Customer (A) pays.

Construction and Analysis of Profit and Loss Account

Accounts of the above transactions

Rs. Debit Capital Sales Receivable (A) Balance Cash A/c 1,000 Merchandise inventory 500 Balance 500 2,000 1,200 Rs. Credit 800 1,200 2,000

Rs. Debit Balance

Capital A/c 1,000 Cash 1,000 Balance

Rs. Credit 1,000 1,000 1,000 Rs. Credit 400 400 800

Rs. Debit Cash

Mercantile Inventory A/c 800 Cost of goods sold Cost of goods sold 800

Rs. Debit Profit & Loss A/c.

Sales A/c 1,000 Receivables (A) Cash 1,000

Rs. Credit 500 500 1,000

Rs. Debit Sales

Receivables (A) A/c 500 Cash 500

Rs. Credit 500 500

33

Understanding Financial Statements

Rs. Debit Merchandise inventory Merchandise inventory

Cost of Goods Sold A/c 400 Profit & Loss A/c. 400 800

Rs. Credit 800

800

Rs. Debit Cost of goods sold Retained earnings

Profit & Loss A/c 800 Sales 200 1,000

Rs. Credit 1,000

1,000

Rs. Debit Balance

Retained Earnings 200 Profit & Loss A/c

Rs. Credit 200 200

200 Balance 200

Rs. Debit Cash

Balance A/c 1,200 Capital Retained Earnings 1,200

Rs. Credit 1,000 200 1,200

In the above example what we have attempted is to complete the accounting process based on a very simple situation. The process of recording and summarising, we resorted to could be explained as follows: Starts business with Rs.1,000. This transaction affects two accounts: Cash increase entry on the debit side of the account. Capital increase - entry on the credit side of the account. Purchases merchandise and stores them. Merchandise inventory increase - entry on the debit side of the account. Cash account decrease- entry on the credit side of the account. Receipt of order for half the merchandise. Receipt of order does not warrant any record. We consider realisation of revenue only when goods are delivered. a) Delivered goods and customer invoiced. Since cash is not collected simultaneously, it represents a credit transaction. It results in an increase in claims against `A'. Accounts receivable is debited. Revenue is earned, sales account is credited. We should also consider the cost of sales. We part with merchandise inventory worth Rs. 400. It is an expired cost, hence a reduction in owner's equity, is an expense. Debit cost of sales account with increase in expense or expiration of cost. We credit the merchandise inventory account to show the reduction in inventory.

b)

34

Cash received from sales. Debit cash and credit increase in revenue, sales. We also recognise expense by debiting cost of sales account and crediting merchandise inventory account.
Receivables collected. Cash increase is recorded by debit in cash account and a credit to receivables (A) account. The credit to receivables account shows the liquidation of our claim (asset). In practice this amounts to repayment of the debt by A.

Construction and Analysis of Profit and Loss Account

5.5

SOME INDIRECT EXPENSES

In the example discussed above, we dealt only with direct revenue and direct expense. Revenue arose from two sale transactions-one on credit and the other on cash. The expense was one simple direct item of expense-the cost of sale or the recognition of expiration of inventory cost. Before we proceed to examine the detailed profit and loss account, we should discuss some of the important indirect expenses.

Bad Debt Expense

In most business situations sale `on credit' is common. We also treat such sale as realised since they produce a certain asset `receivable'. Thus, credit sale is recognised at the point of sale during the accounting period in which the transaction takes place. Uncollected balance at the close of the accounting period is reflected as an asset on the balance sheet. Now, if the customer could not make payment or will not make payment, both these records (record as revenue of the period and record as asset at the close of the period) will amount to overstatement in the records. However, we have no basis for estimating the exact amount of such collection losses. This is so since the 'uncollectability is known only in a subsequent accounting period. It is this situation which warrants us to estimate the amount of expense with respect to collection losses. Let us consider the following example. Suppose, a business makes four credit sales of Rs.250 each during a period. Cost of sales for the same being Rs.500. Profit and Loss Account

Rs. Cost of sales Profit 500 Sales 500 1,000

The balance sheet records arising from this transaction will be:

Rs. 1,000 1,000

Balance Sheet Assets Accounts receivable Rs. Liabilities & Capital 1,000 Retained earnings Rs. 500

Now assuming that one of the accounts is going bad, the collection loss will amount to Rs.250. If we do not take this into account, the implications are: we have overstated receivables (asset in the balance sheet), sales (revenue in the profit and loss account) and profit (retained earnings in the balance sheet). It is possible for us to estimate these losses on account of bad debts and reduce the revenues and thereby profits to that extent. It is achieved by recognising this amount as our increase in expense-bad debts expense-thereby reducing profit.

35

Understanding Financial Statements

Thus, we will prepare profit and loss account and balance sheet as follows:
Profit and Loss Account Debit Cost of Sales Bad debt expense Profit Rs. 500 250 250 1000 Balance Sheet Assets Accounts receivable Less: Estimated collection loss Rs. 1,000 250 750 Liabilities & Capital Retained earnings Rs. 250 1,000 Sales Rs. Credit 1,000

Usually the possible collection losses are estimated and provided for by charging them as expenses of the period. Such estimate is reduced from the value of the asset receivables to show the realisable value of the asset.

Depreciation on Fixed Assets

In our study earlier we have seen that fixed assets have long life and provide benefits beyond one operating cycle. While discussing the idea of expense we saw that expenses are expired costs. All costs incurred on any asset with limited life, thus, expire during its life time. Now it is not difficult to perceive what depreciation is. Consider the following illustration. A machine purchased for Rs.5,000 having five year life and no salvage value is used in a business. During the life of the asset, it will be able to earn a revenue of Rs.10,000. It is simple arithmetic to say that by using the machine we make a profit of Rs.5,000 over its life time (Rs.10,000 revenues less Rs.5,000 cost of the machine) assuming no other costs. The problem of depreciation arises when we have to measure the profits annually. What should be the amount of profit to be recognised every year? We can approach this problem diagramatically. Assume that the following scale shows the amount of revenue earned. We take it that the revenue is earned in equal amounts

36

during the five years of the life of the asset. Assuming no other costs and no salvage value, the cost of the asset becomes expense over a five year period. Now the question is how should we apportion this cost over the life of the asset? If we make the simple assumption that the cost expires in equal proportion, we have the simplest solution. This we could represent as follows:

Construction and Analysis of Profit and Loss Account

Now, having made the assumption of spreading the cost equally, we have come to the conclusion that one-fifth of the cost of the asset expires annually. That portion of the cost of the asset which is reckoned to expire during an accounting period is what is termed as depreciation expense. This also clarifies that, normally, the total amount of depreciation of an asset shall not be more than the depreciable cost of the asset. It is this `expense' which is matched against the revenues of a period for determining profit. From the above example we can easily determine that the profit per annum is Rs. 1,000, that is, Rs.5,000 over the useful life of the asset. Thus, to recapitulate, depreciation expense is the cost of a fixed asset written off against the revenues of different periods during which the asset is used.

5.6

METHODS OF DEPRECIATION

There are several methods of depreciation which differ from one another only from the standpoint of how the cost is treated as expiring over the life of the asset. We shall briefly discuss only two of the most commonly used methods. However, in order to understand the methods we should be clear about the following ideas:
Original cost of the asset: This is the cost incurred in making the asset available for use in the first instance. Salvage value: The expected recovery or sales value of the asset at the end of useful life. Useful life: The expected time period for which the asset is to provide economic service i.e. the period for which the asset could be used for production. Depreciable cost: This is original cost less salvage value. This is the amount of expense the enterprise will be incurring on account of expired costs of the machine over its useful or oreco?omic life. Written down value: Written down value of an asset at any point of time is original cost less depreciation to date (accumulated depreciation). This is also referred to as book value.

Straight Line Method

Under the straight line method the depreciable cost of the asset is proportionately allocated as expense against the revenues during each year of the useful life of the asset.

37

Understanding Financial Statements

Assume that a company acquires a machine at the beginning of operations at Rs. 1,000. It is expected that the machine will last 10 years and will have no salvage value at that time. The depreciation for the machine every year under straight line method will be Rs. 100, or Rs. 1,000 =10. The written down value at the end of first year will be 1,000 - 100 = 900, at the end of second year 1,000 - (100+ 100) or (900 - 100) = 800 and so on, becoming zero at the end of 10 years. Graphically, it could be shown as follows:

If we draw a graph showing the annual depreciation it will be a straight life parallel to the base line. Hence the name straight line method (Figure 5.1). The accumulated depreciation will be increasing annually at a uniform rate becoming equal to the depreciable cost of the asset at the end of useful life (Figure 5.2 ). As shown in Figure 5.2 it is a straight line sloping upward to the right from origin whereas written down value steadily declines to become zero at the end of useful life of the asset. Hence a downward sloping straight line reaching origin at the end of useful life (Figure 5.3).

38

Figure 5.3 : Straight-line Method Written down value

Construction and Analysis of Profit and Loss Account

Written Down Value method

Under this method depreciation at a certain rate is applied to the written down value of the asset as at the beginning of each year. The effect of this method is that the amount of depreciation charge every year is an Amount less than the previous year. In other words, larger amounts are charged to depreciation during the initial years. For example:
A company buys an asset at a cost of Rs. 1,000. It decides to depreciate it at the rate of 20 per cent per annum based on written down value method.

The annual book value, depreciation charge and accumulated depreciation will be as follows (Table 5.1): Table 5.1: Written Down Value Depreciation

Year 0 1 2 3 4 5 6 7 8 9 10

Written down value at the end of the year 1,000 800 640 512 410 328 262 210 168 134 107

Annual depreciation 200 160 128 102 82 66 52 42 34 27

Accumulated depreciation 200 360 488 590 672 738 790 832 866 893

Annual depreciation under `written down' value method is the highest during the first year and keeps on reducing over the subsequent years. This is shown by a rapidly declining curve (Figure 5.4). However, the rate of decline reduces as the number of

39

Understanding Financial Statements

40

years approaches end of the life of the asset. Accumulated depreciation, similarly, increases at a rapid rate during initial years and the rate of increase declines in later years (Figure 5.5). The `written dowel' value of the asset is a declining curve (Figure 5.6). The unallocated portion of the cost is usually charged as depreciation in the last year of the life of the asset.

Depreciation Method: Impact on profit Measurement

What we could learn from the discussion of the depreciation methods is that, depending on the method used, we have a different amount of charge for annual depreciation. It may also be noticed that over the entire life of an asset the total amount of depreciation charge cannot be different. Thus, the difference is only i n terms of annual apportionment. The net effect of the methods is thus in terms of showing less o r more profit in any particular year. This could be explained by continuing with the example. Suppose that the company using the machine in our earlier example earns Rs.500 per annum before depreciation. The difference in annual measurement of profit under straight line and written down value methods will be as follows (Table 5.2): Table 5.2:Profits under Written Down Value and Straight Line Method of Depreciation (1) Year (2) Profit before depreciation (3) Straight line depreciation (4) Net Profit under straight line method of depreciation (2) (3) Rs. Rs. 400 400 400 400 400 400 400 400 400 400 4,000 (5) Written down value depreciation (6) Net profit under written down value method of depreciation Rs. Rs. 300 340 372 398 418 434 448 458 466 366 4,000

Construction and Analysis of Profit and Loss Account

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Total

Rs. Rs. 500 500 500 500 500 500 500 500 500 500 5,000

Rs. Rs. 100 100 100 100 100 100 100 100 100 100 1,000

Rs. Rs. 200 160 128 102 82 66 52 42 34 134* 1,000

* Includes the unallocated depreciation charge, since there is no salvage value for the assets. Under this method there will always be a terminal unabsorbed depreciation. Figures are rounded off.

5.7

FORM OF PROFIT AND LOSS ACCOUNT

So far we have been discussing profit and loss account in the `account' format.That is, listing all the revenues earned on the RHS and all the expenses incurred on the LHS showing profit in case of a credit balance and loss in case of a debit balance. Modern practice is to present the information in a summarised statement giving the details in attached schedules. This achieves the same result because of the relationship: Revenue - Expense = Profit/Loss. We give below a condensed profit and loss account in both the formats. We shall then discuss the items presented. It may help you to copy out this profit and loss account since Subsequent discussions will be based on this example.

41

Understanding Financial Statements

TOOLS INDIA LTD. Profit and Loss Account For the year ending December 2003

(Rs. in Millions)
Debit Cost of goods sold (Schedule 3) Gross profit Personal (Schedule 4) Depreciation (Schedule 5) Other Expenses (Schedule 6) Operating profit Interest (Schedule 7) Profit before taxes Income-tax provision Net profit after tax 130 130 260 49 11 28 42 130 12 30 42 12 18 30 Alternatively, the same profit and loss account could be presented as follows: TOOLS INDIA LTD. Profit and Loss Account For the year ending December 2003 Sales net (Schedule 1) Other income (Schedule 2) Credit 255 5 260

Gross Profit

130

Operating income

42 42 30 30

Profit before taxation

(Rs. in Millions)
Debit Sales Other income Cost of goods sold Gross profit Operating expenses: Personal Depreciation Other expenses Operating Profit Less: Interest expense Net Profit before Income Taxes Less: Provision for Taxes Net Profit 18 (Schedule 7) (Schedule 4) (Schedule 5) (Schedule 6) 49 11 28 88 42 12 30 12 (Schedule 1) (Schedule 2) (Schedule 3) Credit 255 5 260 130 130

42
The condensed profit and loss account will be accompanied by schedules providing

details of various items forming the total. Sales: Net sales shown in the profit and loss account is after deducting Rs. 5 million front gross sales. Schedule l also provides the detailed break up of sales by different divisions of the company as also domestic market and export sales. Schedule 1: Sales

Construction and Analysis of Profit and Loss Account

(Rs. in Millions)
Gross Sales Less: Sales returns and allowances Sales discount Net Sales (inland) Machine Tools Group Watch Group Tractor Group Lamp Group Dairy Machinery Group Export: Machine Tools Group Watch Group Others Total Net Sales 260 1.75 3.25 5 255 83 87 60 13 2 245 6 2 2

10 255

Sales Returns and Allowances: Sales records are prepared as and when goods are shipped to Customers. Goods which are not according to specifications, damaged or defective may be returned by the customers and refund or credit sought. Such refunds or allowances are separately accumulated for the purpose of control by management. At the time of preparation of profit and loss account such allowances are set off against the gross sales and net sales taken as operating revenue earned. Many companies may not disclose this information in published accounts. Sales Discount is a reduction from invoice price granted for prompt payment of the invoice within a specified time limit. This is also sometimes called cash discount. In our example, Tools India Ltd. allowed Rs.3.25 million in discounts to customers. It is usual practice to state the discount offered to customer on the invoice. Discounts or terms of payments are usually presented in short forms or symbols. They may be `Net amount' or `No cash dicount' (N) Net Amount due at End of the Month (N/EOM); Net amount due in 30 days of invoice, no cash discounts (N/30); 5 per cent discount if payment is made in 10 days, net amount to be paid in 30 days (5/10, N/30). An invoice of `5/10', N/30' simply means that 5 per cent discount will be allowed if payment is made within ten days. It also implies that by not paying in 10 days you could avail the normal credit of 30 days. Suppose you have Rs.1,000 invoice with `5/10,N/30'. You are losing 5 percent for 20 days credit. In other words it costs you 360/20 x 5% = 90% per annum in equivalent interest. This knowledge will definitely help you in planning your shortterm finances more effectively. Trade discounts are used as adjustments in price and used when bulk sales are made by wholesaler to retailers. These are novel- brought into accounts. Rather, the sales are valued at net of trade discount.

43

Understanding Financial Statements

Other Income : The revenue earned by an enterprise is usually bifurcated into two parts, operating income and non-operating income. Operating income usually refers to income derived from the main-line operations of the business. Other income. usually arises from activities incidental to the business. Schedule 2 lists the details of non-operating incomes of Tools India Ltd. Schedule 2: Other Income Rs. in Millions Interest - Banks Interest- Staff and Office Export incentives Sales agency commission Profit on sales of assets Dividend on trade investment Other Miscellaneous income Total 0.50 1.20 1.80 0.50 0.30 0.20 0.50 5.00

5.8

COST OF GOODS SOLD

Cost of goods sold is very complex in case of a multi-product, multi- division company where you have large amounts of semi-finished goods. But in case of a trader, who deals in commodities and where each unit bought could be identified with each unit sold, it is very simple. We confront two major problems in this regard. First is with respect to changes in the price per unit of purchases. At what price should we identify the cost of goods sold? Second, how do we evaluate cost of semi-finished goods? Cost of goods sold in summary presented in our example could be understood more clearly from schedule 3. Schedule 3: Cost of Goods Sold

(Rs. in Millions)
Inventory Add: Purchases Freight in Other direct material costs Total goods available Less: Raw material and semifinished Inventory on December 31, 2003 Goods available for sale Less: Finished goods inventory on December 31, 2003 Cost of goods sold 145 15 130 71 110 1 15 135 216 81

44

Activity 5.2
Relate items in Column A to all items A 1. 2. 3. 4. Gross Sales Sales returns and allowances Depreciation Discounts in Column B. B 1. Non-cash expense of the period 2. Total invoice value of goods sold during the period 3. Reduction from invoice price 4. 2/5, N/30 5. Given effect when goods are returned by customers 6. Adjustments to recorded sales.

Construction and Analysis of Profit and Loss Account

5.9

METHODS OF INVENTORY VALUATION

The only thing certain with respect to price normally is that they are not certain. This makes it necessary to evolve a strategy for charging, the cost of materials sold. Two of the most commonly used systems are the `First in, First out' (FIFO) which assumes that the sales are made in the order in which they are. purchased and `Last in, First out' (LIFO), which assumes that goods which are bought last are sold first. This could be illustrated with a simple example. No. of Units January 1 January 5 January 10 January 15 January 20 January 25 Inventory Purchases Purchases Purchases Purchases Purchases Total 500 1,000 2,000 1,000 3,000 2,000 9,500 Units January I 1 January 14 January 16 January 21 January 30 Total Sales Sales Sales; Sales Sales 1,000 500 1,000 2,000 1,500 6,000 Cost per Unit Rs. 3 4 5 6 4 7 Amount Rs. 1,500 4,000 10,000 6,000 12,000 14,000 47,500

If we value the cost of sales on the basis of FIFO we have the following situation:

45

Understanding Financial Statements

Table 5.3: Cost of goods sold and inventory under FIFO Date January 11 January 14 January 16 January 21 January 30 Total Sales Inventory Total Quantity sold 1,000 500 1,000 2,000 1,500 6,000 3,500 9,500 Thus, cost of goods sold and inventroy under FIFO are: Cost of goods sold Inventory Total 27,500 20,000 47,500 Quantity Break-up 500 500 500 1,000 1,000 1,000 1,500 1,500 2,000 Rate X3 X4 X4 X5 X5 X6 X4 X4 X7 Amount 1,500 2,000 2,000 5,000 5,000 6,000 6,000 6,000 14,000 Total Amount 3,500 2,000 5,000 11,000 6,000 27,500 20,000 47,500

If we follow LIFO the picture will be as follows (Table 5.4): Table 5.4: Cost of goods sold and inventory under LIFO Date Quantity Sold January 11 1,000 January 14 500 January 16. 1,000 January 21 2,000 January 30 1,500 Total Sales 6,000 Inventory 3,500 500 1,000 500 1,000' 500 x3 x4 x5 x4 x7 1,500 4,000 2,500 4,000 3,500 Quantity 1,000 500 1,000 2,000 1,500
,

Rate x5 x5 x6 x4 x7

Amount 5000 2,500 6,000 8,000 10,500

Total Amount 5,000 2,500 6,000 8,000 10,500 32,000

15,500 47,500

Total

9,500

Thus, cost of goods sold and inventory under LIFO are: Rs. Cost of goods sold Inventory 32,000 15,500 47,500

46

Total

From the example above we find that the FIFO cost of goods sold, which is based onprices of inventory procured earliest prior to sales, would amount to Rs. 27,500. And the closing inventory of 3,500 units will be valued at Rs. 20,000 which is based on the most current purchase prices. The LIFO cost of goods sold, which is based on the most recent prices of the inventory purchased, is Rs.32,000. Closing inventory, based on the prices of earlier purchase, is valued at Rs. 15,500. In both cases inventory plus cost of goods sold amount to the same, that is, Rs. 47,500 since it is based on actual historical cost only. Here again, over the entire life of the entity there will be no difference, irrespective of the method used in valuing the cost of goods sold. There will also be no difference if the entire inventory is sold. The differences again reflect one of the effects of accounting periods on income measurement.

Construction and Analysis of Profit and Loss Account

5.10 GROSS PROFIT

Gross profit obtained by subtracting the cost of goods sold has great managerial significance. Cost of goods sold usually reflects the direct input costs which, to a great extent, are available with the volume of operations. In other words, per unit cost of goods sold holds a fixed relationship. The gross profit margin should be sufficient to cover operating expenses.

Operating Expenses
All those expenses which are necessary to run the business enterprise but which are not directly associated with the company's output or production or trading are usually termed as operating expenses. Usually these expenses include all items of cost concerned with providing administrative and general support to business operations. It is the usual practice to segregate these costs as falling under two broad groups: selling and distribution and general administrative expenses. The latter also covers personnel expenses including staff and workmens' compensation and other benefits. In case of Tools India Ltd., details of the expenses on account of personnel are given in Schedule 4. Schedule 4: Personnel Expenses (Rs in Millions) Salaries, Wages and Bonus House rent allowance Gratuity Contribution to Provident Fund Contribution to Employees State Insurance (ESI) Workmen and Staff Welfare expenses Total 37.81 2.19 0.75 2.75 0.50 5.00 49.00

Depreciation
Depreciation, as explained earlier, is the expiration of costs of fixed assets. It is usual practice to classify the depreciation expense for different groups of assets. In case of Tools India Ltd., Schedule 5 gives the break up of depreciation for different groups of assets.

47

Understanding Financial Statements

Schedule 5: Depreciation (Rs. in Millions) Fixed Assets Tools and Instruments Patterns Jigs and Fixtures Total Other Expenses Other expenses' give detailed break up of most of the major items of operating expenses other than personnel, depreciation and financing costs. In case of tool India Ltd., the details are provided in Schedule 6. Schedule 6: Other Expenses (Rs. in Millions) Power and Fuel Rent Rates and Taxes Insurance Water and Electricity Repairs to buildings Repairs to machinery Printing and Stationery Advertisement and Publicity Training Audit fees Royalties Sole Selling and other Agents' Commission Directors' Fees Provision for bad debts and advances Loss on assets sold or discarded Provision for warranty repairs Miscellaneous expenses Total 3.10 0.50 0.40 0.50 0.60 0.20 0.80 0.90 2.40 0.10 0.05 0.85 4.70 2.00 0.20 1.30 1,00 8.40 28.00 9.84 0.02 1.14 11.00

5.11 OPERATING PROFIT

Operating profit is the net result obtained from the operations after subtracting depreciation, personnel, and other expenses from gross profit. The amount is earned by the company irrespective of the method of financing, the only other expense to be met being interest expense. This is a measure of operational efficiency of the company, and is usually referred to as OPBIT (Operating Profit Before Interest And Taxes) or EBIT (Earning Before Interest And Taxes).

Interest Expense.
Interest expense' arises out of management's decision to finance part of the expenses from borrowed funds. The level of interest expense represents the amount of risk the company is carrying in terms of fixed commitments, irrespective of the volume of operations and profit. Schedule 7 shows the different items of interest commitments of Tools India Ltd.

48

Schedule 7: Interest Rs. In Millions Debentures Fixed Deposits Loans from Government Team loans from Banks/Financial Institutions Cash Packaging credit from banks Others Total 0.58 1.50 5.00 0.42 3.50 1.00 12.00

Construction and Analysis of Profit and Loss Account

Net Profit Before Tax

Net profit before tax is surplus after meeting all expenses including interest. This is the profit available to the company as a result of both operating and financing performance. This profit is usually referred to as PBT (Profit Before Tax) or EBT (Earnings Before Tax).

Income Taxes
The profit before tax determines the level of taxation. As per the tax laws the amount of tax payable is not determined on the basis of reported net profit. In most cases accounting profit arrived at has to be reclassified and recomputed for determining the tax liability. Further, the tax liability, though certain, is determined only after the tax assessment is completed. This is the reason why tax liability is always provided or as a provision, implying that this liability is based on an estimate. When the amount is actually determined later on, it is set off against this provision.

5.12 NET PROFIT

This is the amount ultimately available to the company for appropriation. That is, this amount could be either distributed as dividends to shareholders (owners) or retained in the business as retained earnings, thereby increasing the owners' investment or equity in the business. This is variously referred to as PAT (Profit After Tax) or EAT (Earnings After Tax). After subtracting dividends declared, any surplus remaining is added to retained earnings, that is, Reserve and Surplus.

Activity 5.3
Classify each item listed in Column A under appropriate classification in item B, assuming that the information relates to a small manufacturing firm. . A 1) 2) 3) 4) Raw material consumed Interest received Dividends received Wages paid to workers B i) Operating revenue ii) Non-operating revenue iii) Cost of goods sold iv) Selling and distribution expenses

5)
6) 7) 8) 9)

Carriage on goods sold

Carriage on goods purchased Salary of clerical staff Rent for office Power and fuel

v) Administrative expenses
vi) None of the above.

49

Understanding Financial Statements

10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20.

Selling agents' commission Advertising Auditors' fees Sales tax Municipal rates on office premises Profit on sale of machinery Bonus paid to workers Sales discount Purchase returns and allowances Dividends paid Interest expense on loans.

5.13 SUMMARY
In this unit we have developed and examined the profit and loss account. This account shows the net profit or earnings generated by the company. Thus, this measures the management's ability to generate income from assets. The profit and loss account summarises the revenues and expenses of an accounting period. As a result of this summary it shows the net profit or net loss experienced by the company during the period. The reader of this account is provided with the past cost structure and profitability. The net profit after payment of dividends shows the amount retained and hence links the balance sheet with the profit and loss account.

5.14 KEY WORDS

Revenue: Assets received from the sale of goods or services to customers. Also includes income generated from assets and investments usually classified as nonoperating revenue. Revenues increase owners' equity. Expense: Any reduction in owners' equity (total assets minus total liabilities) not resulting from distribution to owners. Represents expiration of costs, use or loss of an asset without being replaced by another asset. Realisation: Recognition of the revenue in accounting based oil the assumption that increase in owners' equity arises at the point of delivery or provision of goods or services. Accrual: Income measured on the realisation of revenue independent of the timing of cash receipt and payment. Profit: Revenue minus expenses for a given accounting period. Negative profit (income) is known as loss. Profit and Loss Account: The final summary of all revenues, gains, expenses and losses during an accounting period. Shows the net profit or loss for the period. Depreciation: The amortisation representing allocation of cost expiration of tangible fixed assets over their useful life. Cost: The amount paid or to be paid for acquisition of goods or services.

50

Matching: Income measurement based on comparison of expenses and revenues of a period.

5.15 SELF-ASSESSMENT QUESTIONS/EXERCISES

1. Explain the following: Realisation Concept Accounting Period Concept Matching Concept 2. 3. When should revenue be recognised? What are bad debts? In what way do we deal with the problem of possible bad debts in accounting? What is depreciation and what is the rationale behind making a provision for depreciation in the process of matching income and expenses? Differentiate between: Straight Line method and Written Down Value method of providing depreciation: Operating Profit and Net Profit FIFO and LIFO methods of Inventory valuation. Following is the summarised Profit and Loss Account of Shyam Enterprise for five consecutive periods. Complete the same by supplying missing information.

Construction and Analysis of Profit and Loss Account

4.

5. a)

b) c) 6.

7.

Following information relates to Ramsons operations for a period ending December 31, 2002, the first year of operations. From this information complete the accompanying Profit and Loss Account and Balance Sheet.

51

Understanding Financial Statements

Revenues and expenses of the period are as follows:

Rs. Depreciation expense Purchases (raw material) Wages Purchase discount Sales Rent Insurance Returns inwards and allowances Sales discount Interest expenses Miscellaneous expenses Interest on deposits received Balance shown by asset and liability accounts on 31st December 2002 is as follows: Cash Deposits with bank Inventory of raw material Land Buildings and equipments Advance tax paid Tax Payable Accounts receivable Accounts Payable Capital Long term loan Retained earning 15,000 20,000 10,000 10,000 90,000 5,000 ? 20,000 19,500 75,000 50,000 ? 5,000 50,000 25,000 5,000 1,00,000 3,000 2,000 2,000 1,000 2,000 5,000 2,000

RAMSONS Profit and Loss Account For the Year ending 31st December 2002
Inventory Consumed Wages Gross Profit Depreciation expense Rent Sales discount Insurance Interest expenses Miscellaneous expenses Operating Profit Net Profit before tax Income Tax @ 50% Profits retained Rs. ________ ________ ________ ________ ________ ________ ________ ________ ________ ________ ________ ________ ________ Sales Less: returns and Allowances Gross Profit Purchase discount Rs. ________ ________ ________ ________ ________

52

Operating Profit Interest on deposite Net Profit before tax

________ ________ ________

RAMSONS Balance Sheet As on 31st December 2002 Rs. Liabilities and Capital Capital Liabilities ________ Account payable Tax payable ________ Total current liabilities ________ ________ Long Term Loan ________ Capital ________ Retained earnings ________ ________ ________ Rs. ________ ________ ________ ________ ________

Construction and Analysis of Profit and Loss Account

Assets Current Assets Cash Deposite with bank Account receivable Inventory Advance tax paid Total Current assets Fixed Assets Land Building & equipment Less: Accumulated depreciation

8. The following are the balances taken on 31st December, 2002 from the books of account of Western Plastics Limited:

53

Understanding Financial Statements

In addition, the following information is available: a) The authorised share capital is: 20,000 10% Preference shares of Rs. 10 each, 24,000 Ordinary shares or Rs. 10 each b) c) All the issued ordinary shares are fully paid Depreciation to be provided for 2002 as follows Property Plant, etc. d) e) i) ii) iii) 2% on cost 10% on cost

Provide for the preference dividend due. A final dividend of 10% on the ordinary shares is proposed Ignore taxation. With the help of the above information: Prepare an income statement for the year ended 31 st December, 2002 and a Balance Sheet as at that date. Comment on the salient features of the financial statements you have prepared so far as they provide meaningful information for users' needs. Identifythe main information objectives of shareholders and assess the extent to which these objectives are satisfied by the financial accounts you have prepared

Answers to Activities Activity 5.1

1) 2) 3) 4) 5) 6) 7) Revenue and expenses Revenue Expenses to revenues Expired costs or expenses Accrues Decrease Revenue, accounting.

Activity 5.2
(1) A 1-B2 (2) A2-B 5, B6 (3) A3-B 1 (4) A4-B3, B4

Activity 5.3
1 (iii) 2. (ii) 3, 4. (iii) 5.(iv) 6. (iii) 7. (v) 8.(v) 9.(iii) 10.(iv) 11. (iv) 12.(v) In. (vi) 14. (v) 15. (ii) 16. (iii) 17.(iv) 18.(iii) 19. (vi) 20. (v).

54

Answers to Self-Assessment Questions/Exercises

7 Solution: RAMSONS Profit And Loss Account For the Year ended 31st December, 2002 Purchases Less Inventor} Inventory consumed Less purchase Wages Gross profit Rs 50,000 10,000* 40.000 1.0011 Rs Sales Rs 1,00.000 Rs

Construction and Analysis of Profit and Loss Account

39,000 25,000 32,500 96.500

Less: Returns and Sales discount

2,000 1,500

96,500

96,500 Grass Profit 32.500

Depreciation expense Rent Sales Discount Insurance Interest expense Miscellaneous Operating Profit

5,000 3,000 2.000 2,000 2,000 5,000 18,500 32,500

32.500 Operating Profit Interest on deposit 18,500 2,000 20,500 Net Profit before fax 20,500 20,500

Net Profit before tax

20,500 20,500

Incnmc '(e, 5(1 % Profit Retained

10,250 10,250 20,500

Inventory figure has been obtained from the balances shown under asset and liability accounts.

55

Understanding Financial Statements

Assets Current Assets Cash Deposit with bank Accounts receivable Inventory Advance tax paid Total current assets Fixed Assets Land Buildings and equipment 90,00 Less: Accumulated 5,000 depreciation

Rs. 15,000 20,000 20,000 10,000 5,000 70,000

Liabilities and Capital Current Liabilities Accounts payable Taxes payable Total current liabilities Long Term Loan Capital Retained earnings

Rs IC It 28 00 00 50

50 75. 10,

10,000

85,000 1,65,000 1,16,50 Balance Sheet Total Rs. 4,14,930.

8.

Gross Profit Rs. 1,52,300 Operating Profit Rs. 74,400 Net Profit Rs. 45,120

5.16 FURTHER READINGS

Fraser, L.M. and Ormiston. Ailen 04/10/2003, Understanding Financial Statements Prentice Hall : New Delhi (Chapter 3) Hortagren, C.T., Sundem G.L. and Jhon, A. Elliot, 02/10/2002, b7frocluclion to Financial Accounting Prentice Hall : New Delhi (Chapters 2-4) Khan M.Y. and Jain P.K., 2002, Cost Accounting Land Financial Management, Tata McGraw Hill (Chapter 3) Bhattacharya, S.K. and John Dearden, 1984. Accounting f or Management Text and Cases (2nd Ed) Vani: New Delhi. (Chapters 4,8,9 & 10.) Glautier M. W.E., Underdown B. and A.C. Clark, 1979. Basic Accounting Practivce Arnold Hieneman: New Delhi. (Chapters 2-4) Hingorni N.L. and A.R. Ramanathan, 1986. Management Accounting Sultan Chand New Delhi. (Chapters 3-5) Meigs W.B. and Robert E. Meigs, 1987. Accounting : The Basis For Business Decisions (7th Ed.), McGraw-Hill : New York. (Chapters 3 and 4.)

56

UNIT 6 CONSTRUCTION AND ANALYSIS OF FUND FLOW AND CASH FLOW STATEMENTS
Objectives After you have studied this unit, you should be able to: understand the idea of funds flowing through a business in a dynamic situation appreciate the role of working capital in the operations of a business understand the sources and uses of working capital as well as cash during an accounting period from the financial statements understand and interpret changes in working capital identifying the causes of these changes use the funds flow statement and the cash flow statement as analytical tools.

Construction and Analysis of Fund Flow and Cash Flow Statements

Structure 6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 6.9 6.10 6.11 6.12 6.13 6.14 6.15 Introduction Working Capital and its Need Determining Working Capital Requirements Sources of Funds Uses (Applications ) of Funds Factors Affecting Fund Requirements Analysing Changes in Working Capital Fund Flow Statement Importance of Cash and Cash Flow Statement Sources and Uses of Cash Preparation of Cash Flow Statement Summary Key Words Self Assessment Questions Further Readings

6.1

INTRODUCTION

Depending on the user's purpose, the term `funds' may be used differently. Literally, it means a supply that can be drawn upon. In this sense it is used to mean cash, total current assets or working capital. We use it here in the sense of working capital meaning total current assets less current liabilities. Funds flow is used to refer to changes in or movement of current assets and current liabilities. This movement is of vital importance in understanding and managing the operations of a business. We have seen in the unit dealing with balance sheet that every material transaction changes the position statement (or Balance Sheet). This in other words implies a dynamic situation involving continuous movement of resources into the business,

57

Understanding Financial Statements

within the business and out of the business. The complexity of these flows increases with the increasing size and volume of business. Directly or indirectly, all these flow take place in business through the medium of funds. Funds in the form of cash and cash equivalents, in the right quantity are necessary for the smooth functioning of any business. The continuous movement of cash within the business and out of the business could be understood by studying the cash flow statement.

6.2

WORKING CAPITAL AND ITS NEED

We have earlier defined working capital as total current assets less current liabilities. This, in other words, means all the assets held by the business with the objective of conversion into cash (including cash) during an operating cycle of the business. Of these assets, a part is financed by short-term credits which are to be met during the operating cycle representing current liabilities. Thus current assets less current liabilities or working capital implies amount of resources invested in current assets from sources of finance other than current liabilities. This net amount is also the amount available for use in the business in the form of fund. Consider the following example. Ramsons is a retail outlet dealing in domestic appliances and entertainment electronics equipment, owned by Ram. The investment in the showroom, display counters,' cash register, furniture, fixtures and so on is Rs. 6,00,000. Ram decides to use straigh line depreciation at the rate of 10 per cent per annum. Ramson's estimated sales is Rs. 1,50,000 per month: 50,000 cash sales and Rs. 1,00,000 on credit to be collected in four equal monthly instalments. All sales are made at 25 per cent margin on selling price. Supply and sales constraints would warrant carrying three months sales requirement in the form of inventory. Similarly, month's cash expense requirements have to be held in cash balance. Initial inventory is to be bought for cash and replenishment purchases will receive a month's credit from suppliers. Average monthly cash requirements for meeting operating expenses other than payment for purchases amount to Rs. 26,000. Ram needs to withdraw Rs. 4,000 per month for his personal needs. 1. 2. How much working capital will Ramsons require to start operations? Will he need additional working capital during the first four months? Or will he have surplus working capital during the first four months?

58

You can instinctively answer these questions by saying that Ramsons needs working capital to pay for inventory, for expenses and for keeping a safe cash balance. You can also say that Ramsons will receive funds from operations to meet some of these requirements. To be more specific, how much money does he require? This could be done by working out a schedule of cash receipts and cash payments on a monthly basis. It is also possible for us to prepare proforma monthly profit and loss account and balance sheet. You can also notice that we have chosen the first four months consciously since it completes one operating cycle of the business.

RAMSONS: Schedule of Cash Payments

Month January February March April Explanation Operating Expenses Withdrawals January Purchases Operating expenses Withdrawals February Purchase Operating expenses Withdrawals March purchases Operating expenses Withdrawals Amount Rs. 26,000 4,000 1,12,500 26,000 4,000 1,12,500 26,000 4,000 1,12,500 26,000 4,000 Total Rs. 30,000 1,42,500 1,42,500 1,42,500

Construction and Analysis of Fund Flow and Cash Flow Statements

RAMSONS: Schedule of Cash Receipts

Month January February Explanation Cash Sales Credit Sales of the monthfirst installment Cash sales Credit Sales of the monthfirst installment January sales-second installment Cash sales Credit Sales of the month-first instalment January sales-third instalment February sales-second instalment Amount Rs. 50,000 25,000 50,000 25,000 25,000 50,000 25,000 25,000 25,000 April Cash sales Credit Sales of the month-first instalment January sales-fourth instalment February sales-third instalment March sales second instalment 50,000 25,000 25,000 25,000 25,000 1,50,000 1,25,000 Total Rs. 75,000

1,00,000

March

Opening balance sheet of Ramsons will be as follows: RAMSONS: Balance Sheet as of January 1,2003
Assets Fixed Assets Inventory Cash Rs. 6,00,000 3,37,500 30,000 9,67,500 Liabilities and Capital Capital Rs. 9,67,500

9,67,500

We have assumed that the entire asset requirements are financed by owner's capital. Working capital of Ramsons on January 1, 2003 is as follows: Current Assets: Inventory Cash Total Current Assets Less: Current Liabilities Working Capital 3,37,500 30,000 3,67,500 Nil 3,67,500

59

Understanding Financial Statements

RAMSONS: Schedule of Cash Balances January Opening Balance Cash Receipts Total Cash available Less: Cash Payments Cash Balance 30,000 75,000 1,05,000 30,000 75,000 February 75,000 1,00,000 1,75,000 1,42,500 32,500 March 32,500 1,25,000 1,57,500 1,42,500 15,000 April 15,000 1,50,000 1,65,000 1,42,500 22,500

RAMSONS: Profit and Loss Account for the Month ending 31st January Sales Less: Cost of Sales Other Expenses 1,12,500 26,000 1,50,000 1,12,500 26,000 1,43,500 5,000 6,500 28th February 1,50,000 1,12,500 26,000 1,43,500 5,000 6,500 31st March 1,50,000 1,12,500 26,000 1,43,500 5,000 6,500 1,43,500 6,500 30th April 1,50,000

Depreciation 5,000 Net Profit:

RAMSONS: Balance Sheet as at the end of Assets Fixed Assets Less: Depreciation Net Fixed Assets Inventory Receivables Cash Total Current Assets Total Assets Liabilities and Capital Capital Add: Retained Earnings Owners Equity Accounts Payable 9,67,500 2,500 9,70,000 1,12,500 10,82,500 9,67,500 5,000 9,72,500 1,12,500 10,85,000 9,75,000 1,12,500 9,75,000 1,12,500 10,87,500 9,77,500 1,12,500 9,77,500 1,12,500 10,90,000 31st January 2003 6,00,000 5,000 5,95,000 3,37500 75,000 75,000 4,87,500 10,82,500 28th February 2003 6,00,000 10,000 5,90,000 3,37,500 1,25,000 32,500 4,95,000 10,85,000 31st March 2003 6,00,000 15,000 5,85,000 3,37,500 1,50,00 15,000 5,02,500 10,87,500 30th April 2003 6,00,000 20,000 5,80,000 3,37,500 1,50,000 22,500 5,10,000 10,90,000

60

RAMSONS: Schedule of Working Capital 31st January 2003 Current Assets Less: Current Liabilities 4,87,500 1,12,500 3,75,000 28th February 2003 4,95,000 1,12,500 3,82,500 31st March 2003 5,02,500 1,12,500 3,90,000 30th April 2003 5,10,000 1,12,500 3,97,500

Construction and Analysis of Fund Flow and Cash Flow Statements

Funds From Operations Net Profit Add: Depreciation Total funds generated from operations 6,500 5,000 6,500 5,000 6,500 5,000 6,500 5,000

11,500

11,500

11,500

11,500

Initial Investment (Capital)

Now with the example of Ramsons at hand, it is not difficult for us to understand that Ramsons have invested the `money to make money'. Where has Ramsons invested the money? It is easy to answer this question because the balance sheet of the business tells us what all things Ramsons has done with the money. Refer to the first balance sheet and you will find Ramsons has fixed assets (show room and facilities), inventory (goods or merchandise) which he has purchsed for resale and some cash for meeting expenses and personal needs. This is how Ramsons have invested the capital to start with. Let us first review these items and accounts receivable:

Cash
It is difficult to perceive cash kept in the vault as an investment. Rather, you would be thinking that if we invest cash, then how can cash itself be an investment? But you will realise that a certain minimum amount of cash is necessary for any business. Take a simple case: if you are a retailer, will you send away a customer who does not have exact change? However, you can entertain him only if you keel) change. That is your investment in cash; Similarly, you will have to pay your employees and suppliers at a specific time. I n order to do that you need cash. Thus investment in cash is that amount which is required to be kept on hand to meet day-to-day requirements of cash. This amount is determined after taking into account the regularity and amounts of inflows of cash, the amount and frequency of outflows, as also the uncertaintues related to these. Obviously, as your business grows the need for cash will also grow.

Receivables
In most situations it will be necessary to grant credit to customers. This may be necessary either because of competition or because of the custom of trade. However, when we grant credit to customers it implies that we have to finance the cost of materials for the duration of such credit. In other words, you are financing your customers' business to the extent of the credit granted. Whenever the business is expanding, the volume of receivables will also expand. Please note that the need for financing receivable is not to the full extent of the accounts receivables (sales). You are actually financing only to the extent of cost of goods sold out of the receivables (sales) in question.

61

Understanding Financial Statements

Inventory, Supplies and Prepaid Expenses

You can well appreciate the need for carrying inventory. In order to carry on operations unhindered we need to have sufficient amount of merchandise on hand The quantum we have to keep in store will be determined by the availability and regularity of supply, lead time for delivery and so on. All the same we should carry some inventory in any case. Similar is the case with non-merchandise inventory such as office and factory supplies. We have to carry a minimum stock of these to ensure smooth operations. We also know that there are several expenses which are to be' Lid before we actually use the services, such as rent, insurance and so on. In other words we invest your money in these items of assets in order to ensure smooth operations

6.3

DETERMINING WORKING CAPITAL REQUIREMENTS

Understanding the existing capital needs and how these are financed will help us in understanding the process of financing of business and the flow of funds within the business. The first question we have to answer is how much working capital is needed to start the operation. We could determine the amount of capital required and compare the same with existing capital to see whether it is sufficient and whether there is any excess available for future use. Please note that we are not applying precise techniques of cash management or liquidity planning since that is beyond the scope of this unit. We know from Ramsons that operating requirements of the business requires one month's cash expenses other than payment for creditors to be kept in cash. That is a minimum of Rs. 30,000 cash on hand is required by Ramsons (including Rs. 4,000 his withdrawal). Ramsons have to keep three months sales in inventory. This means that during the first month he starts with three months' sales in the form of inventory. We know that the sales per month is Rs. 1,50,000 sold at a mark up of 25 per cent on sales. Therefore, inventory required to be maintained is three times of 75 per cent of sales. That is, 1,50,000 x .75 x 3 = Rs. 3,37,500 Similarly, we know from the information available that every month one-third of the sales are made on cash and two-thirds on credit to be collected in four instalments. This means, cash collection during the month will be cash sales plus one-fourth of credit sales of the period and one-fourth of three previous months' credit sales. Similarly, in the first month we will be really making one half of the sales for cash and the other half of on credit. In our example. Total Sales Cash Sales Credit Sales First Instalment in Cash Total Cash Collection Credit period of the sales will be as follows: First month sales on credit less first instalment Rs. 75,000. This means. Rs. 75,000 credit for one month Rs. 50,000 credit for one month Rs. 25 000 credit for one month Rs. 1,00,000 Rs.25,000 Rs. 75,000 Rs. 1,50,000 Rs. 50,000

62

This is equivalent to Rs. 75,000 sales made for two months' credit. In terms of working capital requirement, we require one month's financing of the cost of sales with respect to Rs. 1,50,000 sales. That is Rs. 1,12,500 is needed for financing this amount. Thus, we could summarise Ramson's need for funds for financing current asset to start operations, as follows: 3 months' inventory One month's expenses as cash Rs 3,37,500 30,000 3,67,500 During the first month Ramsons will sell one-third of the inventory generating Rs. 75,000 in cash and the other half of Rs. 75,000 to be collected in three instalments. Thus we need some additional funds to finance our granting credit to the customers. Similarly, we would need to replenish the inventory and make payments for expenses. We shall examine these with the help of the balance sheet and profit and loss account of Ramsons for the first four months.

Construction and Analysis of Fund Flow and Cash Flow Statements

6.4

SOURCES OF FUNDS

We have seen that working capital is required to finance that portion of current assets which is not financed by current liabilities. We also saw that the investments represented by current assets are converted into cash during the operating cycle. This implies that our need for financing is for one such cycle. Under normal circumstances every unit of investment in working capital is converted into cash at the end of the cycle at an added value, to the extent of profits. When we are looking at the possible sources of working capital the most important source is this `internal generation'. The very idea of internal sources implies that there is something `external'.

Activity 6.1
1. Please put down what these `internal' and `external' sources are: .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... ....................................................................................................................................

Internal Sources
When we are looking for sources funds it is but natural to start searching at home. What do we have? While examining the need for working capital we could also make an assessment as to whether the existing working capital is sufficient or not. Thus, the first internal source is any excess working capital that we might be having. If we have any non-current assets which do not have any use they could be disposed off, thereby generating additional working capital. Please note that this is not a regular and continuing source of funds. We have seen earlier that every profitable sale brings with it funds in excess of what was expended on the goods sold. In other words, profits generated by the business contribute towards additional working capital. But you may also notice that whenever

63

Understanding Financial Statements

we measure profits, we match the revenue against all expenses relating to the revenue, whether it involves use of funds in the current period or not. Thus the profits measured do not reflect the actual amount of funds available in order to assess t e actual funds generated from current operations we should add back to the profits: all those items of expenses not involving use of funds during the current period. One major example of such an item is depreciation. Thus we could summarise the important possible sources of funds as: 1. 2. 3. Funds generated from operations. That is, profit plus depreciation and o ter amortisations. Sale of non-current assets Any surplus working capital. Did you guess correctly?

Funds from Operations

Refer to Illustration-6.1. The profit and loss account of TIL shows that operations have provided gross addition of Rs. 360 million to funds during the period. These funds represent the sale proceeds of goods and services by the company. We also know what part of these funds is utilised for meeting the cost of input such as material, personnel and other operating costs. Apart from these we have also to me t the interest commitments and costs expiration of the machinery and equipment. However, expiration of costs of the machinery and equipment (Depreciation) is one item which does not require use of funds in the current period. TOOLS INDIA LTD. Summarised Profit and Loss Account For the year ended December 31, 2002 (Rs. Million) Rs. 350 10 360 150 210 60.00 11.90 13.10

Sales Other Income* Cost of goods sold Gross Profit Profit expenses: Personal Depreciation and Amortisation Other Expenses Operating Profits Less: Interest Expense Net Profit before income taxes Less Provisions for taxes Net Profit Less: Dividends Net Profit Retained

85 125 15 110 55 55 20 Rs. 35

64

Other income includes Rs. 1 million profit on sale of furniture.

Thus the funds 'provided from the operations are in fact the revenues earned from operations (as also non-operating incomes) less all immediate costs of goods sold requiring use of funds. In other words, it is net income or profit after taxes plus all the non-cash expenses, such as depreciation and amortisation. The funds flow statement would show funds from operations of TIL as follows: (Rs. in Million) Operations Net Income Add: Depreciation and Amortisation 11.90 66.90 Less: Profit on sale of furniture Total funds provided form operations 1.00 65.90 55

Construction and Analysis of Fund Flow and Cash Flow Statements

External Sources
External sources of funds are resources raised from outside the organisation to augment funds availability for any of the uses to be discussed later. Normally, there are only two ways of doing this: 1. 2. By contributing or raising additional capital, and By increased long-term borrowing.

Please note that short-term creditors are not included as a source of funds since we have already defined funds as "current assets less current liabilities". Thus, working capital represents long-term investment in current assets and hence short-term borrowing will not increase working capital. The sources of funds, as usually presented in the fund flow statement, are enumerated below: Sources of Funds Operations: Net Profit after taxes Add: Depreciation Other amortisations Funds provided by operations New issue of share capital New issue of debentures/bonds Additional long-term borrowing Sale proceeds of fixed assets Sale of long-term investment

6.5

USES (APPLICATIONS) OF FUNDS

Need for additional Funds

A business would require additional capital for two purposes: 1. 2. Financing additional fixed assets, and Financing additional working capital.

65

Understanding Financial Statements

It should not be difficult to appreciate the necessity for having adequate fixed facilities with which to conduct the business. The amount we have invested in the shop, furniture and fixtures (refer to the example of Ramsons) has created the facilities for carrying on the business. It also limits the capacity. We cannot expand our business beyond a certain capacity which is limited by the facilities created by fixed asses . In case of a manufacturing firm, it will be plant capacity; in case of a transport undertaking it may be tonnage of trucks, ships or wagons; in case of show business is and airlines it may be seating capacity, and so on. Any increase in such capacity would require additional investment. Thus, investment in fixed assets is required to expand capacity or to improve the current operation. Usually, addition to investments are judged on the basis of its ability to reduce the present costs or to increase the present output. Additional working capital is required to finance Increased holding of inventory, increased credit to customers and increased cash holding requirements. Obviously current creditors would finance part of this requirements. Obviously, current creditors would finance part of this requirement for working capital. If Ramsons invests in another shop or in expansion of the existing shop, they will require additional funds for investment in fixed assets as also for increased level o current assets. You will notice that whenever additional investment is to be made i non-current assets, we have to use the funds (working capital) available with us ur sss separate arrangement is made for their financing. Likewise, when non-current asse are sold they provide funds or result in sources of funds. We could summarise the usual applications of funds as follows: 1. 2. 3. 4. Acquisition of new non-current assets (fixed assets) Replacement of non-current debt (loans) Payment of dividends Increase in the balance of working capital (current assets-current liabilities)

If the trading or business operations are unsuccessful, they may use funds rather that provide funds. The uses of funds, as they are usually presented in the fund flow statement, are enumerated below: USES OF FUNDS Dividends Non-operating losses not passed through P & L A/c Redemption of redeemable preference share capital Repayment of debentures/bonds Repayment of long-term loans Purchase of fixed assets Purchase of long-term investment Increase in working capital . . . . . . . .

6.6

FACTORS AFFECTING FUND REQUIREMENTS

From the discussions we had earlier, it is not difficult to come to the conclusion that several factors affect the fund or net working capital requirements. Fund requirements vary with the nature and type of business. A firm that provides agency services may require less working capital compared to a firm which carries on business of merchandising. The merchandising firm of course would. require to carry some inventory, give credit and so on. However, a firm which manufactures products may require more working capital than a retailer. The manufacturing company will have to carry inventory of raw material, work-in-process and finished goods.

66

Working capital requirements are directly influenced by sales volume. With every growth in sales volume we need to carry larger inventory, increased number of customers or receivables as also the operating expenses. It is possible that all the expenses may not move up proportionately. However, we will have to finance some of these increases. It is also possible that all the expense may not move up proportionately. However, we will have to finance some of these increases. It is also possible that the increase in sales volume could be brought about by granting extended credits. In other words, by investing more funds we increase the volume of sales. Fund requirements for the business may be seasonal. For example in industries using agricultural raw materials, it may be more advantageous to procure raw materials during harvest season. In case of consumer retailing it may be necessary to hold large inventories during festive season. Most of the fund requirements are restricted to a limited period, and if we provide it on a permanent basis we may have idle funds during most part of the year. Yet another important aspect which may condition fund requirement is the velocity of circulation of current assets. In other words, the length of the operating cycle will influence the need for funds. Shorter the duration of operating cycle faster is the conversion of money invested in current assets into cash and hence lesser the need for net working capital. Net working capital requirement is also influenced by the terms available from the suppliers. The credit terms extended by the suppliers will determine the amount of additional funds required. A firm which carries a month's inventory and grants one month's credit to customers, has to fund the inventory cost of two months. If it could avail two months' credit from the suppliers, the need for holding inventory and funding receivables is nil. In another situation, suppose the firm carries a balance of Rs.10,000 of accounts payable, payable in 30 days and an average accounts receivable balance of Rs. 15,000, receivable in 45 days, the firm will have to keep a net working capital for the difference of receipts from customers and payments to creditors as follows: Fund required to meet payables due within 30 days Less: Funds received from customersReceived in 45 days, that is, Rs.15,000 x 30/45 Fund required in the form of additional net working capital Rs. 10,000 10,000 Nil

Construction and Analysis of Fund Flow and Cash Flow Statements

Assuming the time taken for collection of receivable is 90 days the situation will be: Rs. Fund required to meet payables due within 30 days. Less: Funds received form customers- Rs.15,000 x 30/90 Fund required in the form of additional net working capital 5,000 We could summarise the discussion in respect of the need for working capital by saying that the ability of the firm to circulate the cash raw material inventory work-in process finished goods inventory receivables cash is the most vital and important factor in determining the amount of working capital. However, the exact amount needed to be invested in all these will be determined by the period and quantum of holding of each of these elements. This in turn is also influenced by the factors we have discussed in this sections. 10,000 5,000

67

Understanding Financial Statements

6.7

ANALYSING CHANGES IN WORKING CAPITAL

In understanding the financial statements of a company, one of the first steps involved is the study of the changes in current financial position of the company and the reasons for the changes. We make an attempt at studying these changes and their causes by using the data contained in the summarised comparative balance sheet. (Illustration 6.2) and profit and loss account of Tools India Limited. Illustration 6.2 Tools India Limited Balance Sheet as on December 31, 2003 (Rs. in Million) Assets Rs. Current Assets Cash Accounts receivable (Sundry debtors) Loans and advances Other Current Assets Inventory Total Current Assets Fixed Assets Plant and equipment at cost Less: Depreciation Furniture & fixture at cost Less: Depreciation Investments Intangible Assets Technical Assistance fees Less: Amortisation Total December 31, 2003 Rs. 19.50 32.25 42.58 17.20 12.92 232.00 152.00 71.00 14.50 2.00 3.00 0.50 81.00 12.50 2.00 2.50 330.00 133.00 60.00 8.60 2.30 1.00 0.30 December 31, 2003 Rs. Rs. 10.87 20.28 33.82 15.93 99.10 180.00 73.00 6.30

0.70 260

Liabilities and Capital Current Liabilities Acceptance Sundry Creditors (Accounts Payable) Advances against sales Other liabilities Interest accrued but not due on loans Provisions For taxation Proposed dividend For bonus Other Provision 4.74 27.16 26.60 8.86 2.64 70.00 25.55 2.25 3.40 3.80 35.00 105.00 20.45 2.25 2.35 2.95 28.00 80.00 3.02 18.75 20.28 7.95 2.00 52.00

68

Total current liabilities & Provisions

Long Term Liabilities Bank loans 10.5% debentures Loans from Financial Institutions Total Liabilities Capital Authorised : 5,00,000 shares of Rs. 100 each Issued Subscribed and Paid-up 3,73,100 Shares of Rs. 100 each Reserves and Surplus Total

40.00 25.50 24.50 90.00 195.00

32.14 25.50 22.36 80.00 160.00

Construction and Analysis of Fund Flow and Cash Flow Statements

50.00

50.00

37.31 97.69 330.00

37.31 62.69 260.00

As we have studied at the beginning of this unit, the net change in working capital can be computed easily by subtracting the net working capital at the end of the year from the net working capital at the beginning of the year. TOOLS INDIA LTD Change in Working Capital (Rs. in Million) December 31, 2002 Current assets Less: Current Liabilities Working Capital Working capital on December 31, 2003 Working Capital on December 31, 2002 Increase in Working Capital 180.00 80.00 100.00 127.00 100.00 27.00 December 31, 2003 232.00 105.00 127.00

The Rs. 27 million increase in working capital of TIL shows the composite changes in the operating assets. This does not tell us much in terms of operations of the business. This change could be the net result of changes in all the accounts covered by current items. May be there has been qualitative changes resulting from the depletion of liquid items of current assets and increase in non-liquid items such as inventory. In order to answer these questions we try to analyse the changes in each of the working capital accounts.

Statement of changes in working capital

A statement of changes in working capital helps us in locating where these changes took place. In the first instance we try to show the increase (decrease) in individual items and then try to classify them in terms of increase and decrease in working capital. Since working capital is measured by subtracting current liabilities from current assets, any increase in current assets and any decrease in current liabilities shows an increase in working capital. Similarly, a decrease in current assets and an increase in current liabilities represent a decrease in working capital.

69

Understanding Financial Statements

The statement of changes in working capital (Table 6.1) shows that the increases in current assets amounted to Rs. 52 million, a major part of the increase arising out of cash, receivable and inventory. Decrease in working capital came about mostly from the increased accounts payable, advances from customers and taxes payable. Total amount of decrease in working capital resulting from increase in current liabilities amounted to Rs. 25 million, thus, showing a net increase in working capital of Rs. 27 million. Table 6.1 TOLLS INDIA LTD. Statement of changes in Working Capital for the year ending December 31, 2000 (Rs. In Million)
Dec. 31 2003 Current Assets Cash Accounts receivable Loans and advances Other current assets Inventory Total 19.05 32.25 42.58 17.20 120.92 232.00 Dec. 31 2002 10.87 20.28 33.82 15.93 99.10 180.00 Increase (Decrease) 8.18 11.97 8.76 1.27 21.82 52.00 Working Capital Increase Decrease 8.18 11.97 8.76 1.27 21.82

Current Liabilities & Provisions Acceptances Accounts payable Advances against sales Other liabilities Interest accrued Taxes payable Proposed dividend Bonus payable Other provisions Total

4.74 27.16 26.60 8.86 2.64 25.55 2.25 3.40 3.80 105.00

3.02 18.75 20.28 7.95 2.00 20.45 2.25 2.35 2.95 80.00 25.00

1.72 8.41 6.32 0.91 0.64 5.10 1.05 0.85 52.00

1.72 8.41 6.32 0.91 0.64 5.10 1.05 0.85 25.00

Working Capital

127.00

100.00

27.00

Increasing Working Capital

27.00

6.8

FUND FLOW STATEMENT

An analysis of the fluctuations of current assets and current liabilities i.e. working capital tells us how the working capital has increased or decreased. We want to know where the increased working capital is applied if it has increased, and from where funds have been released if it has decreased. The profit and loss account gives some indication of the results of operations and its impact on the funds position. We try to integrate the impact of operations reported in the profit and loss account and balance sheet by preparing a statement of changes in financial position. It describes the sources from which fluids were received and the uses to which funds were put. This statement of changes in financial position is usually referred to as fund flow statement or statement of sources and application funds.

70

As the title indicates fund flow statement traces the flow of funds through the organisation. In other words, it shows the sources from where the funds were raised, and the uses to which they were put.

The statement of funds flow is usually bifurcated into two logical divisions: sources of funds or inflows during the periods and uses of funds or applications of funds during the period. The division showing sources of funds summarises all those transactions which had the net effect of increasing the working Capital. Uses of funds on the other hand deal with all those transactions which had the effect of decreasing the working capital. We shall illustrate the primary structure of flows as follows (Figure 6.1):

Construction and Analysis of Fund Flow and Cash Flow Statements

The flow of funds statement gives a summary of the impacts of managerial decisions. As such it reflects the policies of financing, investment, acquisition and retirement of fixed assets, distribution of profits, and the success of operations. Let us further extend illustration 6.2 in order to prepare a Fund Flow Statement. From a comparative balance sheet and profit and loss account we could obtain most of the information we require for the preparation of a fund flow statement. We have studied that changes in net-working capital amount are caused by the changes in nonworking capital items. This could be easily seen from the summarised balance sheet of TIL (Table 6.2). We have seen that the net working capital amount increased by Rs. 27 million during 2003, January 1 to December 31. This is other words implies that the working capital from non-current sources should exceed non-current uses by Rs. 27 million. The summarised balance sheet shows the net change in each account. That is, it does not show the increases and decreases separately. Furniture and fixtures value, for example, has increased by a net amount of Rs. 5.90 million. This increase shows an application of funds. In reality, this account was both a source and an application of funds. We purchased new furniture and fixtures worth Rs. 7.90 million (a use of funds) and sold existing furniture and fixtures which had an original cost of Rs. 2 million and on which depreciation had accumulated to the tune of Rs. 1 million (a source of funds). Since the purchase transaction was bigger in amount than the sale transaction, the net result was in the use of funds.

71

Understanding Financial Statements

Table 6.2 TOOLS INDIA LTD. Summarised Balance Sheet (Rs. in Millions) December 31, 2003 December 31, 2002 Working Source Changes in Capital Use 27.00 19.00 5.90 2.00 2.00

Working Capital Fixed Assets Plant and equipment at cost Furniture and fixtures at cost Investments Intangible Assets Technical assistance fees at cost

127.00 152.00 14.50 2.00 3.00 298.50

100.00 133.00 8.60 1.00 242.60 32.14 25.50 22.36

Long-term Liabilities Bank loans 10.5% debentures Loans from Financial Institutions Allowance and Amortisations Accumulated depreciation Plant and equipment Furniture and fixtures Amortisation of technical assistance fees Capital Share capital Reserves & Surplus 37.31 97.69 298.50 Notes: 1) 2) 37.31 62.69 242.60 35.00 56.20 56.20 0.50 0.30 0.20 71.00 2.00 60.00 2.30 11.00 0.30 40.00 25.50 24.50 7.86 2.14

Furniture and fixtures costing Rs. 2 million with an accumulated depreciation of Rs. 1 million is sold for cash at Rs. 2 million. Dividend paid during the year amounted to Rs. 2.25 million.

If we are to construct a statement showing sources and uses of funds during the year, we need additional information. Some of this additional information is available from the profit and loss account and the appropriation of net income. Some other information like sales proceeds of assets will have to be obtained from other records of the company.

72

Funds Flow statement (Rs. in Million)

Sources of Funds Funds from operations: Net income* Less profit on sale of furniture Add: Depreciation, amortization, Provisions: Plant Furniture Technical assistance fee Other Sources of Fund Sale of assets Bank loan Institutional loan Uses of Funds Payment of dividends Purchase of Plant Purchase of furniture Investments Technical assistance fees Increase of working capital 2.25 19.00 7.90 2.00 2.00 27.00 37.25 1.00 36.25 11.00 0.70 0.20

Construction and Analysis of Fund Flow and Cash Flow Statements

48.15

2.00 7.86 2.14

12.00 60.15

60.15

* Net income has been obtained by deducting the previous year's balance of Reserves and Surplus from the current year's balance i.e. 97.69 minus 62.69=35 million. To this, the proposed dividend for the current year of Rs. 2.25 million has been added (as it must have been taken into account while determining the net income to be transferred to Reserves and Surplus. With the necessary background on Profit and Loss Account and Fund Flow Statement having been prepared, you can now watch the Video Programme "Understanding Financial Statement-Part II at your study centre.

Activity 6.2
1. Please list the four main sources of funds in your organisation. . 2. List the four main uses of funds in your organisation. . .

6.9

IMPORTANCE OF CASH AND CASH FLOW STATEMENT

Cash is another form of fund although in a narrow sense, it refers to a supply that can be drawn upon according to the need. Here the term cash includes both cash and cash equivalents. Cash equivalents are highly liquid short term investments which could be easily converted into cash without much delay. It may however be appreciated that the obligations and liabilities of a business arising on a day to day basis must be met through "Cash" or "Cheque". We must also be able to distinguish between "Profit" and "Cash". One cannot pay the creditors, electricity bills, tax or even dividend by "Net Profit". For such and many other purposes, a business needs either physical cash or balance or credit limits with banks. Not to be

73

Understanding Financial Statements

able to meet the business comitments through cash as and when these arise can spell disaster for a business even if it has a strong working capital and has earned handsome profit. So far we had seen that the balance sheet and profit and loss account provide information about the financial position and the results of operations in a financial period. The funds flow statement explained earlier traces the flow of funds through the organisation. But neither of these financial statements can provide information about the cash flows relating to operating, financing and investing activities. To ensure that the right quantity of cash is available in accordance with the needs of a business it is necessary to make a "cash planning" by determining the amount of cash entering the business (cash inflow) and the cash leaving the business (cash outflow). The statement which explains the changes that take place in cash position between two periods is called the cash flow statement. Cash flow statement is an important tool in the hands of the management for short term planning and coordinating of various operations and projecting the cash flows for the future. It presents a complete view about the movement of cash and identifying the sources from which cash can be acquired when needed. The comparison of the actual cash flow statement with the projected cash flow statement helps in understanding the trends of movement of cash and also the reasons for the success or failure of cash planning. Cash flow and fund flow statements are similar to each other in many respects. The main difference however, lies in the fact that the terms "fund" and "cash" import different meaning. The term "fund" in fund flow statement has a wide meaning. A fund flow statement examines the impact of changes in fund's position during the period under review on the working capital of the concern (working capital refers to current assets - current liabilities). Cash in the cash flow statement refers only to cash and or balance with bank, i.e., a small part of the total fund, although very important. The cash flow statement starts with the opening cash balance, shows the sources from where additional cash was received and also the uses to which cash was put and ends up showing the closing balance as at the end of the year or period under review. Whereas there are no opening and closing balances in Funds Flow statement. Increase in current assets or decrease in current liabilities increases the working capital, whereas the decrease in current assets or increase in current liabilities increases the cash flow.

6.10 SOURCES AND USES OF CASH

There are various activities undertaken by a business which prove to be either source or use of cash. These can be classified under three broad categories, i.e., Operating activities, Investing activities and Financing activities. A brief discussion of each of these categories is given below: Operating activities include cash inflows associated with sales, interest and dividends received and the cash outflows associated with operating expenses including payments to suppliers of goods or services, payments towards wages, interest and taxes, etc. Increase or decrease in current assets, e.g., receivables, inventory as well as increase or decrease in current liabilities, e.g., accounts payable, wages payable, interest payable, taxes payable also reflect operating activities. Investing activities refer to long life assets like land and building, plant and machinery, investments and the like. Acquisitions of these assets imply cash outflow whereas their disposal means inflow of cash.

