MBA DUAL SPEC. ( Financial Management & Management Accounting) by IMTS INSTITUTE

I ns t i t ut eofManage me nt & Te c hni c alSt udi e s

FI NANCI ALMANAGEMENT& MANAGEMENTACCOUNTI NG 500

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IMTS (ISO 9001-2008 Internationally Certified) FINANCIAL MANAGEMENT & MGMT. ACCOUNTING

FINANCIAL MANAGEMENT & MGMT. ACCOUNTING

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FINANCIAL MANAGEMENT & MGMT. ACCOUNTING

CONTENTS:-

UNITI:

01-27 Meaning and Importance of Finance-Objectives, Functions and Scope

of Finance-Role of Finance Manager-Organization of Finance Functions.

UNIT II:

28-63

Capital Expenditure Evaluations-Methods of Appraisals-Pay back period, Net Present Value, Internal Rate of Return, Accounting Rate of Return, Profitability Index-Capital rationing.

UNIT III:

64-93

Concept of Working Capital –Gross and Net Working Capital –Factors influencing working capital-Methods of forecasting working capital-Financing Current Assets.

UNIT IV:

94-124

Management of Cash, Receivables and inventories - Cash PlanningCredit Policies- Regulations of Bank Finance.

UNIT V:

125-143

Budgetary control- Budget manual-Classification and Preparation of various Budgets-Functional Budgets-Fixed and Flexible Budgets-Cash Budget-Zero Base Budgeting and Performance Budgeting-Ethic in Finance UNIT- VI

144-149

Management Accounting-Nature And Scope- Meaning- DefinitionsObjects Of Management Accounting And Financial Accounting –Management Accounting And Cost Accounting.

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UNIT-VII

150-156

Analysis And interpretation Of Financial statements- The Concept Of Financial Statement- Limitations Of Financial Statements-Analysis And Interpretation- Tools-comparative Financial Statements- Common Size Financial Statements And Trend Percentages. UNIT- VIII

157-180

Ratio Analysis-Nature, Interpretation and Limitations of ratios- Shortterm and Long-term financial ratios-Profitaility. Efficiency, proprietory and yielding ratios. UNIT-IX

181-198

Fund Flow Analysis-Concept of funds-Sources and uses of fundsConcept of Fund Flow Statement-Managerial uses of Fund AnalysisConstruction of fund flow Statement- Distinction of Cash from funds- Utility of cash flow statement-Construction of cash flow statement. UNIT-X

199-227

Marginal Costing And Break - Even Analysis For Profit Management and Control. Capital Budgeting - Nature of Capital expenses - Concept Of Capital Budgeting- Capital Budgeting Procedures- Methods Of Ranking Investment Proposals- Simple Problems Involving Payback Method- Average Rate Method And Discounted Cash Flow Methods.

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FINANCIAL MGMT. & MGMT. ACCOUNTING

UNIT I MEANING AND IMPORTANCE OF FINANCE In our modern economy, finance is defined as the provision of money at the time when it is required. Finance is one of the major elements, which activates the overall growth of economy. Finance is the life blood of economic activity. This is because in the modern money oriented economy, finance is one of the basic foundations of all kinds of economic activities. It is the master key which provides access to all the sources for being employed in manufacturing and merchandising activities. It has rightly been said that business needs money to make more money. However, it is also true that money begets more money only when it is properly managed. Hence, efficient management of every business enterprise is closely linked with efficient management of its finances. A well knit financial system directly contributes to the growth of the economy. An efficient financial system calls for the effective performance of financial institutions, financial instruments and financial markets. Finance has been traditionally classified into two classes: (i) Public finance and (ii) Private finance. Public finance deals with the requirements, receipts and disbursements of funds in the government institutions. Private finance is concerned with requirements receipts and disbursement of funds in case of an individual, a profit seeking business organization and a non profit organization. Thus, private finance can be classified into: (i) Personal finance; (ii)Business finance and (iii)Finance of non profit organization.

MEANING OF BUSINESS FINANCE/ FINANCIAL MANAGEMENT. The term ‘business finance’ connotes finance of business activities. It is composed of two words. (i)Business and (ii) Finance. The word ‘business’ literally means a ‘state of being busy’. All activities relating to the production and distribution of goods and services for satisfying human wants are known as business. Broadly speaking, the term ‘Business’ includes industry, trade and commerce. Finance may be defined as the provision of money at the time when it is required.

Finance refers to the management of flows of money through an organization. It concerns with the application of skills in the manipulation, use and control of money. The term ‘Business finance’ is an activity or a process which is concerned with acquisition of funds, use of funds and distribution of profits by a business firm.

Thus,

business finance usually deals with financial planning, acquisition of funds, use and allocation of funds and financial controls.

MEANING OF FINANCIAL MANAGEMENT/BUSINESS FINANCE: Financial management means the entire gamut of managerial efforts devoted to the management of finance – both its sources and uses – of the enterprise.

It is mainly

concerned with the proper management of funds. The finance manager must see that the

FINANCIAL MGMT. & MGMT. ACCOUNTING

funds are procured in a manner that the risk, cost and control considerations are properly balanced in a given situation and there is optimum utilization of funds. Every management aims to utilize its funds in a best possible and profitable way. So this subject is acquiring a universal applicability. It is indispensable in any organization as it helps in: 

Financial planning and successful promotion of an enterprise



Acquisition of funds as and when required at the minimum possible cost;



Proper use and allocation of funds



Taking sound financial decisions



Improving the profitability through financial controls



Increasing the wealth of the investors and the nation



Promoting and mobilizing individual and corporate savings.

We can say that financial management as practiced by corporate (business) firms can be called corporation finance or business finance.

DEFINITIONS BUSINESS FINANCE. Wheeler defines business finance as “that business activity which is concerned with the acquisition and conservation of capital funds in meeting the financial needs and overall objectives of business enterprise”. According to Guthmann and Dougall, business finance deals primarily with raising, administering and disbursing funds by privately.

Financial management is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient operations. -- Joseph & Massie. According to Soloman, “Financial management is concerned with the efficient use of an important economic resource, namely, capital funds”. “The finance function is the process of acquiring and utilizing funds of a business”. ----R.C.Osborn.

OBJECTIVES OF FINANCIAL MANAGEMENT. Financial management evaluates how funds are used & procured. In all cases, it involves a sound judgement, combined with a logical approach to decision-making. The core of financial policy is to maximize earnings in the long run & optimize them in the short-run. There are various alternatives available for using business funds. Each alternative course has to be evaluated in detail. The pros and cons of various decisions have to looked into before making a fund selection. The decisions will have to take into consideration the

FINANCIAL MGMT. & MGMT. ACCOUNTING commercial strategy of the business.

Financial management provides a framework for

selecting a proper course of action and deciding a viable commercial strategy. The main objective of a business is to maximize the owner’s economic welfare. This objective can be achieved by: 

Profit maximization and



Wealth maximization.

1. PROFIT MAXIMIZATION: Earning profits by a corporate or a company is a social obligation. Profit is the only means through which an efficiency of organization can be measured. Profit earning is the main aim of every economic activity.

A business being an

economic institution must earn profit to cover its costs and provide funds for growth. No business can survive without earning profit. Profit is a measure of efficiency of a business enterprise. Profits also serve as a protection against risks which cannot be ensured. The accumulated profit enables a business to face risk like fall in prices, competition from other units, adverse government policies etc. Thus profit maximization is considered as the main objective of business. The following arguments are advanced in favour of profit maximization as the objective of business: Advantages/Merits 

Profit is a barometer through which the performance of a business unit can be measured. Thus profit maximization is justified on the grounds of rationality.



Profits ensure maximum welfare to the share holders, employees and prompt payment to creditors of a company.



When profit earning is the aim of business, then profit maximization should be the obvious objective.



Economic and business conditions do not remain same in all the time. There may be adverse business conditions like recession, depression, severe competition etc. A business will be able to survive under favourable situation, only if it has some past earnings to rely upon. Therefore business should try to earn more and more when situation is favourable.



Profit maximization increases the confidence of management in expansion and diversification programmes of a company.



Profit maximization attracts the investors to invest their savings in securities.



Profit indicates the efficient use of funds for different requirements.



Profitability is essential for fulfilling social goals also. A firm by pursuing the objective of profit maximization also maximizes socio economic welfare.

However, profit maximization objective has been criticized on many grounds.

Criticisms /drawbacks / points against profit maximization

FINANCIAL MGMT. & MGMT. ACCOUNTING 

Profit is not a clear term. Is it accounting profit? Economic profit? Profit before tax? After tax? Net profit? Gross profit on earnings per share? Further it is possible that profits may increase but earnings per share decline. For example, if a company has presently 10,000 equity shares issued and earns a profit of Rs.1,00,000, the earnings per share are Rs.10. Now if the company further issues 5,000 shares and makes a total profit of Rs.1,20,000, the total profits have increased by Rs.20,000, but the earnings per share will decline to Rs.8.



Profit maximization objective ignores the time value of money and does not consider the magnitude and timing of earnings. It treats all earnings are equal though they occur in different periods.



Profit maximization does not consider the element of risk.



The effect of dividend policy on the market price of shares is also not considered in the objective of profit maximization. In case, earnings per share is the only objective, then an enterprise may not think of paying dividend at all, because retaining profits in the business or investing them in the market may satisfy this aim.



A firm pursuing objective of profit maximization starts exploiting workers and the consumers. Hence it is immoral and leads to a number of corrupt practices.



It leads to colossal inequalities and lowers human values which are an essential part of an ideal social system.



The true and fair picture of the organization is not reflected through profit maximization.



Profit maximization attracts cut throat competition



A huge profit invites problems from workers. They demand high salary and fringe benefits.



The modern concept of marketing does not encourage profit maximization. A huge profit ultimately disturbs the morale of the customers.

He feels exploited by the

company. 

Some of the industries would like to attain ‘Industry leadership’. They do not bother about the increase in cost and getting a low profit with huge market share.

2. WEALTH MAXIMIZATION Wealth maximization is the appropriate objective of an enterprise. The concept of ‘Wealth Maximization’ refers to the gradual growth of the value of assets of the firm in terms of benefits it can produce. When the firm maximizes the stock holder’s wealth to maximize his individual utility, it means that by maximizing stock holder’s wealth, the firm is operating consistently towards maximizing stockholder’s utility. A stock holder’s current wealth in the firm is the product of the number of shares occurred, multiplied with the current stock price per share.

FINANCIAL MGMT. & MGMT. ACCOUNTING

Stock holder’s current wealth of a firm = No of shares owned x Current stock price per share Wo = NPo Symbolically, given the number of shares that the stock holders owns, the higher the stock price per share, the greater will be the stock holders wealth. Thus a firm should aim at maximizing the current stock price. This objective helps increasing the value of shares in the market.

The share’s market price serves as a

performance index on report card of its progress. It also indicates how well is doing on behalf of the shareholders. We can conclude that Maximum utility refers to maximum stock holder’s wealth refers to maximum stock price per share.

ELEMENTS OF WEALTH MAXIMIZATION: The goals of financial management may be such that they should be beneficial to the owners, management, employees and customers. These goals may be achieved only by maximizing the value of the firm. The elements involved in the maximization of the value of a firm are: Elements of wealth maximization

Judicious choice of funds

Increase in profits

Reduction in cost

Long-run Value Minimized Risk

Increase in profits: A firm should increase its revenue in order to maximize its value. For this purpose, the volume of sales or any other activity should be stepped up. It is a normal practice for a firm to formulate and implement all possible plans of expansion and take every opportunity to maximize its profits. An increase in sales will not necessarily result in the rise of profits unless there is a market for increased supply of goods and unless the overhead costs are properly controlled. Reduction of cost: Capital and equity funds are factor inputs in production. A firm has to make every effort to reduce the cost of capital and launch an economy drive in all its operations.

FINANCIAL MGMT. & MGMT. ACCOUNTING

Sources of funds: A firm has to make a judicious choice of funds so that they maximize its value. The sources of funds are not risk free. A firm will have to assess the risks involved in each source of funds. Maximum risk: Different types of risks confront a firm, “no risk, no gain” is a common adage. However, in the world of business uncertainties, a corporate management will have to calculate business risks, financial risks or any other risks that may work to the disadvantage of the firm before embarking on any particular course of action. While keeping the goal of maximization of the value of the firm, the management will have to consider the interest of either pure or equity stockholders as the central focus of financial policies. Long run value: The goal of financial management should be to maximize the long run value of the firm. It may be worthwhile for a firm to maximize profits by pricing its products high, or by pushing an inferior quality product into a market, or by ignoring interest of employees, or to be precise, by resorting to cheap and “getting rich quick” methods. Such tactics, however, are bound to affect the prospects of a firm rather adversely over a period of time.

For a

permanent progress and sound reputation, it will have to adopt an approach, which is consistent with the goals of financial management in the long run. “More haste, less speed” – is the principle it may profitably follow.

Implications of wealth maximization: There is a rationale in applying wealth maximizing policy as an operating financial management policy.

It serves the interests of suppliers of loaned capital, employees,

management and society.

Besides shareholders, there are short term and long term

suppliers of funds who have financial interests in the concern.

Short term lenders are

primarily interested in liquidity position so that they get their payments in time. The long term lenders get a fixed rate of interest from the earnings and also have a priority over share holders in return of their funds. Wealth maximization objective not only serves shareholder’s interests by increasing the value of holdings but ensures security to lenders also. The employees may also try to acquire share of company’s wealth through bargaining etc. Their productivity and efficiency is the primary consideration in raising company’s wealth. The survival of management for a longer period will be served if the interests of various groups are served properly. Management is the elected body of shareholders. The shareholders may not like to change a management if it is able to increase the value of their holdings. The efficient allocation of productive resources will be essential for raising the wealth of the company. The economic interests of society are served if various resources are put to economical and efficient use.

FINANCIAL MGMT. & MGMT. ACCOUNTING

Advantages of wealth maximization: 

Wealth maximization is a clear term. Here the present value of cash flow it taken into consideration.

The net effect of investment and benefits can measure clearly.

(quantitatively) 

It considers the concept of time value of money. The present value of cash inflows and outflows helps the management to achieve the overall objective of a company.



The concept of wealth maximization is universally accepted, because, it takes care of interests of financial institutions, owners, employees and the society at large.



Wealth maximization guides the management in framing a consistent strong dividend policy to reach maximum returns of the equity holders.



The concept of wealth maximization considers the impact of risk factor and while calculating the NPV at a particular discount rate, adjustment is being made to cover the risk that is associated with the investments.

Criticism of wealth management: The wealth maximization objective has been criticized by certain financial theorists mainly on the following accounts: 

It is a prescriptive idea. The objective is not descriptive of what the firm actually do



The objective of wealth management is not necessarily socially desirable



There is some controversy as to whether the objective is to maximize the stock holder’s wealth or the wealth of the firm which includes other financial claimholders such as debenture holders, preferred stockholders etc.



The objective of wealth maximization may also face difficulties when ownership and management are separated as is the case in most of the large corporate form of organizations.

When managers act as agents of the real owners (equity

shareholders), there is a possibility for a conflict of interest between shareholders and the managerial interests. The managers act in such a manner which maximizes the managerial utility but not the wealth of stockholders or the firm. In spite of all the criticism, wealth maximization is the most appropriate objective of a firm and the side coast in the form of conflicts between the stockholders and debentures holders, firm and society and stockholders and managers can be minimized.

FUNCTIONS OF FINANCE Finance function is the most important of all business functions. It remains a focus of all activities. It is not possible to substitute or eliminate this function because the business will close down in the absence of finance. It starts with the setting up of an enterprise and remains at all times.

The

development and expansion of business rather needs more commitment for funds. The funds

FINANCIAL MGMT. & MGMT. ACCOUNTING will have to be raised from various sources. The sources will be selected in relation to the implications attached with them. The money once received will have to be returned also if its use is proper, then its return will be easy, otherwise it will create difficulties for repayment. The management should have an idea of using the money profitable. The inflows or outflows of funds should be properly matched.

AIMS OF FINANCE FUNCTION. The primary aim of finance function is to arrange as much funds for the business as are required from time to time. This function has the following aims. 1. Acquiring sufficient funds: The main aim of finance function is to assess the financial needs of an enterprise and then finding out suitable sources for raising them. The sources should be commensurate with the needs of the business. If funds are needed for longer periods then long term sources like share capital, debentures, term loans may be explored. A concern with longer gestation periods should rely more on owner’s funds instead of interest bearing securities because profits may not be there for some years. 2. Proper utilization of funds: Though raising of funds is important but their effective utilization is more important. The funds should be used in such a way that maximum benefits are derived from them. The return from their use should be more than their cost. It should be ensured that funds do not remain idle at any point of time. Those projects should be preferred which are beneficial to the business. 3. Increasing profitability: The planning and control of finance function aims at increasing profitability of the concern.

Finance function should be so planned that the concern neither suffers from

inadequacy of funds nor wastes more funds than required. A proper control should also be exercised so that scarce resources are not frittered away on uneconomical operations. The cost of acquiring funds also influences profitability of the business. Finance function also requires matching of cost and returns from funds. 4. Maximizing firm’s value: Finance function also aims at maximizing the value of the firm. It generally said that a concern’s value is linked with its profitability. Even though profitability influences a firm value but it is not all. Besides profits, the type of sources used for raising funds, the cost of funds, the condition of money market, the demand for products are some other considerations which also influence a firm’s value.

FINANCIAL MGMT. & MGMT. ACCOUNTING NATURE AND SCOPE OF FINANCE FUNCTION. 1. Estimating financial requirements: The first task of a financial management is to estimate short term and long term financial requirements of his business. For this purpose he will prepare a financial plan for present as well as for future. The amount required for purchasing fixed assets as well as needs of funds for working capital will have to be ascertained. The estimations should be based on sound financial principle so that neither there are inadequate nor excess funds with the concern. 2. Deciding capital structure: The capital structure refers to the kind and proportion of different securities for raising funds. After deciding about the quantum of funds required, it should be decided which type of securities should be raised. A decision about various sources for funds should be linked to the cost of raising funds. If cost of raising funds is very high then such sources may not be useful for long period. A decision about the kind of securities to be employed and the proportion in which these should be used is an important decision which influences the short term and long term financial planning of an enterprise. 3. Selecting a source of finance: After preparing a capital structure, an appropriate source of finance is selected. Various sources from which finance may be raised include share capital, debentures, financial institutions, commercial banks, public deposits etc. If finances are needed for short periods then banks, public deposits and financial institutions may be appropriate. On the other hand, if long term finance are required, then share capital and debentures may be useful. The need, purpose, object and cost involved may be the factors influencing the selection of a suitable source of financing. 4. Selecting a pattern of investment: When funds have been procured then a decision about investment pattern is to be taken. The selection of an investment pattern is related to the use of funds. A decision will have to be taken as to which assets are to be purchased? The funds will have to be spent first on fixed assets and then an appropriate portion will be retained for working capital. While spending on various assets, the principle of safety, profitability and liquidity should be ignored. One may not like to invest on a project which may be risky even though there may be more profits. 5. Proper cash management: Cash management is also an important task of finance manager. He has to assess various cash needs at different times and then make arrangements for arranging cash. Cash may be required to (a) purchase raw materials, (b) make payments to creditors, (c) meet wage bills, (d) meet day to day expenses. The usual sources of cash may be (a)

FINANCIAL MGMT. & MGMT. ACCOUNTING cash sales, (b) collection of debts, (c) short term arrangements with banks etc. The cash management should be such that neither there is a shortage of it and not it is idle. A proper idea on sources of cash inflow may also enable to asset the utility of various sources. Some sources may not be providing that much cash which we should have thought all this information will help in efficient management of cash. 6. Implementing financial controls: An efficient system of financial management necessitates that use of various control devices.

Financial control devices generally used are: (a) Return on investment, (b)

budgetary control, (c) Break even analysis, (d) Cost control, (e) Ratio analysis, (f) Cost and internal audit. Return on investment is the best control device to evaluate the performance of various devices to evaluate the performance of various financial policies. The higher this percentage better may be the financial performance. The use of various control techniques by the finance manager will help him in evaluating the performance in various areas and take corrective measures whenever needed. 7. Proper use of surplus: The utilization of profits on surpluses is also an important factor in financial management. A judicious use of surpluses is essential for expansion and diversification plans and also in protecting the interest of shareholders. The ploughing back of profits is the best policy of further financing, but it clashes with the interests of shareholders. A balance should be struck in using funds for paying dividend and retained earnings for financing expansion plans etc. A finance manager should consider the influence of various factors, such as: (a) Trend of earnings of the enterprise, (b) Expected earnings in future, (c) Market value of shares, (d) Need for funds for financing expansion etc. A judicious policy for distributing surpluses will be essential for maintaining proper growth of the unit.

VARIOUS APPROACHES TO FINANCE FUNCTION. A number of approaches are associated with finance function, but for the sake of convenience various approaches are divided into two broad categories: 1. The Traditional Approach 2. The Modern Approach

1. THE TRADITIONAL APPROACH: The traditional approach to the finance function relates to the initial stages of its evolution during 1920s and 1930s when the term ‘Corporation finance’ was used to describe what is known in the academic world today as the financial management’. It broadly covered the following three aspects. 

Arrangement of funds from financial institutions



Arrangement of funds through financial instruments. viz., shares, bonds etc.

FINANCIAL MGMT. & MGMT. ACCOUNTING ď&#x201A;ˇ

Looking after the legal and accounting relationship between a corporation and its sources of funds. According to this approach, the scope of finance function was confined to only

procurement of funds needed by a business on most suitable terms. The utilization of funds was considered beyond the purview of finance function. It was felt that decisions regarding the application of funds are taken somewhere else in the organization. However, institutions and instruments for raising funds were considered to be a part of finance function. The scope of the finance function, there evolved around the study of rapidly growing capital market institutions, instruments and practices involved in raising of external funds. The traditional approach to the scope and functions of finance has now been discarded as it suffers from many serious limitations. Criticisms/ Limitations of traditional approach. Outsider-looking in approach: It is outsider looking in approach that completely ignores internal decision making as to the proper utilization of funds. Ignored routine problems: The approach gave undue emphasis to the financial problems arising during the course of incorporation, mergers, consolidation and reorganization of corporate enterprises. This approach ignored the day to day financial problems of business undertaking. Ignored non-corporate enterprises: The approach focused attention only on the financial problems of corporate enterprises. Non corporate industrial organizations outside its scope. Ignored working capital financing: The focus of traditional approach was on procurement of long term funds. Thus, it ignored the important issue of working capital finance and management. No emphasis on allocation of funds: The issue of allocation of funds which is so important today is completely ignored.

2. THE MODERN APPROACH: The traditional approach outlived its utility due to changed business situations since mid- 1950s. Technological improvements, widened marketing operations, development of a strong corporate structure, keen and healthy business competition â&#x20AC;&#x201C; all made it imperative for the management to make optimum use of available financial resources for continued survival. The modern approach views finance function in broader sense.

It includes both

raising of funds as well as their effective utilization under the purview of finance. The finance function does not stop only by finding out sources of raising enough funds, their proper utilization is also to be considered. The cost of raising funds and the returns form their use should be compared.

FINANCIAL MGMT. & MGMT. ACCOUNTING

The funds raised should be able to give more returns than the costs involved in procuring them.

The utilization of funds requires decision making.

Finance has to be

considered as an integral part of overall management. So finance function, according to this approach covers 

Financial planning



Raising of funds



Allocation of funds



Financial controls

The new approach is an analytical way of dealing with financial problems of a firm. The techniques of models, mathematical programming, simulations and financial engineering are used in financial management to solve complex problems of present day finance. The modern approach considers the three basic management decisions, i.e., investment decisions, financing decisions and dividend decisions within the scope of finance functions.

IMPORTANCE OF FINANCIAL MANAGEMENT The importance of financial management cannot be overemphasized.

In every

organization, where funds are involved, sound financial management is necessary.  Sound financial management is essential in both profit and non profit organizations.  The financial management helps in monitoring the effective deployment of funds in fixed assets and in working capital.  The finance manager estimates the total requirements of funds, both in the short period and the long period.  The finance manager assesses the financial position of the company through the working out of the return on capital, debt-equity ratio, and cost of capital from each source, etc and comparison of the capital structure with that of similar companies.  Financial management also helps in ascertaining how the company would perform in future. 

It helps in indicating whether the firm will generate enough funds to meet its various obligations like repayment of the various installments due on loans, redemption of other liabilities etc.

 Sound financial management is indispensable for any organization. It helps in profit planning, capital spending, measuring costs, controlling inventories, accounts receivable etc. 

Financial management essentially helps in optimizing the output from a given input of funds.

CONFLICT OF GOALS: MANAGEMENT VERSUS OWNERS In a company, the decision taking authority lies in the hands of management. Since the company is a complex organization of various interested parties, management has the difficult role of reconciling objectives of these parties.

FINANCIAL MGMT. & MGMT. ACCOUNTING

In doing so, management may not necessarily act in the best interest of the owners (shareholders) and may pursue its own personal goals.

But the possibility of pursuing

exclusively its own personal goals is considered remote because, the continuous supervision by the companies’ owners, employees, creditors, customers and government will restrict managements’ freedom to act in its own interest.

It is certain that management will like to survive over the long run. Thus, overall management objective is very likely to be directed towards this goal. A management can survive only when it is successful: and it is successful when it manages the company better than someone else. Every group connected with the company will evaluate management performance from the point of view of the fulfillment of its own objective.

The survival of management will be threatened if the objective of any of these groups remains unfulfilled. The wealth maximization objective may be generally in harmony with the interest of various groups such as owners, employees, creditors and society. Thus, it may be consistent with the management objective of survival. There can, however, arise situations where a conflict may occur between shareholders and managements’ goals. For example, management may play safe and create satisfactory wealth for shareholders than the maximum.

Such “satisfying behaviour of

management will frustrate the objective of SWM as a normative guide to management.

Q.WHAT DO YOU UNDERSTAND BY FINANCIAL DECISIONS? DISCUSS THE MAJOR FINANCIAL DECISIONS. Financial decisions refer to decisions concerning financial matters of a business firms. There are many kinds of financial management decisions that the firm makes in pursuit of maximizing shareholders wealth, viz., kinds of assets to be acquired, pattern of capitalization, distribution of firm income etc.

Financial decisions can be classified into four major groups: 1. Investment decisions 2. Financing decisions 3. Dividend decisions 4. Working capital management decisions 1. INVESTMENT DECISIONS: Investment decision relates to the determination of total amount of assets to be held in the firm, the composition of these assets and the business risk complexions of the firm as perceived by its investors. It is the most important financial decision. Since funds involve cost and are available in a limited quantity, its proper utilization is very necessary to achieve the goals of wealth maximization. The investment decisions can be classified under two broad groups:

FINANCIAL MGMT. & MGMT. ACCOUNTING ď&#x201A;ˇ

Long term investment decisions and

ď&#x201A;ˇ

Short term investment decisions.

The long term investment decisions is referred to as the capital budgeting and the short term investment decision as working capital management. Capital budgeting: Capital budgeting is the process of making investment decisions in capital expenditure. These are expenditure, the benefits of which are expected to be received over a long period of time exceeding one year. The investment proposals should be evaluated in terms of expected profitability, cost involved and the risks associated with the projects. The investment decisions is important not only for the setting up of new units, but also for the expansion of present units, replacement of permanent assets, research and development project costs and reallocation of funds, in case, investments made earlier do not fetch result as anticipated earlier. Short term investment decision: Short term investment decision, on the other hand, relates to the allocation of funds as among cash and equivalent, receivables and inventories. Such a decision is influenced by trade off between liquidity and profitability. The reason, is that the more liquid the asset, the less it is likely to yield and the more profitable an asset, the more liquid it is. A sound short term investment decision or working capital management policy is one which ensures higher profitability, proper liquidity and sound structural health of the organization. 2. FINANCING DECISIONS: Once the firm has taken the investment decision and committed itself to new investment, it must decide the best means of financing these commitments. Since, firms regularly make new investments, the needs for financing and financing decision is not only concerned with how best to finance new assets, but also concerned with the best overall mix of financing for the firm. A finance manager has to select such sources of funds which will make optimum capital structure. The important thing to be decided here is the proportion of various sources in the overall capital mix of the firm. The debt equity ratio should be fixed in such a way that it helps in maximizing the profitability of the concern. The raising of more debts will involve fixed interest liability and dependence upon outsider. It may help in increasing the return on equity but will also enhance the risk. The raising of funds through equity will bring permanent funds to the business but the shareholders will expect higher rates of earnings. If the capital structure is able to minimize the risk and raise the profitability, then the market prices of the shares will go up maximizing the wealth of shareholders. 3. DIVIDEND DECISION: The third major financial decision relates to the disbursement of profits back to investors who supplied capital to the firm. The term dividend refers to that part of profits of a company which is distributed by it among its shareholders.

FINANCIAL MGMT. & MGMT. ACCOUNTING

The dividend decision is concerned with the quantum of profits to be distributed among shareholders. A decision has to be taken whether all the profits are to be distributed or to retain all the profits in business or to keep a part of profits in the business and distribute others among shareholders. The higher rate of dividend may raise the market price of shares and thus maximize the wealth of shareholders. The firm should also consider the question of dividend stability, stock dividend (bonus shares) and cash dividend.

4. WORKING CAPITAL MANAGEMENT DECISIONS: Working capital (net) generally stands for excess of current assets over current liabilities.

Working capital management decisions therefore refers to all aspects of the

administration of both current assets and current liabilities. A finance manager should therefore chalk out appropriate working capital management policies in respect of each of the components of working capital. This is so because both inadequate as well as excessive working capital positions are bad for any business. Inadequacy of working capital may lead the firm to insolvency and excessive working capital implies idle funds which earn no profits for the business. Working

capital

management decisions of a firm have a great effect on its profitability liquidity and structural health of the organization. Q. “INVESTMENT, FINANCING AND DIVIDEND DECISIONS ARE ALL INTER RELATED”, COMMENT. (OR) Q. “LIQUIDITY AND PROFITABILITY ARE COMPETING GOALS FOR THE FINANCE MANAGER” – COMMENT. Financial management decisions are inter related because the underlying objective of all these decisions is the same, i.e., maximization of shareholder’s wealth. All these decisions influence one another and are inter depended. For example, the decision to invest in some proposal cannot be taken isolation without having necessary finance available for the same. The financing decision in turn is influenced by and also influences the dividend decision. In case the profits are retained for financing of the investment, the profits available for distribution to the shareholders as dividends are reduced. An efficient financial management, thus has to take the optimal joint decision by evaluating each of the decision involved in relation to its effect on shareholders wealth and by considering the joint impact of these decisions on the market value of the company’s shares.

Liquidity versus Profitability The finance manager is always faced with the dilemma of liquidity Vs Profitability. He has to strike a balance between the two. Liquidity means that:

FINANCIAL MGMT. & MGMT. ACCOUNTING



The firm has adequate cash to pay for its bills



The firm has sufficient cash to make unexpected large purchases and above all,



The firm has cash reserve to meet emergencies at all times.

Profitability goal, on the other hand, requires that the funds of the firm are so used as to yield the highest return.

Financial management

Maximization of share value

Financial decision Trade off

Investment Decision

Liquidity Decision

Financing Decision

Return

Dividend Decision

Risk

Liquidity and profitability are very closely related. When one increases, the other decreases. Apparently, liquidity and profitability goals conflict in most of the decisions which the finance mangers take.

For example if higher inventories are kept in anticipation of

increased in price of raw materials, profitability goal is approached but liquidity of the firm is endangered. There is also a direct relationship between higher risk and higher return. Higher risk on the one hand endangers the liquidity of the firm; higher return on the other hand increases its profitability. A company may increase its profitability by having a very high debt equity ratio. However, when the company raises funds from outsider sources, it is committed to make the payment of interest etc at fixed time and in fixed amounts and hence to that extent its liquidity is reduced. Thus, in every area of financial management the finance manager is to choose between risk and return and generally he chooses in between the two. He should forecast cash flows and analyze the various sources of funds.

FINANCIAL MGMT. & MGMT. ACCOUNTING Forecasting of cash flows and managing the flow of internal funds are the functions which lead to liquidity. Cost control and forecasting future profits are the functions of finance managers which lead to profitability. An efficient finance manager fixes that level of operations where both return and risk are optimized. Such a level is termed as risk return trade off and every financial decision involves this trade off. At this level the market value of the company’s shares would be the maximum. The inter relationship between market value, financial decisions and risk return trade off is depicted in the following chart.

Q.WHAT ARE THE FACTORS THAT INFLUENCE FINANCIAL DECISIONS. There are a number of (both external as well as internal) factors that influence the financial decisions. A list of the important external as well as internal factors influencing the decisions is given below. External factors: 

State of economy



Structure of capital and money markets



Requirements of investors



Government policy



Taxation policy



Lending policy of financial institutions.

Internal factors: 

Nature and size of business



Expected return, cost and risk



Composition of assets



Structure of ownership



Trend of earnings



Age of the firm



Liquidity position



Working capital requirements



Conditions of debt agreements

Q.EXPLAIN THE FUNCTIONAL AREAS OF FINANCIAL MANAGEMENT. 1. Estimation of the financial requirements: The requirement of finance to a business concern is continuous. It is needed in all the stages of business cycle namely initial growth, saturation and declining stage. Funds are needed to establish the industry both for meeting capital expenditure and revenue expenditure. Total estimation of funds for these assets are the first assignment of the subject financial management. Funds are also needed at the growth stage for expansion and to increase the production to meet the demand of consumers.

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The requirement of finance arises even at the stage of saturation. It is needed for diversifying the product, so that a firm can continuously stay on in the saturation stage. If the firm became sick to rejuvenate the activities of such business concern, rescheduling repackage of financial services are needed. Hence it is the first task of finance manager. A wrong assessment of financial needs may jeopardize the survival of a concern. 2. Selection of the right sources of funds: After estimating the total funds of business concern, it is the second important step of the finance manager to select the right type of sources of funds at the right time at the right costs. A concern may resort to issue of share capital and debentures. Financial institutions may be requested to provide long term funds. The working capital needs may be met by getting cash credit or overdraft facilities from commercial banks. A finance manager has to be very careful and cautious in approaching different sources. A small concern may find difficulties in raising funds for want of adequate securities or due to its reputation.

The

selections of a suitable source of funds will influence the profitability of the concern. This selection should be made with great caution. 3. Allocation of funds: After mobilizing the total funds of a firm, it is the responsibility of finance manager to distribute the funds to capital expenditure and revenue expenditure. The evaluation of different proposals of project must be made before making a final decision on investment. Each investment must yield fair amount of returns, so that it should contribute to the goal of ‘Wealth Maximization’. 4. Analysis and interpretation of financial performance: The analysis and interpretation of financial statements is an important task of a finance manager. He is expected to know about the profitability, liquidity position, short term and long term financial position of the concern. For this purpose, a number of ratios have to be calculated. The interpretation of various ratios is also essential to reach certain conclusions. Financial analysis and interpretation has become an important area of financial management. 5. Cost – Volume – Profit Analysis: It is another important tool of the financial management, that helps the management to evaluate different proposals of investments.

Make or buy decision, deletion and

continuation of a product line decision can be made by adopting CVP/BEP analysis. This helps the management to achieve long term objective of a firm. 6. Capital budgeting: Capital budgeting is the process of making investment decisions in capital expenditure. It is an expenditure the benefits of which are expected to be received over a period of time exceeding one year. Capital budgeting decisions are vital to any organization. decision may prove to be fatal for the very existence of the concern.

An unused investment

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The crux of capital budgeting is the allocation of available resources to various proposals.

The crucial factor which influences the capital budgeting decision is the

profitability of the prospective investment. For making correct capital budgeting decisions, the knowledge of its techniques is essential. A number of methods like payback period method, rate of return method, net present value method, internal rate of return method and profitability index method may be used for making capital budgeting decisions. 7. Working capital management: Working capital refers to that part of the firmâ&#x20AC;&#x2122;s capital which is required for financing short term or current assets such as cash, receivables and inventories. It is essential to maintain a proper level of these assets. Financial manager is required to determine the quantum of such assets. Cash is required to meet day to day needs and purchase inventories etc. scarcity of cash may adversely affect the reputation of a concern.

The

The receivables

management is related to the volume of production and sales. For increasing sales, there may be a need to give more credit facilities. Though sales may go up but the risk of bad debts and cost involved in it may have to be weighted against the benefits. Inventory control is also an important factor in working capital management. The inadequacy of inventory may cause delays or stoppages of work.

Excess

inventory, on the other hand, may result in blocking of money in stocks, more costs in stock maintaining etc. Proper management of working capital is an important area of financial management. 8. Profit planning and control: Profit planning and control is an important responsibility of the finance manager. Profit is also used as a tool for evaluating the performance of management.

Profit is

determined by the volume of revenue and expenditure. Revenue may accrue from sales, investment in outside securities or income from other sources. The expenditure may include manufacturing costs, trading expenses, office and administrative expenses, selling and distribution expenses and financial cost. The excess of revenue over expenditure determine the amount of profit.

Profit

planning and control directly influence the declaration of dividend, creation of surpluses, taxation etc. Break even analysts and cost â&#x20AC;&#x201C; volume â&#x20AC;&#x201C; profit relationship are some of the tools used in profit planning and control. 9. Dividend policy: Dividend is the reward of the shareholders for investments made by them in the shares of the company. The investors are interested in earnings the maximum return on their investments whereas management wants to retain profits for further financing. The company should distribute a reasonable amount as dividend to its members and retain the rest for its growth and survival.

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A dividend policy is influenced by a number of factors such as magnitude and trend of earnings, desire and type of shareholders, future requirements of the company, government’s economic policy, taxation policy etc. Dividend policy is an important area of financial management because the interests of the shareholders and the needs of the company are directly related to it. 10. Maintaining liquidity and wealth maximization: This is considered to be the prime objective of a business firm. Liquidity of a firm increases the borrowing capacity.

Expansion and diversification activities can be comfortably executed.

Increased liquidity

builds the firm’s ability to meet short term obligation towards creditors or bankers. Once the flow of funds is assumed continuously, flexibility in the planning for investments can be maximized. This helps the firm to meet all types of obligation to the target group like investors, creditors, employees management, government and society.

Thus ‘Wealth Maximization’

takes place in the form of growth of capital over the years.

ROLE OF FINANCE MANAGER Q.CRITICALLY ANALYZE THE FUNCTIONS OF FINANCIAL MANAGER IN A LARGE SCALE INDUSTRIAL ESTABLISHMENT. (OR) Q.WHAT ARE THE RESPONSIBILITIES OF THE FINANCIAL MANAGER IN A MODERN BUSINESS ORGANIZATION? Introduction: Finance manager is a person who heads the department of finance.

He forms

important activities in connection with each of the general functions of management. Specifically, the finance manager should anticipate financial needs, acquire financial resources and allocate funds to various departments of the business. Since the financial manager is an integral part of the top management, he should shape his decisions and recommendations to contribute to the overall progress of the business.

It is his primary

objectives to maximize the value of the firm to its stockholders. TRADITIONAL ROLE 1. Financial forecasting and planning: A financial manager has to estimate the financial needs of a business. How much money will be required for acquiring various assets?

The amount will be needed for

purchasing fixed assets and meeting working capital needs. He has to plan the funds needed in the future. How these funds will be acquired and applied is an important function of a finance manager.

FINANCIAL MGMT. & MGMT. ACCOUNTING 2. Acquisition of funds: After making financial planning, the next step will be to acquire funds. There are a number of sources available for supplying funds. These sources may be shares, debentures, financial institutions, commercial banks etc. The selection of an appropriate source is a delicate task. The choice of a wrong source for funds may create difficulties at a larger stage. The pros and cons of various sources should be analyzed before making a final decision.

3. Investment of funds: The funds should be used in the best possible way. The cost of acquiring them and the returns should be compared. The channels which generate higher returns should be preferred. The technique of capital budgeting may be helpful in selecting a project. The objective of maximizing profits will be achieved only when funds are efficiently used and they do not remain idle at any time. A financial manager has to keep in mind the principles of safety, liquidity and soundness while investing funds.

4. Helping in valuation decision: A number of mergers and consolidations take place in the present competitive industrial world. A finance manager is supposed to assist management in making valuations etc. For this purpose, he should understand various methods of valuing shares and other assets so that correct values are arrived at.

5. Maintain proper liquidity: Every concern is required to maintain some liquidity for meeting day to day needs. Cash is the best source for maintaining liquidity. It is required to purchase raw materials, pay workers, meet other expenses etc. A finance manager is required to determine the need for liquid assets and then arrange liquid assets in such a way that there is no scarcity of funds.

Changing role of finance manager

The changed business environment in the result part has widened the role of a financial manager.

The increasing pace of industrialization, rise of larger scale units,

innovations in information processing techniques, intense competition etc have increased the need for financial planning and control.

The size and extent of business activities are

dependent upon the availability of finances. Financial reporting may be used as a technique for control. In the present business context, a financial manager is expected to perform the following functions.

FINANCIAL MGMT. & MGMT. ACCOUNTING

Changing role of Finance Manager

Traditional role Financial forecasting & planning

New role Mergers –Tax planning

Acquisition of funds

Cost reduction strategies

Investment of funds

Access for foreign Investment

Helps in valuation decision

FOREX Management

Maintains proper liquidity

Information Technology

Communication Network Learning attitude etc.

New role: In addition to the traditional role, the finance manager has to look into the areas where he has to operate his function in the changing environment. 

The government of India has thrown open challenge before the corporate by introducing liberalization, privatization and globalization in the year 1991. From then on continuous changes are taking place in the economic environment. Hence it has become an ardent necessity for the finance manager to look into the areas of mergers, acquisitions, tax planning, tax management, personality development etc.



The new economic policy introduced in the year 1991 facilitated the multinational companies to enter into the country more freely without any restrictions. Hence the concept of mega mergers entered into corporate world.

The technicalities,

negotiations, mode of mergers, acquisitions within the country and outside must be known to the finance manager to operate his function under the global environment. 

In addition to this, the finance manager has to guide the management in adopting tax planning technique and to introduce cost reduction strategies, so that it would help to participate in the competition effectively.



The vision of corporate are aiming at global market, this necessitated the requirement of knowing the knowledge of imports and exports, managing the foreign exchange risk (FERA) and important aspects of international financial management.

In addition to the above roles, he has to adopt himself to changing information technology which calls for expected knowledge in the field of computers. This would not only reduces the cost of operation but also provides greater flexibility. To conclude, the financial manager of a company must be more vibrant, dynamic and should have continuous learning attitude. He should develop the attitude of research and innovations to discharge his duties competitively.

FINANCIAL MGMT. & MGMT. ACCOUNTING

Q.EXPLAIN THE INTERFACE OF THE FINANCE FUNCTION WITH OTHER AREAS. (OR) Q.FINANCE FUNCTION OF A BUSINESS IS CLOSELY RELATED TO ITS OTHER FUNCTIONS. ‘DISCUSS’. Finance function

Purchase

Production

Function

Distribution

Accounting

Function

Personnel

R&D

Function

Finance function of a business is closely related to its other functional areas. Funds will be wasted in the absence of efficient production and in the absence of proper marketing; the firm will not be able to engage funds judiciously in the business. Most of the important decisions of a business enterprise are taken on the basis of availability of funds. Financial policies of a firm should be devised in such a manner so as to match the requirements of other functional areas. The relationship between finance function and other business functions of an enterprise is discussed below: 1. Purchase function: Materials required for production of commodities should be procured on economic terms and should be utilized in efficient manner to achieve maximum productivity. In this function the finance manager plays a key role in providing finance. In order to minimize cost and exercise maximum control, various material management techniques such as economic order quantity (EOA), determination of stock level, perpetual inventory system etc are applied. The task of the finance manager is to arrange the availability of cash when the bills for purchase become due.

