LESSON 1 INTRODUCTION TO ACCOUNTING

OBJECTIVES: To explain the meanings and importance of accounting To know the utility of accounting information to various stakeholders To know the principles which guide the preparation and reporting of accounting statements To familiarize with the frequently used words in accounting

STRUCTURE:
1.1 Introduction 1.2 Objectives of Accounting 1.3 Uses of Accounting Information 1.4 Principles of Accounting 1.4.1 1.4.2 Accounting Concepts Accounting Conventions

1.5 Some Important Terms used in Book Keeping 1.6 Summary 1.7 Key Words 1.1 INTRODUCTION: Accounting can be defined as, `an art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least of a financial character, and interpreting the result thereof. Accounting, which involves recording, classifying and summarizing the transactions of financial nature in order to compute the results and financial position of the business. Accounting facilitates external reporting to the owners or shareholders, potential investors, trade creditors, creditors for expenses, banks and financial institutions, management and employees, society, Income-tax department, academicians, and other interested parties. As this branch of accounting is based

on historical or past data, it is described as the post-mortem of financial transactions. In Financial Accounting all the transactions of financial nature are recorded in a book called Journal in chronological order or in order of their occurrence, then classified in another book called Ledger and finally summarized into a schedule called Trial Balance, from which an Income statement is prepared to know the results of the transactions of financial nature in a business firm as on a particular date and the same are analyzed with the help of the tools of financial analysis, such as, comparative and common size financial statements, trend analysis, Ratio analysis, fund flow analysis and cash flow analysis. These days, Double Entry System of Accounting is followed by every Corporate and also most businesses which are organized in forms other than Corporate. Hence the subsequent discussion in this chapter and latter chapters would be on Double Entry System of Book Keeping. 1.2 OBJECTIVES OF ACCOUNTING: Accounts are maintained 1. To have a permanent record of all mercantile transactions. 2. To maintain records of incomes, expenses and losses in such a way that the net profit or net loss for any selected period may be readily ascertained. 3. To keep records of assets and liabilities in such a way that the financial position of the undertaking at any point of time may be readily ascertained. 4. To enable the review and revision of policies in the light of past experience brought to light by analyzing and interpreting records and reports. 1.3 USERS OF ACCOUNTING INFORMATION: The importance of accounting is to provide meaningful information about a business enterprise to those persons who are directly or indirectly interested in the performance and financial position of business enterprise. Such persons may include owners, creditors, investors, employees, government, public, research scholars and the managers.

1.

Owners:

The owners of a business furnish capital to be used for the purpose of business. They are interested to know whether the business has earned a profit or loss during a particular period and also its financial position on a particular date. They want accounting reports in order to have an appraisal of past performance and also for an assessment of future prospects. 2. Creditors:

The creditors include suppliers of goods and services, bankers and other lenders of money. They are interested in the financial stability of the concern before making loans or granting credit. They look to the ability of the business to pay interest and principal as and when it becomes due for payment. They also look to the trends of earnings as it ultimately affects the solvency of a concern. 3. Investors:

Investors look not only the earning capacity of business but also its financial strength and solvency before deciding whether to subscribe or not for the shares in a Company. They are interested in steady and good return on their capital, the safety of their capital and appreciation in the value of the shares. 4. Employees:

Employees are interested in earning capacity of a concern as their salaries, bonus and pension schemes are dependent on this factor. They have a permanent stake in the business and in order to have an assurance of steady employment they are very much interested in the stability of the organization. 5. Government:

Government is interested in accounting statements and reports in order to see the performance of a particular unit, its cost structure and income in order to impose tax and excise duty.

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Public:

The public as consumers is interested in accounting statements in order to know whether control is exercised on production, selling and distribution expenses in order to reduce the prices of goods they buy. They can also judge whether the economic resources of the concern are being utilized for the benefit of the common man or not. 7. Research Scholars:

Such persons are interested in accounting statements and reports in order to get data for proving their thesis on which they are working and hence to complete their research projects. 8. Managers:

The managers of an enterprise need accounting information for planning, control, evaluation of performance and decision-making. Their main responsibility is to operate the business so as to obtain maximum return on capital employed without causing any detriment to the interest of the stakeholders. 1.4 PRINCIPLES OF ACCOUNTING: Accounting is a system evolved to achieve a set of objectives. The objective being able to communicate accounting information, to its users. In order to achieve the goals, we need a set of rules or guidelines. These guidelines are termed here as Basic Accounting Principles. In order to ensure authenticity, and comparability in the matter of recording and interpretation of Accounts, Accounting Principles are followed. Concepts and Conventions. conventions. 1.4.1 ACCOUNTING CONCEPTS: These Principles can be divided into The following few paragraphs deal with these concepts and

The term `concepts includes those basic assumptions or conditions upon which the science of accounting is based. The following are the important accounting concepts. The term Concept means an idea or thought. Basic Accounting Concepts are the fundamental ideas or basic assumptions underlying the theory and practice of financial accounting. 1. Separate Entity Concept:

Business is treated separate from the proprietor. All the transactions are recorded in the books of business and not in the books of the proprietor. The proprietor is treated as a creditor for the business. When he contributes capital he is treated as person who has invested his amount in the business. Therefore, capital appears in the liabilities of balance sheet of the Organisation. The concept of separate entity is applicable to all forms of business organizations. For example, in case of a partnership business or sole proprietorship business, though the partners or sole proprietor are not considered as separate entities in the eyes of law, but for accounting purposes they will be considered as separate entities. The major effects of this concept are that: a) b) c) 2. Financial position of the business can be easily found out. Earning capacity of business can be easily ascertained. The personal affairs of the owners are not mixed up with that of the business Going Concern Concept:

The assumption is that business will continue to exist for unlimited period of time. There is neither the intention nor the necessity to liquidate the particular business venture in the foreseeable future. On account of this concept, the accountant while valuing the assets does not take into account sale value of assets. Moreover, he charges depreciation on fixed assets on the basis of their expected lives rather than on their market values. 3. Money Measurement Concept:

Only those transactions are recorded in accounting which can be expressed in terms of money. Measurement of business in terms of money helps in understanding the state of affairs of the business in a much better way. For example if a business owns Rs.10,000 of cash, certain

quantity of raw materials, two factories, 1,000 square feet of building space etc. These amounts cannot be added together to produce a meaningful total of what the business owns. However, if these items are expressed in monetary terms such as Rs.10,000 of cash, Rs.12,000 of raw materials, Rs.2,00,000 of factories, and Rs.50,000 of building, all such items can be added and much more intelligible and precise estimate about the assets of the business will be available. The transactions which cannot be expressed in monetary terms fall beyond the scope of accounting. This is also a limitation of accounting. For example, if a business has got a team of dedicated and trusted employees, it is definitely an asset to the business but since their monetary measurement is not possible, they are not shown in the books of the business 4. Cost Concept:

According to this concept, an asset is recorded at its cost in the books of account, i.e., the price which is paid at the time of acquiring it. This concept is mainly applicable for fixed assets. Current assets are not affected by it. Cost concept has the advantage of bringing objectivity in the preparation and presentation of financial statements. In the absence of this concept the figures shown in the accounting records would have depended on the subjective views of a person. However, on account of continued inflationary tendencies the preparation of financial statements on the basis of historical costs, creates problems of credibility in judging the financial position of the business. This is the reason for the growing importance of inflation accounting. 5. Accounting period Concept:

According to this concept, the life of the business is divided into appropriate time periods for studying the results shown by the business after each segment. This is because though the life of the business is considered to be indefinite (according to going concern concept), the measurement of income and studying the financial position of the business after a very long period would not be helpful in taking proper corrective steps at the appropriate time. It is therefore, absolutely necessary that after each segment or time interval the businessman must

`stop and `see back, how things are going. In accounting such a time period or time is called `accounting period. It is usually one year. Every business wants to know the result of his investment and efforts after a certain period. Usually one-year period is regarded as an ideal for this purpose; it may be 6 months or 2 years also. This concept helps financial position and earning capacity of one year may be compared with another year and also in planning and increasing the efficiency of business. 6. Dual Aspect Concept:

This is the basic concept of accounting. According to this concept every business transaction has a dual effect. The two fold aspects are Receiving of benefit and Giving of equivalent benefit. For example, if A starts a business with a capital of Rs.10,000. There are two aspects of the transaction. On the one hand the business has asset of Rs.10,000 while on the other hand the business owes to the proprietor a sum of Rs.10,000 which is taken as proprietors capital. This expression can be shown in the form of following equation: Capital (Equities) = Cash (Assets) 10,000 = 10,000 The term `assets denotes the resources owned by a business while the term Equities denotes the claims of various parties against the assets, Equities are of two types. They are owners equity and outsiders equity. Owners equity (or capital) is the claim of owners against the assets of the business while outsiders equity (or liabilities) is the claim of outside parties such as creditors, debenture-holders against the assets of the business. total of liabilities, thus: Equities = Assets OR Liabilities + Capital = Assets In the example given above, if the business purchases furniture worth Rs.5,000 out of the money provided by A, the situation will be as follows: Since all assets of the business are claimed by someone (either owners outsiders), the total of assets will be equal to

Equities =Assets Capital Rs.10,000 = Cash Rs.5,000 + Furniture Rs.5,000 Subsequently if the business borrows Rs.30,000 from a bank, the new position would be as follows: Equities = Assets Capital Rs.10,000 + Bank Loan Rs.30,000 = Cash 35,000 + Furniture Rs.5,000. The term `accounting equation is also used to denote the relationship of equities to assets. The equation can be technically stated as for every debit, there is an equivalent credit. As a matter of fact the entire system of double entry book-keeping is based on this concept. 7. Matching Concept:

Every businessman is eager to make maximum profit at minimum cost. Hence, he tries to find out revenue and cost during the accounting period. In order to ascertain the profit made by the business during a period, it is necessary that `revenues of the period should be matched with the costs (expenses) of the period. The term `matching means appropriate association of related revenues and expenses. In other words, surplus made by the business during a period can be measured only when the revenue earned during a period is compared with the expenditure incurred for earning the revenue. On account of this concept, adjustments are made for all outstanding expenses, accrued incomes, prepaid expenses and unearned incomes, etc., while preparing the final accounts at the end of the accounting period. 8. Realization Concept:

According to this concept revenue is recognized when a sale is made. Sale is considered to be made at the point when the property in goods passes to the buyer and he becomes legally liable to pay and not when the actual payment is made. For example, A places an order with B for supply of certain goods yet to be manufactured. On receipt of order, B purchases raw materials, employs workers, produces the goods and delivers them to A. A makes payment on receipt of

goods. In this case the sale will be presumed to have been made not at the time of receipt of the cash for the goods but at the time when goods are delivered to A.

9.

Accounting Equivalence Concept:

The proprietor provides funds for acquisition of assets. Hence the assets owned by the business must be equal to the funds provided by the proprietor. Funds provided by the proprietor are called equity. Hence accounting equivalence concept is: Assets = Equities In addition to own funds, money is borrowed which is known as liability. Therefore assets are acquired through equity and liability. Therefore, accounting equation is: Assets = Owners Equity + liabilities 10. Objective Evidence Concept:

This concept relates with the verification of accounting record with Objective evidence. Objective evidence means study of those documents and vouchers on the basis of which accounting record has been made. This helps a lot in auditing of accounts and Account remains free from error and fraud due to existence of vouchers, documents etc. 1.4.2 ACCOUNTING CONVENTIONS: The term `convention includes those customs or traditions which guide the accountant while preparing the accounting statements. The following are the important accounting conventions:

Convention of Consistency Convention of Conservatism. Convention of Full Disclosure.

Convention of Materiality.

1. Convention of Consistency: Continuance of same practice for number of years indicates consistency. Whatever accounting practice has been adopted in one year, the same should be continued in future years also. If depreciation is charged on fixed assets according to diminishing balance method, it should be done year after year. This is necessary for the purposes of comparison. However, consistency does not mean inflexibility. It does not forbid introduction of improved accounting techniques. If better method is found, it must be followed, but a note for making a change must be in the accounts. The biggest advantage of this convention is that it facilitates comparison of one years accounts with other years. 2. Convention of Conservation: Future is uncertain. Though projections may be made about future events, no one can forecast future with perfect certainty in business. Therefore some arrangement or provision is made to meet future uncertainties. Every sincere businessman makes an estimate of future losses and then some provision for it e.g., provision for bad debts is made. However, businessmen mostly ignore the items of future profits. This tendency is termed as conservatism. Therefore, the common accounting practices are: o Do not consider any income or gain till the same is realized in cash. o Create or make a provision for future expected losses and contingencies on the basis of past experience. The convention of conservatism has become target of serious criticism these days especially on the ground that it goes against the convention of full disclosure. It also gives room to the accountant to create secrete reserves (e.g. by creating excess provision for bad and doubtful

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debts, depreciation etc.), and the financial statements do not depict a true and fair view of state of affairs of the business.

3.Convention of Full Disclosure: Accounting records and statements should be honest and materially informative, Exclusion of material facts makes them incomplete and unreliable. This convention is gaining more importance because most of big businesses are run in the form of joint stock companies where ownership is divorced from management. The Companies Act, 1956, not only requires that Income Statement and Balance Sheet of a company must give a true and fair view of the state of affairs of the company but it also gives the prescribed forms in which these statements are to be prepared. The practice of appending notes to the accounting statements (such as about contingent liabilities or market value of investments) is pursuant to the convention of full disclosure. This is done to benefit the proprietor and all those outsiders who are interested in assessing the efficiency of financial position of the business unit. 4.Convention of Materiality: Materiality means relative importance. Whether a matter should be disclosed or not in the financial statements depends on its materiality, i.e., whether it is material or not. According to this convention accounting record should be made of all material facts. Immaterial items may either be clubbed with material items and then recorded or these may be ignored. For example purchase of a waste paper basket, might amount to purchase of a capital asset, since this lasts for more than a year, but by virtue of the amount involved, it is better treated as revenue expenditure. Thus, the term `materiality is a subjective term. The accountant should regard an item as material if there is reason to believe that knowledge of it would influence the decision of the informed investor.

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1.5 SOME IMPORTANT TERMS USED IN BOOK KEEPING: Before you get into the specifics of Accounting, you should be familiar with some of the terms which are generally used in Accounting. A few of them are given below: Business Transactions: Any exchange of money or moneys worth is called business transaction. Events like purchase and sale of goods, receipts and payments of cash for services or on personal accounts are the examples of transactions. When payment for business activity is made immediately, it is called cash transaction, but when the payment is postponed to a future date, it is called a credit transaction. Debtor: A debtor is a person who owes something to the business Creditor: A creditor is a person to whom something is owing, by the business. Debit and Credit: To debit an account means to enter the transaction on the debit side of that account. To credit an account means to enter the transaction on the credit side of that account. Capital: It is the amount invested by the proprietor in the business. For the business, capital is a liability towards the owner. Sometimes it is called `owners equity i.e. owners claim against the assets. Owners equity or capital is always equal to assets minus liabilities. Drawing: It is the value of cash or goods withdrawn from the business by the owner for his personal use. Goods: It includes all commodities or articles in which a trader deals.

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Assets: These are the material things or possessions or properties of the business including the amounts due to it. Examples are Cash and Bank balances, Land and Building, Plant and Machinery etc. Liabilities: The term liabilities denote the amounts which the business owes to others such as loan from bank, creditors for goods supplied, for outstanding expenses etc. Accounts: An account is a summary of the record of all the transactions relating to a person, asset, expense or gain. It has two sides-the left hand side called the debit side and the right hand side called the credit side.

Accounts are of three types Personal, Real and Nominal accounts: Personal Accounts: These are the accounts of natural persons (such as Rams accounts, Gopals account) artificial persons (such as Uday Ltd., Syndicate Bank,) and representative personal account (such as Prepaid Insurance account, outstanding salary account) with whom the trader deals) Real Accounts: Accounts relating to properties or assets of a trader are known as real accounts. It includes tangible assets such as building, furniture, cash etc., and also intangible assets such as goodwill, trade marks, patent rights Nominal Accounts: Accounts dealing with expenses, losses, gains and incomes are called Nominal Accounts, e.g. salaries account, wages account, commission account etc. Real and Nominal Accounts are also called Impersonal accounts because they do not affect any particular person but affect business in general. 1.6 SUMMARY:

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Accounting can be defined as, `an art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least of a financial character, and interpreting the result thereof. Accounting is a system evolved to achieve a set of objectives. The objective is to communicate accounting information to its users. In order to achieve the goals, we need a set of rules or guidelines. These guidelines are termed here as Accounting Principles. The importance of accounting is to provide meaningful information about a business enterprise to those persons who are directly or indirectly interested in the performance and financial position of business enterprise. Such persons may include owners, creditors, investors, employees, government, public, research scholars and the managers. 1.7 KEY WORDS: Double Entry System of Book Keeping Going Concern Concept Cost Concept Dual Aspect Concept Realization Concept Objective Evidence Concept Convention of Conservatism. Convention of Materiality. Try yourself: 1. Explain the principles of Accounting. 2. Discuss important Accounting Concepts 3. Explain the significance of Accounting conventions. 4. Who are the users of Accounting information? FURTHER READINGS: Jain S.P. and Narang, K.L., .Advanced Accountancy, Kalyani Publishers Mukherjee & Khan, Modern Accountancy, Tata Mcgraw Hill Separate Entity Concept Money Measurement Concept Accounting period Concept Matching Concept Accounting Equivalence Concept Convention of Consistency Convention of Full Disclosure.

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LESSON 2 ACCOUNTING CYCLE - I STRUCTURE OBJECTIVES:

Explain importance of Journal, be able to record transactions in STRUCTURE: the journal Know the importance of Ledger, be able to do the ledger posting, and Balance the accounts Describe the importance and utility of Subsidiary books. Prepare the trial balance

STRUCTURE:
2.1 Introduction 2.2 Journal 2.3 Ledger 2.4 Subsidiary Books- Division Of Journal 2.5 Trial Balance 2.6 Accounting Cycle 2.7 Summary 2.8 Key Words

2.1 INTRODUCTION: As discussed in the first chapter, businesses aim at earning profit. Entities which do not have profit earning as an objective also aim to be financially viable. Therefore, earning a profit or being viable is an important objective which is pursued by all organizations. However, it is not possible to ascertain whether operations have been viable or not, unless a proper record of all the transactions is kept in a systematic way.

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Maintaining such a systematic record of all transaction is called book-keeping and when such record-keeping moves on to classifying and summarizing, preparation of final reports and interpretation, we call it accounting. In India, Accounting had been practised as far back as Mauryan Dynasty times which we can see from Kautilyas Artha Shastra. However, the present day accounting has its origins in Luco Paciolis Double Entry System of Accounting. In this chapter, we shall learn to journalise, and post it into the ledger. The two steps mark the beginning of the Accounting cycle. 2.2 JOURNAL :

Journal is the book wherein a business transaction is first written or recorded and therefore it is also known as book of Original Entry. In the French language Jour means day. Journal therefore is a book where day to day transactions are written. written followed by January 2, January 3 and so on. Journal is written chronologically i.e., it is written date wise, for example; transaction relating January 1 are first Journal has columns for Date, Particulars, Ledger Folio, Debit and Credit. The format is as follows:

Date 1999 Jan 1 1999 Jan 2 1999 Jan 3

Particulars

LF

Debit Amount

Credit Amount

In the date column, date of the transaction is recorded, in the particulars column details relating to the accounts affecting the transaction are recorded. Both the debit and credit aspects of the transaction are recorded. The Amounts column relating to the debit and credit are placed side by side. Each transaction entered in the Journal is known as Journal Entry and the act of entering or writing the transaction in the Journal is known as journalizing. A Journal Entry is written in a specific form in which account relating to debit is written in the

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first line and Account relating to Credit is written in the second line. While writing the second line a little space is left and then written as given under.

Date

Particulars Ravis A/c To Cash Dr.

LF

Debit Amount 5000

Credit Amount 5000

Each Journal entry is followed by a narration given in brackets. Narration is the explanation about the journal entry. For E.g.: Date Particulars Ravis A/c To Cash (Paid Cash to Ravi) LF Dr. Debit Amount 5000 Credit Amount 5000

While Journalizing the transaction the rules of journalizing need to be followed. The rules of journalising accounts are as follows: Personal Accounts (A/cs relating to persons Real Accounts (A/cs relating to assets) Debit the Receiver Debit what comes in expenses Credit the giver Credit what goes out and Credit all incomes and gains

Nominal Accounts Debit all (A/cs relating to expenses, losses losses, income and gains) STEPS TO BE FOLLOWED:

1) Identify the accounts being affected in the transaction. 2) Categorize them into real, nominal and personal 3) Apply the relevant rules of debit and credit

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However, in order to journalize it is very important that you should be to identify and classify the accounts into proper categories. You should know the category into which a particular account falls. For example you should know whether Capital Account is a personal account, nominal account or a real account, only then you can apply the rule related to that category. Consider, Cash since it is a real account you should apply the rules relating to real account. And again take Rent since we know that it is a nominal account rules of debit and credit relating to nominal accounts need to be applied while journalising the transactions. Personal Accounts relate to Accounts relating to persons. Persons could mean individuals, business organization, a sole proprietary concern, partnership firm, and so on. It could be a bank, an educational, institution, a hospital or any institution. The term person includes a natural person as well as an artificial person. Real accounts relate to assets. They could be land, building, motor car, machinery, furniture, cash, goodwill, patents and so on. Assets could be Tangible or intangible. Examples of intangible assets could be good will, patents, trade and so on. Nominal accounts relate to expenses, losses, incomes and gains. For eg: Rent, Interest, Salary. Having understood the meaning of a journal, the rules of journalizing, the style of writing a journal entry, the format of a journal, the various type of accounts, we shall now try to enter or write sample business transactions into a Journal. January 1, 2005 Ravi Started business with Cash Rs.50000 In this business transaction it is obvious that Cash A/c is affected. We see that Cash is being brought into the business. So the first account that is affected is Cash and the other is the Personal A/c of the owner which is called as Capital. Now since Cash is a real account the rules of debit and credit relating to Real accounts need to be applied. And the rule is debit what comes in and credit what goes out. We see here that cash is coming into the business and so we need to debit the Cash A/c.

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The other account affected is the Capital A/c. Capital being a personal account, the rule of personal a/cs need to be applied. And the rule is debit the receiver and credit the giver. Here the owner of the business is supplying or giving capital to the business. It may be noted that business unit is separate from the owner. Therefore we credit the capital a/c of the owner. So the journal entry will be written thus: Date Jan 1, 2005 Particulars LF Cash A/c Dr. To Capital A/c (Being Capital brought in) Debit Amount 50000 Credit Amount 50000

If the name is not given it may be written as Cash A/c Dr. To Capital Account. January 2, 2005 Bought Furniture Rs.2000 In this transaction you see that one of the accounts is Furniture, the other being Cash. How do you know that Cash is the other account. It is because you cannot buy anything without paying. If you have bought furniture it means that you have paid for it. Suppose you feel that it could be a credit transaction. Then it may be remembered that if it were a credit transaction, the name of the concern, selling on credit would be given. Since it is not given we may safely assume that the two accounts affected in this transaction are Furniture A/c and Cash A/c. Analysis: After identifying that the two accounts Furniture and Cash are Real accounts

apply the rules of real accounts. Furniture is coming into the organization, debit it. Credit the cash a/c since it is going out of the organization. Date Jan 2,2005 Particulars Furniture A/c LF Dr. Debit Amount 2000 Credit Amount 2000

To Cash A/c (Being Furniture purchased)

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January 3, 2005 Rent paid Rs. 1000 The accounts affected here are Rent and Cash. While Rent is a nominal account (since it is an expenditure) Cash is a real A/c. Treat Rent as per nominal account rule. Debit all expenses, rent should therefore be debited. As per Real A/c Rules Credit what goes out, therefore credit cash account. Date Jan 3, 2005 Particulars Rent A/c To Cash A/c (Being the rent paid) LF Dr. Debit Amount 1000 Credit Amount 1000

It may be noted here, that to whom the Rent is paid is not so important when Cash has changed hands. Now having understood the procedure of writing business transactions in a Journal, it is now the time to get thorough with it. Therefore the following illustrations: (1) Brought into business Cash Rs.50000, Land Rs.100000, building Rs.250000, Furniture Rs.20000, Machinery Rs.200000 Date Feb 1, 2005 Particulars Cash A/c Dr. Land A/c Dr. Building A/c Dr. Furniture A/c Dr. Machinery A/c Dr. To Capital A/c (Being Capital Brought in) LF Debit Amount 50000 100000 250000 20000 200000 Credit Amount

620000

It may be noted that in Double Entry System of book-keeping, Debit = Credit therefore sum of all debits (6,20,000) should be equal to a single credit in the above transactions. Incidentally it may be noted that an entry where there are more than one debit or one credit it is called combined or a composite entry.

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(2) Purchases Rs.30000 Date Feb 2, 2005 Particulars LF Purchases A/c Dr. To Cash A/c (Being purchases made or goods purchases) Debit Amount 30000 Credit Amount 30000

When goods are purchased they may also be referred to as purchases. That is the reason we have debited it as purchases rather than as goods. (3) Purchases from Mohan Raj Rs.45,000 Date Feb 3, 2005 Particulars Purchases A/c LF Dr. Debit Amount 45000 Credit Amount 45000

To Mohan Raj A/c (Purchases on credit from Mohan Raj)

Note: It may be noted here that while in the previous entry Cash has been credited, here Mohan Rajs name has been credited. Thats because it is a credit transaction (so understood because the name of the person has been given). In this case cash has not gone out Mohan Rajs A/c is a personal account and since Mohan Raj has given the goods and the rule is credit the giver therefore his name has been credited. (4) Purchases from Mohan Raj for Cash Rs.35000 Date Feb 4, 2005 Particulars LF Purchases A/c Dr. To Cash A/c (Being the purchases made on Cash) Debit Amount 35000 Credit Amount 35000

Note: How does one know that it is a Cash transaction because it so mentioned. Although the name of the person transacting is given it is clearly mentioned that it is a Cash transaction and so Mohan Rajs name recedes into the background. It is not to be recorded.

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(5) Sales Rs. 25000 Date Feb 5, 2005 Particulars Cash A/c LF Dr. Debit Amount 25000 Credit Amount 25000

To Sales A/c (Being Cash Sales made)

(6) Sale made to Ravi Rs.15000 Date Feb 5, 2005 Particulars Ravis A/c To Sales A/c (Being Sales Credit to Ravi) made LF Dr. on Debit Amount 15000 Credit Amount 15000

(7) Sale made to Ravi Rs.20000 for Cash Date Feb 6, 2005 Particulars Cash A/c LF Dr. Debit Amount 20000 Credit Amount 20000

To Sales A/c (Being Cash Sales made to Ravi for Cash) (8) Machinery purchased Rs.60000 Date Feb 7, 2005 Particulars Machinery A/c To Cash A/c (Being Purchased) LF Dr. Machinery Debit Amount 60000

Credit Amount 60000

It may be noted here that debit is given to machinery and although it is a purchase, purchases a/c is not debited; because the name of the asset that is machinery is specified and it is to be differentiated from Purchases or Goods meant for resale.