74

Financing activities encompass changes in equity and preference capital, debentures, long term loans and similar items. Issuance of equity, preference and, debenture capital as well as raising of long term loans imply cash inflow. Retirement of capital, dividend payments to shareholders, redemption of debentures, amortisation of long term loans, on the other hand are associated with cash outflow. The Cash Cycle: In order to deal with the problem of cash management we must have an idea about the flow of cash through a firm's accounts. The entire process of this cash flow is known as Cash Cycle. This has been illustrated in Figures 6.2 and 6.3. Cash is used to purchase materials from which goods are produced. Production of these goods involves use of funds for paying wages and meeting other expenses.

Construction and Analysis of Fund Flow and Cash Flow Statements

Figure 6.3: Details of the Cash Cycle

75

Understanding Financial Statements

Goods produced are sold either on cash or credit. In the latter case the pending bills are received at a later date. The firm thus receives cash immediately or later for the goods sold by it. The cycle continues repeating itself. The diagram in Figure 6.2 only gives a general idea about the channels of flow of cash in a business. The magnitude of the flow in terms of time is depicted in the diagram given in Figure 6.3. The following information is reflected by Figure 6.3. (a) (b) (c) Raw material for production is received 10 days after placement of order. The material is converted into goods for sale in 37 days (15+2+20) from point of B to E. The payment for material purchased can be deferred to 17 days (15+2) after it is received i.e. (the distance of time between points B to D), assuming that it takes 2 days for collection of payment of the cheque. The amount of the bill for goods sold is received 32 days (30+2) after the sale of goods as is depicted by duration of time between point E to G. The recovery of cash spent till point D is made after 56 days (20+30+2+2+2) as shown between points D to J.

(d) (e)

Managing these inflows (collections) and outflows (disbursements) are discussed in detail in unit 16 in Block No.5.

Ativity 6.3
Meet a responsible executive of Accounting and Finance Department of a manufacturing organisation regarding the following: a) What is the length of its Cash Cycle? Cash Cycle is approximately of ..days. b) Draw the sequence of Cash Cycle showing its successive events with the respective number of days.

. c) Inquire whether or not the organisation is satisfied with its length of cash cycle. What steps it proposes to take for reducing the Cash Cycle?

6.11 PREPARATION OF CASH FLOW STATEMENT

To start with, we need two successive balance sheets and the operating statement or profit and loss account linking the two balance sheets. There are two ways in which this statement can be drawn up. One approach is to start with the operating cash balance, add/deduct the profit/loss from operation to it and then proceed to give effect to the change of each item of current assets and liabilities together with the additions to and reductions in other assets and shareholders funds and long term liabilities and finally arrive at the closing cash balance. This is known as the "Profit basis" statement. For the sake of better understanding, the changes in items of current assets, current liabilities, shareholders' fund, long life assets and long term liabilities can be organised under the three broad categories of operating, investing and financing activities (as discussed above), changes measured under each category, the opening cash balance adjusted to these changes and the closing cash balance arrived at.

76

The second way is to deal only with cash receipts and disbursements. This does not consider non cash items like depreciation, preliminary expenses written off, etc. The latter type of cash flow statement is known as "Cash basis" statement. Preparation of a cash flow statement on cash basis is a straight forward exercise and left to the students. Here, we would take up the cash flow statement on "profit basis" for further examination. A framework of the steps to be followed for this purpose is appended below: Steps involved in preparation of a "Profit basis" cash flow statement: 1. 2. From the first of the two balance sheets, take the closing cash balance, which will be the opening cash balance for the purpose of our cash flow statement. Take the net profit figure. If it is not directly given and you are provided with only Profit and Loss account balances in both the Balance Sheets, ascertain it (net profit) by preparing an "Adjusted Profit and Loss account". For this purpose, all items of profit appropriations as well as non-cash expenses and income are to be added to and subtracted from the balance of P&L account, as the case may be. This gives the figure of "Profit from operation." Adjust increase or decrease in each item of current assets and current liabilities to the "Profit from operation" figure to arrive at the "Cash from operation". Revert back to the "Opening Cash Balance". Add the "Cash from operation" to it. Also add, cash flow from other sources like non-current assets & noncurrent liabilities, e.g., equity and debenture issue, raising term loan, sale of fixed assets. Deduct, cash outflow to various uses, again involving noncurrent or fixed assets and non-current liabilities, e.g., redemption of preference shares/debentures, retirement of term loan, purchase of fixed assets, etc. The balance arrived at (4) above should tally with the closing balance of cash in the second balance sheet.

Construction and Analysis of Fund Flow and Cash Flow Statements

3.

4.

5.

Increases and decreases in various items of assets and liabilities as mentioned under items 3 & 4 above can be optionally organised under operational, investment and financing activities for clarity sake. We use the above approach and procedure in preparing a "profit-basis" cash flow statement in Illustration 6.3.

Illustration 6.3
M/s Navyug Udyog Balance Sheets as at Assets: Freehold Property Plant and Machineries Less: Depreciation Goodwill Investment Debtors Stock Bills Receivable Cash in hand and at bank Preliminary Expenses 1,50,000 1,10,000 15,000 75,000 1,08,000 70,000 42,000 20,000 20,000 6,10,000 1,50,000 1,70,000 5,000 1,30,000 1,32,000 1,02,000 53,000 50,000 15,000 8,07,000 31st March, 2002 Rs. 31st March, 2003 Rs.

77

Understanding Financial Statements

Balance Sheets as at Liabilities: Share Capital (40,000 Equity Shares @ Rs. 10/- per share) General Reserve Dividend Equalisation Reserve Profit and Loss a/c Sundry Creditors Prov. for Taxation Bills Payable

31st March, 2002 Rs. 4,00,000

31st March, 2003 Rs. 5,00,000 60,000

50,000 25,000 40,000 60,000 20,000 15,000 6,10,000

65,000 15,000 55,000 67,000 35,000 10,000 8,07,000

Aditional Information:
1. 2. 3. 4. 5. 6. Shares were issued at a premium of Rs. 1.50' per share. During the year Taxation liability in respect of 2002 was Rs, 20,000 and paid. During the year, Rs. 11,000 was provided for depreciation on Plant and Machinery. An item of the plant the written down value Rs. 20,000 was sold at Rs. 25,000. During the year, a dividend @ 7.5% was paid. Part of the investment costing Rs. 30,000 was sold at Rs. 35,000 and the profit was taken in Profit and Loss account.

Based on the above information, we first set ourselves to ascertain the cash inflow and outflow in respect of Investment, Plant and Machineries and Tax, which cannot be found out by a mere inspection of their balances in two balance sheets. The task is accomplished by preparing the respective accounts and examining the effects of the additional information on each of these. This is followed by preparation of an " Adjusted Profit and Loss a/c" to find out the actual net profit earned during the period, in the light of the additional information now available. In the final stage, the "Cash flow statement" is prepared (Table 6.3). Investment Account To Opening balance To P & L a/c (profit on sale) To Bank (Purchases) 75,000 5,000 85,000 1,65, 000 Plant & Machinery Account To Opening balance To P & L a/c (profit on sale) To Bank 1,10,000 5,000 91,000 2,06,000 By Sale By P & L a/cdepreciation By Closing balance 25,000 11,000 1,70,000 2,06,000 By Sale By Closing balance 35,000 1,30,000 1,65, 000

78

Provision for taxation

To Bank By Closing balance 20,000 35,000 55,000 By Opening Balance By P & L a/c 20,000 35,000 55,000

Construction and Analysis of Fund Flow and Cash Flow Statements

Adjusted Profit and Loss Account

To General Reserve To Dividend To Provision for tax To Depreciation 15,000 By Opening balance 30,000 By Dividend Equalisn. Reserve 35,000 By Plant and Machineries profit on sale 11,000 By Investment-profit on sale. By profit for the year (balancing figure) 10,000 5,000 55,000 1,61,000 1,61,000 40,000 10,000 5,000 5,000 1,01,000

To Goodwill To Preliminary expenses To Closing balance

Table 6.3 Statement of Cash flow for the period 1.4 2002 to 31.3.2003 Rs.
Opening Cash balance as on 1.4.2002 Add/(deduct): Cash flow from Operating Activities Net profit (Ref: P&L Adjustment a/c) Add: Decrease in current assets Increase in current liabilities: Sundry Creditors Deduct: Increase in current assets Debtors Stock Bills Receivables Decrease in Current liabilities Bills payable Payment of tax Add/(deduct): Cash flow from Investment activities Add: Sale of Plant & Machineries Add: Sale of Investment Deduct: Purchase of Plant Machineries Deduct: Purchase of Investments Add/(deduct): Cash flow from Financing Activities Add: Issue of share capital Share premium Deduct: Payment of dividend Closing Cash Balance as on 31.3.2003 and 20,000 1,01,000 Nil 7,000 7,000 24,000 32,000 11,000 5,000 20,000 25,000 92,000 25,000 35,000 60,000 91,000 85,000 1,76,000 (1,16,000) 16,000

67,000

1,00,000 60,000 1,60,000 30,000 1,30,000 50,000

79

Understanding Financial Statements

Activity 6.4 Mention the four major operating activities included in a cash flow statement. .

6.12 SUMMARY
In this unit we have tried to develop the idea of flow of funds within the organisation. Starting with the funds requirement for an organisation, we have tired to trace the sources and uses of funds. We tried to study the important sources of funds, namely, the operations, sale of fixed assets, long-term borrowings and issue of new capital. Similarly, important uses of funds were traced to acquisition of fixed assets, payment of dividends, repayment of loans and capital. The whole exercise reveals the areas in which funds are deployed and the source from which they are obtained. Finally, we learned how to go about doing the funds flow analysis with the help of published accounting information. We learnt, distinguishing between cash and fund as also cash flow statement and funds flow statement. The importance of cash and cash flow statement was dwelt upon. Our discussion centered around cash flow statement on "cash basis" and "profit basis". We learnt how to go about doing the cash flow analysis with the help of accounting information and finally presenting the cash flows in the form of a "cash flow statement".

6.13 KEY WORDS

Working Capital: Current assets minus current liabilities. Funds from Operations: The change in working capital resulting from operations. Difference between inflow of funds in the form of revenue and outflow of funds in the form of expenses. Sources of funds: The sources from which we obtain working capital for application elsewhere. Sources include operations, extraordinary profits, sale of fixed assets, new long-term borrowings, new issue of capital and the reduction of existing working capital. Use of Funds: Also referred to as application of funds means use of additional working capital and includes amounts lost in operations (Operating loss), acquisition of fixed assets, working capital used for retiring long-term loans, payment of dividends and amounts utilised to increase working capital. Cash from Operations: It refers to "Profit from Operation" duly adjusted against the increase or decrease in the current assets and liabilities. Cash Equivalents: These are highly liquid short term investments which could be readily converted to cash and which are subject to an insignificant risk of changes in value.

80

Cash Cycle represents the tithe during which cash is tied up in operations.

6.14 SELF-ASSESSMENT QUESTIONS/EXERCISES

1. 2. 3. 4. 5. 6. 7. 8. 9. What is working capital and what factors affect the size of working capital in an enterprise?
" "

Construction and Analysis of Fund Flow and Cash Flow Statements

Current assets to an extent are financed by current liabilities" Explain. Operations provide funds" Comment.

Differentiate between "Schedule of Changes in Working Capital" and "Fund Flow Statement. Does a substantial balance in Retained Earnings indicate the presence of large cash balance? "Net Profit of a business cannot pay dividend". Comment. Explain the purposes of a cash flow statement. What are the differences between a cash flow statement and funds flow statement? X Ltd. has a sales revenue of Rs. 1,000. Depreciation for the period is Rs.200. Other operating expenses are Rs.900. Net loss for the period is Rs.100. What is the amount of funds generated from operations during the period by X Ltd.? Under what circumstances can the funds from operation be zero? The following information and the balance sheet relate to Shyamsons Ltd.: SHYAMSONS LTD Balance Sheet as on 31st December
Year 1 Year 2 Net change during the year Increase Decrease Rs. Rs. Rs. Rs. 15,000 25,000 35,000 85,000 (10,000) 1,50,000 10,000 10,000 5,000 25,000 50,000 50,000 1,50,000 2,000 3,000 5,000 20,000 10,000 5,000 5,000 15,000 5,000

a) b) 10.

Assets Cash Receivables Inventory Plant and Machinery Cost Less: Accumulated depreciation Total Assets Liabilities & Capital Sundry Creditors Outstanding expenses Debentures payable Long-term loans Capital Retained earnings

10,000 20,000 20,000 85,000 (15,000) 1,20,000 8,000 7,000 10,000 5,000 50,000 40,000 1,20,000

Net profit for the period after charging Rs.5,000 on account of depreciation was Rs. 20,000. A piece of equipment costing Rs.25,000 on which depreciation accumulated in the amount of Rs. 10,000 was sold for Rs. 10,000. Dividends paid during the year amounted to Rs. 10,000.

81

Understanding Financial Statements

Prepare a Sources and Uses of funds statement in the following format: SHYAMSONS LTD. Sources and Uses of Funds (in Rs.) Uses of funds Purchase of Plant and Machinery Repayment of Debentures Payment of dividends Increase in working capital Total uses of Funds 11. Sources of Funds Operations: Net income Add: Loss in sale of machinery Add: Depreciation Sale of equipment Long-term loan Total Sources of Funds

The Balance Sheet of Bestwood Limited as at 31st March 2002 and 31st March 2003 are as follows: 31st March 2002 2003 31st March 2002 2003 Rs. 50,000 36,000 32,800 27,200 4,000 Rs 50,00C 44,400 35,600 28,000 2,000

Issued share capital Profit and Loss account Corporation tax due: 31st March 2002 31st March 2003 Creditors

Rs. 60,000 54,000

Rs. 80,000 Freehold property at cost 46,000 Equipment (see note) Stock in trade Debtors - Bank 8,000 26,000

12,000 24,000

1,50,000 1,60,000

1,50,000 1,60,000

Note: Equipment movements during the year ended 31st March 2003 were: Cost Depreciation Rs. Rs. 60,000 24,000 18,000 78,000 8,000 70,000 7,600 31,600 6,000 25,600 44,400 Net Rs. 36,000

Balance at 31st March 2002 Additions during the year Depreciation provided during the year Disposal during year Balance at 31 March 2003
st

The company's summarised profit calculation for the year ended 31st March 2003 revealed: Sales Rs. Rs. Gain on Sale of equipment 2,00,000 800 2,00,800 Less: Cost of goods and trading expenses 1,73,200 Depreciation 7,600 Net Profit Corporation tax on profits of the year 1,80,800 20,000 8,000 12,000

82

Retained profit of the year

During the year ended 31st March 2003 Bestwood Ltd. made a bonus issue of 1,000 ordinary shares of Rs. 10 each by capitalisation from the profit and loss account. With the help of the above information, prepare a fund flow statement for Bestwood Ltd. revealing the sources and applications of funds during the year ended 31st March 2003.

Construction and Analysis of Fund Flow and Cash Flow Statements

Answers to self-assessment Questions/Exercises

9. (a) (b) Funds generated from operations = Rs. 100 When operating cash expenses are equal to operating incomes or revenues. SHYAM SONS LTD. Sources and Use of Funds Use of Funds Purchase of Plant and Machinery Payment of dividends Increase in net working capital Total uses of funds Rs. Sources of Funds Operations: 25,000 Net Income 10,000 Add Depreciation 20,000 Sale of equipment Long-term loan 60,000 Total Sources of Funds 20,000 5,000 30,000 10,000 20,000 60,000 Rs. Rs.

10. Solution:

Repayment of Debentures 5,000 Add: Loss on sale of Machinery5,000

Year 1 Current Assets Less: Current Liabilities Working Capital Increase in Working Capital 11. Decrease in working Capital Rs. 400 Funds from Sale of equipment Rs. 2,800. 50,000 15,000 35,000

Year 2 75,000 20,000 55,000 20,000

6.15 FURTHER READINGS

Fraser Lyn. M and Aileen Ormiston, 04/10/2003 Understanding Financial Statements, Prentice Hall: New Delhi (Chapter 4). Pandey, I.M., 1999, Financial Management, Vikas Publishing House : New Delhi Horngren, Charles T., Sundem Gary, L., 1994 (9th Ed.) Introduction to Management Accounting, Prentice-Hall: Englewood-Cliffs of India Pvt. Ltd., New Delhi. (Chapter 14) Glantier, M. W. E., Underdown B. and A.C. Clark, 1979, Basic Accounting Practices, Arnold Heineman: New Delhi: (Chapter 6, Section 6). Hingorani, N.L. and A.R. Ramanathan, 1986, Management Accounting, Sultan Chand : New Delhi. (Chapter 8).

83

UNIT 7
Objectives

UNDERSTANDING AND CLASSIFYING COSTS

Understanding and Classifying Costs

The Objectives of this unit are: to familiarise you with the process of determination of costs, particularly in a manufacturing concern to explain how the costing techniques are useful in the process of managerial decision-making.

Structure 7.1 7.2 7.3 7.4 7.5 7.6 7.7 7.8 7.9 7.10 7.11 7.12 Introduction Cost Accounting Costs Elements of Cost Components of Total Cost Cost Sheet Classification of Costs Some other Concepts of Costs Summary Key Words Self-assessment Questions/Exercises Further Readings

7.1

INTRODUCTION

You will recall that units 1 and 2 of this Course gave you detailed outline about the conceptual frame work of accounting and the role the accountant is required to play in the present commercial and industrial set-up. You have seen that he is more of an adviser to the management. He functions as the channel through which accounting information flows to the management efficiently and effectively. He gathers information, breaks it down, sifts it and organises it into meaningful categories. He separates relevant information from irrelevant and then ranks the former according to the degree of importance to management. He also compares the actual performance with the planned one and reports and interprets the results of operations to all levels of management and to the owners of the business. In performing the above multiple duties, the accountant has to make use of different management accounting techniques. Cost techniques have a precedence over other techniques since accounting treatment of costs is often both complex and financially significant. For example, if a firm proposes to increase its output by 10%, is it reasonable to expect total cost increase by less than 10%, exactly 10% or more than 10%? Such questions are concerned with the cost behaviour, i.e., the way costs change with the level of activity. Answers to these questions are pertinent for the management accountant or financial analyst, since they are basic for the firm's projections and profits which ultimately

Cost Management

become the basis for all financial decision. It is, therefore, necessary for a management accountant or financial analyst to have a reasonably good working knowledge about basic cost concepts and patterns of cost behaviour. All these come within the range of cost accounting.

7.2

COST ACCOUNTING

In the initial stages cost accounting was merely considered to be a technique for ascertainment of costs of products or services on the basis of historical data. In course of time it was realised, due to competitive nature of the market, that ascertainment of cost' was not so important as controlling costs was. Hence, cost accounting is considered more as a technique for `cost control' rather than as a technique merely for cost ascertainment. Due to technological developments in all fields, `cost reduction' has now come within the ambit of cost accounting. Cost accounting is thus concerned with: Ascertaining the costs. Controlling the costs. Reducing the costsa

7.3

COSTS

Cost Accountant is concerned with costs and hence it will be of relevance to us to understand the meaning of the term `Cost' in a proper perspective. In general, cost means the amount of expenditure (actual or notional) incurred on, or attributable to a thing. For example, if you have purchased a book for Rs. 150, it can be said that the cost of the book to you is Rs.150. Similarly, if furniture manufacturer makes a table by paying Rs.500 for timber, Rs 20.0 as carpenter's wages and Rs.100 as rent of the works, it can be said that the table cost him Rs.800. It may be noted, however, that the term cost cannot be exactly defined. Its interpretation depends on: a) b) the nature of the business or industry; and the context in which it is used.

In a business where selling and distribution expenses are quite nominal, the cost of the article may be calculated without considering the selling and distribution overheads. In a business where the nature of the product requires heavy selling and distribution expenses, the calculation of cost without taking into account selling and distribution expenses may prove very costly to the business. Further the costs may pertain to factory, office or other establishment aspects of operations. For example, prime cost , includes expenditure on direct materials, direct labour and direct expenses. Money spent on materials is termed as cost of materials, that spent on labour as cost of labour and so on. Thus, the use of the term `cost' without background information may be quite misleading. It may also be noted that there is no such things as an exact cost or a true cost because no figure of cost is true in all circumstances and for all purposes. Many items of cost of production are handled in an optional manner which may give different costs for the same product or job without going against the accepted principles of cost accounting Depreciation is one such item. Its amount varies in accordance with the method of depreciation being used. However, endeavour should be made to obtain as far as possible the accurate cost of a product or service.

7.4

ELEMENTS OF COST

Understanding and Classifying Costs

In order to understand the correct interpretation of the term cost, it will be appropriate for us to learn about the basic elements of cost. There are broadly three elements of cost. Material The substance from which the product is made is known as material. It may be in a raw or a manufactured state. It can be direct as well as indirect. Direct Materials: All material which becomes an integral part of the finished product and which can be conveniently assigned to specific physical units is termed as `Direct Material'. The following are some of the examples of direct material: All material or components specifically purchased, produced or requisitioned from stores. Primary packing material (e.g., carton, wrapping, cardboard, boxes, etc.) Partly produced or purchased components.

Indirect Material: All material which is used for purposes ancillary to the business and which cannot conveniently be assigned to specific physical units, is termed as `indirect material'. Consumable stores, oil and waste, printing and stationary material, etc., are a few examples of indirect material. Labour For conversion of materials into finished goods, human effort is needed, such human. effort is called labour. Labour can be direct as well as indirect. Direct Labour: Labour which takes an active and direct part in the production of a particular commodity is called direct labour. Direct labour costs are, therefore, specifically and conveniently traceable to specific products. Indirect Labour: Labour employed for the purpose of carrying but tasks incidental to goods produced or services provided is indirect labour. Such labour does not alter the construction, composition or condition of the product. It cannot be practically traced to specific units of output. Wages of store-keepers, foremen, time-keepers, directors' fees, salaries of salesmen, etca, are all examples of indirect labour costs. Expenses Expenses may be direct or indirect. Direct Expenses: These are expenses which can be directly, conveniently and wholly allocated to specific cost centres or cost units. Examples of such expenses are: hire of some special machinery required for a particular contract, cost of defective work incurred in connection with a particular job or contract etc. Indirect Expenses: These are expenses which cannot be directly, conveniently and wholly allocated to cost centres or cost units. Example of such expenses are rent, lighting, insurance charges; etc.

Cost Management

Chart 7.1: Element of Cost Overheads The term overhead includes indirect material, indirect labour and indirect expenses. Thus, all indirect costs are overheads. A manufacturing organisation can broadly be divided into three divisions: Factory or Works, where production is done. Office and administration, where routine as well as policy matters are decided. Selling and distribution, where products are sold and finally despatched to the customers.

Overheads may be incurred in the factory or office or selling and distribution divisions. Thus, overheads may be of three types. Factory Overheads: They include; Indirect material used in the factory such as lubricants,-oil, consumable stores, etc. Indirect labour such as gate-keeper's salary, time-keeper's salary, manager's salary, etc. Indirect expenses such as factory rent, factory insurance, factory lighting, etc.

Office and Administration Overheads: They include: Indirect material used in the office such as printing and stationery material, rooms and dusters, etc. Indirect labour such as salaries payable to office manager, office accountant, clerks, etc. Indirect expenses such as rent, insurance, lighting of the office.

Selling and Distribution Overheads: They include: Indirect material used such as packing material, printing and stationery material, etc: Indirect labour such as salaries of salesmen and sales manager, etc. Indirect expenses such as rent, insurance, advertising expenses, etc.

The above classification of overheads can be shown by means of Chart 7.2 Chart 7.2: Classification of Overheads Overheads

Understanding and Classifying Costs

7.5

COMPONENTS OF TOTAL COST

Prime cost: It consists of costs of direct material, direct labour, and direct expenses. It is also known as basic, first or flat cost. Factory Cost: It comprises prime cost and, in addition, works or factory overheads which include costs of indirect material, indirect labour and indirect factory expenses. This cost is also known as works cost, production or manufacturing cost. Office Cost: It comprises of factory cost and office and administration overheads. This is also termed as total cost of production. Total Cost: It comprises of cost of production and selling and distribution overheads. It is also termed as Cost of Sales. ' Various components of the total cost can be depicted by means of Chart 7.3. Chart 7.3 : Components of Total Cost Direct material Direct labour Direct expenses Prime cost plus Works overheads Works cost plus Office and Administration overheads Office cost plus Selling and Distribution overheads It may be noted that some accountants do not use the term office cost at all. They prefer to use the term total cost after adding office and administration overheads and selling and distribution overheads to works cost. However, while framing Chart 7.3 we have presumed that office and administration overheads exclusively relate to production. The selling and distribution overheads are inclusive of any office and administration overheads which may have been incurred in respect of sales. Prime Cost or Direct cost or First cost or Flat Cost Works or Factory cost or Production cost or Manufacturing cost Office cost or Total cost of production Cost of Sales or Total Cost

Cost Management

7.6

COST SHEET

The elements/ components of total cost can be presented in the form of a statement, popularly known as `Cost Sheet'. The cost sheet may be prepared separately for each cost center. It may have columns to show total cost, cost per unit, together with the relevant figures of the previous period. The techniques of preparing a cost sheet can be understood with the help of an Illustration. Illustration 7.1 Let us prepare a cost sheet for a company showing different components of cost for 2003 from the following details 2003 from the following details. Raw Materials Consumed Wages paid to labourers Directly chargeable expenses Oil & Waste Wages of Foremen Storekeeper's Wages Electric Power Lighting : Factory Office Rent : Factory Office Repairs and Renewals: Factory Plant Machinery Office premises Depreciation : Office premises . Plant and Machinery Consumable stores Manager's Salary Director's Fees Office Printing & Stationery Telephone Charges Postage and Telegrams Sales men's Commission and Salary Traveling expenses Advertising Warehouse charges Carriage outwards Cost Sheet for January, 2003 Rs. Direct Material: Raw materials consumed Direct Labour: Wages paid to laborers Direct Expenses: Directly chargeable expenses PRIME COST Rs. Rs. 80,000 20,000 4,000 1,04,000 Rs Rs: 80,000 20,000 4,000 200, 2,000 1,000 400 1,000 400 4,000 2,000 1,000 2,000 400 1,000 400 6,000 1,400

3,400 1,400 2,000 4,000 1,000 400 100 200 1,000 400 1,000 400 300

10

Add: Factory Overheads: Indirect Materials: Consumable stores Oil & Waste Indirect Labour: Wages of foremen Storekeeper Wages Indirect Expenses: Electric Power Factory lighting Factory rent Repairs and Renewals: Plant 1,000 Machinery 2,000 Depreciation: Plant and machinery Factory or Works Cost

Understanding and Classifying Costs

2,000 200 2,200 2,000 1,000 400 1,000 4,000 3,000

3,000 400 8,800 14,000 1,18,000 Add: Office or Administrative Overheads : Indirect material: Office Printing and Stationery Indirect labour: Manager's salary Director's fees Indirect expenses: Office lighting Office rent Repairs and Renewals premises Depreciation on premises Telephone charges Postage and Telegrams 4,000 1,000 400 2,000 400 1,000 100 200

400

5,000

4,100 9,500 1,27,500

TOTAL COST OF PRODUCTION Add: Selling and Distribution overheads: Indirect labour: Salesmen's Commission and salary Indirect expenses: Travelling expenses Advertising Warehouse charges Carriage outward COST OF SALES 400 1,000 400 300

1,000

2,100

3,100 1,30,600

11

Cost Management

Activity 7.1 Complete the following Cost sheet

Cost Sheet for June 2003 Opening stock of raw material Add purchases Less: Closing stock of raw material Raw material consumed Direct wages Other Direct expenses 10,000 .. 50,000 12,000

. 30,000 2,000 .

a)

Prime Cost Add: Factory overhead: Indirect material Indirect labour Indirect expenses

6,000 1,000

9,000 b) Factory or Works Cost Add: Office or administration Overheads Cost of Production Add: Opening stock of finished goods Less: Closing stock of finished goods Selling and Distribution overheads d) Cost of goods sold Sale of finished goods Profit for the month 14,000 15,000 8,000 1,03,000 1,33,000 . 17,000

c)

7.7

CLASSIFICATION OF COSTS

12

Costs can be classified into different categories depending upon the purpose for which information is required. The costs can broadly be classified into Fixed, Variable, Semi-variable and Step Costs. Fixed Costs: These are the costs which remain constant irrespective of the quantum of output within and up to the capacity that has been built up. Examples of such costs are: rent, insurance charges, management salary, etc. Fixed costs remain constant per unit of time. As a result, they decrease per unit with every increase in output and vice versa. For example, if Rs.6,000 have been paid as rent for a factory building with an output of 1,000 units, the cost of rent per unit is Rs.6. In case the output increases to 1,200 units, the cost of rent per unit will decrease to Rs.5. In case output is reduced to 800 units, the cost of rent per unit will increase to Rs.7.50. Fixed costs sometimes are also referred to as period costs. They can further be divided into (i) committed fixed cost (ii) discretionary fixed costs. Committed Fixed Costs Consists largely of those fixed costs that arise from the possesssion of plant, equipment and a basic organisational structure. For example, once a building is constructed and plant is installed, nothing much can be done to reduce the costs such as depreciation, property taxes, insurance and salaries of the key personnel, etc., without impairing the organisation's competence to meet the long-term goals. Discretionary Fixed Costs are those which are set at fixed amount for specific time periods by the management in the budgeting process. These cost directly reflect top management policies and have no particular relationship with volume of output. These costs can therefore be reduced or eliminated entirely, if the circumstances so require. Examples of such costs are: research and development costs, advertising and sales promotion costs, donations, management consulting fees, etc. These costs are also termed as managed or programmed costs.

Figure 7.1 shows the behaviour of fixed cost graphically.

Understanding and Classifying Costs

Figure 7.1 : Fixed Cost behaviour Cost in thousand rupees 3 2 1

Fixed Cost line

2 3 Production in thousand units

Variable Costs: These are the costs which vary in direct proportion to output. They increase or decrease in the same proportion in which the output increases or decreases. The example of such costs are direct material, direct labour, power, etc. Variable costs may be said to be constant per unit of output. For example, if a factory incurs Rs. 1,000 on raw material for an output of 1,000 units, the cost of raw material per unit would amount to Real. In case the output increases to 2,000 units, the cost of raw material would proportionately increase to Rs. 2,000 (i.e Re. 1 x 2,000). Similarly if the output decreases to 800 units, the cost of raw material would also decrease to Rs 800 (i.e Re.1 x 800) Variable costs are also referred to as product costs. Figure 7.2 gives graphical presentation of variable costs Figure 7.1 : Variable Cost Behaviour

Variable Costs

Cost in thousand rupees

3 2 1

Production in thousand units Semi-variable Costs: These are the costs which do vary but not in direct proportion to output. They are made up of both fixed and variable cost elements such as depreciation, repairs, light, heat, telephone, etc.

13

Cost Management

Semi variable costs are shown graphically in Figure 7.3 Figure 7.3: Semi-Variable Cost Behaviour

Cost in thousand rupees

3
Semi-variable cost line

2 1

Production in thousand units Identification of fixed and variable elements of semi-variable costs is important for the management for planning their business activities. Different methods are available for this purpose which will be discussed in the next unit. Step Costs: Fixed cost in general remain fixed over a range of activity and then jump to a new level as activity changes. For example, a foreman can supervise a given number of workers. Beyond this number, it is necessary to hire a second foreman, then a third and so on. Similarly, the rental cost of delivery vehicles also follows the same pattern. The general characteristic of fixed cost rising in steps is depicted in Figure 7.4 Figure 7.4: Fixed Costs rising in Steps

Cost in thousand rupees

1 2 3 Production in thousand units

14

Illustration 7.2
A company has provided the following information to you in respect of 10,000 units of output. Let us calculate the total cost for 12,000 units of output and the cost per unit with the following information: Variable cost Fixed Cost Semi-variable Cost (50% fixed) Output 12,000 units Rs. Variable Cost @ Rs.5 Fixed cost Semi-variable cost: Fixed Variable cost @ Rs.4 Total cost Cost per unit 40,000 48,000 Rs. 60,000 30,000 Rs.50,000 Rs.30,000 Rs.80,000 STATEMENT OF COST

Understanding and Classifying Costs

88,000 1,78,000

1,78,000 12,000

Rs.14.83

Direct and Indirect Cost Direct Costs: These are costs which can be directly, conveniently and wholly traced to a product , service or job. Example of such costs are: direct material, direct labour and direct expenses. Indirect Costs: These are costs which cannot be directly, conveniently and wholly identified with a specific product, service or job. They include all overhead costs such as salaries of time keepers, stores keepers, foreman , printing and stationery costs, etc. Indirect or overhead cost are apportioned to different jobs, products or services on a reasonable basis. For example, the indirect factory labour cost may be apportioned over different jobs according to their direct labour cost. Similarly, the selling overheads can be charged to different products according to their sales values. It may be noted that the more the share of the direct cost in relation to the total cost of the product, the greater is the exactness in costing. The reason for this is that indirect costs are allocated (or apportioned) on an estimated basis.

Activity 7.2
In terms of your own organisation give five examples of each of the following: a) b) c) d) e) Direct Costs Indirect Costs Fixed Costs Variables costs Semi-Variables Costs

15

Cost Management

7.8

SOME OTHER CONCEPTS OF COSTS

Shut Down and Sunk Costs Shut Down Costs: These represent the fixed costs which have to be incurred even during the period when a factory is shut down on account of some temporary difficulties, viz., shortage of raw materials, non-availability of requisite labour force etc. During this period, though no work is done, the fixed costs, such as rent, insurance, depreciation, maintenance, etc. for the entire plant are still to be incurred. Such costs of the idle plant are known as shut down costs. Sunk Costs: These are historical or past costs, that is, costs which have been incurred as a result of a decision-made in the past. Such costs cannot be reversed or revised by subsequent decisions. Investments in plant and machinery, building, etc. are some prominent example of such costs. Sunk costs are considered not relevant for decisions concerning the increase in the present profit levels. Let us consider an example. Goa Steel Ltd, purchased a machine for Rs.60,000. The machine has an operating life of five years without any scrap value. Soon after making the investment the management felt that the machine should not have been purchased as it was incapable of . yielding the operating advantage originally contemplated. Originally, it was expected to result in savings in operating cost of Rs.40,000 over a period of ten years. On the other hand, the machine can be sold immediately for sum of Rs. 42, 000. In taking the decision whether the machine should be sold or it should be used, the relevant amounts to be compared are Rs. 40,000 in cost savings over ten years and Rsa 42,000 that can be realised in case it is immediately disposed offa The amount of Rs. 60,000 invested in the asset is not relevant since it is the same in both cases. This amount is sunk cost. Therefore, Goa Steels should sell the machinery for Rs. 42,000 since it will result in a gain of Rs. 2,000 as. compared to keeping and using it. Controllable and Uncontrollable Costs Controllable Costs: These are costs which can be influenced by the action of a specified member of an organisation. For example, the foreman of a production department can control the utilisation of power or raw materials in his department, . These are, therefore, controllable costs as far as he is concerned. Uncontrollable Costs: These are costs which cannot be influenced by the action of a specified member of an undertaking. For example, the foreman of a production department can control the wastage of power in his department, but he cannot control the power which is being wasted in the power house itself resulting in higher cost per unit of power to him. Similarly, he cannot control the increase in the cost of materials consumed in his department, if the purchase department which is the supplying department, buys the materials at higher prices due to its own inefficiency. Such costs are controllable at a particular level of management while they are uncontrollable at some other level of management. The difference between controllable and uncontrollable costs is of particular significance to the management. The executive concerned should be held responsible only for those costs which are within his control and not for costs which are beyond his, control.

Imputed or Hypothetical Costs: These are costs which do not involve cash outlay. 16
They are not included in cost accounts but are important for making management decisions. For example, interest on capital is ignored in cost accounting though it is considered in financial accounting. If two projects require unequal outlays of cash, the

management must take into consideration interest on capital to judge the relative profitability of the projects. Differential, Incremental or Decremental Costs: The difference in total costs between two alternatives is termed as differential cost. In case the choice of an alternative results in increase in the total costs, such increased costs are known as incremental costs. If the choice results in decrease in total costs, the resulting decrease is known as decremental costs. While assessing the profitability of a proposed change, the incremental costs are matched with incremental revenuesa The following illustration will demonstrate the concept of incremental costs.

Understanding and Classifying Costs

Illustration 7.3
A company is presently selling, 1000 'unit @, Rs. 10 per unit. The variable cost per unit is Rs 5 and the total fixed costs are Rs.1,000. The company receives an order for supply of 200 units @ Rs.8 per unit. The execution of this export order will increase fixed cost by Rs.200. The cost and sales data under the existing and proposed situation can be put as under: Existing situation Rs. Rs. Sales Less: Variable costs Less : Fixed costs Profit 5 000 4,000 10,000 9,000 1,000 6 000 4,200 Proposed situation Rs. Rs. 11,600 10,200 1,400 1,200 400 Incremental Cost Revenu Rs. Rs. 1,600

Under the existing situation, there is a profit of Rs.1,000. If the alternative proposal. is considered, it would result in incremental revenue of Rs.1,600 against the incremental cost of Rs. I ;200. Hence the incremental profit will be Rs.400. Out-of-Pocket Costs: Out-of-pocket cost means the present or future cash expenditure regarding a certain decision which may vary, depending upon the nature of the decision made. For example, a company has its own trucks for transporting raw materials and finished products from one place to another. It seeks to replace these trucks by employing public carriers of goods. In making this decision, of course , the depreciation of the trucks is not to be considered, but the management must take into account the present expenditure on fuel, salary to drivers and maintenance which have to be incurred in cash. Such costs for arriving at a decision are termed as out-ofpocket costs. Opportunity Costs: Opportunity cost refers to the advantage, in measurable terms; which has been foregone on account of not using the facilities in the manner originally planned. For example, if an owned building is proposed to be utilised for housing a new project plant, the likely revenue which the building could fetch, if rented out, is the opportunity cost which should be taken into account while evaluating the profit-ability of the project. Suppose you have sizeable deposit in a bank which is fetching you a return of 10% per annum. When your deposit is nearing maturity (but can be renewed), a friend of yours approaches you with a business proposal which is likely to earn for you a return of 18% (after tax). After careful consideration of the factors relating to risk and return, you decide to go in for the proposal. It is obvious that you have to give tip the existing alternative in view of the limited funds that you have. Thus you will no longer have the bank deposit. The sacrifice in the form of 10% interest on your deposit in the bank that you have to 'forego if you go in for business proposal is the opportunity cost for the new alternative.

17

Cost Management

Traceable, Untraceable and Joint Costs Traceable Cost: These are costs which can be easily identified or traced to specific products, services or units of the company such as raw material and labour. etc. Untraceable Cost: These are cost which cannot be identified with a department, process or product Such costs are also termed as common costs, as they are incurred collectively for a number of products or cost centres e.g., overheads incurred for the factory as a whole. As such they are apportioned among various products or cost. centres using suitable criterion. Joint Costs: Whenever two or more products are produced out of one and the same raw material or process, the cost of material purchased and the processing costs are called joint costs. Take the example of an oil refinery where a range of products such as bitumen, petrol, kerosene, diesel, etc., are derived in the process of refining crude oil. All these products have joint cost comprising the cost of crude and the cost incurred in the course of refining. These joint costs are then apportioned to various products on some basis. Conversion Cost: The cost of transforming direct materials into finished products, exclusive of direct material cost, is known as conversion cost. It is usually taken as the aggregate of the cost of direct labour, direct expenses and factory overheads. The above classification concepts of cost help the management in the decision making process. For example, segregation of cost into fixed and variable elements will help the management in analysing the total cost. Similarly, segregation of cost into controllable and uncontrollable categories will help the management in fixing responsibilities of d different executives for unfavourable cost variances. Numerous other examples can be given highlighting the usefulness of the above classification of costs.

Activity 7.3
Classify each of the following as direct or indirect cost (D or I) and as fixed or variable cost (F or V). You will have two answers, D or I and F or V, for each of the following items:

7.9
18

SUMMARY

In order to maximise a firm's wealth, ascertaining and controlling of cost is necessary. Cost control involves controlling different elements of costs, viz. material, labour and expenses. Each of these elements of costs can further be classified into direct and

indirect. The term overhead is used for all indirect costs. Costs can be classified into different categories, such as direct and indirect costs, fixed, variable and semivariable costs; controllable and uncontrollable costs; differential incremental or decremental costs, out -of-pocket costs and opportunity costs, etc. Each classification of costs has its own significance in the managerial decision-making process.

Understanding and Classifying Costs

7.10 KEY WORDS

Cost: The amount of expenditure (actual or notional) incurred on or attributable to a given thing. Conversion Cost: The Cost of converting direct materials into finished products, i.e, direct wages, direct expenses and factory overheads. Controllable Cost: Costs chargeable to a job or cost center which can be influenced by the actions of the persons in whom the control of such a center is vested. Differential Cost: The difference in total cost between two alternatives. Fixed Cost: The cost which remains fixed irrespective of the quantum of output over a certain capacity of the organisation. Opportunity Cost: The value of the benefit sacrificed in favour of choosing a particular alternative or action. Uncontrollable Cost: The costs chargeable to a job or cost center which cannot be influenced by the action of the person in whom the control of the center vests. Variable Cost: The cost which tends to vary in direct proportion to changes in the volume of output or turnover.

7.11 SELF-ASSESSMENT QUESTIONS/EXERCISES

1. 2. 3. 4. 5. 6. What do you understand by cost accounting? State its objectives. What do you understand by cost? Explain its different elements. All controllable costs are direct costs, not all direct costs are controllable. Explain with the help of suitable examples. "Fixed costs are variable per unit, while variable costs are fixed per units". Comment. How would you differentiate between `Direct cost' and `Variable Costs'? Give suitable illustrations. State whether each of the following statements is `True' or `False'.

19

Cost Management

7.

Select the most appropriate answer for each of the following cases: i) Cost accounting mainly helps the management in: (a) earning extra profit: (b) providing information to management for decision-making; and (c) fixing prices of the products. Variable cost per unit: (a) remains fixed; (b) fluctuates with the volume of production; and (c) varies in sympathy with the volume of sales. Fixed cost per unit increases when: (a) production volume decreases; (b) production volume increases; and (c) variable cost per unit decreases iv) v) Opportunity cost helps in: (a) ascertaining of cost (b) controlling cost; and (c) making managerial decisions. Conversion cost is the sum total of: (a) direct material cost and direct wages cost (b) direct wages, direct expenses and factory overheads, and (c) indirect wages and factory overheads. Prepare a cost sheet from the following details: Raw Materials : Opening stock Purchases Closing Direct wages Chargeable Expenses Machine hours worked Machine hour rate Office overheads Selling Overheads Cash discount allowed Interest on capital Units produced Units sold 20,000 1,00,000 40,000 40,000 8,000 16,000 Rs. 2 10% of works cost Rs. 1.50 per unit 1,000 2,000 4,000 3,600 @ Rs. 50 each

ii) iii)

8.

(Hint: Cash discount and interest on capital are to be excluded from costs). 9. Calculate (a) Value of raw material consumed, (b) Total cost of production, (c) Cost of production of goods sold, and (d) The amount of profit from the following particulars: Rs. Opening Stock: Raw materials Finished goods Closing stock Raw materials Finished goods Raw materials purchased Octroi paid on raw materials Carriage inward Direct wages paid Direct expenses Rent, rats and taxes Power Factory heating and lighting Factory insurance 5,000 4,000 4,000 5,000 40,000 4,000 6,000 20,000 2,000 5,000 2,000 2,000 1,000

20

Experimental expenses Office management salaries Office printing and stationary Salary of salesman Advertising Carriage outwards Sales

500 4,000 2,000 600 300 100 1,00,000

Understanding and Classifying Costs

Answers to Activity 7.3

a) b) c) d) e) f) g) h) i) j) k) l) 6. 7 8. (i) F; (i) b; I D D I I I I D I D D D (ii) F; (iii) F; (iv) T; (v) F. (ii) a; (iii) a; (iv) c; (v) b. V V V V F F F V V V V V

Answers to Self-assessment Questions/ Exercises

Prime Cost Rs. 1,28,000; Works cost Rs. 1,60,000 Cost of production Rs. 1,76,000; Cost of sales Rs. 1,63,800; Profit Rs. 16,200

(a) Rs.51,000; (b) Rs. 89,500; (c) Rs. 89,500 and (d) Rs. 10,500

7.12 FURTHER READINGS

Horngren, C.T.; Datar Srikant M and Foster George M, 2002, Cost Accounting : A Managerial Emphasis, Prentice Hall of India: New Delhi ( Chapters 2 and 9 ) Bhattacharyya, S.K., Dearden John, 2002, Costing for Management (Part I), Vikas Publishing House : New Delhi Dopuch, N Birnberg, J.G. and Demiski , Joel, 1982, Harcourt Brace Javanovich: New York. ( Chapter 2) Glautier, M.W.E. and B. Underdown, 1982, Accounting Theory and Practice, ELBS, London: Bombay ( Chapter 27) Maheshwari, S. N. 1987, Management Accounting and Financial Control, 5th Edition, Mahavir Book Depot, Delhi ( Section A, Chapter 3). .Cost Accounting , (2nd Ed.)

21

Cost Management

UNIT 8 ABSORPTION AND MARGINAL COSTING

Objectives The aims of this unit are: to familiarise you with the techniques of Absorption Costing and Marginal Costing to explain the basic features and in that process bring out explicitly the differences between the two techniques to develop an appreciation that Marginal Costing has an edge over Absorption Costing as far as managerial decision making is concerned

Structure 8.1 8.2 8.3 8.4 8.5 8.6 8.7 8.8 8.9 8.10 8.11 8.12 8.13 8.14 Introduction Absorption Costing Marginal Costing Absorption Costing and Marginal Costing : Differences Marginal Cost Segregation of Semi-variable Costs Contribution Break-even Analysis Utility of Marginal Costing Limitations of Marginal Costing Summary Key Words Self-assessment Questions/ Exercises Further Readings

8.1

INTRODUCTION

In the preceding unit, we familiarised you with the different elements of cost i.e. materials, labour and expenses. These elements of cost can broadly be put into two categories: Fixed and variable costs. Fixed costs are those which do not vary but remain constant within a given period of time in spite of fluctuations in production. The examples of fixed costs are: rent, insurance charges, management salaries, etc. On the other hand, variable costs are those which vary in direct proportion to any change in the volume of output. The costs of direct material, direct wages etc, can be put into this category. The cost of a product or process can be ascertained ( using the different elements of cost) by any of the following two techniques: Absorption Costing Marginal Costing

22

8.2

ABSORPTION COSTING

Absorption and Marginal Costing

Absorption Costing technique is also termed as Traditional or Full Cost Method. According to this method, the cost of a product is determined after considering both fixed and variable costs. The variable costs, such as those of direct materials, direct labour, etc. are directly charged to the products, while the fixed costs are apportioned on a suitable basis over different products manufactured during a period. Thus, in case of Absorption Costing all costs are identified with the manufactured products. This will be clear with the help of the following illustration. Illustration 8.1 Tripura Ltd. is manufacturing three products : A, B and C. The costs of manufacture are as follows: A Rs. 2 10 1,000 units B Rs. 3 15 1,000 units C Rs. 4 20 1,000 units'

Direct Labour Selling Price Output

The total overheads are Rs. 12,000 out of which Rs. 9,000 are fixed and the rest are variable. It is decided to apportion these costs over different products in the ratio of output. We would prepare a statement showing the cost and profit of each product according to Absorption Costing. Statement Showing Costs and Profit (According to Absorption Costing Technique) A Per Unit Direct Materials Direct Labour Overheads: Fixed Variable Total Cost Profit Selling Price Total profit 3 1 9 1 10 3,000 1000 9,000 1,000 10,000 3 1 11 4 15 3,000 1,000 11,000 4,000 15,000 3 1 13 7 20 3,000 1,000 13,000 7,000 20,000 Rs. 3 2 Rs. 3,000 2,000 Total Per Unit Rs. 4 3 Rs. 4,000 3,000 B Total per Unit Rs. 5 4 C Total Rs. 5,000 4,000

Rs. 1,000+ Rs. 4,000 + Rs. 7,000= Rs. 12,000

This system of costing has a number of disadvantages: It assumes prices are simply a function of costs. It does not take account of demand. It includes past costs which may not be relevant to the pricing decision at hand. It does not provide information which aids decision-making in a rapidly changing market environment

As a result of these disadvantages, fallacious conclusions may be derived as shown

23

Cost Management

by the following illustration.

Illustration 8.2
With the data given in Illustration 8.1, we would calculate the amount of profit or loss made by Tripura Ltd. in the first two years of its existence, presuming that: i) In the. first year, it manufactures 1,000 units of each of the products A, B and C but fails to effect any sales. ii) In the second year , it does not produce anything but sells the entire stock carried forward from the first year. The profit or loss for the first two years can be ascertained by preparing the Profit and Loss Account for each of these years Tripura Ltd. Profit & Loss Account for the 1st year Rs. Rs. Sales 3,000 4,000 5,000 ______ Direct Labour A B C Overheads: Variable A B C Fixed 2,000 3,000 4,000 ______ 9,000 12,000 Closing Stock Rs. 33,000

Direct Material A B C

1,000 1,000 1,000 3,000 ____ 9,000

12,000 33,000 Tripura Ltd. 33,000

Opening Stock Fixed Overheads Profit

Profit & Loss Account for the 2nd year Rs. 33,000 Sales 9,000 3,000 A 10,000 B 15,000 C 20,000 45,000

Rs.

45,000 45,000

24

The above Profit and Loss Accounts show that in the first year in spite of the fact that the company does not make any sales, there is no loss what so ever; while in the second year, it makes a profit of Rs.3,000. As a matter of fact, the company losses Rs, 9,000 on account of non-recovery of fixed cost in the first year. The Profit and Loss Account does not show any loss because these fixed costs have been included in the closing inventory values and thus carried forward to the next year. As a result, the Profit and Loss Account for the second year has to bear Rs.18,000 on account of fixed costs (i.e. Rs. 9,000 for the first year + Rs. 9,000 for the second year). The real

profit in the second year should have been Rs.12,000 and not Rs. 3,000. This will be elaborated a little later. Thus, the technique of Absorption Costing may lead to rather odd results particularly for seasonal businesses in which the stock levels fluctuate widely from one period to another. Their profits for the two periods will be influenced by the transfer of overheads in and out of stock, showing falling profits when the sales are high and increasing profits when the sales are low. The technique of Absorption Costing may also lead to the rejection of profitable business. The total unit cost will tend to be regarded as the lowest possible selling price. An order at a price which is less than the total unit cost may be refused, though this order may actually be profitable, as shown in Illustration 8.3.

Absorption and Marginal Costing

Illustration 8.3
You are the Managing Director of Usha Automobiles Ltd. and have received a special offer for the supply of 200 components at Rs. 60 a piece from a motorbike manufacturer. Your company has a capacity to produce 1,000 components. You are at present, working at 80 per cent capacity. The present selling price per component is Rs.100. The cost details, as supplied by your Cost Accountant, are as follows: Variable cost per unit Fixed overheads cost per unit (Total Fixed overheads Rs. 24,000) Total Cost per unit Rs. 30 Rs. 70 Rs. 40

Your Cost Accountant advises you to reject the order since you will be getting less than the total cost of the component. How would you react? The advice given by the Cost Accountant is not correct. Since he has based his decision on Absorption Costing, he is advising against accepting the special offer. As a matter of fact, the acceptance of the special order may result in extra profit to the company, as shown below: Statement of Profit Sales Sales in Units Sales in Rs. 800 80,000 (800 x 100) Total Cost: Fixed (Rs) Profit (Rs) 24,000 56,000 24,000 8,000 4,000 24,000 64,000 28,000 200 12,000 (200 x 60) Total 1000 92,000

Thus, if the offer is accepted, the profit will increase from Rs. 24,000 to Rs. 28,000. It is, therefore, advisable to accept the offer rather than reject it.

8.3

MARGINAL COSTING

The technique of Marginal Costing is a definite improvement over the technique of Absorption Costing. According to this technique, only the variable costs are considered in calculating the cost of the product, while fixed costs are charged against the

25

Cost Management

revenue of the period. The revenue arising from the excess of sales over variable costs is technically known as Contribution under Marginal Costing. The following illustration will help you in understanding the technique.

Illustration 8.4
From the data given in Illustration 8.1, Let us prepare a statement of cost and profit according to Marginal Costing Technique. Statement of Cost and Profit (According to Marginal Costing Technique)
Product A Per Total Unit Rs. Direct Material Direct Labour Variable overheads 3 2 1 Rs. 3,000 2,000 1,000 6,000 4,000 10,000 Product B Per Total Unit Rs. 4 3 1 8 7 15 Rs. 4,000 3,000 1,000 8,000 7,000 15,000 Product C Per Total Unit Rs. 5 4 1 10 10 20 Rs. 5,000 4,000 1,000 10,000 10,000 20,000

Total Marginal Cost 6 Contribution Selling Price 4 10

Thus, the total contribution from the three products, A, B and C is Rs. 21,000. The profit will now be computed as follows: profit will now be computed as follows: Total Contribution Fixed Costs Profit Rs. 21,000 9,000

12,000 Marginal Costing helps us in managerial decision-making as can be seen from the following illustrations: Illustration 8.5 With the data given in Illustration 8.2, let us calculate the amount of profit or loss by preparing a Profit and Loss Account according to Marginal Costing technique. Profit and Loss Account for the 1st year Rs. Direct Material A B C Direct Labour A B C Variable overheads Fixed overheads 3,000 4,000 5,000 Sales Closing Stock Loss Rs. -------24,000 9,000

12,000

2,000 3,000 4,000

9,000 3,000 9,000 33,000

33,000

Profit and Loss Account for the 2nd year Rs.

Rs.

26

Opening Stock Fixed overheads

24,000 9,000

Sales A 10,000

Profit

12,000 45,000

B C

15,000 20,000 45,000 45,000

Absorption and Marginal Costing

The above statement shows that the company suffers a loss of Rs. 9,000 in the first year because of non-recovery of fixed overheads, while in the second year it makes a profit of Rs. 12,000. It may be seen from the two years ` Profit and Loss Accounts that the fixed cost of one year has not been carried forward to the next year, Thus, the profit and Loss Account gives a correct picture

8.4

ABSORPTION COSTING AND MARGINAL COSTING : DIFFERENCES

The difference between Absorption Costing and Marginal Costing is based on the recovery of fixed overheads. The difference in valuation of inventory under the two techniques is a consequence of such treatment. However, for the sake of clarity, we are analysing the difference from both angles, viz. recovery of overheads and valuation of stock.

Recovery of overheads
In case of Absorption Costing, both fixed and variable overheads are charged to production. On the other hand, in Marginal Costing only variable overheads are charged to production while fixed overheads are transferred in full to the profit and loss account. Thus, in case of marginal Costing, there is under- recovery of overheads since only variable overheads are charged to production.

Valuation of Stocks
In Absorption Costing stocks of work -in-progress and finished goods are valued at works cost and total cost of production respectively. The works cost or cost of production is so defined as to include the amount of fixed overheads also. In marginal Costing, only variable costs are considered while computing the value of work-in progress or finished goods. Thus, the closing stock in Marginal Costing is undervalued as compared to Absorption Costing. But this does not result in carrying over of fixed overheads of one period to another, as it happens in Absorption Costing. The above points of difference will become clear with the help of the following illustration.

Illustration 8.6
Taking the figures given in Illustration 8.1, let us compute the amount of profit under Marginal and Traditional Costing systems, in case units sold of products A, B and C are 900 each. Statement of Profit (Absorption Costing Systems) A B C Rs. Rs. Rs. Direct Material 3,000 4,000 5,000 Direct Labour 2,000 3,000 4,000 Overheads : Variable Total Marginal Cost Add: Fixed overheads Total Cost of Production Less: Closing Stock 1,000 6,000 3,000 9,000 900 1,000 8,000 3,000 11,000 1,100 1,000 10,000 3,000 13,000 1,300

27

Cost Management

Cost of goods sold Profit Sales Rs. Product A Product B Product C 900 3,600 6,300 10,800

8,100 900 9,000

9,900 3,600 13,500

11,700 6,300 18,000

Thus, total profit under Absorption Costing is:

Statement of Profit (Marginal Costing) A Total Marginal Cost Less: Closing Stock Cost of goods sold Contribution (Sales - Marginal Cost of Production) Sales Thus, total profit under Marginal Costing will be: Rs Product A Product B Product C Total Contribution Less: Fixed cost 3,600 6,300 9,000 18,900 9,000 9,000 13,500 18,000 Rs. 6,000 600 5,400 3,600 B Rs. 8,000 800 7,200 6,300 C Rs. 10,000 1,000 9,000 9,000

Profit Rs. 9,900 The profit under Traditional Costing system is Rs. 10,800 while it is Rs. 9,900 under Marginal Costing system. This is on account of the difference in valuation of closing stock. The closing stock under Traditional Costing system includes fixed cost of Rs. 900. That is why the profit under Traditional Costing System is higher by Rs. 900 compared to Marginal Costing system.

Illustration 8.7
From the following cost, production and sales data of Competent Motors Ltd., prepare comparative income statement for three years under (i) absorption costing method, and (ii) marginal costing method. Indicate the unit cost for each year under each method. Also evaluate the closing stocks. The company produces a single article for sale. Particulars 2001 Selling price per unit 20 10 5,000 Variable manufacturing cost per unit Total fixed manufacturing cost Opening stock Year 2002 20 10 5,000 2003 20 10 5,000 500

28

Units produced Units sold Closing stock

1,000 1,000 Comparative Income Statement (Absorption Costing System) 2001 Per Unit Rs. 2002 Total Rs.

1,500 1,000 500

2,000 1,500 1,000

Absorption and Marginal Costing

Per Unit Rs.

2003 Total Per Unit Rs. Rs. 15,000 10.00 5,000 2.50

Total Rs. 20,000 5,000 25,000 6,665 31,665 12,500 19,165 10,835 30,000

Variable cost Fixed cost Total cost of production Add: Opening stock Less : Closing Stock Cost of production of goods sold Profit Sales

10 5 15 15 15 5 20

10,000 10 5,000 3.33

15,000 13.33 15,000 13.33

20,000 12.50 20,000 12.50 6,665 13,335 12.50 6,665 7.50 20,000 20.00

15,000 13.33 5,000 6.67 20,000 20.00

Variable cost Add: Opening stock Less: Closing stock Cost of production of goods sold Sales Contribution Less: Fixed cost

Comparative Income Statement (Marginal Costing System) 2001 2002 2003 Per Total Per Total Per Total Unit Rs. Unit Rs. Unit Rs. Rs. Rs. Rs. 10 10,000 10 15,000 10 20,000 ----------5,000 10 --10 20 10 10,000 --10,000 20,000 10,000 5,000 10 --10 20 10 15,000 5,000 10,000 20,000 10,000 5,000 10 25,000 --- 10,000 10 15,000 --30,000 15,000 5,000

Profit 5,000 5,000 10,000 From the above illustrations the following general rules can be made out: The profit under Traditional Costing System and the Marginal Costing System will be the same in case there are no opening and closing stocks. In case, there is closing stock (and no opening stock), the profit under Traditional Costing system will be more as compared to Marginal Costing System. In case, there is opening stock (and no closing stock), the profit under Marginal Costing system will be more than the profit under Traditional Costing System. If the quantity of closing stock is more than the quantity of the opening stock (presuming that both opening and closing stocks are valued at uniform prices), profit under Traditional Costing System will be more as compared to profit under Marginal Costing System and vice versa.

Activity 8.1
Prepare a Comparative Inventory and Income Measurement Statement for a firm for years II and III under Absorption and Marginal costing. The statement for the 1st

29

Cost Management

years is given. You may assume the following for your calculations : a) Sales annually remain constant at 36,000 units at Rs. 10 per unit. b) Variable overhead is Re. I Per unit, and fixed overheads is Rs. 20,000 per annum. c) Production in Year I is 40,000 units, Year II is 50,000 units and Year III is 25,000 units. d) Direct materials and labour costs amount to Rs. 6 per unit. You can further assume that overheads absorption rate and actual overhead costs are the same. From (b) and (c) you will see that the fixed overheads absorption rate is Re. .50, .40, .80, per unit in the three successive years. Comparative Inventory and Income Measurement (In thousand rupees)
Year I Units (000) 36 40 40 40 4 4 4 Per Unit Rs. 10 6 1 .5 6 1 .5 240 40 20 24 4 2 30 270 300 Absorption Marginal

Sales Cost of Goods Produced Direct Material and Labour Variable Overhead Fixed Overheads Closing Stock Direct Materials and Labour Variable Overhead Fixed Overheads Fixed Overheads Profit

360 240 40 --24 4 ---

360

280

28

252 108 20 88

90 Year II Units (000) Per Unit Rs. Absorption Marginal

Sales Opening Stock Cost of Goods Produced Direct Material and Labour Variable Overhead Fixed Overheads Closing Stock Direct Materials and Labour Variable Overhead Fixed Overheads Fixed Overheads Profit Year III Units (000) Per Unit Rs. Absorption Marginal

30

Sales Opening Stock Cost of Goods Produced Direct Material and Labour Variable Overhead Fixed Overheads

Closing Stock Direct Materials and Labour Variable Overhead Fixed Overheads Fixed Overheads Profit

Absorption and Marginal Costing

8.5

MARGINAL COST

The technique of marginal costing is concerned with marginal cost. It is, therefore, necessary for you to understand correctly the term `Marginal Cost'. The Institute of Cost and Management Accountants, London, has defined Marginal Cost as "the amount at any given volume of output by which aggregate costs are changed if the volume of output is increased by one unit". On analysing this definition we can conclude that the term "Marginal Cost" refers to increase or decrease in the amount of cost on account of increase or decrease of production by a single unit. The unit may be a single article or a batch of similar articles. This will be clear from the following example. A factory produces 500 tricycles per annum. The variable cost per tricycle is Rs. 100. The fixed expenses are Rs. 10,000 per annum. Thus, the cost sheet of tricycles will appear as follows: Rs. Variable Cost (500 x Rs. 100) Fixed cost 50,000 10,000 60,000 If production is increased by one unit, i.e. it becomes 501 tricycles per annum, the cost sheet will then appear as follows: Rs. Variable Cost (501 x Rs. 100) Fixed cost 50,100 10,000 60,100 Marginal cost per unit is, therefore, Rs 100 Marginal cost ordinarily is equal to the increase in total variable cost because within the existing production capacity an increase of one unit in production will cause an increase in variable cost only. The variable cost consists of direct materials, direct labour, variable direct expenses and variable overheads. The term `all variable overheads' includes variable overheads plus the variable portion contained in semivariable overheads. This portion has to be segregated from the total semi-variable overheads according to the methods to be discussed later. The accountant's concept of marginal cost is different from the economist's concept of marginal cost. According to economists, the cost of producing one additional unit of output is the marginal cost of production. This shall include an element of fixed cost also. Thus, fixed cost is taken into consideration according to the economist's concepts of marginal cost, but not according to the accountant's concept. Moreover, with additional production the economist's marginal cost per unit may not be uniform since the law of diminishing (or increasing) returns may be applicable, while the accountant's marginal cost is taken as constant per unit of output with additional

31

Cost Management

production.

Illustration 8.8
Following information related to a factory which manufactures fans: Production in units 500 1,000 1,500 2,000 2,500 Direct Material Rs. 1,000 2,000 3,000 4,000 5,000 Direct Labour Rs, 750 1,500 2,250 3,000 3,750 Other Variable Costs Rs. 500 1,000 1,500 2,000 2,500 Fixed Total Costs Cost Rs. Rs. 1,000 3,250 1,000 5,500 1,000 7,750 1,000 10,000 1,000 12,250

Let us see the effect of increase in output on per unit cost of production through a graph and calculate the marginal cost of production. Production units 500 1,000 1,500 2,000 2,500 Total Variable Cost per unit Rs. 4.50 4.50 4.50 4.50 4.50 Fixed Cost per unit Rs. 2.00 1.00 0.67 0.50 0.40 Total Cost per unit Rs. 6.50 5.50 5.17 5.00 4.90

Graph Depicting Total Cost per Unit at Varying Levels of Output

The above graph shows that with an increase in production the total cost per unit is decreasing. This happens because the fixed overheads which are constant at all levels of output are spread over successively larger outputs. Hence cost of output per unit goes on decreasing with every increase in volume of output. It will be seen that while the marginal cost of production per unit remains constant (at Rs. 4. 50), the fixed cost per unit decreases from Rs. 2 to 0.40. This phenomenon will have considerable effect in motivating the firm in its decision to increase production, as in the present illustration. Marginal cost under the present illustration can be calculate with the help of the following formula:

32

Marginal Cost = Direct Material Cost + Direct Labour Cost + Other Variable Costs or

Total Cost - Fixed Cost When the production is 500 units, the marginal cost of production shall be equal to Rs. 1,000 +Rs. 750 + Rs. 500, i.e, Rs. 2,250 (or Rs. 3,250 - Rs. 1,000). Marginal cost at other levels of output can be figured out in a similar fashion.

Absorption and Marginal Costing

8.6

SEGREGATION OF SEMI-VARIABLE COSTS

As explained earlier, Marginal Costing Method requires segregation of all costs into two parts-fixed and variable. This means that the semi-variable costs will have to be segregated into fixed and variable elements. This may be done by any of the following methods: Levels of output compared to levels of expenses method, High-low method,

Degree of variability Method,

Scattergraph method, Least squares method.

Each of the above methods has been discussed in detail with the help of the following illustration:

Illustration 8.9
July 2002 August 2002 September 2002 October 2002 November 2002 December 2002 Production Units 100 60 160 120 200 140 Semi-variable expenses 300 264 400 340 460 380

During the month of January, 2003 the production is 80 units only. Let us calculate the amount of fixed, variable and total semi-variable expenses for the month.

Levels of Output to Levels of Expenses Method

According to this method, the difference in output at two different points of time is compared with the corresponding difference in expenses. Since the fixed portion of expenses remains constant, any increase or decrease in total semi-variable expenses must be attributed to the variable portion. The variable cost per unit can be derived by dividing the difference in (total) semi-variable expenses with the difference in the level of output at two points of time. Taking the figures for the month of September and November of the illustration given above, we can calculate fixed and variable components of semi-variable costs: Month September November Production units 160 200 Semi-variable expenses (Rs.) 400 460 Fixed (Rs.) 160* 160** Variable (Rs.) 240 300

33

Cost Management

Difference

40

Rs.60

The variable element included in semi-variable expenses is:

Variable overheads for September= 160 x Rs. 1.50 = Rs, 240 Fixed overheads for September = Rs. 400 - Rs. 240 = Rs. 160

** Overheads (into fixed and variable components) for November have been computed in a. similar manner. Semi-variable Overheads for January: Variable overheads for January 80 x Rs. 1.50 = Fixed overheads 160 280 Rs. 120

High-Low Method
This method is similar to previous method except that only the highest and the lowest levels of output rate are considered out of various levels. This method is also known as the Range Method. The highest production in the illustration is in the month of November while the lowest is in the month of August. The figures for these two months, therefore, have been considered. Month August November Difference * Production units 60 200 140 Semi-variable expenses (Rs.) 264 460 196 Fixed (Rs.) 180** .180** Variable (Rs.) 84* 280

Variable element: 196/140 i.e., Re 1.40 per unit., Variable overheads for August = 60 x Rs. 1.4 = Rs. 84 Fixed overheads for August = Rs. 264 - 84 = Rs. 180 ** Similarly, the fixed and variable overheads for November have been ascertained. Semi Variable overheads for January: Rs. 112 Variable overheads for January: 80 x Rs. 1.40 Fixed overheads 180 292 The High - Low Method takes into consideration two sets of data instead of all the data. The two sets of data are the high cost point and the low cost point relating to a. specific measure of output such as number of units produced (as in our Illustration), labour hours, machine hours etc. As the results in High-Low method are based on observation of extreme data, the results may not be very accurate. Because of relying only on the extreme points, the basis computed for segregation of fixed and variable costs may not be representative of normal situation. As such the High-Low method is generally not recommended. Though a crude alternative to more elaborate Least Squares, this method can give

34

fairly acceptable results if the high and low points are chosen with careful consideration of the data.