2. Productivity function: Production function occupies the dominant position in business activities and it is a continuous process. Production function involves heavy investment in fixed assets and in working capital; naturally, a tighter control by the finance manager on the investment in productive assets becomes necessary.

It must be seen that there is neither over

capitalization nor under capitalization – cost – benefit criteria should be the prime guide in allocating funds and therefore finance and production manager should work in unison.

3. Distribution function: As goods produced are meant for sale, a distribution function is an important business activity. While choosing different distributing channels, media of advertisement and sales promotion devices, the cost benefit criterion should be the guiding factor.

FINANCIAL MGMT. & MGMT. ACCOUNTING If cost reduction in distribution function is effected without compromising efficiently, it will lead to increased benefit to the enterprise in the form of higher profit and to the consumers in the form of lower cost. As every aspect of distributory function involves cash outflow and every distributing activity is aimed at bringing about inflow of cash, both the functions are closely inter related and hence should be carried out in closed unison.

4. Accounting function: The efficiency of the whole organization can be greatly improved with correct recording of financial data.

All the accounting tools and control devices, necessary for

appraised of finance policy can be correctly formulated if the accounting data are properly recorded. For example, the cost of raising funds, expected returns on the investment of such funds, liquidity position, forecasting of sales etc can be effectively carried out if the financial data so recorded are reliable. Hence, the relationship between accounting and finance is intimate and the finance manager has to depend heavily on the accuracy of the accounting data.

5. Personnel function: Personnel function has assumed a prominent place in the domain of business management. No business function can be carried out effectively unless there is a sound personnel policy backed up by efficient management of personnel. A sound personnel policy includes proper wage structure, incentives schemes, promotional opportunity, human resource development and other fringe benefits provided to the employees.

All these matters affect finance. It means that expenditure incurred on

personnel management and the expected return on such investment though labour productivity should be considered in framing a sound personnel policy. Therefore the relation between the finance and personnel department should be intimate. 6. Research and development: In the world of innovations and competitiveness expenditure and research and development is a productive investment and research and development itself is an aid to survival and growth of the firm.

However sometimes expenditure on research and

development involves heavier amount which cripples the enterprise and the expenditure ultimately ends in a fiasco. On the other hand, heavily cutting down expenditure of research and development blocks the scope of improvement and diversification of the product. So there must be a balance between the amount necessary for continuing research and development work and the funds available for such a purpose. Usually, this balance is struck out by joint efforts of finance manager and the person at the helm of research and development.

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PROCESS OF FINANCIAL MANAGEMENT

Financial planning And control Feedback

Financial decisions Market price Share Risk and 1. Investment decision Of share holder return The financialdecision management process begins with the financial 2. Financing wealth While P planning and decisions. Characteristics 3. Dividend decision implementing these decisions, Of thethe firmfirm has to acquire certain risk and returnW=NP characteristics. These characteristics determine the market price of shares and shareholder wealth. The process must include the feedback system to enable it take corrective measures, if required. The figure below depicts the process of financial management:

ORGANISATION OF FINANCE FUNCTIONS. Q.HOW SHOULD THE FINANCE OF AN ENTERPRISE BE ORGANISED? DISCUSS.

Board of Directors Managing Directors Finance committee

Vice president Production

Vice president Finance

Financial controller

Planning and control

Annual Reports

Vice president Sales

Treasurer

Budgeting

Profit analysis

Accounting and payroll

Additional Cash Receivables Relations Audit with Funds Management Management The finance function is very vital for every type of business enterprise. There is aBanks need to set & Financial up a sound and efficient organization to achieve its goals. However, organization of finance Institutions

FINANCIAL MGMT. & MGMT. ACCOUNTING function is not standardized one. It varies from enterprise to enterprise, depending upon its nature, size and other requirements. In a small concern, whose operations are simple and there is little delegation of authority no separate executive is appointed to handle finance function. It is the owner who performs all these functions himself. But in medium and large scale concerns, a separate department to organize all financial activities may be created at top level under a direct supervision of Board of Directors or a highly placed official. This function may be headed by a committee or a top management executive. All important financial decisions are taken by the committee or the executive but routine decisions are left to the lower levels of management.The finance function is centralized because of its importance. The financial decisions are crucial for the survival of the concern. In large concerns, for organizing finance functions, the Controller and Treasurer are appointed.

FUNCTIONS OF CONTROLLER: Planning and control: To establish, coordinate and administer, as part of management, a plan for the control of operations. This plan would provide to the extent required in the business, profit planning, programmes for capital investing and for financing, sales forecasts and expense budgets. Reporting and interpreting: To compare actual performance with operating plans and standards, and to report and interpret the results of operations to all levels of management and to the owners of business. To consult with the management about the financial implications of the business. Tax administration: To establish and administer tax policies and procedures. Government reporting: To supervise co-ordinate the preparation of report to government agencies. Protection of assets: To ensure protection of business assets through internal control, internal auditing and assuring proper insurance coverage. Economic appraisal: To appraise economic and social forces and government influences and interpret their effect upon business. FUNCTIONS OF TREASURER: Provision of finance: To establish and execute programmes for the provision of the finance required by the business, including negotiating its procurement and maintaining the required financial arrangements. Investor relations:

FINANCIAL MGMT. & MGMT. ACCOUNTING To establish and maintain an adequate market for the company’s securities and to maintain adequate contact with the investment community. Short term financing: To maintain adequate sources for the company’s current borrowings from the money market. Banking and custody: To maintain banking arrangements, to receive, have custody of and disburse the company’s moneys and securities and to be responsible for the financial aspects of real estate transactions. Credit and collections: To direct the granting of credit and the collection of accounts receivables of the company. Investments: To invest the company’s funds as required and to establish and coordinate policies for investment in pension and other similar trusts. Insurance: To provide insurance coverage as may be required.

FINANCIAL MGMT. & MGMT. ACCOUNTING

UNIT-II CAPITAL EXPENDITURE EVALUATIONS CAPITAL BUDGETING Q.GIVE THE MEANING AND DEFINITION OF CAPITAL BUDGETING. MEANING: Capital budgeting is the process of making investment decisions in capital expenditure. A capital expenditure may be defined as an expenditure the benefits of which are expected to be received over period of time exceeding one year. The main characteristic of a capital expenditure is that the expenditure is incurred at one point of time whereas benefits of the expenditure are realized at different points of time in future or a capital expenditure is an expenditure incurred for acquiring or improving the fixed assets, the benefits of which are expected to be received over a number of years in future. Kinds of Capital Budgeting Proposals (i)

Cost of acquisition of permanent assets as land and building, plant and machinery, goodwill etc

(ii)

Cost of addition, expansion, improvement or alteration in the fixed assets

(iii)

Cost of replacement of permanent assets

(iv)

Research and development project cost etc.

Kinds of capital budgeting proposals

Replacement Expansion

Modernization of investment expenditures

Strategic investment proposals

Diversification

Reasearch & development

FINANCIAL MGMT. & MGMT. ACCOUNTING

Capital expenditure involves non-flexible long-term commitment of funds. Thus capital expenditure decisions are also called as long term investment decisions. Capital budgeting involves the planning and control of capital expenditure. It is the process of deciding whether or not to commit resources to a particular long term project whose benefits are to be realized over a period of time, longer than one year. Capital budgeting is also known as Investment Decision Making, Capital Expenditure Decisions, Planning Capital Expenditure and Analysis of Capital Expenditure. DEFINITION: Charles T. Horngreen has defined capital budgeting as, “Capital budgeting is long term planning for making and financing proposed capital outlays”. According to G.C.Philippatos, “Capital budgeting is concerned with the allocation of the firm’s scarce financial resources among the available market opportunities.

The

consideration of investment opportunities involves the comparison of the expected future streams of earnings from a project with the immediate and subsequent streams of earning from a project, with the immediate and subsequent streams of expenditures for it”. Richard and Greenlaw have referred to capital budgeting as acquiring inputs with long run return. In the words of Lynch, “Capital budgeting consists of planning development of available capital for the purpose of maximizing the long term profitability of the concern”.

Q.EXPLAIN THE NATURE OF INVESTMENT DECISIONS/ FEATURES OF INVESTMENT DECISIONS.

Capital expenditure for long period

FEATURES OF CAPITAL BUDGETING

Forecasting

Planning asset capacities The important features which distinguish capital budgeting decision from the ordinary day to day business decisions are: (i)

Capital budgeting decisions involve the exchange of current funds for the benefits to be achieved in future

(ii)

The future benefits are expected to be realized over a series of years

(iii)

The funds are invested in non flexible and long term activities

(iv)

They have a long term and significant effect on the profitability of the concern

(v)

They involve generally huge funds

(vi)

They are irreversible decisions

FINANCIAL MGMT. & MGMT. ACCOUNTING

They are ‘strategic’ investment decisions, involving large sums of money, major

(vii)

departure from the past practices of the firm, significant change of the firm’s expected earnings associated with high degree of risk, as compared to ‘tectical’ investment decisions which involve a relatively small amount of funds that do not result in a major departure from the past practices of the firm.

Q.DISCUSS THE NEED AND IMPORTANCE OF CAPITAL BUDGETING DECISIONS. Capital budgeting decisions are most important business decisions.

All types of

capital investment are made only after evaluating its cost benefit analysis. Following are the cause of its importance in management decisions.

The success and failure of business

mainly depends on how the available resources are being utilized. Capital budgeting decisions are vital to any organization as they include the decisions as to: 

Whether or not funds should be invested in long term projects such as setting of an industry, purchase of plant and machinery etc.



Analysis the proposal for expansion or creating additional capacities



To decide the replacement of permanent assets such as building and equipments



To make financial analysis of various proposals regarding capital investments so as to choose the best out of many alternative proposals.

The need, significance or importance of capital budgeting arises mainly due to the following: a) Involvement of heavy funds: Capital budgeting decisions require large capital outlays. It is therefore absolutely necessary that the firm should carefully plan its investment programme so that it may get the finances at the right time and they put to most profitable use. An opportune investment decision can give spectacular results. On the other hand, an ill-advised and incorrect decision can jeopardize the survival of even the biggest firm. b) Long term implications: Capital expenditure involves not only large amount of funds but also funds long term or more or less on permanent basis. The long term commitment of funds increases the financial risk involved in the investment decision.

Greater the risk

involved, greater is the need for careful planning of capital expenditure, i.e., Capital budgeting. c) Irreversible decisions: In most cases, capital budgeting decisions are irreversible. This is because it is very difficult to find a market for the capital assets. The only alternative will be to scrap the capital assets so purchased or sell them at a substantial loss in the event of the decision being proved wrong. d) Most difficult to make: The capital budgeting decisions require an assessment of future events which are uncertain. It is really a difficult task to estimate the probable future events, the probable benefits and costs accurately in quantitative terms because of economic, political, social and technological factors. e) Long-term effect on profitability: Capital budgeting decisions have a long term and significant effect on the profitability of a concern. Not only the present earnings of the firm are

FINANCIAL MGMT. & MGMT. ACCOUNTING affected by the investments in capital assets, but also the future growth and profitability of the firm depends upon the investment decision taken today. An unwise decision may prove disastrous and fatal to the very existence of the concern. Capital budgeting is of utmost importance to avoid over investment or under investment in fixed assets. f) National importance:

Investment decision though taken by individual concern is of

national importance because it determines employment, economic activities and economic growth. Thus we may say that without using capital budgeting techniques a firm may involve itself in losing project. Proper timing of purchase, replacement, expansion and alternation of assets is essential. Q.DISCUSS IN DETAIL THE CAPITAL BUDGETING PROCESS. Capital budgeting is a complex process as it involves decisions relating to the investment of current funds for the benefit to the achieved in future and the future is always uncertain.

However, the following procedure may be adopted in the process of capital

budgeting: a) Identification of Investment Proposals: The capital budgeting process begins with the identification of investment proposals. The proposal or the idea about potential investment opportunities may originate from the top management or may come from the rank and file worker of any department or from any officer of the organization. The departmental head analyses the various proposals in the light of the corporate strategies and submits the suitable proposals to the Capital Expenditure Planning Committee in case of large organizations or to the officers concerned with the process of long term investment decisions.

b) Screening the Proposals: The Expenditure Planning Committee screens the various proposals received from different departments. The committee views these proposals form various angles to ensure that these are in accordance with the corporate strategies or selection criterion of the firm and also do not lead to departmental imbalances.

c) Evaluation of Various Proposals: The next step in the capital budgeting process is to evaluate the profitability of various proposals. There are many methods which may be used for this purpose such as pay back period method, rate of return method, net present value method, internal rate of return method etc. All these methods of evaluating profitability of capital investment proposals have been discussed in detail separately in the following pages of this chapter. It should be noted that various proposals to the evaluated may be classified as: ď&#x201A;ˇ

Independent proposals

ď&#x201A;ˇ

Contingent or dependent proposals and

FINANCIAL MGMT. & MGMT. ACCOUNTING ď&#x201A;ˇ

Mutually exclusive proposals.

Independent proposals are those which do not compete with one another and the same may be either accepted or rejected on the basis of a minimum return on investment required. The contingent proposals are those whose acceptance depends upon the acceptance of one or more other proposals, e.g., further investment in building or machineries may have to be undertaken as a result of expansion programme. Mutually exclusive proposals are those which compete with each other and one of those may have to be selected at the cost of the other.

d) Fixing Priorities: After evaluating various proposals, the unprofitable or uneconomic proposals may be rejected straight away. But it may not be possible for the firm to invest immediately in all the acceptable proposals due to limitation of funds. Hence it is very essential to rank the various proposals and to establish priorities after considering urgency, risk and profitability involved therein.

e) Final Approval and Preparation of Capital Expenditure Budget: Proposals meeting the evaluation and other criteria are finally approved to be included in the Capital Expenditure Budget. However, proposals involving smaller investment may be decided at the lower levels for expeditious action. The capital expenditure budget lays down the amount of estimated expenditure to be incurred on fixed assets during the budget period.

f) Implementing proposal: Preparation of a capital expenditure budgeting and incorporation of a particular proposal in the budget does not itself authorize to go ahead with the implementation of the project. A request for authority to spend the amount should further be made to the Capital Expenditure Committee which may like to review the profitability of the project in the changed circumstances. Further while implementing the project, it is better to assign responsibilities for completing the project within the given time frame and cost limit so as to avoid unnecessary delays and cost over runs. Network techniques used in the project management such as PERT and CPM can also be applied to control and monitor the implementation of the projects.

g)Performance Review: The last stage in the process of capital budgeting is the evaluation of the performance of the project. The evaluation is made through post completion audit by way of comparison of actual expenditure on the project with the budgeted one and also by comparing the actual return from the investment with the anticipated return. The unfavourable variances, if any should be

FINANCIAL MGMT. & MGMT. ACCOUNTING

looked into and the causes of the same be identified so that corrective action may be taken in further.

Q.WHAT ARE THE KINDS OF INVESTMENT DECISIONS? Capital budgeting refers to the total process of generating, evaluating, selecting and following up on capital expenditure alternatives.

The firm allocates or budgets financial

resources to new investment proposals-Basically, the firm may be conformed with three types of capital budgeting decisions.

Accept reject decision: This is a fundamental decision in capital budgeting. If the project is accepted, the firm would invest in it. If the proposal is rejected, the firm does not invest in it. In general, all those proposals which yield a rate of return greater than a certain required rate of return or cost of capital are accepted and the rest are rejected.

Mutually Exclusive Project Decisions:

Mutually exclusive projects are those which

compete with projects in such a way that the acceptance of one will exclude the acceptance of the other projects. The alternatives are mutually exclusive and only one may be chosen.

Capital Rationing Decision:

In a situation where the firm has unlimited funds, all

independent investment proposals yielding return greater than some predetermined level are accepted. However, this situation does not prevail in most of the business firms in actual practice.

They have a fixed capital budget.

A large number of investment proposals

complete for these limited funds. The firm must therefore, ration them.

The firm allocates funds to projects in a

manner that it maximizes long run returns. Thus capital rationing refers to a situation in which a firm has more acceptable investments than it can finance. It is concerned with the selection of a group of investment proposals out of many investment proposals acceptance under the accept-reject decision. Capital rationing employs ranking of the acceptable investment projects.

The

projects can be ranked on the basis of a predetermined criterion such as the rate of return. The projects are ranked in the descending order of the rate of return

Cash flow for investment analysis The evaluation of long-term investment decisions or investment analysis to be consistent with the firmâ&#x20AC;&#x2122;s goal involves the following three basic steps: 1. Estimation or determination of cash flows. 2. Determining the rate of discount or cost of capital. 3. Applying the technique of capital budgeting to determine the viability of the investment proposal.

FINANCIAL MGMT. & MGMT. ACCOUNTING The first important step i.e., estimation or determination of cash flows. If a firm makes an investment today, it will require an immediate cash outlay, but the benefits of this investment will be received in future. Thus, it will have an effect on future cash flows over the life of the asset. While taking such financial decision, the firm has to compare the total inflows with the total of cash outflows from the investment. But, the estimation of future cash outflows is not an easy task because of uncertainties of the future.

CONCEPT OF CASH FLOWS. Q.DISTINGUISH BETWEEN ACCOUNTING PROFITS AND CASH FLOWS.WHY ARE CASH FLOWS CONSIDERED TO BE A BETTER MEASURE OF ECONOMIC VIABILITY AS COMPARED TO ACCOUNTING PROFITS? There are two alternative criteria available for ascertaining future economic benefits of an investment proposal, (i) accounting profits, and (ii) cash flows. The term ‘accounting profit’ refers to the figure of profit as determined by the income statement or profit and loss account, while ‘cash flow refers to cash revenue minus cash expenses. The difference between these two criteria arises primarily because of certain noncash expenses such as depreciation, being charged to profit & loss account. Thus, the accounting profits have to be adjusted for such non-cash charges to determine the actual cash inflows. In fact, cash flows are considered to be better measure of economic viability as compared to accounting profits for the following reasons: 1. The appropriate objective of a firm is not to maximize profits; rather it is to maximize the shareholder’s wealth which depends upon the present value of cash flows available to them and not the accounting profits. When the firm makes a new investment, traditional accounting procedure spread out the initial investment be capitalizing it over the life of the asset and then reducing future net benefits by subtracting an annual depreciation charge. But this accounting treatment does not reflect the original need for cash at the time of investment, nor does the accounting treatment reflect the actual size of the net cash inflows or outflows in later years. Only cash flows reflect the actual cash transactions associated with the project, and since investment analysis is concerned with the question: Are future economic inflows sufficiently large to warrant the initial investment? Only the cash flow method is appropriate for investment decision analysis.

2. The second reason for considering cash flows to be a better measure of economic viability as compared to accounting profits pertains to accounting ambiguities in determining net profits. there are many ambiguities that arise in accounting profit approach on account of various accounting practices regarding method of valuation of inventory, allocation of costs, method of depreciation and amortization of various

FINANCIAL MGMT. & MGMT. ACCOUNTING other expenses. Thus, different net profits may be arrived at under different accounting practices and procedures. But, there will be only one set of cash flows associated with the project. The cash flow approach, thus, avoids the accounting ambiguities and is a better measure as compared to the accounting profits approach.

3. The third reason in favour of cash flow approach is its recognition of time value of money. It recognizes the time value of money by considering the actual cash inflows and outflows. On the other hand, usual accounting practices considers revenues when earned and expenses when incurred on the accrual basis rather than when cash is actually effected. It may, sometimes amount to only paper profits if the revenue (sale) is not realized. Therefore, from the view point of investment analysis, the ash flow approach is the only appropriate method.

Q.EXPLAIN IN DETAIL (1) CONVENTIONAL AND NON-CONVENTIONAL CASH FLOWS; AND (2) INCREMENTAL CASH FLOWS. (1) CONVENTIONAL AND NON-CONVENTIONAL CASH FLOWS

CONVENTIONAL CASH FLOWS When an initial cash outlay (outflow) is followed be a series of cash inflows of uniform or unequal amounts, it is called conventional cash flows. Most of the capital investment decisions follow this pattern. for example, a firm may invest Rs.2,00,000 initially in a project at time zero and may expect to receive an annual cash inflow of Rs.40,000 at the end of each year for 8 years.

The other example of conventional cash flows could be where a firm may invest sayRs.5,00,000 initially and as a result may expect to receive cash flows of Rs.1,00,000 at the end of first year,Rs.1,50,000 at the end of second year,Rs.2,00,000 at the end of third year, Rs.1,00,000 at the end of fourth year and Rs.1,50,000 at the end of fifth year. NON-CONVENTIONAL CASH FLOWS Non-conventional cash flows on the other, refers to the cash flow pattern where not one but a series of cash outflows are followed by a series of cash inflows of equal amounts. For example, a project may require an investment of Rs.1,50,000 in the beginning of first year and another Rs.30,000 at the beginning of second year followed by cash inflows of Rs.30,000 ,Rs.40,000 ,Rs.70,000,Rs.80,000 and Rs.40,000 at the end of each year of the first five years respectively. Another example of non-conventional cash flows may be where a firm may purchase a machine for Rs.1,00,000 initially at time zero and may expect to receive annual cash inflows of Rs.25,000 each year for5 years and then another cash outflow of Rs.30,000 may be

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required for overhauling of the machine in the sixth year to generate further cash inflows of Rs.20,000 each year for next 5 years.

(2) INCREMENTAL CASH FLOWS. All investment decisions involve comparison of alternative proposals. In case of a single proposal, the comparison will be between investing in the project and not-investing in the project. However, in case of two or more proposals, the comparison will be between investing in one project or the other. Single project proposals are evaluated on the basis of ‘absolute cash flows’, whereas, competing project proposals are evaluated on the basis of ‘relative or incremental cash flows’. The term ‘incremental cash flows’ refer to the differential cash flows between the two proposals.

Incremental Cash Flows For Proposal 1 And Proposal 2 Cash Flows Year( t0 )Rs.

(Rs.)

Proposal 1

50,000

20,000

15,000

10,000

5,000

Proposal2

30,000

11,000

9,000

5,000

2,000

20,000

9,000

6,000

5,000

3,000

Q.EXPLAIN THE VARIOUS TYPES (COMPONENTS) OF CASH FLOWS.

Q.EXPLAIN IN DETAIL THE DETERMINATION OF RELEVANT CASH FLOWS. 1. INITIAL INVESTMENTThe initial investment is an outlay of cash that takes place in the initial period t=0 when an asset is purchased. It comprises, primarily, of cost of the new asset to purchase land, building, machinery, etc, including expenses on insurance, freight, loading and unloading, installation cost and expenses on modification and repairs, etc. before the asset is put to use .In addition to the cost of the asset, new investment in capital assets may also require increased investment in working capital, i.e. the excess of current assets over current liabilities. Thus, the net working capital increases are also added to the cost of the asset. Further, if the new investment makes use of some existing facilities, the opportunity cost of the same should also be added to arrive at the amount of initial investment. For example, if a firm proposes to invest in a machine to be installed at some surplus land of the firm, the firm should find out the opportunity cost of selling the land and add the same while calculating the initial investment. In the same manner, in case of replacement decisions, the existing asset may be sold if the new asset is purchased.

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The sale proceeds of the discarded asset should, therefore, be deducted while determining the amount of initial investment.

Until recently a deduction (tax credit) under income tax act equal to 25 percent of the cost of the asset was allowed as investment allowance in the period in which the asset was installed for production. However, the investment allowance has now, been discontinued fro st

1 April 1990.The computation of cash outflows, comprising the initial investment has been shown in the following table.

Computation of initial investment Rs. Purchase price of the asset(including duties and taxes if any)

Add: Insurance, freight, Loading, Unloading and Installation Costs

Add: Net Increase in Working Capital Requirements

Add: Opportunity cost(if any)

Less: Cash inflows in the form of sale proceed(of the old assets in case of replacement decisions)

Less: Investment Allowance(if any, discontinued from 1.4.1990)

2. OPERATING CASH FLOWS/NET ANNUAL CASH FLOWS Every investment in capital assets is expected to generate future benefits in the form of net annual cash flows from operations. These annual cash inflows should be estimated on an after-tax basis. In simple words, net annual cash flows refer to the annual net earnings (profit) before depreciation and after taxes.

Depreciation being a non cash charge is added back to the earnings before tax, but tax, being a cash expense has to be deducted to determine the net annual cash flows. The net amount cash flows can be determined as below: NCF = Cash Revenues – Cash Expenses – Tax or, NCF = Net Earnings After Tax + Depreciation – Tax

The following table will be useful in determining net annual cash inflows.

FINANCIAL MGMT. & MGMT. ACCOUNTING

Determination of Net Annual Cash Inflows Years 1

4â&#x20AC;Śâ&#x20AC;Śn (amount in Rs)

Cash Revenues (Sales) Less: Cash Expenses (Operating costs) Earnings Before Depreciation and Tax (CFBT) Less: Depreciation Earnings Before Tax Less: Tax Earnings After Tax Add. Depreciation Cash Inflows After Tax (CFAT)

3. TERMINAL CASH FLOWS At the end of the economic life of a capital asset i.e., the last year when the asset is terminated, there is usually, some value in the asset left. The asset may be sold at that point of time as scrap or it may fetch some salvage value. This inflow to a firm in the last (terminal) year is called terminal cash flow. Similarly in the case of replacement decision where an old existing asset is replaced with a new asset, the reduction in cost of the new asset, i.e., the sales value of the old asset, is the terminal cash flow of the asset replaced. In addition to the salvage value of the asset, the firm may also recover the increased net working capital that was tied up in the initial year. Thus, this release of working capital should also be added to the salvage value of the asset to determine the terminal cash flows.

EXPLAIN

THE

VARIOUS

FACTORS

WHICH

INFLUENCE

THE

CAPITAL

EXPENDITURE DECISIONS. There are many other factors which have to be taken into consideration while taking a capital expenditure decision. These are: 1. Urgency: Sometimes an investment is to be made due to an urgency for the survival of the firm or to avoid heavy losses.

In such circumstances, the proper evaluation of the proposal

cannot be made through profitability tests. The examples of such an urgency are: breakdown of some plant and machinery, fire, accident etc.

2. Degree of certainty: Profitability is directly related to risk, higher the profits, greater is the risk or uncertainty.

Sometimes, a project with some lower profitability may be selected due to

FINANCIAL MGMT. & MGMT. ACCOUNTING constant flow of income as compared to another project with an irregular and uncertain flow of income.

3. Intangible factors: Sometimes a capital expenditure has to be made due to certain emotional and intangible factors such as safety and welfare of workers, prestigious project, social welfare, goodwill of the firm etc.

4. Legal factors: An investment which is required by the provisions of law is solely influenced by this factor and although the project may not be profitable yet the investment has to be made.

5. Availability of funds: As the capital expenditure, generally requires large funds, the availability of funds is an important factor that influences the capital budgeting decisions. A project, howsoever profitable, may not be taken for want of funds and a project with a lesser profitability may be sometimes preferred due to lesser pay-back period for want of liquidity.

6. Future earnings: A project may not be profitable as compared to another today, but it may promise better future earnings. In such cases it may be preferred to increase earnings.

7. Obsolescence: There are certain projects which have greater risk of obsolescence than others. In case of projects with high rate of obsolescence, the project with a lesser pay-back period may be preferred than one which may have high rate of obsolescence, the project with a lesser pay-back period may be preferred than one which may have higher profitability but still longer pay-back period.

8. Research and Development Projects: It is necessary for the long term survival of the business to invest in research and development projects though it may not look to be profitable investment.

9. Cost Considerations: Cost of the capital project, cost of production, opportunity cost of capital, etc are other considerations involved in the capital budgeting decisions.

Q.STATE THE LIMITATIONS OF CAPITAL BUDGETING.

FINANCIAL MGMT. & MGMT. ACCOUNTING 1. The analytical techniques (investment return and time) are, to some extent, estimates. Even with all the knowledgeable factors’ collected and duly analyzed, there are many unknown factors which cannot be foreseen, controlled or avoided. 2. Capital investment can be determined in some cases with a high degree of accuracy; but in the development of a new product, or in the opening of anew sales territory, the amount can only be approximated. 3. All the techniques of capital budgeting presume that various investment proposals under consideration are mutually exclusive which may not practically be true in some particular cases. 4. The techniques of capital budgeting require estimation of future cash inflows and outflows. The future is always uncertain and the data collected for future may not be exact. Obviously the results based upon wrong data may not be good. There are certain factors like morals of the employees, goodwill of the firm etc which cannot be correctly quantified but which other wise substantially influence the capital decision. 5. To estimate the useful or economic life of an investment is perhaps the most tenuous thing. 6. Urgency is another limitation in the evaluation of capital investment decisions. 7. Uncertainty and risk pose the biggest limitation to the techniques of capital budgeting. METHODS OF APPRAISALS OF CAPITAL BUDGETING Q. EXPLAIN THE VARIOUS CAPITAL BUDGETING EVALUATION TECHNIQUES. Q. EXPLAIN THE METHODS OF RANKING INVESTMENT PROPOSALS. At any given time, large number of investment proposals can be there and the funds available or funds which can be raised are always limited. So, it is not possible to take up all the proposals of investment. It is essential to select from amongst the competing proposals those which give the highest benefits. The essence of capital budgeting is the ‘balancing Act’ of matching the available resources with the acceptable projects. There are a large number of methods in practice all over the world in the sphere of capital expenditure decisions.

Which ever method is selected, it should:

1) Provide a basis for distinguishing between acceptable and non-acceptable projects; 2) Rank different proposals in order of priority. 3) Have suitable approach to choose from among the alternatives available; 4) Adopt ‘criterion’ which can assess any kind of project; 5) Be logical by recognizing the time value of money and the importance of returns. The following is the popular classification of various methods of capital budgeting:

A) Traditional Methods (Non-discounted cash flow methods) 1. Pay-back period method

FINANCIAL MGMT. & MGMT. ACCOUNTING 2. Improvement in traditional approach to pay-back period method. 3. Accounting rate of return or average rate of return method.

B) Non-traditional (or) (Discounted cash flow methods- DCF methods) 1. Net Present Value(N.P.V) Method; 2. Profitability Index(or) Excess Present Value Index Method (P.I Method) 3. Internal Rate of return (I.R.R) method.

(A) Traditional methods These methods generally ignore ‘time value of money’ and treat incomes estimated for different future periods alike. These methods have been traditionally used in business units.

1. PAY-BACK PERIOD METHOD The ‘Pay-back’ method sometimes called ‘pay-out’ or ‘pay-off’ period method represents the period in which the total investment in permanent assets pay back itself. This method is based on the principle that every capital expenditure pays itself back within a certain period, out of the additional earnings generated from capital assets. Thus, it measures the period of time for the original cost of the project to be recovered from the additional earnings of the project itself. Under the method the various investments are ranked according to the length of their pay-back periods in such a manner that investment with a shorter pay-back period is preferred to the one which has a longer pay-back period. In case of evaluation of a single project, it is adopted if it pays back for itself within a period specified by the management and if the project does not pay itself within the period specified by the management then it is rejected. The pay-back period can be ascertained in the following manner.

Methods of calculation of pay-Back period (A) when cash inflows are uniform Calculate annual net earnings (profit) before depreciation and after taxes, these are called annual cash inflows. If annual net cash inflows are uniform, the following formula can be used to ascertain pay-back period.

Pay-back period = Initial Cost of Asset/Initial Investment in Project Annual cash inflow (B) when cash inflows are not uniform Pay-back period is computed with the help of ‘cumulative cash inflows’ when cash flows are not uniform. Of course formula method cannot be used here.

FINANCIAL MGMT. & MGMT. ACCOUNTING st

Starting from the 1 year, the net cash inflows are shown cumulatively. When the cumulative inflows are equal to the investment, the total time period in years and months is noted. Here the pay-back period is the time taken for the cumulative net cash inflows to equal the investments.

Merits The pay back period method has the following merits: (i)

It is easy to understand

(ii)

It is simple to operate.

(iii)

This method makes it clear that there is no profit on any project unless pay back period is over.

(iv)

By using this method, the business unit can judge the period for which its funds will remain tied up if the project is approved.

(v)

This method is particularly suitable in industries where risk of obsolescence is high. In such cases, project having short pay-back period shall be preferred.

(vi)

This method is preferable, where funds are in very short supply. They may be invested to yield more by selecting projects having shorter pay back periods.

Demerits The method has the following demerits: (i)

This method is delicate and rigid. A slight change in the division of labour and cost of maintenance will affect the earnings and as such may also affect the pay back period.

(ii)

It treats each asset individually in isolation with other assets, while assets, in practice, cannot be treated in isolation.

(iii)

It ignores capital wastage and economic life by restricting consideration to the project’s gross earnings.

(iv)

It overplays the importance of liquidity as a goal of capital expenditure decisions. While no firm can ignore its liquidity requirements but there are more direct and less costly means of safeguarding liquidity levels. The overlooking of profitability and over stressing the liquidity of funds can in no way be justified.

(v)

It overlooks the cost of capital which is the main basis of sound investment decisions.

(vi)

It overstates the worth of flows within the pay-back period in that it assigns implicitly equal importance to cash flows at the end of years 1 and year ‘n’.

(vii)

It ignores the earnings beyond the payback period while in many cases these earnings are substantial. This is true particularly in respect of research and welfare projects.

FINANCIAL MGMT. & MGMT. ACCOUNTING

PROBLEM NO: 1 A Project Costs Rs.1,00,000 and yields an annual cash inflows of Rs.20,000 for 8 years. Calculate its pay-back period. Solution The Pay-back period for the project is as follows:

Pay back Period = Initial Outlay of the Project Annual Cash Inflow

= 1,00,000 20,000

= 5 Years.

PROBLEM NO: 2 There are two projects A and B . The cost of the projects is rs.30,000 in each case. The cash inflows are as under: Cash inflows Year

Project A

Project B

10,000

2,000

10,000

4,000

10,000

24,000

Calculate pay back period. Solution The Pay-back period is 3 years in both the cases. However, Project A should be preferred because the cash inflows in Project A are greater when compared to Project B during the initial years.

Project

Project A Cash inflow

Project B Cumulative

Cash inflows

cash inflows st

End of 1 year

Cumulative cash inflows

10,000

2,000

year

10,000

20,000

4,000

6,000

3 year

10,000

30,000

24,000

30,000

PROBLEM NO: 3 A project costs Rs.5,00,000 and yields annually a profit of Rs.80,000 after depreciation at 12% p.a. but before tax at 50%.calculate pay-back period.

FINANCIAL MGMT. & MGMT. ACCOUNTING

Solution:

Rs. Profit before tax

80,000

Less tax @ 50%

40,000

Profit after tax

40,000

Add back depreciation @ 12% on Rs.5,00,000

60,000

Profit before depreciation but after tax or annual cash inflow

1,00,000

Pay back period = Cost of the project Annual cash inflow = 5,00,000

= 5 years

1,00,000 Problem.No.4 Calculate the pay back period for a project which requires a cash outlay of Rs.1,00,000 and generates cash inflows of Rs.25,000,Rs.35,000,Rs.30,000 and Rs.25,000 in the first, second, third and fourth years respectively. Solution: Project A Project Cash inflow st

1 year nd

Cumulative cash inflow

25,000

year

35,000

60,000

3 year

30,000

90,000

25,000

1,15,000

4 year

The cost of the project is Rs.1,00,000. In the first 3 years Rs.90,000 is recovered. The th

remaining Rs.10,000 is recovered in the 4 year. Time required to earn Rs.25,000 is twelve months. 10,000 x 12 Time required to earn Rs.10,000 = ---------------25,000

= 4.8 months.

Pay-back period = 3 years and 4.8 months.

FINANCIAL MGMT. & MGMT. ACCOUNTING

2. IMPROVEMENTS IN TRADITIONAL APPROACH TO PAY-BACK METHOD: The popularity of pay-back method has promoted efforts to eliminate some of its major draw backs. The following are some of the more popular improvements to traditional pay-back period concept.

(a) Post pay-back profitability method: A serious limitation of pay-back period is that it ignores the post pay-back returns of projects. To rectify the defect, post pay-back profitability and an index are used by some firms. Post pay-back profitability is computed by ascertaining the amount of net cash inflows estimated in each of the years, after the pay-back period. They are shown as a percentage of the investments in the project. Post pay – back profits Post pay-back profitability index = ------------------------------- x 100 Initial investment

Projects with higher index are preferable when two or more projects have more less similar pay-back period. (b)Post pay-back period method: Here the length of the post pay-back period with positive cash inflows is the criterion. It is also called ‘surplus life over pay-back’ method. Projects with longer post pay-back periods with significant even cash flows are preferred. (c)Pay-back reciprocal method (or) ‘Unadjusted rate of return method’: Pay-back reciprocal method is employed to estimate the rate of return of income generated by a project. Such rate of return can be used as a criterion to rank different projects and choose the ones with the highest rate of return. Annual cash inflow Pay-back reciprocal (or) adjusted rate of return = ---------------------------- x 100 Investment

This method can be employed only when the following two conditions are fulfilled: 

Annual cash inflows are uniform throughout a project’s life time



The project under consideration has a long life, preferably at least twice the pay-back period.

(d)Discounted pay-back method: The most serious limitation of pay-back period method is that it ignores time value of money by treating cash inflows in different future years alike. To circumvent the limitation and to make pay-back period method more effective, the discounting concept is ‘infused’ into the traditional pay-back period method.In this method, the estimated future net cash-inflows are

FINANCIAL MGMT. & MGMT. ACCOUNTING

discounted at an appropriate rate (usually cost of capital rate) to find their present values. The discounted cash flows are used to ascertain pay-back period. Problem.No.5 Calculate discounted pay-back period from the information given below: Cost of project

Rs.6,00,000

Life of project

5 years

Annual cash inflow

- Rs.2,00,000

Cut-off rate

10%

Solution: Years 1

Inflows Rs. 2,00,000

P.V. at 10 Discount factor .909

Present value Rs. 1,81,800

Cummulative Present value Rs. 1,81,800

2,00,000

.826

1,65,200

3,47,000

2,00,000

.751

1,50,200

4,97,200

2,00,000

.683

1,36,600

6,33,800

2,00,000

.621

1,24,200

7,38,000

Cumulative present value of cash inflows at the end of the third year is Rs.4,97,200 and it is Rs.6,33,800 at the end of the fourth year.

Hence, discounted pay-back period falls in

between 3 and 4 years. To be exact, 1,02,800 Discounted pay-back period = 3 years + -----------1,36,600 = 3 他 years approx Problem.No.6 For each of the following projects compute (i) pay-back period, (ii) post-back profitability and (iii) post-back profitability index: (a) Initial Outlay

Rs.50,000

Annual Cash Inflow (After tax but before depreciation) Estimated Life

Rs.10,000 8 years

(b) Initial Outlay

Rs.50,000

Annual Cash Inflow (After tax but before depreciation) First Three years

Rs.15,000

Next Five years

Rs.5,000

Estimated Life

8 years

Salvage

Rs.8,000

Solution: Investment (a) (i) Pay-back period

---------------------------Annual Cash Inflow

FINANCIAL MGMT. & MGMT. ACCOUNTING

50,000 =

------------- = 5 years 10,000

(ii) Post Pay back Profitability

Annual Cash Inflow (Estimated LifePay back period) =

10,000(8 – 5) = Rs. 30,000

30,000 (iii) Post back Profitability Index

------------ x 100 = 60% 50,000

(b) (i) As the Cash Inflows are not equal during the life of the investment, the Pay back period can be calculated. st

1 year’s Cash Inflow 2

year’s Cash Inflow

3 year’s Cash Inflow th

4 year’s Cash Inflow Hence, the pay-back period is 4 years. (ii) Post pay back Profitability = Annual Cash Inflows x Remaining Life after pay-back period = Rs. 5,000 x 4 = Rs.20,000 20,000 x 100 (iii) Post Pay-back Profitability Index = --------------------- = 40% 50,000

3. ACCOUNTING RATE OF RETURN METHOD: This method takes into account the earnings expected from the investment over their whole life. It is known as Accounting Rate of Return method for the reason that under this method, the Accounting concept of profit (net profit after tax and depreciation) is used rather than cash inflows. According to this method, various projects are ranked in order of the rate of earnings or rate of return. The project with the higher rate of return is selected as compared to the one with lower rate of return. This method can also be used to make decisions as to accepting or rejecting a proposal. The expected return is determined and the project which has a higher rate of return than the minimum rate specified by the firm called the cut off rate, is accepted and the one which gives a lower expected rate of return than the minimum rate is rejected.

Computation of Accounting or Average Rate of Return: There are three variations of the accounting rate of return (a)Total income method (or) Return per unit of investment method:

FINANCIAL MGMT. & MGMT. ACCOUNTING

Here, the total income, after depreciation and tax, over the life time of a project is shown as a percentage of net investment in the project (Original cost – Scrap value).

Formula:

A.R.R =

Total earnings (after depreciation and tax) x 100 Original cost of investment – scrap value

(b)Annual return on original investment method Formula: A.R.R = Annual average net earnings

x 100

Original investment – scrap value Here, annual average net earnings is the average of net profit after depreciation and tax of all the years in the economic life of the investment. If there is scrap value, it may be subtracted from the original investment.

(c)Annual return on average investment method: Formula: A.R.R = Annual average net earnings x 100 Average investments Average investment is again a disputed term.

The following four alternative

interpretation of ‘Average investment’ are in practical use. (i)Average investment =

Original investment 2

(ii) Average investment = Original investment – Scrap value of the asset/Project 2 (iii)Average investment = Original investment + Scrap value of the asset 2 (iv)Average investment =

Original investment – Scrap value + additional net 2 working capital + Scrap value

Merits: 1. It is also simple and easy to understand like pay back method 2. It takes into consideration the total earnings from the project during its entire economic life 3. This approach gives due weight to the profitability of the project

FINANCIAL MGMT. & MGMT. ACCOUNTING

4. Investment with extremely long lives, the simple rate of return will be fairly close to the true rate of return. It is often used by financial analysts to measure performance of a firm. Demerits: This method suffers from the following limitations: 1. One apparent disadvantage of this approach is that its results by different methods are inconsistent 2. This method also ignores the time factor which is very crucial in business decisions as the4 amount of interest and discount is powerfully affected by it 3. This method does not determine the fair rate of return on investment. It is left to the discretion by the management. So use of this arbitrary rate of return may well cause serious distortions in the selection of capital projects. 4. It is simple an averaging technique which does not take into account the various impacts of external factors on overall profits of the firm.

Problem.No.7 A project requires an investment of Rs.5,00,000 and has a scrap value of rs.20,000 after 5 years. It is expected to yield profits after taxes and depreciation during the five years amounting to Rs.40,000, Rs.60,000,

Rs.70,000 ,Rs. 50,000 and Rs.20,000.Calculate the

average rate of return on investment. Solution:

Total Profit = Rs.40,000+60,000+70,000+50,000+20,000 = Rs.2,40,000

Rs.2,40,000 Average Profit = ------------------ = Rs.48,000 5 Net Investments in the project = Rs.5,00,000 – 2,00,000 (Scrap value) = Rs.4,80,000

Average Rate of Return

Average Annual Profit

x 100

Net Investment in the Project =

48,000 x 100

= 10%

4,80,000

Problem.No.8 Calculate the average rate of return of project ‘A’ and project ‘B’ from the following. Project A

Project B

Investment

20,000

30,000

Expected life(No salvage value) years

FINANCIAL MGMT. & MGMT. ACCOUNTING

Project net income(after interest Depreciation and taxes) Years

2,000

3,000

1,500

3,000

1,500

2,000

1,000

6,000

10,000

If the required rate of return is 15% which project should be undertaken?