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(9) Sale of Land Rs.500000 Date Feb 8, 2005 Particulars Cash A/c To Land A/c (Being Sale of Land) LF Dr. Debit Amount 50000 Credit Amount 50000

(10) Cash Withdrawn for Office Use Rs.30000 Date Feb 9, 2005 Particulars LF Cash A/c Dr. To Bank A/c (Being Cash withdrawn from Bank for Office use) Debit Amount 30000 Credit Amount 30000

(11) Cash withdrawn for personal use Rs.10000 Date Feb 9, 2005 Particulars Drawings A/c LF Dr. Debit Amount 10000 Credit Amount 10000

To Bank A/c (being Cash withdrawn for personal use)

Note: The above drawings are meant for personal use of the entrepreneur and not for office, so Cash is not entering the Office, therefore Cash is not entered as a debit instead drawings is to be debited, because to that extent the owner owes to the business. (12) Rent paid Rs. 750 Date Feb 10, 2005 Particulars Rent A/c To Cash A/c (Rent paid) (13) Rent paid to Shyam Rs.8000 Date Feb 11, 2005 Particulars Rent A/c To Cash A/c (Rent paid) LF Dr. Debit Amount 8000 Credit Amount 8000 LF Dr. Debit Amount 750 Credit Amount 750

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In the above transaction although name is given since Rent A/c is more important, which is an expense; therefore rent is debited. (14) Interest Received Rs.2000 Date Feb 11, 2005 Particulars Cash A/c LF Dr. Debit Amount 2000 Credit Amount 2000

To Interest A/c (Being Interest Received)

(15) Commission Received Rs. 1500 Date Feb 13, 2005 Particulars Cash A/c LF Dr. Debit Amount 1500 Credit Amount 1500

To Commission A/c (Being Commission Received) (16) Interest on Capital Rs.800 Date Feb 15, 2005 Particulars Interest on Capital A/c Dr. To Cash A/c (Being Interest paid on Capital) 2.3 LEDGER: LF Debit Amount 800

Credit Amount 800

Ledger is a book where account wise information is documented. While the Journal gives data in chronological form, the ledger gives account wise information. All the transactions related to a particular account are put at one place. For e.g., if you would like to know the transactions you carried out with your customer Ravi you need not search throughout the journal to trace out transactions relating to Ravi instead you go to ledger and locate Ravis A/c thereon and find all the transactions relating to Ravi. It is more useful than the day to day information provided in the journal. Ledger is the second stage in the Accounting cycle. From the journal transfer is made into the ledger under various heads of account. This process of transfer is known as Ledger posting.

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HOW IS LEDGER POSTING DONE: Various accounts which are found affected in the journal are opened in the ledger. An account is in T form. On either side of the account debit and credit aspects are shown. The name of the account is given on the top. The debit aspects relating to the account are recorded on the left side, while Credit aspects are recorded on the right side as shown below: Name of the Account Debit side Credit side

On debit side, To is used as a prefix of the account while on the credit side the word By is prefixed. A look at the Format shall further clarify this: NAME OF THE ACCOUNT Dr. Date Particulars JF Dr. side To Name of the A/C Amount Rs. Date Particulars JF Cr. Side By Name of the A/c Cr. Amount Rs.

Now let us post some Journal entries into the ledger. Example:1 JOURNAL Date 1.10.2005 2.10.2005 3.10.2005 Treatment: Particulars Cash A/c Dr. To Capital (Being capital brought in) Purchases A/c Dr. To Cash (Being purchase made) Cash A/c Dr. To Sales (Being Sales made) JF Amount 1,00,000=00 15,000=00 20,000=00 Amount 1,00,000=00 15,000=00 20,000=00

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LEDGER CASH A/C Dr. Date Particulars JF Amount Rs. 100000 20000 Date Particulars JF Cr. Amount Rs. 15000

1st Oct To Capital 2005 3rd Oct To Sales 2005 CAPITAL A/C Dr. Date Particulars JF

2nd Oct By Purchases 2005

Cr. Amount Rs. Date Particulars JF Amount Rs. 100000

1st Oct By Cash 2005

PURCHASES A/C Dr. Date Particulars JF Amount Rs. 15000 Date Particulars JF Cr. Amount Rs.

2nd Oct To Cash 2005

SALES A/C Dr. Date Particulars JF Amount Rs. Date Particulars JF Cr. Amount Rs. 20000

3rd Oct By Cash 2005

It may be noted from the above that in the first transaction cash A/c is showing a debit balance. Therefore in the Cash A/c the transaction is written on the debit side. It may be noted that

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when the name of the account having the credit balance is written Viz: in the Cash A/c it is written as To Capital Account. Whereas in the capital account which shows credit balance it is written as By Cash A/c on the credit side. In the second transaction purchases A/c is showing a debit balance and therefore in the purchases A/c the transaction is written on the debit side as To Cash A/c. Whereas in the Cash A/c which is showing credit balance it is written as By purchases. In the third transaction Cash A/c is showing a debit balance and therefore on the debit side of the cash account it is written as To Sales, while in the Sales A/c it is recorded as By Cash. From the above three transactions it is seen as to how ledger posting or transfer of transaction is made from the journal to the ledger. Example: 2 Journalise the following transactions and post them in the Ledger: Capital brought in Rs.50,000 Purchases Rs.10,000 Purchases from Ravi Rs.5,000 Sales Rs. 8,000 Sales to Mohan Rs.7,000 JOURNAL Date Particulars Cash A/c LF Dr. Dr. 50,000 Cr. 50,000 10,000 10,000

To Capital A/c (Being Capital brought in) Purchases A/c Dr. To Cash A/c (Being purchases made for Cash)

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Mohan A/c To Sales A/c (Being Cash Sales made) Cash A/c To Sales A/c (Being Cash Sales made) Purchases A/c To Ravi A/c

Dr.

7,000 7,000

Dr.

8,000 8,000

Dr.

5,000 5,000

(Purchases made on Credit) CASH A/C Dr. Date Particulars To Capital To Sales Total Amount 50000 8000 58000 Date Particulars By Purchases By Balance C/d Total Cr. Amount 10000 48000 58000

CAPITAL A/C Dr. Date Particulars Amount To Balance C/d 50000 Total 50000 Date Particulars By Cash Total Cr. Amount 50000 50000

PURCHASES A/C Dr. Date Particulars To Cash To Ravi Total Amount 10000 5000 15000 Date Particulars By Balance c/d Total Cr. Amount 15000 15000

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SALES A/C Dr. Date Particulars To balance c/d Total Amount 15000 15000 RAVI A/C Dr. Date Particulars To Balance c/d Total Amount 5000 5000 Date Particulars By Purchase Total Cr. Amount 5000 5000 Date Particulars By Cash By Mohan Total Cr. Amount 8000 7000 15000

MOHAN A/C Dr. Date Particulars To Sales Total Amount 7000 7000 Date Particulars By Balance c/d Total Cr. Amount 7000 7000

A brief explanation of how the above entries are posted in the ledger is given below: In the first transaction we see that Cash A/c is showing a debit balance. Therefore in the Cash A/c we write To Capital A/c on the debit side. Capital A/c is showing a credit balance therefore on the credit side of the capital a/c we write By Cash. Similarly in the second transaction purchases a/c is showing a debit balance and so on the debit side of purchase a/c we write To Cash and since cash a/c is showing credit balance we write By purchases in the Cash A/c. The other transactions are also posted on the same lines. In the above manner all the transactions in the journal are referred to and transactions relating to a particular account are written under that particular head. After such posting is done the debit and the credit side are totaled up separately to find out which side is heavier. If the debit side of an account is more than that the credit side of that particular account it is said to possess debit balance. If the credit side is heavier the account is said to have credit balance.

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It is very important to know which side of the account is heavier, because it explains the position of the account. For eg: Consider the following Cash A/c.
CASH A/C. Dr Cr.

Date

Particulars To Balance B/d To Sales To Ravi To Commission Total

Amount 30000 15000 8000 3000 56000

Date

Particulars By Purchases By Salaries By Rent By Interest Total

Amount 10000 2000 3000 5000 20000

We see in the above account that the Debit side has total of Rs.56,000 whereas the credit side has a total of Rs.20000. It is obvious that the debit side is heavier by Rs.36,000. Therefore it is said that the Cash A/c has a debit balance, the balance being Rs.36000. Debit balance in the Cash A/c (Rs.36000) implies that in the Cash A/c there is still a balance of Rs.36000 and it is carried down (C/d) to the next period. Thats why it is written as By Balance C/d. In the beginning of the next period it is written as to Balance B/d meaning to say that balance has been brought down from the previous period. Suppose you are closing the account on 31st January, the balance is carried down on that day and is shown as an opening balance in the next period. Look at the account shown hereunder: CASH A/C Dr. Date Particulars To Balance B/d Jan 2005 To Sales To Ravi To Commission Total 1.2.05 To Balance b/d Amount 30000 15000 8000 3000 31.1.05 56000 36000 Date Particulars By Purchases Jan 2005 By Salaries By Rent By Interest By Balance C/d Total Cr. Amount 10000 2000 3000 5000 36000 56000

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What do Debit and Credit Balances mean: 1. If a personal account shows a debit balance it means that the person is a debtor which means he has to pay money to the firm. If it shows a credit balance he has to receive money from the firm. 2. If Real accounts show debit balance it means that the firm owns property or asset to the extent of balance in the account 3. If a nominal account shows a debit balance it means than an expense or loss to that extent has been incurred by the firm and vice versa. Posting of a compound entry: Consider the following Compound Entries and try to understand how these are posted. Ex:1 Cash A/c Furniture A/c To Capital Account (Being Capital brought in the form of Cash) We see that there are two debits for one credit in such a case three accounts are opened. Cash A/c, Furniture A/c and Capital A/c. Cash A/c shows a debit against the credit of capital account. Furniture A/c also shown a debit against the credit of Capital A/c which shows a Credit balance has two details: the Cash A/c and Furniture A/c. Therefore in the Cash A/c since it is showing the debit balance, on the debit side of the Cash A/c it is written as To Capital. In the Furniture A/c which is also showing debit balance it is written as To Capital Rs.40000. In the Capital A/c which has two debits it is written as By Cash Rs.10000 and By Furniture Rs.40000. Please examine the following accounts. Dr. Dr. Rs.10000 Rs.40000 Rs.50000

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CASH A/C Dr. Date Particulars To Capital Amount 10000 Date Particulars By Purchases Cr. Amount 10000

FURNITURE A/C Dr. Date Particulars To Capital Amount 40000 CAPITAL A/C Dr. Date Particulars Amount Date Particulars By Cash By Furniture 2.4 SUBSIDIARY BOOKS - DIVISION OF JOURNAL Journal is the book of original entry or the main book where in business transactions are entered in a chronological order. But when the transactions are too many, quick location of a particular transaction may not be easily done. Therefore, Journal is divided into 8 parts or eight subsidiary books viz: 1000 40000 Cr. Amount Date Particulars By Purchases Cr. Amount 10000

1) Cash Book 2) Purchases Book 3) Sales Book 4) Purchase Returns 5) Sales Returns 6) Bills Receivable 7) Bills payable 8) Journal proper

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Thus subsidiary books are parts or sub-divisions of a journal. The following paragraphs explain more about the individual Subsidiary Books. CASH BOOK The Cash Book records transactions dealing with receipts and payments of cash. The Format is given below: CASH BOOK Date Receipts L/F Amount Rs. Date Receipts L/F Amount Rs.

Here it may be seen that a Cash Book looks like a Cash Account. The Cash Book is different from other subsidiary books since it is two sided. It records two aspects, the receipts aspect as well as the payments aspect. It serves both the purpose of a journal and also a ledger. PURCHASES BOOK The Purchase Book records all the Credit purchases, the Voucher No. Invoice No the Name of the Creditor and then amount of Purchases are given. The Format of the Purchase Book is given below:

PURCHASE BOOK Date Name of the Creditor L/F Invoice No. Amount in Rs.

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SALES BOOK The Sales Book, also called the Day Book, records all the Credit Sales. The Voucher No. the Name of the Debtor and the amount of sales are recorded. The format of the Sales Book is given below:

SALES BOOK Date Name of the Debtor L/F Invoice No. Amount in Rs.

PURCHASE RETURNS BOOK The Purchase Returns Books records all the Returns made out of Credit Purchases. The format of the purchase returns is given below.

PURCHASE RETURNS BOOK Date Debit No. Name L.F. Amount in Rs.

Debit Note: It is a note made out in duplicate. The duplicate copy is kept for office record and the original one is sent to the seller. The partys account is debited with the amount written in the purchase returns book. SALES RETURNS BOOK Sales Returns Book shows the goods returned by the customers to whom goods have been sold. The format of the sales return book is given below:

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SALES RETURNS BOOK Date Credit Note. Name L.F. Amount in Rs.

Credit note is also like a debit note. It is also made out in duplicate. The duplicate copy is kept for office record.

BILLS RECEIVABLE BOOK Bills Receivable Book records the amounts receivable against Bills or exchange by the business receivable lying with us. The format of the Bills Receivable Book is given below:

BILLS RECEIVABLE BOOK Date Drawee Tenure Payable at Due Date

BILLS PAYABLE BOOK The Bills payable book records all the bills payable by the business. The format is given below. BILLS PAYABLE BOOK Date Drawer/Payee Tenure Payable at Due Date

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JOURNAL PROPER: This books makes a record of certain special entries like opening Entries, Closing entries, adjustment entries and rectification entries, transfer entries, Entries relating to dishonour of promissory notes withdrawal of goods by the proprietor for personal use or loss of goods by theft, fire etc., Credit purchase of Sale of assets; Bad debts etc., Those transactions which cannot be entered in any of the seven specific subsidiary books, get entered in the Journal Proper. 2.5 TRIAL BALANCE:

The fundamental principle of Double Entry System of Book Keeping is that for every debit there must be a corresponding credit. It follows, therefore, that the sum total of debit amounts should equal the sum total of credit amounts of ledger at any date. Trial Balance is a statement of all the debit and credit balances. It is basically prepared to check the arithmetical accuracy. It is prepared from the balances obtained from the Ledger. However, it may be noted that the agreement of the Trial balance is not a conclusive proof of accuracy. Although it points out certain errors, several errors may remain undetected even after the preparation of the trial balance.

TRIAL BALANCE THE LINK: The agreement of the Trial Balance reveals that both the aspects of each transaction have been recorded and that the books are arithmetically accurate. If the Trial Balance does not agree, it shows that there are some errors, which must be detected and rectified before the final accounts are prepared. Thus, Trial balance forms a connecting Link between the ledger accounts and the final accounts. It is the third stage in the accounting cycle.

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A specimen of Trial Balance is given below: TRIAL BALANCE OF _______________ AS ON: _____________ S.No. Name of the Accounts Dr. Balance Cr. Balance

As already said the trial balance may agree and yet there may be some errors. The following types may remain undetected, even after the tallying of Trial Balance.

i) ii) iii) iv) v)

Omission of an entry in a subsidiary book A wrong entry in a subsidiary book Posting an item to the correct side but in the wrong account Compensating errors Errors of principle

PREPARATION OF TRIAL BALANCE: Let us take a small example to understand and how a trial balance is prepared. From the following balances taken from the ledger of Sri Ltd., prepare a trial balance as on 31-3-2004:

Opening Stock Traveling Expenses Rent & Taxes Salaries & Wages Freight out wards Discount received Commission paid Bank Account Sundry debtors Trade creditors

24000 775 1050 3145 130 220 216 12054 13600 10000

Carriage inwards Returns inwards Sales Purchases Disallowed Capital Account Drawings Account Bills receivable Bills payable Closing stock

100 1200 42000 31500 450 57000 9000 16000 4000 31600

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TRIAL BALANCE OF SRI LTD.,AS ON 31-03-2004 Debit Balances Rs. 24000 774 1050 3144 130 100 1200 42000 31500 450 220 216 12054 13600 10000 57000 Total 9000 16000 1,13,220 1,13,220 Credit Balances Rs.

Opening Stock Travelling Expenses Rent & Taxes Salaries & Wages Freight outwards Bills payable Carriage Inwards Returns Inwards Sales Purchases Discount allowed Discount received Commission paid Bank account Sundry debtors Trade creditors Capital account Drawings account Bills receivable

4000

Note: Closing stock is already included in Purchases and therefore should not be shown in the Trial Balance. It should be given as an adjustment while preparing Final Accounts.

2.6 ACCOUNTING CYCLE: Ledger Journal Final Accounts The accounting cycle shows that a business transaction is first entered into Journal, the book of original entry. From there it is transferred or posted to the Ledger. From the Ledger Trial Balance

38

Balances a Trial Balance is prepared. Trial balance is a statement of debits and credits. From these balances the Final Accounts are prepared. Thus it may be remembered that the Accounting Cycle starts with Journal and ends with the Final Accounts. At the Journal stage documentation of the Business transactions is done, while at the Ledger stage account wise information is obtained and summarized and at the Trial Balance stage List of Debit and Credit balances is obtained to check the arithmetical accuracy and at the final accounting stage the profit or loss position of the business is found out. 2.7 SUMMARY: Maintaining a systematic record of all transaction is called book-keeping and when such record-keeping moves on to classifying and summarizing, preparation of final reports and their interpretation, we call it accounting. Journal is the book wherein a business transaction is first written or recorded and therefore it is also known as book of Original Entry. Steps to be followed while journalizing are: Identify the accounts being affected in the transaction; Categorize them into real, nominal and personal and; apply the relevant rules of debit and credit. Ledger is a book where account wise information is documented. While the Journal gives data in chronological form, the ledger gives account wise information. transactions related to a particular account are put at one place . Journal is the book of original entry or the main book where in business transactions are entered in a chronological order. But when there are too many transactions, Journal is divided into 8 parts or eight subsidiary books. Thus subsidiary books are parts or sub-divisions of a journal. Trial Balance is a statement of all the debit and credit balances. It is basically prepared to check the arithmetical accuracy. It is prepared from the balances obtained from the Ledger. All the

2.8 KEY WORDS:

Journal Narration Nominal Account Ledger Journalising Real Account Personal Account Ledger Posting

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Balancing Credit Balance Trial Balance Try Yourself:

Debit Balance Subsidiary Books

1. Journalize the following transactions in the books of Mr. Joy. April 1, 2004 April 2, 2004 April 3, 2004 April 5, 2004 April 6, 2004 April 7, 2004 April 8, 2004 April 9, 2004 April 10, 2004 April 11, 2004 April 15, 2004 2. Bank A/c Dr. Discount Dr. To Bills Receivable Post the above entries. Capital brought in Rs. 100000 Bought Machinery Rs. 50000 Purchased Good Rs. 25000 Sales Rs. 10000 Sales to Shalom Rs. 15000 Purchases from Princy Rs. 20000 Received to Divya Rs. 15000 Received Interest Rs.5000 Received Commission Rs.3000 Bought Furniture from Teja Ltd on Credit Rs. 10000 Paid Salaries Rs.5000 56000 500 5500

3. Given below is a Cash account, point out whether Cash book shows Debit or Credit. CASH A/C Dr. Date 1.1.04 15.1.04 20.1.04 Particulars To Balance B/d To sales To Ramya Total Amount 8000 2000 1000 11000 Date 17.1.04 19.1.04 31.1.04 Particulars By Purchases By Rent By Balance C/d Total 3000 1000 7000 11000 Cr. Amount

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4. From the following balances prepare the Trial Balance of MJS Ltd. Purchases 1,57, 500 Sales 2,10,000 Return Inwards 6,000 Carriage Inwards 500 Freight Outwards 650 Salaries & Wages 15,720 Rent & Taxes 5,260 Traveling Expenses 3,870 Opening Stock 1,20,000 Discount allowed 2,250 Discount received 1,100 Commission paid 1,080 Bank account 60,270 Sundry Debtors 68,000 Trade Creditors 50,000 Capital Account 2,85,000 Drawings Account 45,000 Bills Receivable 80,000 Bills Payable 20,000 Closing stock 1,58,000 5. What is Journal? 6. What are the various types of accounts? 7. Explain the rules of Journalising. 8. Classify the following accounts. a. Capital b. Cash c. Furniture d. Salaries e. Goodwill 9. What do you mean by ledger posting 10. If a personal account is showing a debit balance, what does it indicate 11. Cash Book records all ----------------------- transactions. 12. Purchases Book records ---------------------. 13. Adjustment entries are written in --------------------.

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14. Omission of an entry in a Subsidiary book affects the agreement of Trial Balance.(Yes/ No) 15. Compensating Errors go undetected by The Trial Balance.(Yes/ No)

Answers: 1. Date April 1, 2004

JOURNAL OF Mr. Joy Particulars Cash A/c To Capital A/c (Being Capital Brought) Dr. Debit Rs. 100000 Credit Rs. 100000

April 2, 2004

Machinery A/c To Cash A/c (Being purchase of Machinery)

Dr.

50000 50000

April 3, 2004

Purchases A/c To Cash A/c (Being Goods purchased)

Dr.

25000 25000

April 5, 2004

Cash A/c To Sales A/c (Being Sales made)

Dr.

10000 10000

April 6, 2004

Shalom A/c To Sales A/c

Dr.

15000 15000

(Being Credit Sales made to Shalom) April 7, 2004 Purchases A/c To Princy A/c (Being Credit purchases made) Dr. 20000 20000

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April 8, 2004

Cash A/c To Sales A/c (Being Sales made)

Dr.

15000 15000

April 9, 2004

Cash A/c To Sales A/c (Being Sales made)

Dr.

5000 5000

April 10, 2004 Cash A/c To Commission A/c (Being Commission received) April 11, 2004 Furniture A/c To Teja Ltd A/c (Furniture purchased on Credit) April 15, 2004 Salaries A/c To Cash A/c (Being Salaries paid)

Dr.

3000 3000

Dr.

10000 10000

Dr.

5000

5000

2. Dr. Date Particulars To Receivable

BANK A/C Cr. Amount Bills 5000 Date Particulars Amount

DISCOUNT A/C Dr. Date Particulars To Bills receivable Amount 500 Date Particulars Cr. Amount

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BILLS RECEIVABLE A/C Dr. Date Particulars Amount Date Particulars By Bank By Discount 4. Total of Trial Balance Rs 5,66,100. 8. (a) Personal A/c, (b) Real A/c, (c) Real A/c, (D) Nominal A/c (e) Real A/c. 11. Cash 12. Credit Purchases 13. Journal Proper 14. Yes 15. Yes 5000 500 Cr. Amount

FURTHER READINGS:
Jain S.P. and K.L. Narang, Fundamentals of Accounting, Kalyani Publishers Jawaharlal, Financial Accounting, Wheeler Publishing Nitin Balwani, Accounting and Finance for Managers, Excel Books

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LESSON 3 ACCOUNTING CYCLE-II (FINAL ACCOUNTS)

OBJECTIVES To be able to appreciate the need for preparation of Final Accounts. To be able to prepare the Trading A/c To be able to prepare the Profit and Loss A/c To be able to prepare the Balance Sheet

STRUCTURE:
3.1 Introduction 3.2 Capital and Revenue Items 3.3 Profit & Loss Account 3.4 Balance Sheet 3.5 Adjustments 3.6 Summary 3.7 Key Words

3.1 INTRODUCTION:

The final stage in the accounting cycle is the preparation of final accounts. It is common knowledge that the ultimate objective of maintaining accounts is to find out profit or loss position and also the financial position of the organization concerned.

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Final accounts are prepared from the debit and credit balances of the trial balance. statement of assets and liabilities known as the balance sheet. 3.2 CAPITAL AND REVENUE ITEMS:

Final

accounts are constituted of the profit and loss account (also called Income Statement) and a

It may be noted that before preparing final accounts a distinction needs to be made between capital and Revenue items. While the revenue items are to be shown in the Profit & Loss A/c. The Balance Sheet records all capital items in the form of the assets and liabilities as on a particular date.

Capital Expenditure

Revenue Expenditure

1) Amount spent on acquiring permanent 1) Amount spent on the conduct of asset business and maintenance of capital assets

2) The expenditure adds to the revenue 2) This Expenditure may not do so earning capacity of the business 3) May add to the value of an existing asset 3) Revenue Expenditure does not add to any value to net asset 4) shown in the balance sheet 4) Shown in the trading or profit and loss account

3.3 PROFIT & LOSS ACCOUNT: As already stated profit and loss A/c shows the net income or net expenditure position of the business organisation. It consists of two parts namely: Trading A/c and (2) Profit and Loss A/c. The preparation of the main profit and loss account begins with the Trading Account and ends with the Profit and Loss account. While Trading Account records the balances which are

46

directly related to the manufacturing the product, the profit and loss account records the expenses and incomes and expenses, profits and losses which are related to the business but not directly related to the making of the product saleable. TRADING ACCOUNT: There is a distinction even between the Trading account and Profit and Loss A/c. The trading accounts obtains gross profit or loss. On the debit side, items relating to opening stock, purchases, wages, carriage, wages, fuel & power, manufacturing expenses, coal, water and gas, motive power, octroi, import duty, custom duty, consumable, foreman/work managers salary, Royalty on manufactured goods are taken; That is the cost of good sold is obtained. On the credit side, sales, closing stock etc are taken. That is the value of net sales is obtained. The difference between the sales and cost of goods sold gives the gross profit / loss position of the concerned firm. PROFORMA OF TRADING A/C Trading A/c for the year ending : _________ Particulars Amount Rs. Dr. To Opening Stock To Purchases To Carriage on purchases Less: Purchase Returns To Wages To Fuel and Power To Coal, Gas and Water To Factory Rent To Gross Profit C/d Total Total By Closing stock By Sales Less: Sales Returns Particulars Amount Rs. Cr.

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PROFIT AND LOSS A/C: The profit and loss account is prepared in order to find out the net profit / loss position of the concern. The expenses and incomes taken in the profit and loss account are of indirect nature and include the following:Proforma of Profit And Loss A/C Amount By gross profit brought down Rs. By Interest Received By Discount Received By Commission Received By Rent from Tenants By Income from Investments By Apprentice premium By Interest on debentures By Income from any other sources By Miscellaneous Revenue receipts By Net loss transferred to Capital A/c

To gross loss brought down Amount To Office Salaries Rs. To Expenses To Advertisement To Traveling Salaries To Expenses incurred on commission To Bad Debts To Godown Rent To Export Expenses To Carriage outwards To Bank charges To Agents commission To Rent, Rates and Taxes To Heating and Lighting To selling and distribution expenses To Printing and Stationery To Postage and Telegram To Telephone Charges To Legal charges To Audit fees To Insurance To General Expenses To Depreciation To Repairs & Maintenance To Discount allowed To Interest on capital To Interest on loans To Discount on bills discounted To Extraordinary expenses To Loss by Fire (Not covered by Insurance) To Net profit transferred to capital A/c

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3.4 BALANCE SHEET: A balance sheet shows the financial position of a business on a certain fixed date. The financial position of any concern/organization is shown by its assets on a given date and its liabilities on that date. The excess of assets over liabilities represents the capital which serves as a pointer to the financial condition of the concern. It may be noted that a balance sheet is not an account but a mere statement of assets and liabilities on a particular date. The left hand side of the balance sheet shows all the liabilities while the right side displays the Assets position. The specimen proforma of a balance sheet is given below: BALANCE SHEET OF _________________ COMPANY AS ON : _____________ LIABILITIES CURRENT LIABILITIES: Bills payable Sundry creditors Bank Overdraft LONG TERM LIABILITIES: Loan from Bank Loan from Wife FIXED LIABILITIES: Capital Rs. ASSETS LIQUID ASSETS: Cash in Hand Cash at Bank FLOATING ASSETS: Sundry Debtors Investments Bills Receivable Stock in Trade Prepaid Expenses FIXED ASSETS: Machinery Building Furniture & Fixtures Motor Car INTANGIBLE ASSETS: Goodwill Patents Copyright Licenses FICTITIOUS ASSETS: Advertisement Miscellaneous Expenses Profit & Loss A/c TOTAL TOTAL Rs.

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In the reverse order of preference the Balance Sheet may be prepared as follows: BALANCE SHEET LIABILITIES 1. Fixed Liabilities 2. Long Term liabilities 3. Current Liabilities ASSETS 1. Fictitious Assets 2. Intangible Assets 3. Fixed Assets 4. Floating Assets 5. Liquid Asset TOTAL: TOTAL:

Thus it goes to say, that the items in the balance sheet may be marshaled either in the order of permanence or liquidity. Example: From the following balances of XYZ Ltd on 31.3.2004 you are required to prepare the Trading and Profit and Loss Account and a Balance sheet as on that date: Amount Rs. Stock on April 1 Bills Receivable Purchases Wages Insurance Sundry Debtors Carriage Inwards Commission (Dr) Interest on capital Stationery Returns inward Capital 1000 4500 39000 2800 1100 30000 800 800 700 450 1300 17900 Commission (Cr) Return Outward Trade Expenses Office Fixtures Cash withdrawal Cash at bank Rent and Taxes Carriage outward Sales Bills payable Creditors Closing stock Amount Rs. 400 500 200 1000 500 4750 1100 1450 50000 3000 19650 25000

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TRADING & PROFIT AND LOSS A/C OF XYZ LTD FOR THE YEAR ENDING : 31-3-2004 Particulars To Opening Stock Amount Rs. Dr. 1000 Particulars By 50000 Less: Returns 1300 By Closing Stock Sales: 48700 I/W 25000 Amount Rs. Cr.