Absorption and Marginal Costing

Degree of Variability Method

In this method, degree of variability is estimated for each item of semi-variable expenses. Some semi-variable items may have 40% variability while others may have 60% variability. The method is simple to understand. However, determining the degree of variability may be quite difficult. Assuming the degree of variability is 60% in semi-variable expenses and taking the month of October as a basis, the analysis can be done as under: Variable element = (60% of Rs. 340) i.e. Rs. 204 Fixed element = Rs. 340-204 = 136 On the above basis, the variable expenses for 80 units (the production of January 2003) will be as follows:

Hence, the total semi-variable expenses for January, 2003 are Rs. 136 + Rs. 136 = Rs. 272.

Scattergraph Method
In this method the given data are plotted on graph paper and line of best fit is drawn. The method is explained below: The volume of production is plotted on the horizontal axis and the costs are plotted on the vertical axis. Corresponding costs of each volume of production are then plotted on the paper, thus several point are shown on it. A straight line of best fit is then drawn through the points plotted. This is the total cost line. The point where this line intersects the vertical axis is taken to be the amount of fixed element. A line parallel to the horizontal axis is drawn from the point where the line of best fit intersects the vertical axis. This is the fixed cost line. The variable cost at any level can be known by noting the difference between fixed cost and total cost lines.

35

Cost Management

An observation of the graph tells us that fixed expenses are Rs. 170 approximately. For the month of January 2003, the semi-variable expenses are Rs. 290 (which can be ascertained from the line of best fit in the graph at the level of 40 units). As such, the variable expenses will be Rs. 120 (Rs. 290-170).

Method of least squares

This method is based on the mathematical technique of fitting an equation with the help of a number of observations. The linear equation, i.e, a straight line equation, can be assumed as:

An equation of second order, i.e, a curvilinear equation can be drawn as y = a + bx + cx2 and the various sub-equations to solve it (i.e., to find out the values of constants a, b and c, shall be:

A linear equation can be obtained with the help of the following values, thus: Months Production Expenses Rs. (units) y x 100 300 60 264 160 400 120 340 200 460 140 380 x = 780 y = 2,144

July 2002 August 2002 September 2002 October 2002 November2002 December 2002 Total

x2 10,000 3,600 25,600 14,400 40,000 19,600

xy 30,000 15,840 64,000 40,800 92,000 53,200

x2 = 1,13,200 xy = 2,95,840

Assuming the equation as y = a + bx, we have to find the values of constants a and b with the help of above figures. The other two equations are:

36

Absorption and Marginal Costing

8.7

CONTRIBUTION

It has already been stated earlier in the unit that the difference between selling price and variable cost (i.e. the marginal cost) is known as `Contribution' or `Gross Margin' In other words, contribution is the sum of fixed costs and the amount of profit. It can be expressed by the following formula. Contribution = Selling Price-Variable Cost or = Fixed Cost + Profit From the above, we can conclude that profit cannot result unless contribution exceeds fixed costs. In other words, the point of no profit no loss' will be at a level where contribution is equal to fixed costs. Let us take an example. Variable cost Fixed cost Selling Price Contribution = = = Profit = = Rs. 5,000 Rs 2,000 Rs. 8,000 Selling Price Variable cost Rs. 8,000 Rs. 5,000 Rs. 3,000 Contribution Fixed cost Rs. 3,000 Rs. 2,000 Rs. 1,000 As contribution exceeds fixed cost there is a profit of Rs. 1,000. If fixed cost is assumed at Rs. 4,000, the position will change as under: Contribution Fixed Cost = Profit (Loss) Rs. 3,000 Rs. 4,000 = (Rs. 1,000) The sum of Rs. 1,000 represents the extent of loss since the fixed costs are more than

37

Cost Management

contribution. At the level of fixed cost of Rs. 3,000, there shall be no profit and no loss. The concept of Break-even Analysis emerges out of this basic fact.

8.8

BREAK-EVEN ANALYSIS

The term 'Break-even Analysis refers to a system of determination of that level of activity where total cost equals total selling price. However, in the broader sense, it refers to that system of analysis which determines the probable profit at any level of activity. The relationship between cost of production, volume of production, profit and sales value is established by break-even analysis. The analysis is also known as `Cost-Volume-Profit analysis. Break-even analysis is useful for a manager in the following ways: It helps him in forecasting the profit fairly accurately. It is helpful in setting up flexible budgets, since on the basis of Cost-Volume Profit relationship, one can ascertain the costs, sales and profits at different levels of activity. It assists in performance evaluation for purposes of management control. It helps in formulating price policy by projecting the effect which different price structures will have on costs and profits. It helps in determining the amount of overhead cost to be charged at various levels of operations, since overhead rates are generally pre-determined on the basis of a selected volume of production.

Thus, cost-volume-profit analysis is an important medium through which one can have an insight into effects on profit due to variations in costs (both fixed and variable and sales (both volume and value). This enables us to take appropriate decisions. This aspect will be discussed in detail in the next unit of this course. However, it will be expedient for us to understand at this stage the meaning of and the technique of determining the break-even point.

Break-even Point
It refers to that level of activity where the income of the business exactly equals its expenditure. In other words, it is a `no profit, no loss' point. If production is increased beyond this level, profit shall accrue to the business and if it is decreased below this level, loss shall be suffered.

38

At the break-even point the profit is zero. In case the volume of output of sales is to be computed for `a desired profit'. The amount of `desired profit' should be added to fixed costs in the formulae given above. For example.

Absorption and Marginal Costing

Illustration 8.10
A factory manufacturing fans has the capacity to produce 250 fans per annum. The marginal (variable) cost of a fan is Rs. 400 which is sold for Rs. 500. Fixed overheads are Rs. 12,000 per annum. Let us calculate the break-even points for output and sales and show what profit will result if output is 90% of capacity? Contribution per fan is Rs. 500 - Rs. 400 Rs. 100.

Break-even Point for Output

Break-even Point for Sales

39

Cost Management

Activity 8.2
Consider any profit-oriented organisation. Talk to a well informed functionary of Accounting and Finance Department of such an organisation regarding its break-even point. At what percentage of the capacity the organisation is having its break-even point presently? Analyse in terms of the break-even point it had 3-5 years ago. Has break-even point moved downward or upward? Why? ..................................................................................................

8.9
40

UTILITY OF MARGINAL COSTING

The technique of Marginal Costing is of immense use to the management in taking various decisions, as explained below:

Helps in determining the volume of production: Marginal Costing helps in determining the level of output which is most profitable for a running concern. The production capacity, therefore, can be utilised to the maximum possible extent. It helps in determining the most profitable relationship between cost, price and volume in the business which helps the management in fixing best selling price for its products. Thus, maximisation of profit can be achieved. This has been explained in greater detail in a separate unit. Helps in selecting production lines. The technique of Marginal Costing helps in determining the most profitable production line by comparing the profitability of different products. Certain products or activities may turn out to be unprofitable with the passage of time. Production of such products can be discontinued while production of those products which are more profitable can be taken up. It can help in the introduction of new products and work as a good guide for deciding the optimum mix of products keeping in mind the available capacity and resources. Helps in deciding whether to produce or procure: The decision whether a particular product should be manufactured in the factory or procured from outside source can be taken by comparing price at which it can be had from outside. In case the procurement price is lower than the margin cost of production, it will be advisable to procure the product from outside rather than manufacture it in the factory. Helps in deciding method of manufacturing: In case a product can be manufactured by two or more methods, ascertaining the marginal cost of manufacturing the product by each method will be helpful in deciding as to which method should be adopted. Helps in deciding whether to shut down or continue: Marginal Costing, particulaly in periods of trade depression, helps in deciding whether the production in the plant should he suspended temporarily. or continued in spite of low demand for the firm's products. This can be understood with the help of following illustration.

Absorption and Marginal Costing

Illustration 8.11
A company has a manufacturing capacity of 1,000 units per month. The cost details are as under: Direct Material Direct labour Variable overheads Fixed overheads Rs. 3 per unit. Rs. 2 per unit. Rs. 1 per unit. Rs. 2,000 per month.

The Company has been selling its products at Rs. 10 per unit. Due to depression in the market, the product can now be sold only at Rs. 7 per unit. The depression is expected to continue for a period of three months. The accountant advises you to discontinue production since the selling price is less than the total cost of the product. What would be your reaction? The accountant of the company seems to have calculated the total cost per unit according to Absorption Costing technique as under: Rs. Direct material Direct labour Variable overheads Fixed overheads (2,000/1000) Total cost 3 2 1 2 8

As the cost per unit is Rs. 8 compared to the expected selling price of Rs. 7, the accountant obviously has advised the management to suspend the production till the

41

Cost Management

situation returns to normal. However, the decision to suspend production even in this unusual situation is not in the interest of the company. The fact of the matter is that in spite of suspending production, the company will still have to incur fixed cost of Rs. 2,000 per month. If the company continues to manufacture and sell the product, it will be in a position to reduce its loss to Rs. 1,000 per month, as shown below: Rs. Selling price per unit Less: Variable Cost Direct material Direct labour Variable overheads Contribution 3 2 1 6 1 Rs. 7

The total contribution on 1,000 units will amount to Rs. 1,000 and this will go to some extent in recovering the fixed cost per month of Rs. 2,000. As such the net loss will be limited to Rs. 1,000 only as compared to Rs. 2,000, if production is suspended.

8.10 LIMITATIONS OF MARGINAL COSTING

Marginal Costing technique has some limitations as explained below: Difficulty in classification of costs between fixed and variable elements: It is a tough job to analyse costs under `fixed' and `variable' elements. The nature of costs in several cases may not be very clear. Moreover, some items of costs may be partly fixed and partly variable. Splitting of such costs into fixed and variable components may have to be based on assumptions. Besides, some overheads may have no relation either with the volume of output or with the time factor. As such, they cannot logically be categorised either as fixed or variable. The decisions of the management regarding bonus to workers, facilities to administrative staff, etc. are some such examples. Difficult application: Marginal Costing technique is difficult to apply in many firms. Its scope is highly circumscribed where job costing is the need. Notwithstanding the above-mentioned limitations of marginal costing it is regarded as a highly useful technique for analysis of several business decisions.

8.11 SUMMARY
Marginal Costing and Absorption Costing are the two techniques which can be used for ascertaining the cost of a product, job or a process. Absorption Costing is also termed as Traditional or full Cost method. According to this technique, the cost of a product is determined after considering both fixed and variable costs. in other words, all costs are identified with or absorbed into the manufactured products. Marginal Costing is a technique where only the variable costs are considered while computing the cost of products. The fixed costs are met against the total contribution of all the products taken together. Marginal Costing is regarded as superior to traditional costing so far as managerial decision-making is concerned. It identifies only such costs with the jobs or products which directly vary with the level of output. The uncertainty and irrationality associated with apportionment of fixed cost in traditional costing is thus avoided.

42

The technique of Marginal costing greatly helps the management in taking appropriate managerial decisions, viz., dropping a product line, making or buying a component,

shut-down or continuation of operations in periods of trade depression, fixation of minimum selling price of a product, etc. Marginal Costing involves computation of marginal cost. The term marginal cost is synonymous with the term `variable cost'. It comprises of direct material, direct labour, variable direct expenses and variable overheads. The semi-variable overheads are also segregated into fixed and variable categories according to some suitable method. Such segregation of costs into fixed and variable categories helps also in determining the break-even or no profit no loss point. A firm will start making profits only after it reaches the break even level. The sooner it reaches this level, the better it will be. Hence, the break-even level of activity is also of considerable significance to management. Marginal Costing technique has some limitations. The categorisation of costs into fixed and variable elements is a difficult and tedious task. However, in spite of these limitations, marginal costing is regarded as a highly useful technique of analysis for several business decisions.

Absorption and Marginal Costing

8.12 KEY WORDS

Absorption Costing: A technique where all costs, fixed as well as variable, are allotted to cost units. Break-even Point : It refers to the level of activity where the income of the business exactly equals its expenditure. It is also termed as `no profit, no loss' point. Contribution It refers to the excess of selling price over variable cost. Marginal Cost The variable cost of one more unit of a product or service, i.e. a cost which would be avoided if the unit was not produced or service not provided. Marginal Costing: A technique whereby marginal cost of a product is ascertained. Only variable costs are charged to production. Fixed costs are charged against the contribution of the period. It is also termed as `variable costing'.

8.13 SELF-ASSESSMENT QUESTIONS/EXERCISES

1. 2. b) 3. 4. Explain briefly the technique of Marginal Costing. In what ways you consider this technique useful in Management Accounting? a) Explain and bring out in a comparative form the means of income determination under marginal and traditional costing systems.

Explain the different methods for segregating semi-variable overheads. What benefits are gained from Marginal Costing? Are there any pitfalls in its application? State whether each of the following statements is True or False: a) Fixed costs are included in the valuation of work-inprogress and finished goods stocks under marginal costing. b) The valuation of stock is higher in absorption costing as compared to marginal costing. c) Semi-variable costs form a part of product cost in marginal costing. d) Absorption costing is not as suitable for decisionmaking as marginal costing is.

True True True True

False False False False 43

Cost Management

5.

From the following choose the most appropriate answer: i) ii) iii) Contribution margin is also known as (a) Marginal Income; (b) Gross Profit; (c) Net Income. Period cost means: (a) Variable cost; (b) Fixed Cost; (c) Prime cost. If fixed cost is Rs. 10,000 and P/V ratio is 50%, the break-even point will be: (a) Rs. 20,000 (b) Rs. 40,000 (c) Rs. 50,000 (d) None of these. If Profit-Volume Ratio is 40% and sales value Rs. 10,000, the variable costs will be: (a) Rs. 4,000 (b) Rs. 40,000 (c) Rs. 10,000 v) (d) None of these. If sales are Rs. 2 lakhs, fixed cost Rs. 30,000, P/V ratio 40%, the amount of profit will be: (a) Rs. 50,000 (b) Rs. 80,000 (c) 12,000.

iv)

6.

Fill in the blanks: a) b) c) d) e) f) g) The technique of Marginal Costing is based on classification of costs into.costs. Contribution is the difference between sales and .. In marginal costing atcost. stock of finished are goods to is valued products

Both fixed and variable costs under..costing.

charged

Profit-Volume ratio shows the between.and.

relationship

At break-even point, total cost is equal to. At break-even point, the contribution will be equal to ..

7.

Hansa Ltd. produces a standard type of article. The results of the last four quarters of the year 2003 are as follows: Quarters I II III IV Output (Units) 200 300 400 600

The cost of direct material is Rs.60 and direct labour is Rs. 40 per unit. Variable expenses are Rs. 20 per unit. Fixed expenses are Rs. 1,20,000 per annum. Find out cost per unit of each quarter. 8. From the following data, prepare statements of cost according to both absorption costing and marginal costing technique: Sales Direct Material Direct Labour Factory overheads: Fixed Variable Administrative overheads Fixed Selling Overheads Fixed Variable Product X Rs. 15,000 6,000 4,000 3,000 1,000 500 1,000 500 Products Y Rs. 30,000 12,500 5,000 4,000 1,500 1,000 1,000 1,500 Product Z Rs. 40,000 18,000 7,000 3,000 2,500 1,000 1,500 1,500

44

9.

Production costs of Ambitious Enterprises Limited are as follows: 60% 2,400 24,000 7,200 12,800 44,000 Levels of Activity 70% 80% 2,800 3,200 28,000 8,400 13,600 50,000 32,000 9,600 14,400 56,000

Absorption and Marginal Costing

Output (in Units) Cost (in Rs) Direct Materials Direct Labour Factory overheads Works Cost

The management is considering a proposal to increase production to 90% level of activity. The proposal is not expected to involve any increase in fixed factory overheads. You are required to prepare a statement showing the prime cost, total marginal cost and total factory cost at 90% level of activity. (Hint: Fixed Overheads Rs. 8,000) 10. The following figures relate to the repairs and maintenance costs incurred in a machine shop and the corresponding machine hours for a period of six months: Month January February March April May June Total Machine hours 2,000 2,200 1,700 2,400 1,800 1,900 12,000 Repairs & Maintenance 3,000 3,200 2,700 3,400 2,800 2,900 18,000

You are required to segregate the repairs & maintenance cost into fixed and variable elements. 11. The following data are obtained from the records of a company: First year Second year Sales Rs. 1,60,000 Rs. 1,80,000 Profit 20,000 28,000 Calculate the break-even point. From the following data, calculate: i) Break-even point expressed in rupee sales. ii) Number of units that must be sold to earn a profit of Rs. 1,00,000 per year. Selling price Rs. 20 per unit Variable manufacturing costs Rs. 10 per unit Variable selling costs Rs. 5 per unit Fixed Factory overheads Rs. 5,00,000 per year Fixed selling costs Rs. 2,00,000 per year Ahmed Khan sells a popular brand of men's sports shirts at an average price of Rs.28 each. He purchases the shirt from a supplier at a unit cost Rs.18. The costs of operating his shop are all fixed costs and amount to Rs.54,000 a year. He pays commission to his salesmen at the rate of Re. 1 on each shirt sold.

12.

13.

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Cost Management

Required: i) ii) iii) Answer to Activity 8.1

How many shirts must be sold in a year to break-even? Compute the sales revenue at the break-even. Compute the monthly sales revenue required to earn a net profit before tax of Rs.45,000 a year.

Year II Absorption Costing Inventory Profit 133.20 93.20 Marginal Costing 126 88 Absorption Costing 54.60 86.40

Year III Marginal Costing 49 88

While Profit under Marginal Costing is the same for all the three years, it is different under Absorption costing. Why? Please read the text and attempt the answer: Answers to Self-assessment Questions/Exercises 4. 5. 6. 7 8. (a) False; (b) True; (C) False; (d) True (i) a (Marginal Income); (ii) b (Fixed Cost) (iii) a (Rs.20,000); (iv) d (Rs.6,000) (v) a (Rs. 50,000) (a) Fixed and variable; (b) variable costs; (c) marginal; (d) absorption; (e) contribution, sales, (f) total sales; (g) fixed costs (i) Rs.270, (ii) Rs.220, (iii) Rs.195.0, (iv) Rs.170.0 Absorption Costing Profit: Product X Rs(-) 1,000, Product Y Rs.3,500; Product Z Rs.5,500; Marginal Costing Contribution: Product X Rs. 3,500 Product Y Rs.9,500, Products Z Rs. 11,000 Prime cost Rs. 46,800; Marginal Cost Rs. 54,000; Works Cost Rs. 62,000 Fixed Cost Rs.1,000 Rs. 1,10,000 (1) Rs. 28,00,000; (ii) 1,60,000 units, (i) 6,000 shirts (ii) Rs. 1,68,000 (iii) Rs. 25,667

9. 10. 11. 12. 13.

8.14 FURTHER READINGS

Horngren, C.T., Datar, S.M. & Foster, G.M., 2002, Cost Accounting: A Managerial Emphasis 1 1 ed., Publishers: Pearson Education Tulsain, P.C., 2000, Practical Costing, Vikas Publishing 1-louse: New Delhi (Chapter 1 1) Anthony, Robert N. and James S., Reeche, 1987, Accounting Principles, Irwin: New York, (Chapter 15-17) Moore, Carl L. and Robert K Jaedicke, 1976, Managerial Accounting. South Wester' Publishing Co., (Chapter 12& 13) Glautier, M.W.E. and B. Underdown, 1982, Accounting Theory and Practice, ELBS: London, (Chapter 33) Maheshwari, S.N. 1937, Management Accounting and Financial Control (5th ed.) Mahavir Book Depot (Section C, Chapter 4). Audio Programme

46

Emerging Horizons in Accounting and Finance - Part VI: Cost Audit in India

UNIT 9 COST-VOLUME-PROFIT ANALYSIS

Objectives The aims of this unit are to: acquaint you with the nature of Cost-Volume-Profit analysis illustrate the factors which affect Cost-Volume-Profit relationships examine the role of break-even analysis by elaborating the Cost-VolumeProfit framework. discuss the applications of Cost-Volume-Profit relationships in specific decisions

Cost-Volume-Profit Analysis

Structure 9.1 9.2 9.3 9.4 9.5 9.6 9.7 9.8 9.9 9.10 Introduction What is Cost-Volume-Profit Analysis? Interplay and Impact of Factors on Profit Profit Graph Cost Segregation Marginal Cost and Contribution Summary Key Works Self-assessment Questions/Exercises Further Readings

9.1

INTRODUCTION

Managers have to take frequent decision which involve considerations of selling prices, variable costs, and fixed costs. Many of these decisions are a part of their planning responsibilities and have, as such, to be based on predictions about costs and revenues. Almost every question that is posed has a `cost-profit' aspect. you may react to what Horngren (1985, p43 ) states about cost-volume-profit relationships: "Cost -volume-profit analysis is a subject inherently appealing to most students of management because it gives a sweeping overview of the planning process and because it provides a concrete example of the importance of understanding cost behaviour-the response of costs to a wide variety of influences." Probably, you belong to the category of management students identified by Horngren. If you have a propensity to know about the planning process and the cost behaviour, you are sure to get at once interested in the study of cost-volume-profit relationship.

9.2

WHAT IS CVP ANALYSIS?

The Cost -Volume-Profit (CVP) analysis is an attempt to measure the effect of changes in volume, cost, price and products-mix on profits. You will appreciate that while these variables are inter-related, each one of them, in turn, is affected by a number of internal and external factors. For instance, costs vary due to choice of plant, scale of operations, technology, efficiency of work-force and management efficiency. Etc

47

Cost Management

Also, cost of inputs bought externally is affected by market forces. While many wideranging factors influence costs and profits, the largest single variable affecting them in the short-run is the volume of output. Hence, the CVP relationship acquires a vital significance for the manager facing a wide spectrum of short-run decisions like: what are the most profitable and what are the least profitable products? How does a reduction in selling prices affect profits? How does volume or product-mix affect product costs and profits? What will be the break-even point if volume and costs change? How an increase in wages and /or other operating expenses will affect profit? What will be the effect of plant expansion on costs, profit and volume of sales? Answers to all such questions will have to be formulated in a cost-benefit framework and CVP analysis will offer the technique for doing it. You may, in fact, perceive CVP analysis as one ofthe decision-models which managers employ to choose among alternative courses of action. The basic (simplified) CVP model may be outlined as follows:

You may now be getting ready to comprehend the CVP concept. You will observe that profits are a function of the interplay of costs, prices, and each one of them is relevant to profit planning. In fact, variance between actual and budgeted profit arises due to one or more of the following factors: selling price, volume of sales, variable costs, and fixed costs. You will also appreciate that these four factors which cause deviations in planned profits, differ from each other in terms of controllability by management. It is obvious that selling prices largely depend upon external farces. Costs, of course, are more controllable. But they pose a problem of measurement. This is more so when a firm manufactures two or more products. Nevertheless, a knowledge of fixed and variable costs is essential if costs are to be controlled. Consider a tenuous cost volume-profit transit. "Sales price change volume change unit cost change profit structure change" You may try an answer to the question: How will costs change in the foregoing situation? Would you succeed? Probably, not quite so at this stage! But the CVP decision model will of course have an answer within its own assumptive framework

9.3

INTERPLAY AND IMPACT OF FACTORS ON PROFIT

We have said above that costs and volume do influence profit. You wilhat observe more objectively the extent and nature of this impact with the help of an illustration. It is proposed to evaluate the effect of Price changes on net profit, volume changes on net profit, price and volume changes on net profit, an increase or decrease in variable costs on net profit, an increase or decrease in fixed costs on net profit, all four factors viz., price, volume, variable costs, and fixed costs on net profit.

48

Illustration 9.1 The following assumptions are made in the illustration: normal sales volume is 2,00,000 units at a selling price of Rs. 2 per unit; capital investment is Rs. 2,00,000 and management expects to earn a fair return on it: fixed costs are Rs. 1,60,000; variable expenses are Re. 1 per unit. Solutions for the three situations are tabulated separately. The control column of each table shows, normal volume' and a decrease in volume/price by 10% and 20% is shown on the left, while an increase in volume/price by the same percentages is shown on the right of the `central column', calculations show not only net profit or loss for each set of conditions but also the net profit per unit, the percentage return of investment, and the break-even point. Influence of price changes on Net Profit. Table 9.1 Particulars Units Sale (Rs.) Variable cost (Rs) Marginal Income (Rs.) Fixed costs (Rs.) ' Net Profit (Net Loss) Rs Net Profit ( Net loss) per unit ( Rs.) % change in profit Return on investment Break-even point rupee sales Decrease in price Normal Increase in Price 20% 10% Volume 10% 20% 2,00,000 2,00,000 2,00,000 2,00,000 2,00,000 3,20,000 2,00,000 1,20,000 1,60,000 (40,000) (.20) - 200 % -20% 3,60,000 2,00,000 1,60,000 1,60,000 0 100% 0% 4,00,000 2,00,000 2,00,000 1,60,000 40,000 .20 4,40,000 2,00,000 2,40,000 1,60,000 80,000 .40 + 100% 40% 4,80,000 2,00,000 2,80,000 1,60,000 1,20,000 .60 + 200 % 60%

Cost-Volume-Profit Analysis

20%

4,26,667 3,60,000 3,20,000 2,93,333 2,74,286

You may note the following from the above situation: (a) a 10% decrease in price reduces profit to zero, while a 10% increase in price increases profit by 100%. (b) with lower selling prices and a constant volume, the break-even point increases. This happens because a reduction in sales revenue on account of decrease in sales price reduces the marginal income (contribution). A much greater number of units have to be sold in order to recover the fixed costs. Influence of volume changes on Net Profit. Table 9.2 Particulars Decrease in volume 20% 10% 1,60,000 1,80,000 Units 3,20,000 3,60,000 Sales (Rs.) 1,60,000 1,80,000 Variable cost (Rs.) Marginal income (Rs.) 1,60,000 1,80,000 1,60,000 1,60,000 Fixed costs (Rs) 20,000 Net Profit (Rs.) .11 -100% Net Profit per unit (Rs.) -50% 0% % change in profit Break-even point in sales (Rs.) 3,20,000 3,20,000 Normal Increase in Volume Volume 10% 20% 2,00,000 2,20,000 2,40,000 4,00,000 4,40,000 4,80,000 2,00,000 2,20,000 2,40,000 2,00,000 2,20,000 2,40,000 1,60,000 1,60,000 1,60,000 80,000 60,000 40,000 .33 .273 .20 +100% +50% 3,20,000 3,20,000 3,20,000

49

Cost Management

You may note here the following: (a) a 20% decrease in volume reduces sales to the break-even point which remains constant because variable costs change in proportion to sales. (b) a 20% increase in volume improves profit by 100% . A similar increase in price (viz., by 20%) increases profit by 200% (see above). Influence of changes in prices and volume on Net Profit. Table 9.3 Particulars Increase in price 20% 10% Decrease in Price 10% 20%

Units Sales (Rs) Variable costs (Rs.) Marginal income (Rs) Fixed costs (Rs.) Net profit/(Net loss) Rs Net profit per unit Rs. % change in profit Return on investment Break-even point (Rs.)

and and Decrease in VolumeNormal Increase in Volume 20% 10% Volume 10% 20% 1,60,000 1,80,0002,00,000 2,20,000 2,40,000 3,84,000 1,60,000 2,24,000 1,60,000 64,000 .40 +60% 32% 3,96,0004,00,000 1,80,0002,00,000 2,16,0002,00,000 1,60,0001,60,000 56,000 40,000 .31 .20 +40% 28% 20% 3,96,000 2,20,000 1,76,000 1,60,000 16,000 .0727 -60% 8% 3,84,000 2,40,000 1,44,000 1,60,000 (16,000) (.066) -140% 8 % loss

2,74,286 2,93,3333,20,000 3,60,000 4,26,667

Please note in this situation that (a) the prices increase, as assumed would result in higher profits, even if it is accompanied by a decrease in volume of the same order. The reverse, however, is true of a price decrease accompanied by a volume increase,. (b) that the break-even point would be at its lowest when prices are increased and volume decreased because higher rupee volume with lower unit volume reduces the variable cost ratio. Activity 9.1 You may continue your computations for the remaining three situations referred to at the beginning of this section and list your conclusions. The break-even point may be calculated with the help of the following formula:

You will observe from the conclusions derived from the above exercises that such operations would be found quite useful in all such cases where irrational tendencies for price-cutting or for achieving high sales volume exist. Please note the following in our discussion so far with a view to develop understanding for subsequent sections 1. CVP analysis explores the fundamental relationships between cost -volumeprofiit variables. You will observe that changes in volume influence cost and profit and, while this process gets underway, a stage is reached when cost is equated with revenue at acertain level of output or at a certain volume of sales. This is recognised as `break-even point.' You must understand that break-even point,

50

is a point which is incidental to CVP analysis and, therefore, attempts to define CVP analysis as break-even analysis, should be considered only restrictive. It must be admitted that break-even analysis does become an integral part of CVP analysis but the two are not co-terminus.

2.

You will grasp the CVP fundamentals along the following routes a) b) First, the profit -volume relationship will be analysed and the basic framework of `Profit Graph' will be presented. The assumptions underlying the construction and analysis of a `Profit Graph' will be postulated and the concept of " Planned range of activity' will be discussed. A crucial step in the understanding of CVP analysis would be a segregation of costs into fixed and variable components. Procedures for doing this would be briefly examined. The concepts of `marginal cost' and `contribution' will be introduced and this will lead to `break-even analysis ' and `margin of safety'. After a look at the conventional break-even chart the use of such charts for various purposes will be demonstrated. Finally, CVP analysis will be presented in mathematical formulations. With this, you should be in a position to understand practical applications of CVP analysis for business decisions. You will be expected to do assignments on these aspects.

Cost-Volume-Profit Analysis

c)

d) e) f)

9.4

PROFIT GRAPH

A business Firm usually pursues a profit objective. In a way, it plans for maximising its profit. Both the operations plan and the over-all plan of the firm are couched in terms of this `profit objective; and their primary variables are cost, volume, and profit forecast for the planning period (or horizon). The critical variable is usually the `volume of sales forecast' around which costs and profit estimates are built. A question often faced in the planning stage itself is: what will happen to profit if the forecast level of sales changes? Such a question will not always be irrelevant because conditions change so rapidly. A manager seeking an appropriate answer to this question would obviously want to get some guidance. The profit graph which shows the relationship between profit and volume (P/V relationship) helps to provide the questioning manager a possible answer. You will recall from the calculations presented in the previous section about gauging the impact of changes in price, volume, etc., on profit that a term called 'marginal income' was calculated ( please see item number 4 in each of the Tables 9.1, 9.2 and 9.3). Please note that, `marginal income' is the difference between sales and variable expenses and represents total contribution to fixed expenses and profit. This term may be understood in another way as well. If variable expenses are expressed as a per cent of sales we get the variable cost ratio. Then, total contribution or marginal income is equal to "1-variable cost ratio". In all the three situations given in Section 9.3, the variable cost ratio for the normal volume of sales is 50% or .50. Total contribution or marginal income would , therefore, be 1-.50 = .50 or 50%. Another term for `marginal income' is P/V ratio or the profit -volume ratio. You must note that the P/V ratio is not obtained by dividing sales volume by profit but by deducting the variable cost ratio from unity (1)

51

Cost Management

Figure 9.1: Profit Graph With the basic purpose of the profit graph and some of its vital variables having been clarified, you may now move on to a hypothetical profit graph with a view to comprehending relationships involved .Figure 9.1 provides this graph. We may explain the construction of the graph to you and will then specify the assumptions behind this graph in the following section. OX on the X-axis provides sales volume, and OY on the Y -axis plots profit above 0 and loss below O.OFC measures the fixed cost. The line FCP joins two points viz. FC the fixed cost and P the profit expected to be released as the profit-volume plan. The area encompassed by XBE is the margin of safety while the point BE is the break-even point. BEPX is the profit area and the line FCBEP is the total contribution or the PV line. If the sales volume does not materialise at point X, as per the plan, and drops to X' the profit zone will shrink to a new profit area BEX'. Further declines in sales volume will be absorbed by the margin of safety after which losses will begin showing up. All these points will come up for further clarification in subsequent sections. Activity 9.2 1 2 3 4 5 6 a) b) c) d) e) The cost -Volume-Profit analysis is another name given to break-even analysis CVP relationships aid in planning Yes [ ] [ ] [ ] Profit responses to price increases are greater than to price reductions. [ ] P/V ratio is obtained by dividing sales volume by profit. [ ] Lower selling prices will push up the break-even point if: Volume remains constant profit targets are raised plant capacity is expanded new products are added none of the above. [ ] [ ] [ ] [ ] No [ ] [ ] [ ]

CVP analysis is on a profit-volume graph; hence cost is an irrelevant variable.

52

7 a) b) c) d) e) 8 a) b) c) d) e) 9 a) b) c) d) e) 10

The margin of safety is the difference between [ ] [ ] planned sales and actual sales planned sales and break -even sales planned profit and realised profit planned profit and fixed profit none of the above. If sales volume of a firm is Rs. 10 lakhs, variable costs are Rs. 6 lakhs, profit is Rs. 2 lakhs, the P/V ratio will be [ ] [ ] 20 per cent 33 per cent 40 per cent 60 per cent none of these The proposition that the break-even point would be at its lowest when prices are increased and volume decreased is [ ] [ ] generally true seldom true true in the case of a multi-product firm only never true none of these To be able to control, costs must be segregated into fixed and variable. [ ] [ ]

Cost-Volume-Profit Analysis

Assumptions in Profit Graph You have seen the Profit Graph and have got your first exposure to it. May be, few doubts have started bothering you. Your queries may take the following form: "How will the total contribution line emerge as straight line if variable costs per Unit do not remain constant, or if efficiency of operations improves within the planned range of activities, and so on?" You are probably right in thinking so. We have already stated that the CVP is a decision-model and, as with most such models, there are some simplifying assumptions which undoubtedly make the underlying analysis a bit unreal but nevertheless easier to comprehend. You may consider the following assumptions in particular: a) Variable costs are a constant cost per unit of volume. This will mean that the variable cost rate is constant even if the total variable costs will increase in direct proportion to increase in output volume or sales quantum. Total fixed costs remain constant throughout this planned range of activity. Efficiency of operations remains unchanged throughout the planned range of activity.. All costs and particularly, the semi-variable and mixed costs can be separated into fixed and variable elements. Selling prices per unit of sale remain constant Sales-mix for a multi-product firm remains constant. Volume is the only relevant factor affecting cost. Factor prices e.g. material prices, wage rates etc., remain unchanged. Costs and revenue are being compared on a single activity base e.g., sales value of output or units produced. Further, stock levels will not vary significantly in the period covered by the plan. Variations in opening and closing inventories are insignificant. The important implications are: there is a relevant range of activity over which cost behaviour is linear; all prices remain unchanged; and costs can be classified into fixed and variable costs.

b) c) d) e) f) g) h) i)

j)

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Cost Management

Activity 9.3 You have studied cost behaviour patterns in the unit on `Understanding and Classifying Costs'. This behaviour is relevant to CVP analysis as you must have noted. If it is taken that the set assumptions about cost behaviour are nowhere near the real life situation, the whole exercise is reduced to a hypothetical pictorial presentation. With this backdrop, examine the truth of the following statement: The idea of a relevant range to justify linear rather than non-linear cost patterns may not be correct but "a linear expression of total cost may often be a reasonable reflection of reality". (Middleton, 1980) (Hint: It is plain that the accountant's assumptions are unrealistic. But he does not seem to be very much in error; firstly, because obtaining more accurate cost functions is both difficult and expensive. Often, the cost of obtaining more accurate data would exceed the value of any additional information that may be gained from such accurate data: secondly, because most decisions that managers take are within the relevant range of volume where the linearity assumption may not appear unreasonable).

9.5

COST SEGREGATION

Some broad guidelines may be suggested to divide costs into two dominant groups viz., fixed and variable. They are listed below: a) Costs which remain invariant to volume of activity would be considered fixed. In fact, no costs are fixed forever. The concept is relative to the planning horizon (usually a short-run one) and to the relevant range of activity. Costs which vary in direct proportion to volume of activity will be classified as variable costs. Costs which otherwise belong to a mixed category, i.e., which neither belong neatly to category (a) nor to category (b) above, would, in fact, be apportioned to one of the two categories viz., fixed or variable.

b) c)

If a mixed cost varies in some (not direct) proportion to output or volume of activity, it will be classed as variable cost. If a mixed cost, on the other hand, is predominantly fixed, it would be classed as a fixed cost. Activity 9.4 Give some examples (other than you gave in Unit 7) of each of the cost categories stated in this Section. Methods to segregate costs In the previous unit, various methods of segregating semi-variable costs into fixed and variable elements were discussed. Here, we repeat two statistical techniques which may be employed to separate fixed costs and variables costs.

54

 Least squares Scatter Diagram We illustrate these methods. Illustration 1 Least Squares: Power charges are a semi-variable or a mixed cost of Aravali Ltd. It is proposed to segregate them into fixed and variable components, using the method of least squares. Monthly data regarding direct labour hours and electricity charges are given below: Month January February March April May June July August September October November December Total: Direct Labour hours (000) 34 30 34 39 42 32 26 26 31 35 -43 48 420 Electricity Charges Rs. 640 620 620 590 500 530 500 500 530 550 530 680 6,840

Cost-Volume-Profit Analysis

The following calculations are made for the variable rate and the fixed element of electricity charges:
Variable rate:

xy x
2

Fixed element : Y = a+bx Where Y is the dependent variable, x is the independent variable, (i.e., direct labour hours in the example), a is the constant i.e, the fixed cost element to be solved, and b is the slope of the regression line i.e., the variable cost per unit. Calculation of Fixed and Variable Elements Month Direct Deviation Electricity Deviation labour from mean Expenses From mean xy Flours x=35 Y y=570 x2 January February March April May June July August September October November December X (`000) 34 30 34 39 42 32 26 26 31 35 43 48 -5 -1 +4 +7 -3 -9 -9 -4 0 +8 +13 640 620 620 590 500 530 500 500 530 550 580 680 +70 +50 +50 +50 -70 -40 -70 -70 -40 -20 +10 +110 1 25 1 16 49 9 81 81 16 0 64 169 -70 -250 -50 +80 -490 +120 +630 +630 +160 0 +80 +1430

55

x2=512 xy =2,270

Cost Management

Variable electricity rate b =

xy x
2

2270 = 4.4 paise per thousand labour hours 512

= 44 Paise per 100 labour hours or .0044 per labour hour.

Fixed element of electricity charges `a' can be found out by substituting values in the equation, a + bx, where Y=570 X = 35,000 labour hours we get : Rs. 570 = a + .0044 (35000) Rs. 570 = a + Rs. 154 Rs. 570 Rs: 154 = a Rs. 416 = a (the fixed element) Scatter Diagram: The regression equation calculated above may be fitted by free hand on a diagram where direct labour hours are plotted on the X-axis and electricity charges are plotted on the Y-axis. There will be 12 points scattered within the quadrant space of the graph. A line may be made to pass through these points so that there is roughly an equal member of points above and below the line. The vertical intercept of the regression line thus drawn (i.e., the point at which the line intersects the Y-axis ) will measure the fixed element of the electricity charges. The slope of the regression line may be found to ascertain the variable rate per 100 labour hours. Alternatively, the fixed expense as given by the vertical intercept may be multiplied by 12 to get the annual fixed expenses on electricity. This may be deducted from the total electricity charges of Rs.6,840. The balance may be divided by the total annual labour hours viz. 4,20,000 hr., and that quotient would be the approximate rate per labour hour. Activity 9.5 You may draw the scatter diagram using the data given in the example and follow the procedure outlined above. Then, determine the fixed and variable elements of electricity charges. Verify your results with the results computed above. . . . .

9.6

MARGINAL COST AND CONTRIBUTION

Once the fixed and variable costs are segregated it becomes possible to calculate the total contribution as well as total contribution per unit. You will recall that total contribution is equal to the difference between sales and variable ( marginal) costs. Total contribution per unit is expressed in per unit terms by dividing both sales and variable costs by the total number of units and deducting per unit variable cost from per unit selling price. Total contribution may be directly divided by total number of units to obtain similar results.

56

You should remember that total contribution is the contribution of sales revenue to fixed cost recovery and profit after meeting the total variable costs.

You may also recapitulate that total contribution may also be expressed as a percentage in which case it is recognised as P/V ratio. This is 1-variable cost ratio. And variable cost ratio is sales divided by total variable cost. You must understand now the basic thrust of the Profit Graph presented in an earlier section. So far, you must be wondering how the contribution line was plotted on that graph. Now, probably, it is easier to comprehend. The contribution line is, in fact, obtained by plotting contribution per unit figures against different levels of sales values. You may switch back to the Profit Graph and have a closer look at the contribution line. This line originates from the loss zone and raises up to the break-even point BE on the sales volume line. You may interpret this part of the contribution line up to BE i. e. the break-even point as indicative of the recovery of fixed costs only. It is only after this point that the contribution line combines itself with the X-axis and the right Y-axis to form a triangle PXBE which has been marked as the profit area. Break-even Point We had earlier stated that the break-even point is not all that is contained in the CVP analysis. It is only incidental to such an analysis. You have already seen that the break-even point is just one point on the whole journey of the contribution line as it transits from the fixed cost point F to the profit point P via the sales revenue line viz, the X-axis . The horizontal intercept of the contribution line at BE is the break-even point. At this point, total costs and total revenues are held in equilibrium and a noprofit no loss position emerges. Margin of Safety The Profit Graph, while revealing the estimated profit or loss at different levels of activity also suggests the magnitude by which the planned activity level can fall before a loss is experienced. This is known as the Margin of Safety and is obtained by deducting the break-even sales from the planned sales. A graphical glimpse into cost-volume -profit structures: Two cases of companies A and B are presented. You may examine the sales and total cost lines and offer your comments. You should note the differences between these graphs and the profit graph presented earlier.

Cost-Volume-Profit Analysis

57

Cost Management

A major difference between companies. A and B is in terms of the location and slope of their respective total cost line. Company A has a high ratio of fixed cost to total cost because the vertical intercept of its total cost line is very high. In contrast, company B's vertical intercept is quite low and it has accordingly a low ratio of fixed costs to total costs. The following results follow: a) Once the break-even point is reached for company A, large profits are made quickly as volume rises. The profit growth for company is slower after this break-even point. Company B, however, has larger Margin of Safety than company A and can, therefore, sustain difficult business spells without immediately cutting down on its level of activity. Company A cannot hazard a similar course and may have to shut down much earlier.

b)

Break-even Chart You will appreciate the break-even analysis is a transitional stage of CVP analysis. Many authors in fact, discuss the interchangeability of these two because the derivation of break-even analysis from CVP analysis is very subtle. The break-even chart also emerges from the Profit Graph, but the contribution line is replaced by the total cost. The new relationships which must receive attention in the wake of this major change, viz., replacement of the contribution line by the total cost line are presented in the two graphs below:

Figure 9.4 provides an idea of a conventional break-even chart. Figure 9.5, however, depicts a situation where sales revenue may have declined as a result of lowering selling prices to liquidate a higher volume of goods and the company moves into a situation where loss is incurred. The point of maximum profit is also shown on the graph.

58

Purpose of Break-even Charts The figures presented in this sub-section provide a glimpse of the uses to which break-even analysis can be put to. The objective is to offer a visual comprehension of a few illustrative situations. This will hopefully make the mathematical section more comprehensible.

Cost-Volume-Profit Analysis

59

Cost Management

Activity 9.6 Study Figures 9.6 through 9.11 and note your comments on important conclusions that you would arrive at from each Figure. . . . . . . CVP and Break-even Analysis : A resume This concluding section of the unit presents CVP relationship and break-even application in the form of mathematical formulations. The following abbreviations are used: FC = Fixed Cost C = Contribution P = Profit S = Sales P/V ratio = profit-volume ratio BE point = Break-even point MS = Margin of Safety VC = Total Variable Cost 1 2 FC = C- P or alternatively (P/V ratio x S) P C = FC + P or alternatively P/V ratio x S

Illustration 9.2 The following data relates to a firm for an accounting period: Rs. Sales 20,000 12,000

60

Variable cost

Contribution Fixed cost Profit

8,000 6,000 2,000

Cost-Volume-Profit Analysis

P/V ratio =

8, 000 = 40% 20, 000

Units manufactured and sold 10,000 The following changes have been planned: a) b) c) d) Fixed cost increases to Rs. 7,000 Selling price per unit reduced to Rs. 1.50 Rs. 2,000 minimum additional profit is required for additional fixed cost of Rs. 1,000. Extra profit is also required and this is put at Rs. 1,000.

The new P/V ratio is

3, 000 =20% 15, 000

Applications of CVP Formulae: A Determination of the level of sales (Rs.) a) To achieve a given profit when fixed cost and P/V ratio are known:

b)

To maintain the current profit after an increase in fixed cost when the new fixed cost and original P/V ratio are know:

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Cost Management

62

9.7

SUMMARY

Cost-Volume-Profit Analysis

Cost volume profit analysis provides a framework within which the impact of volume changes in the short-run may be examined on profit. Cost behaviour is added as a dimension and corresponding changes in profit, break-even point, and margin of safety are observed. Break-even analysis is an integral part of CVP analysis, even though the former is just incidental to the latter. CVP analysis is used as a tool of planning. A profit plan is essentially to be based on it. A number of managerial decisions are often premised on this vital tool of analysis. Examples of such decision are: distribution channels, outside contracting, sales promotion expenditures, and pricing strategies. The conventional break-even chart is based on a number of assumption, the most relevant being the 'planned range of activity', The `short-run,, and `linearity of cost functions'. Many useful conclusions can be drawn from CVP and break-even analysis. Notice, for example, the following: a) A firm with a high proportion of fixed cost to total cost is accompanied by a high break-even point, and carries a potential for substantial profits once the break-even point is reached. A company with a low proportion of fixed cost to total cost, on the other hand, commands greater flexibility in terms of profitable operation. An increase in sales prices lowers the break-event point and increases the margin of safety. An increase in costs pushes up the break-event point and lowers the margin of profit.

b) c) d)

9.8

KEY WORDS

CVP analysis is a technique of analysis to study the effects of costs and volume variations on profit. Break-even point is a level of sales (volume or value) where total costs and total revenues are equal. Margin of safety is the excess of sales, budgeted or actual, over the break-even sales volume. It shows the amount by which sales may decrease before losses occur. Margin of safety ratio is a relative expression of margin of safety and is obtained by dividing the sales with actuahat (or budgeted) sales. Unit contribution line is the relationship between contribution (i.e., sales minus variable costs) per unit and different sales levels shown on a profit graph. Profit Graph is a depiction of the unit contribution hatine on a graph with sales on the horizontal scale and profit/fixed cost/ loss on the vertical scale. PV ratio is the percentage of contribution to sales. Variable cost ratio is the percentage of variable costs to sales value. Mixed costs are costs which carry both fixed and variable element. These are also known as semi-variable costs.

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Cost Management

9.9
1 2 3

SELF-ASSESSMENT QUESTIONS/EXERCISES
What is CVP analysis? Does it differ from break-even analysis? How do you compute the break-even point? Though the break-even chart and profit graph intend to show the same information, they seem to differ from each other'. Examine and explain the statement This break-even approach is great stuff. All you need to do is worry about variable costs. The fixed costs will take care of themselves. Discuss. What is meant by margin of safety? How is it determined? You are asked to employ break-even analysis for suggesting likely profits and losses at different levels of sales activity. Do you think your report would be invalidated by certain factors? Give your answer with examples. Please state whether the following statements are true or false:( T/F) a) b) c) d) e) f) Mixed costs are used independent of fixed and variable costs in costvolume profit analysis The variable cost ratio is 1-P/V ratio. The higher the break-even point the lower the fixed costs. An increase in total costs unaccompanied by a change in sales reduce the margin of safety. Semi- variable costs cannot be separated into fixed and variable elements. Break-even analysis is invalid for a multi-product firm. total costs remain unchanged. fixed costs at new capacity are increased. fixed costs increase and sales grow. variable costs per unit increase. none of the above.

4 5 6

Increase in capacity reduces the margin of safety if a) b) c) d) e)

If sales and fixed costs remain unchanged, contribution will remain unchanged only when. a) b) c) d) e) revised profit increases margin of safety is increased fixed costs increase total variable costs remain constant none of the above reduces the contribution increases the P/V ratio increases the margin of safety increases the new profit none of above does not affect the break-even point lowers the break-even point increases the break-even point lowers the new profit none of the above

10

An increase in variable costs a) b) c) d) e)

11

An increase in sales price a) b) c)

64

d) e)

12

Budget sales of a firm are Rs. 1 crore, fixed expenses are Rs. 10 lakhs, and variable expenses are Rs. 50 lakhs. The expected profit in the event of 10 % increase in total contribution margin and constant sales would be a) b) c) d) e) Rs. 40,00,000 Rs, 60,00,000 Rs. 45,00,000 Rs. 55,00,000 None of the above

Cost-Volume-Profit Analysis
1 1

13

If the ratio of variable costs to sales of a firm is 30% and its fixed expenses are Rs. 63,000, the break-even point would be a) b) c) d) e) Rs. 90,000 Rs. 18,900 Rs. 71,100 Rs. 81,900 None of the above

14

Total fixed costs of firm are Rs. 9,000 total variable costs are Rs, 15,000 total sales are Rs. 30,000 and units sold are 10,000. The margin of safety is a) b) c) d) e) 5,000 units 8,000 units 4,000 units 6,500 units None of the above.

15.

If the variable cost per unit is Rs.10, fixed costs are Rs. 1,00,000 and selling price per unit is Rs.20 and if the break-even point is lowered to 8000 units, the selling price would be a) b) c) d) e) Rs.25.00 Rs.30.00 Rs.27.50 Rs.22.50 None of the above

16.

Where total costs are Rs.60,000, fixed costs are Rs. Rs.30,000 and sales are Rs.1,00,000 the break-even point in Rs. would be a) b) c) d) e) Rs.50,450 Rs. 42,857 Rs.45,332 Rs.60,000 None of the above.

17.

A company manufactures and sells four types of products under brand names A, B, C and D. The sales mix in terms of value is 33 3 %, 413 %, 16 3 %o and 8 3 % for A, B, C and D respectively. The total budgeted sales are Rs. 60,000 per month. Operating costs are: Product A 60% of selling price Product B 68% selling price Product C 80% of selling price Product D 40% of selling price Fixed costs amount to Rs.14,700 per month

65

Cost Management

You are required to a) b) calculate the break even point for the products on an overall basis, and calculate the new break even point if the sales mix undergoes the following change: Sales mix 25% 40% 30% 5% describe and explain the main factor which contributes to a shift in the breakeven point in the new position. Janata Ltd. reported poor profits for the previous year. This point came up to discussion at a management meeting convened to discuss profitability in the following year. Bhasker Mitter, the Sales Manager, has attended the said meeting. He stressed his belief that greater volume in terms of sales was the answer to the problem of the company. An increase in volume in the previous year had not materialised. In fact, the sales value was the same as the year before with no major volume change, and yet the profit had dropped. Bhaske Mitter mentioned that products 423 had not sold in the current year as well as it did in the previous year. Acharya, the factory manager, expressed the hope that Bhasker Mitter would achieve a higher sales level next year because he had taken delivery of a costly and new pieces of plant and machinery and this should an increased rate of production. Purnendu Kumar, the Managing Director, presented the following chart submitted by his accountant, Naveen Sethi, in his efforts to discuss a plan for the future:

Products A B C D c) 18.

Naveen Sethi explained the chart and then the meeting adjourned for lunch:

66

You are required to a) b) Describe the cost-volume -profit relationships implied in the statements of Analysis Bhasker Mitter and Acharya. Give a possible explanation of the chart prepared by Naveen Sethi.

Cost-Volume-Profit Analysis

Answers and Approaches to Activities Activity 9.1

Conclusions a) b) 20% increase in variable costs raises break even point to the present normal sales volume leaving no profit at all. 20% decrease in variable cost doubles profit per unit, lowers the break even point to almost Rs.1,50,000 below the normal sales volume, and yields 100% more profit.

Influence of change in fixed costs:

Conclusions a) b) A 20% increase in fixed costs still preserves the profit but a 20% decrease lowers the break-even point to the lowest of any situation so far. Decrease in fixed costs does not yield the same profit as does the decrease in variable costs.

67

Cost Management

Conclusions a) b) Break-even point is quickly reached when prices are reduced, costs increased and yet volume remains insufficient to overcome changes. Increase in price accompanied by a decrease in volume coupled with a cost reduction programme will lead to most satisfactory results.

Activity 9.2 1. No 2. Yes 3. No 4. Yes 5. No 6. (a) 7. (b) 8. (c) 9. (a) 10. Yes Solution:

Activity 9.4 Fixed Costs: Rent, rates and taxes Executive salaries Insurance Audit fees Insurance Direct materials Direct labour Power and fuel Discount on sales Salesmans commission Maintenance and supervision Telephone Inventory carrying costs Publicity and Advertising Transport and vehicles

Variable Costs

Semi-variable costs:

Activity 9.6 Figure 9.6: Figure 9.7: Figure 9.8: Rise in sales level, increase in profit, break-even point lowered, and margin of safety increased. Variable cost rises, total cost rises, revised profit declines, breakeven point rises, margin of safety is lowered. Fixed cost rises ( please note that the vertical intercept of the total cost line shifts upwards in contrast with Figure 9.7 where the revised total cost line commences form the same point as the original total cos line), total costs rise, revised profit declines, break-even point rises, am margin of safety is reduced. Capacity expansion increases both profits and fixed costs. The break even point is increased and the safety margin is decreased. Shows how the profit zone beyond the break-even point is appropriate among suppliers of capital. It also shows the profits retained in business. Note the steepness of the slope of individual product contribution lines. This indicates relative profitability. The figure is a profit graph with average and individual product contribution lines. The breakeven point and margin of safety can be determined. They are not marked on the graph.

Figure 9:9: Figure 9.10:

Figure 9.11:

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Answers to Self-assessment Questions/Exercises 7. (a) False (b) True (c) False (d) True (e) False (f) False 8. (c) 9. (d) 10. (a) 11. (b)

Cost-Volume-Profit Analysis

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Cost Management

17 (a)

Solution Calculation of Break -even point A 33 /3%

1

Product Sales mix Sales (Rs.) Variable cost (Rs.) Contribution Fixed costs Profit

B 412/3% 25,000 17,000 8,000 -

C 162/3% 10,000 8,000 2,000 -

D 8'/3%

TOTAL 100%

20,000 12,000 8,000 -

5,000 60,000 2,000 39,000 3,000 21,000 14,700 6,300

b)

Effect of change in sales mix

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18.(a) The CVP relationships implied in the statements are as follows: Bhasker Mitter: Greater volume in terms of sales was the answer to the problem of the company High volume would aim at lowering the total unit cost per product. A low contribution per unit with high fixed costs would require high volume to obtain a reasonable profit. A low volume with high fixed costs would be serious for company profitability. " The sales value was the same as the year before with no major volume change yet the profit had dropped ...... product 423 had not sold in the current year as well as in the previous year'. This result appears to be due to a change in the mix of sales with greater volume of less profitable products than product 423 making up the total volume of sales in units: Acharya: 'Delivery of an expensive raw piece of plant and machinery and this should mean an increased production rate'. This machinery will increase fixed costs. Although the increased production rate will reduce unit cost, the profit implied in the increased contribution per unit is dependent on the increased volume . Higher fixed costs will have reduced the margin of safety. b) A possible explanation of the chart supplied by Naveen Sethi is as follows: Plan A gives the highest costs with the resultant highest break-even point and the lowest margin of safety. Variable costs and revenue are indicated as a constant per unit. Fixed costs are indicated as a constant amount for the range of activity shown. Plan B gives a lower level of fixed costs than plan A and this lowers the break-even point with a corresponding increase in the margin of safety. Plan C gives increased profit for the same level of fixed costs as plan 13, thus lowering the break-even point further and giving the highest margin of safety. The increased profit may be explained by a reduction of variable costs or a possibly improved mix of sales, or perhaps both.

9.10 FURTHER READINGS

Horngren, C.T. Datar, Srikant M, Foster. George M, 2002, Cost Accounting : A Managerial Emphasis (11th ed) : Prentice Hall of India : New Delhi Khan M.Y. and Jain P.K., 2000, Management Accounting (Chapter 14), Tata McGraw Hill Glautier, M.W.E. and B, Uunderdown , 1982, Accounting Theory and Practice, ELBS. Bombay (Chapter 32) Dopuch, N Birnbirg J.G. and Joel Demiski, 1974, Cost Accounting Harcourt Brace Javanovich: New York (Chapter4) Video Programme Accounting in Decision Making

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UNIT 10 VARIANCE ANALYSIS

Objectives This unit aims at: acquainting you with the ways in which the management can monitor and guide the operations of a business to meet the desired goals, particularly in respect of costs and sales. helping you in identifying the factors responsible for deviation of actual performance from the standard performance and in taking such remedial measures as may be necessary.

Structure 10.1 10.2 10.3 10.4 10.5 10.6 10.7 10.8 10.9 10.10 10.11 10.12 10.13 Introduction Meaning of Variance Cost Variances Direct Material Variances Direct Labour Variances Overhead Variances Sales Variances Control of Variances Variance Reporting Summary Key Words Self-assessment Questions/Exercises Further Readings

10.1 INTRODUCTION
Profit making is the prime objective of business enterprise. Profit depends basically on two factors-Costs and Sales. In order to achieve better performance, it is necessary that you lay down your targets in respect of both of them. Your objective should e to maximise the sales and minimise the costs. This will result in maximisation of the profits and, in the long run the wealth of the firm. Variance analysis is intimately connected with budgetary control which helps the management in: planning future activities comparing actual performance with the budgeted performance identifying the variances as to their causes ensuring that remedial measures are taken at appropriate time.

10.2 MEANING OF VARIANCE

Variance is the difference between budgeted and the actual level of activity. Since, as explained earlier, profitability of a business depends both on costs and sales, it will be

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Cost variance is the difference between ` what should have been the cost' (popularly termed as standard cost) and `what has been the cost ` (i.e. actual cost). In case the actual costs is less than the standard cost, the variance is termed as `favourable'. However, if the actual cost is more than the standard costs, variance is termed as `adverse' or `unfavourable'. Sales variance is the difference between `what should have been the sales' (popularly) termed as Budgeted sales) and `what have been the sales ` (i.e. the actual sales). In case the amount of actual sales is more than the budgeted sales, the variance is termed as 'favourable'. However, if the amount of actual sales is less than the budgeted sales, the variance is termed as `adverse' or `unfavourable'. Thus, variances may be classified into two categories:

Variance Analysis

In the following pages, we will explain both the above types of variances in details.

10.3 COST VARIANCES

Cost variances can be put in the following chart:

Direct expenses constitute an insignificant portion of the total cost of the product. Hence, direct expense variance is generally not calculated. If it is desired to calculate the direct expense variance, it can be computed in the same way as the variable overhead variance is calculated, since in most cases direct expenses are variable. At this point, however, we suggest that you have a look at Exhibit -10.1, given towards the end of this unit, which presents a bird's eye view of all the variances discussed in this unit and their inter-relationships. Whenever you are in doubt, a reference to this Exhibit may prove helpful. In the course of discussion in this unit, you will find that abbreviations for different variances have been used. For your facility, we present below a list of all such abbreviations together with the full names of the variances. Abbreviations for Different Variances DMCV DMPV Direct Material Cost Variance Direct Material Price Variance

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DLCV DLRV DLEV OCV VOCV FOCV FOEXPV FOVV SVV SPV SVOLV

Direct Labour Cost Variance Direct Labour Rate Variance Direct Labour Efficiency Variance Overhead Cost Variance Variable Overhead Cost Variance Fixed Overhead Cost Variance Fixed Overhead Expenditure Variance Fixed Overhead Volume Variance Sales Value Variance Sales Price Variance Sales Volume Variance

10.4 DIRECT MATERIAL VARIANCES

Three types of direct material variances are explained here. The first one is Direct Material Cost Variance (DMCV) which is equal to the difference between the standard cost of direct materials specified for the output achieved and the actual cost of direct materials used. The standard cost of materials is computed by multiplying the standard price with the standard quantity for actual output, and the actual cost is computed by multiplying actual price with the actual quantity.

Formula for Computation:

Direct Material Cost Variance = (DMCV) Total Standard Cost for _ Total Actual Cost Actual Output

(Standard Price x Std. Qty. for Actual Output) - (Actual Price x Actual Quantity) If the actual cost is more than the standard cost, it would result in an adverse variance and vice-versa. Let us take an example. Standard output Actual output Std. qty. per unit Total actual qty. used Std. rate per unit Actual rate per unit DMCV = = = = 800 units 1,000 units 1 kg 1,200 kg. Rs.4 per kg Rs. 5 per kg.

Standard Cost for actual output Actual Cost 1,000 x 1 x 4-1,200 x 5 Rs. 4,000 - Rs. 6,000 Rs. 2,000 (Adverse)

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If standard output and actual output are different as in this case, the variances are to. be calculated keeping in view the actual output. The information regarding standard output (which is different from standard quantity) is thus not relevant.

The material cost variance may arise either on account of change in price or change in quantity or both. Thus, material cost variance may be further analysed as `material price variance' and `material usage variance'

Variance Analysis

Direct Material Price Variance DMPV is concerned with that portion of the direct material cost variance which is due to the difference between the standard price specified and the actual price paid. Formula for computation

If the actual price is more than the standard price, the variance would be adverse and in case the standard price is more than the actual price, it would result in a favourable variance. The material price variance, on the basis of figures given in the above example will be computed as follows: DMPV = = i) 1,200 x (4 - 5) Rs. 1,200 (Adverse)

The reasons for price variance may be as under: Fluctuations in market prices: a) b) ii) iii) iv) Market trends may be bullish or bearish. Increase or decrease in prices on account of agreement between various suppliers or on account of Government intervention. .

Buying efficiency or inefficiency High or low costs of transportation and carriage of goods. Changes in or laxity in pursuing purchase policy: a) b) c) Superior or inferior (non-standard) material might have been purchased; Purchases might have been effected in small quantities instead of in bulk or vice versa; Substitute and cheaper materials might have been used.

v) vi) vii)

Emergency purchase- placing rush orders for immediate delivery at the prevalent price. Fraud in purchases and loss of discounts. Incorrect: setting of standards.

Some of the facts may be controlled by the management if care or proper control is exercised, while others may be beyond the control of management. If the factors are controllable, the buying department is usually answerable for unfavourable variations.

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Direct Material Usage or Quantity Variance DMUV is that portion of direct material cost variance which is due to the difference between the standard quantity specified (for the output achieved) and the actual quantity used. Formula for computation

The actual quantity, if more than the standard quantity, would cause an unfavourable variance and vice-versa. The usage variance will be computed as follows on the basis of figures given in the above example. DMUV = = 4 X (1,000-1,200) Rs. 800 (Adverse)

The total of material price and quantity variances is equal to material cost variance. Thus, DMCV = = = DMPV + DMUV Rs.1200 (A) +800 (A) Rs. 2,000 (A)

The reason for direct material usage variance may be as under: i) ii) iii) iv) v) vi) vii) viii) Inefficiency, lack of skill or faulty workmanship resulting in more consumption of raw materials. Lack of proper unkeep and maintenance of plant and equipment, and frequent breakdown during production process leading to wastage of material Non-consideration of product design and method of processing, etc. which fixing standards. Incorrect processing of materials resulting in wastages. Non-recording of returns of material to stock (or stores) or inter-transfers from one job to another. Improper inspection and supervision of workmen resulting in adverse quantity variance due to careless handling and processing. Too strict supervision or inspection resulting in excessive rejections of materials. Substitution of specified materials with unspecified materials causing greater consumption of the latter. Price variance could be favourable because unspecified material is likely to be cheaper. Incorrect setting of standards, leading to variations. Excessive wastage, scrap, Spoilage, Shrinkage, leakage, etc. causing an adverse usage variance.

ix) x)

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Computation of Various Direct Material Variances Illustration 10.1 Form the following particulars, let us find the(i) Material Cost Variance, (ii) Material. Usage Variance, (iii) Material Price Variance. Quantity of material purchased Value of material purchased Standard quantity of materials per unit of finished product Standard rate of material Opening stock of material Closing stock of material Finished products during the period 4,000 units Rs.10,000 2 kg Rs.2 per kg 1,000 kg 2,000 kg 1;000 units

Variance Analysis

Standard Quantity of materials required : 1,000 x 2 = 2,000 kg. Actual Qty. of Material used = Material purchased + Opening Stock - Closing Stock = 4,000+1,000-2,000 = 3,000 kg. Standard Price = Rs. 2 per unit. Actual Price 4,000 units = Rs.10,000 = Rs.2.50 per unit.

*Presuming FIFO Method ii) DMUV = Standard Price x (Standard Quantity - Actual Quantity) = Rs. 2 x (2,000 - 3,000) = Rs. 2 x (-1,000) = Rs. 2,000 (Adverse) iii) DMPV = Actual Quantity x (Standard Price - Actual Price) = 1,000 x (2 - 2) + 2,000 x (2 - 2.50) = Rs. 1,000 (Adverse) It will be observed that the total of materials usage and material price variance is equal to material cost variance. Activity 10.1 Calculate: (i) material usage variance, (ii) material price variance, and (iii) material cost variance in respect of a manufacturing concern which has adopted standard costing. The firm furnishes the following information. Standard data Material for 100kg.of finished products (140 kg), Price of materials Actual data Output Material used Cost of material 60,000 kg 80,000 kg Rs. 2,60,000 Rs. 4 per kg

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10.5 DIRECT LABOUR VARIANCES

The deviations in cost of direct labour may occur because of two main factors: (1) difference in actual rates and standard rates of labour, and (ii) the variation in actual time taken by workers and the standard item prescribed for performing a j( ) or an operation. Labour variances are very much similar to material variances and they can be very easily calculated by applying the same techniques as used in calculation of mater .1 variances. (The readers can work out the various formulae for Direct Labour Variances by simply putting the word `time' in place of `qty'. in the formula meant for Direct Material Variances.) The various labour variances may be put as under. It is the difference between the standard direct wages specified for the activity achieved and the actual direct wages paid. Formula for computation.

Illustration 10.2 Standard output Standard time per unit Standard rate per hour Actual output Total actual time taken Actual rate per hour DLCV = = Rs. 3 x 160 x 2 - Rs. 3.50 x 300 200 units 2 hours Rs. 3 160 units 300 hours Rs.3.50

Rs. 960 - 1,050 = Rs. 90 (Adverse)

The direct labour cost variance may arise on account of difference in either rate of wages or time. Thus, it may be further analysed as (i) Rate variance, and (ii) Ti e or Efficiency variance. This has been shown in the chart below:

Direct Labour (Wages) Rate Variance It is that portion of direct labour (wages) variance which is due to the difference between the standard or specified rate of pay and actual rate paid. Formula for computation.

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Direct Labour Rate Variance (DLRV)

Actual time x (Standard Rate - Actual Rate)

Variance Analysis

If the actual rate is higher than the standard rate, it shall result in an unfavourable variance and vice versa. Taking the figures given in the above illustration, the direct labour rate variance will be computed as follows: DLRV = = 300 hrs x (Rs. 3 - Rs. 3.50) Rs.150 (Adverse)

The reasons for direct labour rate variance may be as under: i) ii) iii) iv) v) vi) vii) viii) ix) Deployment of more efficient and skilled workers giving rise to higher payment. Higher payment due to shortage of availability of labour. Lesser payment due to abundant availability of labour or high competition among them for employment. Employment of unskilled labourers causing lower actual rates of pay. Extra-Shift allowance to workers or overtime allowance (for work done after normal hours) leading to higher wages. Higher piece rates for better quality production Change in the system of wage payment( from time wages to piece wages or vice versa , introduction or withdrawal or incentive or bonus schemes etc. Change in wage rates, probably due to a revised agreement with labour union/ Higher rates during seasonal or emergency operations

Direct Labour Efficiency (Time) Variance It is that portion of the direct labour variance which is due to the difference between the standard labour hours specified for the activity achieved and the actual. labour hours expended. Formula for computation Labour Efficiency = Standard Rates x Standard time Variance _ Actual time (for actual output)

Taking the figures given in Illustration 10.2, the labour efficiency variance will be computed as follows: Labour Efficiency Variance = Rs. 3 x (320 hrs -300 hrs). = Rs.60 (Favourable) It will be seen that the work has been finished in 150 hours, compared to 160 hoursthe standard time set for the production. This could be attributed to efficiency of workers. That is why, this variance is known as Labour Efficiency Variance. The total of labour rate and efficiency variance is equal to labour cost variance. Verification DLCV = Labour Rate Variance + Labour Efficiency Variance = Rs. 150'(A) + 60 (F) = Rs. 90 (Adverse) Labour efficiency variance may be caused by the following: i) ii) iii) Defective or bad materials Breakdown of plant and machinery Failure of power

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iv) v) vi) vii) viii) ix) x) xi)

Efficient working by the labourers and fuller utilisation of time due to incentives given. Loss of time due to delayed instructions from management or delay in receipt pf raw materials. Alteration in the method of production. More time taken by workers due to lack of proper supervision and control by management, making the workers lazy and inefficient. Too rigid a system of inspection and control. Poor working conditions Lower productivity due to lack of training, ability or experience on the part of workers Labour turnover or change -over of workers form one operation or process c department to another.