Solution: Particulars

Project A

Average annual net earnings

6000=

Project B Rs.1500

10,000 = Rs.2000

4 Assigned Investment

Rs.20,000

Rs.30,000

1500

2000

Annual average net earnings x100

------- x100 = 7.5%

------- x 100 = 6.67%

Original invest – Scrap value

20000

30000

Annual rate of return on average

1500

2000

investment =

--------- x 100 = 15%

-------x100 =13.33%

10000

15000

Annual rate

return

original

investment =

Average annual net earnings x 100 Average investment Average investment =

Original investment 2

Project A

= 20000

= Rs.10,000

Project B

= 30000

= Rs.15,000

Project A is preferred. DISCOUNTED CASH FLOW METHOD: The discounted cash flow method is an improvement on the pay back method. This method takes into account the profitability and also the time value of money. These methods also called modern methods of capital budgeting are becoming increasingly popular day-byday. This method is based on the fact that future value of money will not be equal to the present value of money. There are three types of discounted cash flow method. 

Net present value method



Profitability index method



Internal rate of return method

1. NET PRESENT VALUE METHOD:

FINANCIAL MGMT. & MGMT. ACCOUNTING The net present value method is a modern method of evaluating investment proposals. This method takes into consideration the time value of money and attempts to calculate the return on investments by introducing the factor of time element. It recognizes the fact that a rupee earned today is worth more than the same rupee earned tomorrow. The net present value method is based on the fact that the cash flow arising at different periods of time differ in value and are not capable of comparison unless their equivalent present values are found. The present values of all inflows and outflows of cash occurring during the entire life of the project is determined separately for each year discounting these flows by the firm’s cost or a pre-determined rate. The following are the necessary steps to be followed for adopting the net present value method of evaluating investment proposals. 

First of all determine an appropriate rate of interest that should be selected as the minimum required rate of return called the ‘cut off’ rate of discount rate. This rate should be a minimum rate of return below which the investor considers that it does not pay him to invest.



The discount rate should be either the actual rate of interest in the market on long term loans or it should reflect the opportunity cost of capital of the investor



Compute the present value of total investment outlay i.e., cash outflows are ascertained at the determined rate. If the total investment is to be made in the initial year the present value shall be the same as the cost of investment



Compute the present value of total investment proceeds i.e., cash inflows (profit before depreciation and after tax) at the above determined discount rate



Calculate the net present value of each project by subtracting the present value of cash inflows from the present value of cash outflows for each project



If the net present value is positive or zero i.e., when present value of cash inflows exceeds or is equal to the present values of cash out flows, the proposals may be accepted. But in case the net present value is negative, i.e., when the present value of cash inflows is less than the present value of cash flows, the proposals should be rejected.



To select between mutually exclusive projects, the projects should be ranked in order to present values i.e., the first preference should be given to the project having the maximum positive net present value.

FINANCIAL MGMT. & MGMT. ACCOUNTING

The present value of Re.1 due in any number of years can be found with the use of the following mathematical formula. PV =

1 (1  r ) n

Where PV = Present value r = rate of interest discount rate n = number of years The present value for all cash inflows for a number of years is thus found as follows:

PV =

A1 A2 A3 An    .............  2 3 (1  r ) (1  r ) (1  r ) (1  r )n

Merits: 1. It considers the time value of money 2. It considers income over the entire life of the project 3. This method is helpful in comparing the two projects in which the same amount of investment is required 4. Conclusions drawn by this method are not affected by decisions regarding various accounting policies (e.g.) regarding valuation of stock, depreciation etc. Demerits: 1. Some argue that this method is too difficult to use 2. This method is not helpful in comparing projects in which different amount of investments are required 3. This method may be misleading in comparing projects of unequal lines 4. This method is based on the estimates of future earnings. 5. Unless we know the life of the project accurately, estimates of future earnings cannot be made.

Problem.No.9 Bombay traders are proposing to undertake a project at an initial outlay of Rs.50,000 and expect to earn yearly net cash inflows of Rs.15,000 for a period of 6 years. The company’s cost of capital is 10%.present value of Re.1 for 6 years at 10% p.a interest is Rs.4,335. Determine the net present value. Solution: The present value of Rs.1 received annually for all 6 years The present value of Rs.15,000 received annually for all 6 years (-) Cash outlay

Rs.4.335 15,000 x 4.335 65,000 50,000

Net present value 15,000

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Problem.No.10 Priya & co. is considering 2 mutually exclusive projects. Both require an initial cash outlay of Rs.10,000 each and have a life of 5 years. The companyâ&#x20AC;&#x2122;s required rate of return is 10% and pays tax at a 50% rate. The project will be depreciated on a straight line basis. The net cash flows before taxes expected to be generated by the projects are as follows:

Year 1

Project 1 Rs.

4,000

Project 2 Rs.

6,000

3,000

2,000

5,000

Calculate Net present value of each project. Advise the company as to which project should be accepted and why? Solution: Project 1 Computation of NPV

Particulars

Cash flow

4,000

(-)Depreciation (10,000/5)

2,000

(-)Tax @ 50%

1,000

Profit after tax

1,000

(+) Depreciation

2,000

3,000

Annual cash inflows

Computation of NPV

Years

Cash inflow

Present value of 10%

Present

value

cash inflow 1

3000

0.909

2727

3000

0.826

2478

3000

0.751

2253

3000

0.683

2049

3000

0.621

1863

Present value of total cash expenses = 11370 (-) Capital outlay

= 10000 --------

FINANCIAL MGMT. & MGMT. ACCOUNTING Net Present Value

= 1370

Particulars

Cash flow

6,000

3,000

2,000

5,000

(-) Depreciation (10,000/5)

2,000

4,000

1,000

----

3,000

(-)Tax @ 50%

2,000

5,000

----

1,500

Profit after tax

2,000

500

----

1,500

(+) Depreciation

2,000

4,000

2,500

2,000

3,500

Annual cash inflows

Computation of NPV Years

Cash inflow

Present value of 10%

Present value of cash inflow

4,000

0.909

3,636

2,500

0.826

2,065

2,000

0.751

1,502

2,000

0.683

1,366

3,500

0.621

2,173

Present value of total cash expenses = 10,742 (-) Capital outlay

= 10,000 --------

Net Present Value

742 --------

Project 1 is preferred. Problem.No.11 Project X initially costs Rs.25,000.It generates the following cash flows. Years

Cash inflows (Rs.)

Present value of Re.1 at 10%

9,000

.909

8,000

.826

7,000

.751

6,000

.683

5,000

.621

Taking the cut-off rate as 10% suggest whether the project should be accepted or not.

Solution: Computation of NPV Years

Cash

Present value of

inflow

Re.1 at 10%

cash inflow

FINANCIAL MGMT. & MGMT. ACCOUNTING 1

9,000

0.909

8,181

8,000

0.826

6,608

7,000

0.751

5,257

6,000

0.683

4,098

5,000

0.621

3,105

Present value of total cash expenses = 27,249 (-) Capital outlay

= 25,000 --------

Net Present Value

= 2,249 --------

Problem.No.12 The following are the cash inflows and outflows of a certain project.

Years

Outflows

Inflows

Rs.

(Rs.)

1,50,000

30,000

20,000

30,000

60,000

80,000

30,000

The salvage value at the end of 5 years is Rs.40,000. Taking the cut off rate as 10%.calculate net present value. Solution: Net Present Value

Rs.1,86,060 â&#x20AC;&#x201C; 1,77,270 =

Rs.8,790.

Calculations of Present Value of Outflows

Years 0 1

Outflow Rs. 1,50,000 30,000

Present Value @ 10% Discount factor 1 0.999

Present Value Rs. 1,50,000 27,270 1,72,270

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Calculations of Present Value of Cash Inflows Years 1 2 3 4 5 5(salvage)

Outflow Rs. 20,000 30,000 60,000 80,000 30,000 40,000

Present Value @ 10% Discount factor

Present Value Rs.

0.909 0.826 0.751 0.683 0.620 0.620

18,180 24,780 45,060 54,640 18,600 24,800 1,86,060

2. PROFITABILITY INDEX METHOD It is also a time-adjusted method of evaluating the investment proposals. Profitability index also called as benefit-cost ratio (B/C) or desirability factorâ&#x20AC;&#x2122; is the relationship between present value of cash inflow and the present value of of cash outflow. This is a refinement of the net present value method. Instead of working out the net present value, a present value index is found out by comparing the total of present value of future cash inflows and the total of the present value of future cash out flows.

Formula: Excess present value index method

Present value of cash inflow x 100 Present value of cash outflows

The profitability index may be found for net present values of inflows. P.I (Net) =

NPV(Net Present Value) Initial cash outlay

The net profitability index can also be found as profitability index (gross) minus one. The proposal is accepted if the profitability index is more than one and is rejected in case the profitability index is less than one. The various projects are ranked under this method in order of their profitability index, in such a manner that one with higher profitability index is ranked higher than the other with lower profitability index. The main disadvantage of this method is that it is not easy to rank projects on the basis of net present value when the costs of the projects differ.

Merits and Demerits: P.I Method possesses all the merits and demerits of N.P.V method because P.I is a refinement of N.P.V method. However it is more useful in ranking two or more projects. Thus, P.I is more suitable for comparative assessment of projects whereas N.P.V is appropriate to decide about a particular project.

FINANCIAL MGMT. & MGMT. ACCOUNTING

Problem.No.13 The initial cost of an equipment is Rs.6,000. Cash inflows for 5 years are estimated to be rs.2,000 per year. The managementâ&#x20AC;&#x2122;s desired minimum rate of return is 15%.Calculate net present value and excess present value index to arrive at the correct decision. Solution: Profitability index method present value of cash inflow Excess present value index = --------------------------------------- x 100 Present value of cash outflow

6704 =

-------- x 100 6000

111.73%

Present value of Rs.1 received annually for 5 years = 3.352

Present value of Rs.2000 received annually for 5 years (2000 x 3.352) = 6704

Problem.No.14 The initial cash outlay of a project is Rs.50,000 and it generates the following cash inflows in four years

Year

Cash inflows

Rs.20,000

Rs.15,000

Rs.25,000

Rs.10,000

Using present value index method, appraise profitability of the proposed investment assuming 10% rate of discount. Solution: Calculations of Present Values and Profitability Index Year

Cash Inflows

Present

Rs.

Factor

Value

Present Value Rs.

@10% 1

20,000

0.909

18,180

15,000

0.826

12,390

25,000

0.751

18,775

10,000

0.683

6,830 56,175

FINANCIAL MGMT. & MGMT. ACCOUNTING

58 Rs.

Profitability Index (gross) =

Total Present Value

56,175

Less: Initial Outlay

50,000

Net Present Value

6,175

Present Value of Cash Inflows Initial Cash Outflow =

56,175

= 1.1235

50,000 As the P.I is higher than 1, the proposal can be accepted. NPV Net Profitability Index = -------------------------------Initial Cash Outlay

6,175 = -------------- = 0.1235 50,000 N.P.I = 1.1235 â&#x20AC;&#x201C; 1 = 0.1235

As the net profitability index is positive, the proposal can be accepted. 3. INTERNAL RATE OF RETURN METHOD (IRR): This method is popularly known as time adjusted rate of return method.

The internal rate of return is defined as the interest rate that equates the present value of the expected future receipts of the investment outlay. The IRR is found out by trial and error. First, we compute the present value of cash inflows from an investment, using an arbitrarily selected interest rate. Then we compare the present value so obtained with the investment cost. If the present value is higher than the cost figure, we try a higher rate of interest and go through the procedure again. Conversely, if the present value is lower than the cost, lower the interest rate and repeat the process. The interest rate that brings about this equality is defined as the internal rate of return. This rate of return is compared to the cost of capital and project having higher difference. If they are mutually exclusive, one is adopted and the other one is rejected. As this determination of internal rate of return involves a number of attempts to make the present value of earnings equal to the investment, this approach is also called trial and error method. Time adjusted rate of return is the maximum rate of interest that could be paid for the capital employed over the life of an investment without loss on the project.

FINANCIAL MGMT. & MGMT. ACCOUNTING Merits: The internal rate of return method has the following merits: 1. Like the net present value method, it takes into account the time value of money and can be usefully applied in situations which even as well as uneven cash flow at different periods of time 2. It provides for uniform ranking of various proposals due to the percentage rate of return 3. The determination of the cost of capital is not pre-requisite for the use of this method and hence it is better that net present value method where the cost of capital cannot be ignored 4. It considers the profitability of the project for its entire economic life and hence enables evaluation of true profitability. Demerits: 1. It is difficult to understand and is the most difficult method of evaluation of investment proposals 2. The results of NPV method and IRR method may differ when the projects under evaluation differ in their size, life and timings of cash flows. 3. This method is based upon the assumption that the earnings are reinvested at the internal rate of return for the remaining life of the project, which is not a justified assumption particularly when the average rate of return earned by the firm is not close to the internal rate of return. In this sense, net present value seems to be better as it assumes that the earnings are reinvested at the rate of firm’s cost of capital.

Problem.No.15 A company is considering an investment proposal which needs an initial outlay of Rs.1,50,000. It is estimated to fetch net cash inflows of Rs.60,000 p.a for 4 years. Calculate the I.R.R of the project and decide its acceptability if the company’s cut-off rate for investments is 18%. Solution: PV factor =

Initial investment Annual cash inflows

1,50,000 = ----------------

2.5

60,000

IRR = 22% approx.

This project can be accepted because the IRR (22%) is more than the company’s cut-off rate for investment. i.e., 18%.

FINANCIAL MGMT. & MGMT. ACCOUNTING

Problem.No.16 Initial investment Rs.60,000 Life of the asset â&#x20AC;&#x201C; 4 years Estimated net annual cash flows: st

1 year nd

Rs.15,000

year -

Rs.20,000

3 year -

Rs.30,000

Rs.20,000

Year

P.V at 14%

P.V at 15%

.877

.869

.769

.756

.674

.657

.592

.571

Calculate internal rate of return by trial and error method. Solution: Cash Flow Table at Various Assumed Discount Rates of 10% 12% 14% & 15% Discounted Year

Annual

12%

14%

15%

rate 10%

Cash Flow

P.V.F

(Rs.)

P.V

P.V.F.

Rs.

P.V.

P.V.F

Rs.

P.V

P.V.F

Rs.

P.V Rs.

15,000

0.909

13,635

0.892

13,380

0.877

13,155

0.869

13,035

20,000

0.826

16,520

0.797

15,940

0.769

15,380

0.756

15,120

30,000

0.751

22,530

0.711

21,330

0.674

20,220

0.657

19,710

20,000

0.683

13,660

0.635

12,700

0.592

11,840

0.571

11,420

66,345

63,350

60,595

59,285

The present value of net cash flows at 14% rate of discount is Rs.60,595 and at 15% rate of discount it is Rs.59,285. So the initial cost of investment which is Rs.60,000 falls in between these two discount rates. At 14% the NPV is +595, but at 15% the NPV is -715, we may say that IRR = 14.5% (approx).

FINANCIAL MGMT. & MGMT. ACCOUNTING Q.WRITE A SHORT NOTE ON THE COMPARISION BETWEEN NPV AND IRR. 

In the present value method, the present value is determined by discounting the future cash flows of a project at a predetermined or specified rate called the cut-off rate based on cost of capital. But under the internal rate of return method, the cash flows are discounted at a suitable rate by hit and trial method which equates the present value so calculated to the amount of the investment. Under IRR method, discount rate is not predetermined or known as is the case in NPV.



The NPV method recognizes the importance of market rate of interest or cost of capital. It arrives at the amount to be invested in a given project so that its anticipated earnings would recover the amount invested in the project at market rate. Contrary to this, the IRR method does not consider the market rate of interest and seeks to determine the maximum rate of interest at which funds invested in any project could be repaid with the earnings generated by the project.



The basic presumption of NPV method is that intermediate cash inflows are reinvested at the cut-off rate, whereas, in the case of IRR method, intermediate cash flows are presumed to be reinvested at the internal rate of return.



The results shown NPV method are similar to that of IRR method under certain situations, whereas, the two give contradictory results under some other circumstances. However, it must be remembered that NPV method using a predetermined cut-off rate is more reliable than the IRR method for ranking two or more capital investment proposals.

Q. STATE THE SIMILARITIES OF RESULTS UNDER NPV AND IRR Both NPV and IRR methods would show similar results in terms of accept or reject decisions in the following cases:  Independent investment proposals which do not compete with one another and which may be either accepted or rejected on the basis of a minimum required rate of return.  Conventional investment proposals which involve cash outflows or outlays in the initial period followed by a series of cash inflows. The reason for similarity of results in the above cases lies in the basis of decision-making in the two methods. Under NPV method, a proposal is accepted if its net present value is positive, whereas, under IRR method it is accepted if the internal rate of return is higher than the cutoff rate. The projects which have positive net present value, obviously, also have an internal rate of return higher than the required rate of return.

FINANCIAL MGMT. & MGMT. ACCOUNTING

Q.UNDER WHAT CIRCUMSTANCES MAY NPV AND IRR GIVE CONFLICTING RECOMMENDATIONS?

WHICH

CRITERIA

SHOULD

FOLLOWED

SUCH

CIRCUMSTANCES AND WHY? Conflict between NPV and IRR results. In case of mutually exclusive investment proposals, which compete with one another in such a manner that acceptance of one automatically excludes the acceptance of the other, the NPV method and IRR method may give contradictory results, the net present value may suggest acceptance of one proposal whereas, the internal rate of return may favour another proposal .such conflict in rankings may be caused by any one or more of the following problems:  Significant difference in the size (amount) of cash outlays of various proposals under consideration.  Problem of difference in the cash flow patterns or timings of the various proposals , and  Difference in service life or unequal expected lives of the projects.

In such cases, while choosing among mutually exclusive projects, one should always select the project giving the largest positive net present value using appropriate cost of capital or predetermined cut off rate. The reason for the same lies in fact that the objective of a firm is to maximize shareholder’s wealth and the project with the largest NPV has the most beneficial effect on share prices and shareholder’s wealth. Thus, the NPV method is more reliable as compared to the IRR method in ranking the mutually exclusive projects. In fact, NPV is the best operational criterion for ranking mutually exclusive investment proposals.

CAPITAL RATIONING Capital rationing refers to a situation where a firm is not in a position to invest in all profitable projects due to the constraints on availability of funds. We know that the resources are always limited and the demand for them far exceeds their availability. It is for this reason that the firm cannot take up all the projects though profitable, and has to select the combination of proposals that will yield the greatest profitability.

FINANCIAL MGMT. & MGMT. ACCOUNTING

ExampleLet us assume that firm has only Rs.10 lacs to invest and more funds cannot be provided. The various proposals along with their cost and profitability index are as follows:

Proposal

Cost of the project

Profitability index

3,00,000

1.46

1,00,000

0.098

5,00,000

2.31

2,00,000

1.32

1,50,000

1.25

In this example all proposals except No.2 give profitability index exceeding one and are profitable investments. The total outlay required to be invested in all other (profitable) project is Rs.11,50,000 (1+3+4+5) but total funds available with the firm are Rs.10 lacs and hence the firm has to do capital rationing and select the most profitable combination of projects within a total cash outlay of Rs.10 lacs. Project No.5 which has the lowest profitability index among the profitable proposals cannot be taken.

FINANCIAL MGMT. & MGMT. ACCOUNTING

UNIT-III WORKING CAPITAL MANAGEMENT Q. GIVE THE MEANING AND DEFINITION OF WORKING CAPITAL. MEANINGA business unit or an industrial establishment requires two types of finance, Viz., longterm finance and short-term finance. Long term funds are required to create production facilities through purchase of fixed assets such as plant and machinery, land, building, furniture, etc. Investment in this assets represent that part of firm’s capital which is blocked on a permanent or fixed basis is called fixed capital. Funds are also need for short-term purpose for the purchase of raw-materials, payment of wages and other day-to-day expenses, etc. These funds are known as working capital. In simple words, working capital refers to that part of the firm’s capital which is required for financing short term or current assets such as cash, marketable securities, debtors and inventories. Funds, thus, invested in current assets keep revolving fast and are being constantly converted into cash and this cash flow out again in exchange for other current assets. Hence, it is also known as revolving or circulating capital or short –term capital. DEFINITIONAccording to Genestenberg “Circulating capital means current assets of a company that are changed in the ordinary course of business from one from to another, as for example, from cash to inventories, inventories to receivable, receivable into cash”. In the words of Shubin,” working capital is the amount of funds necessary to cover the cost of operating the enterprise.”

Q.EXPLAIN THE CONCEPTS OF WORKING CAPITAL? There are two concepts of working capital: i)

Gross working capital.

ii)

Net working capital.

Gross working capitalIn the broader sense, the term working capital refers to the gross working capital and represents the amount of funds invested in current assets. Thus, the gross working capital is the capital invested in total current assets of the enterprise. Current assets are those which in the ordinary course of business can be converted into cash within a short period of normally one accounting year. Net working capitalIn a narrow sense, the term working capital refers to the net working capital.Net working capital is the excess of current assets over current liabilities, or say:

FINANCIAL MGMT. & MGMT. ACCOUNTING Net working capital = current assets – current liabilities. Net working capital may be positive or negative. When the current assets exceed the current liabilities the working capital is positive and the negative working capital results when the current liabilities are more than the current assets. Current liabilities are those liabilities which are intended to be paid in the ordinary course of business within a short period of normally one accounting year out of the current assets or the income of the business. The gross working capital concept is financial or going concern concept whereas net working capital is an accounting concept of working capital. These two concepts of working capital are not exclusive; rather both have their own merits. The gross concept is sometimes preferred to the net concept of working capital for the following reasons:  It enables the enterprise to provide correct amount of working capital at the right time.  Every management is more interested in the total current assets with which it has to operate than the source from where it is made available.  The gross concept takes into consideration the fact that every increase in the funds of the enterprise would increase its working capital.  The gross concept of working capital is more useful in determining the rate of return on investments in working capital. The net working capital concept, however, is also important for the following reasons:  It is a qualitative concept which indicates the firm’s ability to meet is operating expenses and short-term liabilities.  It indicates the margin of protection available to the short-term creditors, i.e, the excess of current assets over current liabilities.  It is an indicator of the financial soundness of an enterprise.  It suggests the need for financing a part of the working capital requirements out of permanent sources of funds. To conclude, it may be said that, both, gross and net, concepts of working capital are important aspects of the working capital management. The net concept of working capital may be suitable only for proprietary form of organizations such as sole-trader or partnership firms. But the gross concept is very suitable to the company form of organization where there is a divorce between ownership, management and control. However it is made clear that as per the general practice, net working capital is referred to simply as working capital.

Q. DISCUSS THE NEED (OR) OBJECTS OF WORKING CAPITAL IN A BUSINESS. The need for working capital cannot be over emphasized. Every business needs some amount of working capital. The need of working capital arises due to the time gap between production and realization of cash from sales. There is an operating cycle involved in the sales and realization of cash. There are time gaps in purchase of raw material and

FINANCIAL MGMT. & MGMT. ACCOUNTING

production; production and sales; and sales and realization of cash. Thus, working capital is need for the following purposes:  For the purchases of raw materials, components and spares.  To pay wages and salaries.  To incur day-to-day expenses and overheads costs such as fuel, power and office expenses. etc.,  To meet the selling cost as packing, advertising etc.  To provide credit facilities to the customers.  To maintain the inventories of raw materials, work-in-progress, stores and spares and finished goods.

Q. EXPLAIN THE VARIOUS CLASSIFICATION OR KINDS OF WORKING CAPITAL. Working capital may be classified in two ways: a) On the basis of concept. b) On the basis of time. On the basis of concept, working capital is classified as gross working capital and net working capital. This classification is important from the point of view of the financial manager. On the basis of time, working capital may be classified as: 1. Permanent or fixed working capital. 2. Temporary or variable working capital. Kinds of working capital

On the basis of concept

Gross

On the basis of time

Net

Permanent or

Working Capital Working Capital Fixed Working

Variable Working Capital

Regular

ON THE BASIS OF CONCEPTThere are two concepts of working capital: iii)

Gross working capital.

iv)

Net working capital.

Temporary or

Reserve

Capital

Seasonal

Special

FINANCIAL MGMT. & MGMT. ACCOUNTING ON THE BASIS OF TIMEPermanent working capitalTo carry on business, a certain minimum level of working capital is necessary on a continuous and uninterrupted basis. For all practical purposes this requirement has to be met permanently as with other fixed assets. This requirement is referred to as permanent or fixed working capital. Permanent working capital is fixed over a period of time. Permanent working capital is permanently needed for the business and therefore it should be financed out of long-term funds. For example, every firm has to maintain a minimum level of raw materials, work-inprogress, finished goods and cash balances. This minimum level of current assets is called permanent or fixed working capital as this part of capital is permanently blocked in current assets. The permanent working capital can further be classified as regular working capital and reserve working capital. Regular working capital is required to ensure circulation of current assets from cash to inventories, from inventories to receivables and from receivables to cash and so. Reserve working capital is the excess amount over the requirement for regular working capital which may be provided for contingencies that may arise at unstated periods such as strikes, rise in prices, depression etc.

Temporary or variable working capitalThe amount of such working capital keeps on fluctuating from time to time on the basis of business activities. In other words, it represents additional current assets required at different times during the operating year. Variable working capital can be further classified as seasonal working capital and special working capital. Most of the enterprises have to provide additional working capital to meet the seasonal and special needs. The capital required to meet the seasonal needs of the enterprise is called seasonal working capital. Special working capital is that part of working capital which is required to meet special exigencies such as launching of extensive marketing campaigns for conducting research, etc. Temporary working capital differs form permanent working capital in the sense that it is required for short periods and cannot be permanently employed gainfully in the business.

Q. EXPLAIN THE IMPORTANCE / ADVANTAGES OF ADEQUATE WORKING CAPITAL. Working capital is the life blood and nerve centre of a business. Just as circulation of blood is essential in the human body for maintaining life, working capital is very essential to maintain the smooth running of a business. No business can run successfully without an adequate amount of working capital. The main advantages of maintaining adequate amount of working capital are as follows.

FINANCIAL MGMT. & MGMT. ACCOUNTING Solvency of the businessAdequate working capital helps in maintaining solvency of the business by providing uninterrupted flow of production. GoodwillSufficient working capital enables a business concern to make prompt payments and hence helps in exacting and maintaining goodwill. Easy loanA concern having adequate working capital, high solvency and good credit standing can arrange loans from banks and others on easy and favourable terms. Cash discountsAdequate working capital also enables a concern to avail cash discount on the purchases and hence it reduces costs. Regular supply of raw materialsSufficient working capital ensures regular supply of raw material and continuous production. Regular payment of salaries, wages and other day-to-day commitmentsA company which has ample working capital can makes regular payment of salaries, wages and day to day commitments which raises the morale of its employees, increase their efficiency, reduce wastages and costs and enhances production and profit. Exploitation of favourable market conditionsOnly concern with adequate working capital can exploit favourable market conditions such as purchasing its requirement in bulk when the prices are lower and by holding its inventories for higher prices. Ability to face crisisAdequate working capital enables a concern to face business crisis in emergencies such as depression because during such periods, generally, there is much pressure on working capital. Quick and regular return on investmentsEvery investor wants a quick and regular return on his investments. Sufficiency of working capital enables a concern to pay quick and regular dividends to its investors are there may not be much pressure to plough back profit. This gains the confidence of its investors and creates a favourable market to raise additional funds in the future. High moraleAdequacy of working capital creates an environment of security. Confidence, high morale and create overall efficiency in a business.

Q. WHAT SHALL BE THE REPERCUSSIONS IF A FIRM HAS (A)) REDUNDANT WORKING CAPITAL (B) INADEQUATE WORKING CAPITAL? Every business concern should have adequate working capital to run its business operations. It should have neither redundant or excess working capital nor inadequate nor shortage of working capital.

FINANCIAL MGMT. & MGMT. ACCOUNTING Both excess as well as short working capital positions are bad for any business. However, out of the two, it is the inadequacy of working capital which is more dangerous from the point of view of the firm.

Disadvantages of Redundant or Excessive Working Capital 1. It results in unnecessary accumulation of inventories. Thus the chances of inventory mishandling, waste, theft and losses increase. 2. It is an indication of defective credit policy and slack collection period. Consequently, higher incidence of bad debts adversely affects profits. 3. It may result into overall inefficiency in the organization. 4. Tendencies of accumulating inventories to make speculative profits grow. This may tend to make dividend policy liberal and difficult to cope with in future when the firm is unable to make speculative profits. 5. Excess availability of cash tempts the executives to spend more. 6. Due to low rate of return on investment, the value of shares may also fall.

Dangers of inadequate working capital: 1. It stagnates growth. It becomes difficult for the firm to undertake profitable projects due to non-availability of the working capital funds. 2. It becomes difficult to implement operating plans and achieve the firmâ&#x20AC;&#x2122;s profit target. 3. Operating inefficiencies creep in when it becomes difficult even to meet day-to-day commitments. 4. Fixed assets are not efficiently utilized for the lack of working capital funds. Thus, the rate of return on investment slumps. 5. Paucity of working capital funds renders the firm unable to avail of attractive credit opportunities etc. 6. The firm loses its reputation when it is not in a position to honour its short-term obligations. As a result, the firm faces tight credit terms. 7. It directly affects the liquidity position of the business firm. Therefore every firm should aim at maintaining a right amount of working capital on a continuous basis.

FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS Q. WHAT ARE THE DETERMINANTS OF WORKING CAPITAL NEED OF A CONCERN? OR Q.EXPLAIN VARIOUS FACTORS INFLUENCING WORKING CAPITAL The working capital requirements of a concern depend upon a large number of factors. it is not possible to rank them because all such factors are of different importance and

FINANCIAL MGMT. & MGMT. ACCOUNTING the influence of individual factors changes for a firm over time. However, the following are important factors generally influencing the working capital requirements. 1. Nature or character of businessThe working capital requirements of a firm basically depend upon the nature of its business. Public utility undertakings like Electricity, water supply and railways need very limited working capital because they offer cash sales and supply services not products, and as such no funds are tied up in inventories and receivables. on the other hand trading and financial firms require less investment in fixed assets but have to invest large amounts in current assets like inventories, receivables and cash as such they need large amount of working capital. The manufacturing undertakings also require sizable working capital along with fixed investment. 2. Size of business/scale of operationsThe working capital requirements of a concern are directly influenced by the size of its business which may be measured in terms of scale of operations. Greater the size of a business unit, generally larger will be the requirements of working capital. However, in some cases even a smaller concern may need more working capital due to high overhead charges, inefficient use of available resources and other economic disadvantages of small size. 3. Production policyIn certain industries the demand is subject to wide fluctuations due to seasonal variations. The requirements of working capital, in such cases, depend upon the production policy. The production could be kept either steady by accumulating inventories during slack periods with a view to meet high demand during the peak season or the production could be curtailed during the slack season and increased during the peak season. If the policy is to keep production steady by accumulating the inventories it will require higher working capital.

4. Manufacturing process/length of production cycleIn manufacturing business, the requirements of working capital increase in direct proportion to length of manufacturing process. Longer the process period of manufacture, larger is the amount of working capital required. The longer the manufacturing time, the raw materials and other supplies have to be carried for a longer period in the process with progressive increment of labour and service costs before the finished product is finally obtained. Therefore, if there are alternative processes of production, the process with shortest production period should be chosen. 5. Seasonal variationIn certain industries raw material is not available throughout the year. They have to buy raw materials in bulk during the season to ensure an uninterrupted flow and process them during the entire year. A huge amount is, thus, blocked in the form of material inventories during such season, which gives rise to more working capital requirements. Generally, during the busy seasons, a firm requires larger working capital than in the slack seasons

FINANCIAL MGMT. & MGMT. ACCOUNTING

6. Working capital cycleIn a manufacturing concern, the working capital cycle starts with the purchase of raw material and ends with the realization of cash from the sale of finished products. This cycle involves purchase of raw materials and stores, its conversion into stock of finished goods through work-in-progress with progressive increment of labour and service costs, conversion of finished stock into sales, debtors and receivables and ultimately realization of cash and this cycle continues again from cash to purchase of raw material and so on. DEBTORS (RECEIVABLES)

CASH

FINISHED GOODS

[Working CapitalRAW /Operating Cycle of a Manufacturing Concern] MATERIALS WORK-IN-PROGRESS The speed with which the working capital completes one cycle determines the requirements of working capital â&#x20AC;&#x201C;longer the period of the cycle larger is the requirement of working capital. 7. Rate of stock turnoverThere is a high degree of inverse co-relationship between the quantum of working capital and the velocity or speed with which the sales are effected. A firm having a high rate of stock turnover will need lower amount of working capital as compared to a firm having a low rate of turnover. For example, in case of precious stones dealers, the turnover is very slow. They have to maintain a large variety of stocks and the movement of stock is very slow. Thus, the working capital requirements of such a dealer shall be higher than that of a provision store. 8. Credit policyThe credit policy of a concern in its dealings with debtors and creditors influences considerable the requirements of working capital. A concern that purchases its requirements on credit and sells its products/ services on cash requires lesser amount of working capital. On the other hand a concern buying its requirement for cash and allowing credit to its customers ,shall need larger amount of working capital as very huge amount of funds are bound to be tied up in debtors or bills receivables. 9. Business cycleBusiness cycle refers to alternate expansion and contraction in general business activity. In a period of boom i.e., when the business is prosperous, there is a need for larger amount of working capital due to increase in sales, rise in prices, optimistic expansion of business etc. On the contrary in the times of depression i.e., when there is a down swing of

FINANCIAL MGMT. & MGMT. ACCOUNTING the cycle, the business contracts, sales decline, difficulties are faced in collections from debtors and firms may have a larger amount of working capital lying idle. 10. Rate of growth of businessThe working capital requirements of a concern increase with the growth and expansion of its business activity. Although,it is difficult to determine the relationship between the growth in the volume of business and the growth in the working capital of a business ,yet it may be concluded that for normal rate of expansion in the volume of business, we may have retained profits to provide for more working capital but in fast growing concerns ,we shall require larger amount of working capital. 11. Earning capacity and dividend policySome firms have more earning capacity than others due to quality of their products ,monopoly conditions, etc. Such firms with high earning capacity may generate cash profits from operations and contribute to their working capital. The dividend policy of a concern also influences the requirements of its working capital. A firm that maintains a steady high rate of cash dividend irrespective of its generation of profits needs more working capital than the firm that retains larger part of its profit and does not pay so high of cash dividend. 12. Price level changesChanges in the price level also affect the working capital requirements. Generally, the rising prices will require the firm to maintain larger amount of working capital as more funds will be required to maintain the same current assets. The effect of rising prices may be different for different firms. Some firms may be affected much while some others may not be affected at all by the rise in prices. 13. Other factorsCertain other factors such as operating efficiency, management ability, irregularities of supply, import policy, asset structure, importance of labour, banking facilities, etc. also influence the requirements of working capital.

MANAGEMENT OF WORKING CAPITAL Q. WHAT DO YOU UNDERSTAND BY WORKING CAPITAL MANAGEMENT? DISCUSS THE PRINCIPLES OF WORKING CAPITAL MANAGEMENT. Working capital refers to the excess of current assets over current liabilities. Management of working capital therefore, is concerned with the problems that arise in attempting to manage the current assets, the current liabilities and the inter-relationship that exist between them. The basic goal of working capital management is to manage the current assets and current liabilities of a firm in such a way that a satisfactory level of working capital is maintained .this so because both inadequate as well as excessive working capital positions are bad for any business. Inadequacy of working capital may lead the firm to insolvency and excessive working capital implies idle funds which earns no profits for the business.

FINANCIAL MGMT. & MGMT. ACCOUNTING

Working capital management polices of a firm have a great effect on its profitability, liquidity and structural health of the organization. In this context, working capital management is three dimensional in nature: i)

Dimension I is concerned with the formulation of policies with regard to profitability, risk and liquidity.

ii)

Dimension II is concerned with the decisions about the composition and level of current assets.

iii)

Dimension III is concerned with the decisions about the composition and level of current liabilities.

PRINCIPLES OF WORKING CAPITAL MANAGEMENT/POLICY The following are the general principles of a sound working capital management policy.

Principles of Working Capital Management

Principle of risk variation

Principle of cost of capital

Principle of equity position

Principle of Maturity of Payment

Working capital management involves two main processes: Determining the size of the amount of working capitalIt is determined on the basic of size, nature and length of the manufacturing cycle. The policy of the management towards sales and purchases also helps in the process of determining the size of the working capital. Arranging the sources of working capitalOnce the size of the working capital is determined, it is the duty of financial manager to select the right sources of working capital this mainly depends on the availability of the sources for funds. The investment of funds on current assets also facilities the financial manager to arrange for working capital requirements. Working capital management in practiced by taking into account the following aspect they are. (a) Management of cash, (b) Accounts receivables management and

management.

Principles of working capital management: Principles of risk variationRisk here refers to the inability of a firm to meet its obligations as and when they become due for payment. Larger investment in current assets with less dependence on short term

FINANCIAL MGMT. & MGMT. ACCOUNTING borrowing increases liquidity, reduces dependence on short term borrowings increase liquidity, reduce risk and there by decrease the opportunity for gain or loss. On the other hand less investment in current assets with greater dependence on short-term borrowings increase risk, reduces liquidity and increase profitability. A conservative management prefers to minimize risk by maintaining a higher level of current assets or working capital while a liberal management assumes greater risk by reducing working capital. However, the goal of the management should be to establish a suitable trade off between profitability and risk. Principles of cost of capitalGenerally, higher the risk lower is the cost and lower the risk higher the cost. A sound working capital management. Should always try to achieve a proper balance between these two. Principle of equity portionAccording to this principle, the amount of working capital invested in each component should be adequately justified by a firm’s equity position. Every rupee invested in the current assets should contribute to the net worth of the firm. The level of current assets may be measured with the help of two ratios: (i) Current assets as a percentage of total assets and (ii) Current assets as a percentage of total sales.While deciding about the composition of current assets, the financial manager may consider the relevant industrial averages. Principles of maturity of paymentAccording to this principle, a firm should make every effort to relate maturities of payment to its flow of internally generated funds. Maturity pattern of various current obligations is an important factor in risk assumption and risk assessments. Generally, shorter the maturity schedule of current liabilities in relation to expected cash inflows, the greater the inability to meet its obligation in time. To achieve the above mentioned objective of working capital management, the financial manager has to perform the following basic functions: 1. Estimating the working capital requirements 2. Financing of working capital needs 3. Analysis and control of working capital

Q.WHAT FACTORS WOULD YOU TAKE INTO CONSIDERATION IN ESTIMATING THE WORKING CAPITAL NEEDS OF A CONCERN? Forecast/estimate of working capital requirements “Working capital is the life-blood and controlling nerve centre of a business”. No business can be successfully run without an adequate amount of working capital. To avoid the shortage of working capital at once,an estimate of working capital requirement should be made in advance so that arrangements can be made to procure adequate working capital. But estimation of working capital requirements is not an easy task and a large number of factors have to be considered before starting this exercise for a manufacturing

FINANCIAL MGMT. & MGMT. ACCOUNTING

organization, the following factors have to be taken into consideration while making an estimate of working capital requirements:

Factors requiring consideration while estimating working capital 1. Total costs incurred on material, wages and overheads. 2. The length of time for which raw materials are to remain in stores before they are issued for production. 3. The length of the production cycle or work-in-progress, i.e., the time taken for conversion of raw material into finished goods. 4. The length of sales cycle during which finished goods are to be kept waiting for sales. 5. The average period of credit allowed to customers. 6. The amount of cash required to pay day-to day expenses of the business. 7. The average amount of cash required to make advance payments, if any. 8. The average credit period expected to be allowed by suppliers. 9. Time-lag in the payment of wages and other expenses. From the total amount blocked in current assets estimated on the basis of the first seven items given above, the total of the current liabilities, i.e., the last two items, is deducted to find out the requirements of working capital.In case of purely trading concerns, points 1, 2 and 3 would not arise but all other factors from points 4 to 9 are to be taken into consideration.In order to provide for contingencies, some extra amount generally calculated as a fixed percentage of the working capital may be added as a margin of safety. Methods of forecasting working capital Suggested Proformas for estimation of working capital requirements are given on the following pages: For a Trading Concern: Proforma Statement of Working Capital Requirements Amount Rs. Current Assets: ………..

(i)

Cash

(ii)

Debtors or Receivables (For….month’s sales)

(iii)

Stocks(For….month’s sales

………..

(iv)

Advance payments, if any

………..

(v)

Others

………..

Less: Current Liabilities: (i)

Creditors (For….month’s purchases)

(ii)

Lag in payment of expenses (Outstanding expenses, if any)

Working Capital (C.A –C.L)

……….. ……….. -------------

----------………...

FINANCIAL MGMT. & MGMT. ACCOUNTING Add: Provision/Margin for Contingencies Net working Capital Required

76 ----------. -----------

Notes: (i)

Profits should be ignored while calculating working capital requirements as funds provided by profits may or may not be used as working capital.

(ii)

Stock and debtors should be taken at cost unless otherwise required in a given question.

For a Manufacturing Concern

Statement of Working Capital Requirements Amount Rs. Current Assets: (i)

Stock of Raw Material (For….month’s consumption)

(ii)

Work-in-Process(For…months):

………..

(a) Raw Materials ……….. (b) Direct Labour ……......

………...

Stock of Finished Goods (For ….month’s sales):

………...

(a) Raw Materials ………... (b) Labour ………..

………...

………... (iv)

Sundry Debtors or Receivables (For …month’s sales):

………... ………...

(a) Raw Materials ………... (b) Labour ………..

………...

-----------

………..

………...

FINANCIAL MGMT. & MGMT. ACCOUNTING

(v)

Payments in Advance (if any)

-----------

(vi)

Balance of Cash (Required to meet day-to-day expenses)

…………

(vii)

Any other (if any)

------------

Less: Current Liabilities: (i)

Creditors (For….month’s purchases of raw materials) ………..

(ii)

Lag in payment of expenses (outstanding expenses..months)………

(iii)

Others (if any) ………..

Working Capital (C.A –C.L) Add: Provision/Margin for Contingencies Net working Capital Required

Notes: (I) profits should be ignored while calculating working capital requirements for the following reason; a.

Profits may are to be used as working capital.

Even it profits are to be used for working capital it has to be reduced by the amount of income-tax drawings, dividend paid etc.

(II) calculation of work in process depends upon its degree of completion as regards materials, labour and overheads. However if nothing is given in a question as regards the degree of completion we suggest the students to take 100% cost of materials, labour as well as overheads. Because in such a case the average. Period of work in process must been calculated as equivalent period of completed units. The same approach has been followed by various famous authors on this subject. But some authors have assumed in such a case100% consumption of raw material and 50% (one half on an average) in case of labour and overheads.

(III) calculation for stocks of finished goods and debtors should be made be made at cost unless otherwise asked in the question.