To purchases: 39000 Less: Returns outward 500 To wages To Carriage I/w To Gross Profit C/d

38500 2800 800 30600 73700 By Gross Profit B/d By Commission

73700 30600 400

To Insurance 1100 To Commission 800 To Interest on Capital 700 To Rent and Taxes 1100 To Carriage O/w 1450 To net profit transferred to 25200 Capital A/c TOTAL 31000 BALANCE SHEET OF XYZ LTD AS ON: 31.3.2004 LIABILITIES Creditors Bills payable Capital: Add: Net profit Rs. 19650 3000 17900 25200 43100

TOTAL

31000

ASSETS Cash in hand Cash at Bank Bills receivable Stock Sundry debtors Office Fixtures TOTAL

Rs. 500 4750 4500 25000 30000 1000 65750

TOTAL

65750

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3.5 ADJUSTMENTS: Bits of information which are received/discovered after the preparation of Trial Balance have to be accommodated into financial statements. They are, therefore called adjustments. It may be remembered that sometimes adjustments thus need to be made in the final accounts. Since the adjustments are given after the trial balance is prepared, they have to be given the two fold effect. Once they appear in the trading/profit and loss account and the second time in the balance sheet. These adjustments enable the firm to make its accounts fall in line with the matching and such other concepts whichmake the final statements of account to reflect the true and fair view of the affairs of the business. given below: Closing Stock: This may be shown on the credit side of the Trading account and the Second time on the asset side of the balance sheet. Outstanding Expenses: These are expenses due to be paid but not paid. These expenses should be added to the amounts already paid and shown in the trading account or the profit and loss account depending upon whether it is a direct expenditure or indirect expenditure. For Eg: outstanding wages should be added to Wages in Trading account and if it is outstanding salary should be added to Salary account in the profit and loss account. The second effect is that should it should be shown on the liability side of balance sheet. Prepaid (Unexpired) Expenses: These are expenses paid in advance and therefore should be deducted from the respective expenditure on the debit side of Trading and profit and loss a/c and then shown on the asset side of the balance sheet. For instance if insurance is prepaid, it should be deducted from Insurance on the debit side of profit and loss account and should be shown on the asset side of the Balance sheet as prepaid insurance. Treatment for some of the adjustments is

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Accrued Income: That income which has been earned but not received during the accounting year is called accrued income. Such income needs to be added to the respective income on the credit side of the profit and loss and again on the asset side of the balance sheet. Income Received In Advance: Income received but not earned during the accounting year is known as Income received in Advance. This should be deducted from the respective income in the profit and loss a/c and should be shown in the balance sheet as a liability. Depreciation: This is reduction in the value of the fixed Asset and is usually calculated as a percentage of the assets. The amount of depreciation is shown on the debit side of profit and loss account and is to be deducted from the respective asset value in the balance sheet. Bad Debts: Debts which cannot be recovered or become irrecoverable are called bad debts. Since this is a loss for the business it is shown on the debit side of the Profit and Loss account and deducted from Sundry Debtors on the asset side of the Balance sheet. Interest on Capital: This is calculated as a percentage on capital and is shown on the debit side of Profit and Loss account and added to capital on the liability side of the Balance sheet. Interest on Drawings: The two fold effect of this adjustment is that it will be shown on the credit side of profit and loss account and is added to the amount of drawings on the liability side of the Balance sheet. Provision for Doubtful Debts: This is a provision maintained to meet doubtful debts. It is usually calculated as a percentage on sundry debtors and is shown on the debit side of profit and loss account and is deducted from sundry Debtors on the asset side of the Balance sheet. Provision for Discount on Debtors: In order to encourage prompt payment, discount is given to debtors. To meet the expenses of discount a provision is maintained on debtors. This provision, known as Discount on Debtors

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is shown on the debit side of the profit and loss account and is deducted from sundry debtors on the asset side of the balance sheet. Provision for Discount on Creditors: This is calculated as a percentage on creditors and is shown on the credit side of Profit and Loss account and is deducted from sundry creditors on the liability side of the Balance sheet. Deferred Revenue Expenditure: Advertisement expenditure is the best example for deferred revenue expenditure. A huge amount may be spent on advertisement in a single year but the benefits of such advertisements may be spread over the ensuing years too. Therefore only a part of such expenditure will be written off each year. The written off expenditure is shown on the debit side of profit and loss account and the unwritten part of the expenditure is shown on the asset side. Such unwritten off portions of deferred revenue expenditure from fictitious assets. Managers Commission:

Managers Commission may be given at a certain percentage (say 5%) on the net profit (say Rs.50000) before charging such commission; In such a case commission is calculated as follows: Net Profit x Rate of Commission = 50000 x 5/100 = Rs.2500 But sometimes it is given as after charging such commission, In such a case commission is calculated as given below: Profit x % of commission -----------------------------100 + % of commission 50000 x 5 -----------100 + 5 =Rs. 2380.95

This commission needs to be put on the debit side of the profit and loss account and is shown as a liability in the Balance sheet.

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Reserve Fund: Reserve is created out of profit and loss account. It is shown on the debit side of profit and loss account and is also shown on the liability side of the Balance sheet.

Example: From the following Trial Balance of Priya Industries Ltd., prepare Final Accounts after making the necessary adjustments for the year 31-12-2005

TRIAL BALANCE Debit Balances Freehold Land Loose Tools Plant and Machinery Sundry Debtors Cash at bank Opening Stock: 1.1.2005 Insurance Bad Debt Bills Receivable Purchases Cash in hand Rent, Rates etc Interest Wages Trade Expenses Salaries Repairs Carriage Inwards Discount Amount Rs. 35000 5600 45500 18200 11000 10500 300 560 5400 50000 560 1300 250 10700 1560 875 350 290 Mortgage Loans Bills payable Sales Creditors Discount Capital Credit Balances Amount Rs. 20000 3400 121500 15600 175 40000

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Drawings Suspense A/c

2500 80 200675 200675

Adjustments: a) Insurance unexpired to the extent of Rs.90 b) Salaries and Rent are outstanding to the extent of Rs.140 and 60 c) Loose tools are revalued at Rs.4500 d) Allow Interest on capital @ 5% p.a. e) Make a reserve of 5% Debtors for doubtful debts f) Closing stock was valued at Rs.30000 on 31.12.2005 TRADING & PROFIT AND LOSS A/C OF XYZ LTD FOR THE YEAR ENDING : 31-3-2004 Particulars Amoun t Rs. Dr. 50000 50000 10700 350 79950 151500 1560 140 1300 60 1700 By Discount received 1360 150 250 5560 210 175 Particulars Amount Rs. Cr. 121500 30000

To Opening Stock To Purchases To Wages To Carriage Inwards To Gross Profit C/d TOTAL To Salaries Add: O/S Salaries To Rent, Rates etc Add: O/S Rent To Trade Expenses To Interest To Bad Debts To Insurance Less: Prepaid

By Sales By Closing Stock

151500 By Gross Profit b/d 79950

300 90

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To RBDD 910 To Interest on Capital 2000 To Loose Tools Written off 1100 To Repairs 875 To Discount allowed 290 To Net Profit Transferred to Capital A/c 70720 TOTAL: 80125 80125

BALANCE SHEET OF PRIYA INDUSTRIES AS AT 31-12-2005 LIABILITIES Creditors Bills Payable Outstanding Expenses: Salaries Rent Mortgage Loan: Capital Less: Drawings Add: Net Profit 40000 2500 37500 70720 110220 Interest on Capital 2000 140 60 200 Sundry 18200 Less: 910 Closing Stock Prepaid Insurance Suspense Balance Freehold Land Plant & Machinery Loose Tools 149920 35000 45500 4500 149920 A/c 30000 90 (Dr) 80 RBDD Debtors 17290 Rs. 15600 3400 ASSETS Cash in Hand Cash at Bank Bills Receivable Rs. 560 11000 5400

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Note on Bad Debts, RBDD and Reserve for Discount on Debtors Bad Debts imply Debts which can not be received. That is out of Debtors this part of the amount is not going to be received. It is a loss. Therefore it should be shown on the debit side of profit and loss account. If Bad debts are given in the adjustments also, such bad debts should be added to the bad debts given in the trial balance and also shown on the debit side of the profit and loss a/c The New Bad debts or bad debts given in the adjustments should be deduced from the Sundry debtors and then the balance of sundry debtors should be shown on the asset side of the balance sheet. Example TRIAL BALANCE Debit Balances Rs. 50000 1000 Credit Balances Rs.

Sundry Debtors Bad Debts

Adjustment: Bad Debts to be further provided Rs.500

Treatment Profit and loss A/c (Debit Side) Amount Rs. To Bad Debts Add: New Bad Debts 10000 500 1500 Amount Rs.

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Balance Sheet LIABILITIES Rs. ASSETS Sundry Debtors Less: New Bad Debts 50000 500 49500 Rs.

Reserve for Bad and Doubtful Debts: Doubtful Debts imply debts which have not yet become bad but may not be recovered when Credit Sales are made, usually a percentage of debtors fail to pay. In order to meet the loss arising out of such bad and doubtful debts a provision is created. This is known as Reserve for Doubtful Debts or Provision for Doubtful debts. This is calculated on Sundry debtors. Reserve for Doubtful Debts (RBDD) if given in the Trial balance, should be shown on the debit side of Profit and loss a/c If RBDD is given in the adjustments also then there are two ways of showing it. The simple one is show the New RBDD on the credit side of Profit and loss Account and deduct the new RBDD from the Debtors in the balance sheet while showing the balance given in the trial balance on the debit side of the profit and loss account. The other method is compare the New RBDD with the old RBDD. If new RBDD is more the difference between the old and the new is put on the debit side of Profit and Loss A/c and the new RBDD is deducted from the Sundry Debtors. If the New RBDD is less then, the difference is shown on the Credit side and the new RBDD is deducted from Sundry Debtors. Example TRIAL BALANCE Debit Balances Rs. 50000 1500 Credit Balances Rs.

Sundry Debtors RBDD Bad Debts

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Adjustment: Create a reserve for Doubtful Debts @ 5% Treatment Method: 1 Profit and loss A/c Dr. Rs. To RBDD (old) 1500 By RBDD (New @ 5% on 50000 2500 Cr. Rs.

Balance Sheet

LIABILITIES

Rs.

ASSETS Sundry Debtors Less: 2500 RBDD 50000

Rs. (New) 47500

Method: 2 Profit and loss A/c Dr. Rs. To RBDD (New) 2500 Less: Old 1500 1000 Cr. Rs.

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Balance Sheets LIABILITIES Rs. ASSETS Sundry Debtors Less: 2500 RBDD 50000 (New) 47500 Rs.

Example where New Bad Debts provision and also Reserve for Discount on Debtors need to be maintained. TRIAL BALANCE Debit Balances Rs. 50000 500 1000 Credit Balances Rs.

Sundry Debtors Bad Debts Bad Provision (RBDD)

Adjustments: 1) Create further Bad Debts Rs.500 2) Create a reserve for bad and doubtful debts @ 5% on Sundry debtors 3) Create a reserve for discount on debtors @ 2% Treatment: Profit and loss A/c Dr. Rs. To RBDD (Old) To Bad Debts Add: New 500 500 1000 1000 By RBDD @ 5% Cr. Rs. 2475

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To Reserve for Discount on Debtors @ 2% 940

Balance Sheet LIABILITIES Rs. ASSETS Sundry Debtors Less: Bad Debts Rs.49500 47025 Less: Reserve For Discount 940=50 on drawings @ 2% on 47025 46084=50 50000 500 49500 on 2475 Rs.

Less RBDD @ 5%

We thus come to the end of the accounting cycle, by preparing the final statement of accounts, that is the Profit and Loss Account and the Balance Sheet together with the adjustments emanating from the additional pieces of information after the preparation of the Trial Balance. We may here recall the Accounting Cycle we explained to ourselves in Lesson 2. ACCOUNTING CYCLE: Ledger Journal Final Accounts The accounting cycle shows that a business transaction is first entered into Journal, the book of original entry from there it is transferred or posted to the Ledger. From Ledger Balances of the Trial Balance is prepared. Trial balance is a statement of debits and credits. From these balances the Final Accounts are prepared. It may be thus remembered that the Accounting Trial Balance

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Cycle starts with Journal and ends with the Final Accounts.

At the Journal stage

documentation of the Business transactions is done, while at the Ledger stage account wise information is obtained and summarized and at the Trial Balance stage List of Debit and Credit balances is obtained to check the arithmetical accuracy and at the final accounting stage the profit or loss position of the business concern is ascertained.

3.6 SUMMARY: The final stage in the accounting cycle is the preparation of final accounts. It is common knowledge that the ultimate objective of maintaining accounts is to find out operating results and also the financial position of the organization concerned. Final accounts are prepared from the trial balance. Final accounts consist of the profit and loss account (also called Income Statement) and a statement of assets and liabilities known as the balance sheet. Distinction needs to be made between capital and Revenue items. Profit and loss A/c shows the net income or net expenditure position of the business organisation. It consists of two parts namely: (1) Trading A/c and (2) Profit and Loss A/c. The preparation of the main profit and loss account begins with the Trading Account and ends with the Profit and Loss account. While Trading Account records the balances which are directly related to the manufacturing the product, the profit and loss account records the expenses and incomes and expenses, profits and losses which though related to the business are not directly related to the making of the product saleable. A balance sheet shows the financial position of a business on a certain fixed date. The financial position of any concern/organization is shown by its assets on a given date and its liabilities on that date. The excess of assets over liabilities represents the capital Bits of information which are received/discovered after the preparation of Trial Balance have to be accommodated into financial statements. They are, therefore called adjustments. Since the adjustments are given after the trial balance is prepared, they have to be given the two fold effect. These adjustments enable the firm to make its accounts fall in line with the matching and such other concepts to make the final statements of account to reflect the true and fair view of the affairs of the business.

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3.7 KEY WORDS: Final Accounts Profit & Loss Account Balance Sheet Outstanding Expenses Accrued Income Depreciation Interest on Capital Interest on Drawings Provision for Discount On Creditors Reserve Fund Try yourself: 1. The following is the Trial balance of Seema as on 31st December 2005: ] Debit Balances Drawings Sundry Debtors Cash in Hand Interest Opening Stock Cash at Bank Land and Buildings Sales Returns Bad Debts Purchases Carriage Inwards Establishment Charges Rent Advertising Rs. 10000 80000 5000 6000 15000 10000 100000 5000 6000 150000 4000 9000 5000 15000 Credit Balances Capital Sundry Creditors Loand Sales Purchase Returns Discount Bills Payable Provision for Bad Debts Rs. 100000 60000 40000 220000 8000 2000 15000 5000 Capital and Revenue Items Trading Account Closing Stock Prepaid (Unexpired) Expenses Income Received In Advance Bad Debts Provision for Doubtful Debts Provision for Discount on Debtors Deferred Revenue Expenditure

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Office Expenses Wages Bills Receivable Total Additional Information:

9000 15000 6000 450000 Total 450000

a) The stock on hand on kDecember 31, 2005 is Rs.30000 b) Outstanding rent is Rs.1000 c) Prepaid Wages are Rs.2000 d) Bad debts provision is to be maintained at 5 per cent of closing debtorws You are required to prepare Trading and Profit and Loss Account for the year ending 31st December, 2005 and a balance sheet as on that date.

FURTHER READINGS:
Jain S.P. and K.L. Narang, Fundamentals of Accounting, Kalyani Publishers Jawaharlal, Financial Accounting, Wheeler Publishing Nitin Balwani, Accounting and Finance for Managers, Excel Books

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LESSON 4 FINANCIAL STATEMENT ANALYSIS

OBJECTIVES: Explain the meaning and nature of Financial Statements Describe the objectives and types of Financial Statements Recognize the importance and limitations of Financial Statements Understand the meaning and importance of Financial Analysis Prepare Comparative and Common size Financial Statements and interpret them; and Calculate the Trend Percentages and interpret them.

STRUCTURE:
4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9 Introduction Meaning and nature of Financial Statements Objectives and types of Financial Statements Importance and uses of Financial Statements Limitations of Financial Statements Meaning of Financial Statement Analysis Types and importance of Financial Analysis Techniques of Financial Analysis Comparative Financial Statement Analysis

4.10 Common size Financial Statement Analysis 4.11 Trend Analysis 4.12 Limitations of financial analysis 4.13 Summary 4.14 Key words

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4.1 INTRODUCTION: In the previous lesson you have understood the preparation of trading account, profit and loss account and balance sheet. The financial statements viz., the Balance sheet and Profit and loss account are the end products of the accounting process. The accounting system of a firm becomes the basis for financial information. The accounting system helps to measure, compare, analyze and communicate financial data to various interested parties for making rational decisions. Understanding the nature of financial statements, their form, content and factors that affect them in projecting the true and fair view of financial position is the basic foundation for analysis of financial statements.

4.2 MEANING AND NATURE OF FINANCIAL STATEMENTS:

Meaning of Financial statements: Financial statements are the basic and formal means through which the company communicates financial information to various parties. Financial statements serve the varied needs of internal and external parties like owners, employees, management, creditors, investors etc. According to American Institute of Certified Public Accountants (AICPA) Financial statements are prepared for the purpose of presenting a periodical review or report on progress made by the management and deal with the status of investment in the business and the results achieved during the period under review. Financial statements are prepared for the purpose of disclosing the financial position of the business concern at a point of time and also operating results during the period under review. Thus, these are, in one sense, the periodical reports about the progress made by the management of the business concerns.

Nature of Financial Statements The data contained in the financial statements are the combined results of recorded facts, accounting conventions, postulates and personal judgment used in the application of

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accounting principles. Therefore, it is clear that the financial statements are composed of data, which are of a combination of: Recorded facts Accounting conventions adopted to facilitate accounting techniques Postulates or assumptions made Personal judgment of the accountants in using or applying a particular convention or postulates. The financial statements are used by investors and financial analysts to measure the firms performance in order to make investment decisions, so, they should be prepared with utmost care and contain as much information as possible. The financial statements have to be prepared in conformity with the GAAP.

4.3 OBJECTIVES OF FINANCIAL STATEMENTS: A financial statement shows both the performance and the financial position of the concern. These statements are the primary source of information on the basis of which conclusions are drawn about the profitability and financial position of the concern. The basic objective of financial statements is to furnish information required for decision making. The Accounting Principles Board of America (APB) states the following objectives of financial statements. To provide adequate, reliable and periodical information about economic resources and obligations of a business firm to external parties who have a limited access to gather data. To provide useful financial data to evaluate the firms earning capacity and future potential. To supply information which is useful for judging managements ability to utilize the resources of the firm effectively To disclose, to the extent possible other information related to the financial statements that is relevant to the users of these statements. To disclose, significant policies, concepts, methods followed in the accounting process.

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To report the activities of the business concern which are affecting the society and accounting for them To provide information to investors and creditors for predicting, evaluating potential funds in terms of amount, time and uncertainty

4.3.1 TYPES OF FINANCIAL STATEMENTS: Financial statements generally refer to two statements viz., Income statement or Profit and loss account and Balance sheet. Income statement shows only revenue receipts and revenue payments which are of nominal nature. Balance sheet shows all the balances which are of capital nature. The statement which shows total of assets and liabilities is known as Balance sheet. As per Generally Accepted Accounting Principles (GAAP), financial statements include the following. The position statement or balance sheet The income statement or profit and loss account A statement of changes in owners equity and A statement of changes in financial position

The two major financial statements i.e., balance sheet and income statement are required for external reporting and also for internal needs of the management like planning, forecasting and control. These two statements are supported by number of schedules, annexure, supplementing the data contained in the balance sheet and income statement. Apart from these two financial statements, there is a need to know about changes in funds position and movement of cash. For this purpose statement of changes in financial position and a cash flow statement is prepared.

1. Balance Sheet:Balance sheet is the most important financial statement which is prepared to measure the financial position of a concern as on a certain date. The balance sheet communicates information about assets, liabilities and owners funds for a business firm as on a specific date.

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Balance sheet is a static document as it shows assets, liabilities and shareholders funds at a particular point of time. Balance sheet can be called by different names like Statement of financial position, Statement of assets and liabilities, Statement of Net Worth and Statement of Property. The balance sheet can be presented in the accounting form or in the report form. In the account firm or T form of balance sheet, all assets are shown on the right hand side and capital and liabilities on the left hand side. Report form is also called vertical form of balance sheet, where assets and listed on the top of the page and capital and liabilities are shown below the assets.

2. Profit and Loss Account or Income Statement:Profit and loss account reports the operating results of the business during a specific accounting period. It is usually prepared on accrued basis, all expenses incurred and due are debited to profit and loss account, whether they are actually paid or not and similarly all incomes earned and due are credited to it whether they are actually received or not. Net profit or Net loss is the result of these expenses and revenues. This net profit denotes the operational efficiency of the management. Profit and loss account may be divided into three components. Trading account Profit and Loss account Profit and loss appropriation account Trading account reflects the gross profit or loss arising out of trading and manufacturing operations. Whereas profit and loss account reflects the net profit or net loss on account of operating expenses like administration, selling and financial expenses. On the other hand, profit and loss appropriation account reflects the various appropriations made out of profits like dividends, transfer to reserves etc. The income statement is normally prepared in account form dividing it into two parts known as debit side and credit side. On the other hand it can also be prepared in a vertical manner with detailed data. Vertical form of preparing income statements is suitable for further analysis and providing suitable data for decision-making.

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3. Statement of Changes in Owners Equity:Owners equity refers to the shareholders funds which includes paid up share capital, reserves and surplus, undistributed profits and balance in profit and loss account. It is also known as profit and loss appropriation account or income disposal statement. This statement reflects the various appropriations made during the year out of current profits. 4. Statement of Changes in Financial Position:This statement is prepared to know the movement of funds either in working capital or cash during a particular period. The statement of changes in financial position prepared on the basis of funds or working capital is known as funds flow statement and on the basis of cash is known as cash flow statement. These two statements depict the causes for changes in financial position in the form of changes in working capital and changes in cash in the form of sources and uses between two balance sheet dates. 4.4 IMPORTANCE AND USES OF FINANCIAL STATEMENTS:

The financial statements are mirrorS, which reflects the financial position and operating strength or weakness of the firm. The impact of business transactions on the financial position and progress of the enterprise is briefly disclosed by these statements. The users of financial statements include management, investors, shareholders, creditors, government, bankers, employees and public at large. They provide not only information about the efficiency of the management to the various interested parties in the concern but also help in taking rational decisions. The uses and importance of financial statements are presented below:1. As a report of Stewardship:- Management is responsible for the over all performance of the concern. They make several decisions and therefore, need information. Financial statements report on the performance of the policies of the management to the shareholders. 2. As a basis for fiscal policy:- The fiscal policies particularly taxation policies of the government are related with the financial performance of corporate undertakings. Thus,

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financial statements serve as a basis for industrial, taxation and other social and economic policies of the government. 3. Basis for dividend policies:- Potential investors, owners get an idea about the firms financial strength and performance from its financial reports. They are generally interested in the earnings, dividend and growth trends of the firm. The dividend policies of the corporate sector are linked with the government regulations and financial performance of the company. Hence financial statements form basis for dividend policies of companies. 4. Basis for granting of credit:- Companies have to borrow funds from banks and other financial institutions for various purposes. Credit granting institutions are interested in the continuing profitable performance of the firm, so that they can regularly receive their interest and principal sum. So, they need accounting information, which is provided by financial statements to estimate the firms performance. 5. Basis for Investment decisions:- Both present and prospective investors are interested in the financial statements for measuring long term and short term solvency as well as the profitability of the concern. Their prime considerations in their investment decisions are security and liquidity of their investment with reasonable profitability. Financial statements provide information to the investors in taking such important decisions. 6. Aids Government in policy framework:- These statements enable the government to know whether business is following various rules and regulations or not. These statements also form a base for framing and amending various laws for the regulation of the business. 7. As a basis for price fixation:- Customers may be interested in financial statements of a firm, because a careful study of the financial statements may provide information about the prices being fixed by the firm. 8. Helps trade unions and employees:- Trade unions and employees also make use of the financial statements of a firm for the purpose of preparing ground for bargain on matters relating to salary, bonus, fringe benefits, working conditions etc. They analyze the financial statements for measuring the profitability of the firm. 9. Helpful to stock exchanges:- Financial statements help the stock exchanges to understand the financial performance of the concerns to enable it to pass on the information to its members and stock brokers to take decisions about the prices to be quoted.

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In a nutshell, financial statements may be described as a comprehensive index of the financial affairs of a concern and are useful in many ways to a variety of interested parties.

4.5 LIMITATIONS OF FINANCIAL STATEMENTS: Financial statements are the result of the accounting process. But the profit or loss figure and financial position which is disclosed by the Income statement and Balance sheet respectively cannot be taken to be an exact representation of actual position of the concern. The financial statements are based on certain accounting concepts and conventions which cannot be said to be fool proof. The following are the important limitations of financial statements: (i) Interim and not final reports:- Financial statements do not depict the exact position and are essentially interim reports. The exact position can be only known if the business is closed. (ii) Lack of precision and definiteness:- Financial statements may not be realistic because these are prepared by following certain basic assumptions/concepts and conventions. (iii)Lack of Objective judgment:- Financial statements are influenced to a major extent by the personal judgment of the accountant. For example, method of charging depreciation, valuation of closing stock, amortization of goodwill and treatment of deferred revenue expenditure etc. (iv) Records only monetary facts:- Financial statements disclose only monetary facts, i.e., those transactions that are recorded in the books of accounts, which can be measured in monetary terms. (v) Historical in nature:- These statements are drawn after the happening of the events. They attempt to present a view of the past performance and have nothing to do with the accounting for the future. (vi) Artificial view:- These statements do not give a real and correct report about the worth of assets and their loss of value as these are shown on historical cost basis. (vii) Scope for manipulations: These statements are sometimes prepared according to needs of the situation or the whims of the management. For this purpose under or over valuation of inventory, over or under charge of depreciation and other such manipulations may be resorted to.

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(viii) Inadequate information:- There are many parties who are interested in the information given in the financial statements but their objectives and requirements may differ. The financial statements are prepared according to the provisions of the Companies Act, 1956, and may fail to meet the needs of all the users. 4.5 MEANING OF FINANCIAL STATEMENT ANALYSIS:

Financial statements are the end product of the financial accounting practices. Financial statements comprise two major statements, namely balance sheet and income statement. These statements are the records of operating performance with its impact on the financial position and the progress of the firm. Financial statements are prepared primarily for decisionmaking. The information contained in these statements is of immense use in making decisions through analysis and interpretation of financial statements. Financial analysis is a process of synthesis and summarization of financial operative data with a view to getting an insight into the operative activities of a business enterprise. It is the process of identifying the financial strengths and weakness of the firm by properly establishing relationship between the items of balance sheet and income statement. The term financial analysis includes both analysis and interpretation. The term analysis means simplification of financial data, by methodical classification of data given in financial statements. Interpretation means explaining the meaning and significance of the data so simplified. Thus, analysis and interpretation are closely interlinked and are complimentary to each other. Analysis is useless without interpretation and interpretation without analysis is difficult or impossible. 4.6 OBJECTIVES OF FINANCIAL STATEMENT ANALYSIS:

Financial statement analysis is helpful in assessing the financial position and profitability of a concern. Broadly, the objectives of the analysis are to understand the data contained in the financial statements with a view to understand the strengths and weaknesses of the firm,

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thereby enabling to take different decisions regarding the operations of firm. The main objectives for analysis of financial statements are: To assess the present profitability and operating efficiency of the firm as a whole and to To examine the earning-capacity and efficiency of various business activities with the To estimate about the performance efficiency and managerial ability of the management To determine short-term and long term solvency of the business concern with the help of To enquire about the financial position and ability to pay of the concerns seeking loans To determine the profitability and future prospects of the concern. To investigate the future potential of the concern To make a comparative study of operational efficiency of similar concerns engaged in the Thus, the analysis of financial statements helps the management at self-appraisal and also helps the shareholders to judge the performance of the concern. judge the financial health of the firm. help of income statements. of a business concern. the Balance sheet and credits.

identical industry.