Computation of Labour Variances Illustration 10.3 Form the following details calculate the direct labour variances: Direct Labour Rate : Re. 1 per hour Hours set per unit : 10 hours Actual data are given below: Units produced : 500 Hours worked : 6,000 Actual Direct Labour Cost : 4,800 Let us work out the various labour variances. Standard Time = 10 hours x 500 units = 5,000 hours Standard Cost = Standard Rate x Standard Time = Re.1 x 5,000 hours = Rs.5,000 i) Direct Labour = Standard Cost - Actual Cost Cost Variance (DLCV) = Rs.5,000 - Rs.4,800 = Rs. 200 (F) ii) Direct Labour = Actual Time X (Standard Rate -Actual Rate) Rate Variance (DLRC)

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Hence, Labour Rate Variance = 6,000 hours x (Rs. 1.80 p.) = Rs. 1,200 (F) iii) Direct Labour Efficiency = Standard Rate x (Standard Time Actual Time) Variance (DLEV). = Re.1 x (5,000 - 6,000 hours) = 1,000 (Adverse) Verification DLCV = DLRV + DLEV = Rs. 1,200 (F) + Rs. 1,000 (A) = Rs. 200 (Favourable)

Activity 10.2 Calculate labour variances for Travancore Supply Company which produces a single article. The product goes through two operating departments. The standard costs card for this article indicated the following data: Standard time Department A Department B 2 hours 1.5 hours Standard rate Rs.5 Rs.6.00 Total Rs.10 Rs.9

Variance Analysis

The production for the month of July was, 2,000 units. The actual labour costs in the two departments were: Hours Department A Department B 4,000 2,000 Cost Rs. 24,000 Rs. 15,000

10.6 OVERHEAD VARIANCES

The term overhead includes indirect material, indirect labour and indirect expenses. Overheads may relate to factory, office, or selling and distribution departments. However, for the purposes of variance analysis, we can broadly divide the overhead cost variance into two categories as shown below:

Each of these variances are discussed below: Overhead Cost Variance (OCV) It is the difference between the standard overheads for actual output (i.e. recovered overheads) and actual overheads. It is the total of both fixed and variable overhead variances. Overhead Cost variance = Recovered Overheads - Actual Overheads Variable Overhead Cost Variance (VOCV) It is the difference between standard variable overheads for actual output ( or recovered variable overheads) and actual variable overheads. VOCV = Recovered Variable Overheads - Actual Variable Overheads. Causes of variance : This variance may be due to advance payment of expenses, or outstanding expenses or payment of past outstanding expenses during this period, or on account of certain abnormal expenses incurred such as, repairs of machinery due to breakdown, expenses clue to spoilage or defective workmanship or excessive overtime work, etc.

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Fixed Overhead Cost Variance (FOCV) It is the difference between standard fixed overheads for actual output (or Recovered Overheads) and actual fixed overheads. FOCV = Recovered Fixed Overheads - Actual Fixed Overheads Causes of variance : Difference between actual and recovered. fixed overheads ma; be on account. (i) a higher or lower amount of fixed overheads, compared to budge :d fixed overheads, might have been incurred for the same production during the same period (ii) the same amount of fixed overheads might have been incurred for a high or lower production than the budgeted production during the same period. Computation of Overhead Variances Illustration Budgeted Output Budgeted Overheads Fixed Variable Actual Overheads Fixed Variable Actual output Let us calculate the various overhead variances. It will be appropriate to make the following basic calculations before computing th various Overhead Variances. Standard/Budgeted Overhead Rate per Unit Rs. 10,000 = = Re.1 = Budgeted Fixed Overheads Budged Output = Budgeted Overheads Budged Output 10,000 units Rs. 10,000 6,000 4,000 12,000 6,000 6,000 8,000 units

10,000

Standard/Budgeted Fixed Overhead Rate per Unit = Rs. 6,000 = Re. 60 10,000 Standard/Budgeted Variable Overhead Rate per unit

= =

Budgeted Variable Overheads Budged Output Rs. 4,000 = Re. 0.40 10,000

Various Overhead Variances can now be calculated OCV VOCV = = = = = = FOCV = = = Recovered Overheads - Actual Overheads Rs. 1 x 8,000 -12,000 = 4,000 (Adverse) Recovered Variable Overheads -Actual Variable Overheads 8,000 x Re. 0,40 - Rs. 6,000 3,200 = 6,000 2,800 (Adverse) Recoverd Fixed Overheads Actual Fixed Overheads 8,000 x Re. 0.60 - Rs. 6,000 Rs. 4,800 - Rs. 6,000 = Rs. 1,200 (Adverse)

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Verification OVC = VOCV + FOCV 4,000 (A) = 2,800 (A) + 1,200 (A) Activity 10.3 Calculate different overhead variances from the following standard and actual data: Standard Overhead rate: Variable Fixed (Rs. 36,000 / 3,000) Per unit Rs. 3.00 Rs. 12.00 Rs. 15.00

Variance Analysis

Actual data during the period: Output 2,400 units Overhead: Variable Rs. 6,000 Fixed Rs. 28,000 Rs. 34,000

Classification of Fixed Overhead Variance

Fixed Overhead Variance may be classified as shown in the following chart:

Fixed Overhead Expenditure or Budget or Controllable Variance (FOEXPV) This variance is due to the difference between Budgeted Fixed Overheads and the Actual Fixed Overheads incurred. FOEXPV = Budgeted Fixed Overheads-Actual Fixed Overheads Fixed Overhead Volume Variance (FOVV) This variance arises on account of difference between standard and actual output resulting in under or over-recovery of fixed overheads. It is, therefore, the difference between overheads absorbed on actual output (or recovered overheads) and those on budgeted output (or budgeted overheads). FOVV = Recovered Fixed Overheads Budgeted Fixed Overheads.

Illustration 10.5 Calculate the Fixed Overhead Expenditure Variance and Fixed Overhead Volume Variance on the basis of data given in Illustration 10.3. FOEXPV = FOVV = = = Budgeted Fixed Overheads -Actual Fixed Overheads Recovered Fixed Overheads - Budgeted Fixed Overheads Rs. 6,000 - Rs. 6,000 = Nil Rs. 4,800 - Rs 6,000 = Rs. 1,200 (Adverse)

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Verification FOCV Activity 10.4 Caren late the overhead variance with the following data: Item No. of working days in a month Man hours per day Output per man hour in units Overhead cost (Rs.) Budgeted 20 6,000 1.0 1,20,000 Actual 2 6,400 9 1,28,000 = FOEXPV + FOVV 1,200 (A) = Nil + 1,200 (A)

10.7 SALES VARIANCES

Sales are affected by two factors (i) the selling price and (ii) the quantum of sales fhe variations in the standards set and actuals for the purpose may be mainly due to change in market trends. Normally, if the selling price increases, the volume of sales will be lower than the standard. It may result in a favourable variance as to price Id unfavourable variance as to quantity. It is to be borne in mind that higher price here is to be viewed as a favourable variance (higher price paid for material, it will be recalled, causes an adverse variance) and lower volume of sales is to be viewed a unfavourable (in case of materials, it is the other way around, i.e. lower usage of materials than the standard causes a favourable variance). It is well known that demand and supply position in the market decides the quantity of sales as well as the selling price. The variations may be on account of control lab : as well as non-controllable factors. changes in market conditions and demand by customers are, of course, beyond the control of management, but certain factors like urn ably high prices are controllable, and an effort should be made to check adverse variations due to these factors. Sales variances can be understood with the help of the following chart Sales Value Variance

Sales Price Sales Value Variance

Sales Volume Variance

The difference between budgeted sales and actual sales results in Sales Value < xiance. The Formula is: Sales Value Variance = Budgeted Sales - Actual Sales If actual sales are more than the budgeted sales, a favourable variance would ' reported and vice versa. The difference in value may be on account of difference in price or volume of ales which is therefore analysed further.

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Sales Price Variance It can be calculated like material price variance. It is on account of the difference in actual selling price and the standard selling price for actual quantity of sales. The formula is: Actual quantity sold OR Price Variance = X (Standard Price - Actual Price)

Variance Analysis

Standard Sales - Actual Sales

Sales Volume Variance It can be calculated like material usage variance. Budgeted sales may be different from the standard sales. In other words, budgeted quantity of sales at standard price may vary from the actual quantity of sales at standard prices. Thus, the variance is a result of difference in budgeted and actual quantities of goods sold. The formula is: Standard Price X OR Volume Variance = Budgeted Sales Standard Sales (Budgeted Quantity Actual Quantity)

If the standard sales are more than the budgeted sales, it would cause a favourable variance and vice versa? The total, of price and volume variances would be equal to sales value variance. Computation of Sales Variances Illustration 10.6

8 5

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Verification Sales value variance = = = Sales Price Variance + Sales Volume Variance 18,000 (A) + 18,000 (F) Nil

*Budgeted Sales = Budgeted Price x Budgeted Quantity

10.8 CONTROL OF VARIANCES

After the variance have been computed and analysed, the next logical step for the management is to trace the responsibility for the variances to particular individuals or departments. The Management/Cost Accountant may be required to prepare necessary report for this purpose. The report submitted to the management should clearly indicate where action is required. On the basis of this report, the management will try to identify the specific individuals for adverse controllable variances, which being within their control could have been avoided. It was earlier mentioned that certain factors, such as changes in market conditions, demand and supply position, etc. are beyond the control of managers. Hence, action to pinpoint responsibility of such uncontrollable variances is not called for. In case of controllable variances, the responsibility could be traced as shown below to the different departments for different variances.

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It may be noted that variance analysis, in itself, would not help in achieving the desired objective of in minimising costs, unless managerial action is prompt and is in the right direction. The direction, of course, shall be indicated by the analysis of variances, but it is the executive side which would be responsible for taking immediate action, exercising proper control, having a close watch over operations, etc., so that economies may be effected inefficiencies minimised and performance improved. A continuous and rigorous effort in the direction of cost control would help the management to achieve the goal of standard costing.

Variance Analysis

10.9 VARIANCE REPORTING

As stated above, the deviations alongwith their causes should be reported to the management regularly and at the opportune time so that corrective action may be taken immediately. The person or department may be held responsible for any adverse variations after duly accounting for it. The information as to the profit earned by the business is presented through a simple Profit and Loss Account where a system of historical costing is prevalent. Its proforma is given below: Trading and Profit and Loss Account For the Year ending To Direct Materials " Variable Expenses " Fixed Expenses " Net Profit ... By Sales .

However, when a system of standard costing is in operation the information about the standards, the actual and the variances alongwith their causes should be depicted through a statement, so that the management may be able to take quick action in respect of any inefficiencies thus revealed. The statement draws a reconciliation between the Budgeted Profit/Standard Profit and Actual Profit. The preparation of this statement can be understood with the help of the following The profit statement, submitted to the management, should contain notes to explain the causes of the variances. Since the rule of `management by exception' is followed, greater attention in the reported statement is drawn towards the adverse variances, i.e, the reasons for the failure or poor performance are highlighted in particular, alongwith comments on general overall performance. Illustration 10.7 From the following particulars let us try to draw a reconciliation between actual and the budgeted profit explaining the variances due to the various causes: Budgeted /Standards Units 4,000 Rs.20.00 Net price per unit Material per unit Kgs. 4.00 Rate of material per Kg. Rs. 2.00 Labour hours per unit Hrs. 5.50 Rate per labour hour Re. 0.50 Variable overhead per labour hour Rs. 0.80 Fixed overhead per unit Re. 1.00 Direct Material Price = Actual qty. x (Std. price - Actual price) Variance (DMPV) = 14,000 x (Rs. 2.00 - Rs. 2.25) = Rs. 3,500 (Adverse) Actual 3,500 21.00 4.00 2.25 4.50 0.60 1.00 1.20

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Activity 10.5 From the following details, reconcile the budgeted sales with actual sales and standard profit with actual profit in terms of variances:

Activity 10.6 Identify the type of variance which will result in each of the stated situations and also indicate whether the variance is favourable or unfavourable: Jammnadas, a worker in the finishing department of a furniture factory,has gone on leave due to illness and is temporarily replaced by Gangaram. Jamanadas's wages are Rs. 200 per day whereas Ganga is to be paid at Rs. 220 per day. Because of the machining error, the cutting department got only three table tops from each piece of a teak board. Proper cutting should have resulted in four table tops per sheet of teak board. Installation of a new office equipment reduced factory office cost by Rs. 1,00,000 a month. The price of teak board increased by 5 per cent. This price increase was anticipated and was included in the computation of standard material cost. A shipment of lumber from Assam is delayed in transit because of transporters' strike. As a result, it is necessary to substitute a more expensive type of lumber. The standard time for shaping legs is 16 minutes per table. A new manwas assigned to this operation and while he was learning the job, his production rate was three table legs every 21 minutes. The production level in 2002 was 22 per cent higher than estimated at the beginning of the year, while total fixed manufacturing overhead costs were as budgeted.

10.10 SUMMARY
Profitability of a business enterprise depends basically on two factors; costs and sales. The efforts of the management should be to minimise the cost without compromising on the quality and pushing up the sales of the products. This requires proper monitoring of both costs and sales performance. Targets have to be fixed and the actual results should be compared with the pre-determined targets and variances found out.

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Variance refers to the difference between the standard (or budgeted performance) and actual performance. Variance analysis is mainly concerned with ascertaining the quantum of variances together with the analysis of the causes responsible for such variances. It may be noted that in the case of cost variance, if the actual cost is more than the standard cost, it is termed as an adverse variance. While in the case of sales variances, if the actual amount of sales is more than the budgeted sales, it is termed as a favourable variance. Variance reports have to be submitted to the management from time to time. These reports contain details regarding the budgeted/standard performance, actual performance, the quantum of variances and the departments/executives responsible for adverse variances. On the basis of these reports, the management can fix the responsibilities on the executives for controllable variances, and takes necessary steps so that such variances do not occur in future. For variances caused by uncontrollable factors, management should try its best to minimise the effect of such factor or revise budgeted/standard performance, if necessary. Various types of variances can be understood with the help of Exhibit 10.1 Exhibit 10.1: A diagrammatic presentation of variances and their Interrelationships.

Variance Analysis

10.11 KEYWORDS
Direct Labour Cost Variance: It is the difference between the direct wages specified or the activity achieved and the actual wages paid. Direct Labour Efficiency Variance: It is that portion of direct labour cost variance which is due to the difference between the standard labour hours specified for the activity achieved and the actual labour hours expended.

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Direct Labour Rate Variance: It is that portion of direct Labour Cost Variance which is due to the difference between the standard rate of wage specified and actual rate paid. Direct Material Cost Variance: It is the difference between the standard cost of direct materials specified for the output achieved and the actual cost of direct material used. Direct Material Price Variance : It is that portion of the direct material cost variance which is due to difference between the standard price specified and actual price paid. Direct Material Usage Variance: It is that portion of the direct material cost variance which is due to difference between the standard quantity specified (for the output achieved) and the actual quantity used. Fixed Overhead Cost Variance: It is the difference between recovered fixed overheads (i.e. standard fixed overheads for actual output) and the actual fixed overheads. Fixed Overhead Expenditure Variance: It is the variance due to the difference between budgeted fixed overheads and the actual fixed overheads incurred. Fixed Overhead Volume Variance: It is the variance due to the difference between recovered overheads (i.e. standard overheads for actual output) and the budgeted overheads. Over head Cost Variance: It is the difference between recovered overheads (i.e. standard overheads for actual output) and the actual overheads. Sales Price Variance: It is the variance on account of difference between actual selling price and standard selling price for actual quantum of sales. Sales Value Variance: It is the difference between the budgeted sales and the actual sales. Sales Volume Variance: It is the variance on account of difference between budgeted and actual quantity of goods sold at standard price. Variance: It is the difference between the standard/budgeted performance and the actual performance. Variable Overhead Cost Variance: It is the difference between recovered variable overheads (i.e. standard variable overheads for actual output) and the actual variable overheads.

10.12 SELF-ASSESSMENT QUESTIONS/EXERCISES

1 2 3 4 What is a Variance? Why are the variances computed? How can the Variance be controlled? List some possible causes, separately for material price variance and material usage variance" What is Direct Labour Efficiency (Time) Variance? What the managers or supervisors can (or should) do to ensure that their is no such unfavourable Variance? Distinguish between Variable Overhead Cost Variance and Fixed Overhead Cost Variance. Why such variances are caused? Discuss the importance of variance analysis in operational and management control. How does this technique help in, what is popularly known as management by exception?

5 6

92

State whether each of the following statements is True or False : a) A cost variance is said to be favourable if the standard cost is more than the actual cost. b) Material usage variance is that portion of material cost variance which arises due to the difference between standard quantity for the output achieved and the actual quantity. c) Labour efficiency variance is the difference between standard hours for the actual output and the actual hours. d) Direct labour rate variance is the difference between the standard direct wages specified for the activity achieved and the actual direct wages paid. e) Standard sales and budgeted sales are synonymous terms. f) Recovered overheads and absorbed overheads mean one and the same thing. g) Fixed overhead cost variance is the aggregate of the expenditure variance and the volume variance. h) The selling department is responsible for factory overhead volume variance. True False

Variance Analysis

True

False

True

False

True True True True True

False False False False False

Fill in the blanks: a) Variance analysis involves...and ... of variance. b) Variance is the difference between standard performance and the performance. c) Material cost variance is sub-divided into .. variance and .. Variance. d) Overhead cost variance can be classified into .... overhead cost variance and .... overhead cost variance. e) Sales value variance is the difference between ... sales and . sales.

From the following particulars, compute Direct Material Variances: Quantity of direct materials, consumed Actual rate of material purchased Standard quantity of materials required per tonne of output Standard rate of material Output during the period 2,500 kgs. Rs. 3 per kg. 30 kg. Rs. 2.50 per kg. 80 tonnes.

10

XYZ Ltd., which has opted standard costing, furnishes you the following information: Standard: Material for 700 units of Finished products Price of materials Actual: Output Opening Stock 2,10,000 units Nil 1,000 Kgs. Re. 1 per kg.

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Cost Management

Purchases Closing stock You are require to calculate (a) (c) 11 Direct Material Usage Variance, (b) Direct Material Cost Variance.

3,00,000 kg. For Rs. 2,70,000 20,000 kgs.

Direct Material Price Variance and

In a production department of a factory there are 80 workers and the average arte of wages per worker is Re. 1 per hour. Standard working hours per week are 45 and the standard performance is six units per hour. The following information is gathered from the labour records of Bajaj Electrical for January 2003. Pay roll allocation for direct labour Rs. 40,000 Time card analysis shows that 8,000 hours were worked on production lines. Production reports for the period showed that 2,000 units have been completed, each unit requiring standard labour time of 3 hours and a standard labour rate f Rs. 4 per hour. Calculate the labour variances.

12

13

Basu Industries turns out only one article the prime cost standards for which have been established as follows Total Materials 5lbs. @ Rs. 4.20 Labour 2 hours @ Rs. 3 Rs. 21 Rs. 6

The production schedule for the month of July, 2003 required completion of 5,000 pieces. However, 5,120 pieces were actually completed. Purchases for the month of July 2003 amounted to 30,000 lbs. of material at the total invoice price Rs. 1,35,000. Production records for the moth of July 2003 showed the following actual results: Material used Direct labour 15,150 hours 25,700 lbs. Rs. 48,480

Calculate the appropriate material and labour variances. 14 From the following data, calculate overhead variance: Fixed overhead budget for November Variable overhead budget for November Budgeted production for the month Actual production for the month Actual Fixed overhead incurred Actual variable overhead incurred 15 Rs. 50,000 Rs. 1,00,000 25,000 units 27,000 units Rs. 60,000 Rs. 1,20,000

The budgeted and actual sales of Vikas Ltd. Manufacturing and marketing a single product are furnished below: Budgeted Sales 10,000 units at Rs. 10 per unit 5,000 units at Rs. 8 per unit

94

Actual Sales

8,000 units at Rs. per unit

Calculate

(a) (b) (c)

Sales Value Variance Sales Price Variance and Sales Volume Variance = = = = = = = = = = = = Rs. 76,000 (F) Rs.60,000 (F) Rs. 16,000 (F) Department A Department B Department A Department B Department A Department B Rs. 2,000 (F) 1,200 (F) 800 (F) Rs. 1,280 (A) 8,000 (A) Rs. 6,720 (F)

Variance Analysis

Answers to Activities 10.1 DMCV DMPV DMUV DLCV DLRV DLEV 10.3 OCV VOCV FOCV FOCV FOEXPV FOVV Notes: FOCV

10.2

Rs. 4,000 (A) 3,000 (F) 4,000 (A) 3,000 (A) Nil 6,000 (F)

1,000 (A) 7,000 (A) 6,000 (F)

10.4

= Recovered Fixed Overheads Actual Fixed Overheads = 1,26,720 1,28,000 = 1,280 (A) Recovered Fixed Overheads have been calculated as under: Man hours per day Multiplied by output per man hour in units Total units produced per day Multiplied by No. of working days Total units produced in the month Multiplied by standard overhead Cost per unit i.e., Rs. 1,20,000 divided by 1,20,000 (6,000 X 1 X 20) 6,400 X 0.9 5,760 X 22 1,26,720 X1 Rs. 1,26,720

FOEXPV

FOVV

= = = = = =

Budgeted Fixed Overheads Actual Fixed Overheads 1,20,000 1,28,000 8,000 (A) Recovered Fixed Overheads Budgeted Overheads 1,26,720 1,20,000 6,720 (F) Rs. 3,000 (A) Rs. 1,000 (A) Rs. 2,000 (A) Rs. 1,46,000 -1,000 -2,000 1,43,000

10.5

Sales Variance Sales value variance Sales Price variance Sales volume variance Budgeted Sales Less sales price variance (A) Less sales volume variance (A) Actual sales Profit variance 500 (A) Price variance 1,000 (A) Volume variance 1,000 (A) Overall cost variance 500 (A)

95

Cost Management

Statement of Reconciliation of Actual Profit with Budgeted Profit Budgeted Profit = Rs. 60,000 Less unfavourable variances: Due to Price Rs. 1,000* Due to cost 500* 1,500 Add favourable variances due to volume*** Actual Profit * ** 58,500 1,000 59,500

Sales Price Variance is Rs. 1,000 as earlier shown. Variance in profit due to cost is: (Standard cost Actual cost) X Actual Quantity. Applying the formula A (12-13) X 4,000 = 4,000 (A) B (10-9) X 3,500 = 3,500 (F) 500 (A) *** Variance in profit due to volume is (Standard Quantity Actual Quantity) X Standard Profit

Applying formula A (3,000 4,000 X 10 B (10-9) X 3,500 X 6 10.6 a) b)

= =

10,000 (F) 9,000 (A) 1,000 (F)

Labour cost increased because a higher wage was paid. Hence unfavourable Direct Labour Rate Variance (DLRV). Material was wasted. More material was used than allowed by the standard. Hence unfavorable Direct Material Usage Variance (DMUV). Factory office costs are a part of manufacturing overhead. As such it is a favourable Overhead Cost Variance (OCV). Because the price change was anticipated and was already included for calculating standard material cost, it does not result in a variance from standard. Hence, no variance. The substitution resulted in a higher price for material used though the quantity was not affected. Hence unfavourable Direct Material Price Variance (DMPV). Whereas the standard time per leg is four minutes, the new worker took seven minutes. Hence unfavourable Direct Labour Efficiency variance (DLEV). In this situation the actual fixed overhead costs and the budgeted costs were the same though the production level was higher by 22 per cent. The recovery for fixed overhead in made on per unit basis. This will result in favourable Fixed Overhead Volume Variance (FOVV).

c) d)

e)

f)

g)

Answers to Self-assessment Questions/Exercises 7 (a) True; (b) True; (c) True; (d) True; (e) False (f) True; (g) True; (h) True; (i) False.

96

8 9 10 11

(a) calculation, interpretation; (b) actual; (c) price, quantity; (d) fixed, variable; (e) budgeted, actual. DMCV Rs. 1,500 (A); DMPV Rs. 1,250 (A); DMUV Rs. 250 (A) (a) Rs. 20,000 (F); (b) Rs. 28,000 (F); (c) Rs. 48,000 (F) Labour Rate Variance Rs. 360 (F) (Hint: Standard wages Rs. 14,400; Actual wages Rs. 14,040 No note is to be taken of idle time).

Variance Analysis

12 13 14

Rate Variance Rs. 8,000 (A); Efficiency Variance Rs. 8,000 (A); Cost Variance Rs. 16,000 (A); DMCV Rs. 8,130 (A); DMPV = Rs. 7,710 (A); DMUV Rs. 420 (A) DLCV Rs. 2,400 (A); DLRV = Rs. 3,030 (A); DLEV Rs. 630 (F) Volume Variance Rs. 4,000 (F); Expenditure Variance Rs. 10,000 (A); Fixed Overhead Cost Variance Rs. 6,000 (A); Variable Overhead cost variance Rs. 12,000 (A)

15

(a) Rs. 36,000 (F); (b) Rs. 6,000 (F), (c) Rs. 30,000 (F)

10.13 FURTHER READINGS

Bhatta Chary S.K., Dearden John 2002, Costing for Management, Vikas Publishing House, New Delhi (Chapter 7) Khan M.Y. and Jain P.K., 2002, Management Accounting (Chapter 17), Tata McGraw Hill : New Delhi Daff, Trevor. 1986, Cost and management Accounting, Woodhead Fulkner (Chapter 8). Davidson, S. and R.L. Weil. 1977, Handbook of Modern Accounting, McGraw-hill (Chapter 13). Glautier, M.W.E. and B. Underdown. 1982, Accounting Theory & practice, ELBS (English Language Book Society) (Chapter 37). Douch N., Birnberg J.G. and Demiski, Joel. 1982, Cost Accounting. Harcourt Brace Jovanovich: New York (Chapter 11). Maheshwari, S.N. 1987, Management Accounting and Financial Control, 5th edition, Mahavir Book Depot: Delhi (Section C, Chapter 3).

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UNIT 11 FINANCIAL MANAGEMENT : AN INTRODUCTION

Objectives
The objectives of this unit are to familiarise you: with the scope and functions of financial management with the objectives of the business firm to the major decisions of the finance function and with the structure and organisation of finance department. Introduction Scope of Financial Management Finance Functions Objectives of the Firm Risk-Return Trade-off Conflict of Goals: Management vs. Owners Financial Goals and Firm's Objectives Organisation of Finance Function Finance and Related Disciplines Summary Key Words Self Assessment Questions Further Readings

Financial Management : An Introduction

Structure
11.1 11.2 11.3 11.4 11.5 11.6 11.7 11.8 11.9 11.10 11.11 11.12 11.13

11.1 INTRODUCTION
After getting a fairly good idea about accounting, lets, now move on to what Financial Management is? Financial management is a managerial activity concerned with planning and controlling of the firm's financial resources to generate returns on its invested funds. The raising and using of capital for generating funds and paying returns to the suppliers of capital is the finance function of a firm. Thus the funds raised by the company will be invested in the best investment opportunities, with an expectation of future benefits. As every business activity either directly or indirectly involves the acquisition and use of funds, there is an inseparable relationship between the finance and other functions like production, marketing etc. However, the raising of funds and using of money may not necessarily limit the general running of the business. A firm in a tight financial position will give more priority to financial considerations to devise its marketing and production strategies in tune with its financial constraints. On the contrary, management of a business firm, with plentiful supply of funds, will be more flexible in formulating its production and marketing policies. In fact, the financial policies will be devised to fit the production and marketing decisions under such a situation. Thus although it may be difficult to separate the finance function from the other functions of the business, the finance function can be broadly discussed as:

Financial and Investment Analysis

i. ii.

Managerial functions Routine functions

The managerial functions require greater planning, control and execution of financial activities. Whereas, the routine functions need a greater managerial talent to carry them out. The routine functions are mainly clerical and incidental to the effective handling of the managerial functions. Some of the important routine functions are: i. ii. iii. iv. Supervision of cash receipts and payments and safeguarding of cash; Custody and safeguarding of securities, insurance policies and other valuable papers; Taking care of the methodological procedures of new outside financing; Preparation of the reports arid keeping of the records.

These routine functions are carried out by the people at the supervisory levels. About three to four decades ago, the scope of finance function was limited to routine activities and the involvement of the financial executive in the managerial finance activities is a very recent origin.

11.2 SCOPE OF FINANCIAL MANAGEMENT

The scope and functions of financial management are divided into two broad categories: a. b. Traditional approach Modern approach

Traditional Approach The traditional approach to the scope of financial management refers to its subject matter in the academic literature in the initial stages of its evolution as a separate branch of study. According to this approach, the scope of financial management is confined to the raising of funds. Hence, the scope of finance was treated by the traditional approach in the narrow sense of procurement of funds by corporate enterprise to meet their financial needs. Since the main emphasis of finance function at that period was on the procurement of funds, the subject was called corporation finance till the mid-1950's and covered discussion on the financial instruments, institutions and practices through which funds are obtained. Further, as the problem of raising funds is more intensely felt at certain episodic events such as merger, liquidation, consolidation, reorganisation and so on. These are the broad features of the subject matter of corporation finance, which has no concern with the decisions of allocating firm's funds. But the scope of finance function in the traditional approach has now been discarded as it suffers from serious criticisms. Again, the limitations of this approach fall into the following categories. i. The emphasis in the traditional approach is on the procurement of funds by the corporate enterprises, which was woven around the viewpoint of the suppliers of funds such as investors, financial institutions, investment bankers, etc, i.e. outsiders. It implies that the traditional approach was the outsider-looking-in approach. Another limitation was that internal financial decision-making was completely ignored in this approach. The second criticism leveled against this traditional approach was that the scope of financial management was confined only to the episodic events such as mergers, acquisitions, reorganizations, consolation, etc. The scope of finance function in this approach was confined to a description of these infrequent

ii.

happenings in the life of an enterprise. Thus, it places over emphasis on the topics of securities and its markets, without paying any attention on the day to day financial aspects. iii. Another serious lacuna in the traditional approach was that the focus was on the long-term financial problems thus ignoring the importance of the working capital management. Thus, this approach has failed to consider the routine managerial problems relating to finance of the firm. During the initial stages of development, financial management was dominated by the traditional approach as is evident from the finance books of early days. The traditional approach was found in the first manifestation by Green's book written in 1897, Meades on Corporation Finance, in 1910; Doing's on Corporate Promotion and Reorganisation, in 1914, etc. As stated earlier, in this traditional approach all these writings emphasized the financial problems from the outsiders' point of view instead of looking into the problems from managements, point of view. It over emphasized long-term financing lacked in analytical content and placed heavy emphasis on descriptive material. Thus, the traditional approach omits the discussion on the important aspects like cost of the capital, optimum capital structure, valuation of firm, etc. In the absence of these crucial aspects in the finance function, the traditional approach implied a very narrow scope of financial management. The modern or new approach provides a solution to all these aspects of financial management. Modern Approach After the 1950's, a number of economic and environmental factors, such as the technological innovations, industrialization, intense competition, interference of government, growth of population, necessitated efficient and effective utilisation of financial resources. In this context, the optimum allocation of the firm's resources is the order of the day to the management. Then the emphasis shifted from episodic financing to the managerial financial problems, from raising of funds to efficient and effective use of funds. Thus, the broader view of the modern approach of the finance function is the wise use of funds. Since the financial decisions have a great impact on all other business activities, the financial manager should be concerned about determining the size and nature of the technology, setting the direction and growth of the business, shaping the profitability, amount of risk taking, selecting the asset mix, determination of optimum capital structure, etc. The new approach is thus an analytical way of viewing the financial problems of a firm. According to the new approach, the financial management is concerned with the solution of the major areas relating to the financial operations of a firm, viz., investment, and financing and dividend decisions. The modern financial manager has to take financial decisions in the most rational way. These decisions have to be made in such a way that the funds of the firm are used optimally. These decisions are referred to as managerial finance functions since they require special care with extraordinary administrative ability, management skills and decision - making techniques, etc.

Financial Management : An Introduction

11.3 FINANCE FUNCTIONS

Finance functions can be divided into three major decisions, which the firm must make, namely the investment decision, the finance decision, and the dividend decision. Each of these decisions must be considered in relation to the objective of the firm: an optimal combination of the three decisions will maximize the value of the share to its shareholders. Since, these decisions are interrelated, we must consider their joint impact on the market price of the firm's stock. Now, in the following pages we will briefly discuss each of these decisions.

Financial and Investment Analysis

A.

Investment Decision

The investment decision is the most important one among the three decisions. It relates to the selection of assets in which funds are invested by the firm. The assets, which can be acquired, fall into two broad groups: i. ii. Long-term assets which will yield a return over a period of time in future, Short-term I current assets which are convertible into cash in the normal course of business usually within a year.

Accordingly, the asset selection decision of a firm is of two types. The first of these involving the first category of assets is popularly known as capital budgeting. The other one, which refers to short-term assets, is designated as liquidity decision. i. Capital budgeting decision It is the most crucial financial decision of a firm which relates to the selection of an investment proposal whose benefits are likely to arise in future over the life-time of the project. The first aspect of the capital budgeting decision is the choice of the investment out of the available alternatives. The selection will be always based on the relative benefits and returns associated with it. Therefore, the measurement of the worth of the investment proposal is a major element in the capital budgeting decision. Another aspect of the capital budgeting decision is the analysis of risk and uncertainty. As, the benefits from the proposed investment relate to the future period, their accrual is uncertain. Thus, an element of risk in the sense of uncertainty of future benefits is involved in this exercise. Therefore, the return from the proposed investment should be evaluated in relation to the risk associated with it. Finally, this return should be judged with a certain norm, which is referred by several names such as cut-off rate, required rate, hurdle rate, minimum rate of return, etc. The correct standard to use for this purpose is the company's cost of capital, which is another important aspect of the capital budgeting decision. ii. Liquidity decision

The liquidity decision is concerned with the management of the current assets, which is a pre-requisite to long-term success of any business firm. The main objective of the current assets: management is the trade - off between profitability and liquidity. There is a conflict between these two concepts. If a firm does not have adequate working capital, it may become illiquid and consequently fail to meet its current obligations thus inviting the risk of bankruptcy. On the contrary, if the current assets are too large, the profitability is adversely affected. Hence, the key strategy and the main consideration in ensuring a trade-off between profitability and liquidity is the major objective of the liquidity decision. Besides, the funds should be invested optimally in the individual current assets to avoid inadequacy or excessive locking up of funds in these assets. Thus, the liquidity decision should obtain the basic two ingredients, i.e. overview of working capital management and the efficient allocation of funds on the individual current assets. B. Financing Decision

The second major decision of the firm is the financing decision for determining the best financing mix of the firm. After determining the asset-mix, the financial manager must decide the mode of raising the funds to meet the firm's investment requirements. The major issue in this decision is to determine the proportion of equity and debt capital. Since the involvement of debt capital affects the return and risk of shareholders, the financial manager should get the optimal capital structure to maximise the shareholders' return with

minimum risk, in other words the cost of capital is the lowest and the market value of the share is the highest at that combination of debt and equity. Thus, the financing decision covers two inter-related aspects: (i) capital structure theory, and (ii) capital structure decision. C. Dividend Decision

Financial Management : An Introduction

The third important decision of a firm is its dividend policy. The financial manager must decide whether the firm should distribute all profits or retain it in the firm or distribute part and retain the balance. The dividend decision should be taken in terms of its impact on the shareholders' wealth. The optimum dividend policy is one, which maximizes the market value of share. Thus, if the shareholders are not indifferent to the firm's dividend policy, the financial manager must determine the optimum dividend-payout ratio. Another important aspect of the dividend decision is the factors determining dividend policy of the firm in practice. To summarise, the financial management involves the solution o f the three decisions of the firm according to the modern approach. The traditional approach with a very narrow perception was devoid of an integrated conceptual and analytical framework. In contrast the modern approach has broadened the scope of financial management to ensure the optimum decisions by fulfilling the objectives of the business firm.

11.4 OBJECTIVES OF THE FIRM

It is clear from the above discussion that the modern approach to financial management is to give answers for three questions: where to invest and in what amounts how to raise and in what amount, and when to pay dividends. These aspects relate to the firm's investment, financing and dividend policies. In order to meet them rationally, the firm must have an objective. It is generally agreed that the financial objective of the firm should be the maximisation of owners' economic welfare. However, there is a disagreement as to how the economic welfare of the owners can be maximised. The two well known and widely discussed criteria in this respect are: a. Profit maximisation, and b. Wealth maximisation

A.

Profit Maximisation

According to this concept, actions that increase the firm's profit are undertaken while those that decrease profit are avoided. The profit can be maximised either by increasing output for a given set of scarce input or by reducing the cost of production for a given output. The modern economics states that the profit maximisation is nothing but a criterion for economic efficiency as profits provide a yardstick by which economic performances can be judged under condition of perfect competition. Besides, under perfect competition, profit maximisation behaviour by firms leads to an efficient allocation of resources with maximum social welfare. Since, the capital is a scarce material, the financial manager should use these capital funds in the most efficient manner for achieving the profit maximisation. It is, therefore, argued that profitability maximisation should serve as the basic criterion for the ultimate financial management decisions. The profit maximisation criterion has, however, been questioned and criticised on the following grounds: i. its vagueness ii. it ignores the timing of benefits iii. it ignores risk

Financial and Investment Analysis

One practical difficulty with profit maximisation criterion is that the term profit is vague and ambiguous as it is amenable to different interpretations, like, profit before tax or after tax, total profit or rate of return, etc. If profit maximisation is taken to be the objective, the problem arises, which of these variants of profit to be maximised? Hence, a vague concept of profit cannot form the basis of operation for financial management. A more important technical objection to profit maximisation is that it ignores the differences in the time pattern of the cash inflows from investment proposals. In other words, it does not recognise the distinction between the returns in different periods of time and treat them at a par which is not true in real world as the benefits in earlier years should be valued more than the benefits received in the subsequent years. Another limitation of profit maximisation as an operational objective is that it ignores the quality aspect of benefits associated with a financial course of action. The quality here refers to the degree of certainty with which benefits can be obtained. As a matter of fact, the more certain the expected return, the higher the quality of the benefits. Conversely, the more uncertain the expected returns, the lower the quality of benefits, which implies risk to the investors. Generally, the investors want to avoid or at least to minimise the risk. Hence, the concept of profit maximisation is unsuitable as an operational criterion for financial management, as it only considers the size of benefits but gives no weight to the degree of uncertainty of future benefits. Therefore, from the above discussion, it clear that the profit maximisation concept is inappropriate to a firm from the point of view of financial decisions, i.e. investment, finance and dividend policies. It is not only vague and ambiguous but also it does not recognise the two basic aspects, i.e., risk and time value of money. The most appropriate operational decision criteria should consist of the following aspects: i. it must be precise and exact;

ii. it should consider both quality and quantity dimension of the receipts; iii. it should be based on the bigger the better principle; and iv. it should recognise the, time value of money. An alternative to profit maximisation, which solves these issues is the wealth maximisation objective. B.

Wealth Maximisation

The most widely accepted objective of the firm is to maximise the value of the firm for its owners. The wealth maximisation goal states that the management should seek to maximise the present value of the expected returns of the firm. The present value of future benefits is calculated by using its discount rate (cost of capital) that reflects both time and risk. The discount rate (capitalisation rate) that is applied is, therefore, the rate that reflects the time and risk preferences of the suppliers of capital. The next feature of wealth maximisation criterion is that it takes; both the quantity and quality dimensions of benefits along with the time value of money. Other things being equal, income with certainty are valued more than the uncertain ones. Similarly, the benefits received in earlier period should be valued more than the benefits received in later period, in this criterion. Thus, the objective of wealth maximisation has a number of distinct merits.

10

It is quite clear that the wealth maximisation is, no doubt, superior to the profit maximisation objective. The wealth maximisation objective involves a comparison of present value of future benefits to the cash outflow. If the activity results in positive

net present value, i.e. the present value of future stream of cash flows exceeds the present value of outflows, reflecting both time and risk, it can be said to create wealth and such actions should be undertaken. Conversely, actions with value less than its cost reduce the wealth of the firm and should be rejected. In case of mutually exclusive projects, when only one is to be chosen, the alternative with the greatest net present value should be selected. According to Ezra Solomon's symbols and methods, the net present wealth can be ascertained as under: i. W=VC where W = Net Present Wealth V = Gross Present Wealth C = Investment / Capital Outflow ii. V=E/K Where E = Size of future stream of benefits K = Capitalisation rate / discount factor reflecting both risk and timing of benefits attached to E. iii. E=G- (M+I+T) Where G = average expected future cash inflows (earnings before interest, taxes and dividends); M = average annual re-investment required to maintain G at the projected level expected flows of annual payments on account of interest, dividend and charges T = expected annual outflows on account of taxes According to the modern approach the objective of the financial management is to maximise the wealth of the firm. The objective of wealth maximisation can also be explicitly defined by short-cut method symbolically as under:

Financial Management : An Introduction

When A1, A2, .... An represent the stream of benefits (cash inflows) expected to occur on the investment project; Co is the cost of the project k is the discount factor / capitalisation rate to calculate the present value of expected cash flows; and, W is the net wealth of the firm (the difference between the present value of stream of expected benefits and the present value of cash outflow). It is abundantly clear from the above discussion that the wealth maximization criterion recognizes the time value of money and also tackles the risk, which is ascertained by the uncertainty of the expected benefits. That is why, it is rightly said that maximization of wealth is more useful than minimization of profits as a statement of the objective of most business firms.

11

Financial and Investment Analysis

11.5 RISK-RETURN TRADE-OFF

The financial decisions of the firm are interrelated as they jointly affect the market value of the shares by influencing return and risk. This relationship between return and risk can be expressed as: Return = Risk-free rate + Risk premium Here the risk free rate is a compensation for time and risk premium for risk coverage. In order to maximise the market value of the firm's shares, a proper balance between return and risk should be maintained. Such a balance is called as risk-return trade-off. It is the overview of the functions of financial management, which is depicted, in the following figure:

Figure 11.1: An overview of financial management

11.6 CONFLICT OF GOALS: MANAGEMENT VS OWNERS

In the joint stock company form of organisations, the decision-making lies in the hands of its management. While taking the decisions, the management need not necessarily act in the best interest of the shareholders and may pursue their own personal welfare, job security, etc. In other words, there may be a divergence between the shareholders' wealth maximization goal and the actual goals pursued by the management of the business firm. The main reason, which has been attributed for this, is the separation of ownership and control (management) in these organisations. But in practice, the possibility of pursuing exclusively the managernents personal welfare is considered remote because the continuous supervision by the owners, employees, creditors, customers, government will restrict management's freedom to act for their own interests. Every group connected with the company will evaluate the management performance from their point of view. The survival of the management will be threatened if their objectives remain unfulfilled. The wealth maximization criterion may be generally in accordance with the interests of the parties who are related to the organisation. However, situations arise where a conflict may occur between the shareholders' and managements goals, that is the management may play safe and create satisfactory wealth for the shareholders which may not be the maximum one. Such type of attitude of management towards the shareholders goal will frustrate the objective of shareholders wealth maximization.

11.7 FINANCIAL GOALS AND FIRM'S OBJECTIVES

12
In the shareholders' wealth maximisation criterion a question may arise: Is wealth maximisation the objective of the firm? Does a firm exist with the sole objective of serving the interests of owners? The business firms do not exist with the main objective of maximising the welfare of shareholders. The survival and the future

growth of the firm always depends on how it satisfies its customers through the quality of goods and services. Further, the firms in practice set their vision or mission concerned with technology, leadership, market share, image, welfare of employees, etc. Hence, the firm designs its strategy around such basic objectives in the areas of technology, production, purchase, marketing, finance, etc. For this, the firm takes its decisions, which are consistent with its strategies. Therefore, the wealth maximisation objective is the second level criterion, which ensures to meet the minimum standard of the economic performance. As a matter of fact, the management is not only the agent of owners, but also trustee for the owners. Hence, it is the responsibility of the management to harmonise the interests of owners with that of creditors, employees, government, society, etc.

Financial Management : An Introduction

11.8 ORGANISATION OF FINANCE FUNCTION

Since the finance function is a major functional area, the ultimate responsibility for carrying out the financial management functions lies with the top management: Board of directors / Managing director / chief executive / committee of the Board. However, the exact nature of the organisation of the finance function differs from firm to firm depending upon the factors such as size of the firm, nature of the business, ability of the financial executive, financial philosophy, etc. similarly, the designation of the chief executive of the finance department also differs widely in case of different firms. In some cases, they are known as finance managers while in others as vice-president (Finance), or Director (Finance), or Financial controller, etc.

Figure 11.2 : Organisation for finance function

Figure 11.3: Organisation for finance function in a multi-divisional Indian company

13

Financial and Investment Analysis

Under the chief executive, there are controllers, treasurers, who will be looking after the sub functions viz., accounting and control; and financing activities in the firm. The functions of treasurer includes obtaining finance; maintaining relations with investors, banks, etc., short-term financing, cash management, credit administration while the controller is related to the functions like financial accounting; internal audit; taxation, management accounting a n d control, budgeting, planning and control, economic appraisal, etc. Figure 11.2 shows that the finance function is one of the major functional areas, and the financial manager / director is under the control of the board of directors.

11.9 FINANCE AND RELATED DISCIPLINES

There is an inseparable relationship between finance o n the one hand and other related disciplines and subjects on the other. It draws heavily on related disciplines and fields of study. The most important of these are accounting and economics, but the subjects like marketing, production, quantitative methods, etc. also have an impact on the finance field. In the following sections these disciplines are noted.

FINANCE AND ACCOUNTING

The relationship between finance and accounting, has two dimensions: i. ii. They are closely related to the extent that accounting is an important input in financial decision making; There are certain differences between them. Accounting is a necessary input into the finance function. It generates information through the financial statements. The data contained in these statements assists the financial managers in assessing the past performance and future directions of the firm and in meeting certain legal obligations. Thus, accounting and finance are functionally inseparable. The key differences between finance and accounting are relating to the treatment of funds and decision-making, which are discussed as under: a. Treatment of funds:

The measurement of funds in accounting is based on the accrual concept. For instance, revenue is recognised at the point of sale and not on collection of credit. Similarly, expenses are recognised when they are incurred but not at the time of actual payment of these expenses. Where as in case of finance the treatment of funds is based on cashflows. That means here the revenue is recognised only when actually received - or actually paid in cash. b. Decision Making:

The purpose of accounting is collection and presentation of financial data. The financial manager uses these data for financial decision-making. It does not mean that accountants never make decisions or financial managers never prepare data. But the primary focus of the function of accountants is collection and presentation of data while the financial manager's major responsibility relates to financial planning, con trolling and decision-making. Thus, the role of finance begins, where the accounting ends.

ECONOMICS AND FINANCE

The development of the theory of finance began in the 1920s as an offshoot of the study of the theory of the firm in economic theory. The financial manager uses microeconomics when developing decision models that are likely to lead to the most efficient and successful modes of operation within the firm. Further, the marginal cost and revenue concepts are used in making the investment decisions, managing working capital, etc in the finance field.

14

11.10

SUMMARY

Financial Management : An Introduction

In this unit we have tried to introduce you to an overview of financial management emphasizing its importance in a firm. We also discussed how the traditional concept of Corporation Finance which considers only the provision of funds required by the business firm was replaced by the modern concept which treats finance as an integral part of the overall management rather than mere raising of funds and the scope of finance. Then the shift of the emphasis to the managerial problems from raising of funds to efficient and effective use of funds. The objectives of profit maximisation, wealth maximisation and their importance has been discussed. Finally, we had covered about the organisation of finance function and related disciplines of finance.

11.11

KEY WORDS

Financial Management: It is an activity concerned with planning and controlling of the firm's financial resources to generate returns on its invested funds to achieve the objectives of the firm. Profit Maximisation: It is one of the objectives of the firm to earn higher returns on its resources, which means higher dividends to the investors. It is nothing but a criterion for economic efficiency as profits provide a yardstick by which economic performances can be judged under condition of perfect competition. Wealth Maximisation: It is the most widely accepted objective of the firm for its owners, which states that the management should seek to maximise the present value of the expected returns of the firm.

11.12
1. 2. 3 4. 5. 6. 7.

SELF ASSESSMENT QUESTIONS

Write in brief about Financial Management and discuss the scope and functions of Financial Management. Distinguish between Profit Maximisation and Wealth Maximisation objectives of the firm? In what ways is the role of a finance manager different from that of an accountant? What are the important decisions of finance functions? Explain their importance and relevance in Financial Management. Discuss the different approaches to Financial Management. What is the nature of the risk-return trade off faced in financial decision making? Discuss the problems of a finance manager in the management of finance functions in the Indian context?

11.13

FURTHER READINGS

Pander, I.M. 2002. Financial Management (8th ed.), Vikas Publishing House : New Delhi Brigham, F. Eugene and Houston F. Joel, 1999, Fundamentals of Financial Management, (2nd ed.), Harcourt Brace College Publishers : Florida (Chapter 1) Soloman, Ezra and Pringle John, 1993. An Introduction to Financial Management, Prentice Hall of India Private Ltd.: New Delhi

15

Financial and Investment Analysis

UNIT 12
Objectives

RATIO ANALYSIS

The main objectives of the unit are to: provide a board classification of ratios identify ratios which are appropriate for control of activities attempt a system of ratios which responds to the needs of control by management

Structure
12.1 12.2 12.3 12.4 12.5 12.6 12.7 12.8 12.9 Introduction Classification The Norms for Evaluation Computation and Purpose Managerial Uses of the Primary Ratio Summary Key Words Self Assessment Questions/Exercises Further Readings

12.1 INTRODUCTION
You have already been exposed to the `Introduction and analysis' of financial statements in Units 4-6 of this course. By now you might have acquired some familiarity with financial ratios that provide basic relationships about several aspects of a business. You may have observed that the Financial media (magazines like Fortune India, Business India Business World, and dailies like Economic Times, Financial Express and Business Standard, among many others) presents many of these ratios to analyse the strengths and weaknesses of individual business firms. Further, the Bombay Stock Exchange makes one of the most exhaustive efforts in the country to analyse financial data of a large number of companies through a set of 21 ratios. An internationally cited use of ratios comes in the ranking of the 500 largest corporations by a financial bi-monthly, viz., Fortune International. This exercise is based on five basic parameters viz., Sales, Assets, Net Income, Stockholders Equity, and Number of employees. The nine rating measures derived from these parameters are: sales change, profits change, net income as a percent of sales, net income as a per cent of stockholders equity, 10-year growth in earning per share, total return to investors (latest year and 10-year average), assets per employee, and sales per employee. This is not an exhaustive list and you may come across many more sources of published ratios including the individual companies, many of which now provide summarised financial information and ratios for the past five or ten years. The point is that users of ratios are vast, ratios that emerge from financial data are numerous and uses to which these ratios can be put are many.

16

12.2 CLASSIFICATION
Financial ratios have been classified in a variety of ways. You may find the following broad bases having been employed in current literature: Primacy Criterion: This distinguishes a measure, which could be considered useful for all kinds and sizes of business enterprises, from many other measures which are not so universal in usage. The first one has been called the Primary Ratio (viz., the Return on Investment or the ROI) and the other category called Secondary measures includes all other ratios. Such measures will essentially vary among firms, and they will select only such of those measures as are relevant for their needs. The British Institute of Management uses this classification for inter-firm comparisons. Ratios tagged to needs of interest groups: The major interest groups identified for this purpose are: a) b) c) Management Owners Lenders

Ratio Analysis

This classification assumes that. management group is different from owner group. Management and operational control: Cost of goods sold and gross margin analysis, profit (net income) analysis, operating expense analysis, contribution analysis and analysis of working capital. Owner's viewpoint Net profit to net worth, net profit available (to, equity shareholders) to equity share capital, earnings per share, cash flow per share and dividends per share. Lenders' evaluation: Current Assets to Current Liabilities, Quick Assets (i.e., current assets minus inventories) to Current Liabilities, Total Debt to Total Assets, Long-term Debt to Net Assets, Total Debt to Net Worth, Long-term Debt to Net Worth, Long-term Debt to Net Assets and Net Profit before Interest and Taxes (i.e., NBIT) to Interest. Fundamental classification Ratios under this classification are grouped according to a basic function relevant to financial analysis. Four such functional groups have been generally recognised. a) Liquidity Ratios are ratios which measure a firm's ability to meet its maturing short-term obligations. The most common ratio indicating the extent of liquidity or lack of it are current ratio and quick ratio. Leverage Ratios are ratios ' which measure the extent to which a firm has been financed by debt. Suppliers of debt capital would look to equity as margin of safety, but owners would borrow to maintain control with limited investment. And if they are able to earn on' borrowed funds more than the interest that has to be paid, the return to owners is magnified. (This aspect has been elaborated and illustrated in the next Unit of Financial and Operating Leverage). Example include debt to total assets, times interest earned, and charge coverage ratios. Activity Ratios are ratios which measure the effectiveness with which a firm is using its resources. Example include Inventory. turnover. Average collection period, Fixed assets turnover, and Total assets turnover. Profitable Ratios are ratios which measure management's overall effectiveness as shown by the returns generated on sales and investment. Examples

b)

c)

d)

17

Financial and Investment Analysis

could be profit (net or gross) margin. Net Profit to total assets or ROI, Net profit after taxes to Net worth. One more class of ratios is sometimes added to the four groups specified above. This is called the `Market Value `group of ratios, which relate investors' expectations about the company's future to its present performance and financial conditions. Examples would cover Price-earnings (PE) and Market/book-value ratios. The fundamental classification is probably the most extensively used mode of presenting financial statement analysis. Activity 12.1 Table 12.1 on next page lists 21 ratios being computed by the Bombay Stock Exchange. Tick the board class to which each of the 21 ratios belongs to in the blank columns of the Table. You must have begun grouping the ratios on the basis of what you have learnt about them. However, we would help you in this exercise. The very first ratio and for that matter the first three ratios are figured on net worth which is a parameter of great interest to proprietors. Nevertheless, the ratios do not reflect either of the four fundamental ratios viz., liquidity, leverage, profitability and activity. Also, they are not primary since they do not measure final profitability of capital (or investment) committed to the firm. Hence, ratios 1 to 3 are secondary and owner-oriented. Of course, they do reveal one fundamental aspect viz., stability. The Bombay Stock Exchange classifies these ratios under the board group of Stability ratios. This exercise of classification has given you an idea about ratios, which are relevant for controlling business activities, and the ratio in which top management would be particularly interested. Obviously, they are activity ratios which we have classified as `management-oriented' ratios. The primary ratio, which is of universal relevance to top management, will be specifically explained regarding its rationale and construction in this unit. You have noticed that the basic flow of activities of a business firm follows a certain sequence: Investment decision financing of investment acquisition of resources deployment of resources disposal of output reinvestment of surplus. This sequence needs some explanation. A typical business firm would take a decision to invest after an analysis of the projected inflows and outflows of the project. This will be followed by a plan to finance the project, which may be debt finance and / or proprietors' own funds. Finance will then be utilized to build facilities and commercial output will be obtained as per the project schedule (assuming there are no over-runs and delays) Sales revenue will follow the disposal of the output and after meeting all costs and expenses (including tax and finance charges), a decision will be taken to compensate the owners (dividend decision) and reinvest the balance, if any. You will appreciate that the cycle of business activities commences with the deployment of recourses and terminate in the disposal of output. A business would like to have as many such cycles as possible during a time period, say a year. Apart from increasing the number of such cycles during a time period the management would be interested to reduce costs and expenses to the minimum at each stage of the cycle. Accounting ratios, which belong to the category of management-oriented activity ratios, enable business firms to exercise control over operations. The next section of this unit focuses attention on these ratios.

18

Ratio Analysis

Table 12.1 : Table listing 21 ratios being computed by the Bombay Stock Exchange Ratios 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21
Net worth to Total Net block to Net worth Total liabilities to Net worth Current Assets to Current liabilities Quick Assets to Current liabilities Net Sales to Total assets Net Sales to Net worth + Debentures Net Sales to Plant & Machinery at Cost Sundry Debtors to Average Daily Sales Net profit to Total Capital Employed Net Profit + Debenture Interest to Net worth + Debentures Net profit to Total Assets Depreciation Reserve to Gross Block Depreciation Provision to Net Block Tax Tax Provision to Pre-tax profit Preference Capital + Debentures to Equity Capital Debentures to Net worth + Debentures Preference Capital to Net worth + Debentures Equity Capital + Reserve to Net worth + Debentures Times Debenture Interest covered Times Preference Dividends covered

Broad Classes of Ratios Primacy Interest Groups Primary Secondary Management Owner Lender

Liquidity

Fundamental Leverage Profitability

Activity

19

Financial and Investment Analysis

12.3 THE NORMS FOR EVALUATION

You may just be wondering as to how we control activities through ratios. The answer is not difficult to seek. Ratios that we have identified for control of activities measures relationships between key elements at any point of time. Such a measure is then compared with some `norm' and the causes for deviation investigated. An action-plan is then prepared and implemented to remove the cause(s). For example, Nagpur Textile Mills Ltd. reports 89 days of inventories held on an average against net sales during the year 2002. Now, how do we judge if the figure of `89 days' is just about okay for a firm like Nagpur Textile Mills Ltd.? The following appear to be the ways for evaluating this figure: a) Against a trend over time: The following data may be observed for Nagpur Textile Mill: Year 1998 1999 2000 2001 2002 Average No. of days of inventory* 90 118 115 107 98

b)

Against an average of some past period: The relevant data for Nagpur Textile Mill may be evaluated on the basis of the mean of average number of days viz., (90 +118 + 115 + 107 + 89)/5 = 519/5 = 104 days approximately. Against an industry average: A certain number of firms chosen (randomly or otherwise) from textile industry, to which Nagpur Textile Mill Ltd. belongs, may be used to compute the industry average as a norm. Thus; data relating to average number of days of inventory of, say, 20 textile units of the size and type of Nagpur Textile Mills Ltd. may be averaged for a particular year for which Nagpur Textile's ratio is being evaluated. Period averages for firms may also be used to obtain a grand mean for evaluation. Against an average of a cross-section sample: The Reserve Bank of India publishes financial statistics of joint companies. Their sample for the period 1998-99 to 2000-01 included 1927 public limited companies (with paid up capital of Rs 100 crores and above). Year-wise averages for corporate sector as a whole are available. In a similar manner, the ICICI publishes elaborate data on financial performance of companies assisted by them. The latest study pertains to the year 1984-85 and included 417 companies in different industry groups. This sample covers around 50 per cent of the total private corporate sector in terms of paid-up capital. Year-wise average for industry groupings are available.

c)

d)

20

Activity 12.2
The Study of Financial Performance presents the following data with regard to inventory turnover of 43 textile companies. Inventory as % of sales Year 1997-98 1998-99 1999-2000 2000-2001 2001-2002 34 composite mills 24.8 26.5 26.4 26.0 24.4 9 spinning mils 25.1 24.2 24.2 22.9 23.7 Total 43 mils 24.8 26.3 26.1 25.6 24.3

Ratio Analysis

Comment on the suitability of the given data to evaluate the inventory position of Nagpur Textile Mills Ltd. in the year 2002. .

12.4 COMPUTATION AND PURPOSE

A summary of management - oriented activity ratio are given below. This describes the ratios and also their main purposes. Activity Ratios (Secondary Group) Computation Purpose(s) Method Cost of Goods Sold and Gross Margin Analysis Provide an idea of gross margin Cost of Goods Cost of Goods which in turn would depend on sold sold/ Net Sales relationship between prices, Gross Margin Net Sales - Cost of goods sold/net volumes and costs sales Profit Analysis Net Margin Net Profit / Net Reflects management's ability to Sales operate business to recoup all costs & expenses (including depreciation, interest and taxes) and also to provide a compensation to owners Provides a view of operating Operating Margin Net operating effectiveness Income before Interest and Taxes/Net Sales Post-tax Margin Net Profit after Shows after-tax margin to both tax but before owners and lenders. Interest*/ Net Sales The numerator of post-tax margin may be obtained by adding back to net profit the after-tax cost of interest on debt which is pre-tax interest times (1-tax rate) Ratio

I 1. 2. II 3.

4.

5.

21

Financial and Investment Analysis

Ratio III Expense Analysis 6 Operating Ratio

Computation Method Operating expenses / Net sales

Purpose(s) Reflects the incidence of operating expenses (which are defined variously for different costing systems) Indicates the total margin provided by operations towards fixed costs and profits of the period Effectiveness of the use of all assets viz., current and noncurrent. Effectiveness of assets employed on the assumption that current liabilities are available to the business as a matter of course, and will effectively reduce the assets required to be employed Shows the number of times inventory replenishment is required during an accounting period to achieve a given level of sales Amount of trade credit allowed and revolved during a year to achieve a level of sales. Evaluates the effectiveness of the credit period granted to customers.

IV Contribution Analysis 7 Total contribution Net sales - directly variable costs / Net Sales V Management of Capital 8 Gross Assets Net Sales/ Total assets

9 Net Assets turnover

Net Sales / Total assets current liabilities

10 Inventory turnover

Net Sales or Cost of Goods Sold / Average Inventories Net Sales / average receivables
Average Receivables Net Sales

11 Receivables turnover 12 Average collection period Activity 12.3

X 365

State whether the following statements are True or False : a) b) c) d) Cost of goods sold + Gross Margin = Net Sales Net margin is the only measure of profitability of a manufacturing firm Net operating Income (NOI) is the same as Earnings before Interest and Taxes (EDIT) The numerator of the ratio called Post-tax margin is obtained as follows Net profit after interest, depreciation and taxes + Interest (1-tax rate) In calculating the operating ratio, all firms employ a standard definition of operating expenses. The ratio called total contribution can also be calculated as follows : Fixed costs/Net sales - Variable costs Net assets turnover is calculated b y Net sales/ Net Fixed Assets + Net Current Assets + Other assets In computing the inventory turnover ratio, cost of goods sold is a better numerator than net sales

True True True True True True True True

False False False False False False False False

e) f)

g)

22

h)

i) j)

The ratio called Average collection period evaluates all aspects for credit policy Net sales are gross sales as reduced by returns, rebates and excise duty

True True

False False

Ratio Analysis

You have been through a review of the select ratios, which focus managerial attention on some of the critical aspects of a firm's activities. You may acquire a greater degree of confidence in the use of the ratios summarised above if you review their construction process also. What, therefore, follows is an example relating to a company from the paper industry. You have to calculate the twelve ratios tabulated in this section of the unit. Activity 12.4 Compute the twelve activity ratios for the three years with the help of the following information, which has been extracted from the annual accounts of Mahud Paper Industries Ltd. Also offer you comments. On the basis of the limited information available with you what areas would you identify for control?
Year ending on 31st March 20012002 Balance Sheet (Select items) 1. Current Assets 2 3 4 Of which Inventories Net Fixed Assets Total Assets 17.89 6.91 2A Of which S. Debtors 38.28 21.70 10.17 47.68 90.26 41.95 39.74 22.33 10.49 47.18 91.21 43.87 52.23 26.37 10.93 50.08 106.60 45.02 2003 2004 (Amount in Rs. Crores)

5. Current Liabilities Profit & Loss Statement (Select Items) 6 Net Sales 7. Cost of goods sold 8. Directly variable expenses (Wages, salaries and direct manufacturing expenses) 9. Interest 10. Operating Profit (after depreciation and interest) 11 Non-operating profit 12. Pre-tax-profit 13. Provision for taxes 14. Net Profit

95.09 80.88 61.79 4.81 .17 4.34 4.51

113.60 93.12 73.20 4.54 .39 2.49 2.88

155.29 130.65 101.41 5.44 2.60 3.27 5.87 .80

4.51

2.88

5.07

12.5 MANAGERIAL USES OF THE PRIMARY RATIO

The return on investment has been aptly regarded as a primary ratio because it specifies the relative net profit earned on the capital employed. This is one single measure where the final outcome of all business activities gets recorded. It provides not only a vehicle for measuring relative business efficiency but also focuses attention on whether an adequate return has been earned in accordance with the expectations of the investors on the capital contributed by them. In many cases it becomes necessary to disaggregate an organisation into divisions and the return on divisional investment can be employed to gauge the divisional performance

23

Financial and Investment Analysis

However, it may be stated that the concept of ROI (Return on Investment) is not free from ambiguity. This is primarily due to the fact that numerator and denominator of this ratio i. e. return and capital are subject to differing interpretations. As standard definitions of these two basic terms do not exist as yet, the firms define the terms according to their own thinking. While some firms may define investment quite broadly, others may define it narrowly. As a consequence of this, variations of ROI are found in practice, e.g.; ROA (i.e. Return on Assets). You will appreciate these variations better as you go along with the discussion, and the illustrations regarding the analysis of ROI. You may note that the use of ROI which in fact is a combination of some other ratios was pioneered by Du pont. That is why it is sometimes known as the Du point system of Financial control. The Du pont chart is presented in Figure 12.1 and it may be of interest to you to note the manner in which the various key elements converge into a single measure viz:, the Return on Investment: The right block charts out the investment made in various assets and the left block depicts the earnings and costs flowing in and out of the utilisation of these assets. Both the net income and total assets are then related to sales to finally yield the single measure, which peaks the pyramid viz., the ROI. You will notice that Cash, Accounts Receivable, Marketable Securities and Inventories shown on the right block at the bottom are added up as current assets, which then are added (leftward) to fixed, assets. This aggregates into total assets, which are then divided (rightward) into sales to produce a ratio shown as Total Asset Utilisation or Total Assets Turnover. A similar kind of measure based on income emerges from the left block. The bottom four boxes at left sum up Interest Taxes, Depreciation and other operating costs into Total Costs which are then deducted (rightward) from Sales to yield Net Income: The Net Income is divided (leftward) into sales to generate, a ratio known as the Net Margin. The two penultimate measures viz., Total Asset Utilisation and Net Margin are then

24

multiplied together to figure out the Return on Investment at the top box of the chart. The return on investment may be expressed as a relationship in the following formula: ROI = Total Asset Turnover X Net Margin

Ratio Analysis

You may further notice that total assets may be financed partly by owners' funds (known as equity) and partly by borrowed funds (recognised as debt). Given the proportion of assets financed by equity, an appropriate measure of Return on Equity (ROE) may also be derived from the ROI. This will be given by ROE = ROI/Proportion of Total Assets financed by Equity

The term Total Assets / Equity may be recognised as Equity Multiplier and then ROE will be equal to ROI times the Equity Multiplier. Versions of ROI A large number of variations of ROT are found in practice, depending upon how Investment and Return are defined Investment may be defined to include any of the following: 1. Gross capital employed 2. 3. 4. Net capital employed Proprietors' net capital employed Average capital employed Net fixed assets + total current assets + other assets Net fixed assets + net current assets + other assets Total assets - (Current liabilities + long-term borrowing + any other outside funds) Opening + closing balances of capital, reserves, accumulated depreciation and borrowings/2

Similarly, Return may be defined to included any of the following: 1 2 3 4 5 Gross profit Profits before depreciation, interest and taxes (PBDIT) Profits before depreciation, interest and taxes (excluding capital and extraordinary nary profits): PBDIT Profits before tax (PBT) Profits before tax (excluding capital and extraordinary profits): PBT* = Gross Profit/Total Net Assets = Net Profit/Total Net Assets = Profit before tax + Interest/Net Worth + Interest bearing debt. = PBDIT as per cent of average capital Employed

The following versions of ROI are used in practice : 1. Gross Return on Investment 2. Net Return on Investment 3. Return on Capital Employed (ROCE) 4. ROI (based on PBDIT)

25

Financial and Investment Analysis

5. ROI (based on PBT)

= PBT average of capital and as per cent of reserves.