3. Columnar form An alternative Proforma for estimation of working capital requirements in columnar form is given below

Statement of working capital Requirement (A)Current asset particular

Period Week

Total

Raw

Work-in

Finished

materials

process

goods

FINANCIAL MGMT. & MGMT. ACCOUNTING

……….

………….

…………

……….

For Row

For

Materials

Wages

overheads

……..

……….

………

……..

1.Raw materials (a) stock (b) In work-in-process (c) In finished Goods (d) Credit to Debtors 2. Direct labour (a) In work in process (b) In finished Goods (c) Credit to Debtors 3. Overhead (a) In work-inprocess (b) In finished Goods ( c) credit to Debtors 4. Cash at bank

(A) Total current assets (B) Current Liabilities

Period

particulars

Week

Total

5. Credit by Suppliers 6. Lag in payment of Wages 7. Over heads (B) Total Current liabilities Working capital Requirements = (A-B)

Q.DISCUSS THE VARIOUS SOURCES OF FINANCING WORKING CAPITAL. (OR) Q. EXPLAIN THE SOURCES OF FINANCING OF CURRENT ASSETS. The working capital requirements of a concern can be classified as: a) Permanent or fixed working capital requirements. b) Temporary or variable working capital requirements. In any concern, a part of the working capital investments are as permanent investments in fixed assets. This is so because there is always a minimum level of current assets which are continuously required by the enterprise to carry out its day-to-day business operations and this minimum cannot be expected to reduce at any time. The minimum level of current assets give rise to permanent or fixed working capital as this part of working capital is

FINANCIAL MGMT. & MGMT. ACCOUNTING

permanently blocked in current assets. Similarly, some amount of working capital may be required to meet the seasonal demands and some special exigencies such as rise in prices, strikes, etc. This proportion of working capital gives rise to temporary or variable working capital which cannot be permanently employed gainfully in business. FINANCING CURRENT ASSETS Sources of working capital

Permanent or Fixed

Temporary or Variable

1. Shares

1.Commercial banks

2. Debentures

2.Indigeneous bankers

3. Public deposits 4. Ploughing back of profits 5. Loans from financial institutions

3.Trade creditors 4.Instalment credit 5.advance 6. Factoring 7. Accrued Expenses 8. Commercial paper

FINANCING OF PERMANANET/FIXED OR LONG-TERM WORKING CAPITAL Permanent working capital should be financed in such a manner that the enterprise may have its uninterrupted use for a sufficiently long period. There are five important sources of permanent or long-term working capital. 1. SharesIssue of shares is the most important source for raising the permanent or long-term capital. A company can issue various types of shares as equity shares, preference shares. Preference shares carry preferential rights in respect of dividend at a fixed rate and in regard to the repayment of capital at the time of winding up the company. Equity shares do not have any fixed commitment charge and the dividend on these shares is to be paid subject to the availability of sufficient profits. As far as possible, a company should raise the maximum amount of permanent capital by the issue of shares. 2. DebenturesA debenture is an instrument issued by the company acknowledging its debt to its holder. It is also an important method of raising long-term or permanent working capital. The debenture-holders are creditors of the company.A fixed rate of interest are paid on debentures. The debentures as a source of finance have a number of advantages both to the investors and the company. Since interests on debentures have to be paid on certain predetermined intervals at a fixed rate and also debentures get priority on repayment at the time of liquidation, they are very well suited to cautious investors. The firm issuing debentures also enjoys a number of benefits such as trading on equity, retention of control, tax benefits, etc.

FINANCIAL MGMT. & MGMT. ACCOUNTING Pubic depositPublic deposits are the fixed deposits accepted by a business enterprise directly from the public. This source of raising short term and medium term finance was very popular in absence of banking facilities. Public deposits sources of fund have a large number of advantages such as very simple and convenient source of finance. But it is not free from certain dangers such as; it is uncertain, unreliable, unsound and unrealistic source of finance. The Reserve Bank of India has also laid down certain limit on public deposit. Non-banking concerns cannot borrow by way of public deposits more than 25% of its paid-up capital and free reserves. Ploughing back of profitsPloughing back of profits means the reinvestments by concern of its surplus earnings in its business. It is an internal source of finance and is most suitable for an established firm for its expansion, modernization and replacement etc. This method of finance has a number of advantages as it is the cheaper rather costfree source of finance; there is no need to keep securities; there is no dilution of control; it ensures stable dividend policy and gains confidence of the public. But excessive resort to Ploughing back of profits may lead to monopolies, misuse of funds, over capitalization and speculation, etc. Loan from financial institutionsFinancial Institutions such as Commercial Banks, Life Insurance Corporation, Industrial Finance Corporation of India, State Financial Corporations, State Industrial Development Corporation, Industrial Development Bank of India, etc, also provide short-term, medium term and long-term loans. This source of finance is more suitable to meet the medium â&#x20AC;&#x201C;term demands of working capital.

FINANCING OF TEMPORARY, VARIABLE OR SHORT-TERM WORKING CAPITAL The main sources of short-term working capital are as follows: 1.indigenous bankersPrivate moneylenders and other country bankers used to be the only source of finance prior tp the establishment of commercial banks. They used to charge very high rates of interest and exploited the customers to the largest extent possible. Now-a-days with the development of commercial banks they have lost their monopoly. 2.Trade creditTrade credit refers to the credit extended by the suppliers of goods in the normal course of business. As present day commerce is built upon credit, the trade credit arrangement of a firm with its supplier is an important source of short-term finance. The credit worthiness of a firm and the confidence of its suppliers are the main basis of securing trade credit. It may take the form of bills payable whereby the buyer signs the bill of exchange payable on a specified future date.

FINANCIAL MGMT. & MGMT. ACCOUNTING When a firm delays the payment beyond the due date as per the terms of sales invoice, it is called stretching accounts payable. A firm may generate additional short-term finance by stretching accounts payable. 3.Instalment creditThis is another method by which the assets are purchased and the possession of goods is taken immediately but the payment is made in installments over pre-determined period of time. Generally interest is charged on the unpaid price or it may be adjusted in the price. But, in any case, it provides funds for sometimes and is used as a source of short-term working capital. 4. AdvancesSome business houses get advances from their customers and against orders and this source is a short-term source of finance for them. It is a cheap source of finance and in order to minimize their investment in working capital. 5.Factoring or Accounts Receivables CreditA commercial bank may provide finance by discounting the bills or invoices of its customers. Thus, a firm gets immediately payment for sale made on credit. A factor is a financial institution, which offers services relating to management and financing of debt arising out of credit sales. Factors render services varying from bill discounting facilities offered by commercial banks to a total take over of administration of credit sales

including maintenance of sales ledger,

collection of accounts receivables, credit control and protection from bad debts. 6.Accrued expensesAccrued expenses are the expenses, which have been incurred but not yet due and hence not yet paid also. These simply represent a liability that a firm has to pay for the service already received by it. The most important items of accruals are wages and salaries, interest, and taxes. Wages and salaries are usually paid on monthly, fortnightly or weekly basis for he services already rendered by employees. Like taxes, interest is also paid periodically while the funds are used continuously by a firm. Thus all accrued expenses can be used as a source of finance. Further, as interest is payable on accrued expenses, they represent a free source of financing. However, it must be noted that it may not be desirable or even possible to postpone these expenses for a long period. 7.Deferred incomesDeferred incomes are incomes received in advance before supplying goods or service. These funds increase the liquidity of a firm and constitute an important source of short-term finance. However, firms having great demand for its product and services, and those having good reputation in the market can demand deferred incomes.

FINANCIAL MGMT. & MGMT. ACCOUNTING 8.Commercial paperCommercial paper represents unsecured promissory notes issued by firms to raise short-term funds. In India Reserve Bank of India introduced commercial paper in the Indian money market. But only large companies enjoying high credit rating and sound financial health can issue commercial paper to raise short-term funds. Commercial paper is usually bought by investor including banks, insurance companies, unit trust and firms to invest surplus funds for short-period. A credit rating agency, called CRISIL, has been set up in India by ICICI and UTI to rate commercial papers. Commercial paper is a cheaper source of raising short-term finance as compared to the bank credit. 9.Working Capital Finance by Commercial BanksCommercial banks are the most important source of short-term capital. The major portions of working capital loans are provided by commercial banks. They provide a wide variety of loans tailored to meet the specific requirements of a concern. The different forms in which the banks normally provide loans and advances are as follows: a) Loans b) Cash credits c) Overdrafts d) Purchasing and discounting of bills.

DETERMINATION OF WORKING CAPITAL FINANCING MIX. Q. DISCUSS THE VARIOUS APPROACHES TO DETERMINE AN APPROPRIATE FINANCING MIX OF WORKING CAPITAL. Matching approach (or) hedging approachWhen the firm follows matching approach, long term financing will be used to finance permanent working capital. Temporary working capital should be financed out of short term funds. The rationale underlying matching approach is that the maturity of source of funds should match the nature of assets to be financed. Conservative approachAccording to this approach all requirements of funds should be met from long-term sources. Short-term sources of funds should be used only for emergency requirements. Under a conservative plan, a firm finances its permanent current assets and a part of the temporary current assets with a long-term financing. In periods when the firm has no temporary current assets, it stores liquidity by investing surplus finds in marketable securities. Conservative approach is less risky but more costly on compared to matching approach. In other words it is low profit low risk approach. Aggressive approachUnder an aggressive policy firm uses shorter financing than warranted by the matching plan, i.e., the firm finances a part of its permanent current assets with short term financing. On the other hand, more use of short term financing makes the firm more risky.

FINANCIAL MGMT. & MGMT. ACCOUNTING

Q. DISCUSS THE NEW TRENDS IN FINANCING OF WORKING CAPITAL BY BANKS. Banks in India have been providing finance to industry and trade on the basis of security. to ensure its equitable distribution in the right channels and credit has been a subject matter of regulation and control by the government .Since November 1965, a credit authorization scheme has been in operation as part of the reserve bank of India’s credit policy.(As was adopted by the RBI to regulated the end use of bank credit)under this scheme ,all scheduled commercial banks are required to obtain prior authorization of reserve bank of India before sanctioning any fresh credit limits of Rs.one crore or more to any single party or any limit that would enable the party avail Rs.one crore or more from the entire banking system on secured or unsecured basis. The limit of Rs.one crore was subsequently raised to Rs.five crores. To regulate and control bank finance, the RBI has been issuing directives and guidelines to the banks from time to time on the recommendation of certain specially constituted committees entrusted with the ask f examining various aspects of bank finance to industry. The following are the important findings and recommendations of various commitments Dehejia committee reportNational credit council constituted a committee under the chairmanship of Shri.V.T.Dehejia in 1968 to ‘determine the extent to which credit needs of industry and trade are likely to be inflated and how such trends could be checked ‘ and to go into establishing some norms for lending operations by commercial banks. The committee was of the opinion that there was also a tendency to divert short-term credit for long-term assets. Although committee was of the opinion that it was difficult to evolve norms for lending to industrial concerns, the committee recommended that the banks should finance industry on the basis of a study of borrower’s total operations rather than security basis alone. The committee further recommended that the total credit requirements of the borrower should be segregated into ‘hard core’ and ‘short-term’ component. The committee was also of the opinion that generally a customer should be required to confine his dealings to one bank only.

Tandon committee reportReserve bank of India set up a committee under the chairmanship of Shri.P.I.Tandon in July 1974 .The terms of reference of the committee were: 1. To suggest guidelines for commercial banks to follow up and supervise credit from the point of view of ensuring proper end use of funds and keeping a watch on the safety of advances.

FINANCIAL MGMT. & MGMT. ACCOUNTING 2. To suggest the type of operational data and other information that may be obtained by banks periodically from the borrowers and by the reserve bank of India from the leading banks. 3. To make suggestions for prescribing inventory norms for the different industries, both in the private and public sectors and indicate the broad criteria for deviating from theses norms. 4. To make recommendations regarding resources for financing the minimum working capital requirements. 5. To suggest criteria regarding satisfactory capital structure and sound financial basis in relation to borrowings. 6. To make recommendations as to whether the existing pattern of financing working capital requirements by cash credit/overdraft system etc., require to be modified, if so, to suggest suitable modifications. The committee was of the opinion that: (i) bank credit is extended on the amount of security available and not according to the level of operations of the customer,(ii) bank credit instead of being taken as a supplementary to other sources of finance is treated as the first source of finance. Chore committee report The reserve bank of India in march, 1979 appointed another committee under the chairmanship of Shri.K.B.Chore to review the working of cash credit system in recent years with particulars reference to the gap between sanctioned limits and the extent of their utilization and also to suggest alternative type of credit facilities which should ensure greater credit discipline. The important recommendations of the committee are as follows: i.

The banks should obtain quarterly statements in the prescribed format from all borrowers having working capital credit limit of Rs.50 lacs and above.

ii.

The banks should undertake a periodic review of limit of Rs.10 las above.

iii. The banks should not bifurcate cash credit accounts into demand loan and cash credit components. iv. If a borrower does not submit the quarterly returns in time the banks may charge penal interest of one percent on the total amount outstanding for the period of default. v.

Banks should discourage sanction of temporary limits by charging additional one percent interest over the normal rate on these limits.

vi. The banks should fix separate credit limits for peak level and non-peak level, wherever possible. vii. Banks should take steps to convert cash credit limits into bill limits for financing sales. Marathe Committee reportThe reserve bank of India, in 1982, appointed a committee under the chairmanship of Marathe to review the working of credit Authorization scheme (CAS) and suggest measures

FINANCIAL MGMT. & MGMT. ACCOUNTING

for giving meaningful directions to the credit management function of the Reserve Bank. The recommendations of the committee have been accepted by the reserve bank of India with minor modifications. The principal recommendations of the Marathe committee include: i.

The committee has declared the third method of lending as suggested by the Tandon committee to be dropped. Hence, in future, the banks would provide credit fro working capital according to the second method lending.

ii.

The committee has suggested the introduction of the ‘fast track scheme’ to improve the quality of credit appraisal in banks. It recommended that commercial banks can release without prior approval of the reserve Bank 50% of the additional credit required by the borrowers (75% I case of export oriented manufacturing units) where the following requirements are fulfilled: a)

The estimates/projections in regard to production, sales, chargeable current assets, other current assets, current liabilities other than bank borrowings, and net working capital are reasonable in terms of the past trends and assumptions regarding most likely trends during the future projected period.

The classification f assets and liabilities as ‘current’ and ‘non-current’ is in conformity with the guidelines issued by the reserve bank of India.

The projected current ratio is not below 1.33:1

The borrower has been submitting quarterly information and operating statements for the past six months within the prescribed time and undertakes to do the same in future also

The borrower undertakes to submit to the bank his annual account regularly and promptly, further, the bank is required to review the borrower’s facilities at least once in a year even if the borrower does not need enhancement in credit facilities.

Chakravarthy committee reportThe reserve bank of India appointed another committee under the chairmanship of sukhamoy Chakravarthy to review the working of the monetary system of India. The committee

submitted

its

report

April

1985.The

committee

made

two

major

recommendations in regard to the working capital finance. i. Penal interest for delayed paymentThe committee has suggested that the government must insist that all public sector units, large private sector units and government departments must include penal interest payment clause in their contracts for payments delayed beyond a specified period. ii. Classification of credit limit under three different headsThe committee further suggested that the total credit limit to be sanctioned to a borrower should be considered under three different heads: (1) cash credit I to include supplies to government, (2) cash credit II to cover special circumstances, and

FINANCIAL MGMT. & MGMT. ACCOUNTING

(3) Normal working capital limit to cover the balance credit facilities. Kannan committee report In view of the ongoing liberalization in the financial sector, the Indian banks association (IBA) constituted a committee headed by Shri.K.Kannan, Chairman and managing Director of bank of Baroda to examine all the aspects of working capital finance including assessment of maximum permissible bank finance

(MPBF). The committee

submitted its report on 25 February 1997. It recommended that the arithmetic rigidities imposed by Tandon committee (and reinforced by Chore committee) in the form of MPBF computation so far been in practice, should be scrapped. The committee further recommended

that freedom to each bank be

given in regard to evolving its own system of working capital finance for a faster credit delivery so as to serve various borrowers more effectively. It also suggested that line of credit system. (LCS), as prevalent in many advance countries, should replace the existing system of assessment /fixation of sub-limits within total working capital requirements. The committee proposed to shift emphasis from the liquidity level lending (security based lending) to the cash deficit lending called Desirable Bank finance (DBF).

Problem.No.1 Prepare an estimate of working capital requirement from the following information of a trading concern: a) Project annual sales

1,00,000 units

b) Selling price

Rs.8 per unit

c) Percentage of net profit on sales

25%

d) Average credit period allowed to customers

8 weeks

e) Average credit period allowed by suppliers

4 weeks

f) Average stock holding in terms of sales requirements 12 weeks g) Allow 10% for contingencies.

FINANCIAL MGMT. & MGMT. ACCOUNTING

Solution: Step 1: Classify the given information into current assets and current liabilities Step 2: Calculate the cost of sales to find out the components of current assets. This is being done by excluding the percentage of profit out of sales. Statement showing the details of calculating working capital Current Assets

Rs.

Debtors: 6,00,000 x 8/52

92,308

Stock: 6,00,000 x 12/52

1,38,462 2,30,770

Less: Current liabilities:

46,154 1,84,616

Creditors: 6,00,000 x 4/52

18,462

Net working capital

2,03,078

Add: 10% contingencies Working capital required Working note: Cost of sales = Sales â&#x20AC;&#x201C; Profit 25 = 8,00,000 - ------- x 8,00,000 100

=8,00,000 - 2,00,000 = 6,00,000 Assumptions: 1. Calculation of debtors and creditors are being done by considering the cost of sales.

Problem.No.2 Prepare an estimate of working capital requirement from the following information of a trading concern: a) Project annual sales

80,000 units

b) Selling price

Rs.8 per unit

c Percentage of net profit on sales d) Average credit period allowed to debtors e) Average credit period allowed by suppliers

20% 10 weeks 8 weeks

f) Average stock holding in terms of sales requirements 10weeks g) Allow 20% for contingencies Solution:

FINANCIAL MGMT. & MGMT. ACCOUNTING

Statement showing the details of calculating working capital Current Assets

Rs. 10

Debtors: 5,12,000 x ----

98,462

10 Stocks:

5,12,000 x -----

98,462

52 Total current assets

1,96,924 8

Less: Raw materials: 5,12,000 x ----

78,769

52 Net working capital

1,18,155

Add: 20% contingencies

23,631

Total Net working capital

1,41,786

Working note: Cost of goods sold = Sales – Profit 20 = 80,000 x 80 - ------- x 6,40,000 100 = 6,40,000 – 1,28,000 = 5,12,000

Problem.No.3 Proforma cost sheet of a company provides the following particulars: Elements of cost: Materials 40%; direct labour – 20% ; Overheads – 20% .the following further particulars are available: a)

It is proposed to maintained a level of activity of 2,00,000 units.

Raw materials are expected to remain in stores for an average period of one month.

Materials will be in process, an average of half month.

Selling price is Rs.12 per unit.

Finished goods are required to be in stock for an average period of one month.

Credit allowed to debtors is two months.

Credit allowed by suppliers is one month.

You may assume that sales and production follow a consistent pattern.

FINANCIAL MGMT. & MGMT. ACCOUNTING Statement showing the details of net working capital

89 Rs.

Current assets: Raw materials(One month) 2,00,000 x12 x 40 x 100

80,000

Work-in-progress (1/2 month) Raw materials 2,00,000x 12 x 40 x

100

40,000

Labour 2,00,000x 12 x 20 x 100

20,000

Overheads 2,00,000 x 12 x 20

100

20,000

Finished goods( one month) Raw materials 2,00,000x 12 x 20 x 100

80,000

Labour 2,00,000x 12 x 20 x 100

40,000

Overheads 2,00,000x 12 x 20 x 100

40,000

Debtors (Two months) Raw materials 2,00,000x 12 x 40 x 100

1,60,000

Labour 2,00,000x 12 x 20 x 100

80,000

Overheads 2,00,000 x 12 x 20 x 100

80,000

6,40,000

Total current assets Current liabilities Raw materials 2,00,000x 40 x 12 x 5

80,000

FINANCIAL MGMT. & MGMT. ACCOUNTING 100

5,60,000

Net working capital Problem.No.4 X and co., is desirous to purchase a business and has consulted you and one point as which you are asked to advise them is the average amount of working capital which will be required is the first year’s working. You are given the following estimates and are instructed to add 10% to your computed figure to allow for contingencies: 1. Amount Blocked up in stocks

Rs.

Stock of finished goods

5,000

Stock of stores, materials

8,000

2. Average credit sales: Inland sales- 6 weeks credit

3,12,000

Export sales 1 ½ weeks credit

78,000

3. Payment in advances: Sunday expenses (paid quarterly in advance)

8,000

4. Undrawn profit on the average throughout the year

11,000

5. Lag in payment of wages and other out goings: Wages -11/2 weeks

2,60,000

Stock of materials-1 ½ months

48,000

Rent, royalties – 6 months

10,000

Clerical staff-1/2 month

62,000

Manager- ½ month

4,800

Miscellaneous expenses- 1 ½ months

48,000

Solution:

Statement showing the details of calculating working capital

Rs.

Current Assets a) Stock of finished goods

5,000

b) Stock of stores, materials

8,000

c) Sundry debtors: i) Inland:

Rs.3,12,000 x 6 =

36,000

52 ii) Export sales Rs.78,000 x 3 =

2,250 .

38,250

d) Payment in Advance: Sundry expenses = 8,000 x 1/4

2,000

Total Current Asset

53,250

Less: Current Liabilities a) Lag in payment of wages: Rs. 2,60,000 x 3 12

= 7,500 2

FINANCIAL MGMT. & MGMT. ACCOUNTING

b) Lag in payment of materials: Rs. 48,000 x 3 = 6,000 12

c) Rent & Royalties: : Rs. 10,000 x 6

= 5,000

d) Clerical staff : Rs. 62,400 x 1 = 12 e) Managerâ&#x20AC;&#x2122;s salary: Rs.

2,600

2 1 2

x 4,800

= 200

12 27,300

f) Miscellaneous expenses : Rs. 48,000 x 3 12

= 6,000

25,950

Networking capital

2.590

Add 10% contingencies

28,545

Net working capital

Problem.No.5 A Proforma cost sheet of a company provides the following particulars. Elements of cost

Amount per unit

Raw materials

50%

Direct Labour

15%

Overheads

15%

The following particulars are available: a) It is proposed to maintain a level of activity of 3,00,000 units. b) Selling price is Rs.20 per unit. c) Raw materials are expected to be in the stores for an average of 2 months. d) Materials will be in the process an average of one month. e) Finished goods are required to be in stock for an average of 2 months. f)

Credit allowed to debtors is 3 months

g) Credit allowed by suppliers is 2 months. You may assume that sales and production follow a consistent pattern.

FINANCIAL MGMT. & MGMT. ACCOUNTING

Solution: Statement showing the details of net working capital

Rs.

Current assets: Raw materials(two month) 3,00,000 x 20 x 50 x 100

500,000

Work-in-progress (one month) Raw materials 3,00,000 x 20 x 50 x 100

2,50,000

Direct Labour 3,00,000 x 20 x 15 x 100

75,000

Overheads 3,00,000 x 20 x 15 x 100

75,000

Finished goods( two month) Raw materials 3,00,000 x 20 x 50 x 100

5,00,000

Direct Labour 3,00,000 x 20 x 15 x 100

1,50,000

Overheads 3,00,000 x 20 x 15 x 100

1,50,000

Debtors (Two months) Raw materials 3,00,000 x 20 x 50 x 100

5,00,000

Direct Labour 3,00,000 x 20 x 15 x 100

1,50,000

Overheads 3,00,000 x 20 x 15 x

1,50,000

FINANCIAL MGMT. & MGMT. ACCOUNTING 100

93 25,00,000

Total current assets Current liabilities Raw materials

5,00,000

3,00,000 x 20 x 50 x 100 Net working capital

2 12 20,00,000

FINANCIAL MGMT. & MGMT. ACCOUNTING

UNIT-IV MANAGEMENT OF CASH, RECEIVABLES AND INVENTORIES MANAGEMENT OF CASH Q. GIVE THE MEANING AND NATURE OF CASH. Meaning of cashCash is one of the current assets of a business. It is needed at all times to keep the business going. A business concern should always keep sufficient cash for meeting its obligations. Any shortage of cash will hamper the operations of a concern and any excess of it will be unproductive.The term ‘cash’ with reference to cash management is used in 2 senses. In a narrower sense it includes coins, currency notes, cheque, bank draft held by a firm with it and the demand deposits held by it in banks. In a broader sense it also includes “near-cash assets” such as, marketable securities and time deposits with banks.

Such

securities or deposits can immediately be sold or converted into cash if the circumstances requiring. The term cash management is generally used for management of both cash and near-cash assets.

Nature of cashCash itself does not produce goods or service. It is used as a medium to acquire other assets. It is the other assets which are used in manufacturing goods improving services. The idle cash can be deposited in bank to earn interest.A business has to keep required cash for meeting various needs. The assets acquired by cash again help the business in producing cash. The goods manufactured or services produced re sold to acquire cash. A firm will have to maintain a critical level of cash .it at a time it does not have sufficient cash with it, it will have to borrow from the market for reaching the required level. There remains a gap between cash inflows and cash outflows. Sometimes cash receipts are more than the payments or it may be vice-versa at another time. A financial manager tries to synchronize the cash inflows and cash outflows. But this situation is seldom found in real world. Perfect synchronization of receipts and payments of cash is only an ideal situation. PLANNING OF CASH REQUIREMENTS In planning its cash requirements and proper use of the funds subsequently generated through its operations A management should use two tools. (i) A long-range cash projection and (ii) A short-range forecast of cash position.

FINANCIAL MGMT. & MGMT. ACCOUNTING

In making its long range projection of case , a management should first difine in goals it intends to accomplish Over the period under consideration-usually a period which is longer than one year. The managing of the cash is not simple in the corporate world of cash managers (treasures) and accountants (controllers). Determining How much cash a corporation has, is a task that is not easy. Dictionary definitions of cash are not particularly Helpful because they do not take into account the dynamic of entire modern case management are the current accounting practices. All corporation do not use the same accounting treatment of cash the problem of measuring corporate cash in further compounded by the fact that corporate treasure and controllers used different of the cash. Different definitions and accounting results and misunderstanding

and problem and

corporation as well as for uses of published and financial statements to key objective of modern corporate cash management are maximization of the written on liquid and assets and maintenance of the cost financing the assets used by corporations. The minimization of idle cash balance based to the achievement of these objectives. The corporation should either invest all available cash to produce investment income are used cash to reduce debit and the cost of borrowings.

Q WRITE SHORT NOTES ON MOTIVES FOR HOLDING CASH. A distinguishing feature of cash as an asset, irrespective of the firm in which it is held, is that it does not earn any substantial return for the business. In spite of this fact cash is held by the firm with the following motives. Transaction motiveA firm enters into a variety of business transaction, resulting in both inflows and outflows. In order to meet the business obligations in such a situation, it is necessary to maintain adequate cash balance. Thus, cash balance is kept by the firms with the motive of meeting routine business payments. Precautionary motiveA firm keeps cash balance to meet unexpected cash needs arising out of unexpected contingencies such as floods, strikes, presentment of bills for payment earlier than the expected date, unexpected slowing down of collection of accounts receivable, sharp increase in price of raw material etc., the more is the possibility of such contingencies, more is the amount of cash kept by the firm for meeting them. Speculative motiveA firm also keeps each balance to take advantages of unexpected opportunities typically outside the normal course of the business. Such motive is, therefore of purely a speculative nature. Compensation motive-

FINANCIAL MGMT. & MGMT. ACCOUNTING

Banks provide certain services to their clients free of charge. They, therefore usually require clients to keep a minimum cash balance with them, which help them to earn interest and thus compensate them for the free services so provided. Business firms normally, do not enter into speculative activities and, therefore, out of the four motive of holding cash balance, the two most important motives are the transaction motive and the compensation motive.

Q. EXPLAIN THE OBJECTIVES OF CASH MANAGEMENT. Meeting cash disbursementsThe first basic objective of cash management is to meet the payments schedules. In other words, the firm should have sufficient cash to meet the various requirements of the firm at different period of times. The business has to make payment for purchase of raw material, wages, taxes, purchase of plant etc. The business activity may come to a grinding halt if the payment schedule is not maintained. Cash has, therefore, been aptly described as the “oil to lubricate the ever-turning wheels of the business, without it the process grinds to a stop”. Minimizing funds locked up a cash balanceThe second objective of cash management is to minimize the amount locked up as cash balances.

In the process of minimizing the cash balance, the finance manager is

confronted with two conflicting aspects. A higher cash balance ensures proper payment with all its advantages. But this will result in a large balance of cash remaining idle. Low level of cash balance may result in failure of the firm to meet the payment schedule. The finance manager should, therefore, try to have an optimum amount of cash of balance keeping the above facts in view.

Q.ENUMERATE THE FACTORS DETERMINING CASH NEEDS. The amount of cash for transaction requirements is predictable and depends upon a variety of factors which are as follows: 1. Credit position of the firm: The credit position influences the amount of cash required in two distinct ways. First, if a firm’s credit position is sound, it is not necessary to carry a large cash reserve for emergencies. Second, if a firm finances its inventory requirements with trade credit, its cash requirements are considerably smaller, since the firm can synchronize the credit terms it gives to its customers with the terms it receives. 2. Status of firm’s receivable: The amount of time required for a firm to convert its receivable into cash also affects amount of cash needed and of course, reduces total working capital employed. In other words, the longer the credit terms, the slower the turnover.

When out flow is not

synchronized with turn over, a firm must carry amounts of cash relatively larger than would otherwise be required.

FINANCIAL MGMT. & MGMT. ACCOUNTING

3. Status of firm’s inventory account: The status of a firm’s inventory account also affects the amount of cash tied up at any one time. For example, if one business firm carries two months’ inventory on hand and another firm carries only one month’s supply, the former has twice as much investment in inventory and will normally be called upon to maintain a larger investment in cash in order to finance its acquisition. 4. The nature of business enterprise: The nature of firm’s demand definitely affects the volume of cash required.

illustrate, a firm whose demand is volatile, needs a relatively larger cash reserve than one whose demand is stable. Public utility firms exhibit stable demand where as firms that deal with high fashion merchandise or goods that tend to be ‘faddish’ are subject to high degrees of volatility. 5. Management’s attitude towards risk: A more conservative management will hold a larger cash reserve than one that is less conservative. The former usually demands more liquidity than the latter and consequently does not experience the same degree of efficiency. A generalization is made that the firm that effectively plans its working capital policies is less conservative than one that does little or no planning. The obvious conclusion is that planning allows the firm to predict its requirements more accurately, there by eliminating uncertainty, which is the basis for large cash reserves. 6. Amount of sales in relation to assets: Another characteristic affecting the level of cash is the amount of sales in relation to assets.

Firms with large scale relative to fixed assets are required to carry larger cash

reserves. This is the result of having larger sums of invested in inventories however, that cash requirements do not increase in the same proportion as sales. The rule is that as sales increase, cash also increases but at a decreasing rate, it is impossible to determine to what extent each characteristic affects the total volume of cash, but these examples indicate that different types of businesses have different cash requirements.

Q.LIST OUT THE ADVANTAGES OF CASH MANAGEMENT 1. The availability of cash may be a matter of life or death. A sufficiently of cash can keep an unsuccessful firm going despite losses. Conversely, this insufficiency can bring failure in the face of actual or prospective earnings. 2. An efficient cash management through a relevant and timely cash budget may enable a firm to obtain optimum working capital and ease the strains of cash shortage, facilitating temporary investment of cash and providing funds for normal growth 3. Cash may be said to be like the blood stream in a living body, for it is very much the life blood of business. It must be kept circulating around the arteries of the business because if the circulation gets clogged, sickness and death may occur, as they do when a clot forms in an artery.

FINANCIAL MGMT. & MGMT. ACCOUNTING

4. The first priority of any business is survival and this cannot be assured, even in the short run, unless a company remains both liquid and solvent, that is, unless it is able to pay its debts as and when they fall due, both immediately and in the foreseeable future. 5. Cash management involves balance sheet changes and other cash flows that do not appear in the profit and loss account such as capital expenses. 6. It gives an inventory of the financial reserves which are available in the event of a recession. 7. It yields a plan as an integral part of the procedure. 8. It views problems in a dynamic context over a period of time. 9. It yields a number of additional insights into the crucial task of framing a sound debt policy. The focus is on the solvency of the firm in adverse circumstances rather than on the effects of leverage in normal circumstances. 10. While a regularization of cash flows enables a management to achieve a more effective planning, sophistication in handling cash enables a firm to cut down on the amount that it must keep in order to sustain any given level of operations.

Q.EXPLAIN THE DISADVANTAGES OF CASH MANAGEMENT 1. It may offer a solution of compensation which is not justified on the basis of a concrete notion, particularly when the business economy operates in an uncertain world. 2. It considers economic recession as the main source of uncertainty but ignores technological developments, shifts in consumer preferences, political changes etc. Moreover, recessions are not the only source of economic unhappiness. 3. The cost of holding cash is the profit that could have been earned had the funds been put to another use. 4. Financial distress usually is a matter of degree, while the declaration of the bankruptcy is an indication of this distress in an extreme form.

Middle firms of

financial distress occur when a firmâ&#x20AC;&#x2122;s cash flows falls below expectations. Costs of financial distress are thus related to modifications in investment and financial strategic made necessary by the conditions of distress.

Firms often encounter

conditions of financial distress which are sometimes mild and sometimes rather severe.

Q. EXPLAIN THE VARIOUS METHODS OF INVESTING SURPLUS FUNDS. WHAT CRITERIA SHOULD A FIRM USE IN INVESTING IN MARKETABLE SECURITIES? There are, sometimes surplus funds with the companies which are required after sometime. These funds can be employed in liquid and risk free securities to earn some income. There are a number of avenues where these funds can be invested. The selection

FINANCIAL MGMT. & MGMT. ACCOUNTING of securities or method of investment is very important.

99 Some of these methods are

discussed here with: 1. Treasury bills: The treasury bills are issued by RBI on behalf of the central government. Earlier they were issued on the basis of tender floated regularly but now are available on tap system, i.e., on rates announced by RBI every week. These bills are issued only in bearer form. Name of the purchaser is not mentioned on the bills, rather they are easily transferable from one investor to another. No interest is paid on the bills but the return is the difference between the purchase price and face (par) value of the bill. Since there is a backing of the central government, these are risk free securities. 2. Negotiable certificates of deposit (CDâ&#x20AC;&#x2122;s): The money is deposited in a bank for a fixed period of time and marketable receipt is issued. On maturity, the amount deposited and interest are paid. The CDâ&#x20AC;&#x2122;s are different from the treasury bills which are issued on discount. The short term surplus funds can be used to earn interest in this method. 3. Unit 1964 scheme: The Unit Trust of Indiaâ&#x20AC;&#x2122;s unit 1964 scheme is very popular for making short term investments. It is an open ended scheme which allows investors to withdraw their funds on a continuing basis. The units have a face value of Rs.10. The purchase and sale value of units is not based on net assets value but it is determined administratively in such a manner and they give rise gradually over time. 4. Ready forward: A commercial bank or some other organization may enter into a ready forward deal with a company willing to invest funds for a short period of time. Under this system the bank sells and repurchases the same security (that means that company purchases and sells securities in turn) at pre-determined prices. The difference between the purchase and sale price is the income of the company. Ready forwards are generally done in units, public sector bonds or government securities. 5. Badla financing: Badla financing is used in stock exchange transactions when a broker wants to carry forward his transactions from one settlement period to another.

Badla financing is done

through operators in stock exchange. It is the financing of transactions of a broker who wants to carry forward this deal to the other settlement period. The badla rates are decided on the day of settlement. Badla transactions are financed on the security of shares purchased whose settlement is to be carried forward. Sometime this financing facility may be extended for a particular share only. 6. Inter-Corporate deposits:

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These are short term deposits with other companies which attracts a good rate of return. Inter-corporate deposits are of three types: 7. Call deposits: It is a deposit which a lender can withdraw on one day’s notice. In practice it takes three days to get this money. The rate of interest at present is 14 percent on these deposits. 8. Three months deposits: These deposits are popular and are used by borrowers to tide over short-term inadequacy of funds. The interest rate on such deposits is influenced by bank overdraft interest rate and at present the borrowing rate is 22 percent per annum. 9. Six month deposits: The lenders may not have surplus funds for a very long period. Six-month period is normally the maximum which lenders may prefer. The current interest rate on these deposits is 24 percent per annum. Since inter-corporate deposits are unsecured loans, the creditworthiness of the borrower should be ascertained. 10. Bill discounting: A bill arises out of credit sales. The buyer will accept a bill drawn on him by the seller. In order to raise funds the seller may get the bill discounted with his bank. The bank will charge discount and release the balance amount to the drawer. These bills normally do not exceed 90 days. 11. Investment in marketable securities: A firm has to maintain a reasonable balance of cash. This is necessary because there is no perfect balancing of inflows and outflows of cash. Instead of keeping the surplus cash as idle, the firms tries to invest it in marketable securities. It will bring some income to the business. The cash surpluses will be available during slack seasons and will be required when demand picks up again.

The investment of this cash in securities needs a prudent and

cautious approach. The selection of securities for investment should be carefully made so that the amount is raised quickly on demand. 12. Money market mutual funds (MMMF): ‘Money market mutual fund’ means a scheme of a mutual and which has been set up with the objective of investing exclusively in money market instruments. These instruments include treasury bills, dated government securities with an expired maturity of upto one year, call and notice money, commercial paper, commercial bills accepted by banks and certificates of deposits. Till recently, only commercial banks and public financial institutions were allowed to set up MMMFs. But in November 1995, the government has permitted private sector mutual funds also to set up money market mutual fund. MMMFs are wholesale markets for low risk, high liquidity and short term securities. The main feature of this fund is the access to persons of small savings.

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RECEIVABLES MANAGEMENT Q.GIVE THE MEANING OF RECEIVABLESReceivable represent amount owed to the firm as a result of sale of goods or services in the ordinary course of business. These are claims of the firm against its customers and form part of its current assets. Receivables are also known as accounts receivables, trade receivables, customer receivables or book debts.

The receivables are carried for the

customer. The period of credit and extent of receivables depends upon the credit policy followed by the firm.

The purpose of maintaining or investing in receivables is to meet

competition, and to increase the sales and profits.

Q.GIVE THE MEANING AND OBJECTIVES OF RECEIVABLE MANAGEMENT Receivable management is the process of making decisions relating to investment in trade debtors. Certain investment in receivable is necessary to increase the sales and the profits of a firm. But at the same time investment in this asset involves cost considerations also. Further, there is always a risk of bad debts too. Objectives of receivables managementTo take a sound decision as regards investment in debtors It is to promote sales and profits until that point is reached where the return on investment in further funding of receivable is less than the cost of funds raised to finance that additional credit.

CREDIT POLICIES FOR MANAGING RECEIVABLES Q.DISCUSS

THE

VARIOUS

ASPECTS

DIMENSIONS

RECEIVABLES

MANAGEMENT Receivables management involves the careful consideration of the following aspects: 1. Forming of credit policy 2. Executing the credit policy 3. Formulating and executing collection policy

1.Forming of credit policy: a)Quality of trade accounts or credit standards: The volume of sales will be influenced by the credit policy of a concern.

liberalizing credit policy the volume of sales can be increased resulting into increased profits. The increased volume of sales is associated with certain risks too. It will result in enhanced costs and risks of bad debts and delayed receipts. There may be more bad debt losses due to extension of credit to less worthy customers. These customers may also take more time than normally allowed in making the payments resulting into tying up of additional capital in receivables. On the other hand, extending credit to only credit worthy customers will save costs like bad debt losses,

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collection costs, investigation costs etc. The restriction of credit to such customers only will certainly reduce sales volume, thus resulting in reduced profits.

b)Length of credit period: Credit terms or length of credit period means the period allowed to the customers for making the payment. The customers paying well in time may also be allowed certain cash discount. There is no binding on fixing the terms of credit. A concern fixes its own terms of credit depending upon its customers and the volume of sales. The customs of industry act as constraints on credit terms of individual concerns. A firm may allow liberal credit terms to increase the volume of sales. The lengthening of this period will mean blocking of more money in receivables which could have been invested somewhere else to earn income. A finance manager should determine the period where additional revenue equates the additional costs and should not extend credit beyond this period as the increase in cost will be more than the increase in revenue.

c)Cash discount: Cash discount is allowed to expedite the collection of receivables. The funds tied up in receivables are released. The concern will be able to use the additional funds received from expedited collections due to cash discount. The discount allowed involves cost. The financial manager should compare the earnings resulting from released funds and the cost of discount.

d)Discount period: The collection of receivables is influenced by the period allowed for availing the discount. The additional period allowed for this facility may prompt some more customers to avail discount and make payments. This will mean additional funds released from receivables which may be alternatively used.

2.Executing credit policy: After formulating the credit policy, its proper execution is very important.

The

evaluation of credit applications and finding the credit worthiness of customers should be undertaken.

a)Collecting credit information: The first step in implementing credit policy will be to gather credit information about the customers. This information should be adequate enough so that proper analysis about the financial position of the customers is possible. This type of investigation can be undertaken only upon a certain limit because it will involve cost. The cost incurred in collecting this information and the benefit from reduced bad

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debts losses will be compared. The credit information will certainly help in improving the quality of receivables but the cost of collecting information should not increase the reduction of bad debt losses. The proper analysis of financial statements will be helpful in determining the credit worthiness of customers. There are credit rating agencies which can supply information about various concerns. These agencies regularly collect information about business units from various sources and keep this information upto date. The interpreted information can be had from these agencies. These agencies supply this information to their subscribers on a regular basis through circulars, periodicals etc. The information is kept in confidence and may be used when required. Such agencies are not available in India at present, but countries like America have so many agencies in this field. Credit information may be available with banks too. The banks have their credit departments to analyse the financial position of the customer. In case of old customers, businessâ&#x20AC;&#x2122; own records may help to know their credit worthiness. The sales men of the business may also be asked to collect information about the customers.

b)Credit analysis: After gathering the required information, the finance manager should analyse it to find out the credit worthiness of potential customers and also to see whether they satisfy the standards of the concern or not.

The credit analysis will determine the degree of risk

associated with the account, the capacity of the customer to borrow and his ability and willingness to pay.

c) Credit decision: After analyzing the credit worthiness of the customer, the finance manager has to take a decision whether the credit is to be extended and if yes, then, upto what level. He will match the credit worthiness of the customer with the credit standards of the company. If customersâ&#x20AC;&#x2122; credit worthiness is above the credit standards, then there is no problem in taking decision. It is only in the managerial cases that such decisions are difficult to be made. In such cases, the benefit of extending credit should be compared to the likely bad debt losses and then a decision should be taken.

d)Financing investments in receivables and factoring: Account receivables block a part of working capital. Efforts should be made that funds are not tied up in receivables for longer periods. The finance manager should make efforts to get receivables financed so that working capital needs are met in time. The banks allow raising of loans against security of receivables. Generally, banks supply between 60 to 80 percent of the amount of receivables as loans against their security.