4.7 TYPES OF FINANCIAL ANALYSIS:

Various users do the analysis of financial statements from different angles for different purposes. The analysis of financial statements can be classified into different categories as under:(i) On the basis of the nature of the analyst and the material used by him, (ii) On the basis of the objective of the analysis, and (iii)On the basis of the Modus Operandi of the analysis.

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(i) According to the nature of the analyst and the material used by him:- On this basis the financial analysis can be external and internal analysis. (a) External Analysis:- This type of analysis is done by external parties or outsiders like creditors, investors, governmental agencies, credit granting institutions etc. who do not have access to the books of accounts and other related information of the firm. This analysis is dependent on the published financial data of the firm and so can serve only limited purpose. (b) Internal Analysis:- The internal analysis is done by the persons who have access to the internal records and books of accounts of the concern. Such a analysis is done by management, employees of the firm (ii) According to the Objectives of the analysis:- On this basis the analysis can be long-term and short-term analysis. (a) Long-Term Analysis:- This analysis is made in order to study the long-term financial stability, solvency and liquidity as well as profitability and earning capacity of a business concern. This type of analysis helps in the long-term financial planning of the business. (b) Short-Term Analysis:- This type of analysis is made to determine the short term solvency, stability and liquidity and as well as to know the earning power of the concern. Such type of analysis may be helpful for short term financial planning and long term planning. (iii) According to the Modus Operandi of the Analysis:- On this basis, the analysis may be horizontal analysis and vertical analysis. (a) Horizontal Analysis:- This analysis is also called dynamic analysis. This analysis covers a period of several years and it gives considerable insights into areas of financial weaknesses and strengths of the firm. (b) Vertical Analysis:- This analysis is also called static analysis. This analysis is made on the basis of only one set of financial statements at a particular period. Different types of ratios establishing meaningful relationship between the items of financial statements can be computed to understand the financial position of the firm.

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4.7.1 IMPORTANCE OF FINANCIAL ANALYSIS: Financial analysis focuses on managerial performance, corporate efficiency, financial strengths and weaknesses and credit worthiness of the company. A finance manager must be well equipped with the different tools of analysis to make rational decisions of the firm. The importance of financial analysis is not limited to the finance manager alone. Its scope of importance is quite broad which includes top management, creditors, investors, and employees. Financial analysis helps the top management in measuring the companys operations, evaluating individuals performance and also helps in performing the functions of coordination and control. A creditor, through an analysis of financial statements appraises not only the ability of the company to repay but also judges the profitability of the concern to meet all its financial obligations. The investors evaluate the efficiency of the firm in terms of solvency, liquidity, profitability and also future potentiality. Employees and trade unions analyze the financial statements to assess whether the company has sufficient profits to afford a wage increase and whether it can absorb a wage increase through increased productivity or by raising prices. The use of a particular technique depends by and large on the purpose. A technique used by one user need not necessarily serve the purpose of another user because of varied interests in analysis of financial statements.

4.8 TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS In order to analyze and interpret the data in the financial statements, the analyst may use any one or more of the methods or tools. The more commonly used tools of financial analysis are: Comparative Financial Statements

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Common Size Financial Statements Trend percentages Ratio analysis and Funds Flow Statement Cash Flow Statement

In this lesson the first three tools viz, comparative statements, common size statements and trend analysis are explained and the others are discussed in the subsequent lessons.

4.9 COMPARATIVE FINANCIAL STATEMENT ANALYSIS: These are the statements showing the financial position of a firm at different periods of time. Here, both the Income statement and balance sheet are prepared by providing columns for the figures for both, the current year as well as for the previous year and for the changes during the year both, in absolute and relative terms. The elements of financial statements are shown in a comparative form to give an idea about the financial position of two or more periods. In order to use this method of analysis, it is necessary that the same accounting methods, procedures, policies, practices are followed consistently from one period to another, or other wise the very purpose of analysis will be defeated. This type of presentation is useful to the outsiders to take decisions about the company. ILLUSTRATION 1: Convert the following income statement into a comparative Income statement of Anu Ltd. and interpret the changes in 2005 in the light of the conditions in 2004.

Particulars

2004 Rs.

2005 Rs. 36,720 700

Gross Sales Less: Sales Returns

30,600 600

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Net Sales Less: Cost of goods sold Gross Profit Less: Operating expenses Administration expenses Selling expenses Total operating expenses Operating profit Add: Non-operating income Total Income Less: expenses Net Profit Non-operating

30,000 18,200 11,800

36,020 20,250 15,770

3,000 6,000 9,000 2,800 300 3,100 400

3,400 6,600 10,000 5,770 400 6,170 600

2,700

5,570

Solution:Comparative Income statement for the year 2004 and 2005 Particulars 2004 2005 Increase/Decrease Absolute change Rs. Gross Sales Less: Sales Returns Net Sales Less: Cost of goods sold 30,600 600 30,000 18,200 Rs. 36,720 700 36,020 20,250 Rs. 6,120 100 6,020 2,050 % 20.00 16.67 20.07 11.26

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Gross Profit Less: Operating expenses Administration expenses Selling expenses Total operating expenses Operating profit Add: Non-operating income Total Income Less: expenses Net Profit Non-operating

11,800

15,770

3,970

33.64

3,000 6,000 9,000 2,800 300 3,100 400

3,400 6,600 10,000 5,770 400 6,170 600

400 600 1,000 2,970 100 3,070 200

13.33 10.00 11.11 106.07 33.33 99.03 50.00

2,700

5,570

2,870

106.30

Interpretation:1. The company has made efforts to reduce the cost as the cost of goods sold has reduced considerably. 2. The gross profit has also increased in 2005 as compared to 2004 as the sales have gone up. 3. The company has also concentrated on reducing the operating expenses; hence, the percentage of operating profit has increased. The overall performance of the company has improved in the year 2005

ILLUSTRATION 2 The following are the Balance sheets of Reddy Ltd. at the end of 2004 and 2005. Prepare a Comparative Balance sheet and study the financial position of the concern.

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Rs. (000) Liabilities 2004 Rs. Equity Share 600 Capital Reserves Surplus Debentures 200 300 & 330 222 2005 Rs. 800 Land Buildings Plant Machinery Furniture Fixtures Longloans Bills payable 50 45 term 150 200 Other assets Cash in hand 20 & at bank Sundry creditors Other current 5 liabilities 10 100 120 Bills receivable Sundry debtors Stock Prepaid expenses 1435 1697 1435 1697 250 350 2 200 250 150 90 80 fixed 25 30 & 20 25 & 400 600 Assets 2004 Rs. & 370 2005 Rs. 270

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Solution:-Comparative Balance Sheets of Reddy Ltd. for the years 2004 and 2005 Rs. (000) Assets 2004 2005 Increase/Decrease Absolute change Current assets Cash & Bank Rs. 20 Rs. 80 90 250 350 2 Rs. 60 -60 50 100 2 % 300 -40 25 40 -

Bills Receivable 150 Sundry Debtors Stock Prepaid expenses Total Current 620 Assets Fixed Assets Land Buildings Plant Machinery Furniture Fixtures Other Assets Total Assets Fixed 815 Fixed 25 & 20 & 400 & 370 200 250 -

772

152

24.52

270

-100

-27.03

600

200

50

25

25

30

20

925

110

13.50

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Total Assets Liabilities Capital Current Liabilities Bills Payable &

1435

1697

262

18.26

50

45 120 10

-5 20 5

-10 20 100

Sundry creditors 100 Other Current 5

Liabilities Total current 155 175 20 12.90

liabilities Debentures Long term loans Total Liabilities Equity capital Reserves Surplus Total Liabilities Capital & 1435 1697 262 18.26 & 330 222 -108 -32.73 share 600 800 200 33.33 200 150 505 300 200 675 100 50 170 50 33.33 33.66

Interpretation: 1.The Comparative Balance sheet of the company reveals that during 2002 there has been an increase in fixed assets by Rs. 1,10,000 i.e., 13.5% while long term liabilities have relatively

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increased by Rs. 1,50,000 and Equity share capital has increased by Rs. 2,00,000. This fact depicts that the policy of the company is to purchase fixed assets from long term source of finance thereby not affecting the working capital. 2.The current assets have increased by Rs. 1,52,000 i.e., 24.52%. The current liabilities have increased by only Rs. 20,000 ie. 12.9%. This further confirms that the company has raised long term finances even for the current assets resulting in an improvement in the liquid position of the company. 3.Reserves and surplus have decreased from Rs.3.30,000 to Rs. 2,22,000 i.e., 32.73% thus indicating that the company has utilized reserves and surplus for the payment o dividend to shareholders with in cash or by issuing bonus shares. 4.The overall financial position of the company is satisfactory.

4.10 COMMON SIZE FINANCIAL STATEMENT ANALYSIS: Common size financial statements are those in which figures reported are converted into percentages to some common base. Common size financial statement is a financial tool for studying the key changes and trends in the financial position and operating results of a company. In the income statement the sales/total revenue is taken as the base and all the figures of the income statement are expressed as a percentage of sales/total revenue, similarly in the balance sheet the total of assets or liabilities is taken as base and all the figures are expressed as a percentage of this total. Inter firm or Intra firm comparison with the related industry as a whole is possible with the help of vertical common size statement analysis. It also facilitates trend analysis of financial results of a company over a period of time. ILLUSTRATION 3 Convert the following income statement into a common size income statement and explain the changes in 2004 in the light of condition prevailing in 2003.

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2003 Rs. Gross Sales Less: Returns and discount Net Sales Less: Cost of sales Gross sales Operating expenses: Selling expenses Administrative expenses Operating profit Other Income Total Income Other expenses Net Profit 1,400 150 1,550 200 1,350 3,000 1,500 4,500 3,300 1,700 Profit on 15,000 9,100 5,900 15,300 300

2004 Rs. 18,360 350

18,010 10,125 7,885

5,000

2,885 200 3,085 300 2,785

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Solution:2003 Amount in Rs. Gross Sales Less: 15,300 % of Sales 102 2 2004 Amount in Rs. 18,360 350 % of Sales 101.9 1.9

Returns 300

and discount Net Sales Less: sales Gross Profit on 5,900 sales Less : Operating Expenses Selling expenses Administrative expenses Total Operating 4,500 expenses Operating profit Other Income Total Income Other expenses Net Profit 1,400 150 1,550 200 1,350 9.3 1.0 10.3 1.3 9.0 2,885 200 3,085 300 2,785 16.1 1.1 17.2 1.7 15.5 30 5,000 27.7 3,000 1,500 20 10 3,300 1,700 18.3 9.4 39.3 7,885 43.8 Cost 15,000 of 9,100 100 60.7 18,010 10,125 100 56.20

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Interpretation: The analysis of the above income statement reveals the following points: 1. The percentage of gross profit has increased from 39.3% in 2003 to 43.8% in 2004. This is due to decline in percentage of cost of goods sold from 60.7% of sales in 2003 to 56.2% in 2004. The decline in % of cost of goods sold may be due to fall in raw material prices and/or efficiency of the purchasing department. 2. Though the absolute amounts of selling and administration expenses have increased during the year 2004 but this increase is less than proportionate of the increase in sales. Because of this the percentage of operating expenses to sales has declined from 30% in 2003 to 27.7% in 2004. This is a sign of companys operating efficiency and economy in expenditure. 3. The companys percentage of net operating profit of sales has increased from 9.3% in 2003 to 16.1% in 2004 due to the combined effect of decrease in cost of goods sold and operating expenses. This may be possible because of effective management policies of the concern. 4. The increase in the non-operating income of the business is significant but the disproportionate increase in non-operating expenses is not justified. In conclusion it may be said that the company has been operated more efficiently in 2004 as compared to 2003.

ILLUSTRATION 4 From the following Balance sheet of Rayon Company Ltd. for the year ended 31st December, 1997 and 1998, you are required to prepare a Comparative Common size Balance Sheet.

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Balance Sheet as on 31st December ( in Lakhs of Rs.) Liabilities 1997 Rs. Bills payable Sundry Creditors Tax payable 6% Debentures 6% Preference Capital Equity Capital Reserves 200 1,300 245 1,520 Furniture 100 1,300 140 1,520 400 400 Plant 300 270 300 300 Building 300 270 100 100 150 150 Stock Land 200 100 300 100 50 150 1998 Rs. 75 200 Cash Debtors Assets 1997 Rs. 100 200 1998 Rs. 140 300

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Solution: Rayon Company Ltd. Common Size Balance Sheet as on 31st December 1997 and 1998 (Figures in percentage) Particulars Assets Current Assets: Cash Debtors Stock Total Current assets Fixed Assets: Building Plant Furniture Land Total Fixed Assets Total Assets Current Liabilities: Bills Payable Sundry Creditors Taxes payable Total Current liabilities 3.84 11.54 7.69 23.07 4.93 13.16 9.86 27.95 23.07 23.07 7.70 7.70 61.54 100 17.76 17.76 9.21 6.68 51.41 100 7.70 15.38 15.38 38.46 9.21 19.74 19.74 48.69 1997 % 100 1998 100 %

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Long term liabilities: 6% Debentures Capital & Reserves: 6% Preference share capital Equity share capital Reserves Total shareholders funds Total liabilities and Capital 23.10 30.76 15.38 69.24 100 19.72 26.32 16.15 62.19 100 7.69 9.86

Interpretation: The percentage of current assets to total assets was 38.46 in 1997. It has gone up to 48.69 in 1998. Similarly, the percentage of current liabilities to total liabilities (including capital) has also gone up from 23.07 in 1997 to 27.95 in 1998. Thus, the proportion of current assets has increased by a higher percentage say about 10 as compared to increase in the proportion of current liabilities about 5. This has improved the working capital position of the company. There has been a slight deterioration in the debt-equity ratio though it continues to be very sound. The proportion of shareholders funds in the total liabilities has come down from 69.24% to 62.19% while that of the debenture holders has gone up from 7.69% to 9.86%.

4.11 TREND ANALYSIS: In financial analysis, the direction of changes over a period of time is very important. Time series or trend analysis of ratios indicates the direction of change. The financial statement may be analyzed by computing trends of series of information. The procedure involves selection of a base year and converting all the years figures as a percentage of their value in the base years figure. Trend ratios should be studied after considering absolute figures on which they are based, otherwise, they may give misleading results.

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Trend Ratio = Present year value x 100 Base year value

ILLUSTRATION 5 Calculate the Trend Ratios from the following figures of X Ltd. taking 2000 as the base year and comment thereon: Year Sales Stock 2000 1881 709 2001 2340 781 435 2002 2655 816 458 2003 3021 944 527 (In Lakhs of Rs.) 2004 3768 1154 672

Profit before 321 Tax

Solution: Trend Ratios Year Sales Rs. lakhs 2000 2001 2002 2003 2004 1881 2340 2655 3021 3768 in Trend ratio 100 124 141 161 200 Stocks Rs. lakhs 709 781 816 944 1154 in Trend ratio 100 110 115 133 163 Profit before tax Rs. lakhs 321 435 458 527 672 in Trend ratio 100 136 143 164 209

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Interpretation: The following points are worth noting from the trend ratios: 1. There is continuous increase in the sales in the last five years. This is a favorable tendency as success of business depends on sales. 2. Though there is increase in quantity of stock during the last five years yet it is comparatively less than the increase in sales. To keep less stock in spite of increase in the sales is an indicator of efficient inventory management. 3. Profit before tax is constantly increasing and its percentage increase is always more as compared to the percentage increase in sales. In conclusion, it can be said that all the three tendencies are in favour of the business and are indicator of full efficiency prevailing in the concern.

4.12 LIMITATIONS OF FINANCIAL STATEMENT ANALYSIS: Though, financial analysis is an important tool of a firm, determining the financial strengths and weakness of a firm, the analysis is based on the information available in financial statements. As such, the financial analysis also suffers from the same limitations of financial statements. Some other limitations are: Financial analysis is just a study of interim reports Financial analysis does not consider changes in price levels Financial analysis considers only monetary facts, non-monetary facts are ignored. If there is any change in accounting procedures and practices, the financial analysis may be misleading. The financial statements are prepared on the basis of going concern concept, as such it does not disclose correct position of the concern There is not single tool of analysis which is useful to all types of users

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4.13 SUMMARY: An organized collection of data according to logical and consistent accounting procedures is known as financial statements. The methodical classification of the data given in the financial statements is called as analysis and explaining the meaning and significance of the data so simplified is termed as interpretation. The financial statements generally refers to income statement and balance sheet, statement of retained earnings, funds flow statement etc. The financial analysis may be external. Internal, long term, short term, horizontal or vertical. The financial analysis helps a layman also to understand the statements easily and take decision wisely with the help of various tools and techniques of financial statement analysis. Most widely used techniques of financial statement analysis are Comparative statements, Common size statements, Trend analysis, Ratio analysis, funds flow analysis and cash flow analysis.

4.14 KEY WORDS: Financial Statements Interpretation Internal Analysis Vertical Analysis Common-size Statement Financial Analysis External Analysis Horizontal Analysis Comparative Statements Trend Analysis

Try yourself: 1. Explain the meaning and importance of financial statement analysis. 2. Explain briefly the terms analysis and interpretation of financial statements. What are the different tools employed for financial analysis?

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3. Briefly explain how financial information is useful to different users of financial statements? Problems 4. From the following Income statement of Vijay Co. Ltd., prepare Comparative and Common size Income statements for the year 2002 and 2003 and interpret the same. Particulars 2002 Rs. Sales Purchases Opening stock Closing stock Salaries Rent Postage and Stationery Advertising Commission on Sales Interest paid Loss on Sale of Asset Profit on Sale of Investment 4,00,000 2,00,000 20,600 32,675 16,0101 5,100 3,200 2,600 3,160 200 4,000 3,000 2003 Rs. 6,50,000 2,50,000 32,675 20,000 18,000 6,000 4,100 4,600 3,500 500 2,000 4,500

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5. From the following information, prepare a Comparative and Common size Balance sheet and interpret the same. (Rs. 000) Liabilities 2002 Rs. 6% Redeemable Preference Share Capital 6 % Redeemable --5500 2500 116 3,000 13,200 3,450 99 Current Assets: Bills Receivable Advance payment of Tax Loans and Advances Sundry Creditors Provision for Taxation Customers Credit Balances 71,745 27,122 5,012 1,603 51,282 14,734 4,578 2,079 Cash & Bank Sundry Debtors Stock Stores, Spares and Tools Accruals securities) Unclaimed Dividends Provision Dividend for Proposed ( interest in 695 6 237 109 1,890 1,818 2,419 38,700 52,334 500 1,886 36,951 36,769 2,042 1,217 1,584 2500 2500 Investments 1,947 2,429 2003 Rs. Fixed Assets Assets 2002 Rs. 17,662 2003 Rs. 14,806

Preference Share Capital Ordinary Share Capital Reserves & Surplus Profit & Loss Account

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1,113 Provision Liabilities Provision for Gratuity for Contingent 75 ---

1,420

81 198 1,17,987 96,967

1,17,987 96,967

6. From the following data relating to the assets side of Balance sheet of ABC Ltd. for the period ended 31st December 2000 to 31st December 2003, calculate trend percentages taking 2000 as the base year. (Rs. in Lakhs) Particulars 2000 Rs. Cash Debtors Stock Other Assets Land Buildings Plant 400 800 1000 500 1000 1000 500 1200 1200 500 1500 1500 100 200 300 Current 50 2001 Rs. 120 250 400 75 2002 Rs. 80 325 350 125 2003 Rs. 140 400 500 150

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FURTHER READINGS:
Khan M.Y. & Jain P.K., Publishing co.Ltd. Maheswari S.N. , Principles of Management Accounting, Sultan Chand & sons, New Delhi. Pandey I.M., Management Accounting, Vikas Publishing House, New Delhi. Sharma R.K. & Gupta S.K., Management Accounting, Kalyani Publishers, New Delhi. Made Gowda J. , Management Accounting, Himalaya Publishing House, Mumbai Saravanavel P. , Management Accounting, Principles and Practice, Crown publishing House, 1986. Management Accounting, Tata McGraw Hill

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LESSON-5 FINANCIAL STATEMENT ANALYSIS: II (RATIO ANALYSIS)

OBJECTIVES: Explain the meaning of Ratios and Ratio Analysis; State the objectives of Ratio Analysis Grasp the importance of Ratio Analysis; Understand the limitations of Ratios; Classify and interpret different kinds of ratios.

STRUCTURE:
5.1 Introduction 5.2 Meaning of Ratio and Ratio Analysis 5.3 Objectives of Ratio Analysis 5.4 Uses and Significance of Ratio analysis 5.5 Classification of Ratios 5.6 Profitability Ratios 5.7 Liquidity Ratios 5.8 Activity Ratios 5.9 Leverage Ratios 5.10 Coverage Ratios 5.11 Limitations of Ratio Analysis 5.12 Summary 5.13 Key words

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5.1 INTRODUCTION:

We have already studied in the preceding chapter that there are various techniques for analyzing the financial statements, such as Comparative Statements, Common size Statements and Trend Analysis. The Financial Statements viz., the Balance Sheet and the Profit and Loss Account are the end products of the accounting process, which are expressed in absolute monetary units do not provide much scope for understanding the liquidity, solvency profitability and operational efficiency of the business concern. For a meaningful and realistic assessment of the financial position and performance of the firm the financial analyst should try to establish and evaluate the relationships between different items of the Balance sheet and Profit and loss account. Ratio analysis is one of the most powerful tools of financial analysis, which is extremely useful in this regard. It is the process of establishing meaningful relationship between two or more accounting figures of the Balance sheet and/or Profit and loss account. With the help of ratios financial statements can be analyzed more clearly and decision-making is facilitated from such analysis. 5.2 MEANING OF RATIO AND RATIO ANALYSIS:

The term ratio refers to the arithmetical or quantitative relationship that exists between the items or variables in the financial statements. In simple language, ratio is the one number expressed in terms of another and can be calculated by dividing one number with the other. The relationship between two or more accounting figures/groups is called a financial ratio or Accounting ratio. A financial ratio helps the firm to summarize abundant financial data into a concise form and further facilitates interpretation and conclusions about the profitability and solvency of the firm. A ratio may be expressed as quotient or rate or percentage. In financial analysis, a ratio is used as an indicator or yardstick for evaluating the financial position and performance of a firm.

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Since the analysis and interpretation of financial statements is made with the help of ratios, so it may be called as ratio analysis. Ratio analysis is the process of computing, determining and interpreting the relationships between two accounting figures based on financial statements. 5.3 OBJECTIVES OF RATIO ANALYSIS:

With the help of ratio analysis one can measure the financial condition of a firm. Ratios act as an index/barometer of the efficiency of the enterprise. It also facilitates Inter and Intra firm comparison. The main objectives of ratio analysis are to: 1. To analyze the liquidity position of the firm in terms of long term and short term solvency. 2. To know the credit worthiness of the concern. 3. To analyze the capital structure of the business. 4. To evaluate the firms profitability over a period of time and predict its future capacity. 5. To assess the efficiency of the firm in terms of the various assets employed. 6. To find out the financial health of the firm. 7. To measure the earning power of the concern. 5.4 USES AND SIGNIFICANCE OF RATIO ANALYSIS:

Ratio analysis is one of the most powerful tools of financial analysis. With the help of ratio analysis we can know the financial health of a firm. Ratios act as an indicator of the efficiency of the firm. Ratios have wide applications and are of immense use. The important advantages of ratio analysis are: Ratios are important tools, which will help in maximizing profits and minimizing costs. Ratio analysis helps to frame policies for future including capital expenditure decisions. The utility of ratio analysis lies in the fact that it presents data on a comparative basis and enables drawing conclusions regarding the operating efficiency of a firm.

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Ratio analysis helps the employees by providing them the information related to the profitability of the company, which becomes the basis for claiming their benefits. Ratio analysis will be useful to the investor in taking decisions relating to investment by presenting the information relating to financial soundness of the concern. Ratios allow comparisons within the firm and with other firms, so that healthy competition prevails not only between the divisions of the firm but also between the firms.

Ratios are helpful to the management in identifying the loopholes of the firm, so that necessary action can be taken in time. The trend ratios enable to know whether the firm has improved its performance over a period of time. Ratio analysis is very much useful to the management in carrying out their functions like planning, forecasting, coordination and control. Ratios enable the financial analyst to summarize and evaluate the financial data to measure the firms performance in terms of solvency and profitability. With the help of ratio analysis one can measure the firms solvency both long term and short term efficiency and earning power can be assessed.

5.5 CLASSIFICATION OF RATIOS:

For analysis and interpretation of financial statements ratios can be classified in a number of ways depending on the basis adopted. They may be classified on the basis of their source, nature, importance and function. Ratios which are broadly classified according to the purpose or function, which they are expected to perform are called as functional ratios, Liquidity ratios, Solvency ratios, Profitability ratios, Turnover ratios, Coverage ratios are examples of functional ratios. The ratios have to be studied together in order to determine the financial soundness of the business. In order that ratios serve as a tool of financial analysis, ratios have to be classified under the following broad heads.

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Profitability ratios Liquidity ratios Activity or turnover ratios Financial ratios Leverage ratios Coverage ratios

5.6 PROFITABILITY RATIOS:

The profitability ratios measure the operational efficiency or the profitability of the concern. There are different parties who are interested in knowing profits of the firm. Among them there are three groups of persons who are interested in the analysis of the profitability of the firm. The shareholders/owners are interested in the ultimate return on their investment; the management is interested in the overall profitability and operational efficiency of the firm and the bankers, credit granting institutions, creditors who are interested in the credit worthiness of the firm. Therefore, every firm should earn sufficient profits in order to discharge its obligations towards the various parties concerned. Profit is determined by two important factors i.e. sales and investment. Accordingly, profitability ratios can be calculated under these two heads. 1. Profitability ratios in relation to sales and 2. Profitability ratios in relation to investment Every firm should earn adequate profits on each rupee of sales in order to cover its operating and non-operating expenses (like interest charges etc.). Similarly, the firm should earn sufficient return on its investment in assets and in terms of capital employed, otherwise the firms survival will be at stake.