Activity 12.5 The following particulars have been selectively taken from the annual accounts of Kavali Woolen Mills Ltd., for the years 2001, 2002 and 2003. Particulars Income Statement 1. 2. 3. 4. 5. 6. 7. 1 2. 3 4 5 6 7 8 9 10 a) b) Operating profit Interest Gross Profits (1- 2) Depreciation Profit before tax (PBT) : (3 - 4) Tax Net Profit (5 - 6) Fixed Assets (gross) Accumulated Depreciation Net fixed assets (1 - 2 + capital work in progress) Investments Current Assets Current Liabilities and Provisions Net Current Assets (5 - 6) Total Net Assets (3 + 4 + 7) Financed by Net worth Borrowings of which long-term 18.75 6.74 12.01 7.66 4.35 0.05 4.30 94.61 26.90 75.16 8.48 42.61 30.95 11.66 95.30 33.97 61.33 39.27 22.78 8.90 13.88 8.84 5.04 .01 5.03 112.28 34.34 107.23 10.12 59.97 36.53 23.44 140.79 39.41 101,38 71.09 28.48 10.78 17.70 8.84 8.86 .01 8:76 162.16 38.26 127.66 12.29 75.17 56.30 18.87 158.82 53.16 105.66 63.61 Years ending on March 31st 2001 2002 2003

Balance Sheet

Compute Gross Return on Investment, Net Return on Investment, and Return on Capital Employed for the three years. What are your conclusions? Also derive the Return on Equity from the ROI (i.e., Net return on Total Net, Assets). EVERLIGHT COMPANY LIMITED Comparative Balance Sheet December 31, Year 1 and Year 2 December 31st Year 1 Year Rs. 1,200 7,500 14,800 20,500 850 24,000

Illustration 12.1

Assets Cash Bank Accounts Receivable Inventory Repayments Land and Building

Rs. 1,000 6,000 12,600 18,400 800 20,000

26

Plant and Machinery Liabilities and Shareholders' Equity Bills Payable Accounts Payable Other Current Liabilities Debentures (10%) Preference Shares (12%) Ordinary Shares. Rs. 10 each Retained Earnings

30,000 88,800 4,000 6,400 2,000 20,000 10,000 40,000 6,400 88,800

32,000 1,00,850 7,850 6,000 2,200 18,000 10,000 50,000 6,800 1,00,850

Ratio Analysis

Income and Retained Earnings Statement of the Year Ended December 31, Year 2 Sales Revenue Less Expenses: Cost of Goods Sold Selling Administrative Interest Income Tax Total Expenses Net Income Less Dividend : Preferred Ordinary Increase in Retained Earning for Year 2 Retained Earnings, December 31, Year 1 Retained Earnings, December 31, Year 2 With the above information, let us compute the following ratios a) Rate of Return on Assets b) Profit Margin (before interest and related tax effect) c) Cost of Goods Sold to Sales Percentage d) Selling Expenses to Sales Percentage e) Operating Expense Ratio f) Total Assets Turnover g) Accounts Receivable Turnover h) Inventory Turnover i) Rate of Return on Ordinary Share Equity j) Current Ratio k) Quick Ratio l) Long-Term Debt Ratio m) Debt Equity Ratio n) Times interest Charges Earned 1,200 8,000 9,200 400 6,400 6,800 Rs. 28,000 8,000 6,000 2,000 6,400 50,400 9,600 Rs. 60,000

27

Financial and Investment Analysis

o) p) q)

Earnings per (Ordinary) Share Price Earning Ratio Book Value per Ordinary Share

The income tax rate is 40 per cent. The market price of an ordinary share at the end of Year 2 was Rs. 14.80. Let us take all these ratios one by one. a) Rate of Return on Assets. = b) Rs. 9,600 + (1- .40) (Rs. 2, 000) = 11.39 per cent .5 (Rs. 88,800 + Rs.1,00,850) Profit Margin Ratio = c) Rs. 9,600 + (1-40) (Rs. 2,000) = 18 per cent Rs. 60,000 Cost of Goods Sold to Sales Percentage = d) Rs. 28,000 = 46.67 per cent Rs. 60,000 Selling expenses to Sales Percentage = e) Rs. 8,000 = 13.33 per cent Rs. 60,000 Operating Expense Ratio = f) Rs. 8,000+ Rs. 6,000 Rs. 60,000 Total Asset Turnover Rs. 60,000 = .63 times per year = .5 (Rs. 88,800 + Rs.1,00,850) g) Accounts Receivable Turnover = h) Rs. 60,000 = 4.3 8 times per year .5 (Rs. 12,600 + Rs. 1,4,800) Inventory Turnover Ratio = i) Rs.28,000 = 1.44 times per year .5 (Rs. 18,400 + Rs. 20,500) Rate of Return or Ordinary Share Equity = j) Rs. 9,600 - Rs. 1,200 x 100 = 16.28 per cent .5 (Rs. 46,400 + Rs. 56,800) Current Ratio December 31, Year 1 : Rs.38,800 = 3.13:1 Rs.12,400 = 23.33 per cent

28

December 31, Year 2 : Rs. 44,850 = 2.79 : 1 Rs.16,050 k) Quick Ratio : December 31, Year 1 : Rs.19,600 = 1.56 :1 Rs.12,400 December 31, Year 2: Rs.23500 = 1.46 :1 Rs.16,050 l) Long-term Debt Ratio December 31, Year 1: Rs.20,000 = 24.86 per cent Rs. 80,400 December 31, Year 2: Rs. 18,000 = 21.23 per cent Rs. 84,800 m) Debt Equity Ratio December31, Year 1 : Rs.20,000 = 43.1 Rs.46,400 December 31, Year 2 : Rs.18,000 = 31.69 Rs. 56,800 (Equity may or may not include retained earnings. Here, retained earnings have been included) n) Times Interest Charges Earned Rs. 9,600 + Rs. 6,400 + Rs: 2,000 = 9 times Rs: 2,000 o) Earnings per Ordinary Share (EPS) December 31 Year 2: Rs. 8,40 0 = .5 (4000 + 5000) p) Price-Earnings Ratio December 31, Year 2: = q) 14.80 1.87 Book Value per Ordinary Share December 31, Year 1 : = Rs. 46,400 = Rs.11.60 4,000 December 31, Year 2 : = Rs. 56,800 = Rs.11.36 5,000 = 7.91 times = Rs.1.87

Ratio Analysis

29

Financial and Investment Analysis

Illustration 12.2 The information contained in Tables 12.1 to 12.4 relate to a company for the year 2002 and 2003, we shall attempt a comprehensive analysis. Table 12.1 Megapolitan Company Ltd. Condensed Balance Sheet for the years ending December 31, 2003 and December 31, 2002 Increase or (Decrease) Percentage of total Assets 2003 Rs. ASSETS Current Assets Plant and equipment (net) Other Assets Total LIABILITIES & CAPITAL Liabilities: Current liabilities 12% Debentures Total 2002 Rs. Rs. % 2003 2002

1,95,000 1,44,000 51,000 2,50,000 2,33,500 16,500 30,000 4,75,000 4,30,000 45,000

35.4 41.1 33.5 7.1 52.6 54.3 10.5 100.0 100.0

52,500 (22,500) (42.9) 6.3 12.2

56,000

47,000 9,000

(19.1) 11.8 10.9 (9.3) 32.9 40.0

1,00,000 1,25,000 (25,000) (20.0) 21.1 29.1 1,56,000 1,72,000 16,000

Shareholder's equity 9% preference shares 50,000 50,000 (Rs. 100 each) Equity shares (Rs. 10 each) 1,25,000 1,00,000 25,000 Premium on issue of shares Retained earnings Total shareholders equity Total 35,000 20,000 15,000

10.5 11.6 25.0 26.3 23.2 75.0 7.4 4.7

1,09,000 88,000 21,000 3,19,000 2,58,000 61,000 4,75,000 4,30,000 45,000 Table 12.2

23.9 22.9 20.5 23.6 67.1 60.0 10.5 100.0 100.0

Income statement for the years ended December 31, 2003 and December 31, 2002

Increase or (Decrease) 2003 Rs. Net sales Cost of goods sold Gross profit on sales Operating expenses: Selling Administrative Total Operating income 4,50,000 2,65,000 1,85,000 58,500 63,000 1,21,500 63,500 12,000 2002 Rs. 3,75,000 2,10,000 1,65,000 37,500 47,500 85,000 80,000 15,000 75,000 55,000 20,000 21,000 15,500 36,500 (16,500) 3,000 Rs.

Percentage of net Sales % 2003 2002

20.2 26.2 12.1 56.0 32.6 42.9 (20.6) (20.0)

100.0 100.0 58.9 56.0 41.1 44.0 13.0 10.0 14.0 12.7 27.0 22.7 14.1 21.3 2.7 4.0

30

Interest expense

Income before income taxes Income taxes Net Income

51,500 65,000 14,000 20,000 37,500 45,000

(13,500) 6,000 (7,500)

(20.8) (30.0) (16.7)

11.4 3.1 8.3

17.3 5.3 12.0

Ratio Analysis

Table 12.3 Statement of Retained Earnings for the years ended December 31, 2003 and December 31, 2002 Increase or (Decrease) 2003 Rs. 88,000 2002 Rs. Rs. Rs. 57,500 30,500 % 53.

Retained earnings, beginning of year Net Income Less : Dividends on equity shares Dividends on preference shares Retained earnings, end of year

37,500 45,000 (7,500) (16.7) 1,25,500 1,02,500 23,000 22. 12,000 10,000 2,000 20. 4,500 4,500 16,500 14,500 2,000 13. 1,09,000 88,000 21,000 23.

Table 12.4 Schedule of Working Capital as at December 31, 2003 and December 31, 2002 Increase (Decrease) 2002 Rs. Rs. 20,000 43,000 60,000 21,000 (1,000) 15,500 30,000 6,500 or % (5.0) 36.0 50.0 31.0 35.4 46.0 120.0 (41.9) 19.1 43.3 Percentage of total current items 2003 2002 9.7 30.0 46.2 14.1 13.9 29.9 41.6 14.6

Current Assets: Cash Receivables (net) Inventories Prepaid expenses Total current assets Current liabilities Bills Payable Accounts payable Accrued liabilities

2003 Rs. 19,000 58,500 90,000 27,500

1,95,000 1,44,000 51,000 7,300 33,000 15,700 5,000 15,000 27,000 47,000 2,300 18,000 (11,300) 9,000 42,000

100.0 100.0 13.1 58.9 28.0 10.7 31.9 57.4

Total current liabilities 56,000 Working capital

100.0 100.0

1,39,000 97,000

Using the information in the above Tables let us consider analyses that would be of particular interest to: Equity shareholders Long-term creditors Short-term creditors Equity shareholders : Equity shareholders, present and potential, look primarily to the company's record of earnings. They are therefore interested in relationships such as earnings per share (EPS) and dividends per share. Earnings per share are computed by dividing the income available for equity shareholders by the number of equity shares outstanding during the year. Any preference dividend must be subtracted from the net income to ascertain the income available to equity shareholders.

31

Financial and Investment Analysis

2003 Rs. Net Income Less Preference dividend Income available to equity shareholders Equity shares outstanding during the year Earnings per (Equity) share 37,500 4,500 33,000 12,500 2.64

2002 Rs. 45,000 4,500 40,500 10,000 4.05

While dividend may be of prime importance to some equity shareholders, it may not be so for other shareholders. Some shareholders may be interested in receiving a regular cash income, while others may be more interested in securing capital gains through rising market prices. In comparing the merits of alternative investment opportunities, we should therefore relate earnings and dividends per share to the market, value of shares. Dividends per share divided by market price per share would give yield rate on equity shares. Dividend yield is of particular importance to those investors whose objective is to maximise the dividend income from their investments. Earnings performance of equity shares is often expressed as price earning ratio by dividing the market price per share by the annual earnings per share. Thus a share selling for Rs. 40 and having earnings of Rs. 5 per share in the year just ended may be stated to have a price-earning ratio of 8 times. Assuming that the 2,500 additional equity shares issued by the company on January 1, 2003 received the full dividend of 96 paise in 2003, and further assuming the price of the equity shares at December 31, 2002 and December 31, 2003 as given in Table 12.5, earnings per share and dividend yield may be summarised as follows. Table 12.5 Earnings and dividends per equity share Date Assumed Market value per share Rs. 18 14 Earnings per share Rs. 4.05 2.64 Priceearnings ratio 4.44 5.30 Dividend per share Dividends yield %

Dec. 31, 2002 Dec. 31, 2003

1.00 0.96

5.56 6.86

The decline in market value during 2003 presumably reflects the decrease in earnings per share. The investors evaluating these shares on December 31, 2003 would consider whether a price earning ratio of 5.30 and the dividend yield of 6.86 represented a satisfactory situation in the light of alternative investment opportunities. We can also calculate the book value per share. Table 12.6 Book value per equity share 2003 Rs. Total shareholder's equity Less: Preference shareholders equity Equity of ordinary shareholders Number of shares outstanding Book value per equity share 3,19,000 50,000 2,69,000 12,500 21.52
.

2002 Rs. 2,58,000 50,000 2,08,000 10,000 20.8

32

Book value indicates the net assets represented by each equity shares. This information is helpful in estimating a reasonable price for company shares, especially for small companies whose shares are not publicly traded. However, the market price of the shares of a company may significantly differ from its book value depending upon its future prospects with regard to earnings. Long-term Creditors: Long-term lenders (or creditors) are primarily interested in two factors: 1. 2. The firms ability to meet its interest requirements. The firms ability to repay the principal of the debt when it falls due.

Ratio Analysis

From the viewpoint of long-term creditors, one of the best indicators of the safety of their investments may be the fact that, over the life of the debt, the company has sufficient income to cover its interest requirements by a wide margin. A failure to cover interest requirements may have serious repercussions on the stability and solvency of the firm. A common measure of the debt safety is the ratio of income available for the payment of interest to annual interest expenses, called number of time interest earned. This computation for Megapolitan Company would be as follows: Number of Times Interest Earned Operating income (before interest and income taxes) Annual interest expense Times interest earned (a - b) a) b) 2003 Rs. 63,500 12,000 5.29 2002 Rs. 80,000 15,000 5.33

Long-term creditors are interested in the amount of debt outstanding in relation to the amount of capital contributed by shareholders. The debt ratio is computed by dividing long-term debt by shareholders equity as shown below: Debt Ratio 2003 Rs. a) 1,00,000 b) 3,19,000 31.35 2002 Rs. 1,25,000 2,58,000 48.45

Long-term/debt Shareholders equity Debt ratio (a - b)

From creditors point of view, the lower the debt ratio (or higher the equity ratio) the better it is. The lower debt means the shareholders have contributed a bulk of funds to the business, and therefore the margin of protection to creditors against shrinkage of assets is high. Short-term Creditors: Bankers and other short-term creditors have an interest similar to those of the equity shareholders and debenture holders who are interested in the profitability and long-term stability of the business. Their primary interest, however, is in the current position of the firm, i.e. its ability to generate sufficient funds (working capital) to meet current operating needs and to pay current debts promptly. The amount of working capital is measured by the excess of current assets over current liabilities. What is important to short-term creditors is not merely the amount of working capital available but more so-is its quality. The main factors affecting the quality of working capital are (i) the nature of the current assets comprising the working capital, and (ii) the length of time required to convert these assets into cash. In this context we can calculate the following ratios: 1 2 Inventory turnover ratio Account receivable turnover ratio

33

Financial and Investment Analysis

Activity 12.6 In illustration 12.2 we analysed the financial statements (or information) from the point of view of three groups of people and calculated certain ratios. But these ratios by no means were all inclusive. Certain other ratios, useful for these groups of people, can also be computed. For example, some other ratios useful for equity shareholders (present and prospective) are: Return on investment (ROI), Leverage ratio, and Equity ratio. In the context of illustration 12.2: a) Calculate and interprete all such ratios; and b) Calculate and interprete some ratios for groups of people other than the three above who might be interested in the company, e.g., preference shareholders

......................................................................................................................... ......................................................................................................................... ......................................................................................................................... ......................................................................................................................... ......................................................................................................................... ......................................................................................................................... ......................................................................................................................... .........................................................................................................................

12.6

SUMMARY

A large number of financial ratios are in use. They fulfill a wide variety of objectives and functions. Managers evaluate performance and exercise control, investors match their expectations, and lenders undertake credit approvals with their help. Control of business activity is crucial for efficiency. Managerial action follows meaningful information flows. Ratios provide a relevant basis, but all ratios may not serve the objective of control. A profit performance measure, which is widely prevalent, is the Return of Investment, which is considered a primary yardstick for the measurement of operational efficiency. A decomposition of this measure into its key elements as depicted in the Du pont Chart may underline areas, which need managerial control for achieving the basic goal of maximizing the return on capital employed in the enterprise A series of secondary ratios has also been found useful in controlling business activities. Since production and sales are the key parameters in an efficient conduct of business activities, most of these ratios are related in some manner to sales and output. The focus is on revenues and costs and also on the intensity of activity as measured by the various turnover ratios. Going deeper into the conduct of business transactions, a larger number of relationships would be uncovered e.g. stores control, material usage control, labour hours control, machine maintenance quality control, operating cycle control and so on. But the focus in this unit has been on control of activities through ratios emerging from informations externally presented.

12.7 KEY WORDS

Primary Ratio is of primary concern for management because it provides an overall measure of business efficiency and is measured by the much controversial but nevertheless much widely employed Return on Capital Employed. PBDIT or Profits before depreciation, interest and taxes. This amounts to gross cash flow.

34

Liquidity Ratios measure the short-term solvency of the firm.

Leverage Ratios measure the long-term solvency of the firm and also provide an idea of the equity cushion for long-term indebtedness. Activity or Turnover Ratios measure the intensity with which resources of the firm are being utilised. Average Capital Employed is one-half of the sum total of opening and closing balances of capital, reserves, accumulated depreciation and long-term debt. Net Total Assets are obtained by deducting current liabilities from total assets. Equity Multiplier is used to derive the Return on Equity from the Return on Investment, and is computed by dividing Equity into total assets. Ratio Norm is obtained for different kinds of ratios either as an average over time of the same firm, or an industry average or an average of a cross-section of firms, and is used to evaluate performance and for control purposes. Average Collection period is obtained by dividing average accounts receivables with net credit sales and multiplying the resultant with 365 days of the year. It suggests the average credit period actually granted during a year.

Ratio Analysis

12.8 SELF-ASSESSMENT QUESTIONS/ EXERCISES

1. 2. 3. 4. 5. 6. 7. a) b) c) d) List the fundamental accounting ratios. Why are they called fundamental? What are `Stability' ratios?. Can they be classed as fundamental ratios? Enumerate ratios that are appropriate for controlling business activities. What common criterion/criteria bring them together into one category? Which of the control ratios are more important in your view? Why? Point out the major limitation of Return on Capital Employed as a basis for comparing one firm with another. What is Return on Equity? Why do we measure it? The ratios measuring management's overall effectiveness as shown by the return generated on sales and investment are Leverage ratios Profitability ratios Activity ratios Liquidity ratios

8. According to the Du pont analysis, firms dealing with relatively perishable commodities would be expected to have. a) b) c) d) e) 9. a) b) c) d) 10. a) b) High profit margins and high turnover Low profit margins and low turnover High profit margins and low turnover Low profit margins and high turnover None of the above Inventory turnover is defined as_________divided by inventories. Cost of goods sold Accounts receivable Gross profit Net operating income The primary purpose of the current ratios is to measure a firm's Use of debt Profitability

35

Financial and Investment Analysis

c) d)

Effectiveness Liquidity None of these The Du pont System is designed to help pinpoint the trouble if a firm has relatively low rate of return on equity. It focuses on the total asset turnover ratio, the profit margin, and the equity/asset ratio True False Because inventories are less liquid than other current assets, the quick ratio is regarded as being a more stringent test of liquidity than die current ratio. . True False Other things being constant, (assuming an initial current ratio greater than 1.00) which of the following will not affect the current ratio? a) Fixed assets are sold for cash b) Long-term debt is issued to pay off current indebtedness c) Accounts receivables are colleted d) Cash is used to pay off accounts payable e) A bank loan is obtained The average collection period is found by dividing ________ with _________ and then dividing average sales per day into accounts _________. The average collection period is the length of time that a firm must wait after making a sale before it receives_________. Individual ratios are of little value in analysing a company's financial condition. More important is the_________ of a ratio over time, and a comparison of the company's ratios to_________ ratios. Prabhat Industries profit margin is 6 per cent, its total assets turnover ratio is 2 times, and its equity/total assets ratio is 40%. The company's rate of return on equity is (a) 5% (b) 7.5% (c) 12% (d) 30% (e) 20% If the net profit margin for a firm is 20%, and the ROI is 10%, the total assets turnover ratio must be (a) 1 (b) 2 (c) .5 (d) .2 (e) Not possible to compute. Determine the sales of a firm with the financial data given below: Current ratio 2.7 Quick ratio 1.8 Current liabilities Rs. 6,00,000 Inventory turnover 4 times a) Rs. 34,00,000 b) Rs.19,60,000 c) Rs. 21,60,000 d) Rs.14,20,000 e) Rs.16,40,000 Complete the balance sheet and sales data by filling in the blanks using the following financial data: Debt/Net worth Acid Test ratio Total Assets turnover Days sales outstanding in accounts receivable Gross profit margin Inventory turnover 50% 1.4 1.6 times 40 days 25% 5 times

e)
11.

12.

13.

14.

15.

16.

17.

18.

19.

36

Balance Sheet Equity Share Capital General Reserve Accounts Payable Total capital and liabilites Rs. 25,000 26,000 Cash Accounts Receivable Inventories Plant & Equipment Total assets Sales Cost of goods sold 20.

Rs.

Ratio Analysis

Weldone Co. and Goodluck Co, trade in the same industry but in different geographical locations. The following data are taken from the 2002 annual accounts. Turnover Total operating expenses Average total assets during 2002 Weldone Rs. 40,000 36,000 30,000 Goodluck Rs. 60,000 55,000 25,000

Attempt the following (ignore taxation): a) Calculate the rate of return on total assets (profit as a percentage of total assets) for each company. b) Analyse the rates of return in part (a) into the net profit percentage and the ratio of turnover to total assets. c) Comment on the relative performance of the two companies in so far as the information permits. Indicate what additional information you would require to decide which company is the better proposition from the viewpoint of: i) ii) potential shareholder; and potential loan creditors

21. Abrasives Ltd., has the following turnover ratios presented along with the corresponding industry averages: Ratio description Sales / Inventory Sales / Receivables Sales / Fixed assets Sales / Total assets Abrasive's ratio 530/101 = 5 times 530/44 = 12 times 530/98 = 5.4 times 530/300 = 1.77 times Industry average 10 tithes 15 times 6 times 3 times

Financial analysis of the company is presented on the next page in the form of a Du Pont Chart. Study the chart, along with the four turnover ratios and industry averages, and comment on the major weaknesses of the company where managerial attention must be focused for future control.

37

Financial and Investment Analysis

Answers or Approaches to Activities Activity 12.1 Ratio Nos. 1 to 3 4&5 6 to 9 10 to 12 13 to 15 16 to 21 Activity 12.2 a) Nagpur Textile Mills data relating to average number of days of inventory will have to be converted into inventory ratio as follows: Broad Class Secondary, Owners Secondary, Lenders,, Liquidity Secondary, Management, Activity Primary, Management, Profitability, Owners Secondary, Management, Profitability (Appropriation) Secondary, Lenders, Leverage

38

Assuming the numerator to be 365 days, the inventory turnover ratios for the five years will be: Year 1998 1999 2000 2001 2002 b) Inventory turnover ratios 100 365 / 90 365/118 100 100 365 / 115 100 x 365/107 100 x 365 / 89 =24.66 =32.33 = 31.51 = 2932 = 24.39

Ratio Analysis

Nagpur Textile's is a composite mill. It may, therefore, be appropriate to compare the inventory ratios for five years with the annual averages of composite mills for five years. It is manifest that Nagpur Textile's inventory turnover ratio is higher than the industry average for the years 1999-2001. The trend for the last four years since 1999 is for the ratio to decline.

c)

Activity 12.3 a) b) c) d) e) f) g) h) i) j) True False True True False False True True because inventory which is the denominator of the ratio is also carried generally at cost in a world of rising prices. False because it reflects only the average credit period and does not state anything about discounts and credit standards. True

Activity 12.4 Ratio Information inputs (7) (6) Computed ratio for the year 2001 2002 85.06 81.97 14.94 4.74 5.24 6 9.80 99.82 35.02 1.05 1.97 4.09 11.13 32.78 18.03 2.54 4.34 6.53 99.66 35.56 1.25 2.36 5.16 11.03 33.10 2003 84.13 15.87 3.26 5.18 6.30 98.33 34.70 1.45 2.52 6.38 14.50 25.17

1.

Cost of goods sold

2. Gross margin 3. Net margin 4. Operating margin 5. Post-tax margin 6. Operating Ratio 7: Total Contribution 8. Gross Assets Turnover 9. Net Assets Turnover 10. Inventory Turnover 11. Receivables Turnover 12. Average Collection Period (Days)

(6) - (7) (6) (6) (14) (10) + (9) (6) (14)+ (9) x (13)/(12) (6) (6) - (10) (6) (6) - (8) (6) (4) (6) (4) - (5) (2) (7) (6) (2A) (6) / 365 (2A)

39

Financial and Investment Analysis

Activity 12.5 a) Gross Return on Investment Net Return on Investment Return on Capital employed 2001 12.61 4.51 11.63 2002 9.86 3.57 9.90 2003 11.14 5.81 12.61

b)

You may first proceed to find out the Equity multiplier viz., Total Net Assets/Equity for each of the three years, and then multiply the R0I by this multiplier. Equity multipliers for the three years are as follows: Years 2001 2002 2003 Return on Equity Equity multiplier 95.30/33.97 = 2.81 140.79/39.41 = 3.57 158.82/53.16 = 2.99 12.67 12.75 17.37

Answers to Self-Assessment Questions/ Exercises 7 (b) 8 9 10 11 12 13 14 15 16 17 18 19 (d) (a) (d) (True) (True) (c) annual sales; 360; receivable; cost; Trend; industry average; (d) (c) (c) Accounts payable = Rs. 25,500; Total Capital and Liabilities as well as Total Assets = Rs. 76,500; Cash = Rs. 22,100; Accounts Receivable = Rs. 13,600; Inventories = Rs. 24,480; Cost of goods sold = Rs. 91,800; Plant & Equipment = Rs. 16,320; and Sales = 1,22,400. Rate of return on total assets Net profit percentage Asset turnover Weldone Co. 13.3% 10% 1.33 times Goodluck Co. 20% 8.3% 2.4 times

20. a) b) c)

The three ratios provide an estimate of a company's overall performance. They are inter-related: =

40

From the viewpoint of potential investors - shareholders and loan creditors - the overall performance is important. In what way the profit between the two types of finance (loan and equity) is apportioned is also of equal importance. They will therefore need information about capital leverage i.e. the relation-ship between equity and loan capital and the relationship between profits and interest payments.

The potential loan creditor will also require information about security that the. company can provide. The potential shareholders are also interested in future dividends as well as current yields. They will need information about the share prices and earnings per share so that they could make relevant comparison against similar other investment in terms of PEE ratio and yield. 21 a) Profit margin not too bad ; assets turnover quite low. Action required. b) Inventory per unit of sales higher that other firms. Action required. Implications and impact of suggested action (like funds released in the wake of inventory reduction utilized in liquidating debt and reducing interest burden with improved profit prospects) should be highlighted. Excess capacity situation may exist, though not with definitiveness

Ratio Analysis

c)

12.9 FURTHER READINGS

Fraser, M. Lyn and Aileen Ormiston, 04/10/2003, Understanding Financial Statements (Chapter 5) : Prentice Hall. Khan, M.Y. and Jain, P.K., 2000. Management Accounting (Chapter 4), Tata McGraw-Hill : New Delhi. Brigham F. Eugene and Houston F. Joel, 1999, Fundamentals of Financial Management, 2nd ed. (Chapter 3), Harcourt Brace and Company : Florida. Fanning, David and M. Pendlebury, 1984, Company Accounts: A Guide, Allen & Unwin : London. Bhatia, Manohar L., 1986, Profit Centres: Concepts, Practices and Perspectives, Somaiya Publications, Bombay (pp, 166-170) Hingorani N.L. and A.R. Ramanathan, 1986. Management Accounting (Chapter 7) Sultan Chand: Delhi.

AUDIO PROGRAMME
Role and Regulation of Stock Markets

41

41

Financial and Investment Analysis

UNIT 13
Objectives

LEVERAGE ANALYSIS

This unit will enable you to: acquire an understanding of leverage ratios examine the consequences of financial leverage for a business firm trace relationship between financial and operating leverages, and assess the risk implications of financial leverage.

Structure
13.1 13.2 13.3 13.4 13.5 13.6 13.7 13.8 13.9 13.10 13.11 Introduction Concept of Financial Leverage Measures of Financial Leverage Effects of Financial Leverage Operating Leverage Combined Leverage Financial Leverage and Risk Summary Key Words Self-assessment Questions / Exercises Further readings

13.1 INTRODUCTION
You have familiarised yourself with the various kinds of financial ratios-both separately and in their broad groupings. Unit 12 on Financial Ratios introduced the four fundamental bases for ratios viz., liquidity, leverage, activity, and profitability. The ratios discussed in that unit were picked up on the basis of their relevance in controlling business activities. Accordingly, the liquidity and leverage ratios were not covered. Even though a firm's management would always be interested in maintaining a satisfactory level of liquidity and solvency, it is the lender or the banker who would insist upon certain norms and would monitor movements in these ratios. Leverage ratios, which reflect the solvency status of a firm , are covered here in detail. You will get an idea about the basic concept of leverage and will be exposed to the role and effects of financial leverage. We had covered another leverage concept in the unit titled Cost-Volume-Profit Analysis, you will recall the `break-even analysis' that was explained and illustrated in that unit. We derive from that discussion the term operating leverage and examine its importance. Our discussion will also help you to link-up the two concepts of leverage viz., financial leverage and operating leverage.

42

13.2 CONCEPT OF FINANCIAL LEVERAGE

Consider for a moment the common use of the terms `level' and ` leverage'. Webster's dictionary defines them as follows: Lever is an inducing or compelling force. Leverage is the action of a lever or the mechanical advantage gained by it; it also means `effectiveness' or `power' The common interpretation of leverage is derived from the use or manipulation of a tool or device termed as lever, which provides a substantive clue to the meaning and nature, of financial leverage. Could you guess it? Your reply we guess, may well be in the negative. Now, suppose we suggest that our lever is the use of debt or borrowed funds in financing the acquisition of assets. Would you get somewhere near the concept of the term financial leverage? Probably, you need a little explanation. We will do that. You have to look at the following simple (and hypothetical) facts about the GTB (Gain Through Borrowing) Limited. The GTB Limited wanted to purchase fixed assets worth Rs. 80 lakhs for the execution of a project, which was to be financed by raising share capital of Rs. 30 lakhs and term loans of Rs. 50 lakhs. The company was required to earn a minimum return of 20% on its share capital. Other companies of this type were earning this much and unless GTB Limited provided at least this return, no investor would be attracted to buy its shares. The GTB Limited pays tax at 40% and is not required to pay any tax on the interest charges on term-loans. You may do your own calculations for the two situations. We now pose a question to you: What happens to the company's net return (after interest and taxes) on equity if (a) the whole of Rs. 80 lakhs is financed by selling share capital, and (b) the scheme of financing as envisaged in the problem is implemented? You may assume GTB's earning power to be 40% (before taxes and interest) on total assets of Rs. 80 lakhs. We present for your verification a solution below: Table 3.1 Effect of Financial Leverage Rs. 80 lakh as Share capital (Rs. Lakh) Earnings on assets of Rs. 80 lakh @ 40% Less interest : 18% on Rs. 50 lakh Earnings after interest Taxes @ 40% Earnings after taxes Earnings after interest and taxes as a % of share capital 32.0 ----32.00 I2.8 19.2 24% Rs. 30 lakh of share capital plus 50 lakh (Rs. Lakh) 32.00 9.00 23.00 9.20 13.80 46%

Leverage Analysis

If your solution tallies with ours, you may be wondering at the results. The net return on equity is 24% when no debt is used but it is 46% when debt is used. There is a considerable increase in the net return. It is conceivable that a similar outcome may be nowhere near in some other situations even if debt is employed. At this juncture, we would premise that the use of debt funds in a profit-making and

43

Financial and Investment Analysis

tax-paying business improves the net equity returns. The effect which the use of debt funds produces on returns is called financial leverage. You would have noted in the above example that the increase of net equity returns from 24% to 46% has occurred at a certain level of debt viz., when the debt is Rs. 50 lakh against an equity of Rs. 30 lakh (i.e., when the debt - equity ratio is 5:3 or 167%) or when the debt is of Rs. 50 lakh against total assets of Rs. 80 lakh (i.e., when the debt- assets ratio is 5:8 or 62.5%). The sub-section below examines these and other measures of financial leverage. But before we proceed, let us sum up the concept of financial leverage as follows: Financial leverage refers to a firm's use of fixed-charge securities like debentures and preference shares (though the latter is not always included in debt) in its plan of financing the assets Activity 13.1

13.3 MEASURES OF FINANCIAL LEVERAGE

The amount of debt which a firm employs or proposes to employ can be expressed in relation to total assets or total equity. Equity will include paid-up capital and reserves and total assets will be taken at net value . Even though, both equity shares and assets can be measured at market values, the present discussion will use only book values. Market values are difficult to obtain, fluctuate widely and are not available for new undertakings which also make use of the concept of financial leverage in planning their sources of finance. We will illustrate two ratios viz., Debt-equity and Debt-assets ratios both of which are computed from Balance Sheet data and are inter-related. You may note that this section measures the use of financial leverage and not its effects. The latter is measured through Degree of Financial leverage, which is discussed in a later section. We shall explain the concept of financial leverage with the help of an example. Bharat Engines Limited, plans to acquire total assets amounting to Rs. I crore. The company has only two sources of finance viz.; debt and equity. The Finance Director wants to know the changes that will take place in the Debt-equity and Debt-assets ratios for various debt levels i.e., (a) Zero (b) Rs. 10 lakh (c) Rs. 20 lakh (d) Rs. 30 lakh (e) Rs. 50 lakh (f) Rs. 80 lakh (g) Rs. 1 crore. The table 13.2 provides the required calculations:

44

Table 13.2 Debt-assets and Debt-equity Ratios Debt Rs. Lakh Zero 10 20 30 50 80 100 (Total investment in assets = Rs 100 lakh) Equity Debt-assets Rs. Lakh Ratio 100 Zero 90 80 70 50 20 Zero 10% 20% 30% 50% 80% 100% Debt-equity Ratio Zero 11.1% 25% 43% I00% 400%

Leverage Analysis

Please study the last two columns of the above table. The following analysis reflects the basic properties of the two ratios and indicate their inter-relationship: a) The Debt-assets ratio rises at a constant rate and reaches a maximum of 100% The Debt-equity ratio grows exponentially and reaches infinity () The two ratios are mathematically related and can be derived from each other. The following relationships may be used for such derivations: D/E Ratio 1 + D / E Ratio D/ A Ratio 1-D/A Ratio .(1) .(2)

b)

Debt - assets Ratio (D/A) = Debt - equity Ratio (DIE) =

The use of these formulas for deriving one ratio from the other can be demonstrated at any debt level. For example, at a debt level of Rs. 80 lakh, the Debt-assets ratio is 80%. The DIE ratio can be derived by using formula-(2) above: D/E Ratio = 80 = 1- 80 80 20 = 4.00 or 400%

Similarly, with a given DIE ratio of 400% or 4:00, the D/A ratio can be derived by using formula (1) above : D/A Ratio = 4.00 = 4.00 = 80 or 80% 1+4.00 5,00

Both D/A and D/E ratios are used to measure the amount of financial leverage. You may note that the D/E ratio overstates the amount of financial leverage for all levels of debt and becomes indeterminate when debt employed is one hundred per cent. It may, therefore be technically more feasible to employ the Debt-asset ratio as indicator of the use of financial leverage. You may come across some ratios in contemporary literature which attempt to measure the use of financial leverage. They are:

a)

Debt Total Value of the Firm (at market Price) Return on Equity ReturnonTotalCapital

b)

45

Financial and Investment Analysis

Activity 13.2 Answer the following : a) Amount of leverage and degree of leverage are the same b) Debt-equity ratio overstates the use of leverage c) A firm (to be established) can use market values for its leverage ratios d) The D/E ratio is infinite at 100% debt e) D/A and D/E ratios can be derived from each other f) When the D/E ratio is 200%, D/A ratio would be (i) 80% (ii) 100% (iii) 67% (iv) 45% (v) None of these Yes Yes Yes Yes Yes Yes No No No No No No

13.4 EFFECTS OF FINANCIAL LEVERAGE

The example in Table 13.I introduced you to a possible effect of financial leverage on return on equity. You must have noted one important consideration in the use of borrowed funds, that is, the improvement in net equity returns which such a move brings about. In fact, the effect of financial leverage is also measured through another variable viz., earnings per share (EPS). This is done in the case of joint stock companies which have raised their proprietary capital by selling units of such capital known as equity shares. Earnings per share are obtained by dividing earnings (after interest and taxes) by total equity. You may note that if a company has preference shares also on its capital structure, net equity earnings will be arrived at after deducting interest, taxes and preference dividends. Capital structure refers to the permanent long-term financing of a company represented by a mix of long-term debt, preference shares, and net-worth (which included paid-up capital, reserves and surpluses). When the sum total of capital structure components is added to short-term debt, it is known as Financial structure. Financial Leverage and its effects are a crucial consideration in planning and designing capital structures. We may reiterate that the effects of financial leverage are. not always clear and identical in various states of profitability and debt proportions. It may be necessary to explore these effects before a particular long-term finance-mix is recommended for implementation. We shall illustrate the effects of financial leverage by extending the example taken in the previous section. Bharat Engines is considering four alternative debt ratios (i.e. D/A ratios): 0%, 20%, 50% and 80%. The corresponding D/E ratios are: 0%, 25%, 100% and 400%. The equity capital of the company is divided into shares of Rs. 10 each which can be sold in the market at their face value only. The firm estimates a net profit (before tax) of 25% on total assets of Rs. 1 core if business conditions are favourable, a net profit (before tax) of 50% on total assets if conditions are highly favourable, and net loss (before tax) of 25% if conditions are unfavorable. Bharat Engines is assessed to income tax at 40%. In the event of loss, the company could assume a tax credit at this rate. The average interest rate on borrowings by the company is estimated at 15%. Table 13.3 provides an analysis of the effects of all four alternative debt levels on the return on equity as well as on the earnings per share.

46

Table 13.3 Financial Leverage, Equity Returns & EPS Total Investment Rs. 1 Crore Alternative Estimates of Earnings Before Interest & Taxes (EBIT) (in Rs. Lakhs) as of Total Assets Capital Structure (-25%)+25% +50%

Leverage Analysis

I : Debt = Zero, Equity = Rs. 1 Crore EBIT (-25.00) 25.00 50.00 Less interest (at 15%) zero zero zero Earnings (before tax) (-25.00) 25.00 50.00 Less tax at 40% 10.00 10.00 20.00 Net Income (after tax) (-15.00) 15.00 30.00 (-15%) 15% 30% Return on Equity Earnings per share (in Rs. 10,00,000 shares of (-1.50) 1.50 3.00 Rs. 10 each) II : Debt = Rs. 20 lakh, Equity = Rs. 80 lakh EBIT Less interest (at 15%) Earnings before tax Less tax at 40% Net income Return on equity of Rs. 80 lakh Earnings per share (Rs. 8,00,000 shares of Rs. 10 each) (-25.00) 25.00 50.00 3.00 3.00 3.00 (-28.00) 22.00 47.00 11.20 8.80 18.80 (-16.80) 13.20 28.20 (-21%)16.5%35.25% (2.1) 1.65 35.25 25.00 7.50 17.50 7.00 10.50 21% 2.1 25.00 12.00 13.00 5.20 7.80 39% 50.00 7.50 42.50 17.00 25.50 51% 5.1 50.00 12.00 38.00 15.20 22.80 114%

III : Debt = Rs. 50 lakh, Equity = Rs. 50 lakh EBIT (-25.00) Less interest (at 15%) 7.50 Earnings before tax (-32.50) Less tax at 40% 3,00 Net income (19.50) Return on equity of Rs. 50 lakh (-39%) Earnings per share (Rs. 5,00,000 shares of Rs. 10 each) (-3.9) IV : Debt = Rs. 80 lakh, Equity = Rs. 20 lakh EBIT (-25.00) 12.00 Less interest (15%) Earnings before tax (-37.00) Less tax at 40% 14.80 Net income (-22.20) Return on Equity of Rs. 20 lakh (-111%) Earnings per share (Rs. 2,00,000 shares of Rs. 10 each) (-11.1)

3.9 11.40

You may now have a closer look at the effects of leverage. Please note that the analysis presented in Table 13.3 above assumes: a) an average tax rate of 40% or a tax credit at the same rate in a year of loss b) four different levels of debt c) three different states of economy viz., bad, good, and very good d) the fact that equity shares of the company can be sold only at par i.e., at Rs. 10 per share.

47

Financial and Investment Analysis

We offer the following comments on Table 13.3 for further study and analysis by you: a) At zero debt level (viz., capital structure I), the after-tax return on total assets is 60% of the before tax return because the tax rate is 40%. Also, the after-tax return on total assets is equal to the after-tax return on equity. Financial leverage in general is favourable when the return on assets exceeds the cost of debt. This is true of all the four capital structures when the return levels are 25% and 50%. When the return on assets is high, both the net return on equity and earnings per share increase with a rise in the debt ratio. You may notice that when the return on assets is the highest at 50% (last column of Table 13.3), the return on equity increases from 30% at zero debt to 114% at 80% debt level. The corresponding increase in EPS is from Rs. 3.00 to Rs. 11.40. The amount of interest affects the relationship of after-tax return on assets and return on equity at different levels of leverage. The numerators of both the ratios bear the following relationship:

b)

c)

d)

EBIT (I- t) = Net Income + (1- t) Interest charges---------3 Where t = tax rate You may note that the term to the left of the equation is the numerator of return on assets and the term to the right is the numerator of return on equity. You may verify this relationship at any debt level. For example, take capital structure - II in Table 13.3 at an EBIT level of Rs. 25 lakh and substitute relevant values in equation (3). You will get : 25,00,000 (1 - .40) = 13,20,000 + (1 - .40) 3,00,000 Rs. 15,00,000 = Rs. 15,00,000 e) It is significant that while higher amounts of leverage improve equity returns and earnings per share, they produce a higher degree of volatility also in such returns. Table 13.4 below summarizes the minimum, maximum and the range of equity returns at different debt levels on the basis of the data furnished in Table 13.3. Table 13.4 Financial Leverage and Equity Returns Amount of Financial Leverage (Debt-assets Ratio) 0% 20% 50% 80% Minimum -15% -21% -39% -111% Return on Equity (ROE) Maximum 30% 35.25% 51% 114% Range 45% 56.25% 90% 225%

You may observe that the Return on Equity (ROE) varies within a range of 45% when the debt ratio is zero, but the range increases to 225% when the debt ratio rises to 80%. This increased volatility will also be found to be true if you measure the equity return by net income or earnings per share. From this analysis we may, conclude: Financial leverage magnifies the volatility of return whether measured by net income or return on equity or earnings per share. It would, thus, be seen that financial leverage is a double-edged sword. It magnifies returns and also increases their volatility. Increased volatility implies greater risk in the wake of a riding interest burden, which, if not met, may lead to bankruptcy. In the perception of equity shareholders as well as lenders, the riskiness of the firm

48

may increase. This aspect of financial leverage is covered in the last section o f this unit. Activity 13.3 Use the data given in Table 13.3 and draw a graph showing the position of the four capital structures. The X-axis should represent EBIT as a percent of total assets and the Y-axis the per cent return on equity. What conclusions do you draw from the graphs? Are they consistent with the analysis of Table 13.3 given above? .................................................................................................................................... ................................................................................................................................... .................................................................................................................................... .................................................................................................................................... ................................................................................................................................... .................................................................................................................................... .................................................................................................................................... ................................................................................................................................... .................................................................................................................................... .................................................................................................................................... ................................................................................................................................... .................................................................................................................................... .................................................................................................................................... ................................................................................................................................... .................................................................................................................................... .................................................................................................................................... ................................................................................................................................... .................................................................................................................................... .................................................................................................................................... ................................................................................................................................... .................................................................................................................................... .................................................................................................................................... ................................................................................................................................... .................................................................................................................................... .................................................................................................................................... ................................................................................................................................... .................................................................................................................................... .................................................................................................................................... ................................................................................................................................... ....................................................................................................................................

Leverage Analysis

13.5 OPERATING LEVERAGE

We have stated and seen in the preceding section that Financial Leverage magnifies the risk of bankruptcy viz. the financial risk. Now, we have another concept of leverage, which has a close relationship with business risk. This is operating leverage. In fact, operating leverage affects business risk, which may be viewed as the uncertainty inherent in estimates of future operating income. A little recapitulation from our discussion of break-even analysis (Unit 9) will help us to understand the concept of operating leverage. You may note that the operating leverage refers to the degree to which a firm has built in fixed costs due to its particular or unique production process. In a large number of situations, a firm would be in a position to exercise a degree of control on the choice of its technology and the related production processes. The production processes which are accompanied' by high fixed costs but low variable costs are generally the highly mechanised and automated processes. With such processes, the degree of operating leverage is generally high, the break-even point is relatively higher, and thus changes in the sales level have a magnified

49

Financial and Investment Analysis

(or leveraged ) effect on profits. Notice that as the operating leverage (i.e., fixed costs), goes higher, so does the break-even sales volume. Hence greater is the impact on profits of a given change in sales volume. Also notice that Financial Leverage adds another element of fixed expenses i.e., fixed financial charges, and serves to further magnify the impact of total leverage on profits. Operating Leverage : We present the following hypothetical volume - costs - profit profile of three firms A, B and C. Table 13.5 Operating Leverage Rs. in lakh Units sold 30,000 40,000 50,000 60,000 70,000 80,000 90,000 1,00,000 Sales @ Rs. 10/ per unit 3.00 4.00 5.00 6.00 7.00 8.00 9.00 10.00 Firm A Cost 3.60 4.30 5.00 5.70 6.40 7.10 7.80 8.50 Profit -.60 -.30 0.00 .30 .60 .90 1.20 1.50 Rs. 1.5 lakh Rs. 7.00 Cost 4.50 5.00 5.50 6,00 6.50 7:00 7.50 8.00 Rs. 3.0 lakh Rs. 5.00 Firm B Firm C Profit Cost -1.505.70 -1.006.10 -.506.50 0.006.90 .507.30 1.007.70 1.508.10 2.008.50 Profit -2.70 -2.I0 -1.50 -.90 -.30 .30 .90 1.50

Fixed Costs: Variable cost per unit:

Rs. 4.5 lakh Rs. 4.00

You may have noticed the characteristics of the three firms from Table 13.5. They are a) b) Sales volume in units, selling price per unit, and sales value realisation are identical for all the three firms. Fixed costs are the lowest for firm A, medium for B, and highest for C. Firm A has the least automated plant, lowest depreciation charges, low fixed costs, and a higher per unit variable cost. Firm B has a moderately automated plant. Firm C has the most highly automated plant which needs very little labour per unit of output. Its variable costs rise slowly and its overhead burden is relatively higher. Firm C has the lowest variable cost per unit at Rs. 4.00.

50

Activity 13.4 Look at Figures 13.1, 13.2 and 13.3. Comment upon the main features of each firm's volume cost relationships. ...................................................................................................................................... ...................................................................................................................................... ...................................................................................................................................... ...................................................................................................................................... ...................................................................................................................................... ...................................................................................................................................... ...................................................................................................................................... ...................................................................................................................................... Degree of operating leverage : Degree of operating leverage measures the effect of change in volume on net operating income or earnings before interest and taxes. This may be obtained by using the following formula: Degree of operating leverage

Leverage Analysis

( DOL) =

% change in net operating income % change in units sold or sales

Degree of operating leverage will be calculated for a firm when it moves over from one level of sales (volume or value) to another. For example, the degree of leverage for firm B in Table 13.5, when it shifts from a volume of 80,000 units to 90,000 units, would be as below: -

( DOL) =
Where NOI is the change in Net Operating Income NOI is net operating income or earnings before interest and taxes Q is the change in quantity or volume, and Q is quantity or volume Thus, DOL for firm B for a change in output from 80,000 units to 90,000 units would be:

1,50, 000 1, 00, 000 /1, 00, 000 (90, 000 80, 00) / 80, 000
50% 12.5%

50, 000 /1, 00, 000 10, 000 / 80, 000

=
=4

To be able to understand the implications of DOL, you may compare Firm A (least operating leverage) with Firm C (highest operating leverage) at any two given levels of output, say for a change in output from 80,000 units to 90,000 units i.e. an increase of 12.5%. DOLA at 80,000 units =

.30 / .90 = 2.67 10,000 / 80,000 .60 / .30 = 16.00 10,000 / 80,000
51

DOLC at 80,000 units =

Financial and Investment Analysis

You may now notice the manner in which profits change in response to change in volume. Thus, for 12.5% increase in output, profits will increase by 26.7% for Firm A (which is low-leveraged firm) and by I60% for Firm C (which is high leveraged firm). You will find fluctuations in profits to be more steep for firms which are highly leveraged. Thus, the higher the degree of operating leverage the greater will be the fluctuations in profits in response to changes in volume. And this relationship works both ways i.e. when volume increases as well as when it declines. The degree of leverage has implications for a number of business and financial policy areas. The following examples based on the DOL of Firm C illustrate some of these areas : a. The high degree of operating leverage for Firm C suggests that volume may be increased to gain' a steep rise in profits. If Firm C could increase its volume from 1,00,000 units to 2,00,000 units by reducing the selling price to Rs. 9.00 per unit, the net operating income with this price revision would be: NOI = = = = PQ -VQ-F Where P is price per unit, y is variable cost per unit, Q is volume in units and F is total fixed cost. Rs. 9 X 2,00,000 - Rs. 4 X 2,00,000 - Rs. 4.5 lakhs Rs. 18 lakhs - Rs, 8 lakhs - Rs. 4.5 lakhs Rs. 5.5 lakhs

You may note that Firm C is able to increase its profits from Rs.. 1.50 lakhs at a volume of 1,00,000 units to Rs. 5.50 lakhs at a volume of 2,00,000 units. Thus, a doubling of output (by a 10% reduction in sales price from Rs. 10 to Rs. 9) results in profits becoming about 3.6 times. Firm C with a high degree of operating leverage may, therefore, adopt an aggressive price policy. b. A high degree of operating leverage also suggests that profits will swing widely as volume fluctuates: If, Firm C belongs to an industry where sales are greatly affected by changes in the overall level of the economy resulting in wild fluctuation of profits, the degree of financial leverage appropriate to Firm C will be lower than the one for a firm which belongs to an industry not so sensitive to changes in the economy.

13.6 COMBINED LEVERAGE

The degree of operating leverage may be combined with the degree of financial leverage. In fact, degree of operating leverage (DOL) is viewed as the first-stage leverage and degree of financial leverage (DFL) as the second-stage leverage. Since financial leverage measures the effect of changes in EBIT on earnings avail-able to equity shareholders, it may be calculated by using the following formula:

Degree of financial leverage =

% change in Net Income % change in EBIT

The use of this formula may be illustrated before demonstrating the implications of combining DOL and DFL. The data of Table 13.3 for the leverage factors of 20% debt and 80% debt may be utilised to show the effect of an increase of EBIT from Rs. 25 lakhs to Rs. 50 lakhs. The following calculations may be noticed: DFL (80%) the degree of financial leverage at 80% debt. DFL (20%) the degree of financial leverage at 20% debt.

52

(22.80 - 7.80) / 7.80 (50.00 - 25.00) / 25.00 (15.00 - 7.80) 2.92 = = = 2.92 25.00 / 25.00 1.00 (28.20 - 13.20) / 13.20 15.00 / 13.20 DFL (20%) = = = = 1.14 (50.00 - 25.00) / 25.00 25.00 / 25.00 DFL (80%) =
The Figures 2.92 and 1.14 can be easily understood. The former implies that when the debt ratio (or the leverage factor) is 80%, a 10% increase in EBIT produces a 29.2% (10 x 2.92) increase in net income available to equity shareholders. At a leverage factor of 20%, a 10% increase in EBIT brings about only an 11.4% (I 0 x 1.14) increase in net income or earnings available to equity shareholders. You may conclude that a high degree of leverage brings about a higher magnification of equity earnings. In the absence of debt, the degree of financial leverage (DFL) will be 1.00 (i.e. unity). The use of debt will lead to DFL above 1.00 or 100%. The DFL may be viewed as a multiplication factor, and when this multiplication factor is 1.00, there is no magnification in net income or return on equity, or in earnings per share. A combination of operating and financial leverage measures the degree of magnification in Net Income (NI), Return on Equity (ROE), and Earnings per Share (BPS) for a given increase in sales. When the use of operating and financial leverage is considerable, small changes in sales will produce wide fluctuations in NI, ROE and EPS. The Degree of Combined Leverage (DCL) may be measured by using the following formula: DCL = DOL X DFL

Leverage Analysis

DCL =

% change in Net Income EBIT % change in net income (% change in sales) (% change in EBIT) % change in net Income % change in sales

You may note that a number of combinations of DOL and DFL may produce the same DCL. And if management has a target DCL, changes in DOL or DFL may be made to attain the targeted DCL. For instance, if the firm has a high degree of operating leverage clue to the nature of its operations, the degree of financial leverage may be suitably lowered so as not to lower the targeted combined leverage and vice versa.

13.7 FINANCIAL LEVERAGE AND RISK

We posed the question of risk at the beginning of this unit. You would have noted from our discussion so far that the concepts of operating, financial, and combined leverage have been examined to assess the quantum or risk (business, financial and combined), which the firm faces as a result of decisions to change the various degrees of leverage. In fact, the extent to which the various measures of net income fluctuate, for given variations in sales or EBIT, has a direct bearing on many business and financial policies.

53

Financial and Investment Analysis

There are several statistical measures, which help us to quantify risk. We propose to calculate one such measure known as coefficient of variation by using data in Table 13.3 and the additional data given in Table 13.6 below: Table 13.6 Cost Structure of Bharat Engines Ltd. Rs. in lakhs Sales (units) Sales @ Rs. 1,000 per unit Fixed operating cost Variable operating costs (20% of sales in Rs) Earnings before interest and taxes (EBIT) Pre-tax return on total assets (%) The total cost can be estimated as follows: Total Cost = Fixed operating costs + Variables operating costs per unit (Sales) = 40 lakhs + 0.20 (sales) In order to obtain a measure of coefficient of variation, the first step is the assignment of probabilities to the possible levels of sales that the management has forecast. Probability in brief is the chance of some event occurring. If it is absolutely definite, it is 1, otherwise probability is always a fraction of unity (1). The state of the economy is beyond the control of management, but corporate policies are within its control and can be reasonably forecast. The state of the economy may range from `very poor' to `very good' and may accordingly be incorporated in the management's attitudes of pessimism or optimism. Assume that the management of Bharat Engines Ltd., has assigned the following probabilities based on the aforesaid consideration: Table 13.7 Estimated Probabilities Stage of economy A B C Expected sales (Rs. lakh) 18.75 81.25 112.50 Probability of expected sales .2 .5 .3 1875 18.75 40.00 3.75 -25.00 -25.00 8125 81.25 40.00 16.25 25.00 25.00 11250 112.50 40.00 22.50 50.00 50.00

Note : All probabilities must add up to 1.00

54

Now we use information from Tables I3.3, 13.6 and 13.7 and present computations of coefficient of variations in Table 13.8 below:

Leverage Analysis

You may study Table 13.8 and its results carefully. The four sections of the table depict the four capital structures viz., zero debt, 20% debt, 50% debt and 80% debt. You may notice that as the leverage factor (viz., Debt ratio) rises, the coefficient of variation also goes up. Thus, for zero debt, the Cv is 1.163 and for 80% debt it shoots up to 3.919. On the basis of the data furnished and probability information generated, it may be concluded that the business risk (which is the sum of operating risk and financial risk) rises with financial risk in the case of Bharat Engines Ltd.

55

Financial and Investment Analysis

Calculations similar to those given in Table 13.7 can be performed for determining the risk character of the firm in response to amounts of financial leverage stipulated. This analysis helps to plan capital structure.

13.8 SUMMARY
Concepts of financial and operating leverages are important for evaluating business and financial risk of a firm. Operating leverage refers to the use of fixed costs in operations and it is related to the firm's production processes. The greater the operating leverage the higher is the risk in operations. At the same time, a high degree of operating leverage causes profits to rise rapidly after the break-even point is reached. Financial leverage refers to the use of debt in financing non-current assets. If the return on assets exceeds the cost of debt, the leverage is successful i.e., it improves returns on equity. While this being so, a high financial leverage magnifies financial risk. At some degree of financial leverage the cost of debt rises because of increased risk with the higher fixed charges. When this happens, riskiness of the firm also increases in the eyes of equity investors who start expecting a higher return to compensate for the increased risk burden. Financial leverage and operating leverage are related with each other. Both have similar effects on profits. A greater use of either i.e., operating or financial leverage leads to following results: a) The break-even point is raised b) The impact of change in the level of sales on profits is magnified. Operating and financial leverages have reinforcing effects. Operating, or first-stage leverage affects earnings before interest and taxes (i.e., net operating income) while financial, or second-stage leverage affects earnings after interest and taxes (i.e., net income available to equity shareholders). Operating and financial leverages are measured in relative terms to assess their impact on profitability of a firm. These measures are given by the degrees of operating and financial leverage. A combined degree of financial and operating leverage can also be calculated to evaluate effects of changes in sales on net-income or earnings per share. Financial leverage and risk are related variables and the statistical measures known as coefficient of variation can be computed to estimate the risk of the firm at different levels of leverage or debt ratio.

13.9 KEY WORDS

Financial Leverage refers to the use of debt in the financing of a firm. It denotes the presence of fixed-return securities in the capital structure of the firm. Operating Leverage is the use of fixed costs in operations. A high operating leverage factor indicates the presence of automated production processes. Leverage Factor refers to the ratio of long-term debt to total assets. Capital Structure is the long-term financing plan of a firm. It covers debentures, preference shares, other fixed-return securities, long-term loans, equity shares, and reserves and surplus. Financial Structure is the total financing plan of a firm, which, besides all components of capital structure, also includes short-term debt.

56

Degree of Operating Leverage is the percentage change in net operating income in response to a percentage change in sales (volume or value). Degree of Financial Leverage is the percentage change in net income available to equity investors in relation to changes in earnings before interest and taxes. Degree of Combined Leverage is the percentage in net income after interest and taxes in response to percentage variations in sales (volume or value). Risk includes both operating risk (as given by the degree of operating leverage) and financial risk (as reflected by the degree of financial leverage) and is evaluated by a statistical measure known as coefficient of variation.

Leverage Analysis

13.10

SELF-ASSESSMENT QUESTIONS/ EXERCISES

1. Is the use of financial leverage justifiable from a socio-economic standpoint? Explain by listing some advantages and disadvantages. 2. How does the use of financial leverage affects the break-even point? Illustrate. 3. In what way is financial leverage related, to operating leverage? Discuss with an example. 4. `Risk increases proportionately with financial leverage'. Refute this statement with reasons. 5. `Other things remaining the same , firms with relatively stable sales are able to incur relatively high debt ratios.; Do you agree With the statement? 6. Why is EBIT (Earnings before Interest and Taxes or Net Operating Income) generally Considered to be independent of financial leverage?: Why should EBIT actually be influenced by financial leverage at high debt' levels? 7. State whether the following are True or False : a)
b)

Financial leverage affects both net income and BBIT, while operating leverage affect only BBIT Two firms with identical financial and operating leverage may have different degrees of business risk as measured by the coefficient of variation of'
their respective ROE.

True

False

True

False

c)

Business risk refers primarily to uncertainty about future EBIT, While financial risk refers to the added uncertainty about future net income that is caused by the use of debt

True

False

8. Other things being constant,' if Firm A has more Operating leverage than Firm B, then a given percentage decline in sales will cause a larger percentage decline for Firm A than for Firm B in a) EBIT b) Net Income c) Both (a) and (b) d) Neither (a) nor (b) e) None of these 9. One of the components of a firm's financial structure that is not a component of its capital structure is: a) debentures b) reserves

57

Financial and Investment Analysis

c) convertible preference d) shares e) short-term debt f) equity shares 10 . Financial leverage is different from operating leverage in that it is concerned with a) capital structure b) uncertainty of markets c) inefficient financial mangers d) uncertain estimates of EBIT e) None of these 11. In general, financial leverage is favourable whenever the return on assets exceeds the a) cost of equity share capital b) total cost of capital c) net return after taxes d) cost of debt e) none of these 12. Highly leveraged companies are most likely to be found in industries where sales are a) increasing around a trend line b) relatively unstable c) relatively stable d) expected to decline e) relatively uncertain with high margins 13. Fill in the blanks a) Firms that have a high ratio of fixed costs to variable costs are said to operate with a high degree of . degree of b) Other things being constant firms with a operating leverage are better able to employ more. in their capital structures. c) Debt has a ..over equity in that is a deductible expense while is not. 14. A firm has a debt ratio of 75% , and it has total assets of Rs. 20 crores. Before the creditors are unprotected these assets may drop to a value of a) Rs. 10 crores b) Rs. 5 crores c) Rs. 20 crores d) Rs. 15 crores e) none of these. 15. The debt ratio of Firms A and B are 60% and 30%, respectively. Both firms have assets totalling Rs. 50 crores and both have a cost of debt of 8 per cent. Firm A earns 12 per cent before interest and taxes on its total assets. Assume a 50 per cent tax rate and answer the following questions: a) What does A earn on equity after interest and taxes?

58

b) If B is to earn the same rate on equity after taxes as A. What must it earn before interest and taxes on its assets? (A) i) ii) iii) iv) v) 16. 15 % 9% 7% 9% 7% (B) 7% 15% 12% 12% 15%

Leverage Analysis

Triveni Dyes Ltd. desires to increase its assets by 50% to execute large government contracts it has received, the expansion could be financed by issuing additional equity shares at a net price of Rs. 45 per share (the price earnings ratio being 20). Alternatively, debt at a cost of 10% could be increased with a price earnings ratio of 15. The balance sheet is given below: Current Balance Sheet of Triveni Dyes Ltd. Rs. Debt (8%) Equity shares of Rs. 10 each Reserves Total claims 20,000 60,000 10,000 Rs. 90,000 Total assets Rs. 90,000 Total assets Rs. 90,000

Assume that the gross profit margin is 12% of estimated sales of Rs. 4,00,000 and that the tax rate is 35%. What are the expected market prices, after expansion, under the two alternatives? Debt a) b) c) d) e) 17. Rs. 13.150 Rs. 29.30 Rs. 52.35 Rs. 68.10 Rs. 86,50 Equity Shares Rs. 20.20 Rs. 41.70 Rs. 66.20 Rs. 86.20 Rs. 99.20

Chakradhar Seshan has developed a revolutionary new computerized method of preparing tax returns for individuals. He has a choice of computers on which to install his new process. Under Plan L he would lease a computer for Rs. 5 lakhs per year and process returns with a variable cost of Rs. 2 per, return. Under plan S he would lease a smaller, less efficient computer for Rs. one lakh per year, but processing costs under plan B will be Rs, 12 per return. Under either process; Seshan would charge Rs. 22 per return processed. Answer the following questions: i) ii) iii) iv) Which plan has a higher degree of operating leverage Construct break-even charts of the two plans. At what volume of tax returns would Seshan have the same operating profit under either plan? Based on this information only, which plan is more risky?

A.

59

Financial and Investment Analysis

B.

Assume that Seshan decides to use the large computer described under plan L. Seshan now needs Rs. 20 lakhs to build facilities, obtain working capital, and start operations. He has some money of his own with which he would buy stock and the balance of the required funds can be obtained in the form of debt or equity. If Seshan borrows part of the money, his interest charges will depend upon the amount borrowed according to the following schedule: Percentage of debt a Interest rate o upper end of Class- total amount interval in capital borrowed structure

Amount borrowed Up to Rs. 2 Lakhs More than Rs. 2lakhs and up to Rs. 4 lakhs More than Rs. 4 lakhs and up to Rs. 6 lakhs More than Rs. 6 lakhs and up to Rs. 8 lakhs More than Rs. 8 lakhs up to 10 lakhs More than Rs. 10 lakhs and up to Rs. 12 lakhs 10% 20% 30% 40% 50% 60% 9.00% 9.50% 10.00% 15.00% 19.00% 26.00%

Assume further that the equity shares can be sold at Rs, 20 per share regardless of the amount of debt the company uses. This will be the case at the time of initial offering of shares. Then, after the company begins operations, the price of its shares will be determined as a multiple of earnings per share. This multiple, viz., price-earnings (P/E) ratio will depend upon the capital structure as follows: Debt-Assets Ratio 0 10.00 20.00 30 00 40 00 50.00 60.00 to to to to to to to 9.99% 19.99% 29.99% 39 99% 49 99% 59.99% 69.99% P/E Ratio 12.5 12.0 11.5 10 0 80 6.0 5.0

If the company processes 50,000 returns annually and that its effective tax is 40%, calculate the company's EPS at different debt-assets ratios. Answers to Activities Activity 13.1 1. (a) No (b) No (c) No (d) Yes (e) Yes (f) No

Activity 13.2 2. (a) No (b) Yes (c) No (d) Yes (e) Yes (f)

(iii) D/A ratio = =

60

D/E ratio 2.0 2.00 = = = 67% 1+D/E ratio 1+2.00 3.00

Activity 13.3 Return on Equity

Leverage Analysis

Figure : Financial Leverage and Variation in. Equity Returns Conclusions

a) b)

With zero debt, the ratio of ROE to Return on Total Assets (ROTA) as depicted by AA is a relatively flat line. With 80% debt, the ratio of ROE to ROTA as , shown by DD becomes.. very steep.

This implies that as the debt-assets ratio rises, the ratio of ROE to ROTA becomes steeper: Thus, greater financial leverage produces greater volatility in the return on equity. Conclusions are consistent with the analysis of Table 13.3. 4 Firm A has the lowest level of fixed costs and Firm C the highest.

Firm A has a steep total cost curve because the variable cost per unit is high and the low fixed costs of not permitting a net reduction in total costs. Total cost curve of Firm C is relatively flat. The high fixed cost component ' enables the firm to try variable costs, particularly the labour costs. The location of Break-even Points (BEP) is interesting. The BEP for Firm A is at the lowest level of sales of the three firms. For firm C, it is at the highest level of sales. Firm, C which has a BEP at a higher volume is able to record a higher rate of increase in profits once it reaches the BEP, compared to the other two firms. At a high volume of operations, Firm. C begins to command a substantial cost superiority compared to the other two firms and more particularly Firm A. This result is now obvious at a

61

Financial and Investment Analysis

level of 1 lakh units. But if volume of sales rises to 2 lakh units, the per unit costs for the three firms would be as under: Firm Fixed cost Variable cost for 2 lakh units (Rs.lakh) 14.00 10.00 8.00 Total cost Units of sales Per unit cost

(Rs.lakh) A B C 1.50 3.00 4.50

(Rs.lakh) 15.50 13.00 12.50 2,00,000 2,00,000 2,00,000 7.75 6.50 6.25

Firm C can use the cost advantage at higher levels of sales in competitive markets. This will be particularly relevant for export sales. Answers or approaches to Self-assessment Questions / Exercises Hints for some selected questions: 1 a) b) c) Advantages It provides a method for some investors to hold securities with fixed and prior claims. It may encourage real investment. Financial leverage tends to stabilise economic functions by promoting contra cyclical investment: Debt is costly during booms and firms avoid it after a stage. Investment is reduced and a boom is not fed further. Similarly, debt is cheaper during depressions and it may result in higher investment, which pushes the economy out of unstable, to more stable conditions.