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The quality of receivables will determine the amount of loan. The banks will accept receivables of dependable parties only. Another method of getting funds against receivables is their outright sale to the bank. The bank will credit the amount to the party after deducting discount and will collect the money from the customers later. Here too, the bank will insist on quality receivables only. Besides banks, there may be other agencies which can buy receivables and pay cash for them. This facility is known as factoring. The factoring service varies from bill discounting facilities offered by commercial banks to a total take over of administration of the sales ledger and credit control functions.

3) Formulating and executing collection policy: The collection of amounts due to the customers is very important.

The concern

should devise procedures to be followed when accounts become due after the expiry of credit period. The collection policy be termed as strict and lenient. A strict policy of collection will involve more efforts on collection. Such a policy has both plus and negative effects. The policy will enable early collection of dues and will reduce bad debt losses. The money collected will be used for other purposes and the profits of the concern will go up. On the other hand a rigorous collection policy will involve increased collection costs. It may also reduce the volume of sales. The collection policy should weigh various aspects associated with it, the gains and losses of such policy and its effect on the finances of the concern. The collection policy should also device the steps to be followed in collecting over due amounts. The objective is to collect the dues and not to annoy the customer. The steps should be like  Sending a reminder for payments  Personal request through telephone etc.  Personal visits to the customers  Taking help of collecting agencies and lastly  Taking legal action. The last step should be taken only after exhausting all other means because it will have a bad impact on relations with customers. The genuine problems of customers should never be ignored while making collections. The aim should be to make collections and keep amiable relations with customers.

Q. DISCUSS THE ADVANATGES/BENEFITS OF RECEIVABLES MANAGEMENT. 1. It is an interesting fact that business enterprise have little or no understanding of this method of borrowing or of how simply their accounts receivables may be employed as a source of borrowing cash. 2. The assignment of accounts receivables furnishes additional operating cash, and there is no need for diluting the equity and control of owners. Moreover, small and

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medium size corporations find it difficult to raise additional to raise additional cash through security issues. 3. Small, medium size and even large corporations find it expensive to raise funds through long term debt. The accounts receivables financing arrangement provides a business firm with an established source of funds which may be used for long as well as short term purposes, and which does not obligate it to pay to money when it is not needed. 4. Accounts receivables financing is of a revolving nature and provides a continuous source of operating cash 5. It is flexible because borrowing under it may be continued throughout its life or used only temporarily to meet a constant need. 6. If a firm makes use of accounts receivables financing, it does not have to wait to get back the money it has invested in the goods it sells. It simply assigns the credit sales of its financing source. 7. With a wise use of debt capacity, as in the employment of accounts receivables, a firm will have more cash with which to take advantage of any profitable opportunities which may develop. 8. By using accounts receivables financing to release the money which has been invested in its receivables, a firm will have more cash with which to take advantage of any profitable opportunities which may develop. 9. It enables businessmen to protect and improve a firmâ&#x20AC;&#x2122;s credit rating, for the latter is in a position to pay bills on due dates. 10. A firm receives experienced business counsel and technical guidance, for it has to approach a specialized financing institution to obtain accounts receivables financing. 11. To obtain funds from accounts receivables financing, a businessman does not need to be one of the established customers.

Q.WRITE A NOTE ON THE COST OF MAINTAINING RECEIVABLES. The allowing of credit to customers means giving of funds for the customerâ&#x20AC;&#x2122;s use. The concern incurs the following cost on maintaining receivables: Cost of financing receivablesWhen goods and services are provided on credit then concerns capital is allowed to be used by the customers. The receivables are financed from the funds supplied by shareholders for long term financing and through retained earnings.

The concern incurs some cost for

collecting funds which finance receivable. Cost of collectionsA proper collection of receivable is essential for receivable management. The customers who do not pay the money during a stipulated credit period are sent reminders for early payments. Some persons may have to be sending for collecting these amounts. In some cases legal

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resources may have to be taken for collection receivables. All these costs are known as collection costs which a concern is generally required to incur. Bad debtsSome customers may fail to pay the amount due towards them. The amounts which the customers fail to pay are known as bad debts. Though a concern may be able to reduce bad debts through efficient collection machinery but one cannot altogether rule out this cost. FACTORS INFLUENCING THE SIZE OF RECEIVABLES Q. DISCUSS THE FACTORS WHICH INFLUENCING THE SIZE OF RECEIVABLES. Besides sales, a number of other factors also influence the size of receivables. The following factors directly and indirectly affect the size of receivables. Size of credit salesThe volume of credit sales is the first factor which increases or decreases the size of receivables. If a concern sells only on cash basis, as in the case of Bata Shoe Company then there will be no receivables. The higher part of credit sales out of total sales, figures of receivables will also be more or vice versa. Credit policiesA firm with conservative credit policy will have a low size of receivables while a firm with liberal credit policy will be increasing this figure. The vigour with which the concern collects the receivables also affects its receivables. If collections are prompt then even if credit is liberally extended the size of receivables will remain under control. In case receivables remain outstanding for a longer period, there is always a possibility of bad debts.

Terms of tradeThe size of receivables also depends upon the terms of trade. The period of credit allowed and rates of discount given are linked with receivables. If credit period allowed is more than receivables will also be more.

Expansion plansWhen a concern wants to expand its activities it will have to enter new markets. To attract customers it will give incentives in the form of credit facilities. The period of credit can be reduced when the firm is able to get permanent customers. In the early stage of expansion more credit becomes essential and size of receivables will be more. Relation with profitsThe credit policy is followed with a view to increase sales. When sales increase beyond a certain level the additional costs incurred are less than the increase in revenues. It will be beneficial to increase sales beyond a point because it will bring more profits. The increase in profits will be followed by an increase in the size of receivables or vice-versa

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Credit collection effortsThe collection of credit should be streamlined.

The customers should be sent

periodical reminders if they fail to pay in time. On the other hand, if adequate attention is not paid towards credit collection then the concern can land itself in a serious financial problem. An efficient credit collection machinery will reduce the size of receivables. If these efforts are slower then outstanding amounts will be more. Habits of customersThe paying habits of customers also have a bearing on the size of receivables.

The

customers may be in the habit of delaying payments even though they are financially sound. The concern should remain in touch with such customer and should make them realize the urgency of their needs.

FORECASTING OF RECEIVABLES Q.â&#x20AC;&#x153;RECEIVABLE FORECASTING IS IMPORTANT FOR THE PROPER MANAGEMENT OF RECEIVABLESâ&#x20AC;?- DISCUSS. (OR) Q. EXPLAIN THE FACTORS WHICH HELPS IN FORECASTING THE RECEIVABLES. The following factors will help in forecasting receivables Credit period allowedThe Aging of Receivables is helpful in forecasting. The longer the amounts remain due, the higher will be the size of receivables. The increase in receivables will result in more profits as well as higher costs too. The collection expenses and bad debts will also be more. If credit period is less, then the size of receivables will also be less. Effect of cost of goods soldSometimes an increase in sales results in decrease in cost of goods sold. It this is so then sales should be increased to that extent where costs are low. The increase in sales will also increase that amount of receivable. The estimate for sales will enable the estimation of receivables too. Forecasting expensesThe receivable are associated with a number of expenses. These expenses are administration expenses on collection of amounts, cost of funds tied down in receivables, bad debts, etc., at the same time the increase in receivables will bring in more profits by increasing sales. If the costs of receivables are more than the increase in income, further credit sales should not be allowed. On the other hand, if revenue earned by the increase in sales is more than the costs of receivables, then sales should be expanded. Forecasting average collection period and discountThe credit collection policies will spell out the time allowed for making payments and the time allowed for availing discounts. If average collection period is more, then the size of receivable will be more. Average collection period is calculated as follows:

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Average collection period = Trade debtors x No. of working days Net sales Average size receivableThe determination of average size of receivables will also be helpful in forecasting receivables. Average size of receivables is calculated as:

Average size of receivables =

Estimated annual sales x Average collection period. Problem .No.6 From the following information, calculate average collection period: Rs. Total sales

1,00,000

Cash sales

20,000

Sales returns

7,000

Debtors at the end of the year Bills receivables

11,000 4,000

Creditors

15,000

Solutions Average collection period = Trade debtors x No. of working days Net credit sales

Trade debtors

= Rs.11,000 + 4,000 = Rs.15,000

Net credit sales

= Rs.1,00,000 â&#x20AC;&#x201C; 20,000 â&#x20AC;&#x201C; 7,000 = Rs.73,000

Hence, Average Collection Period = 15,000 x 365 73,000 Or A.C.P = 75 days.

Problem .No.7 Bharat Ltd. decides to liberate credit to increase its sales. The liberalized credit policy will bring additional sales of Rs.3,00,000. The variable costs will be 60% of sales and there will be 10% risk for non-payment and 5% collection costs. Will the company benefit from the new credit policy? Solutions Rs. Additional sales revenue

3,00,000

Less: variable cost (60%)

1,80,000

Incremental revenue

1,20,000

Less: 10% for non-payment risk

30,000

FINANCIAL MGMT. & MGMT. ACCOUNTING

109 90,000

Less: 50% for costs of collection

15,000

Additional revenue from increased sales due to liberal credit policy

75,000

INVENTORY MANAGEMENT Q.GIVE THE MEANING AND NATURE OF INVENTORY: The dictionary meaning of inventory is ‘stock of goods, or a list of goods’. The word ‘Inventory’ is understood differently by various authors. In accounting language it may means stock of finished goods only. In a manufacturing concern, it may include raw materials, workin-progress and stores etc. To understand the exact meaning of the word ‘Inventory’ we may study it from the usage side or from the ‘side of point of entry’ in the operations. Inventory includes the following things. a)Raw material: Raw material form a major input into the organization. They are required to carry out production activities uninterruptedly.

The quantity of raw materials required will be

determined by the rate of consumption and the time required for replenishing the supplies. b)Work-in-progress: The work-in-progress is that stage of stocks which are in between raw materials and finished goods. The raw materials enter the process of manufacture but they are yet to attain a final shape of finished goods. c)Consumables: These are the materials which are needed to smoothen the process of production. These materials do not directly enter production but they act as catalysts etc. Consumables may be classified according to their consumption and criticality.

d)Finished goods: These are the goods which are ready for the consumers. The stock of finished goods provides a buffer between production and market. The purpose of maintaining inventory is to ensure proper supply of goods to customers. e)Spares: Spares also form a part of inventory.

The consumption pattern of raw materials

consumables, finished goods are different from that of spares.

The stocking policies of

spares are different from industry to industry. Some industries like transport will require more spares than the other concerns. The costly spare parts like engines, maintenance spares etc are not discarded after use, rather they are kept in ready position for further use.

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Q.DISCUSS THE PURPOSE OF HOLDING INVENTORIES. Although holding inventories involves blocking of a firm’s funds and the costs of storage and handling, every business enterprise has to maintain a certain level of inventories to facilitate uninterrupted production and smooth running of business. In absence of inventories a firm will have to make purchase as soon as it receives orders. it will mean loss of time and delays in execution of orders which sometimes may cause loss of customers and business. A firm also needs to maintain inventories to reduce ordering costs and avail quantity discounts etc. Generally speaking, there are three main purposes or motives of holding inventories. i) Transaction motive- The transaction motive which facilitates continuous production and timely execution of sales orders. ii) Precautionary motive-The Precautionary motive which necessitates the holding of inventories for meeting the unpredictable changes in demand and supplies of materials. iii) Speculative motive-The speculative motive which induces to keep inventories for taking advantages of price fluctuations, saving in re-ordering costs and quantity discounts, etc.

Q.DISCUSS THE RISK AND COSTS OF HOLDING INVENTORIES: The holding of inventories involves blocking of a firm’s funds and incurrence of capital and other costs.

It also exposes the firm to certain risks.

The various costs and risks

involved in holding inventories are as below: a)Capital costs: Maintaining of inventories results in blocking of the firm’s financial resources. The firm has therefore to arrange for additional funds to meet the cost of inventories. The funds may be arranged from own resources or from outsiders. But in both the cases, the firm incurs a cost. In the former case, there is an opportunity cost of investment while in the latter case, the firm has to pay interest to the outsiders. b)Storage and handling costs: Holding of inventories also involves costs on storage as well as handling of materials. The storage costs include the rental of the godown, insurance charges etc. c)Risk of price decline: There is always a risk of reduction in the prices of inventories by the suppliers in holding inventories. This may be due to increased market supplies. Competition or general depression in the market. d)Risk of obsolescence: The inventories may become obsolete due to improved technology, changes in requirements, changes in customer’s tastes etc. e)Risk deterioration in quality: The quality of the materials may also deteriorate while the inventories are kept in stores.

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Q. GIVE THE MEANING OF INVENTORY MANAGEMENT. Inventories often constitute a major element of the total working capital and hence it has been correctly observed, â&#x20AC;&#x153;Good inventory management is good financial managementâ&#x20AC;?. Inventory management covers a large number of issues including fixation of minimum and maximum levels; determining the size of the inventory to be carried; deciding about the issue price policy setting up receipt and inspection procedure; determining the EOQ; providing proper storage facilities, keeping check on obsolescence and setting up effective information system with regard to the inventories.

Q.EXPLAIN THE OBJECTS OF INVENTORY MANAGEMENT. The main objectives of inventory management are operational and financial. The operational objectives mean that the materials and spares should be available in sufficient quantity so that work is not disrupted for want of inventory. The financial objective means that the investments in inventories should not remain idle and minimum working capital should be locked in it. The following are the objectives of inventory management. 1. To ensure continuous supply of materials, spares and finished goods so that productions should not suffer at any time and the customers demand should also be met. 2. To avoid both over stocking and under stocking of inventory 3. To maintain investments in inventories at the optimum level as required by the operational and sales activities 4. To keep material cost under control so that they contribute in reducing cost of production and overall costs. 5. To eliminate duplication in ordering or replenishing stocks. This is possible with the help of centralizing purchases. 6. To minimize the losses through deterioration, pilferage, wastages and damages. 7. To design proper organization for inventory management. A clear cut accountability should be fixed at various levels of the organization. 8. To ensure perpetual inventory control so that materials shown in stock ledgers should be actually lying in the stores. 9. To ensure right quantity goods at reasonable prices. Suitable quality standards will ensure proper quality of stocks. The price analysis, the cost analysis and value analysis will ensure payment of proper prices. 10. To facilitate furnishing of data for short term and long term planning and control of inventory.

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Q.EXPLAIN THE VARIOUS INVENTORY CONTROL TECHNIQUES? Q.EXPLAIN IN DETAIL THE VARIOUS TOOLS AND TECHNIQUES OF INVENTORY MANAGEMENT. 1. DEMAND AND SUPPLY METHOD OF STOCK CONTROL: Levels of Stock & EOQ This method of inventory control utilizes the principles of planning the demand and supply of each item of inventory. The various levels of stock used in demand and supply method are explained in detail below: The purpose of inventory control is to maintain the stocks of raw materials as low as possible. At the same time, they must be made available as and when required by the production department. There may be overstocking or under stocking of materials if there is no proper planning. Proper maintenance of stock level of each type of material is the main function of the stores department. Following are the different levels of stock to be fixed by the store keeper for the purpose of material control. MAXIMUM LEVEL: This is the level above which the stock should not be allowed to exceed at any time. This is fixed by taking into account the following factors: 1) Availability of capital. 2) Storage space available. 3) Rate of consumption of material. 4) Seasonal price fluctuations. 5) EOQ 6) Possibility of change in fashion. 7) Government restrictions as in the case of explosive materials. 8) The cost of maintenance. 9) Time required to obtain fresh supply of material. Formula: Maximum level= Reorder Level + Reorder Quantity – (Minimum Consumption x Minimum Reorder Period) MINIMUM LEVEL (SAFETY STOCK) This is the level below which stock should not be allowed to fall at any time. If the stock goes below this level, there is a danger of stoppage of production for want of materials. This level is fixed by taking into account the following factors: 1. Rate of consumption of material 2. Time required to obtain fresh supply of material 3. Re-order level Formula: Minimum level = Reorder Level – (Normal Consumption x Normal Reorder Period)

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REORDER LEVEL /ORDERING LEVEL (= WHEN TO ORDER) This is the level at which a new order for material is to be placed by the store keeper. In other words, this is the level at which a purchase requisition is made out. It is fixed in between maximum level and minimum level to ensure that the stock on hand does not fall below the minimum level before the receipt of order material. This level is fixed by taking into account the following factors: 1. Rate of consumption of material 2. Minimum level 3. Delivery time 4. Variation in delivery time Formula: Re-order Level = Maximum Consumption x Maximum Reorder Period DANGER LEVEL: This is fixed below Minimum level. When the stock reaches this level, urgent action for purchase of material is taken. Formula: Danger level = Minimum Rate of Consumption x Emergency Delivery Time. AVERAGE STOCK LEVEL: This level indicates the average stock held by the firm. It is calculated as follows: Formula: Minimum Level + Â˝ of Reorder Quantity (or) (Maximum Level + Minimum Level) 2 Economic Order Quantity (EOQ) It is not a stock level. It is the ideal quantity of materials to be purchased at any time. If purchases are made in large quantities, the cost of holding the stock will be higher but the cost of purchasing would be less.

On the other hand, if purchases are made in small

quantities the cost of holding the stock will be less while the cost of purchasing would be high. Therefore the most economical size of order is that the costs of purchasing as well as the costs of holding will be at the minimum.

The EOQ is fixed in such a manner as to minimize the cost of ordering and carrying stock Ordering cost: These arise out of the following factors. a) Rent for the purchasing department. b) The salaries and wages of the staff in the department. c) The depreciation on the equipment and furniture. d) Postage and telephone bills. e) Stationery, travelling expenses and other consumables required by the staff. Inventory carrying cost: These arise out of the following factors:

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a) Loss of interest on the capital invested in materials. b) Rent for the storage space. c) Salaries of the store keeping department. d) Any loss due to pilferage and deterioration. e) Stores insurance charges. f)

Stationary etc used by the stores.

g) Taxes on inventories. EOQ is also known as standard order quantity, optimum quantity or economic lot size. As number of units per order is increased, ordering costs are reduced but at the same time carrying costs are increased as quantity of material kept in stores increases. With the equalization of ordering and carrying costs, the EOQ will be ascertained where the total cost of inventory will be minimum.

EOQ =

2AB CS

A=Annual Consumption or usage of Materials in Units B=Buying Cost per order C=Cost per unit S=Storage and Carrying Cost per Annum

Problem.No.8 From the following particulars calculate (a) Re-order level (b) Minimum level (c) Maximum level Normal usage 100 units per day Minimum usage-50 units per day Maximum usage-150 units per day Reorder quantity 400 units Re-order period-6 to 8 days Solution: Re-order Level = Maximum Consumption x Maximum Reorder Period = 150 x 8 = 1200 units Minimum level = Reorder Level – (Normal Consumption x Normal Reorder Period) =1200 – ( 100 x 7 ) = 1200 – 700 = 500 units Maximum level= Reorder Level + Reorder Quantity – (Minimum Consumption x Minimum

FINANCIAL MGMT. & MGMT. ACCOUNTING Reorder

115

Period)

= 1200 +400 – (50 x 6) = 1600 – 300 = 1300 units

Problem.No.9 The cost of goods sold of E.S.P limited is Rs.5,00,000. The opening inventory id Rs.40,000 and the closing inventory id Rs.60,000. Find out inventory turnover ratio. Solution: Inventory Turnover Ratio =

Cost of goods sold Average inventory at cost

= .

5,00,000

40,000 + 60,000 2

= 5,00,000 50,000

Problem.No.8 Calculate EOQ: Annual consumption 600 units Ordering cost Rs.12 per order Carrying cost 20% Price per unit Rs.20. Solution:

= 10 times

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EOQ =

116

2AB CS

EOQ =

2 x 600 x 12 20 x 20%

3,600

EOQ = 60 units ABC Analysis (control according to values) ABC analysis is also known a proportional parts value analysis. Under this method (Always Better Control) efficient control of store is required to give more care on costlier items. As such, on the basis of the value of different materials, items are grouped into three categories a) High Priced Materials (A) b) Medium Priced Materials (B) c) Low Priced Materials (C) The materials which are costlier and form a small part of the total inventory can be grouped under A. Greater degree of care should be taken in storing and in the case of such items marked ‘A’. For these category materials, high price has to be paid and the number of such items is usually large, marked ‘C’. The materials which have moderate value may be marked ‘B’.

JUST IN TIME INVENTORY (JIT) Business concerns are giving maximum attention to reducing stock levels by establishing cordial relationship with suppliers to arrange for frequent delivery of quantities. This is called just in time purchasing. The objective of JIT purchasing is to obtain delivery of materials immediately before their use.

VED Analysis: Vital, Essential and Desirable analysis is done mainly for control of spare parts. Spares are controlled on the basis of their importance. Vital spares are crucial for production. Non availability may stop production. The ‘stock out cost’ of these spares is very high. Essential spares are spares the ‘stock out’ of which cannot be sustained for more than a few hours and cost of loss of production is high. Desirable spares are needed, but their absence for a short time may not lead to stoppage of production.

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Some items of spares though negligible in value may be vital for production. Such items may not be given importance under ABC analysis method which operates on value based control. Automatic Order System: This method of inventory control is done with the help of computers. Orders for fresh purchases are automatically placed when the inventory reaches ‘Order Point Quantity’ (OPQ). For each type of material, records are maintained by data processing in the form of receipts and issues. This system ensures that materials are always promptly replaced. Ordering Cycle Method: In this method, the review of materials held in stock is done in a regular cycle. The length of cycle depends on the nature of material. Materials which are expensive and essential have a shorter review cycle and Non Vital Materials have longer review cycle. At the time of review order is placed to bring the inventory to the desired level. Min-Max Method: The demand and supply method is an improvisation of Min-Max method. In the MinMax method, each item of material is fixed with its Maximum and Minimum levels. When the quantity reaches Minimum level, an order is placed for such a quantity as would make the inventory reach its Maximum level. Inventory Turnover Ratio: Kohler defines inventory turnover ratio as “a ratio which measures the number of times a firm’s average inventory is sold during a year”. In his view the ratio is an indicator of a firm’s inventory management efficiency.

A high inventory turn over ratio indicates fast

movement of material. A low ratio on the other hand indicates over investment and blocking up of working capital.

Input Output Ratio Analysis: This is yet another method of inventory control. Input output ratio is the ratio of the quantity of material to production and standard material content of the actual output. This is possible in industries where the product and raw material are being expressed in same quantitative measurement such as kilograms, metric tonnes, etc. The input output ratio analysis indicates whether the consumption of actual material when compared with standards is favourable or adverse. Perpetual Inventory System: The ICMA defines Perpetual Inventory as “a system of records maintained by the control department which reflects the physical movement of stocks and their correct balance”. It is clear from the above definitions that perpetual inventory system: a) Is a method or system of recording materials b) Reflects the physical movement of materials and records the balance of material after every receipt and issue c) Facilitates regular checking and avoids the need for closing down for stock taking.

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The records forming part of the system are: (1) Bin Card maintained by the store keeper in which all the physical quantities of receipts, issues and balances are recorded; (2) Stores Ledger Cards maintained by the costing department in which quantities as well as values of receipts, issues and balance are recorded. Physical verification of the stores is also made by a programme of â&#x20AC;&#x2DC;continuous stock takingâ&#x20AC;&#x2122;.

VALUATION OF INVENTORIES Q.DESCRIBE THE DIFFERENT METHODS OF PRICING OF MATERIAL ISSUES/WRITE SHORT NOTES ON FIFO, LIFO, AND WEIGHTED AVERAGE/SIMPLE AVERAGE. The purchase prices of materials fluctuate on account of changes in the product prices, buying from different suppliers and on account of quantity and discounts. Because of price fluctuations, the stock may include several lots of the same material purchased at different prices. When these materials are issued to production. It is important to consider the correct price at which these materials are changed to production. The following are the different methods of pricing the material issues: First In First Out Method (FIFO): Under this method, materials are issued in the order in which they are received in the store. It means that the material received first will be issued first. Advantages: 1. This method is simple to understand and easy to operate. 2. The closing stock is valued at the current market price. 3. Since issues are priced at cost, no profit or loss arises from pricing. 4. This method is made suitable in time of falling prices. 5. Deterioration and obsolescence can be avoided. Disadvantages: 1. When prices fluctuate, calculation becomes complicated; this increases the possibility of clerical error. 2. During the period of price fluctuations, material charged to jobs vary. Therefore, comparison between jobs is difficult. 3. During the period of rising prices, product costs are understated and profits are overstated. This may result in payment of higher dividend out of capital.

Last In First Out Method (LIFO): This method is opposite to FIFO.

Here materials received last are issued first.

Issues are made from the latest purchases. Advantages: 1. Issues are based on actual cost. 2. Issue price reflects current market price 3. Product cost will be based on current market price and hence will be more realistic.

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4. There is no unrealistic profit or loss 5. Simple to operate if purchases are not many and prices are steadily on rising. 6. When prices are rising, this method is helpful in preparation of quotation on estimates. Disadvantages: 1. This method involves considerable clerical work 2. Under falling prices, issues are priced at lower prices and stocks are valued at higher rates. 3. Stock of material shown in the balance sheet will not reflect market price 4. Due to variation in prices, comparison of cost of similar jobs is difficult. 5. This method is not accepted by the income tax authorities.

Base Stock Method: Each business concern usually maintains a minimum quantity of material in stock. This minimum quantity is known as Base Stock. This stock will be used only when an emergency arises. This base stock is considered to be a fixed asset valued at cost price irrespective of the price fluctuations. The quantity in excess of this stock may be valued either by using FIFO or LIFO method. Base stock method is not an independent method. It operates in conjunction with either FIFO or LIFO. Hence the advantages and disadvantages relating to FIFO or LIFO are applicable.

Simple Average Method: The simple average is determined by adding different prices of materials in stock and dividing the total by number of prices. Quantity purchased in each lot is ignored. Advantages: 1. This method is simple to understand and easy to operate. 2. It reduces clerical work. 3. It is suitable when prices are stable. Disadvantages: 1. It does not take into account the quantities purchased. 2. The value of closing stock becomes unrealistic. 3. Material cost does not represent actual cost price. 4. When prices fluctuate, this method will give incorrect result.

Weighted Average Method: This is an improvement over the simple average method. This method takes into account both quantity and price for arriving at the average price. The weighted average is obtained by dividing the total cost of material in the stock by total quantity of material in the stock.

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Advantages: 1. It gives more accurate results than simple average prices, because it considers both quantity as well as price. 2. It evens out the effect of price fluctuations. All jobs are charged at average prices. So, comparison between jobs is more easy and realistic 3. It is suitable in the case of materials subject to wide price fluctuations. 4. It is acceptable to income tax authorities Disadvantages: 1. Stock on hand does not represent current market prices 2. When large number of purchases are made at different rates, the calculation is tedious. So there are more chances of clerical error. 3. With some approximation in average price, there will be profit or loss due to over or under charging of material cost to jobs.

Highest In First Out Method (HIFO) Under this method, materials of the highest price are issued first. According to this method, the closing stock will be of the minimum price or as low as possible. In short, after materials purchases at highest prices are exhausted, materials purchased at the next higher price are issued. This method is suitable for cost plus contracts, but is not common.

Standard Price Method The issue price of materials is predetermined or estimated in this method. The standard price is based on market conditions, usage rate, handling facilities, storage facilities etc. the materials are priced at standard price irrespective of price paid for various purchases.

Market price method In this method the prices charged to production are not costs incurred on the materials but latest market prices. The market prices may either be replacement prices or realizable prices. The replacement prices are used for the materials which are kept in stock for use in production and realizable prices are used for the goods kept for resale. The prices of issue for materials are always the replacement prices. The actual prices paid for acquiring the materials are not considered at the time of issue of materials.

Every issue is made at

the replacement price of that day. It reflects the latest price charged to production.This methjod is a check on the efficiency of the purchasing department

Q. ENUMERATE THE ADVANTAGES/BENEFITS OF INVENTORY MANAGEMENT. a) Elimination of waste in the use of materials. b) Reduction of risk of loss on account of theft, loss, fraud etc. c) Availability of the right quality of material in time.

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d) Avoidance of overstocking. e) Possibility of economic buying. f)

Reviewing and revising of product design and savings in material.

g) Quick and accurate availability of data relating to stores. h) Preventions of production delays.

Q. EXPLAIN THE SIGNIFICANT PROBLEMS OF INVENTORY MANAGEMENT. The inventory theory deals with the determination of optimal procedures for the procurement of the stocks of commodities to meet future demand there are different inventory problems, each varying from situation to situation which may be summed up as under: a) Knowledge of demand, certainty ,risk and uncertainty; b) Method of obtaining a commodity; c) The decision process; d) Analytical conveniences; fixed demand distribution over a period of time or varying demand distribution; e) Time lag in receiving an order; constant time lag or probability distribution. An analysis of inventory problems is fundamentally based on very simple, common sense observations-that in any genuine inventory problem whatsoever, there must be opposing costs. By this, we may think simply that there is a cost associated with doing “too large “and there is a cost associated with doing “too little”. Sometimes, there are several such costs; but there must always be at least one in each direction.

REGULATION OF BANK FINANCE Traditionally, industrial borrowers enjoyed a relatively easy access to bank finance for meeting their working Capital needs. Further , the case credit arrangement, the arrangement, the principal device through which such finance has been provided is quite advantageous from the point of view of borrowers Ready availability of finance in a fairly convenient form led to, in the opinion of many informed observes of the Indian banking scene, over borrowing by industry and deprivation of other sectors. Concerned about such a distortion in credit allocation, the Reserve Bank of India(RBI) has been trying, particularly from the mid-sixties onwards. To bring a measure of discipline among industrial borrowers and to redirect credit to the priority sectors of the economy. From time to time. The RBI has been issuing guidelines and directives to the banking sector towards this end. Important guidelines and directives have stemmed from the recommendations of certain specially constituted groups entrusted with the task of examining various aspects of bank finance to industry. In particular, the following committees have

significant shaped the

regulation of bank finance for working capital in India. The Dahejia committee, the Tandon committee, the Chore Committee, and the Marathe committee. The key elements of regulation are discussed below

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Norms for inventory and Receivables In the Mid-seventies, the RBI accepted the norms for raw materials, stock-in-progress, finished goods and receivables that were suggested by the Tandon committee for fifteen major industries. These norms were based inter alia on company finance studies made by the Reserve

Bank of India, the process periods in different industries, discussions with

industry exports and feed back received on the interim reports. These norms represented in maximum level for holding inventory and receivable in each period From the mid-eighties onwards, special comities were set up the RBI to prescribe norms for several other industries and revise norms for some industries covered by the Tandon committee. The presently, the RBI Has a standing committee which revises norms on an on going basis. However these norms are now regarded as guidelines. Banks have a discretion to discretion to deviate from the norms, taking into account the past holding levels and other factors. Maximum Premissible Bank Finance The Tandon Committee had suggested three methods for determining the maximum permissible bank finance (MPBF). To describe these methods, the following notation is used.

CA = Current assets as per the norms laid down CL

= Non bank current liabilities trade credit and provision

CCA= Core current assets-this represents the permanents component of the working capital.

The methods for determining the MPBF are described below Method1

MPBF =0.75(CA-CL)

Method2

MPBF =0.75 (CA)-CL

Method3

MPBF =0.75 (CA-CCA) â&#x20AC;&#x201C; CL

To illustrate the calculation of the MPBF under three method consider the data for Ambex company Current assets Raw materials

Rs (in millions) 18

Work-in-process

Finished Goods

Receivable (including bills discounted)

Other current assets

2 Total 50

Calculated on the basis of the study group norms or past level, whichever are lower.

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Current liabilities Trade creditors

Other current liabilities

Bank borrowings (including bills discounted)

25 Total 40

The MPBF of Ambex as per the three methods is as follows. Method1

=0.75(CA-CL) =0.75(50-15) =Rs 26/25Million

Method 2

= 0.75(CA)-CL =0.75(50)-15 Rs.22.5 million

Method3

0.75(CA-CCA)-CL =0.75(50-20)-15 =Rs 7.5 million

The second method has been adopted. Note that this method the minimum current ratio works out to be 1.33. An example will illustrate this point suppose the current assets and current liabilities(excluding banks finance)for a firm are 100 and 50 respectively. The MPBF will be. 0.75 (CL)-CA=0.75 (100) -50=25

This means that the current liabilities including MPBF will be: 50+25=75. Hence the current ratio works out to 100/75 =1.33 Forms of assistance Traditionally, banks credit to industry has been mainly in the forms of cash credit which was introduced by the Scottish bankers. Under the cash credit system, the bank barriers the responsibility of the cash management because the borrowers have the freedom determine their drawls within cash credit limit provided the bank. With a view to bringing about better discipline in the utilization of bank credit, in 1995 a ‘loan’system for delivery of bank credit was introduced. Under the new dispensation, with in the MPBF so arrived at in terms of the extant guidelines, bank/consortia/syndicates are required to restrict sanction of the cash credit limits to borrowers up to certain portion(which is currently 60 per Cent )2 of the MPBF. Where borrowers desire to avail of bank credit for the balance portion(which is currently 40 per cent) of MPBF. Or any part thereof this will be considered on merit by banks consortia/syndicates in the form of short-term loan (or loans) repayable on demand working capital purpose for a stipulated period. Banks consortia/syndicates will have the discretion to stipulate repayment of the short-term loan for working capital purpose by a borrower in instalments or by way of a “bullet” or “baloon” payment. In case the loan is repaid before the due date it will be credited the case credit account.

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Information and reporting systems The current information and reporting system followed by banks has been shaped largely by the chore committed recommendations. Its key components are as follows. 1. Quarterly information system –form1 this gives (I) the estimates of production and sales for the current year and the ensuing quarter, and (II) the estimates of current assets and liabilities for the ensuing quarter. 2. Quarterly information system –form2 this gives (I) the actual production and sales during the current year and for the latest completed year and (II) the actual current assets and liabilities for the latest completed quarter. 3. Half-yearly operating systems- Form III This gives natural operating performance for the of year ended against the estimates the for the same. 4. Half yearly funds flow statements – Form III B this give the sources and uses of funds for the half year ended against the estimates for the same. The thrust of the information and reporting system is (I) to strengthen the partnership between borrowers and banker, (II) to give the banker a deeper insight into operations and funds requirements of the borrower, and

(III) To enable the banker to monitor closely the

performance and efficiency for the borrower. Credit Monitoring Based largely on the recommendations of the marathe Commmittee the RBI replaced its credit Authorisation Scheme by its credit monitoring arrangement in 1988. under this, RBI does post-sanction scrutiny of working capitals limits provides by the banks beyond the prescribed cut-off levels. The key issues examined in his scrutiny are 

Whether the minimum current ratio is 1.33 ?



Whether the estimates of sales production profit, current assets and current liabilities are in Line with past trends? If any differ, what is the justification for the deviation



Whether units has complied with the Chore Committee information system requirements ?



Whether the renewal of limits is in time.



Whether the bank is following the for inventory and receivable prescribed by the RBI standing committee? If the banks of the different set of norms what is the justification the same?

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UNIT-V BUDGET & BUDGETARY CONTROL INTRODUCTION:A budget is a written plan covering projected activities of a firm for a definite period of time. It is a monetary & quantitative expression of business plans & policies to be pursued in the future period of time. A budget is prepared to have effective utilization of funds & for the realization of objective as efficiently as possible.

Q.GIVE THE MEANING & DEFINITION OF i. Budget ii. Budgeting iii. Budgetary control BUDGET A Budget is a numerical statement expressing the plans, policies & goals for a definite future period. A budget is a blue print of a plan expressed in quantitative terms. It forms the basis for the budgetary control. Definition I.C.M.A. defines a budget is “A financial and / or quantitative statement, prepared prior to a defined period of time, of the policy to be pursued during that period for the purpose of attaining a given objective”.

BUDGETING Budgeting means the process of preparing budgets. In other words, it is the technique of formulating budgets or it is an art of planning. Definition “The entire process of preparing the budget is known as budgeting”.

BUDGETARY CONTROL Budgetary control is the process of preparation of budgets for various activities & comparing the budgets figures for arriving at deviations if any, which are to be eliminated in future. Thus budget is a means & budgetary control is the end result. Budgetary control is a continuous process which helps in planning & coordination. It also provides a method of control. Definition I.C.M.A. defines budgetary control as “the establishment of budgets, relating the responsibilities of executives to the requirements of a policy, & the continuous comparison of actual with budgets results either to secure by individual action the objectives of that policy or to provide a basis for its revision”.

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Q.WHAT ARE THE ESSENTIAL FEATURES OF A BUDGET.  A budget is a financial statement but it can be a statement of quantities also with or without monetary data.  Budget is prepared for a particular period & it is prepared in advance.  Budget is a detailed plan of the policy to be pursued during the period for which the budget is prepared.  The function of the budget is to attain a specific objective.

Q. EXPLAIN THE OBJECTIVE OF BUDGETARY CONTROL.  To define the goal of the enterprise.  To provide long & short period plan for attaining these goals.  To co-ordinate the activities of different departments.  To operate various cost centres & department with efficiency & economy.  To eliminate waste & increase the profitability.  To estimate capital expenditure requirements of the future.  To centralize the control system.  To correct deviations from established standards.  To fix the responsibility of various individuals in the organization.  To ensure that adequate working capital is available for the efficient operation of the business.  To indicate to the management as to where action is needed to solve problems without delay.

Q. DISTINGUISH BETWEEN ESTIMATES, FORECASTS & BUDGETS. An ‘estimate’ is predetermination of future events either on the basis of guess work or following scientific procedure. ‘Forecast’ is an assessment of possible future events. ‘Budget’ is planning of future events. Forecasting precedes budgeting. Effective budgeting is based on efficient forecasting. In order to prepare a budget it is essential to forecast various important variables like Sales, Selling prices, availability of materials, prices of materials, wage rates etc.

Q. DISTINGUISH BETWEEN FORECAST & BUDGET:Both budgets & forecast are foreseeing the future events. Still there are number of difference between budgets & forecast. Forecasts

Budgets.

1. Forecasts are mostly concerned with

1. Budgets are concerned with planned

expected or probable events.

Events.

2. Generally forecasting is done for a long

2. Budgets are for a shorter, specification of

duration of time.

Time

3. Result of forecasting is planning.

3. Result of planning is budgeting.

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4. Forecasting is a mere estimation.

4. Budget is a target fixed for a period.

5. Forecasting does not act are as tool of

5. Budgets are the target against which

measurement.

actuals are compared.

6. Forecasting refers to events over which

6. Purpose of budget is to control the

there is no control.

Activities.

Q. WHAT ARE THE MAIN STEPS IN BUDGETARY CONTROL? 1. Establishment of budget for each section of the organization. 2. Recording of actual performance. 3. Continuous comparison of the actual performance with the budget. 4. In case there is a difference between actual & budgeted performance, taking suitable remedial action. 5. Revision of budgets if necessary.

Q. WHAT ARE THE ESSENTIALS OF A GOOD BUDGETARY CONTROL SYSTEM? A business budget is a detailed plan covering phases of operations for a definite future period. It is laying down of policies, plans, objectives & goals set in advance by the top management for the enterprises are a whole & for each segment.

The following are the essential requisite for implementary budgetary control successfully . Top management support The budgetary control system have continuous support of top management which can ensure its all round acceptance. Clearly defined organizational structure The authority and responsibility are to be properly defined to pin point the responsibility of specific individuals in key positions. Efficient Accounting System The accounting system should provide the required information in time. Reporting of deviations Efficient system has to be devised to reduce the difference between the budgets and actual performance . Motivation Staffs are to be appraised of the budgets and benefits they are going to derive directly or indirectly Realistic targets The targets set should be realistic so that they are achievable and budgets should not frustrate the workers by fixing unrealistic targets. Participation of all departments concerned

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Budgets are to be set for all the departments so that their participation in implementation will be effective. Flexibility Budgets are prepared on the basis of certain conditions. If there is change in the conditions budgets also should be adjusted to accommodate the changes.

Q. BRIEFLY DISCUSS THE STEPS IN THE INSTALLATION OF A SYSTEM OF BUDGETARY CONTROL. The following steps should be taken in a sound system of budgetary control.

1. Organization Chart: There should be a well defined organization chart for budgetary control. This will show the authority & responsibility of each executive.

2. Budget Centre: A budget centre is that a part of the organization for which the budget is prepared. A budget centre may be a department or a section of a department. (e.g., Production department or Purchase section). The establishment of budget centre is essential for covering all Parts of the Organization. The budget centre are also necessary for cost control purpose. The evaluation of performance becomes easy when different centres are established. 3. Budget Committee: In small companies, the budget is prepared by cost accountant. But in big companies the budget is prepared by the committee. The budget committee consists of a chief executive or managing director, budget officer & the managers of various departments. The managers of various departments prepare their budgets & submit them to their committee. The committee will make their necessary adjustments, co-ordinates all the budgets & prepare a Master budget. The main functions of the committee are 1. To receive & scrutinize all budgets. 2. To decide the policy to be followed. 3. To suggest revision of functional budgets wherever necessary. 4. To approve the finally revised budget. 5. To prepare the Master Budget after functional Budgets are approved. 6. To coordinate the budget programme. 7. To study variations of actual performance from the Budget. 8. To recommend corrective action if and when required. 4. Budget Manual:Budget manual is a book which contains the procedure to be followed by the executives concerned with the budget. It guides the executive in preparing various budgets. It

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is the responsibility of the budget officer to prepare and maintain the manual. The budget manual may contain the following particulars: A Brief explanation of the objectives and principles of budgetary control.  Duties and powers of the budget officer.  Functions and duties of the budget committee.  Budget period.  Accounts classification.  Reports, Statements, Forms and Charts to be used.  Procedure to be followed for obtaining approval. 5. Budget Period:Budget period is the length of time for which a budget is prepared and employed. It may be different in the same Industry or business. The budget period depends upon the following factors. 1. The type of Budget, whether it is a sales Budget, Production Budget, Raw Material Budget or Capital expenditure Budget. A Capital Budget may be for a long period. i.e. 3 to 5 years. Purchase & sales Budget may be for one year. 2. The nature of the demand for the product. 3. The timing for the availability of finance. 4. .The length of the trade cycle. All the above factors are taken into account by fixing the budget period. 6. Key Factor:It is also known as limiting factor or governing factor or principal factor . Key factor is one which restricts the volume of production. It may arise due to the shortage of material, labour, capital, plant capacity or sales.

It is a factor which affects all other Budgets.

Therefore the budget relating to the key factor is prepared before the other budgets are framed.

Q. WHAT ARE THE ADVANTAGES OF BUDGETARY CONTROL?  Budgetary control system defines the policies & objectives of the undertaking as a whole.  It co-ordinates the activities of different departments.  It develops the systematic organization by establishing responsibilities & authorities to departments & executives.  It leads to planned allocation of scarce resources & production facilities.  It sets out plans of action & targets to be achieved by the departments as well as individuals. Therefore everyone knows for what he is responsible & how mush he should do for it, for which a team spirit will be developed.  It promotes efficiency of & economy by creating cost conscious among employees.  It helps in measuring the efficiency of departments & individuals in achieving the budget targets.

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 It facilitates centralized control with decentralized activity.  It facilitates introduction of standard costing.  It acts as an internal audit by continuous scrutiny of departmental results & leads to introduction of intensive remuneration system based on performance.  It reveals whether the things are moving in right direction or not by pin pointing deviation of actual results from budgets.

Q. DISCUSS THE LIMITATIONS OF BUDGETARY CONTROL.  The preparation of a budget under inflationary conditions & changing government policies is really difficult.

