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BCA 3rd Semester BC0044 Accounting and Financial Management

1. What is over capitalization? How do we know overcapitalization has occurred? Ans. Over-capitalization Over-capitalization arises when the present capital of the company is not effectively or properly used. There is excess capital available in the company than the actual requirement. A firm is said to be overcapitalized when its earnings are not sufficient to pay dividends to the investors. For example, if the companys rate of return is 12% and it earns a profit of Rs. 100000 on an investment of Rs. 1200000, we get the fair rate of return to be less than the profits earned. Fair rate of return is 1200000*12% which is Rs.144000. The company is earning less than the fair return in the industry. The company is said to be over-capitalized because the earning of the company is(100000/1200000)*100 which is 8.33% and this is less than the fair rate return of the industry. How do we know over-capitalization has occurred? Actual capitalization of the company exceeds the capitalization warranted by the activity levels. Earnings are lower than the expected returns. There is a fall in the rate of dividends declaration. There is a fall in the market value or the market price of the shares of the company.

Causes of over-capitalization: If a company acquires assets at inflated prices than the book values, over-capitalization occurs. Acquiring unproductive assets, mostly intangible in nature like goodwill, patents, etc. High initial costs by way of preliminary expenses. A company being set up in boom time pays more on acquisition of assets. Once the boom time subsides, it will find the capital over capitalized. Raising more capital than the required amount. Company borrows money at high rates of interest than the moneys could be put into profitable use. A company postponing plant repairs and maintenance will find itself over-capitalized as the efficiency of the plant stands reduced. Excessive taxation by government leaves very little money with the company. The money may be insufficient to meet its daily requirements and the company may resort to borrowings. Borrowing beyond a certain limit leads to over-capitalization

Effects of over-capitalization Fall in profits Fall in dividend rates Loss of investors confidence

Fall in market prices of shares.

2. Explain permanent and temporary working capital. Ans. Working capital management involves managing the different components of current assets and current liabilities. It is an effort to try to maintain a healthy relationship between these two so that a satisfactory level of working capital is maintained. It is very important for a firm to maintain a satisfactory level of working capital, otherwise there are chances of the firm becoming insolvent and going bankrupt. The interface between CA and CL is therefore very important and forms the main subject under working capital management. Permanent and Temporary Working Capital: Permanent working capital is the minimum investment in the form of inventory of raw materials, workin-progress, finished goods, stores and book debts to facilitate uninterrupted operations in a firm. This minimum level is called the permanent or fixed working capital. It is permanent like the firms fixed assets are. Over and above this, the firms working capital requirements fluctuate depending upon the cyclicality and seasonality of product demands. This is referred to as the variable or fluctuating or temporary working capital. These two aspects can be graphically shown as follows:

s3 A. What are the assumptions of EOQ Model? Ans. Economic Order Quantity (EOQ) EOQ refers to the optimal order size that will result in the lowest ordering and carrying costs for an item of inventory based on its expected usage. Answers to questions such as: What should be the quantity ordered for each replenishment of stock, how many orders should be placed to get the raw materials or should the entire requirement be procured once or in installments and if installments, how many of them these are sought to be explained by the EOQ model. The optimum level of inventory is referred to as the Economic Order Quantity. It is the economic lot size. EOQ is defined as that level of inventory order that minimizes the total cost associated with the inventory management. It is that level one unit beyond which is additional cost to the firm and one unit below may hamper production process. The model is based on the following assumptions; nevertheless, it is the most widely used technique in inventory control. Constant or uniform demand: The firm knows with certainty the annual consumption of a particular item of inventory. Constant unit price: The EOQ model is based on the assumption that the per unit price of material does not change and is constant irrespective of the order size. Constant carrying costs: Unit carrying costs are known to vary substantially as the size of inventory increases or decreases. Firms derive economies of scale by increasing order size. However, the EOQ model assumes the carrying costs to be constant. Constant ordering costs: Ordering costs are assumed to be constant whatever the number of orders are and whatever the size is

B. Consider the following data of X Ltd. Calculate EOQ Annual Usage = 10000 units Fixed cost per order= Rs. 150 Purchase price per unit= Rs. 20 Carrying cost= 25%