Disadvantages A major disadvantage is that heavy fixed charges may cause forced liquidation of firms during business downswings and may aggravate the severity of business depressions. If risk is defined as coefficient of variation, it is not possible to generalise the relationship with absolute certainty. With increased financial leverage, risk could rise proportionately, more than proportionately or, less than proportionately. The example in the test of the unit demonstrates a case where risk or the Cv rises less than proportionately with the debt ratio. With some other set of data, a linear relationship could be established, or a relationship where risk increases at a decreasing rate with the debt ratio could be found. Note that in all these cases risk does increase to some extent. 5. If sales tend to fluctuate widely, then cash flows and the ability to service fixed charges will also vary. Consequently, the possibility that the firm is unable to meet its fixed obligations increases. For this reason, firms in unstable industries tend to minimise their use of debt. Financial leverage has no effect on EBIT; it only affects equity earnings or net income, given EBIT. The EBIT is influenced by operating leverage. (a) False (b) True (c) True 8 (c) 9 (d) 10 (a) I1 (d) 12 (c) (a) Operating leverage (b) low; debt (c) tax; interest; dividends.

6.

7.

62

13

14 (b) Total assets Less : Debt (.75 of Rs. 20 crores) = Rs. I5 crores Equity = Rs. 5 crores Rs. 5 crores representing owner's equity is the amount that assets could drop to before creditors would begin to lose protection. 15 (ii) Firm A Debt 60 % Rs. 30 crores Equity 40% Rs. 20 crores Total Assets 100% Rs. 50 crores Firm B 30% Rs. 15 crores 70% Rs. 35 crores 100% Rs. 50 crores = Rs. 6.00 crores = Rs. 2.40 crores = Rs. 3.60 crores = Rs. 1.80 crores = Rs. I.80 crores Rs. 20 crores.

Leverage Analysis

Firm A earns .12 x Rs. 50 crores Less : Interest .08 x Rs. 30 crores Taxable income Less : taxes Net income

Rate of return on equity = Rs. 1.8 crores/ Rs. 20 crores = 9 % Firm B's net income .09 x Rs. 35 crores Add : B's taxes = Rs. 3.15crores = Rs. 3.15 crores = Rs. 6.30 crores = Rs. 1.20 crores = Rs. 7.50 crores = 15 %

Taxable income Add debt interest .08 x Rs. 15 crores EBIT Rate of return on assets = Rs. 7,5 crores/Rs. 50 crores 16 (d) EBIT = = EBIT Interest expenses: (Rs. 1600 + .10 x Rs. 45,000) Taxable Income Tax % 35% Earning per share Price Earning (P/E) ratios Expected Market price (EPS x PE ratio) Gross profit margin X Sales. 12 x Rs. 4,00,000 = Rs. 48,000

Debt Rs. 48,000 -6,100 Rs. 41,900 Rs.14,665 Rs. 27,235 27,235 = Rs. 4.54 15 Rs. 68.10

Equity Rs. 48,000 -1,600 Rs. 46,400 16,240 Rs. 30,160 7,000 = Rs. 4.31 20 Rs. 86.20

6;000 30,160

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Financial and Investment Analysis

17. A. i) Plan A has greater operating leverage owing to higher fixed costs ii) Break-even charts for Plan A and Plan B.3

iii) Profit under Plan A = (Price - VC) Units FC = (Rs. 22 - Rs.2) (x) - 5,00,000 where x is the indifference number of units Profit under Plan B = (Rs. 22-Rs. I2) (x) - Rs. 1,00,000 Set the equation for profits under the two plans equal to one another and solve for x: (Rs. 22 - Rs. 2) (x) - Rs. 5,00,000 = (Rs. 22 Rs. 12) (x) - Rs. 1,00,000 Rs. 20 x Rs. 5,00,000 = Rs. 10x - Rs. 1,00,000 10x = Rs. 4,00,000 x = Rs. 40,000 returns processes. Thus, if fewer than 30,000 returns are processed, Plan B is better but if more than 40,000 returns are handled, Plan A is more profitable. iv) Plan A is more risky because if sales fall below 25,000 units, losses will be incurred. The break-even of Plan B is only 10,000 forms. B. i) The following steps are suggested for the solution: Calcalation of EBIT Sales in Rs. = (50,000) (Rs. 22) Less : Fixed costs Variable costs =(50,000) (Rs. 2) = = = Rs. 5,00,000 = Rs. 11,00,000 5,00,000 1,00,000

64

EBIT

ii)

Calculation of EPS at each Debt-assets ratio using the formula: EPS = (EBITI) (1-t)/ No. of equity shares outstanding Where I = Interest Charges = (Rupees of debt) (interest rate at each D/A ratio). No. of shares outstanding = (Assets - Debt)/Initial price per share. = (Rs. 20,00,000 - debt) Rs. 20.00 The calculations made are:

Leverage Analysis

iii)

Calculation of Sheshan Ltd's expected equity share price at different debtassets ratios

iv)

Amount of debt which Seshan should use: The debt ratio at which share price is maximised will give the desired debt level. This is. 20% or Rs. 4,00,000 of debt. Note that the EPS, is also not the maximum at this debt level. For this to happen, the debt ratio must be 40% and the corresponding debt level must be Rs. 8,00,000

13.11

FURTHER READINGS

Van Horne, James C. 2002. Financial Management Policy, 12th edition, PrenticeHall of India : New Delhi. (Chapter 10&12). Keown, Arthur J. (with Scott, Martin, and Petty). 10/14/2002, Foundation of Finance: The Logic and practice of Financial Management Prentice-Hall of India: New Delhi. Khan, M.Y. and P.K. Jain. 1985. Financial Management, Tata McGraw-Hill: New Delhi. (Chapter 10).

65

Financial and Investment Analysis

UNIT 14
Objectives

BUDGETING AND BUDGETARY CONTROL

The objectives of this unit are to familiarize you with: the basic aspects of financial planning and the role of budgeting various types of budgets some new ideas and development in the area of budgeting.

Structure
14.1 14.2 14.3 14.4 14.5 14.6 14.7 14.8 14.9 14.11
14.12

Introduction Financial Planning What is a Budget? Budgetary Control Classification of Budgets Control Ratios Performance Budgeting Zero base Budgeting Summary Self-assessment Questions/Exercises Further Readings

14.10 Key Words

14.1 INTRODUCTION
At the beginning of the course, we have emphasized the need for managers to be forward-looking. For you, therefore, reviewing the past information alone is not enough since your job involves not only predicting but also shaping the future of your enterprises. This requires proper planning about all activities of the business. Finance being the life blood of a business, financial planning is of utmost significance to a businessman. A budget is an important tool for financial planning and control. However, before we come to the intricacies of budgeting, it will be useful for you to understand the meaning and implications of financial planning.

14.2 FINANCIAL PLANNING

Financial planning is concerned with raising of funds and their effective utilisation with a view to maximise the wealth of the company. It includes the determination of: the amount of funds needed for implementing various business plans the pattern of financing i.e. the form and proportion of various corporate securities , such as shares, debentures, bonds, bank loans to be issued or raised the timing of floatation of various corporate securities

66

In spite of a good financial plan, the desired results may not be achieved if there is no effective control to ensure its implementation. The budget represents a set of yardsticks or guidelines for use in controlling internal operations of an organisation. The management, through budget, can evaluate the performance of every level of the organisation. The discrepancy between plan performance and actual performance is highlighted through budgets. The organisation may have to change the course of its operations in a particular area or revise its plans keeping in view the changing conditions. It will, therefore, be useful for you to understand the complete budgeting process. In this unit, we shall explain what budget is and what budgetary control means. Besides the importance of budgeting as a management tool, the techniques of preparing various types of budgets will also be discussed.

Budgeting and Budgetary Control

14.3 WHAT IS A BUDGET?

A budget is a plan expressed in quantitative, usually monetary terms, covering a specific period of time, usually one year. In other words, a budget is a systematic plan for the utilisation of manpower and material resources. In a business organisation a budget represents an estimate of future costs and revenues. Budgets may be divided into two basic classes : Capital Budgets and Operating Budgets. Capital budgets are directed towards proposed expenditure for new projects and often require special financing (this topic is discussed in the next unit). The operating budgets are directed towards achieving short term operational goals of the organisation, for instance, production or profit goals in a business firm. Operating budgets may be sub-divided into various departmental or functional budgets. The main characteristics of a budget are: a) It is prepared in advance and is derived from the long term strategy of the organisation b) It relates to future period for which objectives or goals have already been laid down

c) It is expressed in quantitative from, physical or monetary units, or both.

Different types of budgets are prepared for different purposes e.g. Sales Budget. Production Budget, Administrative Expense Budgets, Raw-material Budget, etc. All these sectional budgets are afterwards integrated into a master budget which represents an overall plan of the organisation. A budget helps its in the following ways: a) b) It brings about efficiency and improvement in the working of the organisation. It is a way of communicating the plans to various units of the organisation. By establishing the divisional, departmental, sectional budgets, exact responsibilities are assigned. It thus minimizes the possibilities of buck-passing if the budget figures are not met. It is a way of motivating managers to achieve the goals set for the units. It serves as a benchmark for controlling on-going operations. It helps in developing a team spirit where participation in budgeting is encouraged. It helps in reducing wastage's and losses by revealing them in time for corrective action. It serves as a basis for evaluating the performance of managers. It serves as a means of educating the managers.

c) d) e) f) g) h)

67

Financial and Investment Analysis

14.4 BUDGETARY CONTROL

No system of planning can be successful without having an effective and efficient system of control. Budgeting is closely connected with control. The exercise of control in the organisation with the help of budgets is known as budgetary control. The process of budgetary control includes (i) (ii) (iii) preparation of various budgets continuous comparison of actual performance with budgetary performance and revision of budgets in the light of changed circumstances.

A system of budgetary control should not become rigid. There should be enough scope for flexibility to provide for individual initiative and drive. Budgetary control is an important device for making the organisation more efficient on all fronts. It is an important tool for controlling costs and achieving the overall objectives. Installing A Budgetary Control System Having understood the meaning and significance of budgetary control in an organisation, it will be useful for you to know how a budgetary control system can be installed in the organisation. This requires first of all, finding answers to the following questions in the context of an organisation: What is likely to happen? What can be made to happen? What are the objectives to be achieved? What are the constraints and to what extent their effects can be minimised?

Having found answers to the above questions, the following steps may be taken for installing an effective system of budgetary control in an organisation. Organisation for Budgeting The setting up of a definite plan of organisation is the first step towards installing budgetary control system in an organisation. A, Budget Manual should be prepared giving details of the powers, duties, responsibilities and areas of operation of each executive in the organisation. Responsibility for Budgeting The responsibility for preparation and implementation of the budgets may be fixed as under: Budget Controller Although the Chief Executive is finally responsible for the budget programme, it is better if a large part of the supervisory responsibility is delegated to an official designated as Budget Controller or Budget Director. Such a person should have knowledge of the technical details of the business and should report directly to the President of the Chief Executive of the organisation. Budget Committee The Budget Controller is assisted in his work by the Budget Committee. The Committee may consist of Heads of various departments, viz., Production, Sales Finance, Personnel, Purchase, etc. with the Budget Controller as its Chairman. It is generally the responsibility of the Budget Committee to submit, discuss and finally approve the budget figures. Each head of the department should have his own Subcommittee with executives working under him as its members.

68

Fixation of the Budget Period `Budget period' means the period for which a budget is prepared and employed. the budget period depends upon the nature of the business and the control techniques. For example, a seasonal industry will budget for each season, while an industry requiring long periods to complete work will budget for four, five or even larger number of years. However, it is necessary for control purposes to prepare budgets both for long as well as short periods. Budget Procedures Having established the budget organisation and fixed the budget period, the actual work or budgetary control can be taken upon the following pattern: Key Factor It is also termed as limiting factor. The extent of influence of this factor must first be assessed in order to ensure that the budget targets are met. It would be desirable to prepare first the budget relating to this particular factor, and then prepare the other budgets. We are giving below an illustrative list of key factors in certain industries. Industry Motor Car Aluminium Petroleum Refinery Electro-optics Hydel power generation Key factor Sales demand Power Supply of crude oil Skilled technicians Monsoon

Budgeting and Budgetary Control

The key factors should be correctly identified and examined. The key factors need not be of a permanent nature. In the long run, the management may overcome the key factors by introducing new products, by changing material mix or by working overtime or extra shifts etc. Making a Forecast A forecast is an estimate of the future financial conditions or operating results. Any estimation is based on consideration of probabilities. An estimate differs from a budget in that the latter embodies an operating plan of an organisation. A budget envisages a commitment to certain objectives or targets, which the management seeks to attain on the basis of the forecasts prepared. A forecast on the other hand is an estimate based on probabilities of an event. A forecast may be prepared in financial or physical terms for sales, production cost, or other resources required for business. Instead of just one forecast a number of alternative forecasts may be considered with a view to obtaining the most realistic, overall plan. Preparing Budgets After the forecasts have been finalised the preparation of budgets follows. The budget activity starts with the preparation of the sales budget. Then production budget is prepared on the basis of sales budget and the production capacity available. Financial budget (i.e. cash or working capital budget) will be prepared on the basis of sales forecast and production budget. All these budgets are combined and coordinated into a master budget. The budgets may be revised in the course of the financial period if it becomes necessary to do so, in view of the unexpected developments, which have already taken place or are likely to take place.

69

Financial and Investment Analysis

Choice Between Fixed and Flexible Budgets A budget may be fixed or flexible. A fixed budget is based on a fixed volume of activity. It may lose its effectiveness in planning and controlling if the actual capacity utilisation is different from what was planned for any particular unit or time e.g. a month or a quarter, The flexible budget is more useful for changing levels of activity as it considers fixed and variable costs separately. Fixed costs, as you are aware, remain unchanged over a certain range of output. Such costs change when there is a change in capacity level. The variable costs change in direct pro-portion to output. If ' flexible budgeting approach is adopted, the budget controller can analyse the variance between actual costs and budgeted costs depending upon the actual level of activity attained during a period of time. This will be explained in detail a little later. Activity 14.1 Arrange a meeting with one of the officials concerned with budgetary control and administration in your organisation and discuss the following points: a) b) c) The nature and the exact nomenclature of the budgetary control system. The time for which the system has been in operation. The objectives and scope activities) of the system.

14.5 CLASSIFICATION OF BUDGETS

Budgets can be classified into different categories on the basis of Time, Function, or Flexibility. The different budgets covered under each category are shown in the following chart: Chart : Classification of Budgets

70
Let us discuss some of the budgets covered in the above classification.

Rolling Budget Some organisations follow the practice of preparing a rolling or progressive budget. In such organisations, a budget for a year in advance will always be there immediately after a month, or a quarter, passes, as the case may be, a new budget is prepared for twelve months. The figures for the month/quarter, which has rolled down, are dropped and the figures for the next month/quarter are added. For example, if a budget has been prepared for the year 2003, after the expiry of the first quarter ending 31st March 2003, a new budget for the full year ending 31st March, 2004 will be prepared by dropping the figures for the quarter which has rolled (i.e. quarter ending 31st March 2003) and adding the figures for the new quarter ending 31st march 2004. The figures for the remaining three quarters ending 31st December 2004 may also be revised, if necessary. This process will continue whenever a quarter ends and a new quarter begins. Sales Budget Sales Budget generally forms the fundamental basis on which all other budgets are built. The budget is based on projected sales to be achieved in a budget period . The Sales Manager is directly responsible for the preparation and execution of this budget. He usually takes into consideration the following organisational and environmental factors while preparing the sales budget:

Budgeting and Budgetary Control

Organisational factors Past sales figures and trends Salesmen's estimates Plant capacity Orders on hand Proposed expansion or discontinuation of products
Availability of material or supplies Financial aspect Cost of distribution of goods

Environmental Factors General trade prospects Seasonal fluctuations Potential market Degree of competition Government controls, rules and regulations relating to the industry Political situation and its impact on market

It is desirable to break up the entire sales budget on the basis of different products, time periods and sales areas or territories. Illustration 14.1 Andhra Vinyl Ltd. has three sales division at Madras, Bangalore and Hyderabad. It sells two products - I and II. The budgeted sales for the year ending 31st December 2002 at each place are given below: Madras Bangalore Hyderabad Madras Bangalore Hyderabad Product I Product II Product II Product I Product I Product II Product II Product I 50,000 units @ Rs. 16 each 35,000 units @, Rs. 10 each 55,000 units @ Rs. 10 each 75,000 units @ Rs. 16 each 62,500 units @ Rs.16 each 37,500 units @ Rs. 10 each 62,500 baits @ Rs. 10 each 77,500 units @ Rs. 16 each

The actual sales during the same period were:

From the reports of the sales department it was estimated that the sales budget for the year ending 31st December 2003 would be higher than 2002, budget in the following respects: Madras Bangalore Hyderabad Product I Product II Product II Product I 4,000 units 2,500 units 6,500 units 5,000 units

71

Financial and Investment Analysis

Intensive sales campaign in Bangalore and Hyderabad is likely to result in additional sales of 12,500 units of products I in Bangalore and 9,000 units of Products II in Hyderabad. Let us prepare a sales budget for the period ending 31st December, 2003.

Production Budget This budget provides an estimate of the total volume of production distributed product-wise with the scheduling of operations by days, weeks and months, and a forecast of the inventory of finished products. Generally, the production budget is based on the sales budget. The responsibility for the overall production budget lies with Works Manager and that of departmental production budgets with departmental works managers. Production budget may be expressed in physical or financial terms or both in relation to production. The production budgets attempt to answer questions like: (i) What is . to be produced? (ii) When it is to be produced? (iii) How it is to be produced? (iv) Where it is to be produced? The production budget envisages the production programme for achieving the sales target. It serves as a basis for preparation of related cost budgets, e.g., materials cost budget, labour cost budget, etc. It also facilitates the preparation of a cash budget. The production budget is prepared after taking into consideration several factors like: (I) Inventory policies, (ii) Sales requirements, (iii) Production stability, (iv) Plant capacity, (v) Availability of materials and labour, (iv) Time taken in production process, etc. Activity 14.2 From the following details of Mysore Cement Works Limited, complete the production budget for the three-month period ending March 31, 2003 (Production budget for product P has already been worked (out).

72

Type of Product

Estimated stock on Jan. 1, 2003 (Units) 1,000 1,500 2.000 1,500

P Q R S

Estimated sales during Jan-March 2003 (Units) 5,000 7500 6.500 6.000

Desired closing stock on March 31, 2003 (Units) 1,500 2,500 1,500 1,000

Budgeting and Budgetary Control

Production Costs Budgets Basically, there are three elements of cods, namely direct material direct labour and overheads. Separate budgets for each of these elements have to be prepared. The direct materials' budget has two components, (i) materials requirement, bud-get, and (ii) materials procurement or purchase budget. The former deals with the total quantity of materials required during the budget period, while the later deals with the materials to be acquired from the Market during the budget period. Materials to be acquired are estimated after taking into account the losing rind the opening inventories and the materials for which orders have already been placed. Illustration 1.4.2 The Sales Director of Andhra Paraffin Company expects to sell 25,000 units of a particular product next year, The Production director consulted the store-keeper who gave the necessary details as follows:

73

Financial and Investment Analysis

Two kind of raw materials, P and Q are required for manufacturing the product. Each unit of the product requires 2 units of P and 3 units of Q. The estimated opening balance at the commencement of the next year are: Finished products Raw material P Raw material Q Finished Raw material P Raw material Q : 5,000 units : 6,000 units : 7,500 units : : : 7,000 units 6,500 units 8,000 Units

The desirable closing balance at the end of the next year are:

Let us prepare a statement showing material purchase budget for the next year. units to be produced = Sales + Desired closing Stock - Opening Stock = 25,000 + 7,000 - 5000 = 27,000 units. Materials Purchase or Procurement Budget Finished product units Production budget Estimated Opening Balance Estimated Closing Balance Estimated Sales of Product Estimated Purchase of Materials 27,000 +5,000 32,000 -7,000 25,500 Materials in units P 54,000 -6,000 48,000 +6,500 54,500 Q 81,000 -7,500 73,500 +8,000 81,500

Direct Labour Budget : Direct labour budget, like direct materials budget, may be divided into two categories, (i) direct labour requirement budget and (ii) direct labour procurement budget. The former deals with the total direct labour requirement in terms of quantity or/and value, while the latter states the additional direct workers to be recruited. Activity 14.3 The production budget of a factory shows that 1,000 units of a product are to be manufactured during the next month consisting of 25 working days. Each unit is expected to take two hours and each worker is required to work for 8 hours a day. Calculate (a) the number of workers required to complete the job, (b) the number of additional workers to be recruited in case the factory has already 8 workers, and likes to keep two workers in reserve for possible absenteeism, and (c) the Labour Budget if the wages of existing and the new workers are Rs. 500 and Rs. 600 p.m. respectively. Part (a) has already been worked out.

74

Budgeting and Budgetary Control

Overhead Budget The overheads may relate to factory, general administration selling and distribution function. Separate budgets may, therefore, be prepared for factory overheads, administrative overheads and selling and distribution overheads. Factory Overheads Budget: Factory or manufacturing overheads include the cost of indirect material, indirect labour and indirect expenses.. Manufacturing overheads may be classified into (i) Fixed Overheads i.e. which tend to remain constant irrespective of change in the volume of output, (ii) Variable Overheads i.e. which tend to vary with the output, and (iii) Semi-variable Overheads i.e. which are partly variable and partly fixed. The manufacturing overheads budget will provide an estimate of these overheads to be incurred during the budget period. Fixed manufacturing overheads can be estimated on the basis of the past information and knowledge of any changes which may occur during the ensuing budget period. Variable overheads are estimated after considering the scheduled production and operating conditions in the budget period. Illustration 14.3 From the following average figures of pervious quarters, let us prepare manufacturing overhead budget for the quarter ending March 31, 2003. The budgeted output during this quarter is 8,000 units. The figures for the previous quarter are: Fixed overtheads Variable overheads Semi-variable Rs. 40,000 20,000 (@ Rs. 5 per unit) 20,000 (40% fixed and 60% varying @ Rs. 3 per unit)

75

Financial and Investment Analysis

Manufacturing Overheads Budget For the Quarter ending 31st March 2003 (Output 8,000 units) Fixed overheads Variable overheads @ Rs. 5 per unit Semi-variable overheads Fixed Variable (@Rs. 3 per unit) Total Overheads 40,000 40,000 8,000 24,000 32,000 1,12,000

Administrative Overheads Budget: This budget covers the administrative expenses including the salaries of administrative and managerial staff. A careful analysis of the needs of all administrative departments of the enterprise is necessary. The minimum requirements for the efficient operation of each department can be estimated on the basis of costs for the previous years, and after a study of the plans and responsibilities of each administrative department for the budget period. The budget for the entire administrative function is obtained by integrating the separate budgets of all administrative departments. Selling and Distribution Overheads Budget: This budget includes all expenses relating to selling advertising delivery of goods to customers, etc. It is better if such costs are analysed according to products, types of customers, territories and the sales departments. The responsibility for the preparation of this budget rests with the executives of the sales department. There must be a relationship of selling expenses with the volume of sales expected and an effort should be made to control the costs of distribution. The preparation of the budget would depend on analysis of the market situation by the management, advertising policies, research programmes, and the fixed and variable elements. Illustration 14.4 Let us prepare a Sales Overheads Budget for the quarter ending 31st March, 2003 from the estimates given below: Advertisement Salaries of the sales department Expenses of sales department Counter salesmen salaries and allowances Rs. 12,500 25,000 7,500 30,000

Commission to counter salesmen is payable at 1 % of sales executed by them. Travelling salesmen are entitled to a commission at 10% on sales effected through them and a further 5 % towards expenses. Sales Territories A B C Sales at Counters Rs. 4,00,000 6 00 000 7,00,000 Sales by Traveling salesmen 50,000 75 000 1,00,000 Total estimated sales 4,50,000 6 75 000 8,00,000

76

Budgeting and Budgetary Control

Cash Budget Planning cash and controlling its use are important tasks. If the future cash flows are not properly anticipated, it is likely that idle cash balances may be created which may result into unnecessary losses. It may also result in cash deficits and consequent problems. The financial manager should, therefore, plan the needs and uses. Budget is a useful device for this purpose. The cash budget is a summary of the firm's expected cash inflows and outflows over a particular period of time. In other words, cash budget involves a projection of future cash receipts and cash disbursements over various time intervals. A cash budget helps the management in: determining the future cash needs of the firm planning for financing of those needs exercising control over cash and liquidity of the firm

The overall objective of a cash budget is to enable the firm to meet all its commitments in time and at the same time prevent accumulation at any time of unnecessary large cash balances with it. Lets recapitulate what we have already discussed in Unit 6 about cash inflows and cash outflows, which constitute the components of a cash budget. In both these components there are two types of flows, viz. operating cash flows and financial cash flows. Some common elements of each are as follows: Cash Inflows a) Operating : cash sales, receivable collections. b) Financial : interest receipts, sale of marketable securities, issue of new securities. Cash Outflow a) Operating : wage payments, payments of bills and accounts payable, and capital expenditure Payable. b) Financial: dividend payments, interest payments, redemption of securities, loan repayments, purchase of marketable securities, tax payments.

77

Financial and Investment Analysis

Sales Work Sheet Sales bring in a major part of cash inflows. All sales may not be against cash; credit sales are quite common. Each business establishment has its own credit policy for promoting sales. Even when care is taken to ensure that credit sales do not exceed the permitted percentage of total sales and that debtors do not default in paying bills in time, it is a common experience that the total amount of sales is recovered over a period of time. Let us take an example. In a business, 10 per cent of the sales value in a month is realised in cash during the same month; 50 per cent is received in the next month; and the remaining 40 per cent in the month after that. We can find out the estimated cash inflow due to sales for every month with the help of the data on past and future sales. Sales Work Sheet January to March 2003 Nov. Dec. Jan. Feb. March 2002 2002 2003 2003 2003 Past Sales 960 900 Estimated future sales - 900 1,000 1,000 Estimated Cash Receipts from sales: 10% of current month's sales 90 100 100 50% of last month's sales 450 450 500 40% of previous to last Month's sale 384 360 360 Total Cash Collections from receivables 924 910 960 The total cash collections from receivables will be transferred to the cash budget proforma. In a similar manner, a Purchase Work Sheet can also be prepared to find out the estimated total cash disbursements for purchases. For example, 50 per cent of current month's purchases may be paid for in the current month, 40 per cent in the next month and the remaining 10 per cent in the month after that. A proforma Cash Budget with hypothetical figures in presented below Proforma for Cash Budget (in Rs.) Months

Estimated Cash Inflows:

Cash Sales (including collections of current and previous month's sales) Others Total Cash Outflow Bills for Purchases Factory Expenses Head Office Expenses Interest Others Total Excess Inflow during the-month (1-2) Opening Cash Balance Closing Cash Balance (4+3) Minimum Cash Balance Needed Estimated Cash Surplus (5-6) - or Deficit (6-5)

Jan. 9.60 1.90 11.50 6.83 3.49 1.54 1.21 0.40 13.47 1.97 2.32 0.35 2.00 1.65

Feb.

March

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Illustration 14.5 You are appointed as the Finance Manager of Orissa Polymers Limited. Prepare a cash budget for six months of 2003 with the help of the following information: a) Sales on credit cost of material and wages are budgeted as follows (figures for November and December of the previous year are the actual figures for those months). Months Nov. Dec. Jan. Feb. March April May June b) c) d) e) Credit sales 30,000 32,000 28,000 31,000 34,000 29,000 30,000 36,000 Cost of material 5,000 6,000 5,000 7,000 8,000 5,000 6,000 7,000 Wages 10,000 12,000 10,000 11,000 12,000 9,000 11,000 12,000

Budgeting and Budgetary Control

Fixed overheads amount to Rs. 10,000 per month. Preference dividend of Rs. 8,000 for the half year will be due in June. Income tax amount of Rs. 10,000 is payable in January. Progress payment under a building contract are due as follows: March 31 May 31 Rs. 12,000 Rs. 15,000

f)

Goods are sold on terms: Net cash in the following month. Experience indicates that 80% of debtors pay within the period of credit and the remainder do not pay until the following month. Cost of material is payable in the month following the month in which the cost is incurred. Half of the purchases are subjected to a 2% discount and the remaining is payable net. The company pays all its accounts promptly.

g)

h)

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Financial and Investment Analysis

Purchase Budget Desired ending inventory (at cost price) Add Cost of goods (Current Month) Total requirement Less beginning inventory Purchases January 90,000 37,500 1,27,500 (60.000) 67,500 February 97,500 45,000 1,42,500 (90,000) 52,500 March 1,12,500 45,000 1.57,500 (97,500) 60,000

It will be seen that deficiency of cash occurs in the months of January, March, May and June, mainly because some unusual payments like preference dividend, advance income tax and progress payments under building contract are to be made in those months. With the help of the cash budget, the company will be able to plan its shortterm financing. One of the courses is to obtain the overdraft facilities from its bankers. The net cash position in a particular period may show deficit. Hence, arrangements should be made in advance to fill this gap by borrowing or by other means. In case there is a surplus balance, the desirability of investing it in government or other short-term securities should be examined. Any surplus should be invested in safe securities, provided the surplus is fairly considerable and the period of investment is short so as to ensure quick conversion of securities in cash without loss of value. Activity 14.4 Arrange a meeting with an accounting executive of your organisation and ascertain if cash budgeting is being practised? Obtain a proforma of cash budget for your record. What are the major sources of cash inflows and the main uses of cash outflows? In what way our organisation manages any deficit or surplus of cash revealed by the cash budget? ........................................................................................................................................ ........................................................................................................................................ ........................................................................................................................................ ........................................................................................................................................ ......................................................................................................................................... ....................................................................................................................................... Master Budget The Master or final budget is a summary budget, which incorporates all functional budgets in a capsule form. It sets out the plan of operations for all departments in considerable detail for the budget period. The budget may take the form of a Profit and Loss Account and a Balance Sheet as at the end of the budget period. The Master budget requires the approval of the Budget Committee before it is put into operation. It may happen, sometimes, that a number of master budgets have to be prepared before the final one is agreed upon. The budget generally contains details regarding sales (net), production costs, cash position, and key account balances (e.g. debtors, fixed assets, bills payable, etc.). It also shows the gross and net profits and the important accounting ratios.

Fixed and Flexible Budgets

Fixed Budget: A fixed budget is designed to remain unchanged irrespective of the level of activity. This budget is prepared on the basis of a standard or fixed level of activity. Since the budget does not change with the change of level of activity, it becomes an unrealistic yardstick in case the level of activity (volume of production

80

or sales) actually attained does not conform to the one assumed for budgeting purposes. The management will not be in a position to assess the performance of different heads on the basis of budgets prepared by them, because they can serve as yardsticks only when the actual level of activity corresponds to the budgeted level of activity. On account of the limitations of fixed budgeting and its inability to provide for automatic adjustments when the volume changes. Firms whose sales and production, cannot be accurately estimated have given up the practice of fixed budgeting The Master Budget may have the following format: Exhibit 14.1: Budget Format

Budgeting and Budgetary Control

Flexible Budget: The Flexible Budget is designed to change in accordance with the level of activity attained. Thus, when a budget is prepared in such a manner that the budgeted cost for any level of activity is available, it is termed as flexible budget. Such a budget is prepared after considering the fixed and variable elements of cost and the changes that may be expected for each item at various levels of operations. Flexible budgeting is desirable in the following cases: Where, because of the nature of business, sales are unpredictable, e.g. in luxury or semi-luxury trades.

81

Financial and Investment Analysis

Where the venture is new and, therefore, it is difficult to foresee the demand e.g., novelties and fashion products. Where business is subject to the vagaries of nature, such as soft drinks. Where progress depends on adequate supply of labour and the business is in an area, which is suffering from shortage of labour.

14.6 CONTROL RATIOS

Budget is a part of the planning process. After the various budgets, including the master budget, have been prepared, you may like to compare actual performance with the budgeted performance. This can be done by using three important ratios as shown below:

The above ratios are expressed in terms of percentages. If the ratio works out to 100 per cent or more, the trend is taken as favourable. If the ratio is less than 100 per cent, the indication is taken as unfavourable. We shall discuss these ratios in some details. Activity Ratio : Activity Ratio is a measure of the level of activity attained over a period of time. It is obtained by expressing the number of standard hours equivalent to the work produced as a percentage of the budgeted hours.

Activity Ratio =

Standard hours for actual production 100 Budgeted hours

Capacity Ratio : This ratio indicates whether and to what extent budgeted hours of activity are actually utilised. It shows the relationship between the actual number of working hours and the maximum possible number of working hours in a budgeted period.

Capacity Ratio =

Actual hours worked 100 Budgeted hours

Efficiency Ratio : This ratio indicates the degree of efficiency attained in production. It is obtained by expressing the standard hours equivalent to the work produced as a percentage of the actual hours spent in producing that work

Efficiency Ratio =
Activity 14.5

Standard hours for actual production 100 Actual hours worked

82

Calculate : Efficiency, Activity and Capacity ratios and comment on the results obtained for a factory which produces two units of a commodity in one standard hour. Actual production during a particular year is 34,000 units and the budgeted production for the year is 40,000 units. Actual hours operated are 16,000 (Some clues have been provided).

Two units are produced in one standard hour. Hence, for actual production of 34,000 units, standard hours required will be 17,000 (i.e 34,000/2). For budgeted production of 40,000 units, budgeted hours will be 20,000 (i.e. 40,000/2) Efficiency Ratio: ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... Activity Ratio: ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... Capacity Ratio: ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... Activity 14.6 In Activity 14.1 you had described the system of budgetary control in your organisation. Keeping in view the objectives of the system, you now critically evaluate the system in terms of its achievements, and / or failures. What do you think are the causes for failure (total or partial)? Reflect on improving the system. Achievements: ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... Failures: ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ........................................................................................................................ ......................................................................................................................................... Causes for failure: ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... .........................................................................................................................................

Budgeting and Budgetary Control

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Financial and Investment Analysis

Ideas for improvement: ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... .........................................................................................................................................

14.7 PERFORMANCE BUDGETING

As explained in the preceding pages, budgeting is nothing but the technique of ex pressing, largely in financial terms, the management's plans for operating and financing the enterprise during specific periods of time. Any system of budgeting, in order to be successful, must provide for performance appraisal, as well as follow up measures. The traditional (also known as line-item or object-account) budget in government enumerates estimated expenditures by type (and quantity) for a specified period of time, usually one year. The expenditure is classified by object; the personnel are listed by type of position; the budget is divided into sections according to organisational units, department sections; and the types of expenditure are listed by category. The primary purpose of traditional budget particularly in government administration is to ensure financial control and meet the requirements of legal accountability, that is, to ensure that appropriation, sanction or allotment limits for different items are not related to the intended or planned outputs (or achievements). The necessity for linking the expenditures (or inputs in financial terms) to outputs (in physical terms), facilitating the evaluation of outcomes (or result of activities) cannot be overemphasized. Performance budgeting (or programme budgeting) has been designed to correct the shortcomings of traditional budgeting by emphasizing management's considerations/ approaches. Both the financial and physical aspects are incorporated into the budget. A performance budget presents the operations of an organisation in terms of functions, programmes, activities, and projects. In performance budgeting (PB), precise detainment of job to be performed or services to be rendered is done. Secondly, the budget is prepared in terms of functional categories and their sub-division into programmes, activities, and projects. Thirdly, the budget becomes a comprehensive document. Since the financial and physical results are interwoven, it facilitates management control. The Main objectives of PB are: (i) to coordinate the physical and financial aspects; (ii) to improve the budget formulation, review and decision-making at all levels of management (iii) to facilitate better appreciation and review by controlling authorities (legislature, Board of Trustees or Governors, etc) as the presentation is more purposeful and intelligible; (iv) to make more effective performance audit possible; and (v) to measure progress towards long-term objectives which are envisaged in a development plan. Performance budgeting involves evaluation of the performance of the organisation in the context of both specific, as well as, overall objectives of the organisation. It presupposes a crystal clear perception of organisational objectives in general, and short-term business objectives as stipulated in the budget, in particular by each employee of the organisation, irrespective of his level. It thus, provides a definite direction to each employee and also a control mechanism to higher management.

84

Performance budgeting requires preparation of periodic performance reports. Such reports compare budget and actual data, and show variances. Their preparation is greatly facilitated if the authority and responsibility for the incurrence of each cost element is clearly defined within the firm's organisational structure. In addition, the accounting system should be sufficiently detailed and coordinated to provide necessary data for reports designed for the particular use of the individuals or cost centres having primary responsibility for specific cost. The responsibility for preparing the performance budget of each department lies on the respective Department Head. Each Department Head will be supplied with a copy of the section of the master budget appropriate to his sphere. For example, the chief buyer will be supplied with the copy of the materials purchase budget so that he may arrange for purchase of necessary materials. Periodic reports from various sections of a department will be received by the departmental head that will submit a summary report about his department to the budget committee. The report may be daily, weekly or monthly, depending upon the size of business and the budget period. These reports will be in the form of comparison of budgeted and actual figures, both periodic and cumulative. The purpose of preparing these reports is to promptly inform about the deviations in actual and budgeted activity to the person who has the necessary authority and responsibility to take necessary action to correct the deviations from the budget.

Budgeting and Budgetary Control

14.8 ZERO BASE BUDGETING

Earlier we have explained the formulation. of different types of budgets. If the approach adopted in the formulation and preparation of budgets is based on current level of operations or activities, including current level of expenditure and revenue, such budgeting is known as traditional budgeting .This type of budgeting process generally assumes that the allocation of financial resources in the past were correct and will continue to hold good for the future as well. In most cases, an addition is made to the current figures of cost to allow for expected (or even unexpected) increases. Consequently, the budget generally takes an upward direction year after year, inspite of generally declining efficiency. Such a system of budgeting cannot be expected to promote operational efficiency. It may, on the other hand, create several problems for top management. Some of these problems are: Programmes and activities involving wasteful expenditure are not identified, resulting in avoidable financial and other costs. Inefficiencies of a prior year are carried forward in determining subsequent years' levels of performance. Managers are not encouraged to identify and evaluate alternative means of accomplishing the same objective. Decision-making is irrational in the absence of rigorous analysis of all proposed costs and benefits. Managers tend to inflate their budget requests resulting in more demand for funds than their availability. This results in recycling the entire budgeting process.

Thus, the traditional budgeting technique may be quite meaningless in the present context when management must review or re-evaluate every task with a view to utilize the scarce resources in a better manner or to improve performance. The technique of zero base budgeting provides a solution for overcoming the limitations of traditional budgeting by enabling top management to focus on priorities, key areas and alternatives of action throughout the organisation.

85

Financial and Investment Analysis

The technique of zero base budgeting suggests that an organisation should not only make decisions about the proposed new programmes, but should also review the appropriateness of the existing programmes from time to time. Such a review should particularly be done of such responsibility centres where there is relatively high proportion of discretionary costs. Costs of this type depend on the discretion or policies of the responsibility centre or top managers. These costs have no direct relation to volume of activity. Hence, management discretion typically determines the amount budgeted. Some examples are: expenditure on research and development, personnel administration, legal advisory services. Zero base budgeting, as the term suggests, examines or reviews a programme or function or responsibility from scratch. The reviewer proceeds on the assumption that nothing is to be allowed. The manager proposing the activity has, therefore, to justify that the activity is essential and the various amounts asked for are reasonable taking into account the outputs or results or volume of activity envisaged.. No activity or expense is allowed simply because it was being allowed or done in the past. Thus according to this technique each programme, whether new or existing, must be justified in its entirety each time a new budget is formulated. It involves: dealing with particularly all elements of mangers' budget requests critical examination of ongoing activities along with the newly proposed activities providing each manger a range of choice in setting priorities in respect of different activities and in allocating resources.

Process of Zero Base Budgeting

The following steps are involved in Zero base budgeting: Determining the objectives of budgeting: The objective may be 'to effect cost reduction in staff overheads or it may be to drop, after careful analysis, projects which do not fit into achievement of the organisations objectives etc. Deciding on scope of application: The extent to which zero base budgeting is to be introduced has to be decided, i.e. whether it will be introduced in all areas of the organisation's activities or only in a few selected areas on trial basis. Developing decision units Decision units for which cost-benefit analysis is proposed have to be developed so as to arrive at decisions whether they should be allowed to continue or to be dropped. Each decision unit, as far as possible should be independent of other units so that it can be dropped if the cost analysis proves to be unfavourable for it. Developing decision packages : A decision package for each unit should be developed. While developing a decision package, answers to the following questions would be desirable: Is it necessary to perform a particular activity at all? If the answer is in the negative, there is no need to proceed further. How much has been the actual cost of the activity and what has been the actual benefit both in tangible as well as intangible forms? What should be the estimated cost of the level of activity and the estimated benefit from such activity? Should the activity be performed in the way in which it is being performed, and what should be the cost? If the project or activity is dropped, can the unit be replaced by an outside agency?

86

After completing decision packages for each unit, the units are ranked according to the findings of cost-benefit analysis. Essential projects are identified and given the highest ranks. The last stage is that of implementing the decision taken in the light of the study made. It involves the selection and acceptance of those projects which have a positive cost-benefit analysis or which are capable of meeting the objectives of the organisation. The above analysis shows that zero base budgeting is in a way an extension of the method of cost-benefit analysis to the area of the corporate budgeting.

Budgeting and Budgetary Control

Advantages of Zero Base Budgeting

Let us summarise the advantages of zero base budgeting: It provides the organisation with systematic way to evaluate different operations and programmes undertaken. It enables management to allocate resources according to priority of the programmes. It ensures that each and every programme undertaken by managers is really essential for the organisation, and is being performed in the best possible way. It enables the management to approve departmental budgets on the basis of cost-benefit analysis. No arbitrary cuts or increase in budget estimates are made. It links budgets with the corporate objectives. Nothing will be allowed simply because it was being done in the past. An activity may be shelved if it does not help in achieving the goals of the enterprises. It helps in identifying areas of wasteful expenditure and, if desired, it can also be used for suggesting alternative courses of action. It facilitates the introduction and implementation of the system of `management by objectives'. Thus it can be used not only for fulfillment of the objectives of traditional budgeting, but also for a variety of other purposes.

It is contended that zero base budgeting is time consuming. Of course, it is true, but it happens only in the initial stages when decision units have to be identified and decision packages have to be developed or completed. Once this is done, and the methodology is clear, zero base budgeting is likely to take less time than the traditional budgeting. In any case, till such time the organisation is properly acclimatized to the technique of zero base budgeting, it may be done in a way that all responsibility centres are covered at least once in three or four years. Zero base budgeting as a concept has become quite popular these days. The technique was first used by the U.S. Department of Agriculture in 1962. Texas Instruments, a multinational company, pioneered its use in the private sector. Today, a number of major companies such as Zerox, BASF, International Harvester and Easter Airlines in the United State are using the system. Some departments of the Government of India have recently introduced zero base budgeting with a view to making the system of budgetary control more effective.

87

Financial and Investment Analysis

Activity 14.7 Discuss again with an official concerned with the budgetary control system in your organisation in the light of new developments that have taken place in the field of budgeting. Has your organisation adopted any of the features of the new developments of innovations, such as Performance Budgeting, Zero Base Budgeting, etc.? List some of the important steps taken in the recent past.

............................................................................................................................. ............................................................................................................................. ............................................................................................................................. ............................................................................................................................. ............................................................................................................................. ............................................................................................................................. ............................................................................................................................. ............................................................................................................................. ............................................................................................................................. ............................................................................................................................. ............................................................................................................................. ............................................................................................................................. ............................................................................................................................. ............................................................................................................................. ............................................................................................................................. .............................................................................................................................

14.9 SUMMARY
Since finance is regarded as the life blood of business, financial planning is of utmost significance to management. A budget is a quantitative expression, usually in financial terms , of the future plans of an organisation. It includes projections regarding the levels of activity, expenses and revenues. A budget is an important tool of financial planning. It helps in uncovering inefficiencies in operations, in minimising wasteful expenditure and in bringing out weaknesses in the organisation structure. The responsibility for preparing the budget rests on the Budget Controller, who is assisted in his work by a Budget Committee. The Budget Committee may consist of heads of various departments, viz., Sales, Production, Personnel, Purchase, and Finance etc. Each head of the department is made responsible for preparing and executing the budget of his department. In a business organisation, preparation of any budget is preceded by a sales forecast. Production budget is prepared after considering the forecasts embodied in the sales budget and the available productive capacity etc. Production budget includes the preparation of various cost budgets associated with production process. Budgets pertaining to different functions or units are then combined and coordinated into one Master Budget. The budget may be revised from time to time if the changed conditions or new developments so warrant. A budget may be fixed or flexible. A fixed budget is based on fixed volume of activity. If actual capacity utilisation is likely to vary from period to period, flexible budgets are more desirable. A flexible budget is thus prepared for changing levels of activity. It considers fixed and variable costs separately and is therefore more useful to a business where the level of activity cannot be exactly predicted. In a system of budgetary control, control ratios may be computed and used in order to compare the actual performance with the budgeted performance. These ratios are: activity ratio, capacity ratio and efficiency ratio. In case the ratio is hundred percent or more, it is considered favourable. If it is less than hundred percent, it is taken as unfavourable.

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The traditional budgeting technique which takes the current level of operations as the basis for estimating the future level of operations is slowly going out of date. It is being increasingly realised that the traditional technique has serious shortcomings in view of the constantly changing conditions of today. The management is expected to review and re-evaluate the tasks in view of the increasing pressures of environment. The concept of `zero base budgeting' is being considered as a suitable alternative to replacing the traditional method.' `Zero base Budgeting' technique suggests that an organisation should not only make decisions about the proposed new programmes, but should also, from time to time, review the appropriateness of the existing programmes. Nothing is allowed simply because it w as being allowed in the past. Each programme, whether new or existing has to be justified in its entirety each time a new budget is formulated. The concept of `Zero base Budgeting' has been accepted for adoption in the departments of the Central Government, and some State Governments.

Budgeting and Budgetary Control

14.10

KEY WORDS

Budget : A statement in financial terms, prepared prior to a defined period of time, showing the strategy to be pursued during that period for the purpose of attaining a given objective. Budgeting: Art of building budgets. Budgetary Control: The establishment of budgets relating to the responsibilities of executives to the requirements of a policy, and the continuous comparison of actual with budgeted results, either to secure by individual action the objective of that policy or to provide a basis for its revision. Budget Manual: A document, which sets out, inter alia, the responsibilities of the persons engaged in the routine of and the forms and records required for budgetary control. Master Budget: Summary budget, incorporating all component functional, budgets, which are finally approved, adopted and employed. Fixed Budget: A budget designed to remain unchanged irrespective of the level of activity actually attained. Flexible Budget: A budget designed to change in accordance with the level of activity actually attained. Performance Budget: A budget, which specifies the outputs or results to be achieved along with the inputs or expenditure to be incurred during the budget period. Zero Based Budgeting: An operating planning and budgeting process which required each manager to justify his entire budget in detail from scratch. Decision Unit: A significant programme, individual department or unit or level of an organisation that can be analysed from the standpoint of decisions and funding. Decision Package: A programme with goals, activities, and resources along with a document that identifies and describes the programme in terms of its (i) goals, (ii) activities by means of which goals are to be achieved, (iii) benefits to be expected (iv) alternatives to the programme, (v) consequences of not approving the programme and , (vi) financial and manpower resources required.

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Financial and Investment Analysis

14.11

SELF-ASSESSMENT QUESTIONS / EXERCISES

1. What do you understand by 'Budgeting'? Mention the types of budgets that the management of a big industrial concern would normally prepare. 2. What is Budget? What is sought to be achieved by Budgetary Control? 3. What is the significance of' Budgetary Control' in modern business? 4. Outline a plan for Sales Budget and Purchase Budget. What considerations are necessary in the preparation of such budgets? 5. Distinguish between Master budget and Financial Budget. How does management make use of Master Budget 6. What is a `Flexible Budget' and how it is different from ` Fixed Budget'? 7. Explain the methods of forecasting cash requirements. 8. Sate whether each of the following statements is True of False

9. Fill in the blanks: a) b) c} d) e) f) g) h) A system by which budgets are used as a means of planning and controlling all aspects of a business .. is a budget designed to furnish budgeted costs for any level of activity actually attained. is a summary of all functional budgets in a capsule form. Budgetary control helps management to ................................................... Budget is an expression terms. of a business plan in financial

shows the anticipated sources and utilisation of cash. ....................................determines the priorities of functional budgets. A document which sets out the responsibilities of the persons engaged in the routine of and the forms and records required for budgetary control is called ..

90

i) j) k) l)

Cash budget is a .budget. ..is a budget which states the 'additional workers to be engaged in the factory. A budget which consolidates the organisation's overall plan is called.. Capacity Ratio x Efficiency Rate = ..

Budgeting and Budgetary Control

m) It is essential to determine the properand to have well defined . 10. i) ii) Choose the correct answer : Sales budget is a : (a) functional budget, (b) master budget, (c) expenditure budget. In the case of plant the limiting factor may be : (a) insufficient capacity, (b) shortage of experienced salesmen, (c) general shortage of power. iii) The difference between fixed and variable cost has a special significance in the preparations of : (a) flexible budget, (b) master budget, (c) cash budget. iv) The budget that is prepared first of all is : (a) cash budget, (b) master budget, (c) budget for the key factor. v) In case of materials, the key factor may be : (a) insufficient advertising, (b) restrictions imposed by quota, (c) low market demand vi) The budget which commonly takes the form of budgeted Profit and Loss Account and Balance Sheet is: (a) cash budget, (b) master budget, (c) flexible budget. 11. Prepare a materials budget of Bihar Udyog Ltd, based on the following information. The production orders of the products show the following consumption i) Consumption for a batch of 1,000 units of Rate per kg. Rs. 60 60 10 50 25 Total ii) Production (units) Product P Product Q 12,000 units 11,000 units Product P kg 50 10 6 4 70 Product Q kg 80 5 30 10 4 129 Material No. 1 2 3 4 5

12. Draw a Material Procurement Budget (Quantitative) from the following information: Estimated sale of a product is 20,000 units. Each unit of the product requires 3 units of material X and 5 units of Material Y.

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Financial and Investment Analysis

Estimated opening balance at the commencement of the next year: Finished Product Material X Material Y Material on order: Material X Material Y The desirable closing balances at the end of the next year: Finished Product Material X Material Y Material on order: Material X Material Y Q13. 2002 4,000 units 5,000 units 3,500 units 7,500 units 12,500 units 3,500 units 5,500 units 2,500 kgs. 6,000 units 10,000 units

Kashmir Valley Ltd. has submitted the following information : Sales Purchase Wages Other Expenses 7,500 10,000 12,000 12,500 12,000 7,500 9,000 9,000 8,000 11,000 12,000 12,500 2,000 2,500 3,0'00 2,000 2,500 2,250 2,750 2,500 2,000 3,000 3,500 4,250

January February March April May June July August September October November December

40,000 50,000 60,000 70,000 50,000 30,000 35,000 40,000 30,000 50,000 60,000 65,000

20,000 30,000 40,000 40,000 30,000 20,000 15,000 15,000 20,000 25,000 30,000 35,000

The company is engaged in the manufacture of furniture. It recently purchased machinery worth Rs. 50,000 on 1st April, 2003 on deferred payment basis with interest at 12% per annum with the stipulation that the principal is repayable in four quarterly equal installments beginning from April, 2003 and thereafter interest to be paid as at the end of each quarter, i.e. in July, October and January. The company has been carrying deposits of Rs. 50,000 at 16% interest, payable on the last day of June every year. About 40% sales are made on cash basis. A credit period of two months is allowed for sales on credit. Closing cash balance as on 31st March 2003 is projected at Rs. 5,250. Cash discount of 5 % is available if creditors are paid within one month, but not later. The company has been advised by its consultant to maintain minimum cash balance of Rs. 2,500 for day-to-day cash requirements.

92

As the Financial Controller of Kashmir Valley Ltd., please prepare a cash budget for the quarter April to June 2003.

14.

Production cost of a factory for a year is as follows: Direct Wages Direct Materials Production overheads, fixed Production overheads, variable Rs. 80,000 1,20,000 40,000 60,000

Budgeting and Budgetary Control

During the forthcoming year, it is anticipated that: a) b) c) Average rate for direct labour remuneration will fall from Rs. 3 per hour to Rs. 2.50 per hour; Production efficiency will remain unchanged; and Direct labour hours will increase by 33 1/3 %

The purchase price per unit of direct materials and of the other materials and services which comprise overheads will remain unchanged. Draw up a budget and compute a factory overhead rate, the overheads being absorbed on a direct wage basis. 15. ABC Co. wishes to arrange overdraft facilities with its bankers during the period April to June when it will be manufacturing mostly for stock. Prepare a Cash Budget including the extent of bank facilities the company will require at the end of each month for the above period from the following data. a) February March April May June b) Sales 1,80,000 1,92,000 1,08,000 1,74,000 1,25,000 Purchases 1,24,800 1,44,000 2,43,000 2,46,000 2,68,000 Wages 12,000 14,000 11,000 10,000 15,000

50 per cent of credit sales is realised in the month following the sale and the remaining 50 per cent in the following second month. Creditors are paid in the month following the month of purchase. Cash at bank on the 1st April (estimated) is Rs. 25,000. Jammu Manufacturing Company Ltd. is to start production on 1st January 2004. The Prime cost of a unit is expected to be Rs. 400 out of which Rs. 160 is for materials and Rs.240 for labour. In addition, variable expenses per unit are expected to be Rs. 80 and fixed expenses per month Rs.3,00,000. Payment for materials is to be made in the month following the purchase. One third of sales will be for cash and the rest on credit for settlement in the following month. Expenses are payable in the month in which they are incurred. The selling price is fixed at Rs.800 per unit. The number of units manufactured and sold are expected to be as under: January February March 9,000 12,000 18,000 April May June 20,000 21,000 24,000

c) 16.

Draw a cash budget showing requirements of cash from month to month.

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Financial and Investment Analysis

17.

The Sudershan Chemicals Ltd., operates a system of flexible budgetary control. A flexible budget is required to show levels of activity at 70%, 80% and 90% The following is a summary of the relevant information: Sales based on normal level of activity of 70 % (3,50,000) units at Rs. 200 each. If output is increased to 80% and 90% , selling prices are to be reduced by 2.5 % and 5 % of the original selling price respectively in order to reach a wider market. Variable costs are Rs. 100 per unit (70 % is the cost of raw material). In case output reaches 80 % level of activity or above the effective purchase of raw material will be reduced by 5% Variable overheads: Salesman's commission is 2 % of sale value. Semi-variable overheads (total) at 3,50,000 units are Rs. 1,20,00,000. They are expected to increase by 5 % if output reaches a level of activity of 80 % and by a further 10% if it reaches the 90 % level. Total fixed overheads are Rs. 2,00,000 which is likely to remain unchanged up to 100% capacity. Calculate: (a) Efficiency Ratio (b) Activity Ratio (c) Capacity Ratio from the following figures: Budgeted production Standard hours per unit Actual production Actual working hours 880 units 10 750 units 6,000

a)

b)

c) d)

e) 18.

Answers to Self-assessment Exercises

8 (a) F, (b) F, (c) T, (d) F, (e) T, (f) F, (g) T, (h) F, (i) F. is called budgetary control Flexible Budget Master Budget plan and control for some specific future period Cash budget Principal budget factor is termed Budget Manual Short-term Labour Procurement Budget Master Budget Activity Ratio Budget Period, Responsibility Centre.

9. a) b) c) d) e) f) g) h) i) j) k) 1) m)

10. (i) a; (ii) a; (iii) a; (iv)c; (v) b; (vi) b; Material No Qty. (Kg.) Amount (Rs.) 12. Units to be procured X: 65,000; Y: 1,07,000 13. Closing balance April Rs. 2,250 May Rs. 2,500 June Rs. 2,500 1 1,480 88,800 2 175 10,500 3 330 3,300 4 182 9,100 5 92 2,300

94

14. 15.

Cost of production Rs. 3,08,889, Production overhead rate 112.5 %. Closing balance (Overdraft) April (Rs. 56,000) May (47,000) June (1,67,000)

Budgeting and Budgetary Control

17. 18.

Budgeted Profit: 70 % : Rs. 214 lakhs. 80 % : Rs. 250.4 lakhs, 90 % : Rs. 269.65 lakhs. (a) 125%; (b) 85.23%; (c) 68.18%.

14.12 FURTHER READINGS

Arthus, J. Keown, .1. William Petty, John D. Martin, David, F. Scott, 10-14-2002, Foundation of Finance : The Logic and Practice of Financial Management, Prentice Hall : New Delhi (Chapter 14) Horngren Charles T. Sundem Gary L. Stratton William, O. Introduction to Management Accounting, 11 th ed (Part 2); Prentice Hall of India : New Delhi McAlpine, T.S. 1976. The Basic Arts of Budgeting, Business Books (Chapter 2, 6, 7, and 9). Moor, Carl L. and Robert K. Jaedicke. 1976. Managerial Accounting, South Western Publishing Co., (Chapter 17 and 18). Chandra, Prasanna, 1985. .Managers' Guide to Finance and Accormting, Tata McGraw-Hill: Delhi (Chapter 8 & 24). Prem Chand. 1969. Perjbrniance Budgeting, Academic Books: New Delhi. Pyhrr, Peter A 1973. Zero Base Budgeting, John Wiley & Sons: New York. Maheshwari, S.N. 1987. Management Accounting and Financial Control, Sultan Chand: New Delhi.(Section C, Chapter 1).

AUDIO/VIDEO PROGRAMME
Audio Emerging Horizons in Accounting & Finance - Part I: Zero Base Budgeting Video Management Control Systems: Part I & II

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Financial and Investment Analysis

UNIT 15
Objectives

INVESTMENT APPRAISAL METHODS

The objectives of this unit are to: develop an appreciation for the need for proper investment appraisal familiarise you with various methods of appraising capital projects, including their relative merits and demerits introduce some other concepts relevant in investment appraisal.

Structure
15.1 15.2 15.3 15.4 15.5 15.6 15.7 15.8 15.9 15.10 15.11 15.12 Introduction Types of Investment Proposals Need for Appraisal Project Report Methods of Appraisal Depreciation, Tax and Inflows Cost of Capital Limitations of Investment Appraisal Techniques Summary Key Words Self Assessment Questions/Exercises Further Readings

15.1

INTRODUCTION

One of the aspects of financial management is proper decision-making in respect of investment of funds. Successful operation of any business depends upon the investment of resources in such a way as to bring in benefits or best possible returns from any investment. An investment can be simply defined as expenditure in cash or its equivalent during one or more time periods in anticipation of enjoying a net inflow of cash or its equivalent in some future time period or periods. An appraisal of any investment proposal is necessary to ensure that the investment of resources will bring in desired benefits in future. If the financial resources were in abundance, it would be possible to accept several investment proposals, which satisfy the norms of approval or acceptability. Since resources are limited, a choice has to be made among the various investment proposals by evaluating their comparative merit. This would facilitate the identification of relatively superior proposals keeping in mind the limited available resources. It is apparent that some techniques should be followed for making appraisal of investment proposals. In this unit we shall describe the various appraisal methods and acquaint you with their relative merits so that you could identify the appropriate method for appraising investment proposals in different situations.

96

15.2 TYPES OF INVESTMENT PROPOSALS

According to the terminology used in financial management the terms `investment decision', `investment projects' and 'investment proposal' are generally associated with application of long-term resources. What is a `long terra'? There is no hard and fast rule to define it, but by common practice and in accordance with the financing policies, practices and regulations of the financial institutions and banks a period of ten years and above is generally treated as long term. Thus all proposals or projects involving investment of funds for a period often years or more will fall in the category of investment proposals. Long-term investment of funds may be generally needed for the following purposes. Expansion of operation Diversification in operations Replacement/Modernisation of plant and machinery Research and Development

Investment Appraisal Methods

Expansion A manufacturing unit, for example, is presently producing one-lakh units per year. If it intends to double the production this will obviously increase the need for funds. The variable cost in aggregate will increase. Accordingly, the current assets will increase. Thus the financial resources required for working capital will have to be increased. In case the production carried so far was less than the capacity, no additional investment of funds is needed for long term. In case the existing infrastructure-plant, machinery and other permanent or fixed assets-is inadequate, the proposal for doubling the production will involve additional investment of funds for long term. It must, however, be noted that the financial needs for such a project will include not only expenditure on fixed assets but also an increase in working capital. Diversification The management of an enterprise such as the Indian Tobacco Company (ITC), as it happened, decided to diversify its production into other lines by adding to its original business a new area of hoteliering. Philips, famous for radio and electric bulbs etc., diversified into production of other electrical appliances and television sets. This process of diversification would involve use of large financial resources for longterm investment. Replacement Machines used in production may either wear out or may be rendered obsolete on account of new technology. The productive capacity of he enterprise and its competitive ability may be adversely affected. Some funds maybe needed for modernisation of a certain class of machines or for renovation of the entire plant or building etc. To make them more efficient and productive. Modernisation and renovation will be a substitute for total replacement. Funds will obviously be invested for long-term. Where renovation/modernisation is not desirable or feasible, funds (obviously larger amounts) will be needed for replacement. Research and Development There has been a growing realisation that the efficiency of production and the total operations can be improved by application of new and more sophisticated techniques of production and management. New technology can be borrowed or developed. There is a greater realisation that investment of funds (obviously long term and large amounts) in constant research is very useful. productive and ultimately profitable though there may be no immediate benefits or returns from such investments.

97

Financial and Investment Analysis

Activity 15.1 Try to look for the expenditure of capital nature incurred by your organisation over the last 3-5 years. What necessitated this expenditure? Identify the nature of this expenditure in terms of the purposes mentioned in the above section. You may like to talk to a knowledgeable person in your organisation regarding the basis of the decision and the factors that went into it. .

1.5.3

NEED FOR APPRAISAL

You must have observed that the investment proposals: (i) involve large amount of funds (ii) involve greater amount of risk on account of unforeseen situation and (iii) often mean irreversibility once the investment decision is made. In view of these the task of appraising investment proposals is very important in financial management.

15.4

PROJECT REPORT

Preparation of a project report is a complicated process. It includes not only the projections of financial data related to outflow and inflow of cash, but also a meticulous exercise to assess the following aspects: Potentiality for the marketing of the project Technical feasibility of the project Availability of managerial skills Environmental impact Financial viability

In this unit we are mainly concerned with only the financial aspects for the appraisal of an investment proposal.

Relevant Data
The following need to be considered before appraisal is taken up: The amount and timing of initial investment outlays The amount and timing of subsequent investment outlays The economic life of the project

Salvage value at the end of the project The amount and timing of cash inflows

1. Initial Investment Outlays 98

This covers the total cash required to implement the proposal. It includes expenditure on design, survey, consultancy fees and the working capital costs, such as costs of

maintaining stocks, contingency reserves to cover the cost of supporting additional debtors. Benefit of credit from suppliers will have the effect of reducing the quantum of additional working capital required. 2. Subsequent Investment Outlays The cost of maintenance, replacement and updating exercises are to be treated as outflows during the period in which they are expected to be incurred. 3. Economic Life of a Project The economic life of a project is to be distinguished from the life of an individual asset. A building may have a life of sixty years, plant may have a life of fifteen years and some equipment may have a life of five years only. The economic life of the project is determined by the duration of the `earnings flow' generated by the project. The economic life may end: a) When the cost of replacement or renovation becomes uneconomical in relation to the likely benefits; b) c) d) When the viability of the project is adversely affected due to obsolescence, When rising maintenance costs exceed the estimated disposal value; and When the development of new technology necessitates new investment.

Investment Appraisal Methods

4. Salvage Value Some equipments may have some value for the enterprise at the end of the life of the project or there may be an anticipated sale value of the equipment. Such amount is to be treated as an inflow at the end of the life of the project. 5. Operating Cash Flows Three main areas are to be considered here: a) Sales revenue: It is a function of sales volume and unit selling price. Any miscalculation of sales revenue may have a crucial impact on appraisal of an investment proposal. In assessing any investment opportunity, the additional or incremental revenues generated by it need to be considered. Investment may also be undertaken to reduce operating costs. For instance, an existing plant and machinery or equipment may be replaced by a newer model, which is more economical to operate. The new piece of equipment may either be more efficient (or more productive) or it may require relatively less consumption of electricity or maintenance costs, etc. It has to be noted that the ultimate impact of cost-saving equipment is the same as that of the new equipment for building up additional capacity, that is , the overall revenue is increased. b) Production costs: A distinction between fixed and variable costs will be very meaningful to anticipate the likely behaviour of costs. Only incremental costs have to be considered. c) Other direct costs: These costs will cover selling and promotion costs and additional rent, etc. The net inflow/outflow of cash can be worked out by allocating the aforesaid items period-wise. It may appear to you that in order to make an appraisal regarding the financial viability of an investment proposal, or to make a choice between two proposals, it will be enough to find out the net cash flow, that is the difference between total outflow (amount to be invested) and the inflow (net of Sales Revenue Expenditure + Salvage Value).

99

Financial and Investment Analysis

See for example the following situation: Illustration 15.1 Year Net Cash Flows (Rs. 000) A 0 1 2. 3 4 5 Total 40 150 200 220 230 370 1210 B -360 200 '300 400 450 600 1590

The preceding illustration tells us only that proposal B generates a total cash flow of Rs. 15,90,000 whereas proposal A brings in only Rs. 12,10,000. This alone does not help us in arriving at any appropriate decision, unless we know the total investment needed for each of them the time value of money and the desired acceptable rate of return on investment. Hence it will be useful to examine a few methods of assessing the return on investment.

15.5

METHODS OF APPRAISAL

The main methods used for evaluating investment proposals are: Pay Back Period Accounting Rate of Return

Discounted Cash Flow

Net Present Value Internal Rate of Return Profitability Index

Pay Back Period

In simple terms it means the total period within which the total amount invested will be recovered throughout net cash flow (after tax). Suppose a sum of Rs. 5 lakh has to be invested in a project whose expected net cash flows are as follows: Illustration 15.2 Incremental Cash Flow (Rs. 000) Year Annual (-) 500 1 2 3 4 5 185 125 140 170 180 Annual Cumulative (-) (-) (-) (-) (-) 500 315 190 50 120 300

100

It is apparent that the total money invested is Rs. 5 lakh which is shown as a negative cash flow. This could be recovered during the fourth year. To be exact, the payback period is 3.29 years (i.e., three years and three and a half months approx.), as calculated below:

Investment Appraisal Methods

P=E+
where

B C

P stands for payback period E stands for number of years immediately preceding the year of final recovery B stands for the balance amount still to the recovered C stands for cash flow during the year of final recovery

Anybody can say that shorter the period the better it is. Early and certain results are better than more uncertain long-term estimates. The Payback method is simple to calculate. The greatest weakness of this method is that it ignores the timing and amount of all cash inflows. It does not take any cognizance of the cash flows after the payback period. Thus, this method is not appropriate either for absolute or comparative appraisal. Let us observe the following example of two projects. Illustration 15.3 (Rs. 000) Project A Years 0 1 2 3 4 5 (-) Cash Cumulative Flow 700 100 200 300 400 500 Cash Flow (-) (-) (-) (-) 300 800 3.25 years 700 600 400 100 (-) Project B Cash Flow 700 400 300 200 100 Cumulative Cash Flow (-) (-) (-) (-) 300 2 years 700 300 0 200

Payback period

In both cases the investment is Rs. 7 lakhs, which is shown as negative cash flow in zero year. It is apparent that the payback period is shorter for project B and as such. it may be preferred. Project A, being a slow starter in cash flows, is likely to be rejected. As we noted earlier, this method ignores the total benefits or cash inflows generated by projects. In this particular illustration, Project A generates cash flows for a period longer than B. Project B brings in returns for a lesser number of years and that too at a decreasing rate. The payback method thus concentrates only on the liquidity aspect and ignores the overall profitability of the project. It would be better not to depend solely on this method because it is simple. As this method does have some utility it need not be rejected totally but may be assigned the status of a secondary or subsidiary criterion. In this context, a maximum period of payback may be laid down and a project exceeding this period may not be entertained.