Thus, the accurate position of the business cannot be

estimated.  Accuracy in budgeting comes through experience. Hence it should not be relied on too much in the initial stages.  Budget is only a management tool. It is not a substitute for management in decisionmaking.  Budgeting involves heavy expenditure, which small concerns cannot afford.  There will be active & passive resistance to budgetary control as it points out the efficiency or inefficiency of individuals.  The success of budgetary control depends upon willing co-operation & team work. This is often lacking.

Classification and preparation of various budgets Q. BRIEFLY EXPLAIN THE DIFFERENT TYPES OF BUDGETS. A. CLASSIFICATION ACCORDING TO TIME:1. Short period budget:Long term budgets are prepared to reflect long term planning of the business. Generally, the long-term period varies between 5 to 10 years. They are prepared by top level Management. Example-Capital expenditure, R&D budgets. 2. Short term budgets:These budgets are generally for a duration of one year and are expressed in Monetary terms. 3. Current Budgets:The duration of current budgets is generally in months and weeks. These budgets are prepared for the current operation of the business. FUNCTIONAL BUDGETS B. CLASSIFICATION ACCORDING TO FUNCTION:A functional budget is a budget which relates to any of the functions of an organization. The following are commonly used functional budgets. 1. Sales Budget:-

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A Sales Budget is an estimate of expected sales during a budget period. It is expressed either in monetary or in quantitative terms. A Sales budget is known as a nerve centre or backbone of the enterprise. It contains information relating to sales, month wise, product wise, and area wise. This Budget is prepared by the Sales manager with the help of some top Management Staff and Executives. The Sales Budget may be classified in the following manner. 1. Products. 2. Area of Territories. 3. Salesmen or Agent. 4. Types of customers and 5. Periods (Example weekly, monthly, quarterly, half yearly, & annually)

This Budget is prepared by the sales manager taking into account by the following:1. Past sales figures 2. Salesmen estimates 3. Plant capacity 4. Availabilty of raw materials 5. Seasonal Fluctuation. 6. Availability of finance. 7. Competiton. 8. Orders on Hands. 9. Other factors like political conditions government policies, etc.,

2. Production Budget:It is a Budget prepared by the production manager showing the forecast of output. The objective is to determine the quantity of production for a budgeted period. It is in quantity of units to be produced during the budget period. It is based on the sales budget. Apart from the sales budget, optimum utilization, of plant, availability of raw materials, labour are to be considered. It must avoid over work in rush seasons. It must maintain stock of finished goods.

3. Material Budget:To carry out the production satisfactorily regular supply of materials during the budget period is ensured by preparing by a Budget. In this, the decision regarding the quantity of materials as shown at different time during that period is followed. Only direct materials are taken into account, indirect materials are not taken into account and they are considered under overheads. The material budget helps proper planning of purchases. It shows the estimated quantities as well as the cost of raw materials required for production budget.

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4. Labour Budget:It is a part of the Production budget.

The budget is prepared by the personnel

department and it shows an estimate of the requirements of labour to meet the production target on the basis of previous records and budgeted production. This budget gives detailed information relating to the number of workers, rates of wages and cost of labour hours to be employed.

5. Worker overhead budget:It sets out the estimated cost of indirect materials, indirect labour, and indirect factory expenses during the budget period in order to achieve the target. This is classified into fixed, variable and semi variable. This facilitates preparation of budgets and further department wise and subdivision to have effective control.

6. Administrative expenses budget:The budget is an estimate of administrative expenses to be incurred in the budget period. Eg. Rent, salaries, insurance etc.,

7. Selling and distribution overhead budget:This budget relates to selling and distribution of products for the budget period and is based on sales budget. It is generally prepared territory wise by the sales manager of each territory. The costs are divided into fixed, variable and semi variable and estimate is taken on the basis of past records. 8. Capital Expenditure Budget:This budget shows the estimated budget on fixed assets, land, building, plant, and machinery etc. It is a long term budget. The capital expenditure is necessitated on account of replacement of old machines, increased demand of products, expansion of industry adoption of new technological progress etc., 9. Cash Budget:This budget represents the amount of cash receipts and payments and balance during the budgeted period. It is prepared after all the functional budgets are prepared by the chief accountant either monthly or weekly giving the following hints a.

It ensures sufficient cash for business requirements

It proposes arrangements to be made over draft to meet any shortage of cash.

It reveals the surplus amount and the effect of the seasonal fluctuations on cash

positions. The objective of cash budget is proper coordination of total working capital sales, investment and credit. 10. Master Budget:-

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Finally, master budget is prepared incorporating all functional budgets. It is defined as “the summary budget incorporating the functional budget which is finally approved, adopted and employed”. The budget may take the form of budgeted profit and loss account & balance sheet. It contains Sales, production cost, cash position, debtors, fixed assets, bills payable etc. It also shows the gross and the net profits and the important accounting ratios. It has to be approved by the board of directions before it is put into operation.

C. CLASSIFICATION ACCORDING TO FLEXIBILITY:1. Fixed Budget:Fixed Budget is also called static budget. It may be defined as “a budget designed to remain unchanged irrespective of the level of activity actually attained”. This budget is most suitable for fixed expenses, which have no relation to the volume of output. It is useful for comparison with actual performance when the level of activity changes. 2. Flexible Budget:Flexible budget is also called variable budget. It may be defined as “A budget designed to change in accordance with the level of activity actually attained”. It shows estimated costs and profit at different levels of output. It facilitates comparison of actual performance with the budget at any level of output. To prepare flexible budget, all costs should be classified into fixed, variable and semi-variable.

This budget is used in the following cases:o

Where sales cannot be accurately predicted because of the nature of business.

Where the concern is suffering from shortage of materials, labour, plant capacity etc.,

Where production during the year varies from period to period, due to the seasonal nature of the industry.

Where it is difficult to forecast the demand accurately.

ZERO BASE BUDGETING Q. WHAT IS ZERO-BASE BUDGETING (ZBB) ? Zero Base Budgeting is a management technique aimed at cost reduction and optimum utilization of resource. This technique was introduced by the US department of agriculture in 1961. Peter.A. Phyrr designed its basic frame work in 1970 and popularized its wider use in the private sector. In 1979, President Jimmy Carter issued a mandate asking for the use of ZBB throughout the federal government agencies for controlling state expenditure. The technique has become quite popular in the US.

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Meaning:The traditional technique of budgeting is to take previous year’s cost levels as a base for preparing this year’s budget. This type of budgeting assumes that allocation of funds in the past was correct. In most cases, an addition is made to the previous years figure to allow for an increase in cost. Because of this, budgets (particularly government budgets) take an upward direction inspite of declining efficiency year after year. Thus, the inefficiency of a previous year are carried forward in formulating the subsequent year’s budget. Managers tend to inflate their budget requests resulting more demand for funds. ZBB is starting from scratch. Every year is taken as a new year and previous year is not taken as the base in the preparation of budget. Rather Zero is taken as base. Something will not be allowed simply because it was allowed in the past. A manager has to justify why he wants to spend. The manager proposing an expenditure or activity has to prove that it is essential and the amounts asked for are reasonable.

Definition:Zero based budgeting is defined as “a planning and budgeting process which requires each manager to justify his entire budget required in detail from scratch (hence Zero base) and shifts the burden of proof to each manager to justify why he should spend money at all. The approach requires that all activities be analyzed in decision packages which are evaluated by systematic analysis and ranked in the order of importance.”

-Peter.A.Phyrr.

Q. ENUMERATE THE STEPS IN ZERO BASE BUDGETING.  The objective of zero base budgeting should be well defined. When the objective is clear, efforts will be made to achieve that objective.  A cost benefit analysis should be undertaken.  The extent to which zero base budgeting is to be applied should be designed.  Only those projects should be taken first where the net benefit is more compared to other projects. It helps in fixing priority on the basis of benefits and then utility.

Q. WHAT ARE THE USES OF ZBB. 

It enables management to allocate funds according to the jurisdiction of the programme. Priority can be fixed for various activities & funds can be allocated accordingly.



It does not perpetuate inefficiency by carrying it forward to the next budgeting period.



It improves the efficiency of the management as each manager has to justify the demand for resources. Only those activities will be undertaken which will have justification & will be essential for the business.



It brings to light inflated budget allotment requests. It is well suited to such activities such as marketing, administration, servicing etc.

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

It helps in identifying economic & uneconomic areas.



Management will be able to make optimum use to resources. A list of priorities will be prepared & cost benefit analysis will be the guiding principle in fixing the priority.



It is the most effective technique as it aims at finding out the best alternative use of the scarce resources of the concern.

Q. DISCUSS THE LIMITATIONS OF ZBB. 1. Time consumingZBB requires more time than the traditional budgeting as there is no basis on which estimates are to be made. Moreover the process of ZBB is lengthy & time consuming as it involves classification of decision formulation of decision packages & ranking of decision units. 2. Lack of skilled managerial personnelIt requires skilled managers at all levels of the organization. In practice, skilled managerial personnel may not be available. 3. Limited applicationIt cannot be directly applied to direct material, direct wages & overheads associated with production function. Problem.No.1 BPL Ltd. Wishes to arrange overdraft facilities with its bankers during the period April to June 2000 when it will be manufacturing mostly for stock. (a) Prepare a cash budget for the above period from the following data, indicating the extent of the bank facilities the company will require at the end of each month: Credit sales

Purchases

Wages

Rs.

February 2000

1,80,000

1,24,000

12,000

March

1,92,000

1,44,000

14,000

April

1,08,000

2,43,000

11,000

May

1,74,000

2,46,000

10,000

June

1,26,000

2,48,000

15,000

(b) 50 percent of credit sales are realized in the month following the sales and the remaining 50 per cent in the second month following. Creditors are paid in the month following the month of purchase. Wages are paid at the end of the respective month. (c) Cash at bank on 1-4-2000(estimated) Rs.25,000.

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Solution: BPL Ltd. Cash Budget for 3 months ending June 2000 April

May

June

Rs.

Opening balance

25,000

53,000

-----

90,000

96,000

54,000

96,000

54,000

87,000

2,11,000

2,03,000

1,41,000

14,000

11,000

10,000

1,44,000

2,43,000

2,46,000

1,58,000

2,54,000

2,56,000

53,000

(51,000)

(1,15,000)

51,000

1,15,000

Receipts: Realization from Debtors

Total

Payments: Wages Purchases

Total

Surplus or (Deficit)

------

Estimated overdraft (assumed)

53,000

-----

Closing balance

Note: It is assumed that payment of wages and for purchases are made in the following month.

Problem.No.2 Summarized below are the income and expenditure forecasts of Gemini ltd. For the month of March to August,2000. Month

Sales

Purchases

(credit)

(all credit)

March

60,000

36,000

April

62,000

May

Wages

Manufacturing

Office

Selling

expenses

9,000

4,000

2,000

4,000

38,000

8,000

3,000

1,500

5,000

64,000

33,000

10,000

4,500

2,500

4,500

June

58,000

35,000

8,500

3,500

2,000

3,500

July

56,000

39,000

9,500

4,000

1,000

4,500

August

60,000

34,000

8,000

3,000

1,500

4,500

You are given the following further information: (a) Plant costing Rs.16,000 is due for delivery in July payable 10% on delivery and the balance after three months. (b) Advance tax of Rs.8,000 is payable in march and June each.

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(c) Period of credit allowed(i) by suppliers 2 months and (ii) to customers 1 month. (d) Lag in payment of manufacturing expenses Â˝ month. (e) Lag in payment of all other expenses 1 month. st

You are required to prepare a cash budget for three months starting on 1 May, 2000 when there was a cash balance of Rs.8,000. Solution:

GEMINI LIMITED Cash budget for the quarter ended 31 July, 2000 May

June

July

Rs.

Receipts : Opening Balance

8,000

15,750

12,750

62,000

64,000

58,000

70,000

79,750

70,750

36,000

38,000

33,000

Wages

8,000

10,000

8,500

Manufacturing Expenses

3,750

4,000

3,750

Office Expenses

1,500

2,500

2,000

Selling Expenses

5,000

4,500

3,500

Debtors Total

Payments: Creditors

Advance Tax

------

8,000

------

Delivery of plant (10% payment of delivery) Total Closing Balance

------

1,600

54,250

67,000

52,350

15,750

12,750

18,400

Problem.No.3 Draw up a flexible budget for overhead expenses on the basis of the following data and determine the overhead rates at 70%, 80% and 90% plant capacity.

particulars

At 70%

At 80%

At 90%

capacity

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Variable overheads Indirect labour

12,000

Stores including spares

4,000

Power (30%, 70% variable)

20,000

Repairs and maintenance(60%fixed,40%variable)

2,000

Depreciation

11,000

Insurance

3,000

Salaries

10,000

Semi variable overheads

Fixed overhead

Total overheads

62,000

Estimated direct labour hours: 1,24,000 hrs. Solution: Flexible Budget for the period -------

At 70%

At 80%

At 90%

Capacity

Rs.

Variable Overheads: Indirect labour Stores including spares

10,500

12,000

13,500

3,500

4,000

4,500

6,000

12,250

14,000

15,750

1,200

700

800

900

11,000

3,000

10,000

-------------

------------

58,150

62,000

65,850

-------------

------------

1,08,500

1,24,000

1,39,500

Rs. 0.536

Rs. 0.500

Rs. 0472

Semi – Variable Overheads: Power – Fixed Variable Repairs and Maintenance Fixed Variable Fixed Overheads: Depreciation Insurance Salaries

Total Overheads

Estimated direct labour hours Direct labour hour rate

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Working:

Direct labour rates have been computed as follows: At 70% capacity =

Rs. 58,150 =

Re. 0.536

1,08,500 hrs. At 80% capacity =

Rs. 62,000 =

Re. 0.500

1,24,000 hrs. At 90% capacity =

Rs. 65,850

= Re. 0.472

1,39,500 hrs.

Problem.No.4 The expenses for budgeted production of 10,000 units in a factory are furnished below: Per unit(Rs) Material

Labour

Variable overheads

Fixed overheads(Rs. 1,00,000)

Variable expenses(direct)

Selling expenses(10% fixed)

Distribution expenses(20% fixed)

Administration expenses

Total cost per unit

155

Prepare a budget for production of: a)8,000 units b)6,000 units c) Indicate cost per unit at both the levels. Assume that administration expenses are fixed for all levels of production. Solution

Per

Total

Per

Total

Per

Total

Unit

Amount

Unit

Amount

Unit

Amount

Production expenses:

Rs.

Materials

70.00

7,00,000

70.00

5,60,000

70.00

4,20,000

Labour

25.00

2,50,000

25.00

2,00,000

25.00

1,50,000

Overheads

20.00

2,00,000

20.00

1,60,000

20.00

1,20,000

5.00

50,000

5.00

40,000

5.00

30,000

10.00

1,00,000

12.50

1,00,000

16.667

1,00,000

1.30

13,000

1.625

13,000

2.167

13,000

11.70

1,17,000

11.70

93,600

11.70

70,200

1.40

14,000

1.750

14,000

2.334

14,000

Direct variable exp Fixed Overheads: Selling expenses: Fixed Variable Distribution expenses: Fixed Variable

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140

5.60

56,000

5.600

44,800

5.600

33,600

5.00

50,000

6.250

50,000

8.333

50,000

155.00

15,50,000

159.425

12,75,400

166.801

10,00,800

Working:

Fixed expenses remain fixed irrespective of the level of output. Selling expenses Rs.13; Variable expenses per unit is constant. Fixed 10% (i.e., 13 x 10/100) = Rs. 1.30

For 10,000 units = 10,000 x 1.30 = Rs.13,000

Variable 90% (i.e., 13 x 90/100 )= Rs.11.70 Fixed Budget Problem.No.5 A company which supplies its output on contract basis as component to an assembling firm has a contract to supply 10,000 units of its only product during 1999. The following were the budgeted expenses and revenue. Material

Rs. 15 per unit

Wages

Rs. 10 per unit

Works expenses â&#x20AC;&#x201C; (Fixed)

Rs. 40,000

Variable General expenses (all fixed)

Rs. 4 per unit Rs. 60,000, Profit is 20% on sale price. Prepare

the budget for 1999 showing the costs and profit. Master Budget Particulars

Output 10,000 units Total Rs.

Per unit

Materials

1,50,000

15.00

Wages

1,00,000

10.00

2,50,000

25.00

40,000

4.00

40,000

4.00

3,30,000

33.00

60,000

6.00

3,90,000

39.00

97,500

9.75

4,87,500

48.75

Prime cost Add: Works expenses : Fixed Variable

Works cost Add: General expenses Total cost Add: Profit 3,90,000 x 20/(100 â&#x20AC;&#x201C; 20) Sales

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PERFORMANCE BUDGETING The main emphasis of budgeting is to control organizational activities and related expenditure. Budgets are mainly used in government administrative activities to control financial expenditure and much significance is laid on financial aspects. Traditional budgeting does not relate financial input and physical output. Performance budgeting is designed to overcome this limitation of traditional budgeting. The term â&#x20AC;&#x2DC;performanceâ&#x20AC;&#x2122; was originally used in the U.S.A by the first Hoover Commission in 1949 when it recommended the utilization of budgets function wise for specific programmes and different activities the emphasis of performance budgeting is incorporation of financial and physical activities. The financial and physical aspects are correlated by establishing relationship between outputs and inputs. Performance budgeting results in a budget which presents the operations of an enterprise in terms of functions, programmes, activities and projects. Performance budgeting determines targets in respect of various responsibility levels. The measurement of actual performance both in terms of physical and financial terms in relation to budgets is the main feature of performance budgeting. The important features of performance budgeting are as follows: a) Specific job or work to be executed is predetermined. b) Function wise estimation of targets both in terms of financial as well as physical aspects. c) Determination of techniques of measurement of output in relation to input.

Important elements of performance budgeting 1. Laying down of objectives: Performance budgeting involves evaluation of performance of an enterprise in the context of both specific and overall objectives of an organization. The prerequisites of the performance budgeting is to define the objectives of the enterprise. This sets the frame work for the specification of objectives for individual activities and projects. 2. Classification of activitiesAppropriate classification of activities is to be incorporated in performance budgeting. The classification is done by functions and subdivision is done into programmes, activities and projects. This classification is done to integrate physical and financial aspects of each activity and programme. 3. Fixation of standards For objective working of performance budgeting, physical targets are set for each programmes or activity and incorporation of financial estimation is also done. Efficiency of performance budgeting depends on evolving suitable work measurement units, norms, yardsticks, standards and other performance indicators. 4. Accounting systemThe performance of different activities in financial terms will be revalued by good accounting system as the accounting structure reveals function wise financial details of activities.

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5. Decentralized responsibility structure and delegationThe decentralized style of management is the essence of performance budgeting. Decentralized responsibility structure necessitates the delegation of financial power down the line commensurate with the responsibilities with the responsibilities to be carried out at different levels. 6. Performance reportingEffective reporting system is very much essential in performance budgeting. Meaningful information reporting down the line is essential for decision and control. It is also essential for performance evaluation. effective reporting helps in comparison of targets with actuals and spotting of variances. On receipt of reporting of variances decisions at various levels are exercised to pin point the responsibility and taking of remedial measures. Purposes of performance budgeting: the main purposes of performance budgeting are as under: 1. To integrate physical and financial aspects of each activity and programme. 2. To improve the budgeting at various levels. 3. To facilitate performance audit and to make it more effective. 4. To compare the performance against short-term and long-term objectives.

ETHIC IN FINANCE Ethics in general is concerned with human behavior that is acceptable or "right" and that is not acceptable or "wrong" based on conventional morality. General ethical norms encompass truthfulness, honesty, integrity, respect for others, fairness, and justice. They relate to all aspects of life, including business and finance. Financial ethics is, therefore, a subset of general ethics. Ethical norms are essential for maintaining stability and harmony in social life, where people interact with one another. Recognition of others' needs and aspirations, fairness, and cooperative efforts to deal with common issues are, for example, aspects of social behavior that contribute to social stability. In the process of social evolution, we have developed not only an instinct to care for ourselves but also a conscience to care for others. There may arise situations in which the need to care for ourselves runs into conflict with the need to care for others. In such situations, ethical norms are needed to guide our behavior. "Ethics represents the attempt to resolve the conflict between selfishness and selflessness; between our material needs and our conscience." Ethical dilemmas and ethical violations in finance can be attributed to an inconsistency in the conceptual framework of modern financial-economic theory and the widespread use of a principal-agent model of relationship in financial transactions. The financial-economic theory that underlies the modern capitalist system is based on the rationalmaximizer paradigm, which holds that individuals are self-seeking (egoistic) and that they behave rationally when they seek to maximize their own interests. The principal-agent model of relationships refers to an arrangement whereby one party, acting as an agent for another,

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carries out certain functions on behalf of that other. Such arrangements are an integral part of the modern economic and financial system, and it is difficult to imagine it functioning without them. The behavioral assumption of the modern financial-economic theory runs counter to the ideas of trustworthiness, loyalty, fidelity, stewardship, and concern for others that underlie the traditional principal-agent relationship. The traditional concept of agency is based on moral values. But if human beings are rational maximizers, then agency on behalf of others in the traditional sense is impossible. The ethical dilemma presented by the problem of conflicting interests has been addressed in some areas of finance, such as corporate governance, by converting the agency relationship into a purely contractual relationship that uses a carrot-and-stick approach to ensure ethical behavior by agents. In corporate governance, the problem of conflict between management (agent) and stockholders (principal) is described as an agency problem. Economists have developed an agency theory to deal with this problem. The agency theory assumes that both the agent and the principal are self-interested and aim to maximize their gain in their relationship. A simple example would be the case of a store manager acting as an agent for the owner of the store. The store manager wants as much pay as possible for as little work as possible, and the store owner wants as much work from the manager for as little pay as possible. This theory is value-free because it does not pass judgment on whether the maximization behavior is good or bad and is not concerned with what a just pay for the manager might be. It drops the ideas of honesty and loyalty from the agency relationship because of their incompatibility with the fundamental assumption of rational maximization. Most of our needs for financial servicesâ&#x20AC;&#x201D; management of retirement savings, stock and bond investing, and protection against unfore-seen events, to name a fewâ&#x20AC;&#x201D;are such that they are better entrusted to others because we have neither the ability nor the time to carry them out effectively. The corporate device of contractualization of the agency relationship is, however, too difficult to apply to the multitude of financial dealings between individuals and institutions that take place in the financial market every day. Individuals are not as well organized as stockholders, and they are often unaware of the agency problem. Lack of information also limits their ability to monitor an agent's behavior. Therefore, what we have in our complex modern economic system is a paradoxical situation: the ever-increasing need for getting things done by others on the one hand, and the description of human nature that emphasizes selfish behavior on the other. This paradoxical situation, or the inconsistency in the foundation of the modern capitalist system, can explain most of the ethical problems and declining morality in the modern business and finance arena.

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UNIT – VI MANAGEMENT ACCOUNTING 1. INTRODUCTION:Management Accounting is a primarily concerned with providing information relating to the conduct of the various aspects of a business like cost or profit associated with some portions of business operations to the internal parties viz; management. This category of accounting is called as “Management Accounting”.

EVOLUTION OF MANAGEMENT ACCOUNTING:

The objective of accounting is not only to keep records and prepare final accounts but also to help management in its basic functions which are becoming day-by-day more complex and complicated. But it was found that the traditional accounting i.e financial accounting could not meet requirements of the management today due to many reasons. The first and foremost reason is that financial accounting provides information only about past records. It does not tell the management as to how the business has fared at each stage of operation. It also does not tell what should be the future policy of the management in order to achieve the targets set or to set new targets. Thus financial accounting cannot cope with the varies business problems. So to overcome the defects and limitations of financial accounting which is said to be static, management accounting which is a dynamic process has been evolved.

MEANING OF MANAGEMENT ACCOUNTING:-

The term Management accounting refers to accounting for the Management Management accounting provides necessary information to assist the management in the creation of policy and in the day-to-day operations. It enables the management to discharge all its functions that is planning, organizing, staffing, direction and control. efficiently with the help of accounting information.

DEFINITIONS:“Management accounting is concerned with accounting information that is useful to management” ---R.N.Anthony As fer Anglo American council of productivity, “Management accounting is the presentations of accounting information in such a way as to assist management in the creation of policy and in the day-to-day operations of an undertaking”.

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According to John seizer Management accounting as “ The application of accounting techniques to the provisions of information designed to assist all levels of management in planning and controlling the activities of the firm”.

OBJECTIVES OF MANAGEMENT ACCOUNTING:-

The objectives of management accounting are :1. To assist the management in promoting efficiency. Efficiency includes best possible services to the customers, investors and employees. 2. To prepare budgets covering all functions of a business. i.e. production, sales, research and finance 3. To analysis monetary and non- monetary transactions. 4. To compare the actual performance with plan for identifying divisions’ and their causes. 5. To interpret financial statements to enable the management to formulate future policies. 6. To submit to the management at frequent intervals operating statements and short-term financial statements. 7. To an analyse for the systematic allocation of responsibilities. In short, the objective of management accounting is to help the management in making decisions and implementing them efficiently.

FUNCTIONS OF MANAGEMENT ACCOUNTING:-

Function of Management accounting include all activities connected with collecting, processing, interpreting and presenting information to the management. The main function of Management accounting are:1. Fore casting:- Making short-term and long-term forecasts and planning the future operations of the business 2. Organizing:- organizing the human and physical resources of the business. This is done by assisting specific responsibilities’ to different people. 3. Co-ordination:- providing different tools of co-ordination. Examples of such tools are budgeting, financial reporting, financial analysis, interpretation etc. 4. Controlling:- controlling performance by using standard costing, various analysis and budgetary control. 5. Analysis and inter predation:- Analyzing and interpreting financial data in a simple and purposeful manner. 6. Communicating: Communicating the results of business activities through prompt and accurate reporting system. 7. Economic appraisal:- Appraising of social and economic forces and government policies and interpreting their effect on business.

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ADAVANTAGES OF MANAGEMANT ACCOUNTING

As management accounting has emerged to overcome the limitations of financial accounting, it is needless to point out that many advantages which are not associated with financial accounting are available with management accounting. The advantages of management accounting are summarized below:1. Helps in decision making:- Management accounting helps in decision- making such as pricing, make or buy, acceptance of additional orders, selection of suitable product mix etc. These important decisions are takenwith the help of marginal costing technique 2. Helps in planning:- planning includes profit planning, preparation of budgets, programmes of capital investments and financing. Management accounting assists in planning through budgery control, capital budgeting and cost- volume profit analysis. 3. Helps in organizing:- Management accounting uses various tools and techniques like budgeting, responsibility accounting and standard costing. A sound organisational structure is developed to facilitate the use of these techniques. 4. Facilitates

communication:-

Management

accounting

provided

with

up-to-date

information through periodical reports. These reports assist the management in the evaluation of performance and control. 5. Helps in co-ordination: The functional budgets ( purchase budget, sales budget, overhead budget etc ) are integrated into one, Known as master budget. This facilitates clear definition of departmental goals and coordination of their activities. 6. Evaluation and control of performance:Management accounting is a convenient tool for evaluation of performance-with the help of ratios and variance analysis, the efficiency of departments can be measured. Management accounting assists the management in the location of weak spots and in taking corrective actions. 7. Inter predation of financial information:Management accounting presents information in a simple and purpose full manner. This facilitates quick decision-making. 8. Economic appraisal:- Management accounting includes appraisal of social and economic forces and government policies. This appraisal helps the management in assessing their impact on the business. LIMITATIONS OF MANAGEMENT ACCOUNTING

No system in the universe is perfect. This applies to accounting system also.This applies to management accounting system also. The management accounting system suffers from certain limitations. These limitations are taken into account the so-called advantages cannot be reaped. The various limitations of management accounting are listed below:-

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1. Based on accounting information :- Management accounting derives information from past financial accounting and cost accounting records. If the past records are not reliable, it will affect the effectiveness of management accounting.

2. Wide scope:- Management accounting has a very wide scope incorporating many disciplines. This results in inaccuracy and other practical difficulties. 3. Costly:- The installation of management accounting system requires a large organization. Hence, it is very costly and only big concerns can afford to adopt it. 4. Evolutionary stage:- Management accounting is still in its initial stages. Tools and techniques are not fully developed. This creates doublts about the utility of management accounting 5. Opposition to change:- Introduction of management accounting system requires a number of change in the organization structure, rules and regulations. This rearrangement is not generally liked by the people involved. 6. Intuitive decisions:- Management accounting helps in scientific decisions making. Yet because of simplicity and personal factors the management has a tendency to arrive at decisions by intuition. 7. Not a alternative to management:- Management accounting will not replace the management and administration. It is a tool of the management.

Decisions are of the

management and not of the management accountant.

MANAGEMENT ACCOUNTING VS FINANCIAL ACCOUNTING

Financial accounting and Management accounting are two interrelated facts of the accounting system. They are not independent of each other. They are interdependent. They are Supplementary in nature. A distinction is always drawn between financial accounting and management accounting since they differ in their emphasis and approaches. Some of the points of differences between these two accounting systems are given below:-

1. Objectives:- The main objective of financial accounting is to supply information in the form of profit and loss account and Balance sheet to outside parties like share holders, creditors, government etc. But the objective of management accounting is to provide information for internal use of management.

2. Performance analysis:- Financial accounting is concerned with the overall performance of the business. On the other hand management accounting is concerned with the departments. It reports about the performance and profitability of each of them.

3. Data used: Financial accounting is mainly concerned with the recording of past events where as management accounting is concerned with future plans and policies.

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4. Nature:- Financial accounting is based on measurement while management accounting is based on judgement. Because of this financial accounting is more objective and management accounting is more subjective.

5. Accuracy:- Accuracy is an important factor in financial accounting. But approximations are widely used in management accounting. This is because most of the information is related to the future and interest for internal use.

6. Legal compulsion:- Financial accounting is compulsory for joint stock companies. But management accounting is only optional.

7. Monetary transactions:- Financial accounting records only those transactions which can be expressed in terms of money. On the other hand, management accounting records not only monetary transactions but also non-monetary events, namely technical changes, government polices etc.

8. Control:- Financial accounting will not reveal whether plans are properly implemented. Whereas management accounting will reveal the deviations of actual performance from plans. It will also indicate the causes for such deviations. MANAGAMANT ACCOUNTING Vs COST ACCOUNTING.

Costing has been defined as classifying recording and appropriate allocation of expenditure for the determination of the costs of products or services. Cost accounting will tell the management as to how the business has fared and each stage of operation. But cost accounting will not tell them anything about the future policy to be adopted. The following are the main differences between cost accounting and management accounting: 1. Objective:- The objective of cost accounting is the ascertainment and control of costs of products or services. But the objective of management accounting is to help the management in decision making, planning, control etc. This objective is achieved by furnishing relevant accounting information to the management.

2. Scope:- cost accounting deals primarily with cost data. But management accounting deals with both cost and revenue. It includes financial accounting, cost accounting, budgeting, reporting to management and interpretation of financial data. Thus the scope of management accounting is wider than that of cost accounting. 3. Data used:- In cost accounting, only those transactions which can be expressed in figures are taken. only quantative

aspect is recorded in cost accounting. But management

accounting uses both quantitative and qualitative information.

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4. Nature:- Cost accounting uses both past and presend figures. But management accounting is concerned with the projection of figures for future. The policies and plans are prepared for providing future guidelines.

However, cost accounting and management accounting are Complementary in nature. Cost accounting furnishes detailed cost information. Management accounting analysis and presence the data in a more meaningful and informative manner. It helps the management to use the cost data effectively.

Summary:-

Accounting can no longer be considered as a mere language of business. Now a need has arisen for accounting to provide information, relating to the conduct of the aspects of a business like cost or profit associated with some portions of business operations to the internal parties viz. Management. Traditional accounting i.e financial accounting cannot provide this. Hence management accounting was evolved to fulfill this need. Thus the objectives of management accounting are to present the required facts and information for the use of management in a quantive form and to help in effective performance of managerial functions i.e. planning, organizing, controlling, and decision- making etcA concern will derive many advantages with the help of management accounting like systematic regularity in the business activities through efficient planning and effective organization, increase in efficiency of the concern by comparing actual performance with expected performance and suggesting remedial measures to avoid the recurrence of adverse variances, cost reduction and consequent price reduction by the application of various types of controls in accounting areas etc.

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UNIT-VII FINANCIAL STATEMENT ANALYSIS After reading this lesson the student should be able to Understand the implications of financial statements as performance records of an enterpriseAppreciate the methods to carry out Financial statement analysis, Learn the procedure

to prepare comparative financial

statements, Trend percentages and common size statements Financial statements refers to a package of statements such as Balance sheet, income statement, fund flow statement, cash flow statement

and statement of retained

earnings. The balance sheet and income statement are traditional financial statement. Other statements are prepared to supplement them. Objectives:- The following are the main objectives of financial statements analysis:1. To establish the earning capacity of the concern. 2. To judge the financial (both liquidity and solvency) Position and financial performance of the concern. 3. To determine the debt capacity of the concern. 4. To decide about the future prospects of the concern. NATURE OF FINANCIAL STATEMENTS:According to the American Institute of certified public Accounts, â&#x20AC;?Financial statements reflect a combination of recorded facts, accounting principles and personal judgmentsâ&#x20AC;?. The following points explain the nature of financial statements:1. Recorded facts:- The term recorded facts refers to the data taken out from accounting records. Facts which have not been recorded in the financial books are not depicted in financial statements however important they might be. For example. Fixed assets are shown at cost irrespective of their market or replacement price, since only cost price is recorded in the books. 2. Accounting principles:- Certain accounting principles concepts and conventions are followed in the preparation of financial statements. For example, the convention of valuing stock and cost or mark price whichever is less is followed. The principle of valuing assets at cost less depreciation is followed for balance sheet purpose. 3. Personal judgment:- personal judgment has as important bearing on the financial statements. For example, the selection of a method for stock valuation depends on the personal judgment of the accountant. LIMITATIONS OF FINANCIAL STATEMENTS Financial statements are relevant and useful for a concern. But they do not present a final picture. Financial statements suffer from the following limitations: 1. Financial statements are only interim reports. They are not final, because the exact financial position can be known only when the business is closed.

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2. Many items in the financial statements are based on the personal judgment of the accountant. 3. In the balance sheet, assets are recorded at their original costs.

Replacement cost or

realisable value of the assets is ignored. Hence it does not reveal the true position of the business. 4. No monetary factors such as credit worthiness reputation of the management, influence the financial position of a concern. But the financial statements do not take in to account these factors. 5. Financial statements ignore the changes in price level. Hence their use is limited during inflationary periods. 6.

Financial statements are records of past events only. past can never be a hundred percent representative of the future.

7. Financial statements are prepared on the basis of certain accounting concepts and conventions. Any change in the method or procedure of accounting limits the utility of financial statements. 8.

The balance sheet fails to show how working capital was raised and used during the year. This is a serious limitation as changes in working capital are important to assess the financial health of a company. INTERPRETATION OF FINANCIAL STATEMENTS

Analysis and interpretation of financial statements is the most important step in accounting. To have a very clear understanding of the profitability and financial position of a company, the financial statements have to be analysis and interpreted. Analysis refers to the methodical classify cation of the data given in the financial statements.

For example, the

amount of capital employed is not directly available in the balance sheet. The figures have to be re-arranged to calculate the amount of capital employed. The term â&#x20AC;&#x153; interpretationâ&#x20AC;? means explain the meaning and significance of the data so arranged It is the study of the relationship between various financial factors. The relationship between profit and capital employed, current assets and current liabilities. sales and gross profit have to be explained. Further to make interpretation more meaningful, comparisons have to be made. comparison of relationship between various financial factors of the same company over a period of time can be made. For, Example, gross profit ratios of several years may be compared similarly comparisons can be made between two or more companies. This is popularly known as inter firm comparisons. Analysis and interpretation are closely related. Interpretation is not possible without analysis and without interpretation analysis has no value. Hence, the term analysis is widely used to refer both analysis and interpretation. In short, analysis and interpretation of financial statements require the following: 1. Methodical classification of the data given in the financial statements. 2. Explaining the meaning and significance of the relationship between various financial factors. 3.

Comparisons of these relationships.

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It is a process of evaluating the relationship between the various components of a financial statement to obtain a clear understanding of a firms position and performance.

METHOD OF FINANCIAL STATEMENTS ANALYSIS

It is now clear that the analysis of financial statements provide necessary insights towards establishing relationships and trends to determine whether or not the financial position and length of operations as will as financial progress of the company are satisfactory or not. some of the analytical methods used to analyses financial statements are: 1.

Comparative financial statements

Common size financial statements

Trend percentages

Ratio analysis

Fund flow analysis.

Comparative statements:Financial statements are prepared as on a particular date or for a particular period.

For example, balance sheet indicates the financial position as at the end of the period and the income statement shows the operating results for a period (usually a year). But a financial analyst is interested in knowing whether the business is moving in a favorable or unfavorable direction. For this purpose, figures of the current year, have to be compared with those of the previous year. Compared financial statements provide information to assess the direction of change in the business. In these statements, figures for two or more periods are placed side by side to facilitate comparisons.

Any financial statement can be proponed in a comparative form. But in practice, balance sheet and income statement are alone prepared in a comparative form. Under the companies Act, 1956, companies are required to show figures for the previous year together with current year figures in their profit and loss account and balance sheet.

Proforma of Balance sheet as on………………. particulars

1.Liquid assets

Current year

Previous year

Figures(Rs)

FINANCIAL MGMT. & MGMT. ACCOUNTING Cash at bank

xxx

Cash in hand

xxx

Bills receivable

xxx

Marketable

xxx

153

securities Total(1)

II Inventories:Raw materials

xxx

Finished goods

xxx

Total(2)

xxx

III. Total current assets (1+2)=3

xxx

Bills payable

xxx

Creditors

xxx

Bank over draft

xxx

Out Sanding

xxx

Total(4)

xxx

Provision for taxation

xxx

Proposed Dividends

xxx

Other provisions

xxx

Total (5)

xxx

Provisions (4+5)=6

xxx

Vii Net working capital (6-3)=7

xxx

Land and buildings

xxx

Plant and machinery

xxx

Furniture and fixtures

xxx

Equipment and tools

xxx

Total (8)

xxx

Total capital employed (7+8)=9

xxx

Less Balance

xxx

Total

xxx

Iv current liabilities:

V. provisions:-

Vi Total current liabilities and

Viii Net Block.

Ix capital employed as represented by equity:Equity share capital:-l Reserves and profit and loss:a/c Balance

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x capital employed as represented by bonds and debentures:Debentures

xxx

LT loans

xxx

other secured loans

xxx

Performa of profit and loss a/c as anâ&#x20AC;Ś

Particulars

current year figures Rs

Sales

previous year figures Rs.

xxx

_____

Adm : overhead expenses

xxx

Distribution over head expenses

xxx

Selling overhead expenses

xxx

Financial overhead expenses

xxx

______

Less: cost of goods sold (cost of materials consumed + direct wages + other direct expenses)

Gross profit Less: overhead expenses:

Net profit

COMPARATIVE BALANCE SHEET

The single balance sheet shows assets and liabilities as an a particular data. The comparative balance sheet shows the value of assets and liabilities on two diffident dates. If helps in comparison. A comparative balance sheet has two columns to record the figures of the current year and the previous year. A third column is used to show the increase or decrease in figures. A forth column may be added for giving percentage of increase or decrease. Thus, while in the balance sheet the emphasis is on status in the comparative balance sheet it is on change. Comparative balance sheet indicates whether the business is moving in a favorable or unfavorable direction it is very useful for studying the trends in an enterprise. Comparative income statement:An income statement shows the operating results of a business for a designated period of time. A comparative income statement shows the operating results for a number of accounting periods so as to facilitate comparison. It gives an idea of the progress of a

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business over a period of time. It gives an idea about the improvement in sales, profit and other expenses over the previous year. A comparative income statement has two columns for the figures of the current year and the previous year. A third column is used to show the increase or decrease in figures. A forth column may be added for giving percentage of increase or decrease.

2. COMMON SIZE STATEMENTS:Financial statements present absolute figures.

A comparison of absolute figures

could be misleading. For example, cost of sales in absolute figures might have gone up but as a percentage of sales it might have come down. Hence, for a better Understanding and comparison, the figures are converted into percentage of some common base. The statements which report the figures as a percentage of some common base are called common size statements. Sales is taken as the conmen base in the common size income statements. All expenses are recorded as a percentage of sales. In the common size balance sheet, total assets or liabilities is taken as the common base. Each item is expressed as a percentage of the total. Command size, Statements are useful to a financial analysist.

They make

comparison easy and meaningful. 2. TREND PERCENTAGES:Trend analysis is very helpful in making a comparative study of the financial statements of several years. Under this technique, information for a number of year is taken up and one year (usually the first year) is taken as the base year. Each item of the base year is taken as 100 and on that basis, the percentage for other years are calculated. For example, if sales in the base year is Rs.10,000 and in the next year it is 20,000, the trend percentages will be 100 and 200 respectively. Substitution of percentages for large amounts makes the statements brief and easily understand able.

In short, comparative statements, common size statements and trend analysis present the information contained in balance sheet and income statement in a form suitable for analysis. Such presentation helps in a better understanding of the financial statements. Summary: Financial statements convey a lot of information to both the external as well as internal users.

Meaningful comparison can be drawn from a systematic analysis of the

financial statements by carrying out the comparative analysis, constructing common size statements as well as Trend percentages. The construction of comparative statement explores the periodic changes in various items listed in both balance sheet as well as in profit and loss account . This periodic changes could be analysed either in absolute values or in terms of percentage changes The common size statements analysis tries to provide an in-death examination of each of the financial statements by developing inter relationship between various items with

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one ‘base’ figure. In case of income statement the annual ‘sales’ figure acts as the ‘base’ to find the proportionate changes in different costs and the profit margins annually. The Trend percentage method tries to explore into possible trends in the operating performance of the enterprise through the construction of trend percentages keeping one of the year’s performance as the ‘base’. Therefore this method examines more number of years of information compared to the earlier one. So, these analysed figures of financial statements are more meaning full for decision making.

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UNIT-VIII RATIO ANALYSIS Financial statements are statements of income and balance sheet which highlight the income or profitability and change in the fixed assets and capital during a specific period. It provide a summarized analysed view of the operations of a firm. These statements may be more fruitfully used if they are analysed and interpreted to have an insight into the strengths and weakness of the firm. The success of the company’s financial plans is based on the financial analysis which is the starting point for making plans, before using any sophisticated forecasting and budgeting procedures. Various tools are employed by the interested parties in analysing the financial information contained in these statements. Ratio analysis one of the important techniques to explain salient features of financial statements It is needed for evaluating the financial statements. Meaning The relationship between two figures expressed mathematically is called a ‘Ratio’ It is a numerical relationship between two numbers which are related in some manner. Ratio analysis is a technique of analysis and interpretation of financial statements. It is the process of determination and interpretation of various rations for helping in decision making. Ratio analysis involves thtee steeps: 1. Calculation of appropriate rations from the financial statements. 2. Comparision of the rations with standards or with rations of the past period-

comparision

can also be made with the ratios of other firms. 3. Interpretation of ratio.

DEFINITION “Ratio is expression of the quantitative relationship between two numbers” -Wixon,Kell and Bedford, “Ratio as simple one number expressed in terms of another” -Robert Anthony SIGNIFICANCE/MERTS/IMPORTANCE OF RATIO ANALYSIS

Test of solvency:The use of ratio is useful in testing the solvency position of the company. when

percentage of gross profit to sales is increasing, it shows the efficiency of profitability. Likewise, when ratio of current assets to current liabilities shows upward trend, it means sufficient working capital. Thus the claim of creditors can be paid easily.