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Profitability ratios in relation to Sales:Under this category, many ratios are calculated relating to different concepts of profits to sales. Some of them are:Gross Profit Ratio:The gross profit ratio is also called the gross margin ratio or average mark up ratio. This ratio establishes the relationship between Gross profit and Net sales. It is expressed as a percentage of Gross profit earned on sales. The formula for calculating the gross profit ratio is as under: Gross Profit Ratio = Gross Profit x 100 Net Sales Where Gross profit = Net sales Cost of goods sold Net Sales = Total sales- Sales Returns Cost of Goods Sold = Opening stock+ Purchases+ Direct expenses- Closing Stock The ideal norm for this ratio is higher the ratio, the better it is. A low ratio indicates that there is a decrease in selling price without a proportionate decrease in cost of goods sold or there is an increase in cost of production. The gross profit should be sufficient to meet fixed expenses and non-operating expenses, and for building up of reserves. Operating Ratio:This ratio establishes relationship between operating cost and the net sales, which is expressed as a percentage of sales. Operating cost is the sum total of the cost of goods sold and other operating expenses for running the business. But it excludes all non-operating incomes and expenses like interest and dividends, interest paid on long term borrowings, profit or loss on sale of fixed assets. It is calculated as follows: Operating ratio = Operating cost x 100 Net Sales

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Where operating cost = Cost of goods sold+ Administration expenses+ Selling and Distribution expenses Financial expenses Abnormal losses. Cost of goods sold = Sales Gross Profit Or Operating ratio = Cost of Sales x 100 Net Sales Cost of Sales = Cost of goods sold + Operating expenses It is always better to have a lower ratio. Higher operating ratio is unfavourable because it would leave small amount of operating profit for meeting financial charges and for creating reserves. Operating Profit Ratio:This ratio establishes the relationship between operating profit and Net Sales. It is calculated as follows:Operating Profit Ratio = Operating Profit x 100 Net Sales Operating Profit Ratio = 100 Operating ratio Where Operating profit = Gross profit Operating expenses. This ratio should be always on the higher side. The ratio denotes the amount left over after meeting all the operating costs and operating expenses. Expenses Ratio:Operating costs comprises of Manufacturing costs, administration expenses and selling and distribution expenses. In order to know how individual expenses have their impact on sales, these expense ratios are calculated. These expense ratios are given below: 1. Manufacturing cost ratio = Manufacturing cost x 100 Net Sales 2. Administration expenses ratio = Administration expenses x 100 Net Sales 3.Selling and Distribution expenses ratio = Selling and distribution expenses x100 Net Sales Or

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Any item of expenditure can be shown as a ratio to sales. A lower expenses ratio is better for the firm. Net Profit Ratio:It is an important ratio as it indicates the overall profitability of the firm. It is calculated by dividing net profit by net sales. The purpose of this ratio is to reveal the amount of profit left to shareholders after meeting all costs and expenses of the business. The ideal ratio is higher the ratio better it is. Higher ratio indicates greater profitability of the concern. Therefore, Net Profit ratio = Net profit after tax x 100 Net Sales Profitability Ratios in relation to Investment:Profitability of a firm can be measured in terms of the investment made. The profitability of a firm can also be analyzed with reference to assets employed in the business. In order to know how much amount of profits is earned on the investment made on the assets, there are a number of other profitability ratios, which are calculated for estimating the efficiency of the concern. The important ratios are discussed here under: Return on Investment Ratio (ROI Ratio) This ratio is also known as return on capital employed (ROCE) or over all profitability ratio or primary ratio. The Profitability of the firm can be analyzed from the point of view of the total funds employed into the business. Capital Employed = Equity share capital + Preference share capital + Reserves and Surplus +Profit and loss account balance+ long-term loans+ Debentures-Fictitious assets. Alternatively, it is also calculated as Capital employed = Tangible assets + Intangible fixed assets + Current assets Current liabilities

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Fictitious assets means any amount shown on the assets side of the balance sheet such as preliminary expenses, discount on issue of shares and debentures, debit balance of profit and loss account, deferred revenue expenditure. Higher the ratio the better it is. Higher the return on capital employed the more efficient the firm is. The formula for calculating the ROI is as follows:ROCE = Net profit before Interest and Tax x 100 Capital Employed Return of Assets Ratio (ROA Ratio) This ratio is calculated to evaluate the profitability of the investment made in the assets of the firm. It is calculated by the following formula: ROA = Net Profit after Taxes x 100 Total Assets Where Total assets = Fixed assets +Current assets +Investments. Fictitious assets are not included for calculation of this ratio. With the help of this ratio the firm can know whether is assets are properly utilized or not. Higher the ratio better it is for the company. Return on Net worth Ratio A return on shareholders equity is calculated to assess the profitability of the owners investment. The ratio measures the relationship between the Net profit and shareholders funds. The shareholders equity is also called net worth, which is calculated as follows:Net worth (shareholders equity or funds) = Equity share capital+ Preference share capital+ Reserves and surplus Fictitious assets. And Return on Net worth ratio = Net profit after tax x 100 Net worth

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The higher the ratio, the better it is for owners of the company. However, in order to know whether the returns are adequate or not, inter firm comparisons should be made. Return on Equity Shareholders Funds Equity shareholders who are the owners of the company are eligible for all the profits remaining after paying out all outside claims and preference dividend. This ratio expresses the equity shareholders return on their investments. It is calculated as Return on Equity shareholders funds = Profit after tax Preference Dividend x100 Equity shareholders funds Where Equity shareholders funds = Equity share capital +Reserves and surplus Accumulated losses. A higher ratio is better for the equity shareholders. Return on Fixed Assets Ratio This ratio is calculated to measure the profit after tax earned against the investments made in fixed assets, to find out whether the assets are properly used or not in the business. It is calculated as Return on Fixed Assets ratio = Profit after Tax x 100 Fixed Assets The higher the ratio, better for the company. Return on Current Assets Ratio This ratio is calculated to measure the profit after tax earned against the investments made in current assets. It is calculated as Return on Current assets = Profit after Tax x 100 Current Assets

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Return on Working Capital Ratio Working capital is the capital which is required to meet the day to day operations of the concern. It is calculated by the following formula: Working capital = Current assets Current liabilities This ratio enables us to understand how the working capital was utilized in running the business for earning the profits. The ratio is calculated as under: Return on Working capital ratio = Net profit after interest and tax x 100 Working capital Earnings per Share (EPS) The profitability of a firm can also be measured in terms of number of equity shares. This ratio is known as EPS, which is useful in investment analysis and also financial analysis. EPS is calculated by employing the following formula: EPS = Net profit after tax Preference Dividend Number of equity shareholders The higher the EPS, the better is the performance of the company. To assess the relative profitability of the firm its EPS should be compared with that of similar concerns and the industry average. Dividend per Share (DPS) This ratio establishes the relationship between the net profits distributed after interest and preference dividend to equity shareholders and the number of equity shares. The purpose of this ratio is to show dividend paid to equity shareholders on per share basis. It is calculated as: Dividend per share = Earnings distributed as dividend to equity shareholders Number of equity shares

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From the present and potential investors point of view, a higher dividend per share is a good sign. A large number of investors are usually interested in DPS rather than in EPS. However, the company should consider a number of factors before declaring any dividend. Price Earnings Ratio (PE ratio) This ratio establishes the relationship between market price of share of a company and EPS of that company. The PE ratio indicates the expectations of the equity investors about the earnings of the firm. This ratio helps the shareholders in deciding whether the shares should be sold or purchased. PE ratio is calculated as follows: Price Earnings Ratio = Market price per share x 100 EPS From the point of view of investors, the higher the ratio, the better it is. Dividend Yield Ratio and Earnings Yield Ratio The purpose of calculating dividend yield ratio is to know current rate of return to the shareholders as a percentage of their investment. It is calculated as: Dividend yield ratio = Dividend per share x 100 Market value per share The purpose of calculating earnings yield ratio is to evaluate the rate of return of shareholders in relation to the market value per share. It is calculated as: Earnings Yield ratio = EPS x 100 Market value per share The earnings yield and the dividend yield evaluate the profitability of the firm in terms of the market price of the share. The higher these ratios, the better would be the return to shareholders and vice versa.

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Dividend Pay-out ratio (D/P ratio) The DP ratio is the relationship between the DPS and the EPS of the firm. This ratio indicates as to what proportion of EPS is being declared as dividend and what percentage is retained by the company in the business. The proportion of retained earnings is equal to 100-DP ratio. DP ratio is calculated as under: Dividend Pay out ratio = Dividend per Share Earning per share The shareholder must look for a low pay out ratio. Book value of Equity Share It is the relationship between the amount of net worth or shareholders funds of the firm, to one equity share of the business. It is determined as: Book value of equity share = Equity shareholders funds or Net worth Number of equity shares

5.7 LIQUIDITY RATIOS:

These ratios are also termed as working capital ratio or short-term solvency ratio. These ratios measure the short-term solvency of the firm. Liquidity is the ability of a firm to meet its current or short-term obligations when they become due. The short-term creditors like suppliers of goods, banks which provide short term credit are primarily interested in the companys ability to meet its short term obligations. The firm can meet its short term obligations only when it has sufficient liquid funds. Some of the common liquidity ratios are: Current Ratio Liquid Ratio Absolute Quick Ratio

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Current Ratio /Working Capital Ratio Current ratio is the most widely used ratio, which studies the short term financial position of the company. This ratio establishes the relationship between current assets and current liabilities. For computing this ratio, the following formula is used. Current ratio = Current Assets Current Liabilities This ratio is also called working capital ratio. The reason being the two components of working capital, i.e., current assets and current liabilities are used for calculating this ratio. Current assets are the assets, which can be converted into cash within one year. Cash in hand, cash at bank, inventory/stock, Debtors, bills receivable, short term investments, outstanding incomes, prepaid expenses, etc are the examples of current assets. Current liabilities are those liabilities, which are to be paid within one year. Creditors, Bills payable, outstanding expenses, bank overdraft, tax payable, dividend payable, short term loans etc are the examples of current liabilities. The standard norm for the current ratio is 2:1. If the current assets are 2 times of current liabilities, then the business operations will not be adversely affected as current liabilities can still be paid. If the ratio is less than 2, the business doesnt enjoy adequate liquidity. And if the ratio is more than 2, it implies that funds are idle and has not been invested them properly. Therefore, every firm should strike a balance between liquidity and profitability. Quick Ratio or Acid Test Ratio This ratio measures the relationship between quick current assets and current liabilities. Quick current assets are those assets, which can be quickly converted in cash without loss of time or value. It includes all current assets except stock and prepaid expenses.

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Quick assets = Current assets (Stock + prepaid expenses) It is an acid test of a concerns liquidity position. The quick ratio is calculated by dividing quick assets by current liabilities. Quick Ratio = Quick Assets Current liabilities Sometimes instead of total current liabilities, only those current liabilities are taken, which are really payable within one year. Then the formula for calculating quick ratio will become: Quick ratio = Quick Assets/Liquid Assets Quick liabilities Generally, a Quick ratio of 1:1 is considered to be ideal. Ratio below 1 is an indicator of inadequate liquidity and above 1 is also not advisable. Absolute Quick Ratio or Super Quick Ratio This ratio establishes relationship between the absolute liquid assets and liquid liabilities. However, for calculation purposes, it is taken as absolute quick assets to current liabilities. Absolute quick ratio = Absolute quick assets Current liabilities Absolute quick assets = cash in hand + cash at bank + short term marketable securities Current liabilities The ideal ratio is 0.5:1. This ratio is a conservative test of liquidity and is not widely used in practice.

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5.8 ACTIVITY RATIOS OR TURNOVER RATIOS/ PERFORMANCE RATIOS: Turnover Ratios measure the relationship between sales and various assets. Activity ratios are employed to evaluate the efficiency with which the firm manages and utilizes its resources and assets. These ratios are also called turnover ratios, because they indicate the speed with which assets are being converted or turned over into sales. These activity ratios are also known as efficiency ratios, because these ratios indicate the efficiency with which the firm manages and uses its assets. Some of the important Activity ratios are discussed below: Capital Employed Turnover Ratio or Capital Turnover Ratio This ratio examines the efficiency of Capital employed in the business. This ratio indicates the firms ability to generate sales per rupee of the Capital Employed.

Capital Turnover Ratio = Net Sales Capital Employed The higher the ratio, the more efficient is the firm in the utilization of owners and long term creditors funds. Total Assets Turnover Ratio This ratio shows the firms ability in earning sales in relation to Total assets employed in the business. This ratio measures the overall performance and efficiency of the firm. This ratio is calculated as under: Total Assets Turnover ratio = Total Sales Total Assets The standard norm for this ratio is 2 times. A higher ratio indicates overtrading and lower ratio indicates that the assets are idle.

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Fixed Assets Turnover Ratio This ratio indicates the firms efficiency in utilizing the fixed assets for generating sales and earning profits. This ratio is considered important because firms make large investments in fixed assets for producing sales. It is calculated by dividing net sales by fixed assets. Fixed Assets Turnover ratio = Net Sales Net Fixed Assets Net fixed assets imply fixed assets after depreciation. Normally, a ratio of 5 times is considered as ideal. The fixed assets turnover ratio can further be divided into turnover of each item of fixed assets to know the extent of each fixed asset in relation to sales, whether they have been properly utilized. Then the formula will be: Plant and Machinery Turnover ratio = Buildings Turnover Ratio = Net Sales Buildings (Net) Current Assets Turnover Ratio It indicates the efficiency of the firms investments in current assets in relation to Net Sales. This ratio is calculated as : Current Assets Turnover ratio = Net Sales Current Assets A higher ratio indicates the firms efficiency in earning profit by efficient utilization of current assets and vice versa. Net Sales

Plant and Machinery (Net)

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Working Capital Turnover Ratio This ratio indicates whether or not working capital has been effectively utilized in making sales. It is calculated as under: Working capital Turnover Ratio = Net Sales Net working capital Or = Cost of goods sold Net Working Capital

There is no standard norm for this ratio. Firms should have adequate and appropriate working capital to justify the sales generated. Stock Turnover Ratio or Inventory Turnover Ratio This ratio indicates the rapidity with which the stock is turned into sales. It also indicates the efficiency of the firms inventory management. It is calculated as under: Stock Turnover Ratio = Cost of goods sold Average Inventory Average Stock = Opening Stock + Closing Stock 2 In case, the information regarding cost of goods sold and average stock is not given, then stock turnover ratio can be calculated as: Stock Turnover Ratio = Sales Closing Stock Higher the ratio, the better it is for the company, as the ratio shows that the finished stock is turned over rapidly. Usually a stock turnover ratio of 8 is considered as an ideal one.

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Stock Velocity or Stock Conversion Period It indicates the time taken by the stock to get converted into sales, which is expressed in terms of months, weeks or number of days. That is Stock Velocity (Days) = Average Stock x 365 Cost of goods sold Or Stock Velocity (Months) = Average Stock x 12 Cost of goods sold Or Stock Velocity (Weeks) = Average Stock x 52 Cost of goods sold A higher stock velocity is always better. Debtors/Receivables Turnover Ratio It establishes the relationship between accounts receivables i.e.(Debtors+Bills receivable) and credit sales. This ratio indicates the speed with which these debtors are collected which affects the liquidity position of the firm. Debtors turnover ratio is calculated as under: Debtors Turnover ratio = Net Credit Sales Average Trade Debtors Where net credit sales = credit sales sales returns Trade debtors = Sundry debtors+ Bills receivable+ Accounts receivable Average trade debtors = Opening trade debtors +Closing trade debtors 2 If the information about credit sales and average debtors is not given, then total sales and closing debtors should be taken for calculating debtors turnover ratio. A debtors turnover ratio of 10-12 is usually considered as ideal. A higher debtors turnover ratio is an indicator of sound credit management policy.

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Debt Collection Period Ratio/Debtors Velocity/ Average Collection Period It shows the time taken for the debtors to get converted into cash. It is calculated as Debt Collection Period Ratio = No of days or Months or weeks in a year Debtors Turnover ratio Lower the period, it is better for the firm and the ideal period is 30-36 days. Creditors/Accounts Payable Turnover Ratio It expresses the relationship between creditors and purchases. The purpose of this ratio is to know the speed with which payments are made to creditors for credit purchases. This ratio gives the average credit period enjoyed from the creditors and is calculated as: Creditors Turnover ratio = Net Credit Purchases Average Creditors Or Creditors Turnover ratio = Total Purchases Closing Creditors A high ratio indicates that creditors are not paid in time, while a low ratio indicates firms inefficiency in availing the credit facility allowed by creditors. Creditors Velocity/Average Payment Period Ratio This ratio shows the number of days taken by the firm to pay off its debts and is calculated as: Creditors Velocity = Number of days or months or weeks in a year Creditors Turnover ratio The average payment period gives an ideal about the number of days the fir m can post pone, on an average, its payment to the creditors.

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5.9 FINANCIAL AND LEVERAGE RATIOS:

The financial position of the firm can be analyzed from two angles viz., the short term financial position and the long term financial position. The short-term financial position can be studied from liquidity ratios, which has already been discussed. The long term creditors like debenture holders, financial institutions etc. judge the financial soundness of the firm in terms of its ability to pay interest regularly during the period of loan as well as make repayment of the principal amount on maturity. The long-term solvency of the firm can be examined with the help of the leverage or capital structure ratios. These ratios are also known as long term solvency ratios or capital gearing ratios. There are two aspects of the longterm solvency of the firm, to repay the principal amount on maturity and pay interest at periodic intervals. These two aspects give rise to two types of leverage ratios. 1. The first type of leverage ratios, which establishes the relationship between borrowed funds and owned funds and are computed from Balance sheet. Some of the leverage ratios are: (a) Debt-Equity ratio (b) Proprietory ratio ( c) Capital gearing ratio 2. The second type of leverage ratios, which are also called as coverage ratios are computed from profit and loss account. They are: (a) Interest coverage ratio (b) Dividend coverage ratio Debt-Equity Ratio This ratio is also called External equities to internal equities ratio. It shows the relationship between borrowed funds and owners funds or external funds (debt) and internal funds (equity). There are a number of approaches to the calculation of debt equity ratio.

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Debt equity ratio = External equities Shareholders funds

Or = Total debt Internal equities

Total debt includes long-term liabilities and current liabilities. Shareholders funds consist of equity share capital, preference share capital, capital reserves, revenue reserves, accumulated profits and other surpluses. However, accumulated losses and deferred expenses are to be deducted. Another approach is Debt equity ratio = Long term debt Shareholders equity Debt equity ratio of 2:1 is considered ideal. A very high debt equity ratio is unfavourable and low ratio implies that the creditors are relatively at lower risk. Proprietory Ratio This ratio is also known as equity ratio or net worth to total assets ratio. The purpose of this ratio is to express the obligation of owners in the total value of assets. It gives an idea about the extent to which the owners have financed the firm. It is calculated as: Proprietory ratio = Net worth Total Assets Or = Proprietory funds Total Assets

Where proprietory funds include equity share capital, preference share capital, Reserves and surplus and undistributed profits and accumulated losses should be deducted. There is no standard norm for this ratio. But some of the financial experts view that proprietory funds should be from 67% to 75% and outsiders funds should be from 25% to 33%. A high ratio implies that the firm is not optimally utilizing its outsiders funds. Capital Gearing Ratio This ratio establishes a relationship between funds bearing fixed interest or fixed dividend and the equity shareholders funds. The fixed interest bearing funds are debentures and long term loans and fixed dividend bearing funds are preference shareholders. The proportion of

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debentures and preference share capital to net worth or equity funds is referred to as capital gearing ratio. It can be calculated as: Capital Gearing Ratio = Funds bearing fixed interest/fixed dividend Equity shareholders funds A firm is said to be highly geared when the sum of preference capital and all other fixed interest bearing securities is more than the equity capital. On the other hand, a firm is said to be low geared when the sum of equity capital is more that the sum of preference capital and all other fixed interest-bearing securities. The ideal norm for this ratio is 2:1. 5.10 COVERAGE RATIOS:

The second type of leverage ratios is coverage ratios. In order to judge the solvency of the firm the creditors assess the firms ability to service their claims. In the same way, preference shareholders evaluate the firms ability to pay the dividend. These aspects are revealed by the coverage ratios. These ratios measure the ability of the firm to satisfy the claims of creditors, preference shareholders and debenture holders. These ratios are: Interest Coverage ratios and Dividend coverage ratios

Interest Coverage Ratio This ratio is also known as Debt Service Ratio. One of the approaches to test the solvency of the firm is interest coverage ratio. A firm is considered solvent then its business is earning sufficient profits to pay the interest charges, particularly where payment of fixed interest on long term loans is concerned. The ratio is calculated as under: Interest Coverage Ratio = Earnings before interest and tax Fixed interest charges A Debt service ratio of around 6 times is normally considered as ideal. Higher the ratio, the better it is from the point of creditors. But too high a ratio indicates that the firm is very

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conservative in using the debt. On the other hand, a low coverage ratio indicates excessive use of debt. Dividend Coverage Ratio This ratio examines the relationship between net profit after interest and taxes and preference dividend of preference shares. The objective of this ratio is to show the number of times the preference dividend is covered by net profit after interest and tax. It also measures the capacity of a firm to pay dividend to preference shareholders. Thus Dividend Coverage ratio = Net Profit after interest and tax but before preference dividend Preference Dividend The higher the ratio, the better it is from the preference shareholders point of view. This ratio indicates the safety margin available to the preference shareholders. Illustration 1 The following is the Balance Sheet of X Ltd., as on 31.12.2003. Rs. Equity Capital Fixed Assets 18,00,000 5,00,000 Rs. 13,00,000

(500 shares of Rs. 5,00,000 100) 7% Pref. Capital Reserve & Surplus 6% Debentures 1,00,000 Cash

50,000 1,50,000 2,00,000 3,00,000 7,00,000

4,00,000 10% Investments 7,00,000 Debtors Stock

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Creditors Bills Payable Outstanding exp Taxation Provision TOTAL

60,000 1,00,000 10,000 1,30,000 20,00,000 TOTAL 20,00,000

Additional Information Net Sales Profit before Tax Rs. 30,00,000 Rs. 2,00,000 Cost of Goods Sold Profit after Tax Rs. 25,80,000 Rs. 1,00,000

Calculate appropriate ratios from the given information. Solution From the given information, all the types of ratios, viz., capital structure ratios, liquidity ratios, activity ratios and profitability ratios, can be calculated. Capital structure or Leverage ratios Debt Equity ratio = Long term Debt = Rs. 7,00,000 = 0.7:1 or 70% Shareholders Equity Rs.10,00,000 OR = Total Debt = Rs. 10,00,000 = 1:1 Rs. 10,00,000

Shareholders equity

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Proprietory ratio = Net worth/Total assets Net worth = Shareholders funds = Rs. 10,00,000 Total assets = Fixed assets + current assets = 13,00,000+ 7,00,000 = Rs. 20,00,000. Proprietory ratio = 10,00,000/20,00,000 = 0.50 Capital Gearing ratio = Funds bearing fixed interest and fixed dividend = 7,00,000+1,00,000 Equity share holders funds = 8,00,000/9,00,000 = 0.89 Coverage ratios Interest Coverage Ratio = EBIT=Rs.2,00,000+Rs. 42,000 = 5.67 times Interest Rs. 42,000 5,00,000+4,00,000

Preference Dividend Coverage = Profit after Tax =Rs. 1,00,000 = 14.29 times Pref. Dividend Rs. 7,000

Fixed Charges Coverage

= EBIT Interest+Pref.Div.

= Rs. 2,42,000

= 4.94 times

Rs.42,000+Rs.7,000

Liquidity ratios Current Ratio = Current Assets = Rs. 7,00,000 = 2.33:1 Current Liabilities Rs. 3,00,000 Acid Test Ratio = Liquid Assets = Rs. 7,00,000 Rs. 3,00,000 = 1.33:1

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Current liabilities

Rs. 3,00,000

Super Quick Ratio = Cash +Mkt. Securities = Rs. 50,000+ Rs. 1,50,000 = 0.67:1 Current Liabilities Activity ratios Total Assets Turnover =Sales = Rs. 30,00,000= 1.5 times Total assets Rs. 20,00,000 Capital Employed Turnover OR Net Worth Turnover = Sales = Rs. 30,00,000 = 1.76 times Rs. 17,00,000 Rs. 3,00,000

Capital Employed Fixed Assets Turnover = Sales

=Rs. 30,00,000 = 2.31times

Fixed Assets Rs. 13,00,000 Current Assets turnover= Sales = Rs. 30,00,000 = 4.29 times

Current assets Rs. 7,00,000 Working Capital turnover = Sales = Rs. 30,00,000 =7.5 times

Net working Capital Rs.7,00,000-Rs.3,00,000 Stock Turnover =Sales =Rs. 30,00,000 Closing Stock =10 times

Rs. 3,00,000

Debtors turnover = Credit sales Or Total Sales =Rs. 30,00,000 =15times

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Average Drs.

Debtors

Rs. 2,00,000

Average collection period= Days in a year =365 =24 days Debtors turnover 15 Profitability ratios Gross Profit Margin= Sales- Cost of Goods Sold X 100 Sales =Rs. 30,00,000-Rs. 25,80,000X 100=Rs.4,20,000X100=14% Rs. 30,00,000 Net Profit Margin = Net Profit after Tax X100 Sales =Rs. 1,00,000 X 100 = 3.33% Rs. 30,00,000 Rs. 30,00,000

Return on Assets =Net profit after Tax X100 = = Rs. 1,00,000X100 =5% Total Assets Rs. 20,00,000

Return on Capital Employed =Profit after Tax=Rs. 1,00,000 =5.88% Total Capital employed Rs. 17,00,000 Return on Shareholders Equity=Profit After Tax = Rs. 1,00,000 =10% Shareholders Equity Rs. 10,00,000

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Return on Equity Shareholders Equity = Profit after Tax-Pref. Dividend . Equity shareholders Equity =Rs. 1,00,000-Rs. 7,000 = 10.33% Rs. 9,00,000 Earnings per share = Profit after Tax Pref. Dividend No. of Equity Shares = Rs. 1,00,000-Rs.7,000 = Rs 18.6. Rs. 5,000 Illustration 2 With the help of the following ratios regarding X Ltd., draw up the Balance Sheet: Current Ratio Liquidity Ratio Net Working Capital 2.5 1.5 Rs. 3,00,000

Stock Turnover (cost of Sales/Cl.stock) 6 times Gross profit ratio 20% 2 times 2 months 0.80 0.50

Fixed Assets turnover ratio (On cost of sales) Debt collection period Fixed assets to shareholders net worth Reserves and surplus to capital

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Solution The current ratio is given as 2.5 which means that if the current liabilities are 1, the current assets will be 2.5. The difference between current assets and current liabilities represents the net working capital = 2.5-1.00 =1.5 But net working capital is given as Rs. 3,00,000 i.e., 1.5= Rs. 3,00,000 Therefore, 1 = 3,00,000 = Rs. 2,00,000 = Current liabilities 1.5 Current assets are 2.5 times of current liabilities. Therefore, current assets = 2,00,000x2.5= Rs. 5,00,000 Liquidity Ratio = Liquid Assets Current liabilities

1.5

=Liquid Assets Rs. 2,00,000

Therefore Liquid Assets= Rs. 2,00,000x 1.5= Rs. 3,00,000 Current Assets Liquid Assets=Stock Rs. 5,00,000-Rs.3,00,000= Rs.2,00,000 Therefore Stock =Rs. 2,00,000 Stock Turnover = 6= Cost of Sales =Cost of Sales Closing Stock 2,00,000

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Therefore Cost of Sales = Rs. 2,00,000X6 = Rs. 12,00,000 Gross Profit Ratio = 20%= Gross Profit Sales i.e., cost of sales = 80% of sales, therefore, sales = cost of salesx100 80 =12,00,000 x 100 =Rs. 15,00,000 80 Fixed assets turnover = Cost of Sales Fixed Assets 2 =Rs. 12,00,000

Fixed Assets Therefore Fixed Assets= Rs.12,00,000 = Rs.6,00,000 2 Debt Collection period =No of months in a year Sales/Debtors =No. of months in a year X Debtors Sales

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2 = 12xDebtors 15,00,000 Therefore, Debtors = Rs. 15,00,000x2/12= Rs. 2,50,000

Fixed Assets to shareholders net worth=Fixed Assets = 0.80 Net Worth =Rs. 6,00,000 = 0.80 Net worth = Net worth = Rs. 6,00,000= Rs. 7,50,000 0.80 Reserves and Surplus to capital=0.5 Reserves & Surplus/Capital = 0.5 Where as net worth = Share capital + Reserves & Surplus 7,50,000 = Share capital + Reserves & Surplus Or Share capital = 7,50,000 Reserves & Surplus Reserves & Surplus/7,50,000 Reserves & Surplus = 0.5 7,50,000 x0.5 0.5 Resrves &Surplus = Reserves & Surplus 3,75,000 = 1.5 Reserves and Surplus That is Reserves and surplus = 3,75,000/1.5 = Rs. 2,50,000

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Share Capital = Rs. 5,00,000 Balance Sheet as on .. Share capital Reserves& Surplus Current Liabilities Long term debt (Bal fig) 5,00,000 2,50,000 2,00,000 1,50,000 11,00,000 Fixed Assets Stock Debtors Cash 6,00,000 2,00,000 2,50,000 50,000 11,00,000

5.11 LIMITATIONS OF RATIO ANALYSIS:

Ratios analysis plays a pivotal role in the process of Analysis and interpretation of data in the financial statements. Even though ratio analysis is simple to calculate and easy to understand, they are not free from certain drawbacks. These limitations are: 1. Limitations of Financial statements:-Ratios are derived from financial statements. The financial statements suffer from a number of limitations and ratios which are derived from these statements are also subject to the same limitations. 2. Reliability of the data:- The analyst should know the reliability and soundness of the figures from which the ratios are calculated. Otherwise, the conclusions may be misleading. 3. Comparison:-Ratios are helpful in analyzing the efficiency of the firm only when they are compared with the past results of the firm or with the results of the similar firms. Such comparisons only provide glimpses of the past performance. 4. Change in Accounting practices:- Ratios mislead, whenever there is a change in the accounting procedures.

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5.

No Fixed Standards:- To make ratios as acceptable norms, there should be some well acceptable standards. But unfortunately, no such standards exist. They vary from, industry to industry and from firm to firm.

6.

Price Level changes:- Financial statements are based on historical cost concepts and no consideration is made to the changes in the price levels. And the ratios also suffer from the same limitations.

7.

Ratios alone are not enough:- Ratios are only indicators, they cannot be taken s final regarding the financial health of the concern. They are only means of financial analysis and not an end in itself.

8.

Absolute figures are distortive:-Ratios are calculated from absolute figures. It is basically a quantitative analysis and not a qualitative analysis. They can never be substitute for the raw figures.

9.

Difficulty in Definitions:- The differences in the definitions of various items of the balance sheet and income statement make the interpretation of ratios a difficult task. Some such items are Net profit, Net worth, and Capital employed which convey different meanings.

10.

Single Ratio is not adequate:-Instead of single ratio, often a number of ratios are calculated to make a better interpretation of the financial data, which sometimes is confusing rather than helpful in decision making.

11.

Other factors:-Apart from financial factors, other factors like economic, social and political factors also should be considered to make ratio analysis meaningful. It may be concluded that ratio analysis is a useful tool of financial analysis, but it mechanically done, it in not only misleading but also dangerous.

5.12 SUMMARY : Ratio is a mathematical relationship existing among two or more items in the financial statements. The process of establishing and interpreting various ratios between figures and groups of figures may be termed as Ratio analysis. Ratio analysis helps in ascertaining the financial condition of a firm. Ratios are used to evaluate the performance such as liquidity,

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solvency, profitability and operational efficiency of a firm. Though ratio analysis is one of the most powerful tools of financial management they suffer from some limitations. Ratios themselves are not of much significance. They become useful only when they are compared with some standards.

5.13 KEY WORDS:

Ratio Primary ratio Liquidity Ratios Leverage Ratios Try Yourself: 1. Define the meaning of Ratio. 2. Give two objectives of Ratio analysis. 3. Give two uses of Ratio analysis. 4. Given Net sales Rs. 1,00,000; Gross profit Rs. 60,000. Calculate Cost of goods sold ratio. 5. From the following calculate (i) Operating ratio (ii) Operating profit ratio. Given Operating cost Rs. 70,000; net sales Rs. 1,00,000. 6. Given Net profit after taxes Rs. 1,12,450; current assets Rs.1,00,000; current liabilities Rs. 80,000. Calculate return on working capital. 7. Name any three Current Assets. 8. Given Current ratio is 2:2; working capital: Rs. 10,000; Calculate Current Assets and Current liabilities. 9. What is the formula for calculating Price Earnings Ratio? 10. Stock turnover ratio = 6 times, Calculate stock velocity (in days). 11.What for Interest coverage ratio is useful? 12.Average debtors are 13.Given Cash Rs. 20,000, Bill receivable Rs 10,000, Sundry debtors Rs. 50,000, stocks Rs. 40,000, Sundry creditors Rs. 60,000, cost of sales Rs 3,00,000. Calculate working capital turnover ratio. Ratio Analysis Profitability Ratios Activity Ratios Coverage Ratios

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14.Calculate the Debtors turnover ratio from the following: total Sales Rs.2,00,000, Cash sales Rs. 40,000, Opening debtors Rs. 20,000, Closing debtors Rs. 30,000, Opening balance of bills receivable Rs.15,000 and closing balance of bills receivable Rs. 25,000. Answers to Try Yourself: 1. A ratio is a numerical relationship existing between two related figures in the financial statements. 2.1. To assess the profitability of a firm. 2. To find out the financial condition of a firm. 3.1. Ratio analysis facilitates inter firm comparison. 2. Ratio analysis helpful to the management in performing the important functions like planning, coordination, control and forecasting. 4. COGS = (40,000 x100) / 1,00,000 = 40% 5. (i) Operating ratio =( 70,000 x100) / 1,00,000 =70% (ii) Operating profit ratio = 100 Operating ratio = 100 70% = 30% 6. Return on working capital = 1,12,450 x 100 /20,000 = 562.25% 7. Cash in hand, Sundry Debtors, Inventory (Stocks) 8. Current liabilities = Rs. 10,000 current assets = Rs. 20,000 9. Price Earning Ratio =Market price of Equity share/Earnings per share 10. Stock velocity ( in days) = 365/6 = 60.83 days. 11. It is useful for knowing the firms debt servicing capacity. 12. Average Debtors =( Opening trade debtors + Closing trade debtors) / 2 13. Working capital turnover ratio = 3,00,000/60,000 = 5 times 14. Debtors turnover ratio = 1,60,000/45,000= 3.56 times Questions: 1. What do you understand by ratio analysis? Discuss its objectives and limitations. 2. Ratio analysis is a tool to examine the health of business with a view to make financial results more intelligible. Explain. 3. Examine the relationship between Solvency, Liquidity and Profitability?

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FURTHER READINGS:
Battacharya S.K. & Dearden J., Accounting for Management, Vikas Publishing House, New Delhi. Khan M.Y. & Jain P.K., Management Accounting, Tata McGraw Hill Publishing co.Ltd. Maheswari S.N. , Principles of Management Accounting, Sultan Chand & sons, New Delhi. Pandey I.M., Management Accounting, Vikas Publishing House, New Delhi. Sharma R.K. & Gupta S.K. , Management Accounting, Kalyani Publishers, New Delhi.

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LESSON 6 FUNDS FLOW ANALYSIS

OBJECTIVES: Define of Funds and explain significance of Fund Flow Statements Differentiate between Income, Position, and Funds Flow Statements Illustrate and explain the Preparation of Funds Flow and Cash Flow Statement Classification of Cash Flow Statement as per AS-3 (Revised)

STRUCTURE:
6.1 Introduction 6.2 Procedure for Preparing Funds Flow Statement 6.3 Financial / Total Resource Basis 6.4 Working Capital Basis 6.5 Cash Basis Cash Flow Statement 6.6 Status and Applicability of AS-3 (Revised): Cash Flow Statement 6.7 Summary 6.8 Key Words

6.1 INTRODUCTION: Every company has to prepare its balance sheet at the end of the accounting year. It reveals the financial position of the company at a certain point of time. However, it does not present any analysis, as it is simply a statement of assets and liabilities. Its usefulness is, therefore, limited for analysis and planning purposes. The statement of sources and application of funds serves the purpose, which is the popularly known as Funds Flow Statement. Funds Flow Statement is a widely used tool in the hands of financial executives for analyzing the financial performance of a concern. Though it is not mandatory for external reporting, leading organizations always prepare such a statement along with the balance sheet for internal

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consumption. This statement shows how the activities of a business have been financed or how the available financial resources have been used during a particular period.

An income statement is primarily a presentation of revenue and expenses items and computation of net income for the period and the position statement gives a snapshot of the assets and liabilities on a specific date. Both these statements do not explain the changes in assets, liabilities, and owners equity. The Funds Flow Statement is a report of financial operations of a business undertaking. It generally reports changes in current assets and current liabilities and is much useful for financial executives, financial institutions and creditors for the analysis of financial position of the company.

Different thinkers interpret the term funds differently. They may mean (i) financial resources (arising from both current and non-current items) (ii) working capital (the difference between current assets and current liabilities) and (iii) cash. It is critically important to understand the specific funds movements caused in the business system by daily management decisions on investment, operations, and financing. Management decisions, in one form or another, affect the companys ability to pay its bills, obtain credit from suppliers and lenders, extend credit to its customers, and maintain a level of operations that matches the demand for the companys products or services, supported by appropriate investments. Every decision has a monetary impact on the ongoing cycle of uses or sources of funds. It is managements job to strike a proper balance between the inflows and outflows of funds at all times and to allow for any changes in level of operations, caused by management decisions or by outside influences, that may affect these flows.

6.2 PROCEDURE FOR PREPARING FUNDS FLOW STATEMENT: As there are varied interpretations for funds, the preparation of funds flow statement differs depending on how we define the term. In a very narrow sense, it may mean only cash, the more comprehensive view may capture financial resources, and between these two extreme

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view points lie the working capital definition of funds. All the three analytical methods are discussed below which give further clarity to the concept of flow of funds.

6.3 FINANCIAL RESOURCES BASIS: Under this technique, a single statement is prepared which captures all the items in the balance sheet. The sources of funds will include a reduction in current assets and fixed assets and increase in current liabilities and non-current liabilities including equity. On the other hand, an increase in current assets and fixed assets together with a decrease in current liabilities and non-current liabilities are recorded under uses of funds. As all the items in the balance sheet are considered, the sources of funds

Illustration 1 From the following details available for two balance sheet dates prepare a statement of Sources andUses of Funds on Financial Resources Basis. Liabilities As on 1st Jan 1986 Rs. Share Capital Debentures General Reserve P&L a/c Depreciation Reserve Provision for Doubtful Debts 20,000 30,000 1,80,000 2,60,000 2,00,000 3,00,000 As on 31st Assets Dec.1986 Rs. 5,00,000 Investments As on 1st Jan 1986 Rs. 60,000 4,80,000 10,000 As on 31st Dec. 1986 Rs. 40,000 8,70,000 ---

6,00,000 7,00,000 Fixed Assets 4,00,000 Current Assets Debentures

10,20,000 12,40,000

1,20,000 1,40,000 Discount on

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Current Liabilities

1,50,000 1,20,000 ----------- -----------15,70,000 21,50,000 ------------ ----------15,70,000 21,50,000

Solution: Statement of Sources and Uses of Funds Sources Increase in Share Capital Increase in General Reserves Increase in Profit and Loss Account Increase in Debentures Increase in Provisions Increase in Depreciation Reserve Decrease in Investments Decrease in Discount of Debentures Total Sources 1,00,000 1,00,000 20,000 3,00,000 10,000 80,000 20,000 10,000 6,40,000

Uses Increase in Fixed Assets Increase in Current Assets Decrease in Current Liabilities Total Uses 2,20,000 3,90,000 30,000 6,40,000

Interpreting the Funds Flow Statement This company is not able to generate enough funds internally for its capital expenditure requirements as Rs 2,00,000 generated through an increase in the P&L A/c, General Reserves, and Depreciation Reserves are less than the increase in Fixed Assets at Rs 2,20,000. Issue of equity share capital and debentures amounting to Rs 4,00,000 seems to be for meeting the

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working capital requirements of Rs 3,90,000. While the companys customers are able to access further credit, the suppliers are denying credit to this company. This increase in current assets significantly in the face of decrease in current liabilities is definitely a discouraging sign.

6.4 WORKING CAPITAL BASIS: Under this technique, the following three statements are prepared. A proforma of these statements are given at the end. (a) Statement of Changes in Working Capital: Where increase in current assets and decrease in current liabilities increases working capital and decrease in current assets and increase in current liabilities decreases working capital.

(b) Funds From Operations: The net profit/net loss that is reported by an entity is not the actual fund position for the accounting year. Hence, we need to make adjustments to the profit and loss account to arrive at the actual funds generated/lost from operating activities. To sustain any business, its core activities should generate a positive fund flow. The very purpose of preparing this statement is to discover the operational excellence of a company as is reflected in the funds from operations and not get carried away by a healthy net profits which can never tell the actual story. Hence, to the net profits reported in the income statement, we need to add all the non-cash expenses like depreciation and amortization and non-operating items such as dividends and taxes.

(c) Funds Flow Statement: It captures both sources and uses of funds. All items which generate fund inflows such as an increase in share capital, term loans, debentures, sale of assets, decrease in working capital, and funds from operations are recorded under Sources, while items which result in outflow of funds such as purchase of assets, redemption of debentures, payment of taxes, payment of dividends, increase in working capital, and funds lost in operations are recorded under Uses.

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Statement of Changes in Working Capital

Particulars

31st Dec ----------------------------2004 2005

Changes in Working Capital -------------------------------Increase Decrease

================================================================== Current Assets Stock Bills Receivable Debtors Cash in Hand Cash in Bank ` Prepaid Expenses ----------------------------------------------------------------------

-----------------------------------------------------------Total Current Assets -----------

-----------------------------------------------------------Current Liabilities Short Term Loans Bills Payable Trade creditors Outstanding Expenses ---------------------------------------------------

-----------------------------------------------------------Total Current Liabilities -------------

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-----------------------------------------------------------Net Working Capital (CA-CL)-------------

-----------------------------------------------------------Net Increase/decrease in Working Capital -------

Funds Form Operations

Net Profit for the current year Add: Non-Fund Items & non-trading Charges i) Depreciation and Depletion ii) Amortization of Fictitious and intangible assets like writing off preliminary expenses, discount on ----issue of debentures or preference shares, Goodwill, Patents etc. iii) Provision for taxation iv) Appropriation of Retained Earnings such as Transfer to General Reserve, Sinking Fund etc. v) Proposed Dividend vi) Less on Sale of fixed assets (if debited to P&L Account) ---------------------

----

--------

LessNon-Fund items and non-trading incomes i) Dividend received and receivable -----

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ii) Excess provision written back iii) Profit on sale of fixed assets (if already credit ed to Profit & Loss account) iv) Profit on revaluation of fixed assets (if already credited to Profit & Loss account) Trading Profit or Funds from Operations

-----

-----

-----

----------

Fund Flow Statement (Account Form) Sources of Funds 1. Funds from Operations 2. Issue of Share Capital Rs. --------Application of Funds 1. Loss from operations 2. Redemption of Debentures or preference shares 3. Issue of Debentures ----3. Repayment of Longterm loans 4. Long-term Loans 5. Sale of Fixed Assets 6. Non-trading receipts ----7. Decrease in Working Capital -----------------4. Purchase of Fixed Assets 5. Non-trading payments 6. Increase of Working Capital -------------------------Rs. ------

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Illustration 2. The following is the Balance Sheet of ABC Ltd (Rs. in lakhs) AS AT 30.6.82 LIABILITIES AS AT AS AT 30.6.83 30.6.82 ASSETS AS AT 30.6.83 18.00 9.50

Share Capital (Equity Shares 10.00 of Rs.100 each) 14.50 10% Redeemable Preference Shares of 7.50 Rs.100 each 0.50 Share Premium Capital Redemption -Reserve 8.00 General Reserve 3.00 Profit & Loss a/c Provision for 5.00 Taxation

13.00 Plant 8.00 Stock 20.00 15.00 Debtors 3.00 Bank Balance 1.00 Miscellaneous 2,50 0.25 5.00 4.50 5.00 6.00

2.50 1.00

Current 6.00 Liabilities 2.25 ------------------ ------40.00 45.50 40.00 45.50 ============================================================= =========== The following further information is furnished: 1. The Company declared a dividend of 20% for the year ended 30th June 1982, to equity shareholders on 30th September 1982. 2. The Company issued notice to preference shareholders holding preference shares of the face value of Rs.5 lakh for redemption at a premium of 5% on 1st December 1982 and the entire proceedings were completed before 31st December 1982 in accordance with the law. 3. The Company provided depreciation at 10% on the closing balance of plant. During the year one plant whose book value was Rs.2,60,000 was sold at a loss of Rs.30,000

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4. Miscellaneous expenditure incurred during the year ended 30th June 1983 Rs.25,000 for share issue and other expenses. Prepare a statement of sources and application of funds for the year ended 30th June 1983 on net working capital basis. Solution ABC Ltd Statement of Changes in Working Capital (Rs.in lakhs) Balance as on 30th June .. Changes inWorking Capital 1982 1 983 Increase Decrease (i) Current Assets Stock Debtors Bank Balance (A) (ii) Current Liabilities and Provisions: Current Liabilities Provision for Taxation (B) Working Capital (A)-(B) Net Increase in Working Capital 8.00 15.00 3.00 ------26.00 ------6.00 5.00 -----11.00 ------15.00 3.25 ------18.25 9.50 14.50 2.50 -------26.50 ------2.25 6.00 -----8.25 -----18.25 ------18.25 ------5.25 3.25 -----5.25 1.50 ---0.50 0.50

3.75 --

-1.00

(2) Computation of Funds From Operations Increase in P & L A/c Add: Non-cash items and Non-operating items Depreciation Miscellaneous Expenses Written Off 2.00 0.25 2.00

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Loss on Sale of Assets Transfer to General Reserve Equity Dividends Funds From Operations

0.30 1.50 2.00 6.05 8.05

Funds Flow Statement for the year ended 30th June 1983

Sources of Fund 1. Issue of equity shares

Amount (Rs.in lakhs) 10.00

Application of Fund 1. Redemption of preference shares (at a Premium of 5%)

Amount (Rs. in lakhs)

5.25 9.00+ 2.00 0.25 3.25 --------19.75

2. Sale of Plant 3. Funds from operation

1.70 8.05*

2. Purchase of Plant 3. Equity Dividends 4. Miscellaneous expenditure 5. Increase in Working capital

--- --------19.75

Interpreting the Funds Flow Statement ABC Ltd has a healthy fund flow from its operations as nearly 40% of the total funds originated from its core business activities. It has issued ownership securities to the tune of Rs 10.00 lakh to augment the financing of modernization of its plant. A significant portion of fund flows have been used for discharging preference shares at a premium as per the commitment made at the time of issue. Dividends to the extent of Rs 2.00 lakh and additional working capital needs amounting to Rs 3.25 have mopped up the residual funds. Thus, ABC

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Limited has financed its capital expenditure with long-term sources to enhance its earning capacity in the future. Working Notes:
Plant Account

(Rs.in lakhs) To Balance b/d 1.70 To Cash a/c (Purchase of Plant being balancing figure) 9.00 By Depreciation By Balance c/d ---------22.0 By Adjusted P&L a/c (loss on sale of Plant)

(Rs.in lakhs) 3.00 By Cash (Sale of Plant)

0.30 2.00 * 1 8.00 ----------22.00

*Closing balance of Plant is Rs.18 lakh after charging depreciation @ 10% on closing balance. Therefore, depreciation must have been charged on 18 x 10/9 = Rs.20 lakh. Thus, the amount of depreciation comes to Rs.2 lakh i.e., 10% on Rs. 20 lakh.

Illustration 3. The following Balance Sheet of Runbaxy & Co. Ltd., for the years 1984 and 1985 are given. You are required to prepare a Funds Flow Statement on working capital basis.

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(Figures are as at 31st December) (000 omitted) Liabilities 1984 Rs. Share Capital Share Premium General Reserve P and L Account Debentures 6% 150.00 .. 75.00 15.00 105.00 75.00 7.50 30.00 129.00 ====== 586.50 1985 Rs. 225.00 7.50 90.00 25.50 75.00 84.00 9.00 45.00 142.50 ======= 703.50

Provision for Depreciation on Plant Tax

Provision for Depreciation on Furniture Sundry Creditors

Assets

1984 Rs.

1985 Rs. 150.00 150.00 13.50 120.00 105.00 97.50 67.50 ======= 703.50

Land Plant Furniture Investment Debtors Stock Cash

..

150.00 156.00 10.50 90.00 45.00 90.00 45.00 ======= 586.50

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Additional information: (i) (ii) (iii) (iv)

Solution

Plant purchased for Rs. 6,000 (depreciation value Rs. 3,000) was sold for cash Rs.1,200 on 30th September 1985. On 29th June 1985, Furniture was purchased for Rs. 3,000. Depreciation on Plant 8% and Depreciation on Furniture 12 % on average cost. Dividend 22 % on original Share Capital.

Statement of Changes in Working Capital __________________________________________________________________________ 1984 1985 Increase Decrease I. Current Assets Debtors Stock Cash .. .. (A) II. Current Liabilities: Tax Liability Sundry Creditors (B) III Working Capital: (A)-(B) Net Increase in Working Capital 61,500 ---------82,500 ----------82,500 ---------90,000 61,500 --------90,000 21,000 82,500 30,000 45,000 ----15,000 13,500 1.29,000 1,42,500 ----------- ---------1,59,000 1,87,500 45,000 1,05,000 90,000 45,000 97,000 67,500 60,000 7,500 22,500 -------

----------- ----------1,80,000 2,70,000

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Funds Flow Statement for the year ended 31st December 1985

Sources of Fund

Amount Rs.

Application of Fund Rs.

Amount

1. Issue of Share Capital 2. Premium on share issued+ 7,500 3. Sale of Plant* 4. Funds from operations* 1,200

75,000 Debentures

1. Redemption of 30,000 3,000 30,000 33,750 61,500 -------------1,58,250

2. Purchase of Furniture* 3. Purchase of Investment 4. Payment of Dividend 5. Increase in Working Capital

74,550

--------------1,58,250

___________________________________________________________________________

Interpreting the Funds Flow Statement This company has to improve its working capital management as most of the resources generated from business operations are being utilized for meeting the additional working capital needs. The company is not judiciously applying its funds as investments (non-core activities) are absorbing a significant amount of funds at Rs 30,000. There is absolutely no creation of fixed asset to increase the earning capacity in the future and the purpose of mobilizing equity shares appears to be for discharging debentures and paying dividends.

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Working Notes: Plant Account To Balance b/d (1.1.85) 1.56,000 By Cash (sale) By P&L a/c (loss on sale) By Prov. for Dep. A/c (on Plant sold) By Balance c/d (31.12.85) 1,200 1,800 3,000 1,50,000 --------------1,56,000

------------1,56,000 Provision For Depreciation on Plant Account Rs. To Plant a/c (Prov. Written off on Plant sold) To Balance c/d 3,000 84,000 --------87,000 By Balance b/d (1.1.85) By P&L a/c (New Prov. Created @ 8% on Rs.1,50,000)

Rs. 75,000

12,000 -------87,000

Furniture Account
To Balance b/d (1.1.85) To Cash (Purchase, Being balancing figure) Rs. 10,500 3,000 --------13,500 -------13,500 By Balance c/d (1.1.85) Rs. 13,500

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Provision For Depreciation on Furniture Account Rs. To Balance c/d (31.12.85) 9,000 ------9,000 By Balance b/d (1.1.85) By P&L a/c Rs. 7,500 1,500* ------9,000

*Depreciation on Furniture: 12 % on Rs.10,500 (opening balance of Furniture) 12 % on Rs.3,000 for 6 months (on Furniture purchased on 29.6.85)

Rs. 1,313 Rs. 187 ----------Rs. 1,500

Funds from Operations . To Non-trading Items: Rs. By Balance b/d 15,000 Depreciation on Plant Depreciation on Furniture Loss on sale of Plant Appropriation for Divided Transfer to General Reserve To Balance c/d 12,000 1,500 1,800 33.750 15,000 25,500 --------89,550

Rs.

By Fund from operations (being balancing figure)

74,550

-------89,550

6.5 CASH BASIS- CASH FLOW STATEMENT: A funds flow statement on cash basis requires preparation of two statements: (a) Cash From Operations: To the net profits/net losses reported in the income statement, we need to add all the non-cash expenses like depreciation and amortization, provision for dividends and taxes together with transfers to reserves; and any decrease in current assets and increase in current liabilities. Further, we need to deduct any increase in current

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assets, decrease in current liabilities. The net figure if it is positive, it indicates Cash From Operations which is a Source and if it were to be negative, it indicates Cash Lost in Operations which is a Use of funds.

(b) Cash Flow Statement: It captures both sources and uses of cash. It begins with the opening balance of cash. To this all items which generate cash inflows such as an increase in share capital, term loans, debentures, sale of assets, and cash from operations are recorded under Sources, while items which result in outflow of funds such as purchase of assets, redemption of debentures, payment of taxes, payment of dividends, and cash lost in operations are recorded under Uses. Finally, it ends with the closing balance of cash. Illustration 4 The Comparative Balance Sheets of a company are given below. 1995 Rs. Share Capital Debentures Creditors Provision for Doubtful Debts Profit & Loss 350 5,020 51,550 400 5,280 51,600 51,550 51,600 35,000 6,000 5,180 1996 Rs. 37,000 3,000 5,920 Cash Book Debts Stocks Land Goodwill 1995 Rs. 45,000 7,450 24,600 10,000 5,000 1996 Rs. 3,900 8,850 21,350 15,000 2,500

Additional information available are: (i) (ii) (iii) Dividends paid amounted to Rs.1,750 Land was purchased for Rs.5,000 and amount provided for the amortization of goodwill amounted to Rs.2,500. Debentures were repaid to the extent of Rs,3,000

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You are required to prepare a Cash Flow Statement. Cash From Operations (Rs) P&L a/c 1996 Less: P&L a/c 1995 5,280 5,020 260 Add: Dividend 1,750 2,500 3,250 50 740 8,550 Less: Increase in Debtors 1,400 ------Cash from Operations 7,150 ====

Add: Goodwill written-off Add: Decrease in Stocks Add: Increase in Provision for Doubtful Debts Add: Increase in Creditors

Cash Flow Statement

Cash Inflow: 1. Cash Balance 1-1-1996 2. Issue of Shares 3. Cash from Operations

Rs. 4,000 2,000 7,150 -------13,650

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-------Cash Outflow: 1. Purchase of Land 2. Payment of Dividend 3. Repayment of Debentures 4. Cash Balance on 31-12-1996 5,000 1,750 3,000 3,900 -------13,650 --------

Interpreting the Cash Flow Statement There has been a slight dip in the cash balances at the end of the period despite issuing shares (Rs 2,000) and generating a healthy flow from operating activities (Rs 7,150). This is because the company acquired land and discharged debt while paying dividends amounting to Rs. 1,750 respectively. The company could have avoided issuing equity if it had skipped dividends and thereby avoided transaction costs. This would have had a marginal impact on cash balances at the end of the year. To reduce its overall capital, the company should leverage by borrowing additional funds to finance the fresh acquisition of fixed assets.

6.6 STATUS AND APPLICABILITY OF AS -3 (REVISED): Cash Flow Statement: The Institute of Chartered Accountants of India had recently revised AS-3 (Statement of Changes in Financial Position) issued in 1981. AS-3 (Revised) is mandatory in nature with effect from 1st April 2001 for all the listed companies and other enterprises whose turnover exceeds Rs 50 crores for the accounting period.

Preparation of Cash Flow Statement: The cash flow statement of an enterprise should report cash flows during the period classified by operating, investing, and financing activities in a manner, which is most appropriate to its business.

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Operating Activities Cash flows from operating activities are primarily derived from the principal revenueproducing activities of the company. Cash flows from operating activities are: Cash receipts from sale of goods and services; Cash receipts from royalties, fees, commissions, and other revenues; Cash payments for all operating expenses; Cash receipts and cash payments of insurance enterprise for premiums and claims, annuities and other policy benefits; and Cash payments or refund of income taxes.

Investing Activities The investment activities are those that are related to the investment of funds in the fixed assets and other investments. The separate disclosure of cash flows arising from investing activities shows the extent to which expenditures have been made for resources intended to generate future income and cash flows. They can be: Cash payments to acquire fixed assets, intangibles and those relating to capitalized research and development costs and self-constructed fixed assets; Cash receipts from disposal of fixed assets and intangibles; Cash payments to acquire shares, warrants, or debt instruments of other enterprises and interests in joint ventures; Cash advances and loans made to third parties (other than advances and loans made by a financial enterprise); Cash receipts from the repayment of advances and loans made to third parties (other than advances and loans made by a financial enterprise); and Cash receipt by way of interest, dividend or any other cash income from the investee enterprise.

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Financing Activities These activities include those relating to long-term funds i.e., share capital and borrowings. Cash flows arising from financing activities may include: Cash proceeds from issuing shares or other similar instruments; Cash proceeds from issuing debentures, loans, notes, bonds, and other short or long-term borrowings; Cash repayments of amounts borrowed; Interest or dividend repayments; and Cash payments for redemption of bonds, debentures, or preference shares.

6.7 SUMMARY: In this unit, we have discussed the need for constructing a funds flow and cash flow statements to supplement the information provided by income and position statements. Funds flow analysis details the financial resources availed and the ways in which such resources are used during an accounting period. As the sources side captures the funds generated from operations internally, it explains reasons for liquidity problems of the firm even though it is earning profits. The changes in working capital position can also be tracked by observing the surplus / deficit of funds during an accounting period. The top management may, however, like to know the ability of an enterprise to generate cash and cash equivalents and the timing and certainty of their generation. This warrants preparation of a cash flow statement, which provides the information about the cash receipts and cash payments of a firm for a given period.

6.8 KEY WORDS:

Working capital Cash from operation Funds Flow Statement

Total resources; Funds from operations Cash Flow Statement

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Try Yourself: 1) The following Balance Sheet of VST & Co. Ltd., for the years 2004 and 2005 are given. (Figures are as at 31st March) (Rs in Lakhs) Liabilities Share Capital General Reserve P and L Account Debentures 9% Tax Sundry Creditors 1984 Rs. 50.00 75.00 12.00 85.00 30.00 48.00 ====== 300.00 1984 Rs. .. 50.00 75.00 10.00 40.00 80.00 45.00 ======= 300.00 1985 Rs. 75.00 90.00 15.00 75.00 45.00 42.00 ======= 342.00 1985 Rs. 60.00 80.00 13.00 65.00 87.00 37.00 ======= 342.00

Assets Land Plant Furniture Debtors Stock Cash

Additional information: Plant purchased for Rs. 4 lakhs (depreciation value Rs. 1 lakh) was sold for Rs. 1,50,000 during the year. Depreciation to be provided on Plant 10 % and Furniture 12 % on average cost. An interim dividend of Rs 9 lakhs was paid on 1st December. You are required to prepare Funds Flow and Cash Flow Statements

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2) Prepare a statement from the figures given below showing application and sources of funds during the year 1986 under all the three methods learnt in this chapter.

Liabilities

As on 1st As on 31st Assets Jan 1986 Dec.1986 Rs. Rs. 6,00,000 7,00,000 2,00,000 4,00,000 3,00,000 4,00,000 1,20,000 1,40,000 2,60,000 30,000 2,20,000 -----------21,50,000 Fixed Assets Investments Current Assets Discount on Debentures

As on 1st As on 31st Jan 1986 Dec. 1986 Rs. Rs. 10,20,000 12,40,000 60,000 1,60,000 4,80,000 7,50,000 10,000 ---

Share Capital Debentures General Reserve P&L a/c

Depreciation Reserve 1,80,000 Provision for Doubtful Debts 20,000 Current Liabilities 1,50,000 ----------15,70,000 Additional Information:

------------ ----------15,70,000 21,50,000

During the year equity dividend @ 15% was paid for 1985. Depreciation amounting to Rs 80,000 was provided on Fixed Assets.

FURTHER READINGS: Sashi.K.Gupta and R.K.Sharma, Financial Management, Kalyani Publishers, New Delhi. Ravi. M.Kishore, Financial Management, Taxmann Allied Services, New Delhi.

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LESSON-7 COST VOLUME PROFIT ANALYSIS

OBJECTIVES:

STRUCTURE the relationships between cost, volume, selling price and To explain profit To explain the utility of Breakeven Analysis for Profit Planning To apply Breakeven Analysis for Managerial Decision Making

STRUCTURE:
7.1 Introduction 7.2 Assumptions of Breakeven Analysis 7.3 Breakeven Point (BEP) 7.4 Contribution 7.5 Profit- Volume Ratio 7.6 Margin of Safety 7.7 Profit Goal 7.8 Breakeven Analysis in Multi-product Firm 7.9 Applications of BEP Analysis for Managerial Decision Making 7.10 Limitations of CVP Analysis 7.11 Summary 7.12 Key Words 7.1 INTRODUCTION: Every Organisation, whether commercial or otherwise needs to create a surplus. While commercial organizations necessarily exist to make a surplus which they would call a profit, non-commercial organizations also need to make a surplus, if they need to sustain themselves and survive. Hence every Organisation or firm needs to make a surplus and devise plans to make a surplus and be financially viable.

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One of the methods of profit planning for manufacturing organizations is the Cost-Volume Profit-Analysis or C-V-P Analysis for short. This method aims to examine the inter relationships that exist between cost, selling-price of the product, and the volume of sales on the profit and use these inter relationships to aid in Profit Planning C-V-P Analysis is synonymously used with Breakeven Analysis, which is by far the most popular tool of C-V-P Analysis.

7.2 ASSUMPTIONS OF BREAKEVEN ANALYSIS : C-V-P Analysis as a tool of profit planning is based on certain assumptions which are explained below. 1. Segregability of Costs: Breakeven Analysis assumes that all costs can be segregated into Fixed Costs and Variable Costs. Even those costs which are semi-variable in nature can ultimately be separated into fixed and variable components. Fixed Costs : Fixed costs are those costs which are incurred by a firm and therefore remain unchanged no matter what the level of production. Variable Costs: Variable Cost are those costs which are directly involved in the making of the product and therefore vary in direct sympathy with the level of output. A point to be noted here is that while Fixed Costs remain constant in aggregate, the per unit fixed costs varies as the production levels vary, whereas variable costs remain constant per unit, but change in aggregate as the level of production Changes. 2. Constancy of Selling Price: The second assumption is that the selling price of the firm irrespective of its

level of output. These are the costs which are not directly related to making of the product,

products remains constant, no matter what the level of output. This is in contravention to the normal economic laws of supply and demand where we see that price is a function of supply and demand.

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3. Constancy of Product Mix: Another assumption on which CVP Analysis is based is that the firm produces only one product, i.e., it is a uni-product firm or even if it is a multi-product firm, the product mix would remain constant and not change. 4. Synchronisation of Production and Sales: CVP Analysis also assumes that there is perfect harmony between production and sales that all that has been produced will be sold and therefore there will not be any changes in levels of inventory. 7.3 BREAKEVEN POINT (BEP): As already explained CVP Analysis mainly depends on the concept called Breakeven Point. Breakeven Point is that level of output and sales, where the total costs (TC) are equal to Total Revenues (TR). TC = TR TC = FC (fixed costs) + FC (variable costs) Since costs are equal to revenues, the firm has neither a profit nor a loss at this level of output. Breakeven Point can be ascertained algebraically using the following: BQ = F S-V Where BQ stands for BEP in quantity or No. of units. F stands for Fixed Cost. S stands for Selling Price per unit. V stands for Variable Cost per unit. Example: If S = Rs.10, V = Rs.6 and Fixed Costs are Rs.80,000, BQ =? BQ = F SV = 80,000 10 6 = 20,000 units

To verify @ a sales level of 20,000 units

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Sales Revenue is 20,000 x10 = Variable cost is 20,000 x 6 = Contribution Less: Fixed costs Profit/Loss

2,00,000 1,20,000 -----------80,000 80,000 ----------NIL ------------

7.4 CONTRIBUTION: The difference between the Sales Revenue and the Variable Costs is called contribution because it contributes to the firm to cover the fixed cost and if any balance is left out after covering fixed cost, the same goes to contribute to the profit of the firm.

Breakeven Point can also be ascertained in terms of value, by simply multiplying BQ by S, Therefore, Total Sales revenue at which point the firm will break even, in terms of rupees can be known as under. BRs = Example: If S = Rs.30, V = Rs.20, and F is Rs. 20,000, Compute the BEP in quantity and Rupees. BRs = BQ x S or = 2,000 units F (1 V/S) Fx S ( SV) or F (1 V/S)

BQ = 20,000 30 20

BRs = 10,000 x 30 = Rs. 6,00,000 OR 20,000 ( 1 20/30 ) = 20,000 x 30 = Rs.6,00,000 10

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7.5 PROFIT- VOLUME RATIO: We see that Breakeven point in rupees can be ascertained by using the equation. BEPRs = F ( 1 V/S) Within this formula, the part V/S is called the variable cost ratio, and the entire denominator is called Contribution Ratio or Profit Volume (P/V) Ratio. Which goes to say that BEPRs = F Contribution/P/V Ratio Example: Budgeted Sales Budgeted Variable Cost Budgeted Fixed Cost Breakeven Sales = F P/V Ratio OR 3000 x 5 2 = Rs.7500 Which is 15,000 9,000 3,000 3,000 1 9000/15000 = 3000 2/5

7.6 MARGIN OF SAFETY: CVP Analysis can also be used to ascertain the margin of safety. Margin of safety refers to the volume/value by which sales can decline before the firm begins to incur a loss. Margin of Safety = Budgeted/Actual Sales Breakeven Sales

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Example: Estimated Sales Estimated VC = Rs.5,00,000 = Rs.3,00,000

Estimated Fixed Costs = Rs.1,00,000 Solution: BQ = F SV = 80,000 1 3/5 = 20,000 units

Therefore Margin of Safety = Estimated Sales Breakeven Sales = 5,00,000 2,50,000 = Rs. 2,50,000 Which means that the sales can fall by as much as 50% of value without the firm incurring a loss.

7.7 PROFIT GOAL:

C-V-P Analysis could also be used to ascertain the sales that need to be generated to achieve a specified amount of profit. Desired Sales = F + P P/V Ratio Where P stands for desired amount of profit. Example: F P = = Rs.50,000 Rs. 50,000 40% F + P P/V Ratio = 50,000+ 50,000 0. 4 = 1,00,000 0.4 = Rs.2,50,000

P/V Ratio =

Sales required to earn the desired profit and Rs. 50,000 are =

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To Verify:

Sales Variable costs 60% Contribution Less: FC Profit

2,50,000 1,50,000 ------------1,00,000 50,000 -----------50,000 ==========

Desired After Tax Profit: Similarly, Sales required to earn a desired after tax profit also can be ascertained by the slightly modifying the formula. Sales required to earn a desired Profit after tax (PAT) = Where t stands for rate of tax. Example: Budgeted Sales: Rs 5,00,000; Budgeted Variable costs : Rs 3,00,000 Budgeted Fixed Costs: Rs 1,00,000; Tax rate: 40% Calculate Sales required to earn desired profit of Rs. 54,000. Solution: Sales required to earn desired profit = F+ (Desired Profit/1-Tax rate) P/V ratio = 1,00,000+( 54,000/1-.40) 0.40 = 1,00,000+ 90,000 0.40 Verification: Sales (-) Variable cost @ 60% of Selling Price 4,75,000 2,85,000 = = 1,00,000+ (54,000/.6) 0.40 1,90,000/0.40 = Rs 4,75,000 F + PAT/ 1 - t P/V Ratio

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Contribution (-) Fixed cost PBT (-) Tax @40% Profit after tax

1,90,000 1,00,000 90,000 36,000 54,000 ========

7.8 BREAKEVEN ANALYSIS IN MULTIPRODUCT FIRM:

As already explained CVP or Breakeven Analysis is based on the assumption that the costs of the firm are of two categories i.e., fixed and variable. Variable costs are those costs which are incurred directly for the purpose of producing the product such as material or labour. These are, therefore, product costs. Whereas fixed costs are those costs which are incurred by the firm independent of the output such as rent, insurance and so on. These are not product costs but are period costs. A problem which arises with period costs is that they are not apportionable between products on an absolutely objective basis. This is a major difficulty in computing breakeven point in multi-product firms. Because, period costs or fixed costs cannot be accurately apportioned or attributed to different products, BEP cannot be ascertained for individual products in a multiproduct firm. However, individual P/V ratios and the BE point for the firm as a whole is ascertainable.

Problem: The following data relate to Shalom & Co. for the period ending March 31, 2005. Product Sales Variable Costs X Rs 1,00,000 60,000 Y Rs 1,50,000 1,05,000 Z Rs 2,50,000 1,75,000

If total fixed costs are Rs 76,000, calculate the firms break-even point and profit.

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Solution: BEP Calculations for a Multi- Product Firm Product X Sales mix Sales revenue(Rs) Variable Costs (Rs) Contribution(Rs) Fixed Costs(Rs) Net Profit (Rs) P/V ratio BEP for the Firm (Rs) 40% 30% 30% 20% 1,00,000 60,000 40,000 Y 30% 1,50,000 1,05,000 45,000 Z 50% 2,50,000 1,75,000 75,000 Total 100% 5,00,000 3,40,000 1,60,000 76,000 84,000 32% = 76,000/0.32 = 2,37,500 Alternate Way of computing the firms P/V Ratio: The firms P/V ratio = PVratio x proportion = 0.4x0.2+0.3x0.3+0.3x0.5 =0.08+0.09+0.15 =0.32 = 32% 7.9 APPLICATIONS OF BEP ANALYSIS FOR MANAGERIAL DECISION MAKING: Break-even analysis is very useful in managerial decision-making. It aids decision-making in umpteen number of situations such a, Fixation of Selling price, Decision relating to the most profitable product-mix, Decision relating to Make or Buy, Shut down or Continue decisions, Key factor or Limiting factor, Dropping a Product line, Retaining or replacing a machine, Substitution of one factor or the other, Diversifying or Non-diversifying etc. Hereunder are a few illustrations which will help you appreciate the application of this technique for decision making.

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Make or Buy Decision Problem : A Manufacturing company finds that it costs Rs. 31.50 to make component X. The same is available in the market at Rs.28.50 each with an assurance of uninterrupted supply. The break-down of the cost is Marginal Cost of X Material Labour Variable Solution: The Marginal Cost of making is to be compared with the buying price: Marginal Cost of X Material Labour Variable 13.75 8.75 2.50 25.00 Since this is less than the cost of buying, then the part has to be made rather than bought. If purchase price of X is Rs.24.50 buying is advantageous. 13.75 8.75 2.50 25.00 Should the component be bought or made? Would your decision change if purchase price of X is Rs.2450.

Fixation of Selling Price Problem: A firm produces a single product. The variable cost of producing one unit is Rs.12. The firm desires to maintain a P/V ratio of 40% to cover fixed cost and earn a reasonable profit. Determine selling price of each unit.

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Solution: The firms Variable Cost Rs. 12 per unit. The firm intends to maintain 40% P/V ratio or contribution ratio. Therefore variable costs are permitted to be 60% of SP; Rs 12 should constitute 60%. SP = Rs 12 x 100 = Rs.20 60 Alternatively using formula SP per unit = VC per unit = 12 1- P/V ratio 1 0.4 = Rs.20

Quoting Prices for Special Situations: Problem: A product has been selling exclusively in Indian market. The manufacturer has received his first export enquiry and wants to quote as competitively as possible. The latest Indian cost sheet is as follows. Rs. per unit Raw materials 17 Direct Labour 6 Services (2/3 variable) 3 Work OH (fixed) 3 Office OH (fixed) 1 --30 Profit 3 ----SP per unit 33

Quote the lowest price.

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Solution:
Lowest Price per unit for export

Raw Materials Direct labour Services

17 6 2 ----25 ----The lowest price that can be quoted is Rs.25. -

Caveats: 1. Existence of manufacturing capacity should be checked. If spare manufacturing capacity does not exist, additional fixed costs in terms of adding capacity will have to be incurred. 2. Direct Costs of export order like insurance, specialized packing, export duty should also be considered 3. Cash subsidy, export incentives to be considered. Problem : Due to trade recession, a company is getting inadequate government orders and is operating below 60%,normal capacity. However, it is a temporary phase and the management has taken a decision not to retrench labour. An enquiry has been received for 10000 units which can be manufactured under existing capacity with the following costs. Direct materials: Direct labour : Time required : Variable OH Fixed OH : Rs. 5 per unit Rs. 2.50 per unit 1 hr per unit 600% direct labout Compute minimum price and substantiate

: 400% direct labour

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Solution: Direct material Direct labour Variable OH (400% DL)

Per Unit 5 2.50 10 -------17.50 ---------

Total 50,000 25,000 100000 ---------175000 ----------

The lowest price is Rs17.50 per unit Recovery of Rs.25,000 as wages which are for the present fixed cost because of management decision not to retrench labour. Shut down or Continue Decisions Problem : A company produces a single product. Its selling price and cost of production per unit are as under. Output Material Cost Labout Cost Variable OH Fixed expenses Total Cost 40,000 units Rs. 2.00 Rs. 2.00 Rs. 1.00 Rs. 2.00 ------------Rs. 7.00

Due to depression the company is not able to sell at the existing price of Rs.8/- per unit. However, the entire output can be sold at Rs.6/- per unit. Advise whether the company should continue or close.

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Solution: If the product is being sold for Rs.6/-, there is a loss of Rs.1 per unit. Therefore Total Loss = 1x 40,000 = Rs. 40,000 However, it is recovering Rs,2/- of fixed cost per unit other wise the firm would incur a loss of Rs.2 x40,000 units = Rs. 80,000. The firm is able to reduce its loss by continuing. Or Profit Statement: Sales Revenue 6 x 40,000 = 2,40,000 (-) VC Contribution (-) FC Loss Problem : Lara Company Operates at normal capacity of 1,00,000 unit and sells them @ Rs.60/- per unit. The unit cost of manufacturing at normal capacities is as follows. Direct material Direct labour Variable OH Fixed OH Total 16.25 6.50 8.25 10.00 ----------41.00 ----------The variable S&D expenses are Rs.1.50 per unit. Due to recession, the company feels that only 10,000 units can be sold next year at Rs.50/- per unit. Shut down option is available. In 2,00,000 40,000 80,000 40,000

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case of shut down fixed manufacturing overhead can be reduced to Rs.7,25,000/- for the next year. Additional costs of shut down are estimated to be Rs. 1.82,500/-. Advise whether to shut down or not. Solution: To Continue Sales Revenue (10,000x50 (-) VC Contribution (-) Fixed Costs Operating Loss (10,000x32.50) 5,00,000 3,25,000 -------------1,75,000 10,00,000 --------------8,25,000 --------------Therefore since there is greater loss in case of shut down, it is advised to continue. 7.10 LIMITATIONS OF CVP ANALYSIS: The CVP analysis is subject to the following limitations. C-V-P Analysis as a tool of profit planning is based on certain assumptions which have been explained earlier. assumptions themselves become the major limitations. Segregability of Costs: Breakeven Analysis assumes that all costs can be segregated into Fixed Costs and Variable Costs. Not all costs can be easily and accurately separated into fixed and variable elements. Total fixed costs do not remain constant beyond certain ranges of activity levels but increase in a step-like fashion. It assumes that output is the only factor affecting costs, but there are other variables which can affect costs, e.g., inflation, efficiency and economic and political factors. Constancy of Selling Price: The second assumption is that the selling price of the firm products remains constant, no matter what the level of output. This is in contravention to the These Shut down costs Unavoidable FC Additional shut down cost Shut Down 7,25,000 1,87,500 ------------9,12,500 -----------

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normal economic laws of supply and demand where we see that price is a function of supply and demand. CVP analysis assumes that costs and sales can be predicted with certainty. However, these variables are uncertain and the Finance Manager must try to incorporate the effects of uncertainty into his information. Constancy of Product Mix: Another assumption on which CVP Analysis is based is that the firm produces only one product, i.e., it is a uni-product firm or even if it is a multi-product firm, the product mix would remain constant and not change. However, the sales mix will be continually changing owing to changes in demand Synchronisation of Production and Sales: CVP Analysis also assumes that there is perfect harmony between production and sales that all that has been produced will be sold and therefore there will not be any changes in levels of inventory. There is an assumption that there are either no stocks, or no changes in stock levels. Profit is therefore dependent on the sales volume. However, when changes in stock levels occur and such stocks are valued using absorption costing principles, then profit will vary with both production and sales. If sales are depressed, profit can be raised by increasing production and thereby increasing stock levels. Profit is therefore a function of two independent variables (sales and production). The conventional break-even chart is two dimensional and cannot cope with two independent variables. It is important to note that if stocks are valued using marginal costing principles then profit is a function of sales, only, and the conventional CVP analysis applies. 7.11 SUMMARY: Every Organisation, whether commercial or otherwise needs to create a surplus One of the methods of profit planning for manufacturing organizations is the Cost-Volume ProfitAnalysis or C-V-P Analysis for short. C-V-P Analysis as a tool of profit planning is based on certain assumptions. CVP Analysis mainly depends on the concept called Breakeven Point. Breakeven Point is that level of output and sales, where the total costs (TC) are equal to Total Revenues (TR). CVP Analysis can also be used to ascertain the margin of safety, ascertain the sales that need to be generated to achieve a specified amount of profit. Sales required to

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earn a desired after tax profit also can be ascertained Break-even analysis is very useful in managerial decision-making. It aids decision-making in umpteen number of situations such as Fixation of Selling price, Decision relating to the most profitable product-mix, Decision relating to Make or Buy, Shut down or Continue decisions, Key factor or Limiting factor, Dropping a Product line, Retaining or replacing a machine, Substitution of one factor or the other, Diversifying or Non-diversifying etc. The CVP analysis, however, is subject to certain limitations. As a tool of profit planning certain the assumptions on which C-V-P Analysis is based become its major limitations. However, in the short-run CVP Analysis is of immense use as a profit planning device.

7.12 KEY WORDS: Breakeven Point (BEP) Profit- Volume Ratio Profit Goal Try yourself: 1. From the following particulars calculate (i) (ii) BEP in Rs & Units Number of units that must be sold to earn a profit of Rs 90,000 Contribution Margin Of Safety

Fixed Factory costs : Rs 60,000 Fixed Selling costs: Rs 12,000 Variable Manufacturing cost per unit : Rs 12 Variable Selling cost per unit: Rs3 Selling price per unit: Rs24 Solution: BQ =8000 units; BR =Rs.1,92,000 Required Sales to earn a profit of Rs 90,000 is 4,32,000 units Further Readings: I.M. Pandey, Financial Management, Vikas Publishing, New Delhi. N.K. Prasad, Principles of Cost Accounting, Book Syndicate Private Limited, Calcutta.

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LESSON-8 BUDGETING

OBJECTIVES: Explains the meaning and importance of Budgeting Discusses various types of Budgets Discusses various techniques of Budgeting

STRUCTURE:
8.1 Introduction 8.2 Importance of Budgets 8.3 Pre-requisites for Effective Budgeting 8.4 Process of Budget Formulation 8.5 Types of Budget Formulation 8.6 Techniques of Budgets 8.7 Key words 8.1 INTRODUCTION:

Budgeting is essentially a process of funding the activities needed to achieve the objectives of the organization, during a definite period of time. In its most basic form budgeting may be seen as the financial expression of the sources of funding for and the allocation of such resources to the various activities of the over a specified time period1. Thus there are two important steps in the budgeting process: (a) the determination of funds, and (b) allocation of funds. The scope of

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budgeting to a large extent, depends upon the purposes for which an organization exists, from a typical government budgeting to a truly business budgeting.

In the early stages of evolution of management in the business, budgeting served almost every need of the business. Budgeting, thus, was identified with every aspect of management. It is a formal expression of policies, plans, Budgeting is essentially a managerial process. A business budget is a plan covering all phases of operations for a definite period in the future. objectives and goals laid down in advance by the top management for the concern as a whole and for each sub division thereof.2 Budget is an important document prepared by an organization. The Institute of costs and Works Accountants defined the budget as a financial and/or quantitative statement, prepared and approved prior to a defined period of time, of the policy to be pursued during that period for the purpose of attaining given objective. It may include income, expenditure and the employment of capital.3 From the above definition, the characterization of Budget can be as shown below: 1. It is a financial and or quantitative statement 2. It is prepared in advance pertaining to a definite period, say for one year 3. Its purpose is to attain pre determined objectives 4. It reflects policies of an organization 5. It includes items of income and expenditure 8.2 IMPORTANCE OF BUDGETS: i) Budget serves as an instrument of Planning and Control. Planning is the first step in the management process. achieving them. Planning function determines

organizational objectives and policies, programmes, schedules, procures and methods for Planning is essentially decision making since it involves choosing among alternatives and it also encompasses innovation. Thus planning is the decision on any phase of organisedactivity.4 Budget is essentially deciding about the alternatives to achieve objectives set out for the organization as well as for various departments and on allocation of resources to

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achieve the targets during the defined period. Budget enforces a discipline of planned thinking and action for encompassing entire organization. Budget also decides on which activities need to be carried out and at what level (volume) and at what cost.

Budget serves also serves as a tool of control. Control is the next step after formulation of budgets. Control is equally an important element in the managerial process, to ensure that the actual performance in the organization conforms to plans for realization of objectives set out. The interest of the management does not end with the formulation of a budget, but extends to implementing the budget which finally results in the achievement of objective. Thus the scope of budgeting extends to controlling the activities to conform to the budget. Budgetary control is the logical extension of budget formulation. The Institute of Cost and Works Accountants defined the budgetary control as the establishment of budgets relating the responsibilities of executives to the requirements of a policy and the continuous comparison of actual with the budgeted results either to secure individual action the objective of that policy, or to provide a basis for its revision.
5

By this definition, budgetary control is considered as a tool of management control

system by measuring the performance, reporting to the different levels of management relating the budget with actual performance and enabling the management to take corrective action. The feed back system sometimes leads to correction of plans because of changes in underlying assumption made in plans. Thus budgetary control will be useful when it aids the management in monitoring the performance on a continuous basis, comparison and reporting promptly and accurately.

ii)

Budgeting facilities coordination of different functions.

According to Welch Coordination is the process whereby each sub-division of a concern works toward the common objective, with due regard for all other sub-divisions and with a unity of effort.6 For example, there should be proper balance among the various functions like sales, production, purchasing, personnel and finance etc to achieve the organizational objectives. This can be achieved only through proper coordination. Coordination to a great extent depends upon communication. Coordination is facilitated when each responsible executive is informed as to the

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targets and actual performance with reference to the budget of his area of responsibility, related functions and for the entire organization.

iii)

Budgeting facilitates communication:

Management is effective where there is proper communication so that every body understands in the same way. Budgeting ensures a two-way communication between top management and floor level staff. Top management communicates to the floor level staff the budgets which indicate targets to be achieved and the floor level managers indicate their requirements of resources to achieve the targets. Finally the budget will be finalized after discussion at various levels. Secondly, each function or division depends on other functions/divisions to achieve their targets. A horizontal communication among various departments and functions in the form of group meetings and discussions will remove misgivings and bring in the necessary cooperation. This is achieved by budgeting process where in several meetings are held with representatives of all functions and departments. Only after achieving consensus among various departments the budget will be finalized. Thus budgeting facilitates important management process of communication in the organization. 8.3 PRE-REQUISITES FOR EFFECTIVE BUDGETING: The following mentioned factors should be prevalent for proper budgeting: 1. 2. The budgeting process should be fully supported by top management There should be an organization chart with clear identification of responsibilities for managing resources and achieving results. It should also depict relationships between various responsibility centres. 3. 4. Budget manual which prescribes the procedures to be followed and various formats for preparing the budget All the staff charged with the responsibility of achieving budget should be actively involved in the formulation of budget

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5.

Budget calendar There should be budget calendar with possible scheduled dates for initiating budget, communicating approved budgets to various heads of departments, periodicity of performance reports, revision of budgets etc.

6.

Uniform terminology - the budget department should develop uniform terms for common understanding of all the concerned with the formulation and implementation of budget.

8.4 PROCESS OF BUDGET FORMULATION:

Procedure for budget formulation varies according to nature, needs, resources: i) Classification of organization structure in terms of functions, programmes and activities

show precise objectives, the work done and the organizational responsibilities by each of them. Function is a broad grouping of operations which are directed towards accomplishment of a major purpose of an organization. Programme implies broad category within a function that identifies end products of major organization. The purpose of a programme is to contribute to the An activity contributes towards achievement of the objective of the function to which it belongs. Activity is a division of a programme into homogenous type of work on schemes. ii) attainment of the end result of the programme to which it belongs. Establishment of proper measures of work or services to be rendered under each programme and activity developing appropriate norms or standard for appraisal of performance of each programme and activity in relating to its objectives. iii) iv) Construction of accounts along with functional lines is necessary for synchronization of Budget committee is formed with heads of decisions chaired by the Chief Executive Officer budget heads and accounting heads. of the organization and coordinated generally by the head of Finance division also known as budget officer v) Chairman of the budget committee or CEO initiates budget process by communicating the heads of departments broadly indicating the business environment and suggested targets to be achieved by the organization.

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vi)

The heads of department in turn communicates to the various heads of budget centres for

formulating the budgets relating to their respective centres of activities. These centres propose the requirements of resources, for various activity levels. vii) After internal discussion with various heads of budget centres, the heads of departments/functions propose the budgets to the Budget committee. viii) The Budget Committee discusses the proposals with heads of departments/functions and draws upon draft budget for the entire organization. ix) x) The board of directors finally approves the budget The budget officer communicates the budgets of various departments for implementation.

From the discussion the main advantages of budgeting are as follows: i) ii) iii) iv) v) vi) It is an instrument of management It evaluates factors affecting future of the organization It promotes cooperation among departments and coordination of different functional heads It is powerful tool of communication It motivates employees to exceed the provisions performance It tries to improve efficiency and accountability at various levels of the organization.

Limitations of Budgeting: i) ii) its success depends upon the support of the top management it is not a substitute to good management and leadership

8.5 TYPES OF BUDGET: Budgets can be classified on the basis of time, activities, approach and variability. These are explained below. On the basis of time: Budgets can be classified on the basis of time. Broadly we can classify them into short term, medium term, and long-term budget. Long-term budgets are used for assessing the long tem

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requirement of funds for meeting long term investments say 5 year to 10 years. This budget can be considered as capital budget which deals with items of larger investments such as Land, buildings, investments into new business, products, research and development. The benefits from these investments can be seen only after long period such as 3 to 5 years. The finances required for meeting such large and long term investments have to be planned carefully. The investments have to be evaluated not only from financial (cost/benefits) perspective but also from other important perspectives. Therefore the long-term budgets are prepared at the highest level of the organization. Typical capital Budget can look like as shown in Figure:1

FIGURE 1: CAPITAL BUDGET FOR THE PERIOD 2006 TO 2010

(Rs. In Millions) Items EXPENDITURE 1. Land 2. Buildings 3. Plant & Machinery 4. New Business 5. Technology Development 6. Other Assets TOTAL FINANCED BY 1. Internal Resources 2. Loans 3. Equity capital 4. Sales of existing assets/business TOTAL Year 2006 2007 2008 2009 2010

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The medium term budget can be referred to beyond one year to 3 years. The short-term budget is proposed for one year. The Annual budget is broken down monthly budgets to understand the peaks and troughs and mismatch between income and expenditure.

One the basis of activities / functions: On the basis of operations / functions two types of budgets are prepared: 8.5.1 i) ii) iii) iv) v) vi) Master budget it is based on all departmental activities it is summary of the budgets of all departments / functions it shows the full plan of budget period budget officer prepares it after the departmental budgets prepared by the heads of respective departments it is recommended by Budgetary Committee to the Board of Directors for approval After the approval by the Board it is communicated to the top management for implementation. vii) A copy of the Budget relating to reach department is sent to respective heads of departments viii) Master budget includes sales, production cost, including direct labour, direct material, factory overheads, administrative expenses, profits, profit planning etc. ix) Master budget can be explained with the following Figure 2

FIGURE 2: MASTER BUDGET OR THE PERIOD _______________ (Amount Rs. In Millions) Particulars Net Sales (Sales Return) Less: Manufacturing costs Direct Material Budgeted period Previous period

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Direct Labour Factory overhead Gross Profits: Less: Operating expenses Office Expenses Selling and Distribution expenses Operating Profits: Add: Non-operating income Less: Non-operating expenses Net profit before tax Less: Tax Profit after Tax

FIGURE 3: BUDGETED BALANCE SHEET AS ON _________________ (Amount in Rs. Millions) Particulars Fixed Assets: Current Assets Total Assets Budgeted period Previous period

Long term liabilities

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Current Liabilities

Total Liabilities

8.5.2

Cash Budget

Cash forecast precedes a cash budget. A cash forecast is an estimate showing the amount of cash which would be available during a future period say one year for which organization will develop budget and requirements for payment of cash to various agencies during budget arises due to following reasons: i) To ascertain whether cash to the extent needed will be available for running the business. the same period. Cash budget or cash forecasts are instruments of planning rather than control. The need for a cash

ii) To maintain liquidity in the organization iii) To identify in advance likely short falls or surplus cash for the future period so that necessary steps can be taken to correct the situation. A format for Cash budget can be as shown in Figure 4. FIGURE 4: CASH BUDGET FOR THE YEAR ------------------------------(Amount in Rupees) Particulars Opening Balance Add Receipts Sales cash Trade debtors Sale of capital assets Loans received Miscellaneous Total Period 1 Period 2 Period 3 Period 4

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Total receipts Less Payments Trade creditors Cash purchases Wages & salaries Interest payable Loans given Capital expenditure Taxes Dividends Total payments Closing Balance Departmental / Activities budget: i) Budget prepared by every department is known as departmental budget

ii) These budgets will be consolidated into Master budget iii) These budgets clearly shows the projected performance of the department iv) It will enable the top management evaluate the performance at departmental level. Budgets for important departments/activities 8.5.3 Sales Budget

Sales budget is prepared by the sales department by using different techniques. i) Market Research: Market research tries to find out which of the companys products can be sold in a period and in what quantities, at what price and in which market. ii) Analysis of past sales figures: Application of statistical methods of analysis to past sales data helps in revealing trends/ trade cycles, seasonal movements, etc so that correct assessment of potential demand may be made.

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iii) Assessment and reports by salesmen: because of their experience in the market, the sales men, sales managers can forecast sales realistically. This information should be sought. iv) Study of general trade and business situation: information on general trade and business conditions affect sales. Therefore, information is useful to get the feel of the general trade which helps in fine tuning the sales forecast. Sales budget can be prepared on product-wise, customer-wise, outlet-wise and on any other criteria. A format for sales budget can be as shown in Figure 5. FIGURE 5: SALES BUDGET FOR THE PERIOD-------------------------(By product) Month Product 1 Quantity January February March April May June July August September October November December TOTAL Value Product 2 Quantity Value Product 3 Quantity Value Total Sales amount

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8.5.4

Production cost budget

i) Direct material cost, direct labour cost and factory overheads (indirect costs) are included in production cost. ii) Administration costs are budgeted separately and added as a percentage of total production cost iii) If there are more than one product and the product is separately controlled best thing is to separate the budget for each product and then consolidate the budgets of all products to arrive at production Budget iv)Similarly if the production takes place in different plants located separately it is important that each plant manager prepares budget at the plant level / product level and consolidate the budgets of all plants to arrive at production budget. The model in Figure 6 shows format for production cost budget

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FIGURE 6: PRODUCTION COST BUDGET FOR THE PERIOD _________ Product ProductParticulars 1 2 Total

Units Nos. / (Weight) COST: A. Direct Material B. Direct Labour C. Direct Expenses D. Prime cost (A+B+C) E. Factory overheads F. Production cost (D+E) G. Administration overhead H. Cost of production FIGURE 7: MATERIAL COST BUDGET FOR THE PERIOD _________ RAW MATERIAL UNITS Particulars X Y Z

Units of Raw materials for Budgeted Production Add: Closing Stock Less: Opening Stock

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Raw material to be purchased

Price of Raw material per unit Rs.

Cost of Raw materials to be purchased Rs.

8.5.5 i)

Direct labour budget

Labour required (i.e., number of employees at different skill levels of different wage rates)

to achieve the targets. ii) This budget is prepared with the help of labour department which recruit work force iii) The format is shown for typical labour cost budget in Figure 8 FIGURE 8: DIRECT LABOUR BUDGET Budget Centre: Out put : of C Workers MALE: Skilled Semi Skilled Unskilled FEMALE: Skilled Semi Skilled Unskilled Numbers Hours Standard Rate Rs. Total Labour Cost Rs. Period: __________ unit

_________ unit of A __________ unit of B

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8.5.6 i) ii) iii) iv) v)

Production overhead budget All production costs other than Direct Materials cost, Direct Labour cost and direct expenses are included. Expenditure on repair and maintenance of plant and machinery is included Fixed and variable expenses are shown separately for purpose of control Separate records should be maintained for expenses accounted Format for typical production overhead budget is shown in Figure 9

FIGURE 9: PRODUCTION OVER HEAD BUDGET IN THE YEAR ENDING: _____________ Items Variable: Supplies Power Heat and Light Maintenance Total First Quarter Second Quarter Third Quarter Fourth Quarter

I)

Total

Variable

overhead Fixed Supervision Indirect Labour Insurance Taxes Rent Depreciation

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II) Total Fixed III) Total production Over-head

8.5.7

Plant utilization budget

i) This budget is made separately in such organizations where production is largely machine oriented and machines are highly expensive ii) This budget includes total number of machines used, initial value, depreciation and book value of machines, life of machines, operation cost iii) It helps in evaluating the contribution of every machine iv) Format for typical plant utilization budget is shown in Figure 10 FIGURE 10: PLANT UTILISATION BUDET FOR THE PERIOD: _______________ Departments Machine No. of workers available

FIGURE 11: ADMINISTRATION OVERHEAD BUDGET Items of DEPARTMENTS Expenditure Total Rs. Accounts Rs. Rent and Taxes Salaries Supplies Postage Telephone Travelling Audit Bank

Budget Costing Rs.

& Secretarial & Legal Rs.

Common Expenses Rs.

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Interest Bank Charges Hired services Others TOTAL

8.5.8 i)

Selling and distribution overhead budget

Marketing department prepares this budget

ii) Marketing department involves the branch managers, regional and zonal managers in preparing the budget iii) Expenditure incurred for selling and distributing the product are included in this budget iv) Format for typical selling and distribution overhead budget is shown in Figure 11

FIGURE 11: SELLING AND DISTRIBUTION OVERHEAD BUDGET FOR THE PERIOD_____________ (Amount in Rs.) Items A) Variable overheads: Sales Commission Carriage Agents Commission Other items Traveling expenses TOTAL : A B) Fixed overheads: Sales Office Salaries Other fixed expenses of sales office Advertising Total First Quarte r Second Third Quarter Quarte r Fourth Quarter

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TOTAL:B Total selling and distribution overheads On the basis of flexibility 8.5.9 i) ii) iii) a) b) iv) Fixed budget Fixed Budget is a budget which is designed to remain unchanged irrespective of the level of It is formulated for a fixed level of activity Fixed Budget has some limitations: it is inadequate from control point of view it does not compare the budgeting cost with cost for actual achievement This budgeting system is outdated Flexible budget

activity actually attained

8.5.10 i) ii) iii) iv) v) vi) a) b) fashions.

Flexible Budget is made where demand for commodity is seasonal and change according to Budget is changeable in such conditions A flexible budget is a budget which consists of variable budget which changes to level of It is a dynamic budget It provides ready made budget for any level of production Advantages of flexible budget easy comparison as the budget is adjusted to actual level of achievement it is helpful in uncertainty in sales and production

activity and fixed budget which does not change irrespective of the level of activity.

ILLUSTRATION: With the following data for 50% activity prepare a budget for production at 70% and 100% activity level: Production at 50% activity 500 Units

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Material Labour Expenses (40% fixed) Administration (30% fixed) expenses

Rs. 10 per unit Rs. 10 per unit Rs.40,000 Rs.30,000

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Activity levels Particulars 50% 500 Production (units) Rs. Direct Costs 50000 Material (Rs. 100 per unit) 20000 Labour (Rs.40 per unit) 5000 Expenses (Rs.10 per unit) 75000 TOTAL DIRECT COSTS Factory expenses: 24000 Variable (Rs.48 per unit) 16000 Fixed (40% of Rs.40000) Administration expenses: 12000 Variable (Rs.24 per unit) 18000 Fixed (60% fixed) 145000 TOTAL COST 189400 256000 18000 18000 16800 24000 16000 16000 33600 48000 105000 150000 7000 10000 28000 40000 70000 100000 Rs. Rs. 70% 700 100% 1000

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Explanation: i) unit. 8.6 TECHNIQUES OF BUDGETS: There are basically four techniques of budgeting: 1. 2. 3. 4. Appropriation budgeting Performance budgeting Planning, programming, budgeting Zero - base budgeting Variable Factory overhead 60% of Rs.40000 or Rs.24000 for 500 units., i.e., Rs.48 per unit ii) Variable Administration overhead 40% of 30000 i.e., Rs.12000 for 500 units i.e., Rs.24 per

These techniques are explained below. 8.6.1. Appropriation budgeting The traditional budgeting is known as appropriation budgeting where the focus is on appropriation of resources to various activities. Appropriations are approved allocation of resources for various items of expenses. The focus of appropriation budgeting is on control of inputs or resources or expenses. Budget is formulated and controlled on the basis of the nature of expenses such as salaries, travel, maintenance etc. Therefore this technique is also known as line item budgeting. Main features of Appropriation budgeting: 1. 2. The budget is functionally oriented. Budgets are formulated with reference to

functions/departments of the organization. The appropriation is based on the past trends in the expenditure on various items such as salary and travel with some adjustments for increases due to rise in prices of inputs. This is otherwise known as incremental budgeting. 3. The control is procedure oriented. Financial control is the main objective of this approach

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4.

The spending agencies should not spend over and above the approved limit. Thus, budgets

were considered upper limits of expenditure. 5. The proprietary audit is conducted to ensure that the funds are not used for the purpose other than those authorized. Advantages of Appropriation budgeting: 1. Budgets are developed on departmental basis. Therefore, budgeting prevents one department from getting funds at the expense of other department. 2. It is easy to prepare as the budget is based on past data and for line items like salary, travel etc. 3. It is easy to understand as the budgets are prepared for each department on a gross basis. One can judge the worth of each department. 4. It helps in establishing financial control on the resources. The departments can not spend a rupee without prior approval. Budget is an instrument of controlling funds. 5. Control is centralised, uniform and comprehensive. Limitations of Appropriation budgeting: 1. Since budgets are prepared on the basis of past data, it is likely that inefficiencies of the previous years are carried forward. 2. As the budget allocations are not done on rational basis, they would tend to inflate the budget amounts. 3. As the budgets are prepared on the past data, the rigorous analysis of alternatives before finally approving the allocation is absent. 4. The budgeting system does not relate the output / outcome to the inputs. Therefore the efficiency and economy in utilization of the resources are not taken care of. Consequential control is thus absent. 5. The activities / programmes are carried on without examining the need to continue them.

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In view of serious limitations, even the central / state governments which were adopting the appropriation budgeting techniques, switched over to performance budgeting. 8.6.2 Performance budgeting

In view of serious limitations mentioned above, there was a case to reform the budgeting system which will ensure allocation of resources on a satisfactory criteria and for controlling the utilization of resources in the most efficient manner. Performance budgeting system is thus an improvement over the appropriation budgeting in many ways.

According to Mohinder N Kaura, Performance budgeting is essentially a multi level and on going annual process of management planning and control , which enables an organization to accomplish its corporate goals by involving people from top to bottom for formulating and implementing a time bound and realistic action plan.7

A performance budget is an operational document which translates the aspirations of an organization into meaningful and feasible action programmes and activities for realizing the objectives by integrating financial as well as physical targets of performance on major items of business or service. 8 The above definitions do represent the basic characteristics of performance budgeting system as practical both in industry and government.

Features of Performance Budgeting System: The main features of the performance budgeting system (PBS) are as follows: 1. It is essentially a performance / output oriented approach. It involves formulating plans, setting up objectives, laying down policies and relating the proposed activities to the long and short term objectives. 2. There are three components in PBS; classification of activity, performance measurement and performance reporting. 3. The main purpose of PBS is to ensure consequential accountability in addition to procedural accountability.

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4. The structure of performance budget requires that an organization is identified into various activity centres, known as Responsibility Centres. Objectives are specified, costs and outputs are determined for each centre. The costs are also cross referenced to standard line item /object. 5. This approach requires the determination of a set of activity output measures, establishment of relationship between these output measures and the cost of conducting activities.

For example, a budget for a purchase department is prepared after identifying the activity, performance measures and costs. Input cost is expenditure on salaries of staff and other expenses. The activity is placing purchase orders on the vendors. Performance measure is Purchase Order. Output is number of purchase orders. Department Budget for the year 2006-07 Cost : (Input) Rs. 10,00,000 (Salaries etc.) : Purchase department

Purchase orders to be placed with vendors during the year: Rs. 10000 (Output) Budget allowance : Rs. 100 per purchase order

Thus each department has to identify input cost and output (performance measure). 6. Performance is monitored through the performance measurement, performance reporting and review.

Advantages of PBS

The Administrative Reforms Commission of Government of India successively stated the advantages of PBS. They are:

1. Correlate the physical and financial aspects of every function, programme and activity. 2. Improve the budget formulation review and decision making at all levels of operations. 3. Facilitates better appreciation and review.

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4. Enable a more effective performance audit and 5. Measure progress towards accomplishment of long term as well as short term goals.

Implementation difficulties of PBS:

The Performance budgeting system as an approach is still in vogue both in the government and the industry. However there were some implementation difficulties. 1. The classification of organization structure into functions, programmes, and activities. 2. Measurement of productivity in government is difficult 3. Lack of proper classification of accounts to suit the budget formulation and review.

8.6.3

Planning, Programming Budgeting System (PPBS)

Another technique of budgeting, which has been tried out in the tried out in the 60s in the US is known as Planning, Programming Budgeting System (PPBS). According to Peter A Pyhrr, PPB was developed to provide a rational and systematic approach to identify and evaluate the costs and consequences of strategic objectives (Planning) translate the strategic objectives into time phased men and material needs in each organization (programming) and translate time phased men and material needs into financial requirements (budgeting) PPB was designed to encourage analysis of major policy issues and to provide a mechanism to identify the trade offs among programs aimed at similar objectives.9

Features of PPBs: PPBS approach is explicitly linked to a prior planning process. Objectives are set fort the programmes in specific terms. The multi year costs and not just next years costs are estimated. The estimates are made for the entire period of the programme. The information is assembled at the programme level and each functional area or division of the government

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Consideration is given to alternative means of achieving the objectives It incorporates techniques of analysis into budgeting by bringing the skills of economists, engineers, and cost accountants at the decision making level and by moving the budget process close to control planning and program development function. PPBs covers total program cost both capital and operating expenditure The criteria by which one programme alternative will be selected rather than the other will be cost effectiveness, when output measures are non monetary in nature and cost benefit where output measures are monitory in nature.

Areas of improvement associated with PPBS:

Carbon identified nine areas of improvement associated PPBs. These are: 1. Definition of objectives, 2. Information, 3. Use of analysis in decision making 4. Evaluation of programmes 5. Management efficiency, 6. Involvement of officials in the budget process, 7. Recognition of the legitimacy and necessity of analytic argument 8. Comparisons of related programmes in several agencies, 9. State and local interest. 10

The PPBS enables the setting up of clear objectives for each programmes; require collection and display of information on programme inputs and outputs. Thus quality of information is improved. The use of analytic methods and evaluation of programmes enhances the credibility of decision making system. Participation of officials in the budgetary process and evaluation of performance against predetermined programme plans motivate the budgeter in budget implementation.

Problems in implementation of PPBS: a) The experience in implementation of PPBs in the US where it was started was not encouraging and the implementation became more complex. The main reason is placing over emphasis on analysis rather than on operational cost.

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b) The programme structure has become another larger unit in the organization structure. c) Analytical studies proved to be difficult. 8.6.4 Zero base budgeting

Zero base Budgeting (ZBB) is an approach whereby each manager has to justify the resources for the activity afresh for the accomplishment of objectives. The procedure to be followed in ZBB, requires questioning of the current or proposed activities and programmes and evaluation of these in a rational manner so that resources are used in the most efficient and effective manner. The use of ZBB as a tool of planning and control evoked interest in 1960s. It was first used in 1964 in the US Department of Agriculture when it prepared zero-base budgets as a supplementary exercise to its existing budgets. ZBB was used in its full form first in the private sector organization, Texas Instruments in the US when it was conceived by Peter A Pyhrr who was working in that organization at that time as staff engineer.

Need for ZBB:

The government is not able to increase revenues to match with the requirements for various programmes / activities. Similarly industry is facing serious competition. The enterprises have to perform well in the face of competition. This calls for use of resources by the government and industry more efficiently and effectively than ever. In this direction Peter A Pyhn raises the following two questions that are not answered in the traditional budgeting approach. A) How efficient and effective are the current operations that were not evaluated? B) Should the current operations be reduced in order to fund high priority new progreammes or increase profit?

These questions are relevant both for the government and the industry. The answer lies in a unique approach that would compel us to identify and analyze what we were going to set goals, make necessary operational decisions by evaluating the alternatives during the budgetary process. Zero base technique would respond to these needs.

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Steps in Zero base Budgeting: The following steps generally take place while introducing ZBB. 1. Spelling out by the top management of the discrete activities of decision units 2. Construction of decision packages with a specification of corporate objectives, operational objectives, standards and alternative performance methods to achieve these objectives 3. Priority ranking of the endorsed projects by the lower management level, followed by a hierarchical review by higher levels of management with continual consolidated re ranking. 4. Allocation of organizational resources to decision units based on the consolidated ranking of decision packages accepted and projection of available funds. 5. Monitoring the performance of projects on the basis of criteria established in the approved decision packages.11

Decision unit: The first stage in the general structure of ZBB approach is the identification of organization into decision units. The decision units are defined as those parts or components of basic program or organizational entity for which budget requests are prepared and for which managers make significant decision on the amount of spending and the scope or quality of work to be performed.12 Decision units are typically cost centres, functional groups, and such a marketing sales, secretarial service, projects such as research and development or major capital projects. Thus decision units can be compared to responsibility centres in performance budgeting.

Decision Package

A decision package identifies a discrete activity, function or operation in a definitive manner for management evaluation and comparison with other activities.13 Decision packages are developed at the base level to promote detailed identification of activities and alternatives. P A Pyhrr observes that the development of decision packages by the managers who are familiar with

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the activities and who will be operationally responsible of the approved budget, will generate interest in and participation by the managers. Benefits of ZBB: 1. Identification, justification and evaluation of all activities proposed ensures more effective allocation of resources. 2. Evaluation of the need for the activity and consideration of alternatives ways of performing the activity, enables the organization to minimize the costs and strengthens the valve chain. 3. It provides greater flexibility in reallocating the resources. 4. By prioritizing the activities afresh, high priority new programmes can be funded totally or in part by reducing or eliminating current activities. 5. By identification and logical networking of activities, duplication of effort in the organization can be eliminated. 6. ZBB is a flexible process. Revisions during budget period can be done without much effort when the conditions demand as the managers can identify which packages are affected by the changes in conditions and can revise those specific packages. 7. ZBB requires information at the base activity level for review and evaluation. Collection and display of information of all activities in the form of decision packages assures the top management that proper analysis have been done and allows them to take a close look at these packages. 8. ZBB process requires the managers to identify the activities and evaluate them by cost /benefit analysis. Normally, the managers are confronted with the decision to choose the best alternative in conducting the day to day operations. Thus, ZBB provides the opportunity to the managers acquire and improve the analytical skills. 9. Performance of the managers can be measured in terms of benefits accrued and accomplishment of goals as stated in decision packages. This can be carried out periodically during the course of the budget year. These mid course reviews can be taken as a preview to the planning and budgeting cycle that begin later for the next budgeting year.

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Problems in implementation of ZBB: 1. Managers are suspicious of any process that forces detailed examination of activities which would probably expose the managers of their inefficiencies to others. 2. The degree of success of implementing ZBB to certain extent depends upon the communication system obtained in the organization. The organizational climate wherein the lower level manages are given an opportunity to express views freely and frankly and the senior level managers have the tenacity to listen to others and face the critical and close review of activities is important. Absence of this is a major limitation in successful implementation of ZBB. 3. Absence of formalized policy and planning assumptions or poor communication of these across the organization proved to be limiting factors in successful implementation of ZBB. 4. Determining the minimum level effort requires judgement on the part of the activity manager. Establishing this minimum well below the current operating level is unthinkable to many managers, who prefer to identify the minimum level at their current operating level or some times above that level. 5. It is difficult to identify work measures for all the activities for evaluation. It is also difficult t develop data base for future analysis and evaluation. 6. Higher level managers will face difficulty in evaluating the similar packages.

However this approach has been used in various ways other than in the form in which it was implemented in the US.

4.7 SUMMARY: Budgeting is essentially a process of funding the activities needed to achieve the objectives of the organization, during a definite period of time. Budgeting is essentially a managerial process. A business budget is a plan covering all phases of operations for a definite period in the future. . Budget enforces a discipline of planned thinking and action for encompassing entire organization. Budget serves also serves as a tool of control. Budgets can be classified on the basis of time,

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activities, approach and variability.

There are basically four techniques of budgeting:

Appropriation budgeting, Performance budgeting, Planning, programming, budgeting, Zero - base budgeting each with its own advantages, disadvantages and suitability to specific situations.

8.8 KEY WORDS: Budget Master budget Departmental/functional budget Flexible budget Performance budgeting Capital budget Cash budget Fixed budget Appropriation budgeting Zero-base budgeting

NOTES AND REFERENCES 1. Cutt James, Rittez Richard. Public Non- profit Budgeting: The Evolution and Application of Zero-Base Budgeting Toronto, The Institute of Public Administration of Canada, 1984, p.1 2. Welsch Glenn A Budgeting Profit Planning and control Englewood Cliffs, New Jersey, Prentice Hall Inc. 1964 3. Terminology of Cost Accountancy, the Institute of cost and Works Accountants, London, 1966 in Batty J. Eds. Cost and Management Accountancy for students, London Heinemann, 1970. 4. Farmer Richard N. and Richman Barry M. Comparative Management and Economic Progress Homewood, Illinois, Richard D Irwin Inc, 1965, p.17 5. Terminology of Cost Accountancy, the Institute of cost and Works Accountants, London, 1966 in Batty J. Eds. Cost and Management Accountancy for students, London Heinemann, 1970. 6. Welsch Glenn A Budgeting Profit Planning and control Englewood Cliffs, New Jersey, Prentice Hall Inc. 1964 7. Kaura Mohinder N. Performance Budgeting System in Government Organisations Lok Udyog May 1984

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8. Kaura Mohinder N. Performance Budgeting System in Government Organisations Lok Udyog May 1984 9. Peter Pyhrr A. Zero Base Budgeting: A Practical Management tool for Evaluating Expenses New York, John Wiley & sons Inc, 1973 p.142 10. In Peter Pyhrr A. zero Base Budgeting: A Practical Management tool for Evaluating Expenses New York, John Wiley & sons Inc, 1973 pp.148-49 11. Kaura Mohinder N. and Mallikharjuna Rao S. Budgeting for Corporate Success: Indian Practices Calcutta, Indian Accounting Association Research Foundation, 2000 12. General Accounting Office A Glossary of Terms used in Federal Budget office Washington, March, 1981, p.55 13. Peter Pyhrr A. Zero Base Budgeting: A Practical Management tool for Evaluating Expenses New York, John Wiley & sons Inc, 1973 p.6

Try yourself: 1. Explain the meaning of budgeting? 2. Explain the importance of budgeting? 3. Discuss the process of budgeting. 4. Explain the following budgets: a) Master budget b) Sales budget 5. Write short notes on the following budgeting iii) Zero-base budgeting c) Production cost budget d) Flexible budget i) Appropriation budgeting ii) Performance

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