Accounting Rate of Return

This method of working out the rate of return on investment is based on the financial accounting practices of the company for working out the annual profits. The net annual profits are derived after deducting depreciation and taxes. The average of

101

Financial and Investment Analysis

annual profits thus derived is worked out on the basis of the period (number of years) of the life of the project. Illustration 15.4 (Amount in Rupees) Years (after tax) 1 2 3 4 5 Total Cash Flow 13,000 11,000 9,000 '6,400 6,000 45,800 Depreciation 6,000 6,000 6,000 6,000 6,000 30,000 Interest 400 .400 400 400 400 2,000

The investment is Rs. 30,000. Accounting rate of return will be equal to the average of net cash flow (after depreciation, taxes, and interest) as a percentage of investment

(45,800-30,000-2,000) 30, 000

1 5 = 9.2 Per cent

In the above illustration the calculation of the return is based on the original (initial) investment in the project, which is Rs. 30,000. Since the investment in this Illustration is a depreciable asset and is estimated to have five years of useful life with no salvage value, it could be argued that the investment base for calculating ARR ought to be average investment which would be one-half of initial investment, in this case Rs. 30,000/2 = 15,000. The ARR based on average investment would be:

(45,800-30,000-2,000) 15, 000

1 5 = 18.4 Per cent

It will be seen that where there is no salvage value and the average investment is onehalf the original investment, the rate of return will be double the rate calculated on the original investment. In the calculation of ARR, working capital is usually not considered. Any additional working capital needed, however, should betaken into account in calculating the fund requirements of new investment. This method like the Payback Method ignores the time value of cash flows since it does not give any recognition to the timing (1st year, 2 nd year and so on) of the generation of income. The timing of cash flow is an important variable in investment decision-making. Higher earnings in earlier years and lower earnings in later years cannot be taken at par with lower earnings in earlier years and greater earnings in later years. The ARR method thus suffers from a serious drawback by neglecting the quality or pattern of benefits and by ignoring the time value of money. Further, it does not take into account the scrap value of asset (or project) at the end of its useful life. Finally, the calculation of profit is subject to varying practices. The attempts at window dressing and manipulation of accounting data have a distorting influence on the calculation of profit and consequently on the ARR. All these factors make ARR a less reliable method.

102

Discounted Cash Flow (DCF)

This concept is based on the premise of the `time value of money'. The flow income is spread over a few years. The real value of a rupee in your hand today is much more than that of a rupee which you will earn after a year. Why is it so? It is the value of time. The future income, therefore, has to be discounted in order to be associated with the current outflow of funds in the investment. Two methods of appraisal of investment project are based on this concept. These are Net Present Value method and Internal Rate of Return method.

Investment Appraisal Methods

Net Present Value Method

Calculation of the net present value of future income can be related to the understanding of the compounded rate of interest or the general formula of compounding. Sup-pose a sum of Rs. 100 (P) is invested for a period of one year at a rate of interest (r) of 10 per cent per annum. The investment at the end of one year will be equal to (you can refer to Table 3 given at the end of this block):

r P 1+ 100

10 = 100 1+ 100 11 = 100+ 100 = 110

n =1

It can also be stated that Rs. 110 in one year's time is worth only Rs. 100 today. Applying the compounding formula over the number of years to work out the present value (PV) of a future flow of income the formula will be reconstructed as

PV =

P (1+r) n 100

Where P is the amount to be received in future (number of years = n) and r is the annual rate of interest. Suppose we want to know the PV of cash flow of Rs. 500 to be received at the end of five years discounted at 10% rate of interest. The PV will be:

P = 500
(r = 10) 1+ 100
n =5

= Rs. 310.5

Rather than spending your time on calculations, see Table 1 (given at the end of this block) showing the discount factor for 10% over a period of 5 years in respect of the present value of one rupee. It is 0.621. By multiplying it with the expected future income of Rs. 500 the PV of this income will be 500 x 0.621= Rs. 310.5 If a person were to receive a series of equal amounts over a period of

103

Financial and Investment Analysis

five years, say Rs. 1,000 every year, the present value of these receipts can be calculated as given below Years 1 2 3 4 5 Amount Rs. 1,000 1,000 1,000 1,000 1,000 Present Value Factor .909 .826 .751 .683 .621 Present Value Rs. 909 826 751 683 621 3790 The process of reducing future values according to the factors shown to determine the present value is called discounting. When the annual cash flows to be received over a period of time are equal in amount, as in the above case, a simple method of determining the present value is available through Table 2. Taking the above example, you could look in the 10 per cent column at the line for 5 years in Table 2 and find a factor of 3.790. Multiplying it by Rs. 1,000, you would find the present value to be the same i.e. Rs. 3,790 as determined by the longer method using Table I. Table 2. Contains factors which represent the present value of Rupee one received annually for the given number of years (this form of cash flows is commonly known as an annuity). You will realise that by discounting the expected annual returns for each year the project has been covered and not a few years' return as covered under Payback Method. By adding the PV of the annual inflow of cash for each year of the expected life of the project we come to know the PV of the aggregate of the inflows. This can easily be compared with the cash outflow needed today for investment. The investment proposal can be acceptable if the aggregate PV of cash inflow is more than the current outflow. The decision to accept or reject the proposal or to accept the superior one (with higher PV against the same investment) out of two or more proposals can be taken more rationally with the Discounted Cash Flow - Net Present Value Method. We may illustrate the method by comparing two projects. Illustration 15.5 Project Initial Net Cash Income (before depreciation but after Tax) (Rs. in Thousand) Year Rs. A B 20,000 20,000 1 4 8 2 4 6 3 4 2 4 8 2 5 2 2 2' 2 8 2

If the present value of the stream of net cash income exceeds the capital outlay, the firm can be assured of a surplus. When alternative projects are being considered, that project which has positive (or highest) net present value will be selected.

104

Project A Year Net Cash Income Rs. 4000 4000 4000 8000 2000 Discount Factor* 0.935 0.873 0.816 0.763 0.713 PV Rs. 3,740 3,492 3,264 6,104 1,426 18,026 20,000 (1,974) Net Cash Income Rs. 8000 6000 2000 2000 2000 2000 2000 2000

Project B Discount Factor* 0.935 0.873 0.816 0.763 0.713 0.666 0.623 0.582 PV Rs.

Investment Appraisal Methods

1 2 3 4 5 6 7 8

7,480 5,238 1.632 1.526 1.426 1.332 1.246 1.164 21,044 20,000 1,044

Total Present Value Initial Cost Net Present Value

* Refer to Table 1 (at the end of the book) One important point should not escape your notice. In working out the NPV we used a discounting rate (in our Illustrations the rates were 10 per cent and 7 per cent), which is also known as the `cutoff' rate or `hurdle' rate or `required rate of return'. The discounting rate is particularly needed when more than one-investment proposals is to be appraised and the funds available for investment are not sufficient to accommodate all the proposals. Is the discounting rate chosen arbitrarily or is there any basis for its selection? Should it be the rate at which the firm would borrow or lend money, or should it be the current rate of return on capital employed? A business enterprise may set a target rate of return for appraising investment, which ordinarily would not be less than the cost (or interest rate) of funds needed for investment. It may however be stated that monetary interest rates do not reflect the additional risks which may be borne by the business. Logically speaking, therefore, the firm should select that rate of interest, which most adequately represents the risk of the project, i.e. a rate that is presumably close to, if not exactly equal to, the overall rate of return on capital employed. We shall further deal with this subject under `Cost of Capital' a little later. Apart from recognising the time value of money the NPV method considers total benefits of a proposed project over its life. This method is particularly useful for the selection of mutually exclusive projects. The method is in line with the objective of financial management i.e. maximization of the wealth of shareholders. The acceptance of the proposals with positive net present values are expected to have a positive impact on the market prices of shares. Compared to pay back or ARR methods, NPV method is difficult to calculate and understand. What discounting rate is to be used in calculating present values may be difficult to decide. The selection of a particular discounting rate has a crucial effect on the desirability of a project. With a change in rate, a desirable project may turn into an undesirable one and vice-versa. As will be observed in a subsequent section, cost of capital is generally adopted as the basis for the discount rate. Further, NPV is an absolute measure. For projects involving different outlays the NPV method may not give dependable results. It may also not give satisfactory results where the

105

Financial and Investment Analysis

projects under competition have different lives. Other things being equal, a project with shorter pay back would be preferable. Activity 15.2 a) How much money would you have to deposit in a savings account today in order to have Rs. 4,000 in that account at the end of five years if the bank pays a 5 per cent return calculated half-yearly? How much would you have to deposit if you wanted to have Rs.10,000 after five years. How much money would you have in a Fixed Deposit Account after seven years if you deposit Rs. 1,000 today and the bank pays, an 11 per cent rate annually? How much would you have after seven years if you deposit Rs.4,500 today? Suppose you have won a prize in a lottery, you have the opportunity to pick one of the two prizes?

b)

c)

Prize A: Rs. 50,000 a year for the next ten years, paid on December 3 1 of each year. Prize B: Rs. 2,50,000 cash paid today, January 1 Assuming both prizes are tax-free and that you can earn an interest of 6 per cent per annum on your money (also tax-free), which prize would you pick? Which prize would you pick if you could earn 10 per cent on your money? At about what interest rate would you consider the two prizes to be of equal value to you? Internal Rate of Return You have already observed the superiority of the Discounted Cash Flow technique over the Payback Period and the Accounting Rate of Return methods. The main point of difference is the recognition of the tune value of future inflows in the former. The Internal Rate of Return is another method under the Discounted Cash Flow technique which is used for appraising the investment proposals. Under this method, we derive the discounting rate at which the aggregate of the PVs of all future cash inflows equals the present cash outflows for the proposal. The following illustration will make it clear for you. Illustration 15.6 Present Value of Net Cash Flow Year Net Cash Flow At Discount Rate 20% Discount Factor* 0 1 2 3 4 5 100 40 35 30 25 20 1.000 0.833 0.694 0.579 0.482 0.402 Rs. 100.00 33.30 24.30 17.40 12.10 8.00 (-) 4.90 *See Table 1 At Discount Rate 10% Discount Factor* 1.000 0.909 0.826 0.751 0.683 0.621 (-) Rs. 100.00 36.40 28.90 22.50 17.30 12.40 17.30

106

From the above illustration you will realise that at the discount rate of 20 %, the aggregate of the PVs (Rs. 95.10) of future cash inflows is Rs. 4.90 less than the current outflow of each investment of Rs. 100. At discount rate of 10 %, the

aggregate of PVs of future cash inflows is Rs. 17.30 more than the initial cash outflow. In order to equate the inflows and outflows, the rate of discount will be located by interpolation between the two aforesaid rates of 20% and 10 %: This can be done as shown below. Thus the two inflows will be equal if a discount rate of 17.8% is applied. Obviously if this discount rate is higher than the target rate or the interest rate used to work out the cost of funds, the investment project should be acceptable.

Investment Appraisal Methods

IRR = LRD +
Where

(NPVL) R PV

IRR is the Internal Rate of Return LRD is the Lower rate of discount NPVL is the Net Present Value at lower rate of discount (i.e. differences between present values of cash inflows and present value of cash outlay or outflows). PV is the difference in present values at lower and higher discount rates R is the difference between two rates of discount Substituting the values, we get:

IRR = 10+

(17.30) 10 = 17.8 (22.20)

IRR through Payback Reciprocal

The calculation of IRR involves a trial and error procedure, which is tedious and time consuming. This problem can be overcome by using reciprocal of payback, which is a good approximation of the IRR. The method can be used in both the cases where a fixed cash flow is received over the life of the asset and where varying cash flows are received. Where cash inflows are constant (or the same) every year (called annuity): The procedure to calculate IRR is as under: i) ii) Determine the pay back period of the proposed project Look for the factor closest to the pay back period in the year row of Table 2 (the present value of annuity). The relevant year for the purpose would be equivalent to the life period of the project. For instance, if the life of the project is 6 years and its pay back period is 4 years, then we have to look for the factor closest to 4.000 for the year 6 in Table 2. According to Table 2 the factor closest to 4.0 for 6 years are 3.998 (13 % rate of interest) and 4.111 (12 % discount rate). The value closest to 4.0 is 3.998. Therefore, the actual value lies between 12 and 13 per cent, tilting on the side of 12 per cent. This value can be calculated by interpolation as shown in Illustration 15.6.

Where the stream of cash flows is of varying nature: The calculation of IRR under such circumstances is a little more difficult. The way to simplify the process is to use a `fake annuity' as a starting point. The following procedures may be followed: i) Calculate the average annual cash flows to get a fake annuity.

ii) Determine `fake payback period' by dividing the initial outlay with the average annual cash flows after taxes (CFAT) as calculated in step (i). iii) Look for the factor in Table 2 closest to the fake payback period in the same manner as in the case of annuity.

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Financial and Investment Analysis

iv)

Adjust the IRR obtained in step (iii) by comparing the pattern of average annual cash flows as per step (i) to the actual varying stream of cash flows. If the actual cash flow stream happens to be higher in the initial years of the project's life than the average stream, adjust the IRR a few percentage points upward. Conversely, if in the early years the actual cash flow is below the average, adjust the IRR a few percentage points downward. Find out the present value of the uneven cash flows, taking the IRR as the discount rate as estimated in step (iv) by using Table 1. If by chance, the PV of CFAT equals the initial outlays, you have arrived at the right IRR. Otherwise repeat step (v), that is, if you have not struck the right rate of IRR. The net present value will either be positive or negative. If it is positive, work for another rate (i.e. higher rate) which will turn it into a negative figure. If the NPV is negative, work for another rate (i.e. lower rate) which will turn it into a positive figure., When two consecutive discount rates have been found out one of which causes the NPV to be positive and the other causes it to be negative, the actual IRR can be ascertained through the process of interpolation as explained in Illustration 15.6.

v) vi)

In short, therefore, whether the cash inflows of a project are the same each year or are different, you should select two discounting rates in such a manner that the NPV result of the lower rate of discount is a positive amount and the NPV result of the higher discounting rate is a negative amount. You can then apply the interpolation formula and arrive at the correct IRR. If you are strong enough in your intuition and can, with a little effort, guess the two consecutive discounting rates, you need not even bother about what is mentioned in part (b) of the above discussion (viz., when the stream of cash flows is of varying nature). IRR, like the NPV, takes into consideration time value of money and also the total cash inflows and outflows over the entire life of the project (asset). For managers it is easier to understand, as the calculation is always a percentage and not an absolute amount as under Net Present Value method. An added advantage is that it does not require a discounting rate. The method itself provides a rate of return. If projects are chosen with IRR greater than the required rate of return, the method would lead to the realisation of the objective of maximization of wealth of the shareholders. However, IRR requires tedious calculations (based on trial and error procedure or interpolation), as you must have already noted. Under the IRR method it is assumed that cash flows are reinvested at the same rate as IRR. This also implies that if IRR of two projects is say 16% and 20%, the cash flows arising from these two projects will also be reinvested at their respective rates i.e. 16% and 20%. The reinvestment of cash flows at two different rates within the same company may sound rather unrealistic. Whether cash flows from projects would be reinvested in the company or used for other purposes may depend on several factors. In some cases the Cash generated may not be used internally. Activity 15.3 An administrator of a hospital is considering a proposal to purchase a new machine. that will aid productivity in the X-ray department. The machine will cost Rs: 13,791 now and is expected to have a five-year useful life and a zero disposal value, and will result in operational savings of Rs. 4,000 annually. The hospital is not subject to income taxes. The administrator has two alternatives; alternative A is to continue to operate the Xray department without change (i.e. do nothing). Alternative B is to buy the new machine, which will reduce hand processing. Because no change in revenue is indicated, the cash savings is the difference between the cash operating costs under two alternatives.

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1.

Compute the project's expected net present value. Assume that the required rate of return (also referred to as the minimum desired rate of return or hurdle rate) is 6 per cent. (The relatively low interest rate is not unusual for a nonprofit institution). Compute the expected internal rate of return on the project.

Investment Appraisal Methods

2.

Profitability Index It may at times be observed that if we use Internal Rate of Return method, a proposal may be rejected because the IRR is less than that of the other one but actually the former may not be a bad proposal if NPV is worked out by the target rate of discount. Project Cash outflow in year 0 Cash inflow per annum for 5 years Rs. 15,000 20,000 IRR % NPV at 10% Rs.

A B

50,000 68,000

15.4 14.4

6,850 7,800

If the organisation has to, choose one of the two projects and it uses the IRR criterion, Project B will be rejected because it has lower IRR. On the other hand, if it uses a - target rate of 10 % , project B will be selected as it has higher NPV. However if target rate of 15 % is used, Project A will be selected as it looks better. You can yourself compute the figures and verify the results. It has been explained earlier that if the PV of aggregate future cash inflows is higher than the present cash outflow by way of investment, the investment proposal is good. If we have to choose, between two proposals then the better proposal will be the one where the excess of discounted cash inflows over the cash outflow is larger. Illustration 15.8 Proposal A B PV of total inflows Rs. 4,50,000 1,20,000 Outflows Rs. 4,00,000 1,00,000 Surplus Rs. 50,000 20,000

Apparently, proposal A appeals because the net surplus over cash outflows is larger than in case of B. Please note that we are ignoring a very significant point and it is the `rate of return on investment'. The quantum of inflow is irrelevant unless it is viewed against the total amount of investment. Now by applying simple method of calculating rate of return we find that in case of A the return on investment is

50,000100 4,00,000 20,000100 1,00,000

= 12.5 per cent, whareas in case of B it is = 20 per cent. Now it can be rationally stated that proposal B is superior to A.

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The Profitability Index (PI) is the relationship between the present values of net cash inflows and the present value of cash outflows. It can be worked out either in unitary or in percentage terms. The formula is:

Profitability Index =

Present Value of Cash inflows Present Value of Cash outflows

If we apply this formula to the Illustration we find that profitability index for each of the two proposals is:
A B 4,50,000 4,00,000 = 1.125 or 112.5% 1,20,000 1,00,000 = 1.20 or 120%

You will find that the result is identical as per the rate of return on investment calculated earlier. Proposal B, therefore, is superior. Now, a question may be asked. If the result under both the aforesaid methods is identical, then why have two methods? Please note that in case there is a `cut off rate' prescribed by the management for approving investment proposals, a proposal will not be approved if the rate of return is less than the `cut off rate' or the minimum expected rate of return. The profitability index in the absence of a cut off rate may appear to have no relevance. However, if two or more investment proposals qualify this test, a choice may have to be made among these proposals because of resource constraints. Hence for choice making, a proposal with high profitability index may be approved. In case there is no basic cut off rate the profitability index can again be regarded as a good guide for choice making.

15.6 DEPRECIATION, TAX AND INFLOWS

It must be made clear that depreciation is excluded from Discounted Cash Flow (DCF) computations. A common error is to discount cash flows obtained after deducting the amount of depreciation. This type of error, in fact, shows lack of understanding of the basic idea involved in DCF. The DCF approach is fundamentally based on inflows and outflows of cash and not on the accrual concept of revenues and expenses. Depreciation does not involve any cash flow. It is merely a book entry to allocate the cost of the asset over its useful life. It has of course the effect of reducing the disposable income. In the DCF approach, the initial cost of an asset is usually regarded as a lump sum outflow of cash at time zero. The cash inflows in our illustrations are assumed to be after income taxes. Depreciation, as you have noted, is not a factor in discounted cash-flow techniques. Nevertheless, depreciation has some bearing on the annual cash flows because of its connection with income tax. Probably, you are aware that depreciation is deductible as a regular business expense in the determination of the income tax payable. Because depreciation does not require the repeated outlay of cash over the useful life of the asset, it does not reduce the cash earnings from a particular investment. But the incremental earnings from such an investment are taxed at the prevailing rate, and the incremental tax payments (paid in cash) reduce cash earnings. Since depreciation on the asset is a tax deduction, it reduces the tax payment. It thus acts to `shield' part of the cash inflow from the tax burden.
Illustration 15.9

110

Newlook company has the opportunity to purchase a piece of automatic equipment whose original cost is Rs. 12,000. Assuming the annual cash savings from using the automatic equipment to be Rs.5,600 before taxes, depreciation (straight line)-Rs.2,400

(based on the initial cost of Rs. 12,000), no salvage value, five-year life and the tax rate of 50 per cent, calculate cash inflow after taxes.
Tax Purpose Cash inflow

Investment Appraisal Methods

Gross annual cash cost savings Less : Depreciation Net incremental income subject to tax Income tax at 50% (payment in cash) Net cash inflow after taxes

Rs. 5,600 2,400 Rs. 3,200 1,600

Rs. 5,600

1,600 Rs. 4,000

Had depreciation not been deductible, the income tax on Rs.5,600 would have been Rs.2,800 and the net incremental cash inflow Rs. 2,800. As it is, Rs. 1,200 of cash flow is retained; the tax rate (50 per cent) applied to the depreciation deduction (Rs. 2,400) is thus regarded as a `tax shield'.

15.7 COST OF CAPITAL

The net present value techniques for investment appraisal require the use of a desired minimum rate of return which as you have already noted, is also called the hurdle rate, discount rate, required rate of return, or the cost of capital. The rate of return a project is expected to give should be at least equal to the opportunity cost rate, which is determined by what can be earned if the funds were invested elsewhere with similar risk. In general, the riskier the project the higher the expected rate of return. Thus, each investment opportunity could have its own rate of return or cost of capital depending on its risk. In this context it will not be illogical to push up the Required Rate of Return (RRR) as the risk increases. The RRR in fact can be taken as the sum of the risk-free rate of interest plus a risk premium. In financial management, we often separate the investment and the financing decisions. We expect each investment project (with risk equal to the average for the firm) to earn a rate of return equal to at least the average cost of capital for the firm. Basically, there are two ways in which the desired minimum rate can be established. l. The rate could be based on the operating performance of the company itself or the industry with which it is associated.

2. The rate could be based on the company's cost of funds. Obviously, the former method is more subjective. Management may regard its own operating experience as a satisfactory standard to be used for undertaking new capital projects. If industry experience is better, management may decide to adopt this higher level for goal-getting purposes. In some cases, it may be the wish of management to set a desired ate for cut-off purposes which is independent of either and reflective of a level of future profits (i.e. the target rate) intended to improve on both. Cost of funds (or capital), on the other hand, places the minimum level at a point determined by what it costs the company for money in the market. Various methods are available for determining the cost of capital. The cost in the form of interest rate for borrowed funds (debt, loans or bonds) is fairly obvious and determinable. The cost of preference shares is the fixed dividend payable on them. The cost of equity funds is often less clear. The stated rate of dividends on preference shares may not be a proper guide to the cost of this type of capital, because preference stock bears many of the same characteristics as borrowed funds.

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A difficult problem therefore lies in the treatment of common shareholders equity, particularly retained earnings. You could probably say that capital from this source has no cost, being internally generated. This thinking, however, may not be valid. The more persuasive argument is that earnings retained in business have an opportunity cost. If this part of capital cannot earn a satisfactory return by being ploughed back into the operations of the business, it ought to be paid to the shareholders in the form of dividends. One measure of this opportunity cost is the average return which share-holders would have earned on their dividends (after personal income taxes) if the company had not retained profits but had distributed them in dividends (or additional dividends) and the shareholders had invested them. The shareholders have to forego these returns if funds are retained in the business instead. When a company's shares are listed on a stock exchange, the market price will usually reflect the earnings per share (after taxes) currently being earned by the company. The company's practice with respect to dividend payment and retention of earnings will also have an influence on the market price. Thus, one method of determining the cost of common equity capital for the firm with listed shares is to relate its earnings per share to the market value of the stock. The company's cost of capital is a dynamic thing, affected by its current capital structure, its financing plans for the future and any changes in its rate of earnings. To determine an average cost of capital for firm it is necessary to include some provision for capital structure, the expected cost of borrowed funds, and the market-established cost of equity capital.
Illustration 15.10

Assume that a company has 40 per cent of its capital structure composed of debentures (with 14 per cent interest) and 60 per cent of equity shares which show a market value of Rs. 25 per equity share, reflecting current earnings per share (after taxes) of Rs. 7. Cost of capital determined by weighted average would be:
Type of capital Weight After-tax rate Weighted average

Debentures Common stock

40% 60% 100%

7 28 -

2.8% 16.8% 19.6%

In this calculation, the rate of 7 per cent for debentures is the effective cost of interest after taxes, since interest is a deductible expense for tax purposes (i.e. 14 per cent rate before taxes x .50 per cent assumed tax rate). The effective rate of 28 per, cent for common stock (Rs.7 earnings per share/Rs.25 market price) is also taken after takes, so the weighted average of 19.6 per cent is an after-tax rate. In this case, management presumably would reject capital penditure proposals promising less than 19.6 (or say 20) percent return after taxes. Acceptance of those indicating higher returns would, of course, be subject to whatever other constraints management might impose, such as total budget limitations. The RRR or cost of capital thus plays a crucial role in determining the acceptability of an investment proposal.

15.8 LIMITATIONS OF INVESTMENT APPRAISAL TECHNIQUES

112
The investment appraisal techniques appear to be exact. However, it has to be appreciated that the true value of an investment proposal can only be approximated. The results arrived at are dependent upon estimated factors and this has to be constantly

borne in mind. The dependability of the results would, to a large extent, depend upon the extent of objectivity and reliability of the input data, Incessant inflation also complicates the picture. In estimating cash flows, it is important to take account of anticipated inflation. There are essentially three factors in the quantitative techniques for investment appraisal: (1) capital investment, (2) return or cash flows, and (3) project or asset life. While capital investment can be determined in some cases with a high degree of accuracy (e.g., the purchase price and installation cost of a piece of equipment), in other cases (e.g., development of a new product, opening a new sales territory), the amount can only be approximated. The return factor (cash savings, incremental inflows or earnings) nearly always depends on estimates. And these estimates depend upon the subjective probabilities (in analysing risk), which are assigned to possible outcomes. With uncertainties pervading the future, projected cash flows may become, at best, half-truths. The source of most major errors is the estimate of sales volume and price. Determining the amount of cash savings, for example, from the use of labour-saving equipment requires that an experienced engineer or production executive estimates the number of labour man hours to be saved, the increase or decrease in maintenance cost, the effects on power consumption, and a host of other factors. Estimates of the contribution margin in increased sales volume resulting from the introduction of a new product, the opening of a new market, or an augmentation of the advertising programme, are always highly speculative. Finally, the estimate of the useful or economic life of a project or asset is probably the most tenuous of all, for it depends upon several environmental factors technological and marketing. An engineer's guess as to the useful life of a productive asset can be fairly reliable only lithe rate of technological change and obsolescence can be properly estimated. The profitable career of a new product depends upon customer acceptance and competitors reactions-both highly speculative phenomena. Certain statistical techniques based on probability are helpful in minimising the errors of estimating under conditions of uncertainty, but they cannot eliminate uncertainty, and therefore error, entirely. The soundness of the decision, therefore, would not only depend on the right choice (or combination) of appraisal technique (or techniques), but would also depend on sound common sense and judgement of the decision-makers.

Investment Appraisal Methods

15.9 SUMMARY
Effective deployment of capital over the long-term is one of the key means by which management attempts to achieve the objective of wealth maximisation. Decisions affecting investment in long-term capital projects or assets have a major impact on the future well being of the organisation. Apart from being uncertain, such decisions, typically, involve large commitments of funds. This unit focused on how investment decision can be made more effective in contributing to the health and growth of the firm. The use of the methods of analysis will enable the management to rank and choose intelligently among proposals competing for essentially scarce long-term funds. The methods presently in common use are (i) the pay back period, (ii) the accounting rate of return, and (iii) discounted cash flow techniques. The pay back is a `rough-and -ready' means of estimating how long it will take to recoup the original investment from the flow of cash earnings produced by the project. It suffers from a serious drawback i.e. it provides no measure of profitability. It concerns itself only with the liquidity of the investment.

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The accounting rate of return is readily understood and easily determinable, but is subject to serious limitations. It averages cash flows, and fails to distinguish between projects with long lives and those with shorter lives and between those with uneven cash flows. Moreover, it overlooks the all important time value of money. This model is adequate where the return of a project plainly far exceeds the required rate or in case of projects which are not subject to close competition for funds from other projects. The discounted cash-flow techniques are of two basic types: (l) the net present value and (2) the internal rate of return. The former employs some desired (or required) rate of return as a discount factor in determining the present worth of the cash inflows. The investment should show an excess of present value at the desired rate over the initial cost or investment. The latter is the rate of return, which discounts the stream of future cash inflows to the original cost of the investment, which produces them. Under many circumstances, both these DCF technique give identical answers. Profitability index is the percentage relationship between present value of the cash inflows discounted at the desired rate and the cost of the investment. This device offers ready comparability between projects of unlike size and duration. In general, discounted cash flow techniques provide the most reliable appraisals of alternative investment proposals. The use of present value tables makes these techniques reasonably simple to employ. Certain limitations underlie all capital budgeting appraisals. However, the three basic factors of the quantitative analytical-techniques - investment, return, and time - are all, to varying degrees, the results of estimates.. The estimate of future benefits is the key measurement in investment appraisal. Certain techniques like sensitivity analysis have been developed which help to narrow the margin of error of such estimates.

15.10 KEYWORDS
Accounting Rate of Return (ARR): A measure of rate of return for evaluating capital investment proposals, derived from accrual accounting. methods for income determination. Cost of Capital: The cost of raising capital in the market, which may include interest on borrowed money or the relation of company's earnings to the market value of its equity shares. Discounted Cash Flow: A measure of rate of return for evaluating capital investment proposals based on the concept of the time value of money. Discounting: A reduction of some future amount of money to a present value at some appropriate rate in accordance with the concept of the time value of money. Internal Rate of Return (IRR): That rate which equates the present value of the future cash inflows with the cost of the investment which produces them. Net Present Value (NPV): A technique of discounted cash flow for capital expenditure evaluation which seeks to determine whether the present value of estimated future cash inflows at management's desired rate of return is greater or less than the cost of the proposal. Payback Period: The length of time required to equate cash return with the initial cost of capital investment, which is determined by dividing the original investment by the annual cash inflows (cash savings after taxes). Present Value: The amount of money which, if invested immediately at a stated rate, would yield one or more future payments reflecting the increased value of the investment in accordance with the time value of money. Conversely, it may be considered the value of a future stream of payments discounted at a given rate to the present time.

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Profitability Index: The present value of future cash inflows divided by the present value of the initial outlay, also known as benefit-cost ratio. Salvage Value: The residual value of a depreciable asset at the end of its useful life.

Investment Appraisal Methods

15.11 SELF-ASSESSMENT QUESTIONS/ EXERCISES

1. 2. 3. 4. 5. 6. 7. Examine different classes of capital projects and explain why they are often approached differently? What data you would seek before you appraise any capital or asset acquisition, project? Explain the concept of payback period. Why does this method enjoy a good deal of popularity among businessmen? What are its limitations? Explain Accounting Rate of Return and discuss its limitation? What is the meaning of Internal Rate of Return? Are Internal Rate and Payback related? Explain? What is meant by Net Present Value? Why is Profitability Index considered useful? "Discounted cash flow techniques may be fine for some projects, but they have one flaw - they ignore depreciation. Depreciation is an important factor in some types of capital investment. Therefore, discounted cash flow methods are useless when considering investment in depreciable assets". Discuss the logic of this position. How does depreciation act as a tax shield? What are the essential limiting factors in the reliability of capital budgeting measurement techniques including discounted cash flow? .

8. 9.

10. Explain the concept of `cost of capital' as a device for establishing a cut off point for capital investment proposals. 11. State whether the following statements are true or false: a) Capital investment is not necessarily an investment in tangible property. b) All investments are expected to yield inflows. c) A comparison of the investment and the returns (or benefits) cannot be made unless all monetary amounts are stated on the same time basis. d) The net amount invested in the new machine is the cost of the new machine minus the net amount received from the sale of old machine. e) Net working capital that must be held to support the investment is a part of the total investment in an asset or project. f) Depreciation on the asset is included as a cost in computing DCF returns. g) The net working capital released on the termination of a project is not a return (or inflow) of the final year. h) The costs incurred in the past have no bearing on the decisions to be made in future.

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12 The Western India Company is considering the replacement of one of its machines with a newer model, which supposedly will reduce operating costs considerably. The company has prepared the following analysis of costs:
Old Machine Rs. 10,000 12,000 10,000 New Machine Rs. 18,000 6,000 4,000

Depreciation Labour Other Costs Total Annual Costs

32,000

28,000

The old machine originally cost Rs. 80,000 and has been operated for three years out of an estimated eight-year life. The new machine, which has an estimated life of five years, can be acquired for Rs. 90,000 less a trade-in allowance of Rs. 20,000 for the old machine. The other costs listed above consist of repairs, power to operate the machine, lubrication and similar costs. Which of the following statements is false? a) b) c) d) Depreciation on the old machine is a sunk cost. Depreciation on the old machine may be disregarded in deciding whether to replace the old machine. Labour and other costs are out-of-pocket costs. The payback period of the new-machine is seven and one-half years.

13. The Greatways Company is considering replacing an old machine with a newer model having lower maintenance costs. The old machine has a current book value of Rs. 9,000 and a (straight line) depreciation charge of Rs. 3,000 per year for the remaining life of 3 years including the current year. It will have no salvage value. However, at present the machine can be sold in the market for Rs. 6,000. The existing machine requires annual maintenance costs of Rs. 3,000. The new machine will cost Rs. 12,000 and require an annual maintenance costs of Rs.600. It's expected useful life is 3 years with no salvage value. Assuming straight-line depreciation also for new machine and a tax rate of 50%, determine the incremental cash flows (both outflows and inflows) of the replacement decision. 14. Farewell Company has an investment opportunity costing Rs.30,000 with the following expected net cash flow (i.e. after taxes and before depreciation);
Year 1 2 3 4 5 6 7 Net Cash flow Rs. 4,000 4,000 4,000 4,000 4,000 7,000 9,000

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8 9 10

12,000 9,000 2,000

Using 10% as the cost of capital (rate of discount), determine the following: a) b) c) d) Payback period Net present value at 10 % discounting factor Profitability index at 10% discounting factor. Internal rate of return with the help of 10 % discounting factor and 15 % discounting factor.

Investment Appraisal Methods

15. The Deccan Corporation, which has a 50% tax rate and a 20% after-tax cost of capital, is evaluating a project which will cost Rs. 1,25,000 and will require an increase in the level of inventories and receivables of Rs. 25,000 over its life. The project will generate additional sale of Rs. 1,00,000 and will require cash expenses of Rs. 25,000 in each of its 5-year life. It will be depreciated on a straight-line basis. What are the net present value and internal rate of return for the project? 16. The management of Maratha udyog has two alternative projects under consideration. Project `A' requires a capital outlay of Rs. 3,00,000 but project `B' needs Rs. 4,20,000: Both are estimated to provide a cash flow for six years: A Rs. 80,000 per year and B Rs. 1,10,000 per year. The cost of capital is 12% . Show which of the two projects is preferable from the viewpoint of (i) Net Present Value and (ii) Internal Rate of Return. 17. Speedex Dry Cleaning Company is considering the purchase of new wash and dry equipment in. order to expand its operations. Two types of options are available: a Low Speed System (LSS) with a Rs. 40,000 initial cost and a High Speed System (HSS) with a Rs. 60,000 initial cost. Each system has a sixteen years life and no salvage value. The net cash flows after taxes (CFAT) associated with each investment proposals are: CEAT for year 1 through 16 Low Speed System (LSS Rs. 8,000) High Speed System (HSS) Rs. 12,000

Which speed system should be chosen by Speedex, assuming 15 % cost of capital/rate of discount? 18. Space Age Printers, a large and profitable printing press, is faced with the prospect of replacing a large printing system. Two systems currently being marketed will do the job satisfactorily. The Superior system costs Rs. 1,50,000 and will require cash running expenses of Rs. 60,000 per year. The Matchless system costs Rs. 2;25,000 but running expenses are expected to be only Rs. 45,000 per year. Both machines have a ten-year useful life with no salvage value and would be depreciated on a straight-line method. a) b) If the company pays a 40 % tax and has a 11 % after-tax required rate of return, which machine should it purchase? Would your answer be different if the required rate of return is 9% ?

19. Vishwa Bharti Company is examining two mutually exclusive proposals for new capital investment. The data on the proposals are as follows: Net cash outlay Salvage value Estimated life Depreciation Corporate income-tax Cut-off rate used for appraisal
Proposal A Rs. 50,000 2,000 5 years Straight-line Method 50% 10% Proposal B Rs. 60,000 NIL 6 years Straight-line Method 50% 10%

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Financial and Investment Analysis

Proposal A

Earning before Depreciation and taxes I st year II nd year Illrd year IVth year Vth year VIth year

Proposal B
Rs. 12,000 16,000 18,000 24,000 24,000 20,000

Rs. 13,000 15,000 18, 000 22,000 12,000 -

Using both (a) present value method and (b) D C F rate of return (internal rate of return) calculations, you are asked to advise which proposal would be financially preferable, (you may calculate depreciation on the original cost without taking salvage value into account. You may also ignore income tax on salvage value received). 20. Arunachal Limited has been having a job performed by a neighbouring company on a part used in its project at a cost of Rs.5 per part. The annual average, production of this part is expected to be 6,000 pieces. The Arunachal Limited itself can perform this operation by bringing into operation two machines: spare lathe which has a net book value of Rs. 2,000 and a new machine which can be purchased at a price of Rs. 70,000. The new machine is expected to last 7 years. The old machine has a remaining physical life of at least 10 years and could be sold now for approximately Rs. 15,000. The final salvage value of both machine is considered negligible. In performing the operation itself, the Arunachal Limited will incur out-of-pocket costs for direct labour, power supply etc. of Rs. 2 per part. Prepare an analysis (including explanatory comments) which would help to determine whether it is profitable for the company to perform these operations itself. The company normally expects to earn a rate of return before taxes of about 15 % on its invested capital. Ignore income tax effect. 21. The Mahanagar Company, by purchasing and installing a small computer, expects to realise certain cash savings in its data processing operations. The direct cash expenses per month under the present manual-book-keeping machine system are: Rs. Salaries - book-keeping and clerical 9,250 Forms and supplies 1,500 Overtime, payroll, taxes, fringes 2,250 Total 13,000 The existing furniture and equipment are fully depreciated on the books of the company. The computer costs Rs, 1,60,000 including alterations, installation and accessory equipment. The department will be staffed as follows: Data processing supervisor Machine Operator Programmer Key-punch operators (2 @ Rs. 5, 500) Other pay roll costs
Per year Rs. 20,000 8,000 8,500 11,000 4,500

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It is expected that forms and supplies costs will remain unchanged. The computer is expected to be obsolete in five years, having a salvage value of Rs. 10,000 at that time. Assuming a 50 per cent tax rate: a) b) Determine the annual cash flow reflecting the tax shield and Decide whether or not to purchase the computer using discounted cash flow assuming a desired rate of return of 16 per cent after taxes.

Investment Appraisal Methods

22. The Frontline Manufacturing Company is considering the purchase of two different types of machines to manufacture auto speed guages, one of the many products it produces for industrial markets. The two machines are alike in the following ways: each requires an initial investment of Rs. 15,00,000, will last for five years after which the salvage value will be zero and has sufficient capacity to meet the projected steady demand. The main difference between the two machines is the timing and amount of operating cash flows. Machine A's operating cash costs would start out high and then decrease in subsequent years. For machine B, constant operating cash costs are predicted. The incremental net cash flows (revenues minus operating cash costs) for the two machines are expected to be as follows:
After tax Cash Flow per year

Rs. Machine A. Machine B

Rs.

Rs.

Rs.

Rs. 6,00,000 5,00,000

Rs. 11,00,000 5,00,000

15,00,000 2,00,000 15,00,000 5,00,000

4,00,000 4,00,000 5,00,000 5,00,000

The company needs to determine which of the two machines it should buy to manufacture speed guages. Unsure of which method of evaluation to use, the Deputy Managing Director asks that calculations be made for the following methods: 1. 2. 3. 4. 5. Payback period (assume, for this calculation only, that cash flows are spread evenly throughout the year) Accounting rate of return Internal rate of return Net present value (cost of capital = 10 per cent) Net present value (cost of capital = 12 per cent)

a) Perform the above calculations for each machine. For each method state which machine looks like a better investment. b) Why does the net present value method yield different decisions at the two different discount rates? Does the internal rate of return method exhibit the same phenomenon? c) Comment on the usefulness of each of the above Methods for choosing between the two machines.
Answers to Questions/Exercises (11 through 22)

11.

(a) T, (b) F, (c) T, (d) T, (e) T, (f) F, (g) F, (h) T.

12. (d) The payback period is approximately five and five-sixth year. The required outlay is Rs. 70,000 (90,000-20,000). The annual savings in out-of-pocket costs are 22,000 (12,000 + 10,000) less Rs. 10,000 (6,000 + 4,000), or 12,000. The payback period is then Rs. 70,000 12,000.

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13.

Cash inflow due to sale of machine Net cash outflow Total cash inflow each year with new machine

Rs 7,500 Rs 4,500 Rs 1,700

14. a) b) c) d)

Payaback period Net present value Profitability Index Internal rate of Return

= Six years and four months = Rs. 3,917 = Rs. 1.131 (or 113.1%) = 12.75 (approx.)

15 NPV = Rs. 9,600 IRR = 22.78 (try interpolation between 20% and 24%) 16. Project A Project B
NPV IRR

28,880 32,210

15.34 14.68

Project B is preferable as its NPV is more than that of A. Project A is preferable on the basis of IRR. 17. NPV
LSS HSS

7,632

11,448

The High Speed System should be chosen by the company as its NPV is greater than that of the Low Speed System. However, the profitability index of both the systems is the same, that is 119.08. per cent. On the basis of this criterion, the company could be indifferent between the two systems. The decision then would depend on other factors. 18. a) NPV = Rs. 4,332 (negative) Since the NPV is negative, Matchless system should not be acquired. The company should buy the Superior system. b) NPV = Rs. 2,016 Since the NPV is positive at 9% rate of discount the company should purchase the Matchless system. Therefore, the answer is definitely different. 19. a) NPV (Rs.) b) Average cash flow (Rs) Fake payback period IRR
Proposal A Proposal B

-948 13,600 3.846 9.274

1,879 14,500 4.138 11.024

Since the NPY and IRR of proposal B are higher than those of proposal A, proposal B would be financially preferable. 20. The present value of annual savings= Rs. 74,880 Investment required to produce the part (Rs. 70,000 + 15,000) = 85, 000 As the present value of savings is less than the present value of investment required, the part should continue to be purchased. 21.a) Net cash flew after taxes Tax shield amount b) Net present value (positive) The computer should be purchased. 22.
Machine A. Machine B

Rs. 58,000 Rs. 15,000 Rs. 33,086

1)

120

2)

Payback period 3.83 3.00 Machine B is preferable ARR 32% 26.7 % (Note: Calculations are based on average investment) Machine B is preferable and can be purchased if 32 per cent is an acceptable ROI.

3) IRR

18.05

19.88%

Investment Appraisal Methods

Machine B can be purchased if 19.88 per cent is considered a sufficiently high IRR. 4) a) b) NPV (at 10 %) Rs. 4,05,500 Rs. 3,95,500

Machine A's cash inflows occur later than those of machine B. Therefore, at higher discount rates, machine A looks less attractive than machine B. But because machine A's total inflows are greater, at a low enough discount rate its NPV is greater than that of machine B. The crossover point occurs somewhere between the discount rates of 10 per cent and 12 per cent. The internal rate of return of machine B is higher than the crossover rate (beyond which this machine becomes more attractive than machine A), hence, machine B dominates machine A using IRR. The payback period and ROI methods both ignore the time value of money. As the two machines differ mainly in the timing of their cash inflows, failure to consider the time value of money results in an incomplete comparison of cash flows. The internal rate of return method considers all the cash flows and the time value of money, but still does not always lead to the same decisions as the net present value method. As discussed in part (b), the IRR for each machine is constant, whereas the relative NPV's for the two machines depends on the firm's cost of capital. The most useful method for making the purchase decision is the net present value method with careful thought about the firm's measure of its cost of capital.

c)

15.12 FURTHER READINGS

Van Horne, C. James, 2002. Financial Management and Policy 12th ed, PrenticeHall of India: New Delhi. (Chapters 4-7). Horngren, C.T., Datar, S.M., Foster, G.M., 2002. Cost Accounting: A Managerial Emphasis, Prentice-Hall of India: New Delhi. (Chapters 12 and 13). E.F. Brigham Houston, J.F., 1999, Fundamentals of Financial Management (Part IV), Dryden Press Florida. Shrivastava, R.M., 1984. Financial Decision-making, Sterling Publishers: New Delhi. (Chapters 8, 9 and 11).

VIDEO PROGRAMME
PrgjectAppraisal: Institutional Viewpoint

121

UNIT 16
Objectives

MANAGEMENT OF WORKING CAPITAL

Management of Working Capital

The objectives of this unit are to familiarise you with the: concepts and components of working capital significance of and need for working capital determinants of the size of working capital criteria for efficiency in managing working capital

Structure
16.1 16.2 16.3 16.4 16.5 16.6 16.7 16.8 16.9 16.10 16.11 16.12 16.13 16.14 16.15 16.16 16.17 Introduction Significance of Working Capital Operating Cycle Concepts of Working Capital Kinds of Working Capital Components of Working Capital Importance of Working Capital Management Determinants of Workings Capital Needs Approaches to Managing Working Capital Measuring Working Capital Working Capital Management under Inflation Efficiency Criteria Determining Optimal Cash Balance Management of Cash Flows Summary Key Words Self-assessment Questions/Exercises

16.18 Further Readings

16.1 INTRODUCTION
Effective financial management is the outcome, among other things, of proper management of investment of funds in business. Funds can be invested for permanent or long-term purposes such as acquisition of fixed assets, diversification and expansion of business, renovation or modernisation of plants & machinery, and research & development. Funds are also needed for short-term purposes, that is, for current operations of the business. For example, if you are managing a manufacturing unit you will have to arrange for procurement of raw material, payment of wages to your workmen and for meeting routine expenses. All the goods, which are manufactured in a given time period may not be sold in that period. Hence, some goods remain in stock, e.g., raw material, semi-finished (manufacturing -in-process) goods and finished marketable goods. Funds are thus blocked in different types of inventory. Again, the whole of the

Financial Decisions

stock of finished goods may not be sold against ready cash; some of it may be sold on credit. The credit sales also involve blocking of funds with debtors till cash is received or the bills are cleared. Working Capital refers to firm's investment in short-term assets, viz. cash, short-term securities, accounts receivable (debtors) and inventories of raw materials, work-inprocess and finished goods. It can also be regarded as that portion of the firm's total capital, which is employed in short-term operations. It refers to all aspects of current assets and current liabilities. In simple words, we can say that working capital is the investment needed for carrying out day-to-day operations of the business smoothly. The management of working capital is no less important than the management of long-term financial investment.

16.2 SIGNIFICANCE OF WORKING CAPITAL

You will hardly find a running business firm, which does not require some amount of working capital. Even a fully equipped manufacturing firm is sure to collapse without (a) an adequate supply of raw materials to process, (b) cash to meet the wage bill, (c) the capacity to wait for the market for its finished products, and (d) the ability to grant credit to its customers. Similarly, a commercial enterprise is virtually good for nothing without merchandise to sell. Working capital, thus, is the life-blood of a business. As a matter of fact, any organisation, whether profit-oriented or otherwise, will not be able to carry on day-to-day activities without adequate working capital.

16.3 OPERATING CYCLE

The time between purchase of inventory items (raw material or merchandise) and their conversion into cash is known as operating cycle or working capital cycle. The successive events which are typically involved in an operating cycle are depicted in Figure 16.1. A perusal of the operating cycle would reveal that the funds invested in operations are re-cycled back into cash. The cycle, of course, takes some time to complete. The longer the period of this conversion the longer is the operating cycle. A standard operating cycle may be for any time period but does not generally exceed a Figure 16.1 : Operating Cycle

financial year. Obviously, the shorter the operating cycle, the larger will be the turnover of funds invested for various purposes. The channels of the investment are called current assets. Sometimes the available funds may be in excess of the needs for investment in these assets, e.g., inventory, receivables and minimum essential cash balance. Any surplus may be invested in government securities rather than being retained as idle cash balance.

Management of Working Capital

16.4 CONCEPTS OF WORKING CAPITAL

There are two concepts of working capital, namely Gross concept and Net concept. Gross Working Capital According to this concept; working capital refers to the firms investment in current assets. The amount of current liabilities is not deducted from the total of current assets. This concept views Working Capital and aggregate of Current Assets as two inter-changeable terms. This concept is also referred to as `Current Capital' or `Circulating Capital'. The proponents of the gross working capital concept advocate this for the following reasons: i) Profits are earned with the help of assets, which are partly fixed and partly current. To a certain degree, similarity can be observed in fixed and current assets so far as both are partly financed by borrowed funds, and are expected to yield earnings over and above the interest costs. Logic then demands that the aggregate of current assets should be taken to mean the working capital. Management is more concerned with the total current assets as they constitute the total funds available for operating purposes than with the sources from which the funds come.

ii)

iii) An increase in the overall investment in the enterprise also brings about an increase in the working capital. Net Working Capital The net working capital refers to the difference between current assets and current liabilities. Current liabilities are those claims of outsiders, which are expected to mature for payment within an accounting year and include creditors dues, bills payable, bank overdraft and outstanding expenses. Net working capital can be positive or negative. A negative net working capital occurs when current liabilities are in excess of current assets. "Whenever working capital is mentioned it brings to mind current assets and current liabilities with a general understanding that working capital is the difference between the two". Net working capital is a qualitative concept, which indicates the liquidity position of the firm and the extent to which working capital needs may be financed by permanent sources of finds. This needs some explanation. Current assets should be sufficiently in excess of current liabilities to constitute a margin or buffer for obligations maturing within the ordinary operating cycle of a business. A weak liquidity position poses a threat to the solvency of the company and makes it unsafe. Excessive liquidity is also bad. It may be due to mismanagement of current assets. Therefore, prompt and timely action should be taken by management to improve and correct the imbalance in the liquidity position of the firm.

Financial Decisions

The net working capital concept also covers the question of a judicious mix of longterm and short-term funds for financing current assets. Every firm has a minimum amount of net working capital, which is permanent. Therefore, this portion of the working capital should be financed with permanent sources of funds such as owners' capital, debentures, long-term debt, preference capital and retained earnings: Management must decide the extent to which current assets should be financed with equity capital and/or borrowed capital. Several economists uphold the net working capital concept. In support of their stand, they state that: In the long run what matters is the surplus of current assets over current liabilities. It is this concept which helps creditors and investors to judge the financial soundness of the enterprise. It is the excess of current assets over current liabilities, which can be relied upon to meet contingencies since this amount is not liable to be returned. It helps to ascertain the correct comparative financial position of companies having the same amount of current assets. It may be stated that gross and net concepts of working capital are two important facets of working capital management. Both the concepts have operational significance for the management and therefore neither can be ignored. While the net concept of working capital emphasizes the qualitative aspect, the gross concept underscores the quantitative aspect.

16.5 KINDS OF WORKING CAPITAL

Ordinarily, working capital is classified into two categories: Fixed, Regular or Permanent Working Capital; and Variable, Fluctuating, Seasonal, Temporary or Special Working Capital Fixed Working Capital The need for current assets is associated with the operating cycle, which, as you know, is a continuous process. As such, the need for current assets is felt constantly. The magnitude of investment in current assets however may not always be the same. The need for investment in current assets may increase or decrease over a period of time according to the level of production. Nevertheless, there is always a certain minimum level of current assets, which is essential for the firm to carry on its business irrespective of the level of operations. This is the irreducible minimum amount necessary for maintaining the circulation of the current assets. This minimum level of investment in current assets is permanently locked up in business and is therefore referred to as permanent or fixed or regular working capital. It is permanent in the same way as investment in the firm's fixed assets is. Fluctuating Working Capital Depending upon the changes in production and sales, the need for working capital, over and above the permanent working capital, will fluctuate. The need for working capital may also vary on account of seasonal changes or abnormal or unanticipated conditions. For example, a rise in the price level may lead to an increase in the amount of funds invested in stock of raw materials as well as finished goods. Additional doses of working capital may be required to face cutthroat competition in the market or other contingencies like strikes and lockouts. Any special advertising

campaigns organised for increasing sales or other promotional activities may have to be financed by additional working capital. The extra working capital needed to support the changing business activities is called the fluctuating (variable, seasonal, temporary or special) working capital. Figures 16.2 and 16.3 give an idea about fixed and fluctuating working capital. Figure 16.2 :Fixed working capital remaining constant overtime

Management of Working Capital

Figure 16.3 Fixed working capital increasing over time

As seen in Figure 16.2, that fixed working capital is stable over time, where as variable working capital is fluctuating-sometimes increasing and sometimes decreasing. The permanent working capital line, however, may not always be horizontal. For a growing firm, permanent working capital may also keep on increasing over time as has been shown in Figure 16.3. Both these kinds of working capital - permanent and temporary-are required to facilitate production and sales through the operating cycle, but temporary working capital is arranged by the firm to meet liquidity requirements that are expected to be temporary.

16.6

COMPONENTS OF WORKING CAPITAL

You have already noted that working capital has two components: Current assets and Current liabilities. Current assets comprise several items. The typical items are: i) ii) iii) Cash to meet expenses as and when they occur. Accounts Receivables or sundry trade debtors Inventory of: a) Raw materials, stores, supplies and spares,

b) c)

Work-in-process, and Finished goods

Financial Decisions

iv) v)

Advance payments towards expenses or purchases, and other short-term advances which are recoverable. Temporary investment of surplus funds which could be converted into cash whenever needed.

A part of the need for funds to finance the current assets may be met from supply of . goods on credit, and deferment, on account of custom, usage or arrangement, of payment for expenses.. The remaining part of the need for working capital may be met from short-term borrowing from financiers like banks. These items are collectively called current liabilities. Typical items of current liabilities are: i) ii) Goods purchased on credit Expenses incurred in the course of the business of the organisation (e.g., wages or salaries, rent, electricity bills, interest etc.) which are not yet paid for. Temporary or short term borrowings from banks, financial institutions or other parties Advances received from parties against goods to be sold or delivered, or as short term deposits. Other current liabilities such as tax and dividends payable. Some of the major components of current assets are explained here in brief:

iii) iv) v)

Cash : All of us know that the basic input to start any business is cash. Cash is initially required for acquiring fixed assets like plants and machinery which enables a firm to produce products and generate cash by selling them. Cash is also required and invested in working capital. Investments in working capital is required, as firms have to store certain quantity of raw materials and finished goods and also for providing credit terms to the customers. A minimum level of cash helps in the conduct of everyday ordinary business such as making of purchases and sales as well as for meeting the unexpected payments, developments and other contingencies. As discussed earlier cash invested at the beginning of-the operating cycle gets released at the end of the cycle to fund fresh investments. However, additional cash is required by the firm when it needs to buy more fixed assets, increase the level of operations or for bringing out change in working capital cycle such as extending credit period to the customers. The demand for cash is affected by several factors, some of them are within the control of the managers and some are outside their control. It is not possible to operate the business without holding cash but at the same time holding it without a purpose also costs a firm either directly in the form of interest or loss of income that could be earned out of the cash. In the context of working capital management, cash management refers to optimizing the benefit and cost associated with holding cash. The objective of cash management is best achieved by speeding up the working capital cycle, particularly the collection process and investing surplus cash in short term assets in most profitable avenues. We will be subsequently discussing certain issues like the management of cash flows and determination of optimal cash balance, etc. (in this unit). Accounts Receivable: Firms rather prefer to sell for cash than on credit, but competitive pressures force most firms to offer credit. Today the use of credit in the purchase f goods and services is so common that it is taken for granted. Selling goods or providing services on credit basis leads to accounts receivable. When consumers expect credit, business units in turn expect credit from their suppliers to match their investment in credit extended to consumers. The granting of credit from one business firm to another for purchase of goods and services is popularly known as trade credit.

10

Though commercial banks provide a significant part of requirements for working capital, trade credit continues to be a major source of funds for firms and accounts receivable that result from granting trade credit are major investment for the firm. Both direct and indirect costs are associated with carrying receivables, but it has an important benefit for increasing sales. Excessive levels of accounts receivables result in decline of cash flows and many result in bad debts which in turn may reduce the profit of the firm. Therefore, it is very important to monitor and manage receivables carefully and regularly. We would be dealing with this topic in MS-41 : Working Capital Management. Inventory : Three things will come to your mind when you think of a manufacturing unit - machines, men and materials. Men using machines and tools convert the materials into finished goods. The success of any business unit depends on the extent to which these are efficiently managed. Inventory is an asset to the organisation like other components of current assets. Inventory constitutes a very significant part of working capital or current assets in manufacturing organisation. It is essential to control inventories (physical/quantity control and value control) as these are significant elements in the costing process constituting sometimes more than 60% of the current assets. Inventory holding is desirable because it meets several objectives and needs but an excessive inventory is undesirable because it costs a lot to firms. Inventory which consists of raw material components and other consumables, work in process and finished goods, is an important component of `current assets'. There are several factors like nature of industry, availability of material, technology, business practices, price fluctuation, etc. that determines the amount of inventory holding. Holding inventory ensures smooth production process, price stability and immediate delivery to customers. Since inventory is like any other form of assets, holding inventory has a cost. The cost includes opportunity cost of funds blocked in inventory, storage cost, stock out cost, etc. The benefits that come from holding inventory should exceed the cost to justify a particular level of inventory. Marketable Securities: Cash and marketable securities are normally treated as one item in any analysis of current assets although these are not the same as cash they can be converted to cash at a very short notice. Holding cash in excess of immediate requirement means the firm is missing out an opportunity income. Excess cash is normally invested in marketable securities, which serves two purposes namely, provide liquidity and, also earn a return. Activity 16.1 a) List some main items of working capital in your organisation, e.g. inventory of raw material supplies, stores etc. (under their various heads). .............................................................................................................. . ............ b) List some of the major items of operating expenses in your organisation such as wages and salaries of staff.

Management of Working Capital

......................................................................................................................... ....................................................................................................................... .

11

Financial Decisions

c) What is the amount of revolving fund or working capital that organisation maintains to pay for the operating expenses?

....................................................................................................................... .

16.7

IMPORTANCE OF WORKING CAPITAL MANAGEMENT

Because of its close relationship with day-to-day operations of a business, a study of working capital and its management is of major importance to internal, as well as external analysts. It is being increasingly realised that inadequacy or mismanagement of working capital is the leading cause of business failures. We must not lose sight of the fact that management of working capital is an integral part of the overall financial management and, ultimately, of the overall corporate management. Working capital management thus throws a challenge and should be a welcome opportunity for a financial manager who is ready to play a pivotal role in his organisation. Neglect of management of working capital may result in technical insolvency and even liquidation of a business unit. With receivables and inventories tending to grow and with increasing demand for bank credit in the wake of strict regulation of credit in India by the Central Bank, managers need to develop a long-term perspective for managing working capital. Inefficient working capital management may cause either inadequate or excessive working capital, which is dangerous. A firm may have to face the following adverse consequences from inadequate working capital: Growth may be stunted. It may become difficult for the firm to undertake profitable projects due to non-availability of funds. 1. 2. 3. 4. Implementation of operating plans may become difficult and consequently the firm's profit goals may not be achieved. Operating inefficiencies may creep in due to difficulties in meeting even day to day commitments. Fixed assets may not be efficiently utilised due to lack of working funds, thus lowering the rate of return on investments in the process. Attractive credit opportunities may have to be lost due to paucity of working capital. The firm loses its reputation when it is not in a position to honour its short-term obligations. As a result, the firm is likely to face tight credit terms.

5.

On the other hand, excessive working capital may pose the following dangers: 1 2 Excess of working capital may result in unnecessary accumulation of inventories, increasing the chances of inventory mishandling, waste, and theft. It may provide an undue incentive for adopting too liberal a credit policy and slackening of collection of receivables, causing a higher incidence of bad debts. This has an adverse effect on profits. Excessive working capital may make management complacent, leading eventually to managerial inefficiency. It may encourage the tendency to accumulate inventories for making speculative profits, causing a liberal dividend policy, which becomes difficult to maintain when the firm is unable to make speculative profits.

3 4

12

An enlightened management, therefore, should maintain the right amount of working capital on a continuous basis. Financial and statistical techniques can be helpful in predicting the quantum of working capital needed at different points of time.

Management of Working Capital

16.8

DETERMINANTS OF WORKING CAPITAL NEEDS

There are no set rules or formulas to determine the working capital requirements of a firm. The corporate management has to consider a number of factors to determine the level of working capital. The amount of working capital that a firm would need is affected not only by the factors associated with the firm itself but is also affected by economic, monetary and general business environment. Among the various factors the following are important ones. Nature and Size of Business The working capital needs of a firm are basically influenced by the nature of its business. Trading and financial firms generally have a low investment in fixed assets, but require a large investment in working capital. Retail stores, for example, must carry large stocks of a variety of merchandise to satisfy the varied demand of their customers. Some manufacturing businesses' like tobacco, and construction firms also have to invest substantially in working capital but only a nominal amount in fixed assets. In contrast, public utilities have a limited need for working capital and have to invest abundantly in fixed assets. Their working capital requirements are nominal because they have cash sales only and they supply services, not products. Thus, the amount of funds tied up with debtors or in stocks is either nil or very small. The working capital needs of most of the manufacturing concerns fall between the two extreme requirements of trading firms and public utilities. The size of business also has an important impact on its working capital needs. Size may be measured in terms of the scale of operations. A firm with larger scale of operations will need more working capital than a small firm. The hazards and contingencies inherent in a particular type of business also have an influence in deciding the magnitude of working capital in terms of keeping liquid resources. Manufacturing Cycle The manufacturing cycle starts with the purchase of raw materials and is completed with the production of finished goods. If the manufacturing cycle involves a longer period the need for working capital will be more, because an extended manufacturing time span means a larger tie-up of funds in inventories. Any delay at any stage of manufacturing process will result in accumulation of work-in-process and will enhance the requirement of working capital. You may have observed that firms making heavy machinery or other such products, involving long manufacturing cycle, attempt to minimise their investment in inventories (and thereby in working capital) by seeking advance or periodic payments from customers. Business Fluctuations Seasonal and cyclical fluctuations in demand for a product affect the working capital requirement considerably, especially the temporary working capital requirements of the firm. An upward swing in the economy leads to increased sales, resulting in an increase in the firm's investment in inventory and receivables or book debts. On the other hand, a decline in the economy may register a fall in sales and, consequently, a fall in the levels of stocks and book debts.

13

Financial Decisions

Seasonal fluctuations may also create production problems. Increase in production level may be expensive during peak periods. A firm may follow a policy of steady production in all seasons to utilise its resources to the fullest extent. This will mean accumulation of inventories in off-season and their quick disposal in peak season. Therefore, financial arrangements for seasonal working capital requirement should be made in advance. The financial plan should be flexible enough to take care of any seasonal fluctuations. Production Policy If a firm follows steady production policy, even when the demand is seasonal, inventory will accumulate during off-season periods and there will be higher inventory costs and risks. If the costs and risks of maintaining a constant production schedule are high, the firm may adopt the policy of varying its production schedule in accordance with the changes in demand. Firms whose physical facilities can be utilised for manufacturing a variety of products can have the advantage of diversified activities. Such firms manufacture their main products during the season and other products during off-season. Thus, production policies may differ from firm to firm, depending upon the circumstances. Accordingly, the need for working capital will also vary. Turnover of Circulating Capital The speed with which the operating cycle completes its round (i.e., cash raw materials finished product accounts receivables cash) plays a decisive role in influencing the working capital needs. (Refer to Figure 1(.1 on operating cycle). Credit Terms The credit policy of the firm affects the size of working capital by influencing the level of book debts. Though the credit terms granted to customers to a great extent depend upon the norms and practices of the industry or trade to which the firm belongs; yet it may endeavor to shape its credit policy within such constraints. A long collection period will generally mean tying of larger funds in book debts. Slack collection procedures may even increase the chances of bad debts. The working capital requirements of a firm are also affected by credit terms granted by its creditors. A firm enjoying liberal credit terms will need less working capital. Growth and Expansion Activities As a company grows, logically, larger amount of working capital will be needed, though it is difficult to state any firm rules regarding the relationship between growth in the volume of a firm's business and its working capital needs. The fact to recognize is that the need for increased working capital funds may precede the growth in business activities, rather than following it. The shift in composition of working capital in a company may be observed with changes in economic circumstances and corporate practices. Growing industries require more working capital than those that are static. Operating Efficiency Operating efficiency means optimum utilisation of resources. The firm can minimise its need for working capital by efficiently controlling its operating costs. With increased operating efficiency the use of working capital is improved and pace of cash cycle is accelerated. Better utilisation of resources improves profitability and helps in relieving the pressure on working capital.

14

Price Level Changes Generally, rising price level requires a higher investment in working capital. With increasing prices the same levels of current assets need enhanced investment. However, firms which can immediately revise prices of their products upwards may not face a severe working capital problem in periods of rising levels. The effects of increasing price level may, however, be felt differently by different firms due to variations in individual prices. It is possible that some companies may not be affected by the rising prices, whereas others may be badly hit by it. Other Factors There are some other factors, which affect the determination of the need for working capital. A high net profit margin contributes towards the working capital pool. The net profit is a source of working capital to the extent it has been earned in cash. The cash inflow can be calculated by adjusting non-cash items such as depreciation, outstanding expenses, losses written off, etc, from the net profit, (as discussed in Unit 6). The firm's appropriation policy, that is, the policy to retain or distribute profits also has a bearing on working capital. Payment of dividend consumes cash resources and thus reduces the firm ',s working capital to that extent. If the profits are retained in the business, the firm's working capital position will be strengthened. In general, working capital needs also depend upon the means of transport and communication. If they are not well developed, the industries will have to keep huge stocks of raw materials, spares, finished goods, etc. at places of production, as well as at distribution outlets.
Management of Working Capital

16.9

A PPROACHES TO MANAGING WORKING CAPITAL

Two approaches are generally followed for the management of working capital: (i) the conventional approach, and (ii) the operating cycle approach. The Conventional Approach This approach implies managing the individual components of working capital (i.e. inventory, receivables, payables, etc) efficiently and economically so that there are neither idle funds nor paucity of funds. Techniques have been evolved for the management of each of these components. In India, more emphasis is given to the management of debtors because they generally constitute the largest share of the investment in working capital. On the other hand, inventory control has not yet been practised on a wide scale perhaps due to scarcity of goods (or commodities) and ever rising prices. The Operating Cycle Approach This approach views working capital as a function of the volume of operating expenses. Under this approach the working capital is determined by the duration of the operating cycle and the operating expenses needed for completing the cycle. The duration of the operating cycle is the number of day involved in the various stages, commencing with acquisition of raw materials to the realisation of proceeds from debtors. The credit period allowed by creditors will have to be set off in the process. The optimum level of working capital will be the requirement of operating expenses for an operating cycle, calculated on the basis of operating expenses required for a year.

15

Financial Decisions

In India, most of the organisations use to follow the conventional approach earlier, but now the practice is shifting in favour of the operating cycle approach. The banks usually apply this approach while granting credit facilities to their clients.