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158

Helpful in decision making:The main object of financial statement is to tell the financial position of the company

up on which management takes decision. 3. Helpful in financial forecasting and planning:The ratios are utmost use in financial planning, forecasting and work as a future guide. The ratios are used for drawing conclusion such as current ratio is 5:1, it means blocking up of capital as the ideal ration is 2:1 whereas we have 5:1, Rs.3/- are unneessanily blocked. 4. Useful in knowing profitability:The ratios are most useful when comparison is made between companies for profitability. Two types of comparison of percent ratio with past ratio and the second comparison of several previous years are computed with the objective of knowing improvements or down falls in the financial position. 5. Liquidity position:With the use of ratio analysis the meaningful conclusion regarding the sound liquidity position of the firm. The liquidity position is sound if it has the ability to pay its debts when these are due for payments. 6.

Helpful in knowing operating efficiency:The ratios are important from the management point of view where in the

management measures the efficiency of the assets. The sale and its percentage to net profit is increasing every year is a test of increasing in efficiency.

Business Trend:The ratio analysis speaks of the financial discipline of the firm with raged to additions

and down fall. When the trendsis for downfall the management can take corrective decisions. 8.

Helpful In Cost Control:Comparison of actual ratios with the standard reveals the deviations and

weaknesses. This helps the management to take corrective action at the right time. Control of costs as well as performance are ensured. 9.

Helpful in analysing the financial health of the company:The ratio are very useful in highlighting the liquidity, solvency, profitability and Capital

gearing. Thus, these are a useful tool of analysing financial performance. INTERPRETATION OF RATIOS The importance of ratios, as a tool of analysis, lies in its proper interpretation by the financial analyst. There are four different method applied for interpretation of ratios.

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159

The individual ratio by itself may convey a significant meaning of the related items. For

instance, if the current ratio consistently falls below one, it may reveal the impending financial solvency of the concern which only means that the current assets of the units are not even sufficient to meet current liabilities. normal circumstances and

It is very rare with regard to a business concern under

one cannot also jump to any hasty conclusion after studying the

ratios in isolation. Moreover a single ratio at times may fail to reveal the exact financial position. 2.

The interpretation of ratios can be effected by taking into analysis a group of related

ratios in sufficient number. By complication and analysis of group of inter related ratios, the significance of ratios can be fully understood when the same cannot be achieved in isolation. For instance, the value of net profit ratio is increased by taking the ratio disclosing the number of times the proprietor’s investment is turned over in sales every year. 3.

The interpretation of ratios involves comparison of ratios of one business concern with

those of others which is often referred to as “inter firm comparison”.

This comparison

provides the valuable information as in most cases, members of the same industry face similar problems – internal as well as external. These comparisons are often facilitated by the use of the tables summarising the ratios of units in a particular industry. These tables are usually prepared by trade associations and credit agencies. 4.

The interpretation of ratios involves making comparison of ratios of the unit over a

period of years. By this, the same ratio or a group of related ratios of a business concern is compiled and evaluated over a period of years.

This study highlights significant trends

showing the rise, fall or stability achieved by the unit. The average value of a particular ratio for a number of years can save as a standard against which the future performance can also be compared. LIMITATIONS OF RATIOS No doubt ratios are useful tools yet these should be used with utmost care as these suffer from certain drawbacks, which are as: 1.

Need detailed knowledge:The calculation of ratio is not so much difficult as it interpretation. Ratios are tools of

quantitative analysis and not of qualitative analysis. Thus, one should have a fair knowledge of qualitative and quantitative analysis. 2.

Lack of raliable data:-

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Ratio can give misleading results if the analyst does not know the reality and correctness of figures. For example, the value of closing stock is over stated, profit will be inflated, this will result in more taxation when actual profits are less than the profits on which tax has been paid. 3.

Different Basis:There are different methods of valuation of closing stock (i) LIFO (ii) FIFO in both profit

will differ. Similarly profit has different meanings. Some one may say profit before tax and interest, while others may take profit after tax and Interest. Similarly, different methods of depreciation, each method will show different amount of profit. 4.

Different accounting policies:Different firms follow different policies withregard to depreciation, fixed instalments or

diminishing balance method or stock valuation. LIFO, FIFO, thus profit so calculated will not be comparable unless adjustment for profit is not made. 5.

Effects of price level change:While ratio are calculated, no thought is given to inflationary measures which is

responsible for change in price level. Thus the whole utility of ratio analysis becomes stand still. 6.

Bios option:Ratios are only tools it depends upon the uses how to give them practical shape. For

example, profit has different meanings such as EBIT (Earning before Interest and Tax). Some says profit is before interest.

Thus personal opinion is different from business to

business. 7.

Lack of Comparison:Different firms adopt different procedures, records, objectives, and policies in such

situations, comparison will become more complicated. 8.

Evaluation:There are different tools of ratio analysis, which tool is to be needed in a particular

situation depends upon the skill, training, intelligence and expertise of the analyst.

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CLASSIFICATION OF RATIOS In order, that ratios serve as a tool for financial analysis, they are classified as: I

PROFITABILITY RATIOS

FINANCIAL RATIOS

III TURNOVER RATIOS IV CAPITAL STRUCTURE RATIOS (I)

Profitability Ratios:Profits are always measured in term of sales (or) investment.

Profitability ratios

measure the profitability of a firm’s business operations. These ratios are expressed in terms of percentage and always on sales. The following are the important profitability ratios:1.

Overall profitability Ratio:It is also called as “Return on Investment” (ROI) or Return on Capital Employed

(ROCE).

It indicates the relationship between net profit after interest and Tax and the

proprietor’s fund. It is most widely used to measure the overall profitability and efficiency of the business. This ratio is useful to share holder’s and management of the company. Higher the ratio reveals how efficiently the company has used share holder’s fund.

Net Profit (after tax and interest) ROI =

x 100 Share holder’s fund

Share holder’s fund = Equity + Preference share capital, Share Premium, Retained Earnings + Surpluses, General Reserves – Accumulated loss if any. 2.

Return of Equity Share holder’s Fund:The rate of dividend on equity shares differ year to year, depending upon the amount of

profit. The performance of a Company is judged by the amount of return of equity capital.

Net Profit after tax and preference dividend ROE = 100

x Equity share capital paid – up (ie. share holder’s fund)

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162

This ratio is most suitable to equity share holder’s who want to know how much profit are earned by the company and they can be known how much of dividend will be received by them. 3.

Return on Total Assets:This ratio is computed to know the productivity of the total assets.

Net Profit after Tax + Interest Return of Assets (ROA) =

x 100 Total assets excluding fictitious assets

Note: Exclude only fictitious assets and not all intangible assets. Fictitious assets includes assets such as preliminary expenses, Debit balance in the profit and Loss account. The inclusion of interest is conceptually sound because total assets have been financed from the ‘pool’ of funds supplied by the creditors and the owners . The objective of computing the ‘Return on Total assets’ is to find out how effectively the funds pooled together have been used. Hence, it will be proper to include the interest in computing the return on total assets. 4.

Earning per share (EPS):This ratio indicates the availability of total profits per share. It is the small variation of

return on equity capital and is calculated by dividing the net profit after taxes and preference dividend by the total number of equity shares.

Net profit after tax and preference dividend EPS = Number of equity shares

The EPS is a good measure of profitability and for comparing EPS of similar companies. EPS calculated for a number of years indicates whether or not earning power of the company has increased. Illustration – 1. Calculate the Earning per share (EPS) from the following date:Net Profit before Tax Rs. 50,000/-, Tax rate 50% 10% preference share capital (Rs.10/- each) Rs.50,000/-

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Equity share capital (Rs.10/- each) Rs. 50,000/Solution:

Net profit after tax and preference dividend Earning per share = Number of equity share

Net Profit after Tax

Profit before tax - tax

Rs. 50,000 - 25,000 (50%) = Rs. 25,000

Preference dividend

10% of Rs. 50,000/-

No. of Equity Shares

Rs.50,000  Rs. 10 = 5000 shares

Earning per share

Rs.20,000  5000 shares

Rs. 4 per share.

= Rs. 5,000

Illustration – 2. From the following information calculate 1

Return on capital employed

Return on share holder’s funds

Return on total assets

Balance sheet as on ...... Liabilities

Rs.

Assets

Rs.

Share Capital

1,00,000

Fixed assets

8,00,000

Reserves

2,00,000

Current assets

2,00,000

10% Debentures

6,00,000

Creditors

1,00,000 10,00,000

10,00,000

Profit before tax is Rs.1,20,000. Tax rate is 40% Solution: Net profit after tax and interest 1.

Return on capital employed =

x 100 Share holder’s fund or capital employed

Profit before tax

Rs.1,20,000

Add interest (10% on debenture of 6,00,000)

Rs. 60,000 -----------------

FINANCIAL MGMT. & MGMT. ACCOUNTING

164 Rs. 1,80,000 ------------------

Share holder’s fund

Return on capital employed

Share Capital + Reserves + long term debt

1,00,000 + 2,00,000 + 60,000 = 9,00,000

1,80,000 = ------------- x 100 = 20% 9,00,000

Net Profit after tax 2. Return on share holder’s funds

x 100 Equity Share Capital

Profit before tax Less: Tax @ 40%

Rs. 1,20,000 Rs. 48,000 ----------------72,000 -----------------

Share holder’s funds:Share Capital Reserves

Rs. 1,00,000 Rs. 2,00,000 ---------------Rs. 3,00.000 ---------------72,000

Return on share holder’s fund =

x 100 = 24% Net Profit after tax and interest 3,00,000

3. Return on total assets =

x 100 Total assets excluding fictitious assets 72,000

x 100 10,00,000

7.2%

FINANCIAL MGMT. & MGMT. ACCOUNTING

II.

General Profitability Ratio:-

Operating Ratio:-

165

This ratio establishes the relationship between cost of goods sold and other operating expenses on the one hand and the sales on the other hand.

It measures the cost of

operations per rupee of sales. This ratio is calculated by dividing operating costs with the net sales and is generally represented as a percentage. Operating ratio is considered to be yard stick of operating efficiency.

Operating cost Operating Ratio

x 100 Net Sales

Operating cost

Cost of Goods sold =

Cost of goods sold + Operating expenses + Purchases – Closing stock

Opening stock

Manufacturing and Operating expenses = Administrative expenses

Financial + expenses

Selling expenses

This ratio indicates the percentage of net sales that is consumed by operating cost. Higher operating ratio the less favourable it; because it would have a small margin to cover interest, income tax, dividend, reserves. So lower ratio is more favourable. 2.

Operating Profit Ratio:This percentage speaks of how much sales is consumed by operating cost. Higher

operating ratio is always harmful as a small margin is left for interest, income tax, dividend and reserves. It is a test of operating efficiency.

Operating profit Operating Profit Ratio

x 100 Net sales

= Gross Profit – Operating cost

Profit GrossOperating Profit Ratio:-

This ratio expresses the relationship between gross profit and net sales and is usually represented as a percentage. It is calculated by dividing the gross profit by sales.

Gross profit Gross Profit Ratio

x 100 Net Sales

Gross profit

= Sales – Cost of goods sold

Cost of Goods sold = Opening stock + Purchase + All direct expenses

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166

It indicates the efficiency of production or trading operations. A high gross profit ratio is a sign of good management as it implies that the cost of production is relatively low. 4.

Net Profit Ratio:This ratio establishes a relationship between net profit (after taxes) and sales and

indicates the efficiency of the management in manufacturing, selling and administrative and other activities of the firm.

This ratio is the overall measure of firmâ&#x20AC;&#x2122;s profitability and is

calculated as :

Net Profit after tax Net Profit Ratio

x 100 Net sales

It shows what percentage of sales is left to the owners after meeting all costs. An increase in net profit ratio year after year is an indication of improving working conditions and vice versa.

Expense Ratios:This ratios indicate the relationship between various expenses and net sales. The

operating ratio reveals the average total variations in expenses. But some of the expenses may be increasing while some be falling. Hence, expenses ratios are calculated by each item of expenses or group of expenses with the net sales to analyse the cause of variations of the operating ratio. The lower ratio is an indication of greater profitability whereas higher the ratio, lower is the profitability.

Particular expense Particular expense ratio =

x 100 Net sales

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Specific expenses ratio may be calculated as :

Selling and Distribution Expenses a) Selling and Distribution Expenses Ratio = x 100 Net Sales Non Operating Expenses b) Non-operating Expenses Ratio

x 100 Net Sales Cost of goods sold

c) Cost of Goods Sold Ratio

x 100 Net Sales

d) Administrative & Office Expenses Ratio =

Selling and Distributive Expenses x 100 Net Sales

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168

Illustration: st

The following figures relate to Kannan Trades Ltd for the year ended 31 March 2007 st

Trading and Profit and Loss Account for the year ended on 31 March 2007

To To

Opening stock

Gross Profit

Rs. 75,000

purchases

3,25,000 2,00,000

By By By

Sales Less: Returns Closing stock

Rs. 5,20,000 20,000

Operating expenses: Administration Expenses

25,000

Gross Profit

Non operating Income:

65,000

Non operating Expenses:-

Dividend

Loss on sale on assets To

6,00,000 2,00,000

40,000

Selling &Distribution To

5,000

Net Profit

Profit on sale of Shares

9,000

11,000

2,20,000

Calculate 2) Operating profit Ratio 3) Gross Profit Ratio

4) Net Profit Ratio

5) Expenses Ratio Solution: 1) Operating Ratio:Operating Cost Operating ratio

x 100 Net Sales

Operating Cost

20,000

1,50,000 2,20,000

1) Operating ratio

5,00,000 1,00,000

6,00,000 To

Rs.

Cost of goods sold

Rs.

2) Operating Profit Ratio:-

Cost of goods sold + Operating expenses =

Opening stock + Purchases - Closing stock

75,000 + 3,25,000 - 1,00,000

4,00,000 â&#x20AC;&#x201C; 1,00,000

3,00,000

3,00,000 + 65,000 -------------------------- x 100 5,00,000

73%

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169

Operating Profit Ratio

Operating Profit -----------------------Net Sales

Operating Profit

Gross Profit – Operating Expenses

x 100

2,00,000 – 65,000 = 1,35,000

1,35,000 ------------- x 100 5,00,000

27%

Gross Profit ------------------ x 100 Net Sales

2,00,000 ------------- x 100 5,00,000

40 %

Net Profit -------------Net Sales

1,50,000 ----------5,00,000

30.%

3. Gross Profit Ratio:

Gross Profit Ratio

Net Profit Ratio:-

Net Profit Ratio

Expenses Ratio:-

x 100

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5. Expenses Ratio: Administrative Expenses a) Administrative Expense Ratio = -------------------------------- x 100 Net Sales

b) Selling and distribution expenses ratio

II.

40,000 ------------ x 100 5,00,000

Selling and distribution expenses ---------------------------------------- x 100 Net Sales

25,000 ------------- x 100 5,00,000

FINANCIAL (OR) SOLVENCY RATIOS

Financial Ratios indicate about the financial position of the company. A Company is deemed to be financially sound, if it is in a position to carry on its business smoothly and meet its obligation, both short-term and long-term without strain. It is a sound principle of finance that the short-term requirements of funds should be met out of long-term funds. For example if the payment of raw materials, purchases are made through issue of debentures it will create a permanent interest burden on the enterprise.

Similarly, if fixed assets are purchased out

of funds provided by bank overdraft, the firm will come to grief because such assets cannot be sold away when payment will be demanded by the bank. Financial ratios can be divided into two broad categories:1. Liquidity Ratios 2. Stability Ratios I

Liquidity (Short-term solvency) Ratios: Liquidity ratios measure the ability of the firm to meet its current obligations. They

indicate whether the firm has sufficient liquid resources to meet its short-term liabilities. The following are important liquidity ratios:1.

Current Ratio:Current ratio is the relationship between current assets and current liabilities. It is

calculated by dividing current assets by current liabilities.

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Current Assets = Current Liabilities

Current Ratio

The current assets of a firm represent those assets which can be converted into cash within a short period of time, normally not exceeding one year and include cash and bank balances, marketable securities, inventory of raw materials, semi finished and finished goods debtors, provision for bad and doubtful debts, bills receivable and prepaid expenses. The current liabilities defined as liabilities which are short-term maturing obligations to be met within a year, consist of Trade creditors, bills payable, bank credit, provision for taxation, dividends payable and outstanding expenses. It is also known as working capital ratio, since it is related to working capital of the firm. A current ratio of 2:1 is considered ideal. That it is, for every one rupee of current liability there must be current assets of Rs.2. If the ratio is less than two, it may be difficult for a firm to pay current liabilities. If the ratio is more than two, it is an indicator of idle funds. Limitation:-

It is a crude ratio because it measure only the quantity and not the quality of

current assets. 2. Quick Ratio or Liquidity /Acid Test Ratio:It is the relationship between quick assets and quick liabilities. Quick assets are those assets which

readily converted into cash.

They include cash and bank balances, bills

receivables, debtors, short-term investments. Quick liabilities include creditors, bills payable, outstanding expenses.

Quick Assets Quick Ratio

= Quick liabilities

Quick assets

Current assets â&#x20AC;&#x201C; (Stock + prepaid expenses)

Quick Liabilities

Current Liabilities â&#x20AC;&#x201C; Bank overdraft

A Quick ratio of 1:1 is considered satisfactory. Any deviation from this norm indicates either insufficient liquidity of the firm to utilize the resources.

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SOLVENCY RATIOS (LONG-TERM) Solvency ratios assess the long-term financial condition of the firm.

Bankers and

creditors are most interested in liquidity. But share holders, debenture holders, and financial institutions are concerned with the long-term financial prospects. The following are the widely used solvency ratios:

1. Debt-Equity ratio:The debt-equity ratio establishes the relationship between shore holder’s funds and outsiders funds. Share holder’s funds consist of preference share capital, equity share capital and reserves and surplus Outsider’s fund include all long-term and short-term debts.

Outsider’s Fund

Debt Debt – Equity Ratio =

(OR) Equity

share holder’s funds

A Debt equity ratio of 1:1 is considered desirable. It gives an idea of the relative proportions of debt and equity in financing the assets of the firm. Debt equity can also be calculated by the following formula:

Long-term debt Debt – Equity Ratio = The above ratio is useful to analyse the capital structure of a company. It in share holder’s funds

The above ratio is useful to analyse the capital structure of a company. It indicates the proportion of share holder’s funds and long-term debt in the capital structure. The standard debt-equity ratio is 2:1 2.

Proprietory Ratio / Equity Ratio:It is a variant of debt to equity ratio. It establishes relationship between proprietor’s

fund and the total tangible assets. It may be calculated as :

Share holder’s fund Proprietory ratio

= Total tangible assets

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Proprietary ratio indicates the proportion of share holderâ&#x20AC;&#x2122;s funds in the total assets. A high proprietary ratio indicates less danger and risk to creditors in the event of winding up.

III

ACTIVITY (OR) TURNOVER RATIOS:Activity ratios measure the efficiency of asset management. The efficiency in the use of

assets would be reflected by the speed with which they are converted into sales. Activity ratios indicate the relationship between sales and various assets of the firm. In order to find out which part of capital is efficiently employed and which part not, different turnover ratios are calculated. These ratios are as follows: \ 1.

Stock (or inventory) Turnover Ratio:This ratio indicates the number of times stock is turned over during a year. A high ratio

indicates quick movement of stock and vice-versa.

Cost of goods sold Stock turnover ratio

= Average stock

Cost of goods sold

Opening stock + Purchases + Manufacturing cost - Closing stock of

inventory Average stock

Opening stock + Closing stock = 2

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Debtor’s Turnover Ratio:- / Accounts Receivable Turnover Ratio:This ratio shows, on an average, the number of times debtors are turned over during a

year. A higher ratio indicates efficiency in assets management and vice-versa.

Net Credit Sales Debtor’s turnover ratio

= Average Debtors Opening balance + Closing balance

Average debtors

= 2

Net credit sales

Credit Sales – Sales returns

Debtors

Debtors + Bills receivable

Average Collection Period:This ratio indicates the speed with which debtors / accounts receivable are collected. It shows the number of days taken to collect money from debtors.

Debtors + Bills receivable Average Collection Period =

x Credit Sales

No. of Working days in a year

A lower ratio implies quick recovery of money from debtors, when information regarding credit credit sales is not available total sales are taken for calculation of the ratio. 3.

Creditor’s Turnover Ratio:This ratio shows the number of days of credit enjoyed by the unit for purchase of its raw

materials. It is calculated by the folllwing formula.

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Credit Purchase Creditors Turnover Ratio

= Creditors

A hgher ratio indicates quick settlement of dues and a lower ratio reflects liberal credit terms granted by suppliers. Average Payment Period:-

It refers to the number of days taken by the form to

pay its creditors.

Creditors + Bills Payable Average Payment Period =

x Credit Purchase

No. of Working days in a year

Generally, lower the ratio, the better is the liquidity position of the firm. 4.

Fixed Assets Turnover Ratio:Fixed assets turnover ratio explains the relationship between sales and fixed assets.

Sales Fixed assets turnover Ratio

= Net fixed assets

This ratio indicates the sales generated by every rupee invested in fixed assets. A higher ratio is an indicator of greater efficiency in the utilisation of fixed assets. IV

CAPITAL STRUCTURE RATIO This ratio explain how the caapital structure of a firm is mde up or the debt mix adopted

by the firm. The following ratio fall under this category:Capital Gearing Ratio:- This ratio explains the relationshi;p between equity share holderâ&#x20AC;&#x2122;s fund on the one hand and preference share capital and fixed interest bearing loan on the other.

Preference share capital + Fixed interest securities Capital Gearing Ratio

= Equity share holderâ&#x20AC;&#x2122;s funds

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If the preference share capital and fixed interest bearing securites exceed equity

If the prfernce share capital and fixed interest bearing securities exceed equity shareholderâ&#x20AC;&#x2122;s funds, the company is said to be highly geared. The company is said to be low geared, if preference share capital and other fixed- interest bearing securities are less than the equity share holderâ&#x20AC;&#x2122;s funds. In other words, if the retio is more than one, the capital structure is high geared. If it is less than one, the capital structure is low geared. If the ratiio is equal to one, the capital structure is even geared. Illustration: From the following particulars pertaining to assets and liabilities of a Company, calculate: 1.

Current ratio

2) Liquitidity ratio

Debt-equity ratio

3) Proprietory ratio

5) Capital gearing ratio

Balance sheet as on ........................................

Liabilities

Rs.

Assets

Rs.

5,000 Equity Shares of Rs.100 each

5,00,000

Land and Building

6,00,000

2000 8% Preference shares of Rs. 100 each

2,00,000

Plant and Machinery

5,00,000

4,000 9% Debentures of Rs.100 each

4,00,000

Stock

2,40,000

Reserves

3,00,000

Debtors

2,00,000

Creditors

1,50,000

Cash at Bank

Bank overdraft

50,000 16,00,000

Prepaid Expenses

55,000 5,000 16,00,000

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177

Solution:

Current assets 1. Current Ratio

= Current Liabilities

Current assets

Stock + Debtors + Cash + Bank + Prepaid expenses

Rs.

2,40,000 + 2,00,000 + 55,000 + 5,000

Rs.

5,00,000

Current Liabilities = = Current Ratio

Rs.

5,00,000 – ( 2,40,000 + 5,000)

2,55,000

Liquid Liabilities =

Rs.

Creditors + Bank Overdraft Rs. 1,50,000 + 50,000 = 5,00,000 = 2.5 : 1 2.00,000

2,00,000

Current Liabilities – overdraft

2,00,000 – 50,000

1,50,000 2,55,000

Liquid ratio

1.7 : 1

1,50,000 Proprietor’s funds 3.

Proprietory Ratio

= Total tangible assets

Proprietors funds

Equity Share Capital + Preference share Capital + Reserves and Surpluses

Rs.

5,00,000 + 2,00,000 + 3,00,000

Rs.

10,00,000

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Liquid assets 2

Liquid Ratio

= Liquid liabilities =

Current Assets – (Stock + Prepaid expenses)

5,00,000 – ( 2,40,000 + 5,000)

Rs.

2,55,000

Liquid Liabilities

Current Liabilities – overdraft

2,00,000 – 50,000

Rs.

1,50,000

Liquid ratio

Liquid assets

2,55,000 =

1.7 : 1

1,50,000 Proprietor’s funds 3.

Proprietory Ratio

= Total tangible assets

Proprietors funds

Equity Share Capital + Preference share Capital + Reserves and Surpluses

Total asset

Rs.

5,00,000 + 2,00,000 + 3,00,000

Rs.

10,00,000

Rs.

16,00,000 10,00,000

0.625 : 1

16,00,000

External equities 4. Debt - Equity Ratio

Debt

= Internal equities

Debt

Equity

Debentures + Current Liabilities

Rs. 4,00,000 + 2,00,000 = 6,00,000

Equity

Proprietor’s funds = Rs. 10,00,000

Debt - Equity Ratio

6,00,000 = 0.6 : 1 10,00,000 Preference share capital + Long-term debt bearing fixed interest 5. Capital Gearing Ratio = Equity share capital + Reserves and Surplus 2,00,000 + 4,00,000 =

6,00,000 =

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179

om the following, you are required to calculate a) Debtors turn over b) Average of debtors 2007

2006

Illustration 2: From the following, you are required to calculate a) Debtors turn over b) Average of debtors

Net sales Debtors (Beginning of the year) Debtors (End of the year)

2007

2006

18,00,000

15,00,000

1,72,000

1,60,000

2,34,000

1,72,000

Solution: Debtors =

Average Debtors =

2006 = =

= Rs. 1,66,000

2007 = =

= Rs 2,03,000

Debtors turn over for 2006 =

= 9.04

Debtors turn over for 2007 =

= 8.87

Average of debtors Or Average collection period =

Ă&#x2014; No of working days in a year

FINANCIAL MGMT. & MGMT. ACCOUNTING

2006 =

× 365 = 40 days

2007 =

× 365 = 41 days

Illustration 3:

180

A trader purchase goods both on cash as well as on credit terms. The

following particulars ae obtained from the books. Rs Total purchases

5,81,000

Cash purchases

30,000

Purchase returns

51,000

Creditors of the end Bills payable at the end Reserve for discount on creditors

1,05,000 60,000 8,000

Calculate average payment period Solution : Average payment period =

× No of working days in a year

× 365 = 120 days ----------

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UNIT IX FUNDS FLOW ANALYSIS Every company prepares its balance sheet at the end of its accounting year. It is a statement of assets and liabilities of the company as on a particular date. It reveals the financial position of the company. It does not present a detailed analysis. The balance sheet fails to account for the periodic increase or decrease in the working capital of an enterprise. Hence, another statement has become necessary to show the changes in working capital during a period and explain them. The statement is called fund flow statement. Meaning: The funds flow statement is a report on the movement of funds or working capital. It explains how working capital is raised and used during the accounting period. Definition: “A statement of sources and application of funds is a technical device designed toanalyse the changes in the financial condition of a business enterprise between two dates” – Foulke. It will be appropriate to explain the meaning of the term ‘Funds’ and the term ‘Flow of Funds’ before explain the meaning of the term ‘Funds Flow Statement’. Meaning of Funds: The term ‘Funds’ has a variety of meanings.

There are people who take it

synonymous to cash and to them there is no difference between a Funds Flow Statement and Cash Flow Statement.

While others include marketable securities besides cash in the

definition of the term ‘Funds’. The International Accounting Standard No.7 on “Statement of Changes in Financial Position” also recognises the absence of single generally accepted, definition of the term. According to the standard, the term “Fund” generally refers to cash, and cash equivalents, or to working capital of these, the lost definition of the term is by far the most common definition of “Fund”. There are also two concepts of working capital-gross concept and net concept. Gross working capital refers to the firm’s investment in current assets while the term net working capital means excess of current assets over current liabilities. It is in the latter sense in which the term “Funds” is generally used. The terms ‘Current Assets’, ‘Current liability’, non-Current assets and non-current liability are explained below for better clarity. Current Assets: - Current assets are those assets which can be converted in to cash within a short period of time, normally not exceeding one year. These current assets can be of two types:

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Chargeable current assets are those which are appearing as security against bank fiancé, such as inventory, spares and receivables etc. The word inventory includes stocks of raw-materials, and consumable stores, stock in-process and finished goods. Other current assets will include the following:

Cash and bank balances.



Investment by way of government and trustee securities other than for long term purposes.



Inventory of raw materials, semi-finished and finished goods.



Sundry debtors, provision for bad and doubtful debts



Bills receivable



Prepaid expenses.



Advance payment for tax.



Advance for purchase of raw materials, components and spare parts etc.

Current Liabilities: The current liabilities defined as liabilities which are short-term maturing obligations to be met within a year. These include: 

Trade creditors for raw materials and consumable stores and spares



Bills payable



Bank credit



Provision for taxation, sales tax, excise etc.



Dividends payable



Outstanding expenses



Unsecured loans



Public deposits maturing within one year



Interest and other charges accured but not due for payment

Non – Current Assets: All assets other than current assets come within the category of non-current assets. Such assets include good will, land and building, machinery, furniture, long-term investment, patent rights, trade marks, debit balance of profit and loss account, discount on issue of shares and debentures, preliminary expenses. Non-Current Liabilities: All liabilities other than current liabilities come within the category of non current liabilities. They include share capital, long-term loans, debentures, share premium, credit balance in the profit and loss account, revenue and capital reserves (e.g. general reserve, dividend equalisation fund, debentures sinking fund, capital redemption reserve) etc.

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Concept of Flow of Funds: The term ‘flow means change and therefore the term ‘flow of funds’ means ‘change in funds’ or ‘change in working capital’. In other words, ‘flow of funds’ means any increase or decrease in working capital. If the transaction results in the increase of funds, it is called a source of funds, if it results in the decrease of funds, it is known as an application of funds. If the transaction does not affect the working capital there is no flow of funds. The flow of fund occurs only when a transaction involves are current account and another non-current account. When a transaction involves non-current accounts only, no flow of fund occurs since working capital is not altered. Example, issue of shares in consideration for machinery. Similarly if a transaction affects current accounts only, no flow of fund occurs. Example collection of cash from debtors or payment of cash to creditors. Thus, to facilitate a flow of fund (change in working capital) the transaction must affect one current account and another non-current account. Example, issue of shares in consideration for stock acquired, cash payment for building etc. Objectives: The main objectives of fund flow statement are: 1. To show how resources have been obtained and used 2. To indicate the results of current financial management 3. To throw light up on the most important changes that have taken place during a specified period 4. To show how the general expansion of the business has been financed 5. To indicate the relationship between profits from operations, distribution of dividend and raising of new capital or term loans 6. To have an assessment of the working capital position of the concern

MANAGERIAL USES OF FUNDS FLOW ANALYSIS The funds flow statement is of primary importance to the financial management. It is an essential tool for financial analysis. The uses of funds flow statement are:

Analysis of financial operation:

The main purpose of funds flow statement is to analyse the financial operations of the business. The statement explains the causes for changes in the assets and liabilities during a period. It also indicates the effect of these changes on the liquidity of the firm.

Evaluation of the firm’s financing:

The analysis of sources of funds reveals how the firm has financed its development projects in the past. It also reveals the rate of growth of the firm.

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184

Allocation of scarce Resources:

A projected funds flow statement is an instrument for allocation of resources. It lays down the plan for efficient use of scarce resources in future. It enables the management to discharge its financial obligations promptly.

Helps in working capital management: Funds flow statement indicates the adequacy or inadequacy of working capital. The

management can take steps for effective use of surplus working capital.

In case of

inadequacy, arrangement can be made for improving the working capital position. 5.

Acts as a Guide to future: With the aid of projected funds flow statement, the management can plan for meeting

future financial requirements. 6.

Helps financial Institutions: The funds flow statement is also useful to lending institutions like banks IDBI, ICICI,

IFCI and others. It helps them to assess the credit worthiness and repaying capacity of the borrowing company. 7.

Answers to intricate questions: The funds flow statement provides answers to questions such as: 1. Why were the net current assets of the firm down, though the net income was up or vice versa? 2. How was it possible to distribute dividends in absence of or in excess of current income to the period? 3. How was expansion in plans and equipment financed? 4. How was the sale proceeds of plant and machinery used? 5. How the loans were repaid? 6. What become to the proceeds of share issue or debentures issue? 7. How was the increase the working capital financed? 8. Where did the profits go?

LIMITATIONS OF FUNDS FLOW STATEMENT: The limitations of funds flow statement are listed below: 1. Funds flow statement is not a substitute for an income statement or balance sheet. It provides only some additional information regarding changes in working capital. 2. Changes in cash are more important and relevant for financial management than the working capital.

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3. It is not an original statement. It is only a rearrangement of date given in financial statement. 4. Funds flow statement is essentially historic in nature.

A projected funds flow

statement, on the basis of it can not the prepared with much accuracy. 5. It can not reveal continuous changes.

PREPARATION OF FUNDS FLOW STATEMENT: In order to prepare a funds flow statement, It is necessary to fixed out the “Sources” and “Applications” of funds. The term ‘Funds’ refers to working capital. Transactions that increase working capital are sources of funds. Transactions that decrease working capital are applications of funds. The following are the main sources and applications of founds. Sources of Funds

Applications of Funds

Funds from operations

Issue of shares and debentures

Raising of long term loans

Repayment of loans

Income from investment

Purchase of long term investments

Sale of fixed assets and long

Purchase of fixed assets

Payment of taxes and dividend

Drawings (In the case of sole trading

term investments

Funds lost in operations

Redemption of preference shares and debentures

concern or partnership firm) 8.

Loss of cash by embezzlement

Funds from operation:

Profit of a period is an important source of funds. The profit and loss account reveals the net profit or loss of business. The net profit is arrived at after taking into account all terms of income and expenditure (both operating and non-operating, both funds items and nonfunds items). To arrive at funds from operating, adjustments are made in net profit for nonfound and non-operating items. It will be clear from the following:

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186

Calculation of funds from operations:

Net profit earned during the year Add:

xxxx

Non-fund and non-operating items Which are already debited to P & L a/c:

Less:

Depreciation on fixed assets

xxxx

Good will written off

xxxx

Discount on issue of shares, written off

xxxx

Preliminary expenses written off

xxxx

Patents written off

xxxx

Transfer to reserves

xxxx

Loss on sale of fixed assets

xxxx

Non â&#x20AC;&#x201C; fund or Non â&#x20AC;&#x201C; operating items Which are already credited to P & L a/c: Profit on sale of fixed assets

xxxx

Profit on revaluation of assets

xxxx

Rent received

xxxx

Discount received

xxxx

Refund of income tax

xxxx

Funds from operation xxxx

It the profit and loss account shows a net loss, the above procedure will be reversed. 2.

Issue of shares and debentures: Either in term of issuing debentures, or preference

shares or equity shares

constitutes major source of working capital. For example, a company issues Rs2,00,000 equity shares at a premium of 10% Rs 2,20,000 constitutes a source of working capital as it increases cash (CA) and increases NCL. It is important to remember that the face value of

FINANCIAL MGMT. & MGMT. ACCOUNTING

187

the security is immaterial; it is net amount received from the transaction that constitutes the source. 3.

Sale of non-current assets: It is not unusual for a business firm to sell one or more of its non-current assets

particularly in the case of plants and equipment either because they have become useless or more efficient plant and machinery equipment have appeared in the market. If the sale is made for cash or a receivable current assets increase. So, the sale proceeds from the disposition of non-current assets is the source of funds. Whether the non-current asset is sold at a profit or at a loss, is irrelevant for the purpose. The amount is received or receivable in the near future constitute the source. For example, a plant and machinery having a net book value of Rs30,000 has been sold for Rs 20,000; Rs 20,000 would constitute the source of funds; the cost (loss) of Rs10,000 would be transferred to profit and loss account. If it is sold for Rs40,000; Rs40,000 would constitute the source of funds and Rs10,000, being profit, transferred to profit and loss account. 4.

Funds from increase in share capital: Issue of shares for cash or for any other current assets results in increase in working

capital and hence there will be a flow of funds

Application of funds: The uses to which funds are put one called â&#x20AC;&#x2DC;applications of fundsâ&#x20AC;&#x2122;. Following are some of the purposes for which funds may be used: 1. Redemption of preference shares and debentures: The retirement of long term liabilities such as payment to preference shareholders and debenture holders involves the use of cash. There is corresponding decrease in longterm liabilities.

It should be borne in mind that it is not the face value of the security

redeemed that is important; the important thing is to know the actual payment made to retire such securities. 2. Purchase of fixed assets: Purchase of fixed assets such as land, building, plant, machinery, long-term investment etc results in decrease of current assets without any decrease in current liabilities. Hence, there will be a flow of funds.

But incase shares on debentures are issued for

acquisition of fixed assets, there will be no flow of funds. 3. Payment of tax liability: Provision for taxation is generally taken as an appropriation of profits and not as an application of funds. But if the tax has been paid, it will be taken as an application of funds. 4. Recurring payment to investors:

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188

5. Dividends and interest constitute the recurring payments to investors. It represent another use of funds. PROCEDURE FOR THE PREPARATION OF FUNDS FLOW STATEMENT: Fund flow statement is usually prepared for one year on the basis of balance sheets and additional information. Preparation of funds flow statement involves the following steps:1. Schedule of changes in working capital: Working capital is the difference between current assets and current liabilities. The schedule of changes in working capital is prepared to fixed out the increase or decrease in working capital during the year. Current assets and current liabilities are taken to the schedule. Working capital at the end of the current year is compared with that of the previous year. The difference is either increase or decrease in working capital. Increase in current assets will lead to increase in working capital and vice-versa on the other hand, increase in current liabilities will lead to decrease in working capital and viceversa. Increase in working capital will appear on the application side of fund flow statement. Decrease in working capital win appear on the â&#x20AC;&#x2DC;sourcesâ&#x20AC;&#x2122; side of fund flow statement. Proforma of statement of changes in working capital

Effects on working capital

Current Assets: Stock Debtors Cash Bank B/R Prepaid expenses Total (a) Rs

Current liabilities: Creditors B/P Outstanding expenses Total (b) Rs

Previous Year

Current Year

Increase

Decrease

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189

Working capital: (Difference between Decrease in working capital) Total Rs 2. Opening of Accounts of Non – Current items: Accounts are prepared for non – current items to ascertain the source or application of funds. In the preparation of accounts for non – current items, additional information is to be st

considered. For example, the value of machinery on 31 March 2006 and 31 March 2007 are Rs 20,000 and Rs 25,000 respectively and depreciation charged during the year is Rs 5,000. The account will appear as below: Machinery A/c Rs To Balance b/d

20,000

To Cash A/c (B/F)

10,000

By Adjusted P/L A/c

(Depreciation)

5,000

By Balance c/d

25,000

30,000

The balancing figure represents purchase of machinery. It is an application of funds. 3. Preparation of Adjusted profit and loss Account: The adjusted profit and loss account is prepared to ascertain funds from operation or funds lost in operation. The regular profit and loss account shows only the net profit or loss. To ascertain the funds generated by operations the adjusted profit and loss account is prepared by taking into account only the non – fund and non – operating items. Non – fund items refer to expenses and income which do not involve any changes in working capital. Example, depreciation transfer to general reserve, writing back of provision for tax etc.

Non –

operating items refers to expense and income which not directly related to business operations of the company. Example, dividend received refund of tax, profit/loss on sale of assets etc. the balancing figure in the adjusted profit and loss account is either funds from operations or funds lost in operations.

4. Preparation of funds flow statement The above three steps are incorporated in the preparation of funds flow statement. Statement of sources and Applications of Funds Sources

Applications

FINANCIAL MGMT. & MGMT. ACCOUNTING

190

1. Issue of share capital

xxxx

1. Redemption of preferences shares

xxxx

2. Issue of debentures

xxxx

2. Redemption of debentures

xxxx

3. Raising of long term loans

xxxx

3. Repayment of loans

xxxx

4. Income from investments

xxxx

4. Purchase of long term investments

xxxx

5. Purchase of fixed assets

6. Funds from operations

xxxx

6. Payment of taxes and dividends

xxxx

7. Non-trading income

xxxx

7. Drawings (in case of sole trading

xxxx

5. Sale of fixed assets and long term investment

Total

concern or partnership firm) xxxx

9. Non-trading expenses

xxxx Total

xxxx

Increase in working capital as per statement

per statement of changes in

of changes in working capital

xxxx Total

8. Funds lost in operation

xxxx

Decrease in working capital as

working capital

xxxx

Total

xxxx

Illustration: From the following balance sheets of Mr Rajesh prepare a funds flow statement. th

Liabilities

30 June 2006

30 June 2007

Assets

Creditors

18,000

20,500

Cash

Bank loan

15,000

19,500

Capital

77,000

78,000

Total

1,10,000

1,18,000

30 June 2006

30 June 2007

Rs 5,000

2,300

Debtors

17,500

19,200

Stock

12,500

11,000

Land

10,000

15,000

Building

25,000

27,500

Machinery

40,000

43,000

1,10,000

1,18,000

Drawings of Mr Rajesh during the year was Rs20,000. Depreciation charges on machinery was RS 4,000.

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191

Solution: Schedule of changes ijn working capital th

Particulars

30 June

2006

2007

Increase

Decrease

5,000

2.300

---

2,700

Debtors

17,500

19,200

1,700

---

Stock

12,500

11,000

---

1,500

Total (A)

35,000

32,500

Creditors

18,000

20,500

---

2,500

Total (B)

18,000

20,500

Working capital (A-B)

17,000

12,000 5,000

5,000

---

17,000

6,700

Current Assets: Cash

Less: Current Liabilities

Decrease In working capital

--17,000

Sources and applications of funds during the year ended 30 2007 Sources Bank loan

Funds from operation Decrease in working capital

Rs 4,500

25,000 5,000

Applications

Purchase of land

5,000

Purchase of building

2,500

Purchase of machinery

7,000

Drawings

34,500

20,000 34,500

Working: Machinery account Rs To Balance b/d To cash (purchase)

40,000 7,000

Rs By adjusted P/L A/c (depreciation) By Balance C/d

47,000

Capital Account

4,000 43,000 47,000

FINANCIAL MGMT. & MGMT. ACCOUNTING Rs

192 Rs

To Drawings

20,000

By Balance b/d

77,000

To Balance C/d

78,000

By adjusted P/L A/c ( Net profit)

21,000

98,000

Adjusted Profit and Loss account Rs To Machinery

4,000

To Net profit

21,000

Rs By funds form operators

25,000

Distinction between funds flow statement and income statement: The main difference between funds flow statement and income statement are given below; 1. Funds flow statement is prepared to know the sources and uses of working capital. But an income statement is prepared to know the results of the business activities ie profit or loss. 2. Funds flow statement matches the funds raised with funds applied. No distinction is made between capital and revenue items. But the income statement matches cost of goods sold with sales to ascertain profit or loss. It deals with revenue items only. CASH FLOW STATEMENT Cash flow analysis is another important technique of financial analysis. It involves preparation of cash flow statement for identifying sources and application of cash. Cash flow statement may be prepared on the basis of actual or estimated date. Cash flow statements summarize sources of cash inflows and uses of cash outflows of the firm during a particular period of time. It can be prepared for a year, half year, quarter or for any other duration.