Ans.EOQ = sqrt2 x A x S/CA = Annual Usage S = Ordering Cost C = Cost of carrying inventory per unit per annum Annual Usage = 10000 units Cost per order = Rs.150Carrying Cost = 25% Purchase price per unit = Rs.20 EOQ = sqrt2 x 10000 x 150/5 EOQ = sqrt2 x 1500000/5 EOQ = sqrt2 x 300000 EOQ = sqrt600000 EOQ = 774.59 Note: (C = 20 x 25% = 5) 4. Explain the objectives of cash management Ans. Cash Management Cash is the most important current asset for a business operation. It is the force that drives business activities and also the ultimate output expected by the owners. The firm should keep sufficient cash at all times. Excessive cash will not contribute to the firms profits and shortage of cash will disrupt its manufacturing operations. The term cash can be used in two senses in a narrow sense it means the currency and other cash equivalents such as cheques, drafts and demand deposits in banks. In a broader sense, it includes near-cash assets like marketable securities and time deposits in banks. The distinguishing nature of this kind of asset is that they can be converted into cash very quickly. Cash in its own form is an idle asset. Unless employed in some form or another, it does not earn any revenue. Cash management is concerned with (a) management of cash flows into and out of the firm, (b) cash management within the firm and (c) management of cash balances held by the firm deficit financing or investing surplus cash. Cash management tries to accomplish at a minimum cost the various tasks of cash collection, payment of out standings and arranging for deficit funding or surplus investment. It is very difficult to predict cash flows accurately. Generally, there is no correlation between inflows and outflows. At some points of time, cash inflows may be lower than outflows because of the seasonal nature of product sale thus prompting the firm to resort to borrowings and sometimes outflows may be lesser than inflows resulting in surplus cash. There is always an element of uncertainty about the inflows and outflows. The firm should therefore evolve strategies to manage cash in the best possible way. These can be broadly summarized as: Cash planning: Cash flows should be appropriately planned to avoid excessive or shortage of cash. Cash budgets can be prepared to aid this activity Managing cash flows: The flow of cash should be properly managed. Steps to speed up cash collection and inflows should be implemented while cash outflows should be slowed down. Optimum cash level: The firm should decide on the appropriate level of cash balance. Balance should be struck between excess cash and cash deficient stage. Investing surplus cash: The surplus cash should be properly invested to earn profits. Many investment avenues to invest surplus cash are available in the market such as, bank short term deposits, T-Bills, inter corporate lending etc. The ideal cash management system will depend on a number of issues like, firms product, competition,

collection program, delay in payments, availability of cash at low rates of interests and investment opportunities available. Motives of Holding Cash Objectives of Cash Management: This can be studied under two heads: (a) meeting payments schedule and (b) minimize funds committed to cash balances. Meeting payments schedule : In the normal course of functioning, a firm will have to make many payments by cash to its employees, suppliers, infrastructure bills, etc. It will also receive cash through sales of its products and collection of receivables. Both these do not happen simultaneously. A basic objective of cash management is therefore to meet the payment schedule in time. Timely payments will help the firm to maintain its creditworthiness in the market and to foster good and cordial relationships with creditors and suppliers. Creditors give a cash discount if payments are made in time and the firm can avail this discount as well. Trade credit refers to the credit extended by the supplier of goods and services in the normal course of business transactions. Generally, cash is not paid immediately for purchases but after an agreed period of time. There is deferral of payment and is a source of finance. Trade credit does not involve explicit interest charges, but there is an implicit cost involved. If the credit terms are, say, 2/10,net 30, it means the company will get a cash discount of 2% for prompt payment made within 10 days or else the entire payment is to be made within 30 days. Since the net amount is due within 30 days, not availing discount means paying an extra 2% for 20-day period. The other advantage of meeting the payments in time is that it prevents bankruptcy that arises out of the firms inability to honour its commitments. At the same time, care should be taken not to keep large cash reserves as it involves high cost. Minimize funds committed to cash balances : Trying to achieve the second objective is very difficult. A high level of cash balances will help the firm to meet its first objective discussed above, but keeping excess reserves is also not desirable as funds in its original form is idle cash and a non-earning asset. It is not profitable for firms to keep huge balances. A low level of cash balances may mean failure to meet the payment schedule. The aim of cash management is therefore to have an optimal level of cash by bringing about a proper synchronization of inflows and outflows and check the spells of cash deficits and cash surpluses. Seasonal industries are classic examples of mismatches between inflows and outflows. 5. The income statement of Vignesh Ltd is as follows:

Calculate the Gross Profit Ratio, Net Profit Ratio, Operating Ratio, Operating Profit Ratio and Expense Ratio. Ans. Gross Profit Ratio = (Gross Profit/Net Sales) x 100 = (200000/1200000) x 100 = 16.67% Net Profit Ratio = (Net Profit/Net Sales) x 100 = (80000/1200000) x 100 = 6.67%

Operating Ratio = (Cost of Goods sold + Operating Expenses)/Net Sales Cost of Goods sold = Opening stock + Purchases + Direct Expenses Closing Stock = 200000 + 800000 + 100000 100000 =1000000 Operating Expenses = Administrative expenses + Financial Expens4es + Selling expenses = 100000 + 80000 = 180000 Operating Ratio = (1000000 + 180000)/1200000 = 1180000/1200000 x 100 = 98.33% Operating Profit Ratio = (Operating Net Profit/Net Sales) x 100Operating Net Profit = Net Profit + Non-Operating Expenses Non-Operating Incomes = 80000 + 40000 - (60000 + 40000) = 120000 100000 = 200000 Operating Profit Ratio = (200000/1200000) x 100 = 1.67% Expense Ratio Expense Ratio = Operating Expenses/Net Sales x 100 = 1,80,000 / 12,00,000 x 100 = 15.00% 6. Explain the steps involved in Funds Flow Statement. Ans. Meaning of Fund Flow Statement Fund may be interpreted in various ways as (a) Cash, (b) Total current assets, (c) Networking capital, (d) Net current assets. For the purpose of fund flow statement the term fund means net working capital. The flow of fund will occur in a business, when a transaction results in a change i.e., increase or decrease in the amount of fund. According to Robert Anthony, the Fund Flow Statement describes the sources from which additional funds were derived and the uses to which these funds were put. Different Names of Fund-flow Statement A Funds Statement A statement of sources and uses of fund A statement of sources and application of fund Where got and where gone statement Inflow and outflow of fund statement Objectives of Fund Flow Statement The main purposes of Fund Flow Statement are:

1. To help to understand the changes in assets and asset sources which are not readily evident in the income statement or financial statement. 2. To inform as to how the loans to the business have been used. 3. To point out the financial strengths and weaknesses of the business Format of Fund Flow Statement Sources Fund from operation Non-trading incomes Issue of shares Issue of debentures Borrowing of loans Acceptance of deposits Sale of fixed assets Sale of investments (Long Term) Decrease in working capital Applications -Fund lost in operations -Non-operating expenses -Redemption of redeemable preference share -Redemption of debentures -Repayment of loans -Repayment of deposits -Purchase of fixed assets -Purchase of long term instruments -Increase in working capital

Steps in Preparation of Fund Flow Statement 1. Preparation of schedule changes in working capital (taking current items only). 2. Preparation of adjusted profit and loss account (to know fund from [or] fund lost in operations). 3. Preparation of accounts for non-current items (Ascertain the hidden information). 4. Preparation of the fund flow statement. Format of Schedule of Changes in Working Capital Particulars Previous Year Current Year Current Assets Cash in hand Cash at bank Bills Receivable Debtors Inventory Prepaid expenses Short-term investment (A)Total Current Liability Bills payable Creditors Outstanding expenses Accrued Expenses Income received in advance Bank overdraft Cash credit from banks Short-term loan Short-term deposit Provision for taxation Increase in W/c Decrease in W/c

Proposed dividend Provision against current assets (B)Total Working Capital (C=A-B)Increase in W/C Decrease in W/C Fund from operation can be ascertained by preparing adjusted profit and loss account. It may be prepared in statement form or account form.