16.10 MEASURING WORKING. CAPITAL

The factors discussed in the preceding section influence the quantum of working capital in a business enterprise. How to determine or measure the amount of working capital that an enterprise would need was discussed to some extent in Unit 6 dealing with funds flow analysis. Let us attempt to determine the amount of working capital needed by taking up an illustration. Illustration 16.1 Determine the magnitude of working capital (with the help of the following particulars) for Gujarat Tricycles Limited, a newly set up enterprise: a) The proforma cost sheet shows that the various elements of cost bear the undermentioned relationship to the selling price: Materials, parts and components 40% Labour 30% Overhead 10% Production in 2004 is estimated to be 60,000 tricycles. Raw material, parts and components are expected to remain in the stores for an average period of one month before issue to production. Finished goods are likely to stay in the warehouse for two months on an average before being sold and delivered to customers. Each unit of production will be in-process for half a month on an average. Half of the sales are likely to be on credit. The debtors will be allowed two months credit from the date of sale. Credit period allowed by suppliers of raw material, parts and components is one month. The lag of payment to labour is one month. 50% of the overhead consists of salaries of non-production staff. Selling price will be Rs. 2000 per tricycle. Assume that sales and production follow a consistent pattern. Allow 20% to your computed figure for buffer cash and contingencies.

b) c) d) e) f) g) h) i) j) k)

Before we attempt to calculate the working capital, it will be helpful to work out the following basic data: a) b) The yearly production is '60,000 tricycles. Hence, monthly production will be 5000 tricycles. The selling price per tricycle is Rs. 2000. The various elements of cost (i.e. raw material, parts and components, labour and overheads) comprise 80% (40%+30%+10%) of the selling price. Hence cost of production is Rs.1600

16

80 i.e. 2000 100

Gujarat Tricycles Limited Statement of working capital requirements Rs. (in lakhs) Current Assets: Stock of raw material, parts and components (1 Month) Stock of finished goods (2 Months) 5,000 x 1600 u 2 Work- in-Process (1/2 Month) 5,0110 1,600 x % Debtors (50% of sales) (2 months credit) 5.000 x x 1.600 x 2 Less current liabilities Creditors (one month) Wages and Salaries: Wages Salaries (Overheads) Add 20% for buffer cash and contingencies Average working capital required The various figures have been worked out as follows: Cost of raw material etc. Monthly production Cost of material etc per unit Period for which stock Required Hence amount locked up 5,000 X 800 X 1 Cost of finished goods Monthly Production Cost of production per unit Period for which stock Required Hence amount locked up 5,000 X 1,600 X 2 Work-in-Process Stock Monthly Production Cost of production per unit Period for which stock required. Hence amount locked up 5,000 X 1,600 X 1/2 Debtors Sales per month Proportion of credit sales Cost of Production per unit Period of credit Hence amount locked up 5,000 X X 1,600 X 2 5000 Units Rs. 800 1 month Rs. 40,00,000 5000 units Rs. 1,600 (800 + 600 + 200) 2 months Rs. 160,00,000 5,000 units Rs. 1,600 1/2 Month Rs. 40,00,000 5000 Units 50 per cent Rs. 3,600 2 months Rs, 80,00,000 40 1,60

Management of Working Capital

40

80 40 30 5 49

3,20

75 2,45 49 2,94

17

Financial Decisions

Creditors Monthly production Cost of production per unit Cost of raw material etc. being one half Period of which credit available Hence, Working Capital unlocked 5,000 X 800 X 1 Wages and Salaries i) Wages Monthly production Labour cost per unit Lag period for payment Hence, Working Capital unlocked 5,000 X 600 X 1 ii) Salaries Monthly production Portion of Salaries in overheads Overhead cost per unit Lag period for payment Hence, working capital unlocked 5,000 X 200 X X 1 Rs. 5,00,000 5,000 units Rs. 200 1 Month Rs. 30,00,000 5,000 Units Rs. 600 1 Month Rs. 40,00,000 Rs. 800 1 month 5000 Units Rs. 1,600

16.11

WORKING CAPITAL MANAGEMENT UNDER INFLATION

It is desirable to check the increasing demand for capital, for maintaining the existing level of activity. Such a control acquires even more significance in times of inflation. In order to control working capital needs in periods of inflation, the following measures may be applied. Greater disciplines on all segments of the production front may be attempted as under: a) The possibility of using substitute raw materials without affecting quality must be explored in all seriousness. Research activities in this regard may be undertaken, with financial assistance provided by the Government and the corporate sector, if any. Attempts must be made to increase the productivity of the work force by proper motivational strategies. Before going in for any incentive scheme, the cost involved must be weighed against the benefit to be derived. Though wages in accounting are considered a variable cost, they have tended to become partly fixed in nature due to the influence of various legislative measures adopted by the Central or State Governments in recent times. Increased productivity results in an increase in value added, and this has the effect of reducing labour' cost per unit.

b)

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The managed costs should be properly scrutinized in terms of their costs and benefits. Such costs include office decorating expenses, advertising, managerial salaries and payments, etc. Managed costs are more, or less fixed costs and once committed they are difficult to retreat. In order to minimise the cost impact of such items, the maximum possible use of facilities already created must be ensured. Further the management should be vigilant in sanctioning any new expenditure belonging to this cost.

The increasing pressure to augment working capital will, to some extent, be neutralised if the span of the operating cycle can be reduced. Greater turnover with shorter intervals and quicker realisation of debtors will go a long way in easing the situation. Only when there is a pressure on working capital does the management become conscious of the existence of slow-moving and obsolete stock. The management tends to adopt ad hoc measures, which are grossly inadequate. Therefore, a clear-cut policy regarding the disposal of slow-moving and obsolete stocks must be formulated and adhered to. In addition to this, there should be an efficient management information system reflecting the stock position from various standpoints. The payment to creditors in time leads to building up of good reputation and consequently it increases the bargaining power of the firm regarding period of credit for payment and other conditions. Projections of cash flows should be made to see that cash inflows and outflows match with each other. If they do not, either some payments have to be postponed or purchase of some avoidable items has to be deferred.

Management of Working Capital

16.12

EFFICIENCY CRITERIA

Improved profitability of a firm, to a great extent, depends on its efficiency in managing working capital. A single criterion would not be sufficient to judge or evaluate the efficiency in a dynamic area like working capital. Some of the parameters for judging the efficiency in managing working capital are: a) Whether there is enough assurance for the creditors about the ability of the company to meet its short-term commitments on time Hence, a reliable index is whether a company can settle the bills on due dates. The finance department has to plan in advance to maintain sufficient liquidity to meet maturing liabilities. Whether maximum possible inventory turnover is achieved. The adverse effect of ineffective inventory management may not be offset even by the most efficient management of other components of working capital. Whether reasonable credit is extended to customers. This powerful instrument to promote sales should not be misused. The other side of the same coin is receiving credit. Both depend upon a company's strength as a seller and as a buyer. Whether adequate credit is obtained from suppliers. It depends upon the company's position in relation to its suppliers and the nature of supply market i.e. whether there is a single supplier or an oligarchy or a large number of suppliers. With coordination of efforts buyers can be in a position to negotiate competitive credit terms even if there is a single supplier and his ability to control the market. At times the supplier imposes the credit terms as 100% advance i.e. negative trade credit. Whether there are adequate safeguards to ensure that neither overtrading nor undertrading takes place.

b)

c)

d)

e)

The following indices can be used for measuring the efficiency in managing working capital: Current Ratio (CR) CR = Current Assets/Current Liabilities It indicates the ability of a company to manage the current affairs of business. It is useful to study the trend of working capital over a period of time.

19

Financial Decisions

Though the current ratio of 2:1 is considered ideal, this may have to be modified depending on the peculiar conditions prevailing in a particular trade or industry. It is not only the quantum of current ratio that is important but also its quality, i.e. extent to which assets and liabilities are really current. Quick Ratio (QR) QR = Liquid Assets/Current Liabilities Liquid assets mean current assets minus those, which are not quickly realizable. Inventory and sticky debts are generally treated as non-quick assets. The relationship of 1:1 between quick assets and current liabilities is considered ideal, but, like current ratio, it also varies from industry to industry, depending on the peculiar conditions of a particular industry. Cash to Current Assets If cash alone is a major item of current assets then it may be a good indicator of the profitability of the organisation, as cash by itself does not earn any profit, the proportion should usually be kept low. Sales to Cash Ratio Sales to Cash Ratio = Sales/Average cash balance during the period. Cash should be turned over as many times as possible, in order to achieve maximum sales with minimum cash on hand. Average Collection Period (Debtors/Credit Sales) x 365 This ratio explains how many days of credit a company is allowing to its customers to settle their bills. Average Payment Period Average payment period = (Creditors/Credit purchases) x 365 It indicates how many days of credit is being enjoyed by the company from its suppliers. Inventory Turnover Ratio (ITR) ITR = Sales/Average Inventory It shows how many times inventory has turned over to achieve the sales. Inventory should be maintained at a level, which balances production facilities and sale's needs. Working Capital to Sales Usually expressed in terms of percentage, it signifies that for any amount of sales a relative amount of working capital is needed. If any increase in sales is contemplated it has to be seen that working capital is adequate. Therefore, this ratio helps management in maintaining working capital, which is adequate for the planned growth in sales. Working Capital to Net Worth Working Capital/Net wroth This ratio shows the relationship between working capital and the funds belonging to the owners. When this ratio is not carefully watched, it may lead to:

20

a) Overtrading when the conditions are in the upswing. Its symptoms being (i) High Inventory Turnover Ratio (ii) Low Current Ratio; or

b) Under trading when the conditions of market are not good. Its major symptoms are: i) Low Inventory Turnover Ratio ii) High Current Ratio Efficient working capital management should, therefore, avoid both excess and deficit working capital situations. Efficient working capital management demands proper management of its current assets, as excess of these assets would not yield any returns. Cash and marketable securities being least productive need to be managed even more carefully. Cash denotes the liquidity of a business enterprise and plays an important role in nurturing and improving the profitability of an organisation. It is, therefore, essential to make a proper estimate of the cash need and plan for it so as to avoid technical or legal insolvency. Hence, effective management of cash is necessary to ensure adequate liquidity. Activity 16.2 Meet any Accounting or Finance Executive of a business enterprise, whether in the Public or the Private Sector, and talk to him regarding the management of working capital in his enterprise. Please try to gather information on the following questions: a) What methods does the enterprise employ for efficient management of working capital? .......................................................................................................................... .......................................................................................................................... .......................................................................................................................... b) Do the methods under (a) above include Ratio Analysis? What ratios are being computed and why? .......................................................................................................................... .......................................................................................................................... .......................................................................................................................... c) What steps the organisation has taken in the recent past to improve the management of working capital? .......................................................................................................................... .......................................................................................................................... .......................................................................................................................... d) What are the major problems faced by the enterprise regarding management of working capital? .......................................................................................................................... .......................................................................................................................... ..........................................................................................................................

Management of Working Capital

16.13 DETERMINING OPTIMAL CASH BALANCE

Holding of excessive cash is a non-profitable proposition, as idle cash does not earn any income. Similarly shortage of cash may deprive the business unit of availing the benefits of cash discounts, and of taking advantage of other favourable opportunities. It may even lead to loss of credit-worthiness on account of default in paying liabilities when the same become due. Hence, every organisation, irrespective of its size and nature, has to determine the appropriate or optimum cash balance that it would need.

21

Financial Decisions

nature has to determine the appropriate or optimum cash balance that it would need. A firm's cash balance, generally, may not be constant over time. It would therefore be worthwhile to investigate the maximum, minimum and average cash needs over a designated time period. You are aware that cash is needed for various transactions in the organisation. Maintenance of a cash balance however has an opportunity cost in the following ways: a) Cash can be invested in acquiring assets such as Inventory, or for purchasing securities. Opportunies for such investments may have to be lost if a certain minimum cash balance is not held. Holding of cash means that it cannot be used to offset financial risks from the short-term debts. Excessive reliance on internally generated liquidity can isolate the firm from the short-term financial market.

b) c)

Now the financial manager should understand the benefits and the opportunity costs for holding cash. Thereafter, he must proceed to work out a model for determining the optimal amount of cash. First of all a critical minimum cash balance should be conceived below which the firm will incur definite and measurable costs. Apart from risk aversion the existence of the minimum balance is justified by institutional requirements such as credit ratings, checking accounts, lines of credit. The violation of maintaining a minimum cash balance will create shortage costs which will be determined by the actions of creditors on account of postponing their payments or non-availing of cash discounts. At any point of time a firm's (ending) cash balance can be represented as follows: Ending balance = Beginning Balance + Receipts Disbursements If receipts and disbursements are equal for any unit of time, no problem is involved. Ordinarily, however, receipts may be more than disbursements or vice versa. Hence, the ending balance will keep on fluctuating. In actual practice receipts and disbursements do vary, particularly in case of firms having seasonal activities. Suppose, the receipts and disbursements are not synchronized but the variation is predictable, then the main problem will be that of minimizing total costs. In case you set the balance too low you will incur high transaction costs. If you set the balance too high you will lose interest, which you can earn by investing cash in marketable securities. The determination of optimal cash balance under these conditions of known certainty is similar to the inventory problem: The costs of too little cash (transaction costs) can be balanced against the costs of too much cash (opportunity costs). Figure 16.4 clarifies this position. Figure 16.4: The Optimal Working Cash Balance

22

Point C in Figure 16.4 denotes the point where the sum of two costs (opportunity. and transaction costs) is minimum. Efficient management should try to locate this point for determining the optimal cash balance. M is the point where working cash balance is optimal. It is seldom that receipts and disbursements are completely predictable. For a moment let, us take one extreme case where receipts and disbursements are completely random: A model can be developed using the Control Theory and fix maximum and minimum optimal balances as illustrated in Figure 16.5 Figure 16.5 : Cash Balance Control Limits

Management of Working Capital

You can observe from Figure 16.5 that the fluctuating cash balance is on account of random receipts and disbursements. At time t the balance touches the upper control point. At this point the excess of cash is invested in marketable securities. The balance falls to zero point at time t2 and at this stage marketable securities have to be sold to create cash balances. These two control points lay only the maximum and minimum balance. We can conclude that where cash flows (receipts and disbursements) are uncertain the principle will be: the greater the variability the higher the minimum cash balance. Activity 16.3 Meet any Accounting or Finance Executive of a business enterprise, whether in the Public or the Private Sector, and talk to him regarding the management of working, capital in his enterprise. Please try to gather information on the following questions: i) What are the main groups of expenditure for which cash is needed in your organisation: (a) on daily basis ........................................................................................................................ ........................................................................................................................ ........................................................................................................................ (b) on monthly basis ........................................................................................................................ ........................................................................................................................ ........................................................................................................................ (c) at irregular intervals ........................................................................................................................ ........................................................................................................................ ........................................................................................................................

23

Financial Decisions

(d) at regular intervals, other than daily or monthly basis ........................................................................................................................ ........................................................................................................................ ........................................................................................................................ ii) What are the main sources of cash and what arrangements exist for collection, accounting and banking of cash receipts? ........................................................................................................................ ........................................................................................................................ ........................................................................................................................

16.14 MANAGEMENT OF CASH FLOWS

The cash flows could be properly and effectively managed by: Speeding up Collections In order to minimise the size of cash holding, the time gap between sale of goods and their cash collection should be reduced and the flow be controlled. Normally, certain factors creating time lags are beyond the control of management. Yet, in order to improve the efficiency, attention should be paid to the following. All cash collected should be directly deposited in one account. If there are more than one collection centres, all cash receipts should be remitted to the main account with. top speed. Compared to a single collection centre, the aggregate requirement for cash will be more when there are several centres. Concentration of collections at one place will thus permit the firm to store its cash more efficiently. The time lag between the dispatch of cheque by the customer and its credit to our account with the bank should be reduced. Some firms with large collection transactions introduce lock box system. In this system the post boxes are hired at different centres where cash/cheques can be dropped in. The local banker can daily collect the same from the lockers. The collecting bank is paid service charges. In order to minimise time, banks may be asked to devise methods for speeding up the collection of cash. Recovering Dues After sale of goods on credit, either on account of convention or for promoting sales, receivables are created. It may however be useful to reduce the amount blocked in receivables by seeing to it that they do not become overdue accounts. Incentive in the form of discounts for early payment may be given. More important than anything else is a constant follow-up action for the recovery of dues. This will improve position of cash balance. Controlling Disbursements Needless to assert that speeding up of collections helps conversion of receivables into cash and thus reduces the financing requirements of the firm. Similar kind of benefit can be derived by delaying disbursements. Trade credit is a costless source of funds for it allows us to pay the creditors only after the period of credit agreed upon. The dues can be withheld till the last date. This will reduce the requirement for holding large cash balance. Some firms may like to take advantage of cheque book float which is the time gap between the date of issue of a cheque and the actual when it is presented for payment directly or through the bank. Investment of Idle Cash Balances

24

Two other important aspects in cash management are how to determine appropriate cash balance and how to invest temporarily idle cash in interest earning assets or

securities. The first part relating to the theory of determining appropriate cash balance has already been discussed earlier. Now we shall discuss the investment of idle cash balance on temporary basis. Cash by itself yields no income. If we know that some cash will be in excess of our need for a short period of time, we must invest it for earning income without depriving ourselves of the benefit of liquidity of funds. While doing this, we must weigh the advantages of carrying extra cash (i.e. more than the normal requirement) and the disadvantages of not carrying it. The carrying of extra cash may be necessitated due to its requirement in future, whether predictable or unpredictable. The experience indicates that cash flows cannot be predicted with complete accuracy. Competition, technological changes, unexpected failure of products, strikes and variations in economic conditions make it difficult to predict cash needs accurately. Investment Criteria When it is realised that the excess cash will remain idle, it should be invested in such a way that it would generate income and at the same time ensure quick re-conversion of investment in cash. While choosing the channels for investment of any idle cash balance for a short period, it should be seen that (i) the investment is free from default risk, that is, the risk involved due to the possibility of default in timely payment of interest and repayment of principal amount; (ii) the investment shall mature in short span of time; and (iii) the investment has adequate marketability. Marketability refers to the ease with which an asset can be converted back into cash. Marketability has two dimensions -price and time-which are inter-related. If an asset can be sold quickly in large amounts at a price determinable in advance the asset will be regarded as highly marketable and highly liquid. The assets which largely satisfy the aforesaid criteria are: Government Securities, Bankers' Acceptances and Commercial Paper. Activity 16. 4 Discuss with the Chief Executive of Accounting and Finance department of your organisation regarding the broad policies and procedures followed in the sphere of cash management? ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... .........................................................................................................................................

Management of Working Capital

16.15

SUMMARY

An enterprise needs funds to operate profitably. The working capital of a business reflects the short-term uses of funds. Apart from the investment in the long-term assets such as buildings, plant and equipment, funds are also needed for meeting day to day operating expenses and for amounts held in current assets. Within the time span of one year there is a continuing cycle or turnover of these assets. Cash is used, to acquire stock, which on being sold results in an inflow of cash, either immediately or after a time lag in case the sales are on credit. The rate of turnover of current assets in relation to total sales of a given time period is of critical importance to the total funds employed in those assets. The amount needed to be invested in current assets is affected by many factors and may fluctuate over a period of time. Manufacturing cycle, production policies, credit terms, growth and expansion needs, and inventory turnover are some of the important factors influencing the determination of working capital.

25

Financial Decisions

Inflation magnifies the need for working capital. The constant rise in the cost of inputs, if not accompanied with corresponding increase in output prices puts an additional strain on the management. However, by taking several measures on production front and by keeping a strict watch on managed costs and expediting collection of credit sales, etc. the management can contain or at least minimise the upward thrusts for additional working capital. The management should ensure the adequacy and efficiency in the utilisation of working capital. For this purpose various ratios can be periodically computed and compared against the norms established in this regard. For efficient management of working capital, management of cash is as important as the management of other items of current assets like receivables and inventories. Too little cash may place the firm in an illiquid position, which may force the creditors and other claimants to stop transacting with the firm. Too much cash results in funds lying idle, thereby lowering the overall return on capital employed below the acceptable level. An adequate amount of cash is always needed for meeting any unforeseen contingencies and also liabilities as well as day-to-day operating expenses of the business.

16.16 KEY WORDS

Operating Cycle in a manufacturing firm is the time gap between purchase of raw material and sale of finished products. Gross Current Assets means the aggregate of all current assets including cash. Net Current Assets means the aggregate of all current assets (including cash) less current liabilities. It is the same as working capital. Fixed Working Capital is the amount that remains more or less permanently invested as working capital in business. Fluctuating Working Capital is the amount of working capital over and above the fixed minimum amount of working capital. It may keep on fluctuating from period to period depending upon several factors. Inventory Turnover means number of times the average inventory has been sold during a period. Inventory turnover ratio is obtained by dividing cost of goods sold during a period with average inventory for the period. Current Ratio is the relationship between current assets and current liabilities. Quick Ratio is the relationship between quick assets and current liabilities. Inventory is generally not reckoned among quick assets and hence excluded. Debtors Turnover is the relationship between average debtors (receivables) and average turnover. Average Collection Period is the average period, which elapses between sale of goods on credit and the collection of cash. Average Payment Period is the period, which elapses on the average between purchase of goods on credit and the payment to creditors. Credit Policy is concerned with norms and guidelines for determining whether and to what extent credit can be granted to customers in general and various categories of customers in particular. Credit Terms means the terms extended by a firm to its debtors for payment.

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16.17 SELF-ASSESSMENT QUESTIONS/EXERCISES

1. 2. 3. Discuss the concept of working capital. Are the gross and net concepts of working capital exclusive? Explain. Distinguish between fixed and fluctuating working capitals. What is the significance of such distinction in financing working needs of an enterprise? Discuss the significance of working capital management in a business enterprise. What shall be the repercussions if a firm has (a) shortage of working capital and (b) excess working capital? A firm desires to finance its current assets entirely with short-term loans. Do you think this pattern of financing would be in the interest of the firm ? Support your answer with cogent arguments. What factors a financial manager would ordinarily take into consideration while estimating working capital needs of his firm? What is an operating cycle and how a close study of the operating cycle is helpful? How would you as a Finance Manager control the need of increased working capital on account of inflationary pressures? Narrate some real-life examples you might have come across. How would you judge the efficiency of the management of working capital in a business enterprise? Explain with the help of hypothetical data. What is optimum cash balances and how can it be arrived at? If a firms estimates that it will have some idle cash balances from time to time, what advice would you render to the firm? "In managing cash the finance manager faces the problem of compromising the conflicting goals of liquidity and profitability comment. What strategy should the finance manager develops to solve this problem. Assam Timber Ltd., a newly founded company, has applied fora short-term loan to a commercial bank for financing its working capital requirement. You are requested by the bank to prepare a statement on the requirement for working capital for that company. You may add 10% to your estimated figure to cover for unforeseen contingencies. The projected profit and loss account of the company is as under: Sales Cost of goods sold Gross Profit Additional expenses 1,80,000 Selling expenses 1,50,000 Profit before tax Provision for tax Profit after tax Cost of goods sold has been derived as follows: Material sold Wages & manufacturing expenses Depreciation Less Stock of finished goods estimated at 10% of production 25,00,000 18,00,000 7,00,000 3,30,000 3,70,000 1,20,000 2,50,000 9,60,000 7,40,000 3,00,000 20,00,000 2,00,000 18,00,000

Management of Working Capital

4.

5. 6. 7.

8. 9. 10. 11.

12.

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Financial Decisions

The figures above relate to the goods that would be finished (or completed) and not to work in process. Goods equal of 20% of the year's production in terms of physical units are expected to be in progress on an average, requiring full materials but only 50 per cent of other expenses. The company intends to keep two months consumption of material in stock. All the expenses will be paid one month in arrears. Suppliers of material would extend one-month credit. Sixty per cent of the sales are estimated on cash basis while the rest are on two months credit. Seventy per cent of the income tax has to be paid in advance in quarterly installments. The company will require Rs. 50,000 cash to meet day-to-day needs of business. For the purpose of the question you may ignore profit as a source of working capital. Answer to Self-assessment Questions/Exercises 12 Total investment in current assets i) Less current liabilities: Lag in payment of expenses Creditors Add 10% for contingencies Total working capital required: i) 89,167 80,000 1,69,167 6,00,833 60,083 6,60,916 7,70,000

Depreciation is not a cash expense and hence it has been excluded from cost of goods sold for the purpose of determining investment in debtors. Similarly, depreciation has not been taken into account in determining investment in work-in-process and stock of finished goods. For the purpose of determining investment in work-in-process, advertising and selling expenses are not relevant. Hence, they have not to be taken into account. For the purpose of this question profit is to be ignored as a source of working capital. As such income tax has also been disregarded since income tax paid out of profit.

ii)

iii)

16.18 FURTHER READINGS

Van Home, James C., 2002. Financial Management and Policy, Prentice-Hall of India: New Delhi (Part V). Khan M.Y., Jain P.K., 2002. Cost Accounting and Financial Management, Tata McGraw Hill (Chapters 11-16). Kulkarni, P.V., Sathya Prasad B.G., 1999. Financial Management, Himalaya Publishing: Bombay. Kuchhal, S.C., 1985. Financial Management, Chaitanya Publishing: Allahabad (Chapter 9 & 10).

AUDIO/VIDEO PROGRAMMES
Video Working Capital Management 28 Unique Enterprises: A Case Study

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UNIT 17
Objectives

CAPITAL STRUCTURE

Capital Structure

The objectives of this unit are to: explain the importance of decisions regarding capital structure identify the factors that have bearing on determining the capital structure explain the concept of an appropriate capital structure

Structure
17.1 17.2 17.3 17.4 17.5 17.6 17.7 17.8 Introduction What is Capital Structure ? Features of an Appropriate Capital Structure Determinants of Capital Structure Summary Key Words Self-assessment Questions/Exercises Further Readings

17.1 INTRODUCTION
Finance is a important input for any type of business and is needed for working capital and for permanent investment. The total funds employed in a business are obtained from various sources. A part of the funds are brought in by the owners and the rest is borrowed from others-individuals and institutions. While some of the funds are permanently held in business, such as share capital and reserves (owned funds), some others are held for a long period such as long-term borrowings or debentures, and still some other funds are in the nature of short-term borrowings: The entire composition of these funds constitute the overall financial structure of the firm. You are aware that short-term funds keep on shifting quite often. As such the proportion of various sources for short-term funds cannot perhaps be rigidly laid down. The firm has to follow a flexible approach. A more definite policy is often laid down for the composition of long-term funds, known as capital structure. More significant aspects of the policy are the debt equity ratio and the dividend decision. The latter affects the building up of retained earnings which is an important component of longterm owned funds. Since the permanent or long-term funds often occupy a large portion of total funds and involve long-term policy decision, the term financial structure is often used to mean the capital structure of the firm. There are certain sources of long-term funds which are generally available to the corporate enterprises. The main sources are: share capital (owners' funds) and longterm debt including debentures (creditors' funds). The profit earned from operations are owners' funds-which may be retained in the business or distributed to the owners (shareholders) as dividend. The portion of profits retained in the business is a reinvestment of owners' funds. Hence, it is also a source of long-term funds. All these sources together are the main constituents of the capital of the business, that is, its capital structure.

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Financial Decisions

17.2

WHAT IS CAPITAL STRUCTURE?

The term `capital structure' represents the total long-term investment in a business firm. It includes funds raised through ordinary and preference shares, bonds, debentures, term loans from financial institutions, etc. Any earned revenue and capital ' surpluses are included. Capital Structure Planning Decision regarding what type of capital structure a company should have is of critical importance because of its potential impact on profitability and solvency. The small companies often do not plan their capital structure. The capital structure is allowed to develop without any formal planning. These companies may do well in the short-run, however, sooner or later they face considerable difficulties. The unplanned capital structure does not permit an economical use of funds for the company. A company should therefore plan its capital structure in such a way that it derives maximum advantage out of it and is able to adjust more easily to the changing conditions. Instead of following any scientific procedure to find an appropriate proportion of different types of capital which will minimise the cost of capital and maximise the market value, a company may just either follow what other comparable companies do regarding capital structure or may consult some institutional lender and follow its advice. Theoretically, a company should plan an optimum capital structure in such a way that the market value of its shares is maximum. The value will be maximised when the marginal real cost of each source of funds is the same. In general, the discussion on the issue of optimum capital structure is highly theoretical. The determination of an optimum capital structure in practice is a formidable task, and we have to go beyond the theory. That is why, perhaps, significant variations among industries and among' different companies within the same industry regarding capital structure are found. A number of factors influence the capital structure decision of a company. The judgement of the person or group of persons making the capital structure decision plays a crucial role. Two similar companies can have different capital structures if the decision makers differ in their judgement about the significance of various factors. These factors are highly psychological, complex and qualitative and do not always follow the accepted theory. Capital markets are not perfect and the decision has to be taken with imperfect knowledge and consequent risk. You might have become interested in identifying some of the important factors which influence the planning of the capital structure in practice. However, before we discuss these factors let us examine the features of an appropriate capital structure in the next section. Activity 17.1 Look into the financial statement of one large company and one medium or small sized company in the private sector and then arrange a meeting with their executives in the department of Accounting and Finance. Investigate on the following lines: a) What is the composition of the capital structure of the company? Why the company has a particular capital structure and why not some other? Was any capital structure planning done before the companies were set up? .. .. .. .. .. .. ..

30

b)

Note the differences in the capital structures of the two companies and find out the reasons for the differences. .. .. .. ..

Capital Structure

b)

Are the capital structures of the two companies of their own making or have they evolved on account of circumstances beyond their control? .. .. .. ..

d)

Do the companies regard their capital structures optimum? If not, what plans do they have or propose to have to set the capital structure right? .. .. .. ..

17.3 FEATURES OF AN APPROPRIATE CAPITAL STRUCTURE

Capital structure is usually planned keeping in view the interests of the ordinary shareholders. The ordinary shareholders are the ultimate owners of the company and have the right to elect the directors. While developing an appropriate capital structure for his company, the financial manager should aim at maximising the long-term market price of equity shares. In practice, for most companies within an industry, there would be a range of appropriate capital structures within which there are not many differences in the market values of shares. A capital structure in this context can be determined empirically. For example, a company may be in an industry that has an average debt to total capital ratio of 60 per cent. It may be empirically found that the shareholders in general do not mind the company operating within a 15 per cent range of the industry's average capital structure. Thus, the appropriate capital structure for the company ranges between 45 per cent to 75 per cent debt to total capital ratio. The management of the company should try to seek the capital structure near the top of this range in order to make maximum use of favourable leverage, subject to other requirements such as flexibility, solvency, etc. A sound appropriate capital structure should have the following features: Profitability: The capital structure of the company should be most advantageous, within the constraints. Maximum use of leverage at a minimum cost should be made. Solvency: The use of excessive debt threatens the solvency of the company. Debt should be used judiciously. Flexibility: The capital structure should be flexible to meet the changing conditions. It should be possible for a company to adapt its capital structure with minimum cost and delay if warranted by a changed situation. It should also be possible for the company to provide funds whenever needed to finance its profitable activities. In other words, from the solvency point of view we need to approach capital structuring with due conservation. The debt capacity of the company which depends on its ability to generate future cash flows should not be exceeded. It should have enough cash to pay periodic fixed charges to creditors and the principal sum on maturity.

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Financial Decisions

The above are the general features of an appropriate capital structure. The particular characteristics of a company may reflect some additional specific features. Further, the emphasis given to each of these features may differ from company to company. For example, a company may give more importance to flexibility than to retaining the control which could be another desired feature, while another company may be more concerned about solvency than about any other requirement. Furthermore, the relative importance of these requirements may change with changing conditions.

17.4 DETERMINANTS OF CAPITAL STRUCTURE

Capital structure has to be determined at the time a company is promoted. The initial capital structure should be designed very carefully. The management of the company should set a target capital structure and the subsequent financing decisions should be made with a view to achieve the target capital structure. Once a company has been formed and it has been in existence for some years, the financial manager then has to deal with the existing capital structure. The company may need funds to finance its activities continuously. Every time the funds have to be procured, the financial manager weighs the pros and cons of various sources of finance and selects most advantageous sources keeping in view the target capital structure: Thus the capital structure decision is a continuous one and has to be taken whenever a firm needs additional finance. Generally, the factors to be considered whenever a capital structure decision is taken are: (i) Leverage or Trading on equity, (ii) Cost of capital, (iii) Cash flow, (iv) Control, (v) Flexibility, (vi) Size of the company, (vii) Marketability, and (viii) Floatation costs. Let its briefly explain these factors. Leverage or Trading on Equity The use of sources of finance with a fixed cost, such as debt and preference share capital, to finance the assets of the company is known as financial leverage or trading on equity. If the assets financed by debt yield a return greater than the cost of the debt, the earnings per share will increase without an increase in the owners' investment. Similarly, the earnings per share will also increase if preference share capital is used to acquire assets. But the leverage impact is felt more in case of debt because (i) the cost of debt is usually lower than the cost of preference share capital, and (i i) the interest paid on debt is a deductible charge from profits for calculating the taxable income while dividend on preference shares is not. Because of its effect on the earnings per share, financial leverage is one of the important considerations in planning the capital structure of a company. The companies with high level of the Earnings Before Interest and Taxes (EBIT) can make profitable use of the high degree of leverage to increase return on the shareholders' equity. One common method of examining the impact of leverage is to analyse the relationship between Earnings Per Share (BPS) at various possible levels of EBIT under alternative methods of financing. The EBIT-EPS analysis is one important tool in the hands of the financial manager to get an insight into the firm's capital structure management. He can consider the possible fluctuations in EBIT and examine their impact on EPS under different financing plans. You may refer to the section `Effects of Financial Leverage' in Unit 13 (Leverage Analysis), particularly Table 13.3 for a recapitulation of the effects of financial, leverage on earnings per share (EPS) under various financing plans with different mix of equity and fixed return securities, For your facility, we reiterate the demonstration of the effect of financial leverage on EPS by considering three alternative financing plans in Illustration 17.1.

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Illustration 17.1 Plan A : Plan B : Plan C : No debt, all equity shares 50% debt (10%), 30% preference shares (12%), 20% equity shares 80% debt (10%), 20% equity shares

Capital Structure

The face value of equity Shares is Rs. 10. The Rates in parentheses indicate the fixed return on debt and preference shares. The total amount of capital required to be raised is Rs. 2,00,000. The company estimates its earnings before interest and taxes (EBIT) at Rs. 50,000 annually. Table 17.1 Effect of Financial Leverage on EPS (in Rs.) A 50,000 50,000 25,000 25,000 25,000 20,000 1.25 Financing Plan B 50,000 10,000 40,000 20,000 20,000 7,200 12,800 4,000 3.20 C 50,000 16,000 34,000 17,000 17,000 17,000 4,000 4.25

Earnings before interest and taxes Interest Earnings before taxes Income Tax (50%) Earnings after taxes Preference share dividend Earnings available on equity shares No. of shares Earnings per share (EPS)

The effect of financial leverage (trading on equity) is presented in Table 17.1. It will be seen that Plan C is the most attractive from shareholders' point of view as the EPS of Rs. 4.25 is the highest under this plan. The lowest EPS is when the company does not use any debt or fixed return securities. You will note that the proportion of fixed return, securities under plans B and C is the same (80%). However, plan C gives a higher EPS for the reason that dividend on preference share is not deductible for income tax purposes while interest is a deductible charge. Assuming that the estimates about EBIT turn out to be correct, the shareholders would be benefited to the maximum if plan C is adopted. The shares of the company will command a high premium in the market and would be greatly in demand. The managements of companies sometimes intentionally want to make their equity shares very attractive and prized possessions. This they can achieve by the practice of trading on equity. The secret of the advantage in financial leverage lies in the fact that whereas the overall return (before tax) on capital employed is 25% the return on preference share and debt is only 12% and 10% respectively. The savings resulting from this difference enable the management to enhance the return on equity shares. Although leverage increases EPS under favourable conditions, it can also increase financial risk to the shareholders. Financial risk increases with the use of debt because of (a) the increased variability in the shareholder's earnings and (b) the threat of insolvency. A firm can avoid financial risk altogether if it does not employ any debt in its capital structure. But when no debt is employed in the capital structure, the shareholders will be deprived of the benefit of increases in EPS arising from financial leverage.

33

Financial Decisions

Therefore a firm should employ debt to the extent the financial risk perceived by the shareholders does not exceed the benefit of increased EPS. Cost of Capital Measuring the costs of various sources of funds is a complex subject and needs a separate treatment. Needless to say that it is desirable to minimise the cost of capital. Hence, cheaper sources should be preferred, other things remaining the same. The cost of a source of finance is the minimum return expected by its suppliers. The expected return depends on the degree of risk assumed by investors. A high degree of risk is assumed by shareholders than debt-holders. In the case of debt-holders, the rate of interest is fixed and the company is legally bound to pay interest, whether it makes profits or not. For shareholders the rate of dividend is not fixed and the Board of Directors has no legal obligation to pay dividends even if the profits have been made by the company. The loan of debt-holders is returned within a prescribed period, while shareholders can get back their capital only when the company is wound up. This leads one to conclude that debt is a cheaper source of funds than equity. The tax deductibility of interest charges further reduces the cost of debt. The preference share capital is cheaper than equity capital, but is not as cheap as debt is. Thus, in order to minimise the overall cost of capital, a company should employ a large amount of debt. However, it should be realised that a company cannot go on minimising its overall cost of capital by employing debt. A point is reached beyond which debt becomes more expensive because of the increased risk of excessive debt to creditors as well as to shareholders. When the degree of leverage increases, the risk to creditors also increases. They may demand a higher interest rate and may not further provide loan to the company at all once the debt has reached a particular level. Furthermore, the excessive amount of debt makes the shareholders' position very risky. This has the effect of increasing the cost of equity. Thus, upto a point the overall cost of capital decreases with debt, but beyond that point the cost of capital would start increasing and, therefore, it would not be advantageous to employ debt further. So there is a combination of debt and equity, which minimises that firm's average cost of capital and maximises the market value per share. The cost of equity includes the cost of new issue of shares and the cost of retained earnings. The cost of debt is cheaper than the cost of both these sources of equity funds. Between the cost of new issues and retained earnings, the latter is cheaper. The cost of retained earnings is less than the cost of new issues because the company does not have to pay personal taxes which have to be paid by shareholders on distributed earnings, and also because, unlike new issues, no floatation costs are incurred if the earnings are retained. As a result, between these two sources, retained earnings are preferable. Thus, when we consider the leverage and the cost of capital factors, it appears reason-able that a firm should employ a large amount of debt provided its earnings do not fluctuate very Widely. In fact, debt can be used to the point where the average cost of capital is minimum. These two factors taken together set the maximum limit to the use of debt. However, other factors should also be evaluated to determine the appropriate capital structure for a company. Theoretically, a company should have such a mix of debt and equity that its overall cost of capital is minimum. Let us understand this concept by taking an Illustration.

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Illustration 17.2 A company is considering a most desirable capital structure. The cost of debt (after tax) and of equity capital at various levels of debt equity mix are estimated as follows: Debt as percentage of total capital employed 0 20 40 50 60 Cost of debt (%) 10 10 12 13 14 Cost of equity (%) 15 15 16 18 20

Capital Structure

Determine the optimal mix of debt and equity for the company by calculating composite cost of capital? For determining the optimal debt equity mix, we have to calculate the composite cost of capital i.e. Ko which is equal to Kip1+Kep2 Where Ki = Cost of debt pl = Relative proportion of debt in the total capital of the firm Ke = Cost of equity p2 = Relative proportion of equity in the total capital of the firm Before we arrive at any conclusion, it would be desirable to prepare a table showing all necessary information and calculations. Table 17.2 Cost of Capital Calculations Ki % 10 10 12 13 14 Ke % 15 15 16 18 20 pl 0.0 0.2 0.4 0.6 0.6 p2 1.00 0.8 0.6 0.5 0.4 Kip1+kep2= Ko 0+15.0=15 2.0+12.0=14 4.8+9.6=14.4 7.8+9.0=16.8 8.4+8.0=16.4

The optimal debt equity mix for the company is at a point where the composite cost of capital is minimum. From Table 17.2 it is evident that a mix of 20% debt and 80% equity gives the minimum composite cost of capital of 14%. Any other mix of debt and equity gives a higher overall cost of capital. The closest to the minimum cost of capital is a mix of 40% debt and 60% equity where Ko is 14.4%. It can therefore be concluded that a mix of 20% debt and 80%,equity will make the capital structure optimal. Cash Flow One of the features of a sound capital structure is conservation. Conservation does not mean employing no debt or a small amount of debt. Conservatism is related to the assessment of the liability for fixed, charges, created by the use of debt or preference capital in the capital structure in the context of the firm's ability to generate cash to meet these fixed charges. The fixed charges of a company include payment of interest, preference dividend and principal. The amount of fixed charges will be high if the company employs a large amount of debt or preference capital. Whenever a company thinks of raising additional debt, it should analyse its expected future cash flows to meet the fixed charges. It is obligatory to pay interest and return the principal amount of debt. If a company

35

Financial Decisions

is not able to generate enough cash to meet its fixed obligations, it may have to face financial insolvency. The companies which expect large and stable cash inflows can employ a large amount of debt in their capital structure. It is somewhat risky to employ sources of capital with fixed charges for companies whose cash inflows are unstable or unpredictable. Control In designing the capital structure, sometimes the existing management is governed by its desire to continue control over the company. The existing management team may not only what to be elected to the Board of Directors but may also desire to manage the company without any outside interference. The ordinary shareholders have the legal right to elect the directors of the company. If the company issues new shares, there is a risk of loss of control. This is not a very important consideration in case of a widely held company. The shares of such a company are widely scattered. Most of the shareholders are not interested in taking active part in the company's management. They do not have the time and urge to attend the meetings. They are simply interested in dividends and appreciation in the price of shares. The risk of loss of control can almost be avoided by distributing shares widely and in small lots. Maintaining control however could be a significant question in the case of a closely held company. A shareholder or a group of shareholders could purchase all or most of the new shares and thus control the company. Fear of having to share control and thus being interfered by others often delays the decision of the closely held companies to go public. To avoid the risk of loss of control the companies may issue preference shares or raise debt capital. Since holders of debt do not have voting right, it is often suggested that a company should use debt to avoid the loss of control. However, when a company uses large amounts of debt, lot of restrictions are imposed on it by the debt-holders to protect their interests. These restrictions curtail the freedom of the management to run the business. An excessive amount of debt may also cause bankruptcy, which means a complete loss of control. Flexibility Flexibility means the firm's ability to adapt its capital structure to the needs of the changing conditions. The capital structure of a firm is flexible if it has no difficulty in changing its capitalisation or sources of funds. Whenever needed the company should be able to raise funds without undue delay and cost to finance the profitable investments. The company should also be in a position to redeem its preference capital or debt whenever warranted by future conditions. The financial plan of the company should be flexible enough to change the composition of the capital structure. It should keep itself in a position to substitute one form of financing for another to economise on the use of funds. Size of the Company The size of a company greatly influences the availability of funds from different sources. A small company may often find it difficult to raise long-term loans. If somehow it manages to obtain a long-term loan, it is available at a high rate of interest and on inconvenient terms. The highly restrictive covenants in loans agreements of small companies make their capital structure quite inflexible. The management thus cannot run business freely. Small companies, therefore, have to depend on owned capital and retained earnings for their long-term funds.

36

A large company has a greater degree of flexibility in designing its capital structure. It can obtain loans at easy terms and can also issue ordinary shares, preference shares and debentures to the public. A company should make the best use of its size in planning the capital structure. Marketability Marketability here means the ability of the company to sell or market particular type of security in a particular period of time which in turn depends upon -the readiness of the investors to buy that security. Marketability may not influence the initial capital structure very much but it is an important consideration in deciding the appropriate timing of security issues. At one time, the market favours debenture issues and at another time, it may readily accept ordinary share issues. Due to the changing market sentiments, the company has to decide whether to raise funds through common shares or debt. If the share market is depressed, the company should not issue ordinary shares but issue debt and wait to issue ordinary shares till the share market revives. During boom period in the share market, it may not be possible for the company to issue debentures successfully. Therefore, it should keep its debt capacity unutilised and issue ordinary4shares to raise finances. Floatation Costs Floatation costs are incurred when the funds are raised. Generally, the cost of floating a debt is less than the cost of floating an equity issue. This may encourage a company to use debt rather than issue ordinary shares. If the owner's capital is increased by retaining the earnings, no floatation costs are incurred. Floatation cost generally is not a very important factor influencing the capital structure of a company except in the case of small companies. Activity 17.2 You have just read about several factors that affect the determination of capital structure in a company. In this context, meet the finance manager of a large company and ascertain which of these factors had bearing on their capital structure and to what extent. . . . . . . . . . . .

Capital Structure

37

Financial Decisions

17.5

SUMMARY

Capital structure is the composition of various sources of long-term finance in the total capitalisation of the company. The two main sources are ownership and creditor ship securities. Both types of securities as well as the long-term loans from financial institutions are used by most of the large industrial companies. Capital structure planning, initially and on continuing basis, is of great importance to any company as it has a considerable bearing on its profitability. A wrong initial decision in this respect may prove quite costly for the company. While taking a decision about capital structure, due attention should be paid-to objectives like profitability, solvency and flexibility. The choice of the amount of debt and other fixed return securities on the one hand and variable income securities, namely equity shares on the other, is made after a comparison of the characteristics of each kind of securities and after careful consideration of internal and external factors related to the firm's operations. In real life situations compromises have to be made somewhere on the line between the expectations of companies seeking funds and the expectations of those that supply them. These compromises do not change the basic distinctions between debt and equity. Generally, the decision about financing is not of choosing between equity and debt but is of selecting the ideal combination of the two. The decision on debt-equity mix is affected by considerations of suitability, risk, income, control and timing. The weights assigned to these factors will vary from company to company depending on the characteristics of the industry and the particular situation of the company. There cannot perhaps be an exact mathematical solution to the decision on capital structuring. Human judgement plays an important role in analysing the conflicting forces before a decision on appropriate capital structure is reached.

17.6

KEY WORDS

Capital Structure (also known as Financial Structure) is the mix of various types of long-term sources of funds, namely debentures, bonds, loans from financial institutions, preference shares and equity shares (including retained earnings). Cost of Capital is the (weighted) average cost of various sources of finance used by a company. Financial Leverage (or Trading on Equity) is an aspect of financial planning which enables the company to enhance the return on equity shares by using debt with lower fixed cost which is less than the overall return on investment. Financial leverage magnifies the effect of changes in EBIT (Earnings Before Interest and Taxes) on EPS (Earnings Per Share).

17.7
1) 2) 3) 4)

SELF-ASSESSMENT QUESTIONS/ EXERCISES

What is capital structure? Explain the importance of capital Structure and planning? What are the features of an appropriate capital structure? What are the determinants of capital structure? Explain briefly. Do you think that different factors affecting capital structure decision will be viewed differently by different companies? Support your answer with suitable examples. Make a comparative assessment of different types of securities from the point of view of capital structuring. Under what conditions different types of securities would be considered more suitable?

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5)

6)

Write notes on the following: a) b) c) d) Trading on equity Cost of capital Flexibility in capital structure Closely held company

Capital Structure

7)

A company wishes to determine the optimal capital structure from the following information. Determine the optimum capital structure from the viewpoint of minimising the cost of capital. Debt Amount 8,00,000 6,00,000 5,00,000 2,00,000 Equity Amount 2,00,000 4,00,000 5,00,000 8,00,000 After tax Cost of debt Ki% 14 13 12 11 Cost equity Ke% 20 18 16 18

Financing Plan A B C D

17.8

FURTHER READINGS

Khan M.Y. and Jain P.K. 2002. Cost Accounting and Financial Management, Tata McGraw Hill (Part-4). Kulkarni,.P.V. Sathya B.G. 1999. Financial Management, (nineth revised edition), Himalaya Publishing : Bombay. Gitman, L.J.1985. Principles of Managerial Finance, Harper & Row : New York (Chapters 12 and 13). James C., Van Horne and John M. Wachowicz 1985. Fundamentals of Financial Management, Prentice-Hall of India : New Delhi (Chapter 17).

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Financial Decisions

UNIT 18
Objectives

DIVIDEND DECISIONS

The objectives of this unit are: to acquaint you with the meaning, types and purpose of dividend to highlight the various factors which influence the determination of dividend policy

Structure
18.1 18.2 18.3 18.4 18.5 18.6 18.7 18.8 18.9 18.10 Introduction Forms of Dividend Dividend Policy Role of Financial Manager Role of Board of Directors Factors Affecting Dividend Decision Summary Key words Self-assessment Questions/Exercises Further Readings

18.1 INTRODUCTION
A business organisation always aims at earning profits. The utilisation of profits earned is a significant financial decision. The main issue here is whether the profits should be used by the owner(s) or retained and reinvested in the business itself. This decision does not involve any problem is so far as the sole proprietory business is concerned. In case of a partnership the agreement often provides for the basis of distribution of profits among partners. The decision-making is somewhat complex in the case of joint stock companies. Since company is an artificial person, the decision regarding utilisation of profits rests with a group of people, namely the board of directors. As in any other types of organisation, the disposal of net earnings of a company involves either their retention in the business or their distribution to the owners (i.e., shareholders) in the form of dividend, or both. Yet the decision regarding distribution of disposable earnings to the shareholders is a significant one. The decision may mean a higher income, lower income or no income at all to the shareholders. Besides affecting the mood of the present shareholders, dividend may also influence the mood, behaviour and responses of prospective investors, stock exchanges and financial institutions because of its relationship with the worth of the company, which in turn affects the market value of its shares. The decision regarding dividend is taken by the Board of Directors and is then recommended to the shareholders for their formal approval in the annual general meeting of the company. Disposal of profits in the form of dividends can become a controversial-issue because of conflicting interests of various parties like the directors, employees, shareholders, debenture holders, lending institutions, etc. Even among the shareholders there may be conflicts as they may belong to different income groups. While some may be interested in regular income, others may be interested in capital appreciation and capital gains. Hence, formulation of dividend policy is a complex decision. It needs careful consideration of various factors. One thing, however, stands out. Instead of an ad hoc approach, it is more desirable to follow a reasonably longterm policy regarding dividends.

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18.2

FORMS OF DIVIDEND

Dividends Decisions

Dividend ordinarily is a distribution of profits earned by a joint stock company among its shareholders. Mostly dividends are paid in cash, but there are also other forms such as Scrip dividends, Debenture dividends, Stock dividends, and, in unusual circumstances, Property dividends. These are briefly described below: Scrip Dividends Dividends can be paid only out of profits earned in the particular year or in the past reflected in the company's accumulated reserves. Profits do not necessarily meanadequate cash to enable payment of cash dividends: In case the company does not have a comfortable cash position it may issue promissory notes payable in a few months. It may also issue convertible dividend warrants redeemable in a few years. Debenture Dividends Companies may also issue debentures in lieu of dividends to their shareholders. These debentures bear interest and are payable after a prescribed period. It is just like creating a long-term debt. Such a practice is not common. Bonus Shares or Stock Dividends Instead of paying dividends out of accumulated reserves, the latter may be capitalized by issue of bonus shares to the shareholders. Thus, while the funds continue to remain with the company; the shareholders acquire the right and this way their market-able equity increases. They can either retain their bonus shares and thus be entitled to increased total dividend or can sell their bonus shares and realise cash. Ordinarily, bonus shares are not issued in lieu of dividends. They are periodically issued by prosperous companies in addition to usual dividends, Certain guidelines, as laid down by the government, are applicable for issue of bonus shares in India. Property Dividends This form of dividend is unusual. Such dividend may be in the form of inventory or securities in lieu of cash payment. A company sometimes may hold shares of other companies, e.g., its subsidiaries that it may like to distribute among its own shareholders, instead of paying dividend in cash. In case the company sells these shares it may have to pay capital gains, which may be subject to taxation. If these shares are transferred to its shareholders, there is no tax liability.

18.3

DIVIDEND POLICY

The objective of corporate management usually is the maximisation of the market value of the enterprise i.e., its wealth. The market value of common stock of a company is influenced by its policy regarding allocation of net earnings into `plough back' and `payout'. While maximising the market value of shares, the dividend policy should be so oriented as to satisfy the interests of the existing shareholders as well as to attract the potential investors. Thus, the aim should be to maximise the present value of future dividends and the appreciation in the market price of shares. Policy Options Dividend policy refers to the policy that the management formulates in regard to earnings for distribution as dividend among shareholders. It is not merely concerned with dividends to be paid in one year, but is concerned with the continuous course of action to be followed over a period of several years. Dividend decision involves dealing with several questions, such as:

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Financial Decisions

Whether dividend should be paid right from the initial year of operation i.e., regular dividends. Whether equal amount or a fixed percentage of dividend be paid every year, irrespective of the quantum of earnings as i n case of preference shares, i.e. stable, dividends. Whether a fixed percentage of total earnings be paid as dividend which would mean varying amount of dividend per share every year, depending on the quantum of earnings and number of ordinary shares in that year, i.e., a fixed payout ratio. Whether the dividend be paid in cash or in the form of shares of other companies held by it or by converting (accumulated) retained earnings into bonus shares, i.e., property dividend or bonus share dividend.

Dividend Policy Goals

There are several factors, which influence the determination of the dividend policy. As such no two companies may follow exactly similar dividend policies. The dividend policy has to be tailored to the particular circumstances of the company. However, the following aspects have general applicability: Dividend policy should be analysed in terms of its effect on the value of the company. Investment by the company in new profitable opportunities creates value and when a company foregoes an attractive investment, shareholders incur an opportunity loss. Dividend, investment and financing decisions are interdependent and there is often a trade off. Dividend decision should not be treated as a short run residual decision because ' variability of annual earnings may cause even a zero dividend in a particular year. This m a y have serious repercussions for the company and m a y result in the delisting of its share for the purpose of dealings on any approved stock exchange. A workable compromise is to treat dividends as a long-run residual to avoid undesirable variations in payout. This needs financial planning over a fairly long time horizon. Whatever dividend policy is adopted by the company, the general principles guiding the dividend policy should, as far as possible, be communicated clearly to investors who may then take their decisions in terms of their own preferences and needs. Erratic and frequent changes in dividends should be avoided. Reduction in the rate of dividend is a painful thing for the shareholders to bear. The management will find it hard to convince the shareholders of the desirability of a lower dividend for the sake of preserving their future interests.

18.4 ROLE OF FINANCIAL MANAGER

The disposal of the earnings-retention in business or distribution among shareholders is an issue of fundamental importance in financial management. The financial manager plays an important role in advising the management i.e., Board of Directors regarding the decision. It is the latter's privilege to take the decision. The retention of profits in business helps the company in mobilising funds for expansion. Economist's, however, believe that the entire earnings of a business should be paid to its owners

42

who should then decide where to reinvest them. That all of them may decide to reinvest the distributed earnings in the same company is another thing. In case the company has more favourable reinvestment opportunities within it as compared to those offered outside, it would be more profitable for the company to retain earnings than to pay them out as dividends. The shareholders can later be compensated by issue of bonus shares. Let us illustrate this point by taking an example. Suppose the net profit after taxes of a company is Rs. 1 lakh and is totally distributed as dividend to shareholders. The relevant figures would then appear as follows: 1 2 3 4 Amount of dividend to shareholders Less income-tax (say at 40%) on personal income Net amount available to shareholders for reinvestment (1 minus 2) Less reinvestment cost say at 10% Rs. 1,00,000 Rs. 40,000 Rs. 60,000 Rs. 6,000 Rs. 54,000 It is clear from the above example that if dividends are not paid, Rs. 1 lakh of income is available to the company for reinvestment in business. In case dividends are paid, it is likely that not more than Rs. 54,000 would be available for reinvestment (in the same or any other business), assuming that the stockholders are willing to reinvest their entire dividend income. If better outside investment opportunities are available to the shareholders, depending upon the environment prevalent in the capital market, they may not appreciate the recommendation (or action) of the Board of Directors for retention of larger amounts in the business, as they might perceive it to their detriment. As such they would be interested in receiving larger dividends. The dividend policy, particularly the timing of the declaration of dividend, influences the market value of a company's shares. The financial manager, therefore, should be well informed about the capital market trends and the tax policies of the government, besides the rationale behind the, investment programme of the company.

Dividends Decisions

18.5 ROLE OF THE BOARD OF DIRECTORS

The Board of Directors has the power to determine whether and at what rate dividend shall he paid to the shareholders. The payment of dividend is not obligatory. Even a majority of shareholders have no right to interfere with the authority of the Board. So long as the Board acts in good faith, acts on the basis of a reasonable policy, and it does not flagrantly abuse its fiduciary responsibility, its decision cannot be challenged and there is no way to force a dividend by direct legal action. However, there are some restrictions, dictated by law or prudence, on the discretion of the Board of Directors which are as follows. i) ii) iii) iv) v) vi) Dividends may be declared out of any unappropriated surplus. If there is a loss, it should be absorbed first before dividends can be declared. Dividend declarations which impair the capital strength of a corporation must be discouraged. Dividend declarations which might lead to insolvency should be discouraged. A due provision for depreciation, depletion, etc. should be made prior to dividend declaration. Directors can be sued by shareholders, if-they have declared any unlawful dividends or have grossly neglected their interests.

vii) The rights of creditors should be taken care of while taking a decision on dividend.

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Financial Decisions

The corporate management is an elective management. The power of recommending a dividend is delegated by the shareholders to the Board of Directors. The Board declares a dividend in its duly convened meeting by a resolution which sets forth the rate of dividend, the class of stockholders to whom dividend is payable, and the date and mode of dividend payment. At times the interest of the shareholders may come into conflict with those of the company. The Board is expected to act judiciously in taking decision on dividends. The decision has two dimensions. First, the corporate management must satisfy the shareholders by offering them a fair return on their investment by way of dividends. Second, the management has a commitment to ensure the financial stability of the corporation by withholding dividends (i.e. by not declaring dividends), if it feels this course is necessary in order to enable the company to stand on a firm ground. The dividend decision thus is a difficult one because of conflicting objectives and also because of lack of specific decision-making techniques. It is not easy to lay down an optimum dividend policy, which would maximise the long-run wealth of the shareholders. However, there is no gain saying that dividend decision involves sound judgement. There are certain factors that impinge upon the dividend decision and, therefore, should be taken into consideration while deciding a policy in this respect.

18.6 FACTORS AFFECTING DIVIDEND DECISION

It is possible to group the factors affecting dividend policy into two broad categories: Ownership considerations Firm-oriented considerations Ownership Considerations: Where ownership is concentrated in few people, there are no problems in identifying ownership interests. However, where ownership is decentralised on a wide spectrum the identification of their interests becomes difficult. Further; the influence of stockholders' interests on dividend decision becomes uncertain because: (a) the status or preferences of stockholders relating to their position, capital gains, current income, etc. cannot be precisely ascertained; (b) a conflict in shareholders' interests may arise. In spite of these difficulties, efforts should be made to ascertain the following interests of shareholders to encourage market acceptance of the stock: Current income requirements of stockholders Alternative uses of funds in the hands of stockholders Tax matters affecting stockholders Since various groups of shareholders may have different desires and objectives, understandably, investors gravitate to those companies that combine the mix of growth and desired dividends. Since companies generally do not have a singular group of shareholders, the objective of the maximisation of the market value of shares requires that the dividend policy be geared to investors in general. Firm-oriented Considerations: Ownership interests alone may not determine the dividend policy. A firm's needs are also an important consideration which include the following:

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a) b)

Contractual and legal restrictions Liquidity, credit-standing and working capital

c) d) e) f) g) h)

Needs of funds for immediate or future expansion Availability of external capital Risk of losing control of organisation Relative cost of external funds Business cycles Post dividend policies and stockholder relationships.

Dividends Decisions

The following factors affect the shaping of a dividend policy. Nature of Business This is an important determinant of the dividend policy of a company. Companies with unstable earnings adopt dividend policies, which are different from those which have steady earnings. Consumer goods industries usually suffer less from uncertainties of income and, therefore, pay dividends with greater regularity than the capital goods industries. Industries with stable income are in a position to formulate consistent dividend policies. Thus, public utilities may be able to establish a relatively fixed dividend rate. Mining companies, on the other hand, with long gestation period and multiplicity of hazards, may not be able to declare dividends for years. But once they get established, they might afford to make liberal dividend payments. If earnings fluctuate and losses are caused during depression, the continued payment of dividends may become a risky proposition. A company with `wasting' assets-such as timber, oil or mines-which get depleted over time may well pursue a policy of gradually returning capital to its owners because its resources are going to be exhausted. Such a company may offer dividends, which include, in part, a. return of the owner's investment. Generally speaking, large and mature companies pay a reasonably good but not a excessive rate of dividend. Excessive dividends may be paid only by `mushroom' companies. A healthy company with an eye on future, follows a somewhat cautious policy and build up reserves. A company which believes in publicity gimmicks may follow a more liberal dividend policy to its future detriment. A firm with a heavy programme of investment in research and development would see to it that adequate reserves are built up for the purpose. Attitude and Objectives of Management While some organisations may be niggardly in dividend payments, some others may be liberal. A large number of firms may be found within these two extremes. Niggardly organisations prefer to conserve cash. Though such an approach may easily meet their future needs for funds, it deprives the stockholders of a legitimate return on their investment. Liberal organisations, on the other hand, feel that stockholders are entitled to an established rate of dividend as long as their financial condition is reasonably sound. Within these two extremes, a number of corporations adopt several variations. The attitude of the management affects the dividend policies of a corporation in another way. The stockholders who control the management of the company may be interested in `empire-building'. They may consider ploughing back of earnings as the most effective technique for achieving their objectives of building up the corporation is perhaps the largest in the field. Composition of Shareholding There may be marked variations in dividend policies on account of the variations in the composition of the shareholding. In the case of a closely held company, the personal objectives of the directors and of a majority of shareholders may govern the

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Financial Decisions

decision. Widely held companies have scattered shareholders. Such companies may take the dividend decision with a greater sense of responsibility by adopting a more formal and scientific approach. The tax burden on business corporations is a determining factor in formulation of their dividend policies. The directors of a closely held company may take into consideration the effect of dividends upon the tax position of their important shareholders. Those in the high-income brackets may be willing to sacrifice additional income in the form of dividends in favour of appreciation in the value of shares and capital gains. However, when the stock is widely held, stockholders are enthusiastic about collecting their dividends regularly, and do not attach much importance to tax considerations. Thus a company, which is closely held by a few shareholders in the high income-tax brackets, is likely to payout a relatively low dividend. The shareholders in such a company are interested in taking their income in the form of capital gains rather than in the form of dividends, which are subject to higher personal income taxes. On the other hand, the shareholders of a large and widely held company may be interested in high dividend payout. Investment Opportunities Many companies retain the earnings to facilitate planned expansion. Companies with low credit ratings may feel that they may not be able to sell their securities for raising necessary finance they would need for future expansion. So, they may adopt a policy for retaining larger portion of earnings. In the context of opportunities for expansion and growth, it is wise to adopt a conservative dividend policy if the cost of capital involved in external financing is greater than the cost of internally generated funds. Similarly, if a company has lucrative opportunities for investing its funds and can earn a rate, which is higher than its cost of capital, it may adopt a conservative dividend policy. Desire for Financial Solvency and Liquidity Companies may desire to build up reserves by retaining their earnings, which would enable them to weather deficit years or the downswings of a business cycle. They may, therefore, consider it necessary to conserve their cash resources to face future emergencies. Cash credit limits, working capital needs, capital expenditure commitments, repayment of long-term debt, etc. influence the dividend decision. Companies sometimes prune dividends when their liquidity declines. Regularity A company may decide about dividends on the basis of its current earnings which according to its thinking may provide the best index of what a company can pay, even though large variations in earnings and consequently in dividends may be observed from year to year. Other companies may consider regularity in payment of dividends as more important than anything else. They may use past profits to pay dividends regularly, irrespective of whether they have enough current profits or not. The past record of a company in payment of dividends regularly builds up the morale of the stockholders wh o may adopt a helpful attitude towards it in periods of emergency or financial crisis. Regularity i n dividends cultivates an investment attitude rather than speculative one towards the shares of the company.

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Restrictions by Financial Institutions Sometimes financial institutions which grant long-term loans to corporations put a clause restricting dividend payment till the loan or a substantial part of it is repaid.

Inflation Inflation is also a factor, which may affect a firm's dividend decision. In period of inflation, funds generated from depreciation may not be adequate to replace worn out equipment. Under these circumstances, the firm has to depend upon retained earnings as a source of funds to make up for the shortfall. This is of particular relevance if the 'assets have to be replaced in near future. Consequently, the dividend payout ratio will tend to be low. On account of inflation often the profits of most of the companies are inflated. A higher payout ratio based on overstated profits may eventually lead to the liquidation of the company. You are aware that inflation has become an integral part of the present financial climate: While shareholders may delight in immediate income, they will feel sorry lithe company has to suffer in a few years on account of not retaining sufficient earnings to support future growth or not being able to maintain its position in the market place. Inflation has another dimension. In an inflationary situation, current income becomes more important and shareholders in general attach more value to current yield than to distant capital appreciation. They would thus expect a higher payout ratio. Other Factors Age of the company has some effect on the dividend decision. Established companies often find it easier to distribute higher earnings without causing an adverse effect on the financial position of the company than a comparatively younger corporation which has yet to establish itself. The demand for capital expenditure, money supply, etc. undergo great oscillations during the different stages of a business cycle. As a result, dividend policies may fluctuate from time to time. In many instances, dividend policies result from tradition, ignorance and indifference rather than from considered judgement. An industry or a company may have established some `satisfactory standard' for the payment of dividends; and this standard becomes a convention or custom for that industry or company. Activity 18.1 Meet an executive in the Accounting and Finance Department of your organisation (or any other commercial or industrial organisation in case you are not working in such an organisation) and discuss with him on matters related to dividend on the following lines: a) What dividend the company paid last year? ............................................................................................... .................................... ............................................................................................... .................................... ............................................................................................... .................................... ............................................................................................... .................................... ............................................................................................... .................................... ............................................................................................... .................................... ............................................................................................... .................................... ............................................................................................... .................................... ............................................................................................... .................................... ............................................................................................... .................................... ............................................................................................... .................................... ............................................................................................... .................................... ............................................................................................... ....................................

Dividends Decisions

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Financial Decisions

b)

What dividend the company paid over the last 10 years? Did the company skip dividend in any year? Why it had to do so? What is the trend in payment of dividend over this period? Are the dividends constant, increasing or decreasing ? What are the reasons for a particular trend? .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... ....................................................................................................................................

c)

What are the main features of and the major influences on the company's policy on dividends? .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... ....................................................................................................................................

18.7

SUMMARY

Dividend is a portion of the profits distributed to shareholders in a company and is usually expressed as a percentage of nominal value of shares. Dividends are often paid in cash, though in theory other forms also exit. Though the declaration and payment of dividends is a matter, which concerns the Board of Directors, the finance manager plays an important role by advising the Board of Directors regarding the enunciation of a proper dividend policy. Dividend policy involves the decisions whether to retain earnings in the firm for capital investment and other purposes, or to payout the earnings in the form of cash dividend to shareholders. Many financial managers believe that a stable dividend policy with a certain percentage on capital paid up on shares and with periodic increases is a better course to follow. Besides being psychologically appealing, stable dividend also has an information content in that it indicates to investors the managements expectation on levels of long- run earnings and growth. Often the company has to strike a balance between its own needs for funds for financing growth opportunities and the needs and expectations of the investors. In view of this, therefore, dividend policy cannot or should not be regarded as a residual policy. While it is true that companies with strong investment opportunities have relatively low dividend payout ratio and vice versa, most financial managers like to follow a stable dividend policy.

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There are several factors which impinge upon the dividend decision. The attitude and objectives of management, nature of business, composition of shareholdings, cash position, and future needs for funds are some of the important considerations which have a bearing on the dividend decision.

Dividends Decisions

18.8

KEY WORDS

Capital Gain is a gain, which arises on transfer (or selling) of a capital asset due to appreciation in its market value. Under the Indian Income Tax Act, a capital asset must be held for a minimum of three years in order that it gives rise to a capital gain to its owner. Bonus Shares are shares, which are issued by. a company free of charge to its existing shareholders in proportion to the shares held by them. Bonus shares are issued when a company wished to increase its capital by using its retained profits (or free reserves) and feels that its existing share capital does not give a true picture of the amount of capital employed in the firm. Dividend Payout Ratio is the ratio of dividend declared and paid to the total disposable profits.

18.9
1 2

SELF-ASSESSMENT QUESTIONS/ EXERCISES

What is dividend and why is dividend decision important? "While formulating a dividend policy the management has to reconcile its own needs for funds with the expectations of shareholders". Explain the statement. What policy goals might be considered by management in taking a decision on dividends? Discuss the role of a financial manager in the matter of dividend policy. What alternatives he might consider and what factors should he take into consideration before finalising his views on dividend policy? Dividend can be paid only out of profits. Explain this statement. Will a company be justified in paying dividend when it has written off accumulated losses of the past? What factors a company would in general consider before it takes a decision on dividends?

18.10 FURTHER READINGS

Van Home, James C., 2002. Financial Management and Policy, Prentice-Hall of India: New Delhi. Brigham, E.F., 1999. Fundamentals of Financial Management, Dryden Press: Florida (Part V) Kulkarni, P.V., Sathya Prasad B.G., 1999. Financial Management (nineth revised edition), Himalaya Publishing: Bombay. Gitman, L.J., 1985. Principles of Managerial Finance, Harper & Row: New York (Chapter 14)

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