Objectives: The objectives of cash flow analysis are: 1. To show the causes of changes in cash balance between two balance sheet dates. 2. To indicate the factors contributing to the reduction of cash balance in spite of increase in profits and vice-versa.

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Significance and uses of cash flow statement: Cash flow statement is vital significance to the financial management.

Its chief

advantages are: 1. The cash flow statement explains the reasons for low cash balance in-spite of huge profits or large cash balance in spite of low profits. 2. It helps in short â&#x20AC;&#x201C; term financial decisions relating to liquidity. 3. It shows the major sources and uses of cash. The management with the aid of projected cash flow statement can know a. How much cash will be needed b. From which sources it can be obtained c.

How much can be generated internally

d. How much could be obtained from outside

4. It helps the management in planning the replacement of loans, replacement of assets, credit arrangement etc. It is also significant for capital budgeting decisions. 5. On the basis of past yearâ&#x20AC;&#x2122;s cash flow statements projections can be made for the future. The projected cash flow statement helps in planning for the investment of surplus or meeting the deficit. 6. A comparison of actual cash flow statement with the projected cashflow statement helps in understanding the variations and control of cash expenditure. Preparation of cash flow statement: Cash flow statements is usually prepared for one year on the basis of balance sheet and additional information. Preparation of cash flow statements involves the following steps: 1. Opening of accounts for Non-Current items: Accounts are prepared for non-current items to ascertain the inflow and outflow of cash. In the preparation of accounts for non-current items, additional information is to be st

considered. For example, the value of plant (as per balance sheet) on 31 March 2005 and st

31 March 2006 is Rs40,000 and Rs 50,000 respectively and depreciation charged during the year is Rs 10,000. The account will appear as below: Plant Account Rs

To Balance b/d

40,000

By Adjusted P/L A/c (Depreciation)

10,000

To cash ( Balancing figure)

20,000

By Balance c/d

50,000

60,000

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The balancing figure represents purchase of plant. It is an out flow

cash.

Thus by opening of accounts or by comparing non-current items, inflow and out flow of cash are found out. 2. Preparation of adjusted profit and loss Account:The adjusted profit and loss account is prepared to ascertain cash trading profit or cash trading loss. The regular profit and loss account shows only the net profit or loss. It does not show the cash profit realised by trading. Suppose, the net profit shown by profit and loss account is Rs 10,000.

It depreciation of Rs 5,000 had been changed and preliminary

expenses written off were Rs5,000, the cash trading profit would be Rs20,000 (10,000+5,000+5,000). In the preparation of adjusted profit and loss account, the non-cash and non – operating items are alone taken into account. Non- cash items refer to expenses or income which do not cause any change in cash. Example, depreciation, preliminary expenses written off etc. Non-operating items refer to expenses and income which are not directly related to operations of the company. Examples, dividend or interest received, refund of tax, profit or loss on sale of assets etc. The balancing figure in the adjusted profit and loss account is either cash trading profit or cash trading loss. 3. Comparison of current items to determine inflow or outflow of cash: Individual current assets like stock, debtors, prepaid expenses are compared. Increase in current assets is taken as an out flow of cash and vice-versa. For example, if stock shows an increase of Rs5,000 over the balance of the previous year, out flow of cash is Rs 5,000. Increase in current liabilities is taken as in flow of cash and vice-versa. 4. Preparation of cash flow statement:The above three steps are incorporated in the preparation from of cash flow statement. A cash flow statement can be prepared in the following form: Cash flow statement for the year ending on……………….. Balance as on………….. Cash Balance

xxxx

Bank Balance

xxxx

Add: Sources of cash: Issue of shares

xxxx

Raising of long term loans

xxxx

Sale of fixed assets

xxxx

Short term borrowings

xxxx

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Cash from operations : Profit as per P/L account

xxxx

Add/Less Adjustment for non-cash items:Add : Increase in current liabilities

xxxx

Decrease in current assets

xxxx

Less : Increase in current assets

xxxx

Decrease in current liabilities

xxxx

Total Cash available (1)

Xxxx xxxx

Less : Applications of cash:Redemption of redeemable Preference shares

xxxx

Redemption of long-term loans

xxxx

Purchase of fixed assets

xxxx

Decrease in deferred payment liabilities

xxxx

Cash out flow on account of operations

xxxx

Tax paid

xxxx

Dividend paid

xxxx

Decrease in unsecured loans, deposits etc

xxxx xxxx

Total cash available (2) 

xxxx

Closing Balance: Cash Balance

xxxx

Bank Balance

xxxx xxxx



This total should tally with the balance as shown by (1) – (2)

Difference between cash flow statement and funds flow statement: Following are the points of difference between a cash flow statement and funds flow statement: 1. In a cash flow statement, only cash receipts and payments are recorded. But in a funds flow statement increase or decrease in working capital is recorded. 2. The cash flow statement indicates the causes for changes in cash position. The other hand, a funds flow statement shows the causes of changes in working capital.

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3. Cash flow statement is appropriate for short range planning.

While funds flow

statement is appropriate for long range planning. 4. Whenever there is inflow of cash there will definitely be inflow of funds. But it is not vice-versa. Inflow of funds does not necessarily mean inflow of cash. 5. Cash flow statement starts with opening cash balance and closes with the closing cash balance. But there is no opening and closing balances in funds flow statement. Illustration:- Statement of financial position of Mr.Kumar is given below: 30.06.2006

30.06.2007

Liabilities: Accounts payable Capital

30.06.2006

30.06.2007

Assets

29,000

25,000

7,39,000

6,15,000

Cash

40,000

30,000

Debtors

20,000

17,000

8,000

13,000

1,00,000

80,000

6,00,000

5,00,000

7,68,000

6,40,000

Stock Building Other fixed assets Total

7,68,000

6,40,000

Additional information:a. There were no drawings b. There were no purchases or sale of either building or other fixed assets. Prepare a statement of cash flow. Solution:Cash flow statement of Mr Kumar Sources Opening cash balance Decrease in debtors

Uses

40,000 3,000

Decrease in accounts payable

4,000

Increase in stock

5,000

Cash trading loss

4,000

Closing cash balance 43,000

30,000 43,000

Working: Building account Rs

FINANCIAL MGMT. & MGMT. ACCOUNTING To Balance b/d

1,00,000

197

By adjusted P/L A/c (depreciation)

20,000

By Balance C/d

80,000

1,00,000

Other fixed assets account Rs To Balance b/d

6,00,000

By adjusted P/LA/c (depreciation)

1,00,000

By Balance C/d

5,00,000

6,00,000

Capital Account Rs

To Net loss

1,24,000

To Balance c/d

6,15,000

By Balance b/d

7,39,000

Adjusted P/L Account Rs

Rs By Balance b/d

To Building A/c (Depreciation) To other fixed assets a/c (Depreciation) To Cash trading loss

20,000

By Net loss (Transfer to Capital A/c)

1,24,0000

1,00,000 4,000 1,24,000

Illustration 2:

---

1,24,000

After taking into account the under mentioned items, Jain Ltd made a net st

profit of Rs.1,00,000 for the year ended 31 Dec 2006. Rs Loss on sale of machinery

10,000

Depreciation on building

4,000

Depreciation on machinery

5,000

Preliminary expenses written off

5,000

Provision for Taxation

10,000

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198

Good will written off

5,000

Gain on sale of buildings

8,000

Find out Cash from operations Solution: Calculation of cash from operations Rs Net profit earned during one year Add:

1,00,000

Non – cash and non- operating expenses: Loss on sale of machinery

10,000

Depreciation on building

4,000

Depreciation on machinery

5,000

Preliminary expenses written off

5,000

Provision for Tax Good will written off

10,000 5,000 1,39,000

Less:

Non – Cash and non – operating income: Gain on sale of buildings Cash trading profit

Add:

Decrease in current assets and increase in Current liability

Less:

Increase in current assets and decrease in

8,000 1,31,000

---

Current liability Cash from operations

________________

1,31,000

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UNIT – X MARGINAL COSTING Materials, labour and other expenses constitute the different elements of cost. These elements of cost can broadly be put into two categories: Fixed costs and variable costs. Fixed cost are those costs which do not vary but remaining constant within a given period of time and range of activity in spite of fluctuations in production. Variable costs are those costs which may increase or decrease in proportion to increase or decrease in output. The cost of product or process can be ascertained using different elements of costs according to any of the following two techniques: 1. Absorption costing and 2. Marginal costing Absorption costing technique is also termed as Traditional or Full cost method. According to this method, the cost of a product is determined after considering both fixed and variable cost. The variable costs, such as those of direct materials direct labour etc, are directly changed 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. Under marginal costing technique, only variable costs are taken

into account for

purposes of product costing, inventory valuation and other important management decisions and no attempt is made to find suitable bases of apportionment of fixed costs. Marginal costing is also known as Direct costing or variable costing. It is the most useful technique which guides the management in pricing, decision making and assessment of profitability. Concept of Marginal costing: Marginal costing is a technique where only the variable costs are considered while computing the cost of a product. The fixed cost are met against the total fund arising out of the excess of selling price over total variable cost. This fund is known as contribution in marginal costing. According to the institute of cost and work Accountants, London, “Marginal Costing is the ascertainment by differentiating between fixed costs and variable costs, of marginal cost and of the effect on profit or changes in the volume and type of output”. According to the chartered Institute of management Accountants, London, “Marginal costing is a technique where only the variable costs are charged to cost unit, the fixed cost attributable being written off in full against the contribution for that period”. This will be clear with the help of the following illustration. Illustration: A company is manufacturing three products A,B and C. manufacture are as follows:-

The costs of their

FINANCIAL MGMT. & MGMT. ACCOUNTING

200 Products

Direct materials per unit

Direct labour per unit

Selling price per unit

1,000

Particulars

Out put (units)

The total over heads are Rs 6,000 output of which Rs3,000 are fixed and rest are variable. Prepare a statement of cost and profit according to the marginal costing technique.

Solution:-

Product A Particulars

Product B

Product C

Per unit

Total

Per unit

Total

Per unit

Total

Direct materials

3,000

4,000

5,000

Direct labour

2,000

3,000

4,000

Variable over heads

1,000

Total Marginal cost

6,000

8,000

10,000

4,000

7,000

10,000

15,000

20,000

Contribution (sales â&#x20AC;&#x201C; variable cost) Selling price

Thus the total contribution from the three products A,B and C amounts to Rs 21,000 (4000+7000+10,000). The profit will be computed as follows: Rs Total contribution

21,000

Fixed costs

3,000 18.000

Hence it is clear that marginal costing is not a system of cost finding such as job, process or operating costing, but it is a special technique concerned, particularly with the effect of fixed overheads on running the business. The concept of marginal costing is a formal recognition of ideas understanding flexible budgets, break - even analysis and cost volume profit relationship. It is an application of these relationship which involves a change in the conventional treatment overheads in relation to income determination. Features of Marginal Costing:-

of fixed

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201

1. All costs are classified into two-fixed and variable 2. Only the variable costs (Marginal Costs) are treated as the cost of the product. 3. The stock of finished goods and work in progress are valued at marginal cost only. 4. Fixed costs are charged against the contribution earned during the period. 5. Prices are based on marginal cost plus contribution. Contribution is the difference between selling price and variable cost. Marginal Costing Vs Absorption Costing: Since marginal costing is an alternative to absorption costing, it is necessary to compare the two and suggest if possible, the technique is more appropriate in routine costing. Following are the important points of distinction between absorption costing and marginal costing:1. Absorption costing is a total cost technique. That is, both variable and fixed costs are charged to projects. In marginal costing only variable costs are charged to products. 2. Absorption costing values stock at cost which includes fixed cost also. On the other hand, marginal costing values stock at variable costs only. This results in higher value of stock under absorption costing than under marginal costing. 3. In absorption costing, managerial decisions are guided by net profit which is the excess of sales over total cost. In marginal costing, decisions are guided by â&#x20AC;&#x2DC;Contributionâ&#x20AC;&#x2122; which is excess of sales over overhead costs. 4. In total cost technique, there is the problem of apportionment of fixed costs since fixed costs are also treated as product costs. Marginal costing excludes fixed costs. Therefore there is no question of arbitrary apportionment. The above points of difference between absorption costing and marginal costing will be clear with are help of the following illustration: A Company has a production capacity of 2,00,000 units per year. Normal capacity utilisation is reckoned as 90% standard variable production costs are Rs11 per unit. The fixed costs are Rs3 ,60,000 per year. Variable selling costs are Rs 3 per unit and fixed selling costs are Rs 2,70,000 per year. The selling price per unit is Rs20. In the year end on 30

June 2003, the production was 1,60,000 units and sales were 1,50,000 units. The closing th

inventory on 30 June 2003 was 20,000 units. The actual valuable production costs for the year were Rs 35,000 higher than the standard

Calculate the profit for the year: a) by the absorption costing method and b) by the marginal costing method

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202

Also explain the difference in the profit. Solution: In absorption Costing method th

Profit statement for the year ended 30 June 2003 Amount (Rs.) Sales:

1,50,000 units at Rs.20 per unit

Less:

Cost of Production: Variable production cost for 1,60,000 units at Rs.11 per unit

Amount (Rs) 30,00,000

Increase in fixed cost

17,60,000 35,000

Fixed Cost

3,60,000 21,55,000

Add:

Opening stock = 10,000 units (i.e. Sales 1,50,000 units + Closing stock 20,000 units â&#x20AC;&#x201C; production 1,60,000 units) at Rs. 13 (i.e. variable normal capacity unitlisation)

1,30,000 22,85,000

Less:

Closing stock: 20,000 values 21,55,000 current cost x 20,000 1,60,000

2,69,375

20,15,625

Gross Profit

9,84, 375

Gross Profit

9,84,375

Selling expenses: Variable Fixed

4,50,000 2,70,000 Net Profit

7,20,000 2,64,375

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In Marginal costing method th

Profit statement for the year ended 30 June, 2003

Amount (Rs.)

Sales:

Less:

1,50,000 units at Rs.20 per unit Margin Cost: Variable production cost for 1,60,000 units at Rs.11 per unit Additional variable production cost variable cost of opening stock of finished costs

Amount (Rs)

30,00,000

17,60,000 35,000 1,10,000 19,05,000

Less:

Closing stock of finished goods: 20,000 units valued at current variable production cost 17,95,000 x 20,000 1,60,000 Variable production cost of 1,50,000 Units

Add:

Variable selling cost of 1,50,000 units (1,50,000 x 3)

Less:

Contribution Fixed cost: Fixed production cost Fixed selling cost

2,24,375 16,80,625

4,50,000 21,30,625 8,69,375 3,60,000 2,70,000

Net Profit

6,30,000 2,39,375

The difference in profits Rs. 25,000 (i.e.Rs. 2,64,375 â&#x20AC;&#x201C; 2,39,375) as arrived at under absorption and marginal costing methods is due to the element of fixed cost included in the valuation of opening and closing stock under the absorption costing method. Which technique is preferable? Since absorption costing and marginal costing are alternative techniques in the routine cost accounting, it is necessary to say about their appropriateness for product costing. Absorption costing may be preferred on the following grounds.

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1. In modern times foxed costs constitute a substantial portion of total cost production is impossible without incurring fixed costs. As such they are a apart of cost of production. 2. Inclusion of fixed costs in inventory valuation become absolutely necessary if building up of stocks is a necessary part of business operations. For example, in the case of timbers and fire works stocks have to be build-up. If fixed costs are excluded from inventory valuation fictions losses have to be shown in earlier years and excessive profits when goods are actually sold. 3. Profit fluctuations are less when production is constant but sales fluctuate. 4. This technique enables matching of costs and revenue, in the period in which revenue arises and not when costs are incurred. 5. The inclusion of fixed costs does not give room for fixation of price below total cost although some contribution is generated. Marginal costs may be preferred as on the following grounds:1. This technique is simple to understand and easy to operate. 2. Individual fixed costs need not be apportioned on an arbitrary basis. 3. It avoids the contingency of over / under absorption of overheads. 4. Fixed costs accrue on time basis. Hence they should be written off in the period of accrual 5. Accounts prepared under this technique more nearly approach the actual cash flow position. In the light of above arguments in favour of each of techniques, it is not possible to lay down any general rule regarding the use of a particular technique. It is the cost accountant who is the right person to decide in favour of either of the two having regard to its appropriateness to a particular organization. While absorption costing is the basis of financial accounting, it is equally so in the routine cost ascertainment procedure; Since the use of full marginal costing system for product costing is very rare in modern times. However for purposes of planning and decision making marginal costing is the only technique which is universally recognized. Marginal costing â&#x20AC;&#x201C; Role of contribution:Contribution is of vital importance for the system of marginal Costing Contribution is the difference between sales and variable costs and it contributes towards fixed costs and profit.

It helps in sales and pricing policies and measuring the profitability of different

FINANCIAL MGMT. & MGMT. ACCOUNTING proposals.

Contribution is a sure

205

test to decide whether a product is worthwhile to be

continued among different products. Contribution

Sales – Variable cost

Contribution

Fixed cost + profit

Fixed Costs and Variable costs: In marginal costing, a point from ‘Contribution’ the concepts of ‘fixed costs’ and variable costs’ are also important. Expenses that do not vary with the volume of productions are known as fixed expenses. Eg. are Manager’s salary, rent and taxes, insurance etc.

should be noted that fixed charges are fixed only within a certain range of plant capacity. The concept of fixed overhead is most useful in formulating a price, fixing policy. Fixed Cost per unit is not fixed. Expenses that vary almost in direct proportion to the volume of production or sales are called variable expenses.

Eg. Electric power and fuel, packing materials,

consumable stores. It should be noted that variable cost per unit is fixed. However to say that fixed costs that do not vary is wrong. Accordingly, even fixed costs become variable beyond a particular point.

If production increases, substantially

additional accommodation and additional executive staff cause an increase in rent, insurance, salaries etc.

There are also other factors such as inflation, Government’s policies, and

management decisions which bring about a change in the level of fixed costs. Since, fixed costs do not, in total, respond to changes in the level of activity, an increase in volume will result in a decrease in the fixed cost per unit. According to the ICMA Terminology, semi variable costs is “A Cost containing both fixed and variable elements which are partly affected by fluctuations in the volume of output or turnover. In other words, semi variable expenses possess both fixed and variable characteristics. Salaries of foremen and supervisors, electricity charges, telephone charges etc. fall under this category. Semi variable cost is also known as semi fixed costs since it contains both fixed and variable elements i.e. semivariable costs are costs which are mainly variable with a significant fixed element or mainly fixed with a significant variable element. Illustration: Prepare marginal cost statement from the following particulars:Variable cost :

Rs.

Direct material

4,500

Direct Wages

2,500

Factory over heads

1,500 --------

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206

Fixed costs

8,500

Administrative expenses

1,250 --------

Total cost Profit

9,750 5,250 --------15,000 ---------

Sales

Solution: Marginal Cost Statement

Rs. Sales Less:

Less

Rs. 15,000

Variable cost : Direct materials Direct wages Factory over heads

4,500 2,500 1,500 Contribution

8,500 6,500

Profit

1,250 5,250

Fixed cost: Administrative expenses

Illustration: Determine the amount of fixed expenses from the following particulars:-

Sales Direct Material Direct Labour Variable overhead Profit

2,50,000 80,000 50,000 20,000 60,000

Solution: Calculation of mixed expenses:Marginal Cost Statement Rs. Less:

Sales Variable cost : Direct material Direct Labour Variable overhead

Rs. 2,50,000

80,000 50,000 20,000

1.50,000

FINANCIAL MGMT. & MGMT. ACCOUNTING Contribution Less:

Fixed Expenses B/F. Profit

207 1,00,000 40,000 60,000

Merits of Marginal Costing:1. Marginal costing helps in taking decisions such as pricing, accepting foreign orders at low price, to make or buy, selection of suitable product mix etc. 2. It yields better results when combined with standard costing. 3. It enables effective cost control by dividing costs into fixed and variable costs. 4. It enables the proper apportionment of fixed costs. 5. It avoids the complication of over-recovery or under recovery of overheads. 6. It facilitates the study of relative, profitabilily of different products when a number of products are being manufacturing. 7. Inventory valuation becomes more realistic when it is based on marginal cost. 8. Since fixed costs are not absorbed in unsalable stock, there is no question of fictitious or false profits. Demerits:1. It is difficult to separate fixed and variable costs clearly 2. There are semi-variable costs. They are not considered in the analysis. 3. It ignores time element.

In the long run, all costs including fixed costs change.

Therefore, comparison of performance between two periods on the basis of contribution is not possible. 4. Since valuable overheads are apportioned on estimated basis, problem of under or over recovery cannot be totally eliminated. 5. Price fixation and comparison between two jobs can be done without considering fixed costs. 6. The stock is valued at marginal cost. Hence, in the case of loss due to fire, full loss cannot be recovered from the insurance company.

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208

7. Valuation of inventories and profit estimations based on marginal costing are objected to by tax authorities. 8. In controlling costs, marginal costing is not useful in concerns where fixed costs are huge in relation to variable costs. 9. It is found unsuitable in industries like ship building, contract etc., where the value of work-in-progress is high in relation to turnover. If fixed expenses are ignored in the valuation of work-in-progress, losses may occur every year till the contract is completed.

On completion there may be huge profit.

It may create income tax

problems. 10. The systems of budgetary control and standing costing serve the purpose better than marginal costing. Hence, this technique is no required. BREAK EVEN ANALYSIS There may be change in the level of production due to many reasons, such as competition, introduction of new product trade depression or boom, increased demand for the product, scarce resources, change in the selling prices of products, etc.

In such cases

management must study the effect on profit on account of the changing level of production. The management uses Break Even Analysis, which is the technique to do such study. The term Break Even Analysis is interpreted in the narrower as well as broader sense in narrower sense it is concerned with finding out the break even point i.e. level of activity where the total cost equals total selling price used in the broader sense It means that the system of analysis which determines the probable profit at any level of production. The break even analysis establishes the relationship of costs, volume and profits. So this analysis is known as Cost Volume Profit Analysis. It is an important technique used in profit planning and managerial decision – making. Break-even Chart:Break even analysis is made through graphical charts. Break-even chart indicates approximate profit or loss at different levels of sales volume within a limited range. The break-even charts show fixed and variable costs and sales revenue so that profit of loss at any given level of production or sales can be ascertained. Steps involved in construction of a Break-even Chart :Step - 1:

Select a scale for sales (units) on horizontal axis.

Step – 2:

Select a scale for costs and revenues on vertical axis

Step – 3:

Draw the fixed cost-line parallel to the horizontal axis.

FINANCIAL MGMT. & MGMT. ACCOUNTING Step – 4:

209

Draw the total cost line, starting from the point on the vertical axis which represents fixed costs.

Step – 5:

Draw the sales line, starting from the point of origin (Zero) and finishing at point of maximum sales.

Step – 6:

The sales line will cut the total cost line at the point where the total cost equal to total revenues.

Step – 7:

The point of intersection of two lines is called ‘break-even point’. i.e. the point of no profit no loss.

Step – 8:

The lines drawn from intersection to horizontal axis and vertical axis give the sales value and number of units produced at break-even point.

Step – 9:

The loss is shown if the production is less than the break-even point and profit is shown if the production is more than the break-even point.

Step – 10:

The total sales minus break-even sales represent the margin of safety.

Step – 11:

The angle which the sales line makes with total cost line, while intersecting it at break-even point is called ‘angle of incidence’ Break – even Chart

Costs Sales (Rs.)

Angle of incidence B.E. Point

B.E Sales (Rs.) Margin of safety

Fixed cost line

B.E. Sales (Units)

Production (units)

Production Units

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Importance of break-even point:1.

Break-even point helps assessing the viability of the organization and to take

decisions in profit planning and cost control. Break-even point is the point of zero net income where the level of sales is just equal to its costs. 2.

Costs include both fixed and variable costs. It is used as a useful tool in financial

planning to recover cost and to maximize profits. 3.

The changes in operating condition such as, selling price, variable cost and fixed

cost will change the break-even point. 4.

For calculation of break-even point, the costs need to be segregated into fixed cost

and variable costs. 5.

Break even point indicates the level of operating capacity and sales to be achieved

to recover all costs. Any further activity or sales beyond break-even point will lead to earn profit for the concern. Formulae for Break-even Analysis:

Fixed Cost Break-even Point (units) = Contribution per unit Fixed Cost Break-even Point (Rs.) = P/V Ratio (or) Break-even units x Selling price per unit Contribution P/V Ratio

x 100 Sales

Fixed Cost + Desired profit Desired Sales = P/V Ratio At Break-even point Contribution

= Fixed Cost

Contribution

â&#x20AC;&#x201C; Fixed Cost = 0

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211

ASSUMPTIONS OF BREAK-EVEN ANALYSIS The following assumptions are important considerations in break-even analysis. 1.

The break-even analysis requires that all costs should be classified into fixed and

variable components. 2.

It is assumed that all fixed costs remain constant at various levels of activity. But in

practice, it may not be fixed in the long run. 3.

Another assumption is that variable costs are really variable and changes in direct

proportion to the volume of out put

In practice variable costs are not necessarily strictly

variable with output. 4.

It is assumed that production units and sales units are equal and no inventory

exists in the beginning or at the end of the period for which analysis is made. In practice, there will always be existence of inventory. 5.

There will be no change in selling price and it remains constant at all levels of

output and further assumed that there is no change in the sales mix. 6.

It is assumed that productivity, operating efficiency, product specifications and

methods of manufacture and sales will not undergo any change 7.

A break-even chart can depict the position of only one product and fails to present

various products in the sales mix in one chart and different charts are required to be drawn for different products. 8.

Break-even analysis ignores the capital employed in business, which is one of the

important facts in determination of profitability of the company and its products.

ADVANTAGES OF BRAKE-EVEN CHART 1.

Visualises the information very clearly:- The chart visualizes the information very

clearly and a glance at the chart gives a vivid picture of the whole affair. The different elements of cost-direct materials, direct labour, overheads (factory, office and selling etc.) can be presented through an analytical break-even chart. 2.

Profitability of different products can be known:-

The profitability of different

products can be known with the help of break-even charts, besides the level of no profit no loss. The problem of managerial decision regarding temporary or permanent shutdown of business or contribution at a loss can be solved by break-even analysis.

FINANCIAL MGMT. & MGMT. ACCOUNTING 3.

Demonstration of effect of changes in fixed and variable cost:-

212 The effect of

changes in fixed and variables costs at different levels of production or profits can be demonstrated by the graph legibly. The relationship of cost, volume and profit at different levels of activity and varying selling prices is shown through the chart. Thus, it indices the requisites for survival of the company. 4.

Exercising Cost Control :- The break-even chart shows the relative importance of

he fixed cost in the total cost of a product. If the costs are high, it induces management to take measures to control such costs. Thus, it is a managerial tool for control and reduction of costs, elimination of wastage and achieving better efficiency. 5.

Effect of economy and efficiency:-

The Capacity can be utilized to the fullest

possible extent and the economies of scale and capacity utilization can be effected. Comparative plant efficiencies can be studied through the break-even chart. The operational efficiency of a plant is indicated by the angle of incidence formed at the intersection of the total cost line and the sales line. 6.

Helps in forecasting and long term planning:- Break-even analysis is very helpful

for forecasting, long â&#x20AC;&#x201C; term planning, growth and stability. LIMITATION OF BREAK-EVEN CHARTS There are certain limitations of break-even charts â&#x20AC;&#x201C; They are:1.

Stock changes affect income:The break-even chart depicts the volume of production or sales along the X-axis

and thus ignores the effect of changes in stock volume. As a matter of fact, it is assumed that stock changes will not affect the income. This is not true, since the absorption of fixed costs depends on production and not on sales. 2.

Condition of growth not assured:Condition of growth or expansion in an organization are assumed under break-even

analysis. In actual life of any business organization, the operations undergo a continuous process of growth and expansion. 3.

Fixed costs do not always remain constant:The assumption underlying break-even chart do not normally hold good in every

business concern.

Fixed costs vary and do not remain constant at all levels of production.

They have a tendency to raise to some extent after the production is increased beyond a certain level.

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213

4.Variable Costs do not always Vary Proportionately:The variable costs also do not always change in the same proportion in which the volume of production or sales changes. Usually the production cost iincreases if the law of diminishing return is applicable. This presents difficulty in the drawing of the total cost line end the fixed cost line.

5.Sales revenue does not always changes proportionately:

Sales revenue do not vary proportionately with changes in volume of sales due to reduction in selling price as a result of competition or increased production.

Illustration:- Balaji Ltd provides the following data of its operations:-

Selling price per unit Rs:10 variable cost per unit Rs6, fixed cost per annum Rs 80,000 construct break â&#x20AC;&#x201C;even chart and ascertain the break-even point.

Variable Output

Sales

Fixed cost

Total cost

Profit/loss

Contribution

Cost units

Rs Rs

80,000

5,000

50,000

30,000

80,000

1,10,000

60,000

20,000

10,000

1,00,000

60,000

80,000

1,40,000

40,000

15,000

1,50,000

90,000

80,000

1,70,000

20,000

60,000

20,000

2,00,000

1,20,000

80,000

2,00,000

80,000

25,000

2,50,000

1,50,000

80,000

2,30,000

20,000

1,00,000

30,000

3,00,000

1,80,000

80,000

2,60,000

40,000

1,20,000

From the above data we can observe that at 20,000 units of production the total revenue is equal to total costs and we can say 20,000 units is break-even level of production from the above data we can prepare break-even chat as shown belows:

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214

B.E. Point

Margin of safety

Fixed cost line

FINANCIAL MGMT. & MGMT. ACCOUNTING

5,000

10,000

15,000

215

20,000

25,000

30,000

Break – even level of output Profit-volume Ratio Profit-volume Ratio (p/v) reveals the rate of contribution per product as a percentage of turnover It indicates the relationship of the contribution to sales. It helps in knowing the profitability of the business. This ratio calculated with the following formula:

P/v Ratio =

× 100

illustration: Sekar Ltd

has provided the following information sales(@ Rs5 per unit) -20,000 units,

variable cost per unit Rs3, fixed cost Rs8,000 per annum-calculate the P.V Ratio and the break-even sales of the company. Solution:

P/v Ratio

×100

= 40% (or) 0.40 Break – even sales =

= Rs 2,00,000/-

Margin of safety: The margin of safety refers to sales in excess of the break-even volume. It represents the difference between sales at a given activity level and sales at break-even point.

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216

It is important that there should be a reasonable margin of safety to run the operations of the company in profitable position. A low margin of safety usually indicates high fixed over heads so that profits are not made until there is a high level of activity to absorb the fixed costs. Margin of safety provides strength and stability to a concern.

MARGIN OF SAFETY IS CALCULATED BY USING THE FOLLOWING FORMULAE

Margin of safety = Actual sales – Break-even sales

Margin of safety as % Total sales =

x 100

Illustration: st

You are given the data of Bharathi Ltd, for the year ended 31 March 2007, Sales (@Rs10)1,00,000 units variable cost per units. Rs6, fixed cost per annum Rs.3,00,000 Calculate the margin of safety. Solution: Break – even sales =

Margin of safety

= 75,000 units

= Actual sales –Break – even sales = 1,00,000 units – 75,000 units = 25,000 units = 25,000 units x Rs 10 = Rs 2,50,000/-

Illtstration: You are reqired to calculate a) P.V Ratio b) Margin of safety c) Sales d) Variable cost from the

FINANCIAL MGMT. & MGMT. ACCOUNTING following figures. Fixed cost Rs12,000; profit Rs1,000, Break even sales Rs 69,000

Solution: a) Break â&#x20AC;&#x201C; even sales =

Rs 60,000 =

By cross multiplication Rs 60,000 x P.V Ratio = Rs 12,000

~ P.V Ratio =

x 100 =20%

b) Margin of safety: =

x 100 = Rs 5000/-

c) Sales = B.E Sales +margin of safety = Rs 60,000 + Rs5,000 = Rs 65,000/= d) variable cost: Sales = Rs 65,000 Contribution = Fixed cost + profit = Rs 12,000+Rs 1000 = Rs 13000 Variable cost = sale-contribution = Rs 65,000 - Rs13,000=Rs 52,000/-

217

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218

CAPITAL BUDGETING

Capital budgeting ting is the process of making investment decisions regarding capital expenditures. A capital expenditure is an expenditure incurred for acquiring or improving the fixed, assets the benefits of which are expected to be received over a number of years in future. Capital expenditure involves non- flexible long-term commitment of funds. Capital budgeting is also known as long-term planning for investment decisions. Charless T.Horngreen has defined capital budgeting as, â&#x20AC;&#x153;a long term planning for making and financial proposed Capital outlaysâ&#x20AC;?.

Need and importance of capital Budgeting:Capital Budgeting decisions are among the most crucial and critical business decisions special care should be taken in making these decisions on account of the following reasons:1. 1. Heavy investment: All capital expenditure projects involve heavy investments of funds. These funds are raised by the firm from various external and internal sources. Hence it is important for a firm to plan its capital expenditure. 2. 3. 2. Permanent commitment of funds:- The funds involved in capital expenditures are not only large but also more or less permanently blocked. Therefore, these are long term investment decisions. The longer, the time the greater is the risk involved. Hence careful planning is essential 4. 5. 3. Long term effect on profitability:- Capital budgeting decisions have a long term and significant effect on the profitability of the concern. If properly planned, they can increase the size scale and volume of sales as well as growth potential of the concern. 6. 7. 4. Irreversible in nature: In most case, capital budgeting decisions are irreversible. Once the decisions for acquiring a permanent assets is taken, it is very difficult to reverse that decision. This is because, it is difficult to dispose of these assets without incurring heavy losses. LIMITATION OF CAPITAL BUDGETING 1. 1. All the techniques of capital budgeting presume that various investment proposals under consideration are mutually exclusive which may not practically be true in same particular circumstances. 2. 2. The technique of capital budgeting require estimation of future cash inflow and out flows. The future is always uncertain and the data collected for future may not be exact. Obviously the results based upon wrong data cannot be good.

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3. 3. There are captain factors like morale of the employees, goodwill of the firm etc which cannot be correctly quantified but these otherwise substantially influence the capital decision.

I - TRADITIONAL TECHNIQUES 1.PAY-BACK PERIOD METHOED:Pay-back method is popularly known as pay-off, or pat out method. It is defined as the number of years required to recover the initial outlay invested in a project. Computation of pay Back period:It can be calculated as follows: Pay back period = The method can be under stand as follows: If the annual cash in flow are uniform, the pay-back period can be computed by dividing cash outlay (initial investment)by annual cash inflows. If cash inflow of each year is not uniform, the calculation of payback period takes a cumulative form. In such a case, the pay -back period can be found out by adding up the figure of net cash inflows until the total is equal to initial investment. The annual cash inflow is calculated by taking into account net income before depreciation but after taxation. If there are two projects the project which has a shorter pay-back period will be chosen. First, Net inflow shall be calculated as follows:Cash in flow from sales revenue

Less: Operating expenses including depreciation

Net income (before Tax) Less : Income Tax

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220

Net income (after Tax)

Add: depreciation

Net cash inflows

Note: As because depreciation does not affect the cash inflow. It shall not be taken into consideration in calculating net cash inflow but it is admissible deduction under Income tax Act, it has been deducted from the gross sales revenue and added in the net income (after tax). Mertis: 1 It is easy to calculate and simple to understand 2.It is preferred by executives who like quick answers for selection of the proposal. 3.It is useful where the business is suffering from shortage of funds as quick recovery is essential for repayment. 4. It is useful for industries subject to uncertainty, instability or rapaid technological changes 5.It is useful where profitability is not important,

Demerits: 1.This method is delicate and rigid. A slight change in the operation cost will affect the cash inflows and the pay-back period 2.It does not take into account the life of the project, depreciation, scrap value, interest factor etc. 3.It completely ignores cash inflows after the pay-back period. 4. The profitability of the project is completely ignored 5.It gives more importance to liquidity as a goal of capital expenditure decisions which is not justifiable 6. It ignores time value of money, cash flows received in different year are treated equally.

Suitability: Inspire of the above demerits, the pay-back method can profitably be used in each of the following cases: 1.

1. This method is suitable where political or other conditions are seemed to be hazy.

2. It is suitable when a firm suffers from liquidity crisis

3. It is also suitable for a firm

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221

which focus on short –term earning performance of the firm rather its long – term growth. 4.

4. It is a suitable method where production is subject to change in technology.

5. Illustration: A company is considering two mutually exclusive projects. Prefects. Both require an initial as outlay of Rs10,000 each and have a life of 5 years. The companies required rate of return is10% and pays tax at 50% rate. The projects will be depreciated on a straight line basis. The net cash flow (before tax expected to be generated by the projects as follows:

Cash inflows

year

Project I

Project II

Rs 4,000

Rs 6,000

II.

“

4,000

“

3,000

III.

“

4,000

“

2,000

IV.

“

4,000

“

5,000

“

4,000

“

5,000

Calculate payback of each project Solution: Calculation of Net Income and cash flow after taxes: Project I - cash inflow is uniform:year

Cash flow before Taxes

Depreciation

Income Before Tax

taxes

Net

Net Cash flow

income

after Taxs

4,000

2,000

1,000

3,000

4,000

2,000

1,000

3,000

4,000

2,000

1,000

3,000

4,000

2,000

1,000

3,000

4,000

2,000

1,000

3,000

Pay back period =

years

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222

Project â&#x20AC;&#x201C; II cash inflow is not uniform:-

2,000

Income Before Taxes Rs 4,000

3,000

2,000

4 5

year

Cash flow before taxes

Rs 6,000

Deprecation Rs

Net income

Taxes

Net cash flow After taxes

Rs 2,000

1,000

500

2,500

2,000

5,000

2,000

3,000

1,500

3,500

5,000

2,000

3,000

1,500

3,500

4,000

The above table shows that in three years Rs8,500/- (4000+2500+2000)has been recovered. th

Rs1500 is left out of initial investment. In the 4 year the cash inflow is Rs.3500/-. It means payback rd

period is between 3 and 4 years ascertained as follows: Payback period = 3 years +

years

2. AVERAGE ACCOUNTING RATE OF RETURN METHOD It is also known as Accounting rate of return because it takes into account the Accounting concept of profit (i.e profit after deprecation and tax) and not the cash in flows. The project which yields the highest rate of return is selected.

The accounting rate of return may be calculated by any of the following methods: ARR =

x 100 or

ARR =

x 100

The term average annual profit refers to average profit after depreciation and tax over the life of the project;The average investments can be calculated by any of the following methods =

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223

Merits1.It is simple to understand and easy to calculate 1.

2. This method gives due weightage to the profitability of the project

3. It takes into consideration the total earnings from the project during its life time

4. Rate of return may be readily calculated with the help of the accounting data.

Demerits: 1. It uses accounting profits and not the cash inflows in appraising the project 1.

2. It ignores the time value of money profits earned in different prides are valued equally.

3. It considers only the rate of return and not the life of project

4. It ignores the fact that profit can be reinvested

5. This method does not determine the fair rate of return on investment

Illustration:

A project requires an investment of Rs5,00,000 and has a scrap of Rs20,000 after 5 years. It is expected to yield profits depreciation and taxes during the five years accounting to Rs 40,000, Rs 60,000, Rs 70,000, Rs 50,000 Rs 20,000. Calculate the average rate of return on the investment.

Solution: Total profit = Rs 40,000 + Rs 60,000 +Rs 70,000 + Rs 50,000 +Rs 20,000 = 2,40,000

Average profit =

= Rs 48,000

ARR =

x 100

x 100 = 20%

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224

II- DISCOUNTED CASH FLOW METHOD

This method is also known as â&#x20AC;&#x153;Time adjusted rate of returnâ&#x20AC;? (or) Internal rate of return method. It takes in to account both the profitability and the time value of money. This method is based on the fact that future value of money will not be equal to the present value of money. For example, assume of Rs 100 received after one year because by receiving the amount now and investing it some where a fame can get Rs110 (say including 10% interest) after one year. Discounted cash flow methods for evaluating capital investment proposals are or are of three types : 1.Net present value method 2. Excess present value method 3. Internal Rate of return

1. Net present value method:Under this method present value and compare with the original investemend if the present of cash inflows is calculated at the required rate of return (an arbitrary rate of return) and compare with original investment. If the present value is higher than the original investment, the project can be selected otherwise rejected. Formulae to know the present volume of Rs.1 to be received after a specified period at given rate of discount

PV = P 1 -

P =Principal r =Rate of discount

2.EXECSS PRESENT VALUE INDEX:

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225

This is a refinement of the net present value method. Instead of working out the net present value, a present value index is found out by comparing the total present value of cash inflows and the total present value of cash out flows. This can be calculated as follows:

Excess prevent value index =

x100

The higher the profitability index the more desirable is the investment.

INTERNAL

RATE

RETURN: 3. Internal rate of return is the rate of return at which total present value of future cash inflows is equal to initial investment. This method is used when the amount of investment and cash inflows are known but the rate of return is not known. The rate of return is generally found by trial and error method. For example, if a sum of Rs800/- invested in a project becomes Rs1000/- at the end of the year the rate of return comes to25%calculated as follows:

Where, I=cash out flow ie initial investment R=cash inflow r=Rate of return yield by the investment (or) IRR Thus,

(or) 800+800 r =1000 800 r = 1000-800=200 R=

=0.25 (or) 25%

Merits of discounted cash flow method:

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226

This method considers the entire economic life of the project.

It gives due weightage to time factor. That is time value of money is considered

facilitates

comparison

between projects 4.

This

approach

recognishing time factor, makes sufficient provision for uncertainty and risk. 5.

It is the best method where cash in flows are uneven

Demerits:1.

It involves a great deal of calculations. Hence it is very difficult forecast and complicated.

It is very difficult to forecast the economic life of any investment exactly.

The

selection

appropriate rate of interest is also difficult.

4.Profitability Index It is also known as benefit / cost ratio. It is the ratio of present value of the future net cash flows to the initial cash outlay of the project. The index provides a relative measure for judging desirability and evaluating the worth of an investment proposal. It can be calculated as follows: Debtors = It is used as accept or reject criteria for the project. It PI >I then accept the project and PI < I, reject the project. Illustration: The gamma Co., Ltd., is considering the purchase of a new machine. Two alternative machines A and B have been suggested each costing Rs4,00,000. Earnings after taxation are expected are as follows Year

Machine A

Machine B

40,000

1,20,000

1,60,000

2,00,000

2,40,000

1,20,000

1,60,000

80,000

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227

The company has a target of return on capital of 10% and on this basis, you are required to compare the profitability of the machines and share which alternative you consider finally preferable. Note: The present value of Rs1, 10% due in : 1. Year = 0.91 2. Year = 0.83 3. Year = 0.75 4. Year = 0.68 5. Year = 0.62

Solution:

Year

Machine A

Discount factor @ 10%

Cash inflow Rs

Machine B

Present value

Cash inflow

Present value

.91

49,000

36,400

1,20,000

1,09,000

.83

1,20,000

99,000

1,60,000

1,32,000

.75

1,60,000

1,20,000

2,00,000

1,50,000

.68

2,40,000

1,63,000

1,20,000

81,600

.62

1,60,000

99,200

80,000

49,600

Present value of cash inflows =

5,18,400

5,23,200

Machine A Net present value = =

Machine B

5,18,400 -4,00,000

5,23,200 -

1,18,000

4,000

= 1,23,200

Profitability Index =

=1.29

The net present values as well as the profitability index are higher in case of machine ‘B’ and hence machine ‘B’ will be preferred